A few snippets from the news this morning:
- The IMF says inflation is the main global concern and interest rates should rise.
- Merrill Lynch’s latest fund manager survey shows that an unprecedented 41% now think a global recession is either likely or very likely.
- The Dow Jones jumps 1.7% as JPMorgan’s earnings beat expectations.
- Shares in Fannie Mae and Freddie Mac surge 22%.
- Merrill Lynch posts $US4.9 billion loss and looks to sell $US8 billion in assets because fresh capital is unavailable.
The greatest challenge for us all at present is to make sense of the conflicting forces of stagflation and the wild insecurity of markets.
The last item on that list is easy – the SEC ban on naked short selling, combined with total confusion about bank capitalisation and official rescue intentions, has produced a quick bout of short covering.
There’s also a view among long-only managers that the US market may have bottomed.
The IMF’s chief economist, Simon Johnson, is right that rising inflation will make matters worse later if it’s not controlled now, but probably wrong that growth will be 4.1% this year (up from the April forecast of 3.7%) and 3.9% next year.
That’s certainly what the market is saying; global investment managers are in an absolute funk. Merrill Lynch’s chief global investment strategist David Bowers said: “The survey has never seen anything like this since it began a decade ago. Recession risk has taken over from inflation risk.”
However a slight majority are overweight US equities, betting that all the bad news is in the price. They are also overweight cash and, surprisingly perhaps, Russia. They are underweight India, Chile, Korea, Taiwan and Malaysia.
And they are worried that China has been destabilised by its currency peg against the US dollar as the Fed has cut interest rates to 2%. As a result China is importing inflation and will have to jam on the brakes.
This is potentially bad news for the Australian dollar; a crunch in China after the Olympics to control inflation will send the Aussie into a free-fall and cause a very big headache for the Reserve Bank, which is otherwise gearing up for a rate cut.
But the most immediate problem for the world economy, in my view, is keeping up the flow of foreign investment into the US.
$US700 billion a year is needed to finance its current account deficit; as a result, for example, $US1.5 trillion of Fannie Mae’s and Freddie Mac’s debt is held by foreign investors, along with a record proportion of stocks on the NYSE.
Those foreign investors are all doing it very tough now as the currency falls and the debt and equity securities in which they invested fall as well, sometimes horrendously.
When Japan’s housing and share markets collapsed in 1990, the Bank of Japan was able to reduce interest rates to zero because the country did not rely on foreign capital.
If the US attempted to do this, foreign investment would dry up completely. Even with official rates at 2% and the yield curve steepening, the major concern now about the US is whether foreign investors – in particular the sovereign wealth funds in Asia and the oil-exporters – will lose patience.
Last night’s short-covering bounce in bank share prices, including Fannie and Freddie, was encouraging, as was the Merrill Lynch survey showing that fund managers are net overweight US equities, but it’s unlikely the US banks are out of the woods yet.
What has to be avoided at all costs is a “run on America” by global investors, and right now it is vulnerable to a collapse of confidence because of the combination of falling currency, low interest rates that may have to be cut further and a feeble, confused government in its last days.
A retreat by foreign investors from US and that other Anglo-Saxon deficit country – Britain – is an Armageddon scenario. The world’s financial system is located in London and New York; without capital they would fail and the system would freeze.
This article first appeared on Business Spectator