Serious Money:The world's stock markets delivered a reality check to investors in recent weeks and the theories espoused by the peddlers of perennial optimism have been shot to pieces, writes Charlie Fell.
The notion that the US economy would land softly is no longer tenable and the fantasy that the rest of the world, notably southeast Asia, would decouple from the travails in the US, which commands the largest share of global gross domestic product, has not survived the verdict of the marketplace.
Recession talk is everywhere and the gloom is no longer centred exclusively on the US. Japan is on the brink, the UK is not far behind and the deflating Irish and Spanish housing bubbles are cause for concern.
The US economy is in recession and such a view is rapidly becoming consensus, but investors tend to believe the downturn will be brief and mild. This standpoint is easy to understand as it is human nature to look to recent history when decision-making. The US economy has suffered just two recessions in 25 years and both have been short-lived and not particularly harsh.
Unfortunately, today's downturn could prove to be a completely different animal.
US households are addicted to credit and have tapped asset-based gains in recent years to maintain consumption in the face of income gains that have been decidedly below par.
Indeed, the advance in household income so far this cycle has fallen more than 10 percentage points below the cumulative gains recorded at a similar stage in the previous four economic expansions on average. This translates to a shortfall of almost $500 billion (€338 billion) in consumer firepower.
The door to asset-based gains has closed as house prices decline and year-on-year stock price gains disappear.
The world's "consumer of last resort" must also come to terms with less certain income gains as the labour market softens. The banking system is unlikely to help as depleted balance sheets are in need of repair. Indeed, a full-blown credit crunch is entirely possible as weakness and defaults spread to commercial real estate, high-yield credits and beyond.
A thorough analysis of the difficulties that confront the US economy suggests that, at best, growth will be below par through 2008, 2009 and beyond. Alternatively, the inevitable recession could be more severe and longer-lasting than consensus beliefs. Debt in moderation imposes discipline but in excess it is dangerous and US households need to learn how to live in the old-fashioned way.
Investors question whether the rest of the world catches a cold when the US sneezes. The world's stock markets have answered. Indeed, US stock markets outperformed as Hong Kong shares suffered their worst day in history, as trading on the Indian stock market was suspended and as the value of Chinese equities dropped precipitously - so much for decoupling.
Financial decoupling is null and void, but can the high-growth Asian economies survive a US recession? The answer is no. It is certainly true that China is the largest trading partner of several countries in the region, but this is a function of the globalisation of world supply chains. Roughly 70 per cent of the region's exports reach the industrialised world.
The decoupling thesis has not survived the testing conditions of the real world. Asian stock markets were relatively calm through the subprime jitters, but that is hardly surprising as housing troubles are local. The problems have since spread and the economic difficulties emanating from the US have gone global. Investors should steer clear of emerging markets for now.
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