Nervous Markets Ignore Economic Fundamentals
From the March 11, Sunday Times (London)
March 12, 2007
by Irwin Stelzer
It seems that share and commodity prices move in more than one direction -a fact that has come as a shock to some investors. It seems, too, that a perfect storm created by a glitch in the share-price reporting system, an unrelated bit of turmoil on China's market, and Alan Greenspan's unexceptionable statement that a recession is a possibility can cause a stampede to the exits. Not a bad thing, it turns out. Investors have been reminded that there is something called risk, and the prices they pay for the assets they want for their portfolios should reflect a realistic appraisal of that risk.
Some risks, of course, do not lend themselves to precise quantification. President Bush might decide not to leave it to his successor to cope with a nuclear armed Iran, and take steps that trade a steady flow of Middle Eastern oil for long run security. Islamic radicals might overthrow the House of Saud, and have such a preference for caves over palaces that they shut down the kingdom's oil production. Even Greenspan, brave enough to assign a one-in-three possibility to a recession this year, wouldn't try to assign a probability to those scenarios. Nor would he try to predict short-term movements in share prices, which lesser mortals seem to do daily for the delectation of the media.
In making sense of what is going on in the US economy, it is important not to confuse the gyrating market for shares with the underlying economic fundamentals. Almost exactly 70 years ago, John Maynard Keynes surveyed the US economic scene and opined that a slump was unlikely, and that should a recession occur it "would probably appear to the future historian as merely an incident in the upward movement".
But Keynes, a successful investor despite some major misjudgments along the route to material comfort, distinguished the economy from the markets. "On the other hand ... I am much less optimistic of the markets ... They will need continual fresh stimulus, if they are to go higher ... The errors the market will make will definitely be of pessimism and ... prices will be often lower than the underlying situation really warrants ..."
Which brings us to the present-day "underlying situation". It is no news that the housing market is in the doldrums. Inventories of unsold houses are high; builders are pulling back on construction, writing off the value of land they hoped to develop, and offering incentives to prospective buyers; home prices are softening, and speculators who stocked up on Florida condos find their investments below water, if I may be permitted a pun.
More important, institutions that made mortgages available to buyers whose creditworthiness was questionable are wishing they hadn't. HSBC, which is to write off $11 billion in uncollectable loans to low- income families is not the only lender that has had its fingers burnt in the so-called sub-prime mortgage market, which is in meltdown.
Nor is it any news that the economy is slowing. But there is a big difference between slower growth and recession. The recent survey by the Federal Reserve Bank of Kansas found "modest expansion" around the country, with "steady growth in retail sales", "generally positive" tourism activity, "steady or expanding manufacturing activity", agricultural conditions "generally improved", and tight labour-market conditions.
Some areas -most notably Boston and Dallas -seem to be slowing more than others, and car sales are weak in most places around the country. But, all in all, at least for the present, the economy is doing exactly what the Fed wanted it to do when Greenspan began ratcheting up interest rates: it is cooling. The "froth" is off house prices, investors are realigning share prices with more reasonable expectations of risk and growth, and people who shouldn't be lending to people who shouldn't be borrowing are writing down the value of their enterprises. All of these are arguably in the long-run interests of a healthy economy.
The worrying question is the one raised by Greenspan -will slower growth morph into a recession? Fed chairman Ben Bernanke doesn't think so, and is sticking to his projection of "moderate growth in the US economy". Fed governor Kevin Warsh believes there is sufficient liquidity to permit financial markets to continue to function well in the face of higher volatility. Treasury secretary Hank Paulson says the economic fundamentals are sound. And the president of the Federal Reserve Bank of Chicago says "the underlying economic fundamentals are conducive to a pick-up in growth as we move through 2007 and 2008".
They would say that, wouldn't they, argue critics. With growth in corporate profits due to fall from the double-digit levels of recent years, car sales slow, the weakness in housing and manufacturing seeping into the service sector, durable goods sales down, Greenspan's one-in-three odds seem too low. Unless you are impressed with the facts that growth is picking up around the world, and with it our exports, consumer confidence is high, mortgage applications seem to be showing signs of life, jobs are plentiful, investors were confident enough to pour $29billion into volatile markets in the week ending March 6, and incomes and unit labour costs are rising. In which case worry about inflation, not recession.
Perhaps the public knows more than the economic experts. Americans are relaxed.
Over 70% say their finances are "very" or "fairly" secure, and 90% say they are "not too likely" (33%) or "not at all likely" (57%) to lose their jobs. That might explain the relative buoyancy of retail sales, and the unwillingness of Americans to get depressed by the painful realisation that their homes are no longer ATM machines.
Irwin Stelzer is a Senior Fellow and Director of Economic Policy Studies for the Hudson Institute. He is also the U.S. economist and political columnist for The Sunday Times (London) and The Courier Mail (Australia), a columnist for The New York Post, and an honorary fellow of the Centre for Socio-Legal Studies for Wolfson College at Oxford University. He is the founder and former president of National Economic Research Associates and a consultant to several U.S. and United Kingdom industries on a variety of commercial and policy issues. He has a doctorate in economics from Cornell University and has taught at institutions such as Cornell, the University of Connecticut, New York University, and Nuffield College, Oxford.