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Dismal long term view from the Roach

Insight: Watch out for aftershocks
By Stephen Roach

Published: April 14 2008 17:15 | Last updated: April 14 2008 17:15

The author is chairman of Morgan Stanley Asia

But do not confuse that possibility with an all-clear sign for the real economy, stock markets or the political cycle. As the US slips into recession, a chain of increasingly powerful feedback effects is likely to follow. The after-shocks of this crisis will shape the landscape for years to come.

Financial markets have breathed a sigh of relief that the worst may now be over. Maybe that is the case for the crisis, itself.

Every financial crisis is different, but at some point, they all end. It is hard to know if the end of this one is at hand, but there are grounds to believe the worst of the fire-storm may be burning itself out.

Among the reasons: liquidity injections by central banks, especially the US Federal Reserve, have erred on the side of overkill. Moreover, some of the actions have been unconventional, especially the opening of the Fed’s discount window to investment banks for the first time since the 1930s.

And the failure of Bear Stearns is reminiscent of similar catharses that have marked the bottom of earlier crises, from the failure of Herstadt Bank in 1974 to the demise of Long-Term Capital Management in 1998.

However, there is far more to the macro end-game. This crisis has been big enough to have triggered a host of feedback effects that should endure long after financial markets begin to heal.

First and foremost, there is the impact on the real economy. This is particularly true of the US, where income-deficient, housing-dependent consumers are caught in a vice between a cyclical erosion of labour income and the bursting of housing and credit bubbles. Add to that a steep recession of homebuilding activity, and risks have tipped decidedly to the downside for fully 78 per cent of the US economy. As a result, corporate profits should fall well below expectations, especially for the non-financial component of the S&P 500. As indicated by the recent earnings shortfall at General Electric, such optimism, in the face of recession, points to especially painful feedback effects for the stock market.

Second, there are lagged impacts on the broader global economy. In an era of globalisation, the world economy has become tightly linked through cross-border flows of trade, financial capital, information and labour. Export-led developing Asia has been a big beneficiary of the surge in global demand and world trade over the past five-and-a-half years. Now that the global business cycle has turned, Asia will have a very hard time decoupling itself from a consolidation of the US consumer.

Third, it seems quite likely that bruised and battered financial institutions will have to contend with an additional round of pressures. Until now, financial intermediaries have been hit mainly by crisis-related disruptions on the credit front. But as is typically the case with erosion on the demand side of the real economy, a cyclical deterioration in loan quality for households and businesses is coming.

Fourth, feedback effects could also hit commodity markets – the sole surviving bubble in an increasingly bubble-prone world. By now, most are convinced that commodities are in a permanent “super cycle”, with the limited expansion of supply failing to keep up with a growing appetite on the demand side of the equation sparked by commodity-intensive economies such as China and India. However, with global GDP growth in 2008-09 likely to fall well short of the near 5 per cent average pace of the past five years, a cyclical correction in the prices of oil, base metals and other non-food commodities seems likely.

Fifth, a political backlash to this crisis is likely to lead to a new wave of re-regulation. Just as the bursting of the dot-com bubble and an outbreak of corporate accounting scandals led to passage of Sarbanes-Oxley Act of 2002, US politicians now seem equally committed to a recasting of the regulatory framework governing financial markets. The US Treasury has already fired an opening salvo in what is likely to be an intense and drawn-out debate. As an added twist, look for the US Congress to rewrite the Fed’s policy mandate to make the central bank more accountable for avoiding destabilising asset bubbles in the future.

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April 15, 2008 Posted by | Uncategorized | , | Leave a comment