US and Asian economic slowdowns

For the best part of a decade, the US has provided the world with a
comforting sense of global economic security. While Europe was sluggish,
Japan stuttered and emerging markets lurched between boom and bust, the
reliable strength of the US expansion was always there to offer reassurance.
Between 1997 and 1999 the US accounted for almost half of all the growth in
the world economy.

But now the US is in danger of turning into a source of instability. Sharply
slowing growth, plunging consumer and business confidence, volatile equity
and bond markets - and the Federal Reserve's surprise half-point cut in
interest rates this week - all suggest the US economy can no longer be
counted on to provide a safety net.

The fear sweeping through governments and businesses worldwide is that if
the world's biggest and recently most successful economy falls to earth, the
rest of the world will topple.

That fear may be overdone, for even if the US enters a recession, the impact
on different regions of the world will vary. Asian economies and others that
rely heavily on exports to the US will suffer the most. Japan, already in an
enfeebled state, will be weakened once again. But Europe in particular ought
to be able to weather the storm fairly well.

Last year the world economy recorded its strongest growth for a decade as
Europe was boosted by the weakness of the euro, Japan showed fresh signs of
recovery and many emerging economies continued their remarkable bounce back
from the crisis of 1997-98. But forecasts that this year would show only a
modest slowdown seem certain to prove over-optimistic. The International
Monetary Fund has admitted that its estimate of global growth of 4.2 per
cent is unrealistic. Even the latest market forecasts, compiled by Consensus
Economics, the consultancy, of 3 per cent growth in the euro-zone and 2 per
cent growth in Japan, now seem certain to be revised downwards.

Simulations using the IMF's economic model, published last year, suggest
that a fall in share prices that knocked 2 per cent off US gross domestic
product would cut 1 per cent from gross domestic product in the euro-zone
and Japan. If that happened, it might slow the European economy enough to
stop unemployment falling and would yet again defer Japan's hopes of a
recovery.

Yet even a sharp downturn in the US need not set off a global recession.
"We're certainly looking at somewhat slower growth in the global economy but
we do not at this point see anything that could be called a global
recession. Anything less than 2 per cent growth is an outside risk," says
Michael Mussa, IMF chief economist.

For all the talk of the US as the engine of the world economy, the economic
cycles of America, Europe and Asia have not been particularly closely linked
over the past two decades. The economic trends of recent years have had
national or regional rather than global causes.

The US recession of the early 1990s was principally a result of the Fed's
attempts to choke off inflation caused by the over-rapid expansion of the
1980s. Europe's slowdown came later, as Germany bore the costs of
unification and European nations imposed fiscal discipline to enter economic
and monetary union. Japan slumped after property and equity prices fell in
1990 and has never fully recovered. Signs of a revival in 1996 were snuffed
out by a tightening of fiscal policy and the blow to confidence from the
Asian crisis.

The huge US trade deficit - equivalent to some 1.5 per cent of the rest of
the world's output this year - means the US is now a very important for some
emerging market countries. Exports to the US provide a quarter of the entire
national income of Mexico and Malaysia, 8 per cent for South Korea and 12
per cent for Thailand and Taiwan. The concentration of emerging Asian
economies on manufacturing electronics, which helped them recover rapidly
after the 1998 downturn, is also likely to mean they suffer badly from a
technology industry downturn. Economists at HSBC forecast that South Korea
and Malaysia will slow from growth of about 9 per cent this year to less
than 4 per cent next year.

But for most developed countries, the US market is very far from mainstay of
the economy. The euro-zone is relatively closed in global terms, exporting
about 17 per cent of its GDP, and the UK is its biggest market. Exports to
the US account for 2.6 per cent of Germany's national income and 1.7 per
cent of France's. Even adding Europe's modest exports to the emerging
economies that might be hit by a US downturn, the total effect on demand is
likely to be manageable.

With taxes already being cut across Europe, most strongly in Germany and
Italy, domestic demand in the euro-zone will be boosted by about 0.5 per
cent this year. That would be enough to offset any expected loss of export
demand, except in the most severe circumstances.

Europe's links with the US through financial markets may be more significant
than those through trade. The enthusiasm of European companies for acquiring
US assets means that they are more exposed to the US market than before.
Partly as a result, movements in equity prices around the world tend to
follow the US market. Last year global stock markets fell on US weakness, in
spite of the fact that the main worries affecting US markets were domestic.

Yet even if US equities fall further, the reaction in Europe may be muted
because corporate valuations are less stretched. Historic price-earnings
ratios are around 20 in France and Germany, as opposed to 27 for the S&P 500
in the US. European shares lagged the US equity market surge that began in
1995, so they are unlikely to fall so hard.

"What seems to be happening in the US is that everything is normalising:
equities, the dollar, household savings and the trade deficit," says Julian
Callow of

Credit Suisse First Boston in London. "But in Europe we have been pretty
normal already. So we are less exposed to a downturn than the US."

Europe also relies less heavily on equities as a source of of personal
wealth than the US. Equities are worth about 150 per cent of gross domestic
product in the US but only 60 per cent in Germany. So a market crash would
have less effect on spending.

