Hamish McRae: The global slowdown will be shaped by rising economies, not the old world

The long march back towards stability continues. It is impossible to be at all precise but it looks as though we are still in the early stages of the reaction to the excessively easy money conditions of the world during the past four or five years, and that markets will be bumpy for some months yet.

However, and this is the good news, disruptive markets do not continue forever. They never do. So it would be odd if, by the end of the autumn, things had not settled down. The usual signal for a return to calm is for a major financial institution somewhere in the world to need to be rescued, probably buy the central banks. When that happens (and I would be surprised if it were a British one) we can all relax. Until then things will be bumpy.

We are seeing some of those bumps in Britain. The UK financial system is fairly well insulated from the heat generated by global financial markets. There is a folk memory of the secondary banking crisis of the 1970s and the troubles of Third-World lending soon afterwards. We also have a more recent memory of the early 1990s housing slump. So our banks are both well capitalised and have been reasonably cautious in their lending criteria. Nevertheless, strains are evident.

You can see these in a number of ways. One is the rise in the cost of mortgages. The cost of these has continued to climb even though the Bank of England has not continued to increase its base rate. That is because money market rates have tightened ahead of the Bank's rates: the key three month rate is now around 6.9 per cent, more than a clear percentage point above the Bank's rate. Longer-term rates have nudged up, too, and this has had a direct impact on mortgage costs. You can see this in the first graph, which shows the two-year swap rate (what a bank gets or receives for two-year money on the wholesale money market) and the cost of two-year fixes on a mortgage for 95 and 75 per cent loans.

If you look back over the past few years you can see that there was a small gap between the cost of the money to the bank (the swap rate) and the amount it charged on a 75 per cent mortgage, and a slightly larger gap for a 95 per cent one. That is as it should be. You would, if you were a bank, expect to make a tiny profit on a 75 per cent mortgage because the risk is minimal but a slightly better return on a 95 per cent mortgage because the risk is a touch greater. But this year the cost of the money has risen above the 75 per cent mortgage rate and close to the 95 per cent rate. So there is no profit in it for the lender. Conclusion: mortgage rates have to go up, or at the very least, conditions have to be tightened.

That is what seems to be happening. It is too early for this to have fed through to the housing market or to consumer demand but if conditions remain tight, this is bound to happen.

This leads to another question: should the Bank ease the squeeze in the money markets? That was tackled yesterday by Mervyn King, the governor, in his letter to the Treasury Committee, as discussed by Jeremy Warner on page 51. The only point worth adding is that the long-term understanding between commercial banks and the central bank is that the latter will supply very short-term money to the market without limit. It is not the job of the central bank to try to control the price of longer-term funds, unless there is so much disruption that the stability of the banking system is threatened. We have not reached that point and I hope won't get there.. Our main banks are grown-ups: they are large and supposedly well-managed institutions and if the people who run them cannot cope with this well-predicted squeeze, they should not be in the job. A return to calm will start in the US, just as the present difficult conditions started there. So the story moves back across the Atlantic. There will be some sort of cut in US interest rates in the coming weeks and you can justify that on the grounds of the slowing economy. But the room for the Federal Reserve is quite limited, for it and indeed the country is still suffering from the long period of extremely low interest rates between 2001 and 2004. That created a surge of indebtedness at an individual level – people could borrow for plastic surgery for heaven's sake – and almost certainly was a factor in the increase of national indebtedness, too. That, as you can see in the next graph, was already climbing through the 1990s but shot up post 2001. The US has borrowed from around the world to finance its desire to consume. The dollar is now very weak and the ability of the Fed to cut rates will be circumscribed by this weakness. The US has to attract money to cover its current account deficit, now around 7 per cent of GDP. That money will only come in if it can earn a reasonable return.

That raises the obvious question: will the US go into recession? Maybe it will – my guess is that two or three years of slow growth is more likely but that really is just a guess – but for the moment, at least, the economy is still reasonably strong. Yes, there were some poor employment figures last week but if you look at the big picture on employment and unemployment (next graph) the US is a long way from the conditions of previous recessions during the past 30 years. The most interesting thing there is the way the amplitude of the economic cycle seems to have diminished.

Besides, the world economy, which has just had the fastest five years of growth that it has ever achieved, is less dependent on demand from the US consumer than it was in previous cycles. Goldman Sachs reckons that the incremental consumer demand from China, India, Russia and Brazil during the first half of this year was for the first time greater than that from the US. That is a huge turning point. The timing and scale of the coming global slowdown – and I do think there will be one – will be shaped much more by these "new" economies than by the "old" developed world. The world could conceivably keep growing even if the US goes into recession.

If that is right it will have important implications for asset prices. We may see world property prices come back, led by US house prices and maybe even our own prices too, but you can make a plausible case that world share markets are still fairly valued. The final graph, from Credit Suisse, shows how on a 15-year view, share prices are actually rather cheap.

Of course, not all markets are so well based and a global slowdown would affect earnings. We won't know until this bumpy period is over how far financial markets will contaminate the real economy, but meanwhile the surprise surely is how well share prices have weathered the storm... at least so far.