Saturday, June 27, 2009

Daredevil balancing act for the world economy

By John Authers
Published: June 27 2009 (Financial Times)

Remember the Goldilocks economy? Right up until the credit crisis, Goldilocks lent her name to a theory that the economy was "not too hot, not too cold", permitting stable growth.

Goldilocks was devoured by a large group of bears when the crisis began.

Who will give their name to the current economy? Starting in March, stocks across the world enjoyed a great rally but for more than a month now they have been moving horizontally. Almost every indicator of panic or of financial distress is now back to the levels that adhered immediately before the Lehman Brothers collapse last September took the crisis to a new and terrifying intensity.

Nobody in their right mind would claim that we are in a friendly "not too hot, not too cold" environment. So let us instead call this the Blondin economy, after Charles Blondin, the French acrobat who is most famous for his feat of walking across Niagara Falls on a tightrope.

As with Blondin, the drop is vertiginous; various different whirlpools and rocks lie beneath and yet for now the economy's move along the rope seems assured. Just as Blondin needed deliberately to make things more difficult for himself by carrying a man across on his shoulders, pushing a wheelbarrow or frying an egg in the middle of the rope, so the market is beginning to perform some stunts, raising new hazards and dealing with them.

The most frightening whirlpool is in the banking system. It almost collapsed last autumn. Although much criticised, the US administration's "stress tests" seem to have calmed nerves about this for now.

There is no way that the financial system can be allowed to stay in its current shape or under its current regulatory regime. Power is even more concentrated in a few institutions than it used to be. The flaws in regulation are now painfully obvious. Fixing these problems will be difficult and will carry risks but that problem is in the future. Blondin is still walking above it.

Deflation, or lowering prices as activity stagnates, a phenomenon that marked the Great Depression, is another big danger. The enduring problems for the financial system mean that it cannot be ruled out.

But the Blondin market is behaving as though the threat has passed, with bond markets now implying that inflation expectations are back where they were before the crisis. This week's report from the US Federal Reserve suggested that deflation was no longer a significant risk, while a new forecast from the Organisation for Economic Co-operation and Development also suggested that the risk of deflation had been averted.

As for growth, the OECD suggests that the developed world will return to very anaemic growth by the end of next year, while emerging markets, led by China, will be resurgent. Again, this is exactly what the market also implies.

Recovery in the developed world will not stop unemployment from rising even more, the forecast says, so there is a real risk that growth will not materialise at all.

Ahead lies the danger of inflation, a logical fear when government policy is designed to create it. Only weeks ago, investors sold government bonds aggressively, pushing up their yields, in a move that guards typically against inflation. Again, that fear has subsided in the past few weeks. Blondin stays upright.

If none of this sounds like the basis for optimism, that comes from evidence about company inventories. Having been cut back during the worst months of the crisis, they are now insufficient to meet demand. That implies that there could be a surge of output (good for the economy while it lasts), and that companies will have greater pricing power. That should be good for their profits, and so the "earnings season" of profit announcements for the second quarter might provide the next opportunity to blow Blondin off the rope or to speed him on his way.

In this environment, the most obvious discrepancies in valuation between asset classes have been erased. Credit was blatantly dear compared with stocks leading into the crisis two years ago, and blatantly cheap by the turn of this year; neither is true now.

While Treasury bonds were blatantly expensive at the turn of this year, when 10-year bonds only yielded 2 per cent, the yields on offer in the past few weeks, oscillating between 3.5 and 4 per cent, cannot be dismissed easily as too cheap or too expensive.

These asset classes are walking the tightrope. This is less true of the assets in which most hopes are invested, those that stand to benefit most from a "China-centric recovery". Industrial commodities and energy, and the stocks and currencies tied to them, have surged to a point where they would look very overvalued if any problems with the Chinese story came to light.

But for now, the market and the economy are walking the tightrope. They could yet continue to do so. After all, Charles Blondin lived to see his 70th birthday and died in his bed

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