Bears in the WoodsDespite the troubled markets, the world economy is still relatively stro
Bears in the Woods
Despite the troubled markets, the world economy is still relatively strong. Just don't bet your house on it.
The woods and the market
If you meet a bear in the woods, try not to panic or scream; on no account should you turn your back and run. As markets around the world have turned grizzly over the past two weeks, some investors seem to have forgotten the old hikers' maxim. After three years of big gains, many stockmarkets have dropped by 10% or more in less than ten days. The loudest complaints have echoed around emerging markets and commodities. Europe has surrendered most of this year's gains. Americans have so far escaped lightly, but they would be unwise to take comfort. Their housing market, the recent rock of their economy, is where a much grizzlier creature lies in wait.
Most investors tend to look first at equity markets---and they have certainly had a good run virtually everywhere. Yet a repeat of the slump after the bursting of the dotcom bubble in 2001--4)2 remains highly unlikely. In 2000 shares were wildly overvalued. Today price/earnings ratios in most stockmarkets are near, if not below, their long-term averages. This suggests that the slide in shares could be short-lived.
Inflation or interest rates?
So what has caused this burst of volatility? One popular explanation points to the fears of rising inflation and hence higher interest rates. Yet this sits oddly with the decrease in bond yields and the gold price over the past week: if inflation were the reason, you would expect both to have risen. The real puzzle is not why volatility has suddenly increased, but why it had been so low in the past year or so. The answer seems to be an abundance of cheap money, which attracted investors into satisfaction. Now they are starting to demand higher returns on riskier assets. Emerging-market equities, not (generally safer) bonds, suffered the biggest loss in the past week. It could be a healthy correction, though.
What helped us to achieve growth with low inflation?
Indeed, the recent sensitivity need not harm the world economy, which even bears admit has performed greatly. World GDP has grown at an annual rate of more than 4% for 11 consecutive quarters. This is the strongest upturn for more than 30 years. Yet global inflation remains historically low. Strong growth with mild inflation is all the more amazing given the tripling of oil prices since 2003. Past off-price shocks have caused stagflation.
The world has so far shrugged off higher oil prices with the help of two powerful economic forces. The first is the opening up and integration into the world economy of China, India and other emerging economies, This has given the biggest boost to global supply since the industrial revolution.
That, in mm, has magnified the second stimulus. Since the bursting of the dotcom bubble, central banks have pumped out cheap money. In 2003 average short-term interest rates in the G7 economies fell to their lowest in recorded history. Because inflation remained low, the central banks have been slow to mop up the excess liquidity. Cheap money has encouraged households, especially American ones, to borrow and spend lavishly. It is not just house prices that have surged ahead; cheap money has encouraged investors across the world to take bigger risks, creating several smaller bubbles. Together the huge boost to supply (from emerging economies) and the huge boost to demand (from easy money) have offset the burden of higher oil prices, creating the once-impossible combination of robust growth and modest inflation.
Don't panic
The era of cheap money is nearing an end. For the first time in 15 years, the three big central banks are now all tightening monetary policy. The European Central Bank has already followed the Federal Reserve's lead in raising interest rates. Only now are
A.Y
B.N
C.NG