Hamish McRae: Beware of the economic threat from left field

Conventional risks look manageable in 2007. It's the uncoventional ones that concern me
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The Independent Online

Suddenly all the worries about the world economy that dominated most of the past year seem to have evaporated - as the main financial markets have signalled. In the run-up to the Christmas break the markets shot ahead and now this week seem to be consolidating those gains.

So we start the year with a much higher level of general confidence than we had a year ago - and a whole lot higher than last May when the markets threw a wobbly. We also start with a somewhat higher level of share prices, and much higher in some of the emerging markets, where the rise in confidence levels has been even more marked. So if you are interested in peering into the future to assess the behaviour of financial markets in the coming year you have to ask about the basis for this confidence.

We have now had four years on the trot when share prices in almost all major markets have ended the year higher than when they started. For there to be a fifth year would be historically very unusual, though of course to have the three years of falls before that was also very unusual. To judge by the past few days the market thinks so but is another year of rising prices really credible?

Simple question, and one that I think is on all our minds. But what can sensibly be said in response?

You have to start with the economics. Markets are driven not just by the twists of world economy and the authorities' response to that, because their own forward perceptions matter too. But if the world economy were to tank this year then the markets would tank too. Insofar as the world economy is still a US/eurozone story (and as I have argued in these columns that is increasingly becoming an emerging market story too) the crucial issue is whether faster growth in European demand will replace slower growth in the US.

So, issue one: will the US economy achieve a soft-landing? The idea of a US-led world recession (initiated by a housing crash) is certainly around but fears of that are somewhat more muted now than they were six months ago. You can see why in the top graph. The collapse of the housing market seems to have been checked. The downward swoosh in home sales was pretty spectacular and in some markets, such as the auto-industry heartland in Michigan, things are still dire. But the tone has definitely improved; if the recovery continues then while the US economy this year will not continue to boom, at least it is unlikely to collapse.

The next question is whether US companies will remain profitable despite the slowdown. Slower growth means a slower rise in profits and everyone accepts that. The greater imponderable is whether the structural shift in the US towards higher company profits will be sustained. The bottom left-hand graph shows how the corporate sector has become more profitable, measured as a share of GDP, than it has been for more than half a century. You have to ask whether this is an aberration that will correct itself or whether there has been some long-term change that will be sustained for a decade or more.

I don't know the answer to this but it is not hard to see the dire consequences of that share going back to the average level of the post-1980 period. We would be talking about profits being perhaps 8 per cent of GDP rather than their present 12 per cent. On the other hand, profits might stay around the 9-13 per cent region of the 1950s and early 1960s in which case you could sort of justify the present level of US share prices.

A common sense response would be that global financial conditions now are more akin to those of the 1950s than the 1970s and 1980s, and that would give some confidence. Chris Watling at Longview Economics suggests that the global share of profits can be sustained because of the mass of cheap labour entering the world economy from China and India. That ought to hold down the cost of unskilled workers not just in the US but throughout the developed world. If labour gets a smaller share of GDP, then profits can take a higher share. But it would be historically remarkable were that share of profits to go much higher and in particular to stay there for long. You could have a soft US landing and still have a squeeze on corporate profitability.

The main imponderable in Europe is whether the German recovery will be sustained. Germany has just had its best growth for five years, around 2.6 per cent, and confidence remains high. The team at Capital Economics have plotted the link between German economic sentiment and German growth and have got a nice "fit", as you can see on the bottom right. So it is plausible that growth will continue at a reasonable level this year. There is a rise in VAT right now that will pull back domestic demand a bit but the overall picture remains bright. And if Germany comes right the whole of the Eurozone will be pulled along too.

The biggest cloud on the European horizon is the external value of the euro. A dollar collapse, particularly when set against the euro? Possible, but were the euro to become over-strong then inflation would fall and the European Central Bank could go back to cutting rates.

The big point here is that the perceived risks look to be outweighed by the prospect of another year of solid global growth. That growth will be sustained by some rebalancing between the US and Europe, plus reasonable growth in the other large developed economies, including Japan and the UK. Meanwhile China and India race onwards, with China now making a material contribution to world demand. China probably passes Germany to become the world's third largest economy next year.

So you could say that the conventional risks - the ones that economists usually fret over - look manageable in 2007. The markets are reflecting this view. That may of course turn out to be wrong but we know what we are dealing with. The things that concern me more are the unconventional risks, the ones that sit vaguely in the back of the mind and make you kick yourself for not focussing sufficiently on them. Two stand out.

One is that there will be disruption of oil supplies. There is not much point in trying to guess precisely what might happen in the Middle East that might lead to this but the dangers are obvious and are being largely ignored. The other is a financial disruption occurring because we don't fully understand the links - through hedge funds, private equity and the like - in the world financial system.

Now you could say that the chances of either form of disruption occurring this year are small and that is probably right. But it is not zero and the bouyant markets of the past few days are not factoring in much of a discount for risks that are unlikely to materialise but could be devastating if they did. We should celebrate the continuing success of the world economy and in particular the spread of wealth beyond the old developed world and let's do that. But let's try and calibrate the risks as we do.