The British banking crisis is past, the US has cut interest rates and suddenly the clouds have lifted. So what is reality, the gloom of the past few days or the apparently bright dawn of now? Or, to put the question more precisely, is the world economy passing a mid-cycle bump, similar to that of 1997, or are the rough markets of this summer early signals that the end of the long boom is in sight?
The consequences of what happened in the UK will rumble on for some time. The crisis was not well handled and we need to figure out why: was it simply human failure, or is there a structural problem in UK bank supervision? Actually, I suspect it was both, but reaching a measured judgement on this will take time. At least the business was eventually done.
We will come back to the UK in a moment, but let's first look forward to the much more significant consequences of the US Federal Reserve cutting interest rates. The markets, not just in the US but everywhere else, are duly delighted but, then, you would expect them to be.
The best starting point is to consider where we are in the global cycle. In the first graph you can see that, compared with the 1980s and 1990s cycles, this one is middle-aged, not young, but not, on past form, due retirement yet. A cut in global interest rates, led by the US, could give it a boost. But it might be only a short-term boost, and I think we have to ask whether the fundamental features of this cycle make it more or less durable than previous ones.
The 1980s boom ended with a property crash, the 1990s one with the hi-tech crash. In both cases the cycle had been prolonged beyond what people might have expected by these exceptional features. This time I can see one massive reason why the cycle might be more truncated and one equally important one why it might be as prolonged.
The reason why it might be shorter is that it has been driven to a large extent by the US economy in general and the US consumer in particular. Both borrowed heavily to sustain consumption, with the US current account deficit equivalent to 6 per cent of GDP. Both are suffering from the consequences, with the dollar taking the strain nationally and American home-buyers taking it domestically.
A fall in interest rates is arguably only a temporary palliative and could, if it were to discourage foreigners holding dollar assets or borrowers doing something about their debts, make the underlying problems worse.
It is worth putting this decline in US rates in their historic global context. As you can see from the next graph, while rates have come up from the absurdly low levels of two or three years ago, global real interest rates are only just above their long-term average. (Those very low rates carry a lot of the blame for the present global property bubble, something that has unbalanced this cycle and will eventually be associated with its end.)
On the other hand, the reason why this cycle might be as prolonged as the two previous ones is that the baton of maintaining global demand is passing from the US consumers to consumers in the Brics: Brazil, Russia, India and China. According to some Goldman Sachs calculations, consumers in these countries are adding more incremental demand to the world economy than consumers in the US. This is a historic turning point and it raises the possibility that the reason "it's different this time" is that this is the first cycle that can be sustained, not by the US or, indeed, the rest of the developed world, but by the newly developing countries.
Of course, the reason why I put that phrase in inverted commas is that it is what people always say at this point of the cycle – and are always wrong. However, having just come back from a couple of weeks in China and seeing the amazing spectacle of 12 per cent growth at first hand, I think it is reasonable to expect demand from the Brics will help sustain demand for longer than would otherwise be the case.
Put these two opposing forces against each other, stir in this latest cut in US rates and what do you get? There is momentum in global growth right now and that will take time to come off. But notwithstanding this fall in US rates, American demand will be quite weak into next year.
Japanese growth has faltered. While eurozone growth has been solid this year, helped by Germany's wonderful export performance, the latest confidence indicators from Germany have been poor. So some sort of pause in growth does seem to be happening across the developed world: not necessarily a recession by any means, but a shift to a more sober economic climate.
But, thanks to the momentum noted above, this shift will not come through to any great extent this year and, thanks largely to demand in the Brics, probably not even next year. It is 2009 that we should start to worry about.
That is a bit of a way off. You would not expect the markets to be too bothered about that yet, particularly given the wall of savings being generated in Asia and the oil producers, and seeking a home in the markets of the developed world. True, the job of equity markets is to look forward, but given the unattractiveness of the alternative asset classes, you can still make a case for shares in the major markets. That would be the view of a number of equity strategists. For example, Brewin Dolphin's house view is that we are seeing a mid-cycle correction and that the upward trend of share prices world-wide is intact (see final graph).
That seems a sensible view for the next few months, maybe the next year. Nevertheless, there is a widespread view that global residential property is overpriced. It will take more than a half-a-per cent cut in US rates to check the price falls there, and we have yet to see the impact of the Northern Rock débâcle on mortgage supply in the UK. You don't need a very big fall in house prices to change the dynamics of the property market.
There is a general (and utterly unscientific) phenomenon in financial market behaviour that everything takes longer to happen than you would expect but, when it does happen, it happens more suddenly. So it was with the problems with the US sub-prime loans. It was evident the housing market was in trouble and that loans had been made on absurdly lax terms long before the market in such loans collapsed. Then, when the market collapsed, it took a long time for banks to realise the consequences for their balance sheets and for them to hoard cash. But once they did, the pressure on the other banks that relied on the money markets for deposits mounted quickly.
In the US, the downturn in housing market led to a financial market débâcle. Here, it may be the other way round – but we cannot know. That is the next chapter in the story. Even if, as I expect, this cycle proves to be in its late middle-age, and still has a year or more to run, the fragility of global property prices will remain a serious weakness.Reuse content