Hamish McRae: Why the stock market's latest wobble signals worry over the business cycle
Thursday 18 May 2006
The wobble on the financial markets of the past week or so has refocused attention on the nature of the business cycle. Up to now, world growth seems to have blithely ignored rising energy and commodity prices and rising interest rates. Meanwhile, the markets have long been unfazed by the US current account deficit, now close to 7 per cent of GDP.
But wobble signals worries. That there should be some falls in share prices and the dollar is unsurprising. The equity markets have had a very strong run and pauses are inevitable. You can make a reasonable assumption that provided global growth continues most markets are not overpriced. The really quite sharp fall of the dollar, though, is different. It may be welcome from a global macroeconomic perspective - a bit of reality at last - but it will not, in the short term at least, do much to cut the deficit. It is a necessary precondition for correcting that, but it seems sensible to expect a long adjustment, and a correspondingly long period of relative dollar weakness.
The fundamental question, however, is whether global growth can continue while the US has a period of slower growth. If the US economy does indeed slow that removes the developed world's main engine of growth. Continental Europe may grow a bit but don't expect much. There are some doubts about Japan's recent recovery. The UK will have OK growth but we remain vulnerable to a correction in the housing market. Conclusion: do not expect the developed world to grow any faster and viewed overall it will probably slow down a bit in the next couple of years. What then?
Well, we are so used to talking about the world economy in terms of the performance of the G7 developed economies that we tend to forget the change in the balance of economic power that is taking place with astonishing speed. Sure, we talk about the rise of China and India but we usually see this in terms of what effect this has on oil prices or commodity markets, or in holding down global inflation in manufactured goods.
Thanks to the BRIC's (Brazil, Russia, India, China) research by Goldman Sachs, there is much more information about these economies and much more focus on their impact on the world. Goldman has started a monthly report on these economies and that will help further. But I think we all tend to look at the data in structural rather than cyclical terms. In other words, we look at the upward pressure on oil prices or the downward pressure on the price of manufactured goods, or even on wages in the West. We don't think so much about the extent to which the growth of these countries is boosting global growth at this stage of the economic cycle or indeed how it will affect the next stage of the cycle.
There is no issue about the extent to which this cycle is driven by China as well as the US. China is, of course, much smaller (though it passed the UK to become the world's fourth-largest economy last year) but it adds almost as much demand. China adds more to global demand than the whole of the eurozone put together. Russia and India are now also significant contributors to world demand. As you can see from the first graph, those three economies have all put in a solid growth performance since 2000, though Brazil's progress has been more bumpy.
So at this point in the middle (or perhaps towards the end?) of the growth phase of the global cycle, these countries rank alongside the US as the drivers of world growth. China in particular is forcing up oil demand (next graph) and industrial metal demand, accounting for between 15 and 30 per cent of global demand for key metals (final graph). As a result, the character of this is different from that of previous ones: at its simplest, the fact that there is less pressure from inflation in traded goods and more pressure from inflation in commodities.
But what will be the effect of this over the next couple of years as the cycle becomes more mature? The present concern in Western financial markets is not reflected to any significant extent in Asian markets. They want to race on.
You can think of this in two ways. On the one hand, we are protected by our memory of the past two booms, that of the late 1980s and late 1990s, and we don't want to make the same mistakes again. We don't want another bubble. Asia sees things differently. Yes, there was the Asian financial collapse in 1996/97 but that mainly affected the smaller countries, which had relied too much on hot money inflows. When these flows were reversed, they took the pain. But India and China were hardly affected. Both carried on growing as before. As for Russia, it is supremely confident now about its prospects, a confidence fuelled by its energy exports.
So the dangers of a boom getting out of hand are arguably greater thanks to this shift in economic power. "We" may be worried about a coming bust but "they" are not.
The other way of looking at it is to note that a more broadly based global economy may be less prone to a loss of demand in any one sector. Thus even if the old developed world falters, the new one can take up the slack.
You have to be careful about this because much of the growth in the East is driven by the West, and in particular the US. The China/US trading relationship is crucial to both. If there were to be some rupture in that relationship, both would be gravely damaged. Asia trades with Asia too and on a growing scale, but Asian growth is not occurring independently of US growth. And since the relationship has not yet been "stress tested" we don't know what would happen to the Chinese and other Asian economies were US demand to fall.
On the other hand, the Asia/ Asia trading links grow ever stronger. In another two or three years they will be stronger still. These are huge markets and they are getting bigger by the day. The question is whether it is possible to envisage a North American and European downturn without there being a corresponding downturn in Asia. Could the Asian economies just trade more with each other and make up for loss of demand in that way? No one knows the answer to that because it is a new situation: Asia will be relatively much more important than it has been in any previous cycle.
Each cycle is slightly different. The 1970s growth was ended by a surge in inflation and an energy crisis. The 1980s saw a consumer boom that got out of hand. The 1990s one was ended by an excess of investment associated with the communications revolution. The present cycle could come to grief in any number of ways but I am sure that the twin Asian giants, plus the other large emerging economies, will play a crucial role in determining whether it ends with a whimper or a bang.
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