Hamish McRae: We are seeing a slowdown - but it is one that is needed to rebalance the world economy

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The Independent Online

The day starts in the east - and the trading day too. It is a bit early to try to calibrate the long-term significance of the past couple of trading days, but not too early to try to set the bump in the markets in a longer-term context.

The first point surely is that markets are not completely rational entities, weighing up the importance of new information as it comes in and allocating capital flows in response to its implications. There is a wild and wacky element, as we have just seen. By rights, a proposed shift in investment regulation in China, plus some tax changes in South Africa, ought not to give such a kick in the teeth to global markets. The Chinese economy may be growing swiftly, but the market capitalisation of the Shanghai exchange remains tiny by comparison to Wall Street. The tail is wagging the dog. That is odd.

The second point to be made is that the present phase of the bull market has run almost uninterrupted since May last year. That has been an exceptionally long period without a correction. I love that expression "correction", by the way. It implies that the market is basically sensible, pausing periodically to correct any mistakes that creep in. Even though things ain't like that, the idea that markets do need to correct over-enthusiasm is a useful one.

Behind this argument is the judgement that the bull market, like the global economic expansion, has some way to run. The market has certainly been pretty solid, with long periods of progress, interspersed with bumps such as we saw last May (top left graph).

But on what is that judgement based? Some of the best work on global cycles comes from Goldman Sachs, which developed a global leading indicator (GLI) to capture the shape of the cycle and give some advance warning on what might happen. It fits pretty well with European equities, European companies being particularly dependent on what happens to world exports and trade. You can see the fit in the top right-hand graph. Note that it has been weakening a bit in recent weeks, though it remains very much in positive territory, in marked contrast to the movement ahead of the 2000 market reversals.

Even if this line of argument is right - a correction, not a crash - you still have to deal with the real concerns about the world economy that have been bobbing around for some weeks but have surfaced fully in the past few days. The sensible thing to say here surely is that there is some sort of slowdown taking place, but actually a slowdown is rather needed to rebalance the world economy. ING bank has just put out a paper arguing that, just as last year the second half was weaker for growth than the first, this year things may be the other way round. Thus the weakness we are seeing now, particularly in the US, will run on a bit further but there are a number of reasons, not least the possibility of a cut in US interest rates, to expect a stronger performance later in the year.

It was intriguing to see that Alan Greenspan's suggestion that there might be a recession ahead for the US was one of the reasons cited for the fall-out in the markets. It is worth remembering that his "irrational exuberance" speech had a similar impact in the late 1990s. He was quite right, of course, just a couple of years too early.

The issue now is whether cuts in interest rates can indeed sustain growth in the US or, if things do go badly through the spring, rekindle it. Much depends on whether the US can continue to finance its current account deficit. The absolute deficits of selected countries are shown on the bottom graph. As you can see, the two biggest suppliers of savings to the world are the Middle East and China, with Japan, Germany and Russia coming along behind. So much will depend on the investment choices of these countries.

These fall into three groups. There are the two oil and gas producers, the Middle East and Russia. There are two developed countries that have great success at conventional exports but have such large surpluses also because they are deficient in domestic demand: Germany and Japan. And there is China.

As far as the energy duo are concerned it seems reasonable to assume that they will continue in solid surplus for quite a while yet. It is hard to see really cheap energy in the foreseeable future and there is the possibility of more expensive oil and gas, maybe much more expensive. The energy producers will not be ideological in their choice of assets, but they will be increasingly sensitive to returns. They also have no particular reason to want to support the US economy; in both cases, rather the reverse.

For Germany and Japan, the US remains a natural haven for their investments. However, I'm not sure that these surpluses are likely to remain at that level, particularly in the case of Germany, for both are very dependent on buoyant global growth to sustain their exports. They are more sensitive to any slowdown than, say, the UK.

In the case of Japan, the key issue is whether the authorities want to diversify their holdings out of short-term dollar assets. While US interest rates remain much higher than Japanese, maybe not. But at some stage, perhaps quite soon, the long decline of the yen must surely come to an end. When that turning point is reached and the dollar starts to weaken, the practical case for borrowing cheap to invest in higher-yielding US securities would disappear.

And then there is China. It is enormously in the self-interest of China not to do anything that damages its position in the US market. If that means seeing the value of its portfolio of US securities diminish, to some extent China will have to swallow that outcome. We know, though, that China is seeking to improve the return it gets on its dollar assets and will, I am sure, manage these assets much more actively in the future.

In the short run, that will probably be good news for US equities, if China becomes a more significant investor there. In the longer term, China must surely rebalance its assets away from the US so that these reflect the world economy rather than the US one. America has huge advantages over anywhere else in the breadth and liquidity of its capital markets and that is worth a lot. But diversification must make sense: China should not want to have too many of its nest-eggs in the US market.

All this leads to a simple conclusion. That in the short term the markets' jitters, while understandable and "correct", are not a signal of a meltdown, either of the world economy or of the markets themselves. But in the somewhat longer term, the problem of global imbalances will not go away. How they are tackled will shape how this growth cycle eventually ends: with a whimper or a bang.

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