Economic View: 'Disasters' aside, the downturn hasn't changed shape: we're still on course for a soft, not a hard, landing

It was a black week on the markets, there's more bad news to come and the 'r' word is growing in currency. But global growth continues

Hamish McRae
Sunday 27 January 2008 01:00 GMT

Davos – "Less of a disaster, more of a slog" was the way I assessed the global economic outlook in last week's column, promising to report on whether this squared with the judgements of the world's business community gathered here in the Swiss Alps for the World Economic Forum.

Well I think that is basically right, but from the way the markets have behaved in the intervening week, you might conclude it's been less slog and more disaster. It was certainly a disaster for one of Europe's largest banks, Société Gé*érale, whose plight was made vastly worse by the market conditions. I wonder whether Hollywood will make another Rogue Trader film. Last week was not a great one either for the US Federal Reserve, which may in the short run have helped rescue the markets with its emergency cut in interest rates, but may also have made a strategic error by showing signs of panic. The US cost of borrowing is now below the level of inflation – the country has negative real interest rates. That is not sustainable in the medium term. Indeed it was negative real interest rates that helped cause the sub-prime disaster as they encouraged irresponsible lending in a hunt for yield. Besides, the problem facing US money markets is the lack of availability of credit more than its price.

A bumpy week in the markets underlines another theme noted last week: the disconnect between financial conditions and what is happening in the real economy. We are not yet through those market ructions and people here think there will be other nasties to come out. But in a way the SocGen story is good news: part of the whole process of bringing discipline back to banking is for huge institutions to be forced to face up to their stupidity. The Bank Credit Analyst (BCA) group in Montreal notes that US bank shares may be bottoming out, rather as they did in previous credit cycles.

As far as the real economy is concerned, it is hard to argue that the fundamentals are really deteriorating. If they are, at least it's not by much. Forecasts for growth this year are coming down, but I think they are just catching up with what is already out there rather than telling us anything new.

The BCA group offered another intriguing insight last week: the surge in references to "recession" in the press. You can see the results in the graph. Fun stuff it is, but what should we make of it?

The first thing is, you shouldn't believe everything you read in the papers, though at least we journalists are better than the ratings agencies, which lag so far behind reality in both their upgrading and downgrading of risks that they are almost a contra-indicator. When they are cheerful, it is time to take cover; when they are despondent, expect things to brighten up.

What newspapers do well, though, is to provide an indicator of the mood of the business community, and in North America the fear of incipient recession does now seem to be at a similar level to previous cycles.

Again, I find this comforting; the bad news is in the public domain. But that fear of recession is at red-alert levels says nothing about the likely depth of the downturn or indeed whether there will be one at all. Even if there is, global growth continues.

There is a lot of stuff here in Davos about the US being a wounded giant, but there is also a lot of stuff about the growth of the "Brics" (Brazil, Russia, India and China) and of the power of sovereign wealth funds (SWFs).

This last group, the funds that governments mostly in the Middle East and Asia have accumulated either from energy or from export earnings, are the new kids at the top table. Gordon Brown praised them in his speech to the meeting on Friday. Others have not been so welcoming, but the SWFs are not all the same and accordingly should receive a different response. How do you compare, say, the funds of Russia and Abu Dhabi?

As it happens, Breakingviews, a UK-based online service providing assessments of financial events, has just launched a way of comparing the largest SWFs. It looks at transparency, whether the funds want to control management and the friendliness or otherwise of the government concerned. There are some surprises: Russia's fund is transparent and it is not apparently seeking to control the organisations in which it invests. Abu Dhabi, by contrast, is very friendly to the West but is completely opaque: we don't even know the size of the fund itself. So Russia ranks higher.

Evident here is that the world's businesses are now likely to have a new set of shareholders – a new barony to which they are answerable. There will be a power shift from mostly Western institutional investors towards foreign investors – particularly the SWFs, which have increased their footprint by helping inject new capital into troubled US banks. SocGen decided not to go to them but rather to its existing shareholders for more money to replace its losses, but that does not change the overall picture, for over the next few years the SWFs and Asian investors in general will inevitably become the main new source of funds for Western equities. That is the main source of global savings and those savings will be used to buy Western assets.

This is surely the big point. Yes, there will be some sort of global downturn, though given the present momentum of the world economy, my view remains that 2009 will be more of a worry than 2008. But the scale of the downturn will be mitigated by continuing demand from the Brics – or, to put the point slightly differently, continuing demand from these countries will help prolong the present global expansion.

However, correcting the imbalances that have grown up in the US, and to a lesser extent in the UK, will take at least two or three years. Amid stories about recession, this downturn will not, when plotted on a graph, look like a V. It is much more likely to be a shallow U. And no, it will not look like an L. Mercifully, that is most unlikely.

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