Tuesday, October 2, 2007

The Current Economic Environment Is Nothing Like the Past - We Are In Uncharted Territory

In trying to understand what is happening in the financial world today, many in the market spend their time comparing the current situation to something that happened in the recent past (I call it fighting the last war syndrome). As a result everyone is comparing the current market to the Long Term Capital Management (LTCM) of 1998. The situation today is different from the LTCM situation a decade ago. However, using the LTCM history as a model for today’s market is a serious mistake as the article below illustrates. By the way, the article below is written by Stephen King, the managing director of economics at HSBC and is published in The Independent. I mention this because I find the scenario below to be fairly scary. (Also anything in bold or in color is my emphasis and not in the original article.)

Earlier in the year, economic life seemed so straightforward. Growth around the world was buoyant. Inflationary pressures were building. Excess liquidity – however defined – was a major worry. The vast majority of central banks were planning on raising interest rates.
Over the past few weeks, though, this consensus has completely broken down. Investors don't know what to think. Should they still be worried about inflation? Or, instead, should they fret about a sub-prime-induced recession? Should they regard the Federal Reserve's recent interest-rate cuts as temporary aberrations, with rates likely to rise again next year? Or are we on the verge of a sustained period of interest-rate reductions in the US, the UK and elsewhere?

It's not just investors who have these worries. Policymakers, too, are feeling distinctly uneasy, realising they're the victims of events seemingly beyond their control. To be fair to the world's central bankers, they'd been warning for some time about the perils of excessive leverage and the dangers of unnecessary risk-taking. And perhaps there were too many deaf ears around.

The problem now, though, is not so much the abandonment of the old consensus but, rather, the adjustment to a new one. The sub-prime shock has thrown so many issues up in the air that no one, yet, knows quite how they will eventually fall to the ground.

For the time being, people content themselves with stories. They reassure themselves that what will happen now will, in some ways, mimic tales from the past. And, for optimists, the obvious stories to turn to are those which had happy endings (perhaps they were fed on a diet of fairy-tales when they were younger).

Many investors are attracted to the 1998 financial crisis associated with the collapse of Long Term Capital Management, the hedge fund whose managers made bets in Asia and Russia which ultimately went horribly wrong. At the time, the big bad wolf of financial and economic collapse appeared to be lurking just around the corner, but the fear was far worse than the reality. A knight in shining armour turned up – to be precise, Alan Greenspan – to save the day through a series of interest-rate cuts. Despite warnings to the contrary, the end wasn't nigh and, shortly after the LTCM collapse, the developed world embarked on a dot.com fuelled economic boom.
Maybe we're again going through an LTCM moment. But why focus on that episode alone?

While there are similarities – a financial crisis, a couple of US interest rate cuts, a firm response from equity markets – there are also plenty of differences. LTCM was a one-off event, an isolated incident that threatened to bring down the financial system but ultimately failed to do so. The latest round of difficulties seems more complicated. We've already had bank failures in Germany, the UK and, with NetBank's demise on Friday, in the US. This, therefore, is a period of sustained uncertainty, with elephant traps cropping up all over the place. Trust – or lack of it – has become a major issue.

When LTCM struck, the US economy was in a relatively healthy state. Today, US economic fundamentals look a lot more worrying. The housing market has been in dire straits for a couple of years now, yet we have still to see the full force of the downswing. Only recently have house prices started to decline. As credit conditions are tightened in the months ahead, there's a good chance that prices will fall even further. And this story is unlikely to be confined to the US alone. Housing markets also look vulnerable here in the UK, as well as in Spain, Ireland and, possibly, France.

Perhaps the biggest difference, though, between 1998's LTCM crisis and the latest set of problems is the inflationary backdrop. During the 12 months leading up to LTCM's autumn collapse, the Asian crisis and Russian debt default had given rise to major disinflationary trends in the industrialised world. The dollar was strong, as more and more investors fled emerging markets in a flight to US quality. Simultaneously, commodity prices were in a state of collapse, reflecting the economic implosions taking place in the emerging world. Back then, cutting interest rates was relatively easy.

The economic landscape today couldn't be more different. With oil prices at around $80 per barrel and with food prices rising swiftly, the global inflationary picture is nothing like as benign. This contrast reflects the improved fortunes of many emerging markets. Wherever you look – China, India, Russia, the Middle East and many parts of Latin America – growth has proved surprisingly resilient in the face of heightened caution in the US and elsewhere. Many emerging economies are on the fast track to prosperity – and that, in turn, means lots of demand for energy and food.

Moreover, many of these countries are partially dependent on the Federal Reserve for their monetary policies, courtesy of currency regimes which, to a greater or lesser degree, are tied to the dollar (in much the same way that the UK's economic policies were tied to those of Germany's Bundesbank before sterling's ignominious exit from the Exchange Rate Mechanism in 1992).

These currency regimes may not last the course but they point to even more growth and still higher inflation in emerging markets in coming months. The reason is simple. What emerging markets need, given their already robust economies, is higher interest rates. What they'll get, courtesy of the US Federal Reserve, is lower interest rates. Of course, they could choose to raise interest rates independently of decisions reached in Washington, but that would undermine the currency regimes their policymakers seek to protect.

Continued robust growth in emerging markets points to persistent upward pressure on commodity demand and, hence, commodity prices. For the industrialised world, inflationary pressures may therefore remain elevated even if growth is slowing. Whereas in the late 1990s US growth was strong but inflation was low, there's now the risk that growth weakens with inflation remaining stickily high. What, then, should central banks do? Cut interest rates in the hope that inflation eventually subsides? Or leave rates unchanged, risking a collapse in economic activity?

For the Federal Reserve, rapid rate cuts might eventually have to be the order of the day. Politically, it's difficult to imagine US policymakers presiding over rising unemployment and shrinking economic activity, whatever the rate of inflation. The story, though, might not end there. Falling US interest rates would make the control of inflation even more difficult within the emerging world, eventually increasing the temptation to "go it alone" and leave the dollar to its own destiny. Might this lead to a dollar collapse, a loss of US monetary credibility and the end of an economic pax Americana? (Personally, I think this is the most likely scenario and the ultimate result of the current economic issues.)

Perhaps this is a fairy-tale too far. I sense, though, that recent events are not a one-off, a repeat of LTCM. Instead, the story unfolding is one full of sub-plots, geographical intricacies and economic dependencies. It may finish happily ever after. But it might, instead, end up like one of those novels from my namesake, a horrific mixture of weak growth, sticky inflation and, ultimately, a loss of confidence in the dollar's status as a reserve currency.

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