One argument the bulls have used to justify their continued optimism about future prospects in the face of wobbly markets and a fast-expanding credit crunch is the strength of the global economy.
In other words, what happens on Wall Street, stays on Wall Steet.
Logic suggests, however, that in an era when earnings from financial activities account for over a third of corporate profits and more than 20% of the benchmark S&P 500 index is comprised of banks and other financial services companies, that view doesn't really hold water.
In "Lex: The Transmission of Financial Phenomena to the ‘Real World,’" the FT Alphaville blog elaborates further on the connection between Wall Street and Main Street.
How might the hysteria in “financial wonderland” cross into the real world?, asks Lex So far, most central bankers are saying the credit crisis is containable and global growth will remain robust - but “markets have not believed a word of it,” it notes. Now, as turmoil extends into a third week, macro economists are beginning to question their forecasts - and Lex has its own theories.
The transmission of financial phenomena into the real economy is a complex process, it says. But two channels seem most likely:
The first is consumption. Across the world, household spending has been buoyed by both property and equity prices. If the US housing slump deepens, for example, and markets continue to be weak, consumption growth will slow. Wal-Mart’s gloomy outlook and poor auto sales are worrying portents. In turn, many emerging economies, including China, are still geared to western consumption.
The second channel is the effect of rising borrowing costs on companies’ capital expenditure and hiring. Global business spending has been supported by record cash flows, as well as by debt-funded investment. While capex may slow gradually as companies adapt to the new environment, there is already some evidence that software and equipment spending is softening in the US. Employment would also be hit. This would be the final nail for consumption as the level of employment is closely linked to real disposable income growth.
Faced with such events, economists can lose their heads in a crisis, too, warns Lex. “During the Russian crisis in 1998, consensus US growth forecasts for 1999 dropped by 50 basis points in just one month to 1.7 per cent. In spite of this panic, actual growth in 1999 ended up being a healthy 4.4 per cent”, it notes.
A scarier possibility, however, is the opposite phenomenon, concludes Lex: “After a long boom it becomes hard even to envision a recession. When the tech bubble burst early in 2000, it was the end of the year before economists realised that growth was disappearing down a dark hole.”
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