Japan's outlook is less good. Its direct reliance on exports to the US is
not much bigger than Europe's - about 3 per cent of GDP - but exports to the
rest of Asia provide a further 3.6 per cent. In addition, it is vulnerable
to a loss of confidence. The weakness of the Japanese stock market - by far
the worst-performing developed country market last year - and the recent
fall in the yen reflect deepening nervousness about how badly Japan's
fragile economy may suffer.

For the moment, confidence in Europe remains strong: French consumer
confidence hit a new record last month. "The risk, as we saw with the Asian
crisis of 1998, is of a wave of negative sentiment sweeping across the
Atlantic and hitting businesses and consumers," says John Llewellyn, an
economist at Lehman Brothers. If domestic investment and consumption fell,
it would be more serious for European countries than a loss of exports.

The other advantage that Europe has over Japan is that it is possible for
the central bank to make meaningful cuts in interest rates: in Japan rates
are already close to zero. A US and Asian downturn would put downward
pressure on world prices - an effect that has already emerged in the oil
market - and keep the lid on European inflation.

The European Central Bank has scope to cut rates in response. Like the
Federal Reserve in the US, the ECB now has the job of keeping spirits up
during the difficult months ahead. It can at least comfort itself with the
thought that, this time, its job may be easier.

Editorial comment: Dr Greenspan's wonder drug
Published: January 5 2001 20:04GMT | Last Updated: January 5 2001 20:08GMT

Was it a stimulant or a depressant? The market in US technology stocks
responded to Alan Greenspan's half-point cut in interest rates with a wild
whoop of "Yippee!". But after the 14 per cent surge in the Nasdaq Composite
index on Wednesday there was a rapid descent into cold turkey.

Despite a general hope that the US Federal Reserve chairman will soon
administer another fix, the markets have been drifting down again, amid
anxieties of what a chill in the US economy would do to profits and
dividends.

Friday's employment figures were not especially gloomy, but the unexpected
steepness of the Fed's cut showed that it is really worried that the economy
may soon slip from hyperactivity into a dangerous torpor.

For investors, the question must be whether Mr Greenspan can - or will -
lower rates enough to prevent a serious slide in stock prices.

There are two kinds of answer to this question. The first is from the Fed's
perspective. Mr Greenspan has repeatedly indicated that it is no part of his
job to rescue investors from their folly, if they have bid up share prices
to unsustainable values. But at the same time the Fed has a strong interest
in avoiding a panic sell-off that could damage consumers' confidence and so
push the economy into an unnecessary relapse.

Since the Fed has shown now - as in 1998 - that it is prepared to act
pre-emptively to restore financial confidence, investors may judge, as they
appeared to do on Wednesday, that they can breathe more easily.

But aside from confidence, the Fed still needs to ensure that the economy
slows down after four years in which growth has averaged 4½ per cent a year,
well above the rate that even the optimists consider to be sustainable.
Unemployment has almost halved in the last eight years, to 4 per cent, a
level that by historical standards is close to the danger zone of
inflationary pressures. And inflation has been rising in the last two years.

Low annual rate

It is true that this was from a remarkably low annual rate of 1.4 per cent
in early 1998; it is true also that part of the reason for the rise was the
run-up of oil prices this year. But the tightness in the oil markets
reflected the extra demand from a rumbustious US economy. So from all points
of view a slowdown was needed.

If one considered only the real economy, a very rapid slowdown - resulting
in little or no growth in the early part of next year - would not do very
much damage provided it did not last too long. The medicine would be
unpleasant, of course, particularly for those who were laid off. But like a
patient who has had a scare, business investors might take things easier
after the recovery got under way.

Company profits

Unfortunately for stock-holders there is another perspective. Historically,
company profits have reacted in a highly emphatic way to relatively modest
changes in underlying economic growth. In 1979-80, for example, as the
economy turned down, real profits shrank by more than 30 per cent; but they
recovered by 45 per cent between 1983 and 1984. And this was not
exceptional. There has been a pattern of spikes and troughs throughout the
last half-century. The 1990s were exceptional only in that real corporate
profits sustained a steadier rise of about 10 per cent a year up to 1997,
while the fall in profits during the 1998 financial wobble was only a modest
3 per cent

This rise in profits was sustained by a tripling of earnings in the
companies in the Standard & Poors 500 index in the last eight years, a
period in which US gross domestic product rose by "only" 50 per cent. Stock
prices, however, rose even faster than earnings - by more than 4½ times in
the period, presumably because the markets expected the trends of the 1990s
to continue. A period of convalescence for the economy would cause that
assumption to be reconsidered - as the halving of the Nasdaq since last
year's peak vividly suggests.

For investors who take a long view two facts stand out. The rapid rise in
profits as a share of gross domestic product in the 1990s has far from
redressed the balance of the fall in the 1970s. Profits are still only about
8 per cent of GDP compared with about 10 per cent in the 1950s and 1960s.
Through another prism it appears that the average rise in profits over the
last 30 years has been about the same as the growth of GDP. The acceleration
in the 1990s may seem a catch up from the fall in the 1970s.

Even if the recent surge does reflect the impact of new technologies, the 9
per cent rise in profits that US analysts expect for next year could look
extremely optimistic if GDP growth slows to 1 or 2 per cent. So whatever
dosage Mr Greenspan thinks appropriate for the economy may prove too little
too late for the health of the markets.