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(photo credit: )
Three trends have been clearly apparent around the world over the last week or two.
At the macro level, everyone - the IMF, the Fed, private-sector analysts - has been marking down the expected growth rates for major economies in 2008, and even for 2007. At the corporate level, many American companies have issued profit warnings regarding their earnings in the third quarter, the fourth quarter and into 2008.
The big financial firms have made huge write-offs in the third quarter against their battered subprime-related portfolios. Retailers have been warning of reduced spending by consumers. Trucking companies have noted that business is weakening. But despite the negative trends in the macro and corporate sectors, the equity markets have been on a roll.
In a large number of emerging markets, new all-time highs have been made and the "old" ones - from June or July of this year - have been taken out. The American markets are either at all-time highs (such as the Dow Jones Industrial Average) or at multi-year highs (like the Nasdaq). Everywhere, but most especially in China and Hong Kong, it's party time.
You might ask - why are the markets so strong if national economies are slowing and corporate profits are weakening? The answer, from the markets' point of view is that these are minor and transient problems. Market participants are euphoric because the Federal Reserve and other central banks have made it quite clear that they will do everything possible to stave off a recession in the US - despite the growing difficulties facing the indebted US consumer, whose home is losing value and whose access to new injections of credit has been impaired by the credit crunch now underway. Having saved the markets from seizing up because of lack of liquidity, the central banks are now trying to provide enough new liquidity to preempt a serious credit crunch, of the sort which would prevent American consumers from buying as much as they have become accustomed to doing.
One aspect of this policy, discussed here last week, is that it entails debasing the currency. The dollar is losing value against most other currencies, but especially against most commodities.
The more positive side of the return to easy money, however, is that it keeps the wheels of commerce, trade, investment and, yes, speculation, turning rapidly. If the American consumer stops buying, everyone is in trouble. As it is, the US trade deficit has begun to improve in recent months, as Americans cut back on imported consumer goods - while being obliged to pay more for oil and other imported raw materials.
So the equity markets are celebrating the commitment, spelled out in the minutes of the Fed's latest meeting, to do whatever it takes to contain the damage done by the credit crunch triggered by the subprime crisis (yes, that was a long sentence, but it makes sense if you read it slowly). The write-offs and losses of the third quarter are history and even the prospect of a poor Christmas shopping season can be tolerated, so long as it is clear that all this is temporary - because measures have been and will be taken to keep the train on the rails.
In sharp contrast, there has been no similar effervescence in the bond markets. On the contrary, the yield on the US 10-year Treasury bond has risen steadily since the Fed decision last month. Bond market participants are a less excitable bunch and they have probably been thinking about the explicit downgrading of the inflationary threat expressed in those same minutes of the Fed meeting. They note that in countries all around the world, from Iceland to Israel and from Chile to China, the latest inflation readings have been "surprisingly" high. Food prices, in particular, are rising everywhere - as, indeed, they must given the remorseless rise in the price of grains and other key ingredients.
An inflationary environment is always inimical to bonds (unless they are index-linked) but need not be so to equities, at least in the short term. But if rising prices spread to the labor market and workers begin demanding - and receiving - higher wages, then corporate profit margins get squeezed. Firms will respond by raising prices, and then the inflationary cycle is entrenched.
Undoing it takes years and requires a prolonged dose of tight monetary policy, in which interest rates are raised to and kept at levels well above the level of inflation. The equity markets prefer not to think about that scenario, and it's easy to understand why.
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