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The fear spiral
August 14, 2007
Clifford Bennett, FxMax

Are we at the edge of a new reality, a sustained fear spiral? The historical irony is that China may actually save the capitalist day. Clifford Bennett reports

European Central Bank intervention to provide liquidity underscores the depth of the current crisis. Let there be no mistake this is not one of those “will blow over in a few days” scare mongering phases. This is a full blown crisis of liquidity that is quickly spreading, and has the potential to grow into a global crisis of confidence.

Perhaps what stands between a sudden unwinding of global growth and a sustained 2-3 year bear trend in global equity markets, is the continued strong and independent growth of China. The historical shift of economic power from New York to Beijing/Shanghai is palpable. Only a few months ago, and for the very first time, global equity markets responded in kind and were driven by a sharp fall of the Chinese stock market.

It used to be the accepted wisdom that New York drove or at least significantly influenced global equity markets in general. Fortunately that is not entirely the case today.

We now live in a world of a different economic nature. The new reality has China in the driver’s seat. This shift has already taken place.

The key points here are:

1. Financial markets will deteriorate further before they get better.
2. Equity markets may enter a sustained bear phase medium term.
3. The US economy may well be in recession by year end.
4. The global economy will continue to expand at a robust pace.
5. Expect increased volatility, in commodities and commodity stocks, even over what we have already seen, but they should be the first to bottom and recover.
6. The ASX 200 needs to hold above 5,930 to maintain any prospect of immediate recovery. Medium term risk is 5,500, perhaps 5,020.
7. After the volatility in currency markets caused by the unwinding of highly leveraged carry trades, the US dollar will resume it’s decline in spectacular fashion.
8. The Australian dollar will attain parity with the US dollar, US$1.00, by the end of 2008.

Why this macro economic long term historical point is so crucial immediately on the day, and over the next few weeks to months, is that the US economy will be the one to suffer the most and significantly from the steadily spreading wave of uncertainty, bordering on fear, currently emanating from the sub-prime market.

In the US the sub-prime meltdown hits the economy simultaneously at two levels.

1. The financial and banking sector gets an immediate significant hit. The full impact has only just begun to surface. The effect will expand to other areas of investment banks as broad based client caution spreads to all aspects of that entity. Bear Sterns is the clearly the first in the firing line in this regard, but perhaps not the only one.

2. At the ground level of the economy the housing construction industry, already in consolidation, could potentially freeze. The US economy will be squeezed from the ground up and from the ivory investment towers down, at exactly the same time.

Usually, and we have seen this many times before, one sector of the US economy may have an off period, consumer spending may slow, but investment spending takes up the slack or vice versa, equity markets may turn down for a period but the US consumer just keeps spending. This time however we face the prospect of falling equity markets, dwindling fresh investment flow, and dramatically slowing housing construction, all at once.

It is highly unlikely the previously resilient optimism of the US consumer at the shopping mall will save the day on this occasion.

The US runs a real risk of immediate widespread economically stalling caution at every level. The emotion of ‘caution’ is likely to dominate in the near term, and if equity markets continue to trend lower, this emotional level could easily spiral into ‘fear’. That would generate a US recession in Q4 this year, and into 2008.

Such a scenario does not necessarily mean a similar slowing of the global economy. We have already seen the US slow significantly, while the global economy has gone from strength to strength. We live in a less US-centric global economy than we have ever before seen.

The strong growth of intra-regional trade in South America, Asia, and Eastern Europe, and between these regions and a resurgent Western Europe, has allowed manufacturers to continue to prosper even when US demand wanes. Japanese exporters were pessimistic as the US slowed yet their actual export volumes positively surprised even themselves.

So in terms of real economic behaviour, the global economy is now mature enough, and insulated enough through greater diversification of trade flows, to deal effectively with a US recession.

The global economy will continue to grow strongly, and will be increasingly lead by China. It may be a different matter when it comes to financial markets however.

It is important to be aware of this distinction, that we are at the edge of a sustained crisis, but one that operates globally, or spreads from the US to the rest of the world, in a decidedly different manner in the financial markets to that of the underlying real economies.

We may have a period of consolidation, even a bear trend in global equity markets, while the real global economy maintains the current pace of expansion, continuing to support corporate profits outside of the US.



Technically immediate support at 5,930 is important. A move below there could see further capitulation of market psychology toward 5,500, perhaps 5,020. A recovery of resistance at 6,050 would be a little encouraging, but really we need to get back above 6,185 to be sure the absolute low of this significant down phase has been seen. For now further downside is still the dominant risk.

Clifford Bennett, Chief Economist, FxMax. For further information regarding FxMax please email Clifford Bennett.