FYI | Jun 13 2006
By Greg Peel
Unlike other periods of extreme financial market volatility, this one was not triggered by some 9/11-esque shock. Energy prices, leading to inflation fears, are seen as the culprit, but then energy prices were equally as threatening post-Katrina with little of a similar response. The only difference this time was the hysterical run-up in early 2006 and the fact that many observers were calling for a necessary correction.
When bubbles burst they usually do so violently, but this correction shows more signs of a rapid loss of air. The volatility we are now witnessing only emphasises that no one’s that sure whether we’re seeing a burst bubble or a healthy correction. Volatility, says Danske, is only a sign of things to come.
The unusually favourable investment climate in 2003-05 was a product of excessively easy monetary policy leading to a global economy awash with cash, says Danske. Financial markets have in fact experienced too little volatility which has favoured too much risk taking, too much implementation of currency carry trades and too low yields. As energy price increases appeared to be tending to permanent earlier in the year, a reversal of easy monetary policy followed.
This has upset the calm pond of risk-taking utopia. While not overly "tight", Danske suggests it is the movement away from monetary leniency that has upset financial markets. And it will only get worse before it gets better.
The stormy season for financial markets has only just begun, Danske believes. The global industrial cycle is peaking, business confidence indicators are falling, and monetary tightening is not yet over.
But fear not. "It is important not to equate the global industrial cycle with the underlying global growth cycle". Swings in inventories and sentiment tend to exaggerate movements in demand, says Danske. It is easy to cry "slump" when "slowdown" is more appropriate. The extent of the slowdown will be determined by energy prices and housing markets.
Danske believes gasoline prices will fall back during the northern summer. This will allow for continued expansion in consumption in both the US and Europe. The US housing market is cooling but will not crash. However, as indicators fall sentiment will fall with them, and the concern will be as to whether a slump is upon us. More fear.
The US economy will slow, but core inflation will continue to rise in the short term, breaching the 3% target level on the US CPI, Danske believes. This will put the Fed between the proverbial rock and hard place. Bernanke will be determined to kill off inflation and will force the economy to cool. Stagflation will be the catch-cry once more.
Outside of the US, Danske does not see Europe suffering as much from inflation, and notes the European recovery is still in its early stages. Japan will begin a hiking cycle for the first time in a decade, but only at a controlled pace. China’s super cycle has proven immune to industrial swings in the rest of the world, and Danske sees no change to this, especially as China is moving to discourage exports and encourage more domestic consumption.
Danske’s view is thus one of more pain ahead of a ultimate return to the "Goldilocks" scenario of everything’s just right some time in 2007. This is not an uncommon theme from the less bearish side of the economist’s fence. But like all good economists, Danske’s analysts throw up two alternative scenarios.
Scenario one is that the slowdown will be more akin to a slump, supply disruptions will keep oil prices rising, and inflation will be very real. Central banks will keep hiking. Under this scenario equity markets will continue to suffer, housing will fall as consumers become more fearful, and business investment will be put on hold.
Scenario two is that central bank inflation fears prove largely unfounded, volatility will evaporate and Goldilocks will be firmly entrenched once more. The "new economy" paradigm of high growth, high productivity and low inflation will re-establish.
For the time being, Danske is calling for pain ahead of gain.