Fighting contagion

SERIOUS MONEY:Last year will be remembered not only for the panic that gripped the world's credit markets but also for the emergence of global decoupling as a dominant investment theme.

The developing world proved largely immune to America's growing subprime virus, enabling global growth to exceed 5 per cent, comfortably above the long-term average of 3.7 per cent.

Emerging stock markets outpaced their developed counterparts by a considerable margin. In an ironic twist of fate, 10 years after the east Asian crisis and almost a decade since the oil price collapse of 1998, the world's leading investment banks have turned to the embarrassment of riches held in the coffers of the increasingly influential sovereign wealth funds in Asia and the Arabian peninsula for much-needed capital to shore up their ailing balance sheets.

The global decoupling thesis will face a stern test of its credentials in the year ahead as the American economy sinks into recession. Economic contagion has been limited so far simply because weakness has been confined to the non-tradable housing sector, to which the emerging world has proved impervious.

However, deteriorating fundamentals in the world's largest economy have seen the prospect of an American recession, however brief or mild, become consensus opinion. It is fanciful to believe that Asia's export-dependent economies and the Persian Gulf's reliance on high oil prices will emerge unscathed.

American households face serious headwinds that could bring an end to the largest debt-fuelled spending binge in modern history. A consumer-induced recession would have serious implications for the global economy as household spending in the US accounts for almost one-fifth of world GDP.

The result would surely be lower oil prices and east Asia would undoubtedly suffer as, contrary to conventional wisdom, the region is more dependent on growth in the industrialised world than ever with the export share of GDP close to record levels of more than 45 per cent.

The American consumer has been the driving force behind the global economy since the mid-1990s and has continued to be the world's "consumer of last resort" in recent years in spite of modest income gains arising from sub-par employment growth and lacklustre increases in real wages. 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 of the previous four economic expansions on average, which translates to a shortfall of almost $500 billion in consumer firepower.

Sluggish income gains did not curtail American households' free-spending ways, however. They increasingly turned to the wealth gains on their rapidly appreciating homes in order to keep the binge alive. Mortgage equity withdrawals soared to more than $700 billion in 2005 or almost 9 per cent of disposable personal income and more than compensated for the dismal increase in real income.

However, America's worst housing recession in modern times closed the door to this source of funds and with it a substantial component of incremental spending.

A sustained decline in home prices could precipitate a much-needed restructuring of consumer finances. Residential property values are already falling and the more than 10-month supply of existing homes ensures that prices will remain under pressure throughout 2008 and could drop by a further 10 to 15 per cent.

Given that households accumulated a record amount of debt and other liabilities relative to the market value of their assets in the face of rising house prices, retrenchment as values decline could be both material and prolonged. The outlook for household income is hardly encouraging, given that employment growth is sure to disappoint as corporate earnings recession takes hold. Big business report-

ed the first year-on-year dec-line in profits in more than five years during the third quarter of 2007 and corporate profitability will remain under pressure in the year ahead.

Nominal economic growth for 2008 is likely to be at levels that have historically been accompanied by declining earnings. Furthermore, earnings relative to their 10-year average are at their highest level in almost 60 years - which means reversion is sure to follow.

The implications for the labour market are obvious - the unemployment rate is sure to rise in the months ahead.

America's overstretched consumer may face a day of reckoning in 2008 given the less than encouraging outlook for both income- and asset-based gains on top of the budgetary constraints posed by high food and energy costs.

This should spell trouble not only for the developed world but also for the export-driven economies in Asia and oil-reliant countries in the Persian Gulf. An American recession should bring a bear market to Wall Street and, though the inevitable downgrade to growth prospects is unlikely to derail Asia's upward trajectory, it should be enough to spook equity investors.

Investors are well-advised to place safety before risk for now.