* Political action in Europe seen key to market confidence
* Risk aversion drives dollar higher but gold sees selloff
* World equities in steady drift lower
By Richard Hubbard
LONDON, May 11 (Reuters) - Confidence is already in short supply in financial markets and could evaporate further in the coming week if investors judge that Europe’s often fractious political leaders aren’t mapping out a sustainable path through the current crisis.
Over the past week investors have been rocked by the increased likelihood of Greece leaving the euro, and an admission by one of the world’s more highly regarded banks, JPMorgan Chase, of an embarrassing failure in risk management.
Many in the markets are now looking to Europe’s political leaders to signal a shift in the German-led austerity drive across Europe which they now see as threatening the fragile recovery underway in the world economy if cuts are not tempered with some efforts to encourage growth.
Credit rating agency Fitch put the whole of the euro zone on notice on Friday that were Greece to leave the currency bloc as a result of its latest crisis, ignited by a voter rebellion against bailout terms, the remaining countries could find their sovereign ratings at risk.
“If you want to make sure the gradual improvement that you see will continue, you need to improve confidence,” said Patrick Zweifel of Swiss fund manager Pictet Asset Management which manages around $359 billion of assets.
“Only the politicians can do this - even if they only say that they would agree to have some growth measures going forward instead of more austerity.”
The flight to safety by investors over the past week has taken the dollar to a two-month high against a basket of currencies, and pushed German and U.S. Treasury bond yields to new lows.
At the same time the MSCI’s index of global share market performance has steadily given up much of the gains made earlier in the year and, after falls of over two percent in the past week, was close to levels seen in January.
Zweifel, Pictet’s chief economist, says euro zone first quarter GDP data due out on May 15 will confirm the region is in recession, but could well be an improvement over the final quarter of 2011, pointing the economy in the right direction.
Europe’s weak performance contrasts with a U.S. economy which is still seen on track for modest growth and with signs the slowdown in China’s rapid expansion has eased.
The euro area’s finance ministers get the chance to begin outlining a new growth-oriented agenda to bolster the global outlook when they gather on Monday in Brussels, where the crisis in Greece and the budget problems in Spain will likely top the agenda.
The talks will be followed by a full meeting of finance ministers from across the 27-member European Union on Tuesday.
Potentially of even more significance to the markets will be Wednesday’s first talks between the new French president Francois Hollande, the Socialist leader, and Germany’s conservative chancellor Angela Merkel.
The risk keeping investors on edge is that what emerges from these meetings could be a new approach that either relaxes fiscal discipline too far or promotes growth measures that simply increase government spending.
“Adding more debt, when some governments are already rationed, will likely only worsen the outlook for euro area sovereigns,” said Vincent Chaigneau, head of rates strategy at French Bank Societe Generale.
Spain’s experience has exemplified the risks. Ten-year bond yields have shot up to over six percent since Prime Minister Mariano Rajoy on March 2 said his government wouldn’t be meeting its deficit goal for this year and relaxed the goal to 5.3 percent of GDP, up from the 4.4 previously pledged.
Concerns about Europe and its impact on U.S. recovery won’t be far below the surface when G8 leaders gather at Camp David at the end of the week, hosted by President Barack Obama who faces an election in November.
Europe’s problems were part of the reason the widely-watched S&P 500 index touched two-month lows in the past week before some positive news on the jobs market and a sharp rise in U.S. exports for March prompted a slight recovery.
U.S. markets will mull over April retail sales and inflation data on May 15 and the minutes of the latest Federal Reserve policy setting meeting, due out on May 16, for signs of how the central bank may respond after its current market support measures end in June.
In commodity markets, investors are focusing on gold which has not gained at all from the safe haven buying that has driven up the dollar and major government bond prices.
The gold price peaked at around $1,790 an ounce in early April, but has since slipped to $1,580 an ounce with investors liquidating their holdings to cover losses on other markets and move into cash.
“If it does further decline below that very important four-year trendline support (near $1,580) it opens the door to a move probably towards even $1,520 or $1,530,” said Ashraf Laidi, chief global strategist City Index.