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More pain to come

June 9th, 2008 · 1 Comment

Sometimes we prefer to be wrong. Since the inception of this website, we’ve argued here that the economy (the US economy, that is) is in worse, much worse shape than the stock market reflected. Something had to give. Either the economy makes a remarkably quick recovery, or… 

Our main arguments were, and still are:

  • The financial system came close to a meltdown, and although that risk seems to have been averted, financial institutions are hardly in a position to expand credit and there is still a good deal of mistrust amongst them, which has led to a countercyclical reduction in credit
  • The rapid reductions in interest rates as practiced by the Fed is bot less effective than under normal circumstances (because of the risk aversion setting in at other financial institutions which we just explained above) and has created it’s own risk, rising inflation (mainly via a falling dollar)
  • There is an enormous amount of wealth destruction going on in the housing market, and there is not much reason to think that this will be over anytime soon
  • Consumer confidence has fallen through the floor, and is unlikely to recover anytime soon with unemployment (a lagging indicator) now firmly on the rise, and inflation taking off.

So far, there were two surprising developments. The way in which Wall Street has held up is one which we have wondered about for quite some time. It’s linked to a second surprise, the rest of the world has suffered surprisingly little economic fallout, yet.

This development, and the falling dollar, have kept US exports booming, which has propped up large parts of the US manufacturing sector. But sooner or later, this will taper off because of the commodities boom. Inflation is already close to 10% in China (and it’s already like 25-30% in places like Argentina, although official statistics are blatantly manipulated there).

Sooner or later, even these fast moving developing countries have to start worrying just a little bit more about inflation, and take corresponding measures, which will cool off demand. Frankly, we’re surprised not more of that has already happened.

It might have quite a bit to do with the ‘bicycle’ character of the Chinese economy. Growth has to be fast, if it slows down, the economy falls over, just like a bicycle. How’s that? Contrary to the American economy, the Chinese economy’s driving force is business investment.

In so many industries (solar is one we’re following), so much capacity is added each year that if demand for finished products falters just a little bit, a real danger of overcapacity lurks. Overcapacity will bring brute rationalization, and investment in fixed capital, the driving force of the economy, will come to a grinding halt, taking the whole economy down with it.

Many of these fast growing Asian economies display the same characteristics, and we have seen instances in which growth comes to a sudden halt before, when these ‘biclycles’ fell over one by one in the Asian crisis in the mid 1990s.

Then, the trigger was external, currencies had become too overvalued. The sudden devaluation led to a massive increase in external debt (where exchange rates were more or less guaranteed by authorities before the crisis, many businesses borrowed heavily in US$ because of favourable interest rate differentials).

Luckily, the Chinese authorities are acutely aware of such potential problems, and they’re taking steps to steer the economy into calmer waters and let consumers share more of the burden of economic growth (that is, increasing their purchasing power in order to make the economy less dependent upon business investment).

But people sometimes forget, all the talk of emerging economies being able to carry the weight of the world economy, the figures just don’t match up. American consumers still make up the largest market by far, China is only some 10% of that (depending to a certain extent on how you measure it, but you’ll get the message).

While the American consumer, as well as many of it’s financial institutions, have to rebuild balance sheets, which means that the demand for, as well as the supply of, credit will be weak for quite some time to come, emerging countries are not yet able to fill the resulting aggregate demand gap, we fear. The numbers just don’t add up.

In Europe, meanwhile, the president of the European central bank (ECB) is already openly suggesting for interest rate hikes. It’s an extremely logical response to an inflation rate that is already well above 3% and rising, while the charter of the ECB says it should be kept below 2%. Yet markets seemed to have forgotten this little piece of awkward reality.

And then there are incidents like some Israeli minister who, when given a golden opportunity to shut up, threatens Iran and hands them a $10 per barrel of oil mid-year bonus. It was not long ago, when oil was rising from about $40 higher, that many people thought the rise to be an Iran premium (although it was Iran threatening Israel, that time).

Not such a good idea to reintroduce that when oil is at $125. In fact, we were thinking at the time of the possibility that the Iranians were saying those things just to line their own pockets. Bit of an irony having the Israelis doing it for them, this time.

All this doesn’t bode well for the world economy.

Tags: The Markets

1 response so far ↓

  • 1 david // Jun 9, 2008 at 2:49 am

    Nope, it sure doesnt.

    IT does bode well for Domestic oil and gas producers in the US though, and it does bode well for Gold and Gold stocks— better make sure you own the right side of the trade folks. Interestingly enough, the energy stocks may get whacked over the next 4 weeks— while gold goes back over 1000.