What happens when US bubble bursts?
Emotionally, US markets can't accept the possibility of a slowdown - and it will take the country by surprise
Friday 25 June 1999
The picture contains the message: that the US Federal Reserve has allowed or even encouraged an asset price bubble to build up size and momentum; that the Fed will have to prick it; and that when it does so there will be an explosion which will have effects far beyond America's shores.
It takes a certain degree of courage to call the end of a boom and Stephen King and his colleagues at HSBC deserve credit for that. There are a few other "bubble merchants" about. For example, Ed Yardini at Deutsche Bank in New York has been saying that the Millennium bug will lead to recession next year, and the Bank Credit Analyst team up in Montreal have been worrying about stretched values on Wall Street for at least a year.
Here in Britain, Smithers & Co and Phillips & Drew have singing a similar tune. But for every bear there seem to be ten bulls. The mainstream view would be that while United States asset values are very high by historic standards, some over-valuation at least can be justified by the prospect of very low, even zero, inflation and by the vibrancy of the new hi-tech US industries.
The thrust of the HSBC paper is that it is possible to identify features common to all bubbles in the past and that the US current expansion qualifies as one. These include above-trend growth, below trend inflation, a strong currency, financial innovation, current account deterioration, and falling private sector savings.
Out of the 12 indicators chosen, both the UK and Japan in the late Eighties had all 12, while the US now has 10. If you add in the surge in investment which took place in both the UK and Japan, and which is now happening in the US (see graph) the parallels are more striking still. It is hard to conclude that there is not some sort of bubble, though you can argue about how over-blown it has become. At any rate the HSBC conclusion is that while US interest rates may go up later this year, it may take several rises before the bubble bursts, and that there will be more overheating before the bang finally comes, most probably early next year.
The economic effect of that would be that there would be sharp cutbacks in both consumption and investment and that the US economy would be close to recession in early 2001.
Interesting idea, but is it right? It is hard not to agree with the broad thrust of the analysis, for the US situation does bear comparison with the situation both in the UK and in Japan a decade ago.
In Japan the most extreme element of the over-valuation was land and commercial property prices - do you remember how it was calculated that the Emperor's palace in the middle of Tokyo was worth more than the entire state of California? Here it was house prices, and the invention of that expression "negative equity". In the US it is stock market prices, and the phrase "paradigm shift".
My own perception is that, first, US valuations are indeed too high; that two, there has nevertheless been a step change in US economic performance; and that three, the balance of probability is that there will still be a sharp global slow-down beginning before the end of next year and lasting through until, perhaps, 2003.
How can one justify this somewhat gloomy view? The first thing to say is that it is not that gloomy. There is such a thing as the business cycle and though each cycle is slightly different the best we should hope for is mild cycles rather than vicious ones. So at some stage there was always going to be a period of below-trend growth in the US. The boom has been astonishing and many of the reasons behind it are justified: the new technologies are not only creating new focal points of growth, but they are lifting the efficiency of the old industries too.
The problem is that the US markets have not taken on board the possibility of a period of slower-than-trend growth, or the interaction between this slower growth, asset prices and consumer demand. Intellectually they may accept it, but emotionally they don't. When the slow-down comes it will take the country by surprise.
What will be the effects? Let's assume that the US will be flirting with recession before the end of next year. That will lead of a second downward leg of the emerging market crisis, and will stall the European and Japanese recoveries. But the recession may not need to be very deep. Valuations elsewhere in the world are not so stretched; for example land prices in Japan, currently still falling, may well have come back to reasonable levels by Japanese historical standards. Nor is there much of a danger in the US that even a sharp fall in share prices would lead to failures in financial institutions.
In particular the adaptability and flexibility of the US economy will enable it to make a reasonable recovery after a year or two of slow growth. The US may be able to avoid recession altogether, though I expect a technical recession (two quarters of negative growth) is more likely. The key to weathering the slow-down without long-term damage to the US economy will not depend so much on the severity of the recession, but more on how quickly the recovery comes. Flexible America will be better placed than less-flexible Europe and a still-rigid Japan - unless and until Europe and Japan learn more of America's tricks.
Can you then prick the bubble slowly? No, you cannot - the cartoon is right. But once pricked, the bang may prove less damaging to the rest of the world than is currently feared. Or at least that is what both Dr Greenspan and the rest of us should hope.
The best hope here in Britain is that we will not be swept up too badly with the bursting of the American bubble. We have not experienced here anything like the same degree of overvaluation of assets.
Our house prices, for example, are still standing - despite the recent rises - at around three-and-a-quarter times average earnings, compared with a peak of more than four times earnings during the UK bubble in 1988. Share prices are towards the top of their post-war range as measured by P/E ratios. But they are not above them.
People used to say that when America sneezed the rest of the world caught a cold. The best hope is that when America does catch its cold, adaptable economies like the UK's will merely experience a snuffle.
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