Three bears lurking in the financial forest
Sunday 24 August 1997
But, as a new circular by HSBC reminds us, Goldilocks was chased away by three bears. As people return from the summer break, I suspect that the markets will come to focus more and more on potential bad news, rather than crow about the confluence of good. I suspect that as we move into the autumn we will hear more and more concerns being voiced - the feeling that the good times just cannot roll for ever.
You can pick this up already. The HSBC team's three bears come from America, Europe and East Asia. The American bear is a bear market in US equities triggered by a rise in US interest rates. In the right-hand graph you can see the little downturn nibbling away at US share prices during the holiday season. The European bear is in turmoil over EMU. The possibility here is that the Bundesbank will feel it has to do something to German interest rates to recover credibility for the mark, even at the risk of pushing the other big European economies back towards recession. And the East Asian bear is that the collapse of currencies will turn into a round of competitive devaluations.
Others might want to draw attention to other bears. The Japanese economy is extremely fragile, with a sharp fall in consumer demand following the rise in the sales tax in April. It is still not at all clear that the various proposed structural reforms will pull the economy out of what looks like being renewed recession (after good growth last year). And there are bears here, too.
The British economy - unlike the US or even the Japanese - is not big enough to make a material impact on the world economy. I think our importance is more as a source of ideas: the fact that we have the lowest unemployment of the large European economies has to have some effect on economic policy right across the Continent, though we are not thanked for reminding Continentals of their own failure to generate jobs. But the very success in running the economy close to full capacity raises a key issue that will have to be resolved during the autumn and winter. It is: do we land with a bump?
There will be no single, simple answer to that question this autumn. It will be too early to know. In fact I don't think we will know how well we manage the transition from above-trend growth to close to, or even a bit below trend, until this time next year at the earliest. Nevertheless, as the market-makers come back from holiday, they will be watching a series of indicators which will give them clues as to whether the landing will be hardish or softish.
Hardish would mean the present growth phase racing on into next year and then ending quite sharply perhaps in the autumn, with a couple of quarters when there will be very little growth indeed. Christmas would be another record in the shops; but then quite suddenly confidence would evaporate and by next summer the alarm as unemployment to started to climb. (Hard, by the way, means back into recession, but while that is of course possible, I do not think that is really likely next year - if it does happen it is much more likely around the end of the century, perhaps associated with a more general European economic collapse.)
Softish would mean growth coming down quite quickly, with for example the last surge in retail sales representing peak growth and sales being down to annualised growth of perhaps 2 per cent by the winter. It would mean a relatively quiet Christmas in the high street, and growth next year of perhaps 2 per cent rather than the 3.5 - 4 per cent we are going to end up with this year. What are the clues that will tell us which way the economy will flip?
I would list three key indicators, three warning lights which will give an early signal of the economy next year. The first two are conventional.
Warning light number one is the current account. When the UK economy becomes overheated either inflation or imports will take the strain. For reasons which are still not fully understood, there has been no absolutely sure sign of inflation reviving - not just here but anywhere. So far there has been no sign of any deterioration in the current account; if anything it is getting stronger - thanks to strong invisible earnings, the last six months have been in surplus. But the current account is a narrow balance between two enormous variables, and so could move very fast. If it remains in surplus through the second half of the year, then look to the softer landing; if it moves into sharp deficit, then expect a sharp reaction next year.
Warning light number two is house prices. It is perfectly possible to have a sustained economic recovery without a sustained rise in house prices: the first four years of the present recovery saw flat prices, and the last two have still not brought prices everywhere back to the 1988 peak. But the rise over the past year of 8-10 per cent ought not to be sustainable. If we do not see some slackening of the rise through the autumn, that would mean that the four rises in interest rates we have had already have not done the job: expect interest rates to climb for longer to choke it off, and expect a sharper stop in the economy as a whole next year as a result.
Warning light number three is share prices. Economists do not usually think of share prices as giving a respectable warning about anything, though they are a component part of the leading indicator series. There is certainly little direct connection between shares prices here and the UK economy, partly because equity prices reflect global movements - what is happening to Wall Street or world interest rates - and partly because such a large proportion of UK stocks are held by institutions that movements are not felt directly as changes in the wealth of UK individuals. In any case how, you might reasonably ask, can markets which reflect what happens in company performance be a predictor of the economy?
Nevertheless if you look back, equity markets can be a guide. The bear market of 1973-74 signalled that things were amiss before the recession of the mid-1970s. Weakness in the late 1970s preceded the slump of the early 1980s. The crash of 1987 was quickly reversed, in part by what was subsequently recognised as an inappropriate easing of monetary policy, but could be seen as a signal of the downturn which began about 18 months later.
Does that mean a "correction", as they say, in share prices this autumn could be a signal of a move into recession around the turn of the century? Not necessarily. I would actually be more concerned if share prices were to race on upwards through the rest of this year, for the more people believe that there will never be another economic downturn the more vicious that downturn is likely to be.
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