Reality Check Needed Amid World Economy Mood Swings

Wed Aug 18, 2004
By Mike Dolan

LONDON (Reuters) - All of a sudden, if global financial markets are to be believed, a roaring world economy is going to hell in a hand basket.

Half way through a year still likely to record the fastest expansion of the global economy since 1988 -- which at a rate of almost five percent would be a point above the average of the last 20 years -- the sweet mood of the spring has turned sour.

Only this week world equity prices, as captured by the MSCI World Free Index of stock markets, flirted with lows for the year, some eight percent down on February peaks.

No longer dogged by the prospect of demand-driven inflation and rising official interest rates, it seems, long-term U.S. bond yields have dropped as much as 70 basis points in just two months to levels lower than a year ago.

Fund managers polled by Merrill Lynch earlier this month reported their highest holdings of cash since the U.S.-led invasion of Iraq last year, indicating a wholesale retreat from the perceived risks associated with equity or debt.

Even esoteric measures of sentiment, like Societe Generale's in-house monitoring of the number of positive or negative economic stories seen in the world press, point to a downturn. So, who or what spoiled the party?

A continued oil price surge is most people's prime suspect, with many dismissing the inflationary fallout to focus on the growth-sapping scenario of higher energy costs and the tax-like effect of higher oil on business and consumers.

You can add a number of other factor to the list.

U.S. economic reports -- from below-forecast second-quarter output to meager job creation in July's employment report -- looked softer sooner than many had bet on and consumers stateside appear particularly prone to the energy price spikes.

A persistent threat of terror attacks in the U.S. and Europe is also cited as casting a pall and U.S. policy visibility is low ahead of November's Presidential elections.

MOOD SWINGS?

But, like all mood swings, reality is probably somewhere in between the euphoria of January/February and August doldrums.
"This is now a market already starting to think of interest rate cuts and that's pretty extreme against the bigger picture," said Julian Callow, economist at Barclays Capital.

Some would argue the investment shift was less sudden than it first appears. Since April, many funds have bet the only direction for sky-high world growth rates was down.

The buffers had been hit, they argued, and a tightening of easy U.S. monetary and fiscal policies in tandem with China's attempt to cool its overheating economy would take a toll.

This view proved pretty accurate as second-quarter growth in the United States and China -- though still rapid -- disappointed.

But the question remains whether we are seeing a welcome tempering of frenetic economic activity or bracing for collapse -- as some recent financial price trends would suggest.

"The market pendulum may have swung a little too far here," said Avinash Persaud, investment director at fund managers GAM.

"That process may not yet be exhausted but the worst is probably behind us," Persaud added. "I'm more optimistic than pessimistic - so much bad news has been discounted into prices."

ROUND AND ROUND

At this point, some arguments start to become circular.

The oil price rise -- for all it is exaggerated by supply and geopolitical problems -- is mostly a reflection of underlying demand for energy from a strong global economy and the recent "shock" pales relative to historical precedents.

And if the rise in oil prices does weaken the world economy significantly, then demand for oil will presumably start to ease too -- capping the oil price in the process.

Similarly, another fear back in the Spring was that rapid world expansion and lurking inflation would drive super-low interest rates sharply higher, in turn sapping economic strength by pinching highly indebted households. The very anticipation of rising central bank interest rate had already driven up long-term interest rates and that started to bite in Q2.
But, as seen in the slide in Treasury yields, this weight on the world has already lifted somewhat. In other words, the slowdown itself is serving to ease one of the biggest threats to growth in the first place.

The argument that equity prices and valuations were overstretched has also dissipated with the retreat of almost 10 percent in world stocks this year.

Prices that reflect real industrial activity or trade also tell a different story.

Industrial metals prices are hovering just below Spring levels and remain about 11 percent higher than in May. Shipping indices, like Baltic Dry Freight Index, also remain close to April levels -- still well off the super-charged early year heights but up more than 50 percent in two months.

None of this suggests imminent recession or collapse.

Some economists even think the cooling world economy -- forecast by the International Monetary Fund to rack up another 4.4 percent growth next year -- is becoming more balanced.

Goldman Sachs said in a report released on Wednesday that the over-reliance of the global economy on U.S. growth was destabilizing because of the current account imbalances that exaggerated. But it said there were signs of this easing as domestic demand outside the U.S. was starting to come through.

"Perhaps there is some light emerging at the end of a rather long tunnel," the Goldman report said.

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