International Viewpoint: Sub Prime Debacle to Slow US Economy
Publish Date : 25/09/2007Author : Marc Hendriks
Email : marc.hendriks@thomasmiller.com
International Viewpoint
The paralysis in the international money markets caused by the sub-prime mortgage debacle in the US has had an immediate effect on the US and international economies. The short term outlook for the US economy is very uncertain but the aftermath of the sub prime debacle will highlight the extent to which the US economy’s future is increasingly in the hands of other nations.
Sub Prime Debacle to Slow US economy
In August the US economy’s pace of growth was already slowing as a result of the contraction in the housing market. Whether the US housing contraction was sufficient of itself to cause a recession was hotly debated but the discussion is now irrelevant. The disruption to the workings of the international credit markets threatened two pillars of strength of the US economy, the corporate and international sectors. It became evident that the contamination of the international money markets by toxic US sub-prime mortgage debt would be long lasting. Indeed, the closure of the international inter-bank market and a full-scale banking crisis in the UK were developments far greater than imagined when the crisis first broke. The lowering of the discount rate by 50 basis points and the discount rate by 100 basis points by the Federal Reserve recognised the potential danger to the US and international economies of the financial crisis.
The domestic consequences for the US from the contraction in the credit market will be slower economic growth. Although US companies currently have strong balance sheets it is now inevitable that they will be weakened by slowing profit growth. Capital spending in the US has been surprisingly weak over the past five years and it is unlikely that CEOs will re-discover their desire for capital spending when the economic outlook is extremely unclear.
The labour market has been a source of support for the US economy. Revisions to recent data, however, suggest that the demand for labour now only matches the increase in the supply of labour. A further moderation in hiring plans will result in an increase in the unemployment rate and undermine consumer confidence. A collapsing housing market coupled with weakness in the labour market will hamper consumer spending.
International Rescue
The combination of weak consumer and capital spending would previously be sufficient to tip the US economy into recession. However, the US economy is now significantly exposed to the international economy both through international trade and capital markets. Developments overseas will help determine the fate of the US economy.
The US economy is a healthy beneficiary of international trade. Although the US runs a trade deficit with the rest of the world, the deficit is rapidly getting smaller. The second quarter national income and accounts data showed exports rising at an annualised rate of 15% versus just 5% for imports. This is an important source of growth for US industry. The earnings of US corporations are also benefiting from strong growth in profits earned overseas, such profits now account for more than half of US profits.
The main centres of growth in the global economy are Asia and Europe. Asian growth is unlikely to be adversely affected by the credit crunch. Indeed, growth in China might be spurred as reluctance to acquire US financial assets keeps more capital at home. European banks, seduced by the high yields on US sub-prime debt, were one of the largest buyers of the asset. The resultant banking problems were quickly arrested by the European Central Bank providing copious amounts of liquidity to the banks. Consequently the European economy seems set to continue its path of expansion despite the large loss of profitability to the banks. The Bank of England, on the other hand, initially decided to take the moral high ground and refused to help UK banks on the basis that the public sector should not assist the banks for problems of their own making. The sight of people queuing to withdraw their savings for several days from the fifth largest mortgage lender prompted the unprecedented move by the government of guaranteeing every deposit at every bank and an humiliating U-turn by the Bank of England followed. Aside from the economic fall-out, the UK regulator inflicted serious damage on its reputation which might have long lasting consequences for the City of London.
The global economy will certainly slow down from its current record breaking speed as a result of the problems in the credit markets. The fact the main engines of the global economy are economies that are not reliant upon credit from the international capital markets means that the fall-out from the credit crisis will be limited. The continued robustness of the global economy will provide support for the US economy and probably avert a recession, particularly if the Federal Reserve cuts interest rates again.
Inflation put on Back Burner
Prior to the sub-prime crisis the Federal Reserve was concerned about the longer term risks of inflation. The anticipated slower pace of economic growth, accompanied by a rise in the rate of unemployment, will assuage inflation fears. However, a modest cyclical slowdown in the US economy will do very little to counter the long term build-up of inflation that is currently taking place. Normally the mere whiff of a US recession would cause commodity prices to fall. Not today. The price of oil is rising, food prices are rising sharply due to the competition for agricultural crops between food consumption and energy to replace fossil fuel. China’s economic development plans will place upward pressure on basic material prices for years to come.
An additional inflation risk comes from the steady decline in the US dollar. The much talked about free fall for the US dollar is a greater risk post the sub prime debacle as an additional risk premium is likely to be placed on US financial assets. A free fall in the US dollar is most likely to be avoided but its support will come increasingly from government controlled capital inflows which will bring into sharp focus some difficult political issues.
Over the next six months investors will find solace from the sub-prime crisis in the prospect of lower interest rates in the US. If the pace of economic growth slows further this will undoubtedly be the result. This will mask the worrying longer term development of the US becoming further removed from the centre of economic growth, reliant on other economies for is own growth and a slowdown in its potential growth rate raising the spectre of higher inflation. By comparison solving the current sub-prime crisis will be a walk in the park!
Marc Hendriks
