Markets warm towards a more optimistic view of US prospects

Monetary policy has been likened to pulling a brick with a piece of elastic

There has been a profound shift of mood in the London markets in the last few weeks towards the relative performance of the US and the eurozone during the next stage of the economic cycle.

There has been a profound shift of mood in the London markets in the last few weeks towards the relative performance of the US and the eurozone during the next stage of the economic cycle.

To caricature, the majority London view until recently was that the US economy would teeter between a hard landing and softish one next year, while the eurozone's growth was assured for two or three years at least. It followed from this that the foreign exchanges' pessimism towards the euro was overdone.

The majority New York view, by contrast, was distinctly more optimistic about the US and rather less hopeful about Europe. Its view dominated the foreign exchanges, hence the collapse of the euro.

In the last few weeks, however, London has been heading towards New York. Naturally doubts remain on both sides of the Atlantic that the US can engineer a soft landing, but the fact that the US economy has seemingly been unscathed by the plunge in Nasdaq and falls in the other share markets has increased the level of confidence. And, this week's generally positive reaction to the rise in US interest rates has helped a bit further.

Meanwhile, the burst of confidence in the strength of the eurozone recovery has evaporated somewhat. No-one is predicting early recession in the eurozone, but the numbers from Germany, the largest eurozone economy have been slightly disappointing - particularly so given the stimulus to exports from the weak euro.

More worryingly in the medium-term is the growing concern that the eurozone's present recovery might fizzle out in two or three years - a view echoed this week by the Munich-based Ifo Institute for economic research.

This shift of view raises the obvious question: is the new majority view any more likely to be right than the old one?

The best starting point is to try to gauge where we are in the global economic cycle and then look at the relative prospects for different regions in the light of this. If you forget about different countries, or indeed different regions, and look at the world, it becomes apparent that we may be heading into a downturn. The graph on global industrial production has an ominous feel to it.

As JP Morgan points out in its latest newsletter Global Data Watch, world financial conditions have tightened noticeably in the last month. Interest rates are nudging up in the main industrial countries and in much of the developing world; and of course the fall in share prices tightens monetary conditions too. Since mid-April all equity and bond markets have fallen. The bank reckons that the first quarter of this year will turn out to be the peak of the cycle for global industrial production. It is, so to speak, downhill from now on.

Now downhill does not mean recession; it merely means (or may mean) a period of somewhat slower growth. The question then is which parts of the world are more likely to respond positively to tough times and which will be caught out.

Here, to caricature again, you might say that the US has the macro-economic handicap of going into a tougher time with flexible ideas but a load of debt, while the eurozone goes into it with inflexible ideas but a pile of cash.

Germany remains, for the eurozone, the key. The disturbing thing here is the extent to which it has under performed its neighbours. As the other graph shows, it came up solidly last year. But the most recent numbers have been more unsettling. Manufacturing growth is still very positive, running about 6 per cent up on a six-month basis. But the trend is now nudging downwards: there are still a pile of orders in the pipeline but the trend is less strong than it was a few months ago. And, domestic demand is flat.

This last point is the most worrying of all. German retail sales in the first quarter of this year were 2 per cent down on the last quarter of last. Unemployment is still falling but painfully slowly; construction is very weak; and of course this is all before the recent rise in eurozone interest rates, with presumably more to come.

So what should one say? My own view is that we should certainly recognise that a global slow-down has begun. We cannot know how serious it will be, nor can we know how long it will last. There is still lots of momentum in the world economy and that always takes a while to come off. But the longer it does take to slow, the greater the pressure on the policy-makers to check growth.

The distinct tightening of recent weeks is still in its early stages. Given this, we would be unwise not to acknowledge the possibility that policy-makers will get it wrong, either by delaying too long (as the Fed almost certainly has) or by over-tightening.

Monetary policy has been likened to pulling a brick with a piece of elastic. Nothing happens for a long time as you tighten the elastic, then suddenly the brick moves and hits you on the fingers. We are now pulling on the elastic but momentum keeps things going; the danger of trapping our fingers remains some months away.

As for the shift in mood in London, all this really reflects is an up-weighting of the importance of flexibility and a down-grading of the importance of a sound financial base. The practical question for America will be whether, as the world economy slows, the US can correct its financial imbalances in an orderly way; and the practical question for the eurozone is whether, as world growth slows, Germany can be innovative, flexible and enthusiastic enough to pump up domestic growth to replace an inevitably softer market for exports.

And here? As so often we remain structurally a half-way house. The one thing we mercifully can rely on, though, is the great British consumer. Slower growth can be offset by cuts in interest rates, which though their link to mortgages, can be used to pump up the housing market.

Cuts in interest rates? Are we will worrying about another rise? Sure we are, but think beyond the box to next winter or maybe the summer of 2001. At some stage we will be worrying again about a slowdown. The test of economies is not how they perform when things are going well, but how they rate when the going gets tougher.