Friday, October 19, 2007

The Basis for Markets Optimism

The article below is from Spiegel in Germany. The basic premise is that the optimism in the equity markets is the “hope” that the emerging markets can cover the weakness in the US for a while. What worries me is that most emerging markets are export based economies that are relatively small when compared to the US and western Europe. Text in bold is my emphasis.

With the US real estate and financial markets in turmoil, the optimism of stock brokers the world over seems a little out of place. There is, in fact, method to the apparent madness. But how sound is that method?

Stock brokers at the Frankfurt stock exchange are keeping a close eye on Germany's most important share index, the DAX. But have they lost sight of dangers lurking elsewhere?

Stock brokers are merrily celebrating the disaster at their doorstep: The turmoil caused by the US real estate crisis is estimated to have halved economic growth in the United States. The number of foreclosure sales has doubled within a year. And as if that wasn't enough, consumer morale has deteriorated dramatically in the last two months. The evil r-word -- recession -- has long been making the rounds among economists.

But the Dow Jones Industrial Average, still the world's most closely watched share index, reached the highest point in its 111-year history last Tuesday.

The situation is much the same in Germany: In light of the ongoing financial crisis, leading economists are tuning down their growth predictions, as is the federal government. The two most important early indicators of economic trends -- the Ifo index calculated by the Institute for Economic Research in Munich, and the index calculated by the Centre for European Economic Research in Mannheim -- have been dropping for four consecutive months. And the European Central Bank continues to inject billions and billions of euros into the financial system in order to prevent more near bankruptcies.

The most important German stock market index, the DAX, passed the 8,000 points mark last Thursday and remained just 1 percent below its all-time record.

Have stock brokers lost touch with reality? Are they once more in the grip of that optimistic and carefree mood that precedes every crash? Or are there in fact good reasons to be optimistic? "It's all a big test," says Thomas Mayer, Deutsche Bank's chief economist for Europe. "The financial markets are gambling on the possibility that the developing countries have matured."

Stock brokers are basing their calculations on the assumption that, for the first time in history, the emerging economic powers China, India, Russia and Brazil -- along with many developing countries whose economies are also growing rapidly -- are stabilizing the global financial system and global economic growth. Together, they are helping Western industrialized countries out of the fix they've gotten themselves into.

Until now, it was always the major North American and European economic powers that served as anchors for the global economy when major financial turmoil developed -- usually in Asia or South America. The insolvency of Ecuador (1999) and Argentina (2001) and the Mexican crisis (1994) -- but also the Asian and Russian crises (1997 and 1998) -- only caused minor dips in the temperature of the world economy.

Industrialized countries tempered the situation with debt conversion offers and financial injections -- neither of which were entirely selfless, of course. And they had a stabilizing effect thanks to their overwhelming economic output. A crisis in a developing country was no more than a minor spanner in the works of the Western-dominated economic machinery. But the importance of those countries has increased drastically since.

While the G-7 countries were still responsible for about 70 percent of global economic output in 1990, their current share has sunk to below 60 percent. The economic clout of developing countries is growing much faster. Moreover, the economies of those countries have become more stable, impressing observers with their steadily improving balance of account surpluses and shrinking budget deficits.

"These countries are much more resilient today than they were 10 years ago," says Heiner Flassbeck, who served as junior minister under the former German Finance Minister Oskar Lafontaine and who is currently the chief economist at the United Nations Conference on Trade and Development (UNCTAD).

All that is attracting Western investors hungry for returns. They are investing ever greater portions of their wealth in new financial centers such as Singapore, Seoul, Dubai, Sao Paolo and Cairo.

As a result, capital flows between the developed and developing worlds have also increased enormously. "When we started out 20 years ago, we had access to six markets. Now there are 40," says Mark Mobius, funds manager at Franklin Templeton and one of the first Westerners to invest in developing countries' stock exchanges.

Many investors now divert their assets to emerging markets and developing countries when the prospects at home look dim. In the week before last, more than $5.5 billion (€3.9 million) were channeled into emerging market funds. That capital provides additional fuel for economic growth and the boom those countries are already experiencing -- and economies in the industrialized countries profit from that as well. After all, industrialized countries supply cars and machinery and import cheap consumer goods. Orders are pouring in and trade is booming, all of which boosts share prices.

What a brave new world: Many believe that, thanks to globalization, every country profits from every other country -- a classic win-win situation in which there seem to be no losers. In such a scenario, why worry about a real estate crisis of limited regional scope that leads to a financial crisis whose effects are also limited to a particular region?

This kind of speculation can work for a quite a while. Indeed, most newly industrializing countries are hardly affected by the real estate crisis in the United States. The underlying economic data is genuinely reassuring. And it's true that industrializing countries have been bolstering the economies of industrialized countries for a while .

So, why cast doubt on the view that industrializing countries are stabilizing the economies of the industrialized countries? No reason in the short term, according to many economists. But others are striking a more cautionary note. In the midterm, China is especially at risk of being drawn into the vortex developing beyond the Atlantic.

After all, the Chinese economic boom is based on exports to the United States and other Western countries. Moreover, more than 45 percent of China's economic power goes into the somewhat erratic production of capital goods. Private consumption, which has become steadier, accounts for only 35 percent. That's a much riskier combination than was the case in Japan prior to its economic meltdown in the early 1990s. Add a banking system that is still vulnerable and overheated stock markets and there can be no doubt that the economy of the world's most populous country is more prone to crisis than tireless China-optimists like to believe.

If the United States should indeed slide into recession, as Yale University professor Robert Shiller and others predict, then China would be directly affected -- and with it, all of Asia. The other countries on the continent have long been exporting more to China than to the United States. China is the nerve center of an entire region -- and perhaps the entire world.

Critics are reminded of the brave new economic world of the late 1990s, when economists believed that crises had become a thing of the past. The creed of the time was that the productivity of the New Economy -- allegedly enormous -- had suspended the basic laws of economics, so that there could be sustained economic growth without inflation and therefore steadily rising share prices, of course.

That bubble burst shortly thereafter, in 2000.

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