Bears in the
Woods Despite the troubled markets, the world economy is still
relatively strong. Just don’t bet your house on it. The woods and the
market If you meet a bear in the woods, try not to panic or
scream; on no account should you turn your back and run. As markets around the
world have turned grizzly over the past two weeks, some investors seem to have
forgotten the old hikers’ maxim. After three years of big gains, many
stockmarkets have dropped by 10% or more in less than ten days. The loudest
complaints have echoed around emerging markets and commodities. Europe has
surrendered most of this year’s gains. Americans have so far escaped lightly,
but they would be unwise to take comfort. Their housing market, the recent rock
of their economy, is where a much grizzlier creature lies in wait.
Most investors tend to look first at equity markets---and they have
certainly had a good run virtually everywhere. Yet a repeat of the slump after
the bursting of the dotcom bubble in 2001--4)2 remains highly unlikely. In 2000
shares were wildly overvalued. Today price/earnings ratios in most stockmarkets
are near, if not below, their long-term averages. This suggests that the slide
in shares could be short-lived. Inflation or interest
rates So what has caused this burst of volatility One
popular explanation points to the fears of rising inflation and hence higher
interest rates. Yet this sits oddly with the decrease in bond yields and the
gold price over the past week: if inflation were the reason, you would expect
both to have risen. The real puzzle is not why volatility has suddenly
increased, but why it had been so low in the past year or so. The answer seems
to be an abundance of cheap money, which attracted investors into satisfaction.
Now they are starting to demand higher returns on riskier assets.
Emerging-market equities, not (generally safer) bonds, suffered the biggest loss
in the past week. It could be a healthy correction, though. What helped
us to achieve growth with low inflation Indeed, the recent
sensitivity need not harm the world economy, which even bears admit has
performed greatly. World GDP has grown at an annual rate of more than 4% for 11
consecutive quarters. This is the strongest upturn for more than 30 years. Yet
global inflation remains historically low. Strong growth with mild inflation is
all the more amazing given the tripling of oil prices since 2003. Past off-price
shocks have caused stagflation. The world has so far shrugged
off higher oil prices with the help of two powerful economic forces. The first
is the opening up and integration into the world economy of China, India and
other emerging economies, This has given the biggest boost to global supply
since the industrial revolution. That, in mm, has magnified the
second stimulus. Since the bursting of the dotcom bubble, central banks have
pumped out cheap money. In 2003 average short-term interest rates in the G7
economies fell to their lowest in recorded history. Because inflation remained
low, the central banks have been slow to mop up the excess liquidity. Cheap
money has encouraged households, especially American ones, to borrow and spend
lavishly. It is not just house prices that have surged ahead; cheap money has
encouraged investors across the world to take bigger risks, creating several
smaller bubbles. Together the huge boost to supply (from emerging economies) and
the huge boost to demand (from easy money) have offset the burden of higher oil
prices, creating the once-impossible combination of robust growth and modest
inflation. Don’t panic The era of cheap money is
nearing an end. For the first time in 15 years, the three big central banks are
now all tightening monetary policy. The European Central Bank has already
followed the Federal Reserve’s lead in raising interest rates. Only now are the
markets realising that interest rates may rise by more than they had expected.
In the long term, rates should be roughly equal to nominal GDP growth, but in
America and elsewhere they are still well below it. Optimists argue that
America’s economy is coping well with rising interest rates, but it isn’t really
aware of tight money yet. Without easy credit, dear oil will cause more
pain. Until recently, financial markets appeared to be betting
that the Goldilocks economy—neither too hot, nor too cold — was safe from the
bears. The troubled markets are a reminder that sooner or later growth will slow
or inflation will rise. Inflation is not about to spiral upwards but with
diminishing spare capacity, it could gradually rise. America has an extra risk
because Wall Street suspects that Ben Bernanke, the Fed’s new chairman, may be a
soft touch on inflation. If that suspicion persists, he will need to raise
interest rates by more than otherwise—or investors will do the tightening for
him by pushing up bond yields. That would make other assets look
expensive. It is in the American housing market that the bear
may growl loudest. By borrowing against the surging prices of their homes,
American consumers have been able to keep on spending. The housing market is
already coming off the boil. If prices merely flatten, the economy could slow
sharply as consumer spending and construction are squeezed. If house prices fall
as a result of higher bond yields, the American economy could even dip into
recession. Less spending and more saving is just what America needs to reduce
its current-account deficit, but for American households used to years of plenty
it will hurt. The confidence For the world, it is best
that America slows today. Later, imbalances will loom even larger. A few years
ago, Japan and the euro-area economies were flat on their backs. Now they are
growing "above trend", so the world depends less on America than it once did.
The boost to the world economy from China and India will last into the future,
even allowing for mishaps. Wise investors should resist the urge to flee, reduce
their holdings of risky assets and stare down the bear. The world has so far shrugged off higher oil prices with the help the opening up and integration into the world economy of China, India and______.