Threats to Global Economy and Markets

Wednesday, February 17, 2010

The blood pressure of the investment community has been elevated several notches in recent weeks as threats to the global economic recovery have surfaced. Stock markets around the world have slumped with unnerving volatility, even though a consensus of economic forecasters have reassuringly continued to project a solid if not spectacular global recovery in 2010 and the latest batch of corporate earnings reports have been well above analysts’ expectations. Creating additional palpitations has been a sharp drop in commodity prices and a corresponding rise in the dollar as risk-averse investors have responded with a flight to safety.

The Economist (February 13-19, pp. 13, 70-72) provides an excellent, succinct overview of the dangers confronting the world economy and offers pragmatic recommendations to government and central bank policy makers. In its cover article, the magazine emphasizes the gulf between the troubled U.S., European, and Japanese economies “where there are few signs of strong private- demand growth,” and the leading emerging economies of China, India, and Brazil, where there is “strong growth in domestic demand and scant spare capacity.”

The challenge for the policy makers in the developed countries is to engineer growth even as they are forced to come to grips with massive budget deficits. The problem is especially vexing for European leaders, who are under pressure to formulate a rescue plan for Greece and, possibly, for Portugal and Spain as well. We think the European Union will successfully if grudgingly provide a solution that will calm jittery currency markets, although the remedy may result in painful austerity for the indebted countries and political fallout for those governments, notably Germany, that may be called upon to finance a bailout.

In sharp contrast, the Chinese, Indian, and Brazilian governments are concerned that rapid growth will trigger inflation and create asset bubbles. Policy makers here are taking steps to rein in growth, which in turn worries some investors that their braking activity will become excessive and produce a slowdown that endangers the global recovery. The focus is on bank lending restrictions imposed by the Chinese government since the beginning of the year. We share The Economist’s view that “for all the market’s worries, there are few signs that it [the Chinese government] will tighten too much too fast. A slowing is possible, but a serious stumble seems unlikely.” We also note a recent article in The Wall Street Journal (2/8/2010), which reports that last week Citigroup, Bank of America Merrill Lynch, Goldman Sachs, and J.P. Morgan Research all issued reports touting upside expectations in emerging markets this year.

Although we think these threats to the world economy and equity markets will eventually be resolved without calamity, we also acknowledge that investors should not become overly sanguine. We will continue to monitor closely these international developments and we remain flexible. We also alert clients to expect market volatility until these matters are resolved.