28 February 2007

US recession and financial distress

Today we had a meltdown of many stock markets, first in China, then in Europe, the U.S., emerging markets and globally. What happened today is consistent with my outlook for a U.S. hard landing this year.
The China crash had its source in the stock market bubble in China that is now beginning to burst as Chinese authorities started to crack down on these speculative excesses. This crash may be the beginning of a broader downward adjustment in the stock market in China that may lead to a broader economic slowdown in China.
We also had contagion from China to other global stock markets. This contagion is a combination of the China crash and of the lousy economic news out of the US. ..This is not the first time that financial contagion happens from emerging markets to advanced economies: in the fall of 1997 when the Asian crisis became global a collapse of the Hong Kong market in October led to a sharp sell-off of the Dow Jones (500 points in one day), as the one we had today. Also the collapse of Russia in August 1998 led - with a short lag - to contagion to US financial markets and to the LTCM near-bankruptcy. So shocks from emerging markets can affect markets and economies in developed countries, especially when the latter have meaningful financial and real vulnerabilities, like the US today.
The US is likely to enter into a recession in 2007; and even a likely and early easing of monetary policy by the Fed will not prevent such a recession as there are too many weaknesses in the US economy: a housing recession, an auto recession, a manufacturing recession, a real investment recession (as corporations are reducing real capital investment and inventories are falling), a US consumer that is on the ropes and at its tipping point; a meltdown in sub-prime mortgages that is leading to a generalized credit crunch in the economy. It is already ugly and it will get uglier in the real economy and in the financial markets. We are likely to observe a vicious cycle where a credit crunch and a persistent sell-off in equities leads to a worsening of the real economy with a hard landing (recession) that then weakens further the financial system. One cannot rule out a broader banking crisis if a deep recession occurs.
What will be the fallout of a US recession for the rest of the world? Europe, Asia and the rest of the world will not decouple from a US hard landing. If the US were to experience a soft landing Europe and the rest of the world will do fine. But if a US recession does occur there will be a significant economic slowdown in Europe, as well as in China, Asia and other emerging markets. China will be a primary victim as its excesses and its dependence on exports to the US are particularly important. So it is still the case that when the US sneezes the rest of the world gets the cold.
A US recession will be the result of the bubbles and excesses of the US economy in the last few years: a housing bubble now going bust; negative household savings; negative government savings (i.e. large budget deficits), low national savings and thus a large current account deficit. The party will be soon over; and the complacency and under-pricing of risk in financial markets will soon be corrected with painful consequences for the US and the global economy. The US economy has been living in a financial bubble for too long. Now this bubble is bursting – yesterday in housing and sub-prime, today in the stock market, soon enough in a wide range of other risky assets. The fallout will be very painful for the US and the world once a US recession and severe financial sector distress interact in a vicious cycle.

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