By Nariman Benravesh
World stock markets have been pushed down sharply by a
convergence of at least four forces recently: 1) a major sell-off
in China's overvalued stock market; 2) data releases that have
highlighted the weakness of the US economy; 3) signs of stress in
US mortgage markets; and 4) ill-timed comments by former Federal
Reserve Chairman Alan Greenspan about the possibility of a
recession.
While stock markets are likely to suffer through more volatility
in the next few months, the fundamentals don't point to an extended
bear market. Moreover, this increased volatility will probably only
have a small impact (if any) on growth.
China's stock market correction was long overdue, but won't hurt
growth.
The nearly 9 percent drop in the Shanghai market on February 27
was relatively small compared with the huge increases in recent
months.
During 2006, the Shanghai composite stock index rose 130
percent, compared with only a 16 percent rise for the Dow Jones
index. After rising steadily for much of last year, this market has
experienced something of a roller coaster in the past two
months.
This volatility is largely a function of three factors. First
the market is very thin the Chinese government is still the largest
stockholder, and only about 10 percent of the shares are traded.
Second, 70 percent of the investors are individuals who tend to be
less patient and more prone to panic than institutional investors.
Finally, the stock turnover in the Shanghai market is three to five
times higher than the New York Stock Exchange. This means that the
market's volatility is likely to remain high in the near future.
Moreover, given the overvaluation of Chinese stocks, further
declines in prices seem likely in the coming months.
Despite concerns about the impact of this event, growth in
China's economy will probably remain very strong in the coming
year. Chinese consumers do not have large equity holdings, and most
Chinese companies do not rely on the stock market for
financing.
Global Insight continues to believe that China will grow by 10
percent this year, despite the National People's Congress targeting
only 8 percent for this year.
While the government is concerned about speculative excesses in
the stock market, as well as housing and real estate in Shanghai
and Beijing, it is unlikely to do anything that will threaten
growth.
China's growth is more important to the global economy than the
Chinese stock market.
While the big drop in Shanghai's market was one of the triggers
of the recent turmoil in equity markets, evidence of a "rice bowl
crash" is very limited.
To begin with, stock market capitalization in the Chinese
mainland is small relative to the United States, Europe and Japan.
Furthermore, the United States and other major markets are not
overvalued. There is little doubt that US stock prices did rise too
much in the past few months, given the outlook for sluggish growth
in the US economy and single-digit increases in earnings.
However, price/earnings ratios are now below where they were in
the mid-1990s. This means that while US financial markets will
likely be less calm than in the past few months, stock prices are
more likely to move sideways than experience a long
contraction.
Consequently, further drops in the Shanghai market will probably
have a smaller impact on the US market than occurred on February
27.
Part of the contagion effect from the Chinese stock market to
the rest of the world had to do with concerns about the potential
impact on the country's growth and, therefore, the impact on export
earnings of the United States, European and Japanese companies.
While China only accounts for about 6 percent of the global
economy, compared with 30 percent for the United States, the
Chinese economy has generated about 15 percent of global growth in
the last five years and accounts for an even higher percentage of
the profits of many multinational corporations.
This global dependence on China's economy is set to grow in the
coming decades. Thus, it was no surprise that in the wake of the
stock market turmoil, companies with large export exposure to China
were hurt the most.
In the final analysis, the sell-off in Shanghai was more of a
wake-up call to investors, who had become too complacent about risk
than the beginning of some global financial crisis.
While the US economy will struggle in the coming months, the
risk of a recession is still low notwithstanding Greenspan's
comments.
One of the larger concerns of investors is the rather shaky
outlook for the US economy. Recent data have been more negative
than positive, suggesting that growth this year will be slower than
previously expected.
On the downside, housing is still stuck in a fairly deep
recession, and a recovery is not expected until the end of the
year. Prices have been falling by about 5 percent in the most
overvalued markets.
While this is beginning to attract some buyers, the inventory of
unsold homes is still around seven months, which is uncomfortably
high for builders.
In the meantime, as prices slide, the sub-prime mortgage market
is beginning to show signs of stress, with delinquency rates rising
sharply and expected to go much higher.
?
So far, the impact on the conventional mortgage market and on risk
spreads in bond markets has been very limited. However, markets are
quite jittery and there has been a flight to quality, as evidenced
by falling government bond yields.
More troubling is recent evidence of increasing risk aversion by
the corporate sector. As a result, capital spending, which was
supposed to be an engine of growth this year, is sputtering.
Similarly, because of the US housing recession and sluggish auto
sales, the manufacturing sector is caught in the middle of a major
inventory adjustment cycle. Weaker inventory accumulation accounted
for half of the downward revision in fourth quarter US growth from
3.5 percent to 2.2 percent. Further efforts by US businesses to cut
inventories are likely to keep growth weak in the first half of
this year.
On a more positive note, consumer confidence and consumer
spending seem to be holding up. This is largely thanks to steady
jobs and income growth. In particular, despite the troubles in the
manufacturing sectors of the economy, the service sectors are still
doing pretty well.
Another source of strength for the US economy is exports, which
have been growing at double-digit rates. Further weakness of the
dollar, along with strong growth in other parts of the world, means
that the US will enjoy export-led growth this year and probably for
the next few years.
Global Insight predicts that US economic growth in the first
half of this year will be between 2 percent and 2.5 percent.
However, we expect growth in subsequent quarters to accelerate
modestly, as the housing downturn eases. For the year as a whole,
growth will likely be around 2.5 percent.
Despite Greenspan's comments, the risks of a recession are still
quite low. While growth could weaken further, if the housing
downturn gets worse or companies become more risk averse, it would
take one or more big shocks to trigger a recession.
Global Insight assesses the probability of a US recession at 15
percent to 20 percent.
Unless the recent stock market volatility in the US turns into
an extended bear market, the impact on growth will be very limited.
The 3.3 percent drop in the Down Jones index on February 27 was
only the 268th largest drop on record. Increased volatility is
unlikely to have an impact on consumer spending, but could make
companies a little more risk averse.
The Federal Reserve's job has once again become more
difficult.
Until recently, the Fed was expected to keep interest rates at
current levels for an extended period of time.
However, the recent market turmoil has increased the downside
risks and the odds that the Fed may cut rates in the late spring or
over the summer.
Two types of events could influence the Fed's decision about an
interest rate cut. First, Federal Reserve Chair Ben S. Bernanke and
his colleagues may have no choice but to ease rates if the US
economy decelerates further, because of a deeper recession in
housing or more weakness in capital spending.
Second, they could move even more aggressively if stock prices
fall by a large amount in the next few weeks and months. In the
past 20 years, the Fed has moved decisively to limit the damage
from large stock market crashes.
Right after the 22.6 percent drop in the Dow Jones index on
October 19, 1987, Greenspan assured markets that enough liquidity
would be provided to ensure that financial markets would not freeze
up. This set the stage for 4.4 percent growth in the following
year.
In the final analysis, while the most likely scenario is for the
United States to avoid a recession, growth will be weak and
financial waters very choppy.
The writer is chief economist of Global Insight, a leading
international economic and financial forecasting firm.
(China Daily March 9, 2007)
