FYI | Jan 17 2008
By Chris Shaw
No-one needs telling it has been a bad start to 2008 on financial markets, with major indices posting day after day of losses in what is traditionally one of the better months of the year as the world faces up to the year’s outlook of a weakening US and global economy.
But according to Commonwealth Bank chief economist Michael Blythe even though bad news is likely to keep coming out of the US in the next few months and this will impact on investor sentiment, there is now the risk the market is overplaying the potential downside.
The reason is investors are assuming a number of developments are going to play out because conventional wisdom says this will be the case, while Blythe suggests the evidence of past periods shows this is not always true.
For example he notes the theory that problems on Wall Street always flow through to Main Street doesn’t necessarily hold true, as while financial shocks have occurred over the past two decades policymakers have succeeded in avoiding the worst possible outcomes with respect to the real economy.
It is also not simply “given†that a housing downturn in the US signals a recession, as Blythe points out using the US housing cycle as a guide it would have been possible to have predicted 15 of the past 10 US recessions, meaning the indicator is somewhat flawed when used on its own.
While the credit crisis suggests a full-blown credit crunch is inevitable (particularly given the difficulties in rolling over borrowings in credit markets at present) Blythe also discounts this theory as there remains a global excess of savings over investment and at some point the demand for financial assets will return.
There is even some sign of this occurring now in his view as sovereign wealth funds are starting to take stakes in financial assets such as Citigroup while Bank of America is moving to take full control of US housing lender Countrywide.
Looking even more closely at the US economy Blythe points out there is no certainty a recession will even occur, as outside of the housing sector economic momentum remains solid and many of the usual elements required to create a recession such as a fall in government spending have not yet emerged.
While the latest data suggest US consumers are slowing their spending Blythe doesn’t see this as a tick in the recession is coming column either, as while consumption growth may well be sub-trend this year it is still a good chance of remaining strong enough to keep the US economy out of recession.
The de-coupling story is also worthy of note as Blythe points out over the past decade the correlation between US growth and growth in the rest of the world has halved, meaning it is not the case now that every time the US sneezes the rest of the world catches a cold.
This also augers well for commodity prices as while in the past a slowdown in the US would flow through into lower commodity prices the correlation between the US economy and commodity prices is also breaking down, helped here of course by the demand for metals and other resources coming out of China.
In other words, Blythe’s argument is yes the bad news will continue for a while and the US economy will struggle in the first half of the year but with the Federal Reserve already lowering interest rates and with further cuts to follow there is scope for the US economy to ride out the storm in the medium-term.
