Thought some of you might find this to be of interest. China may merely have provided the escape hatch to release the pressure building up on the market from other sources. ################################ Source: - http://www.economist.com/opinion/displaystory.cfm?story_id=8776220 Markets and the world economy A walk down Wall Street Mar 1st 2007 From The Economist print edition The lessons investors should learn from a wobbly week in the financial markets THE beating of a butterfly's wing? No: it was more than that. A snort from a dragon's nostrils? That is more like it. A fall of 8.8% in China's main stockmarket index on February 27th rumbled around the world, clobbering share prices just about everywhere. And when American traders looked at the news about their own economy—companies' weak orders for durable goods, worries about “subprime” mortgages, and Alan Greenspan, no less, musing about the possibility of recession—they took fright. On the worst day for American shares since March 2003, sell orders were so heavy that at one point the New York Stock Exchange could not process them all. Although the stockmarkets commanded the headlines, more telling evidence of the jitters lay in the many other places in which people buy and sell ever more arcane flavours of risk (see article). Lately, investors have been blithely content to chase yield wherever it might be found, not least in the private-equity market (see article). This week they were reminded that this can be a dangerous game. Up, sharply, went the standard measure of stockmarket volatility, itself a tradable item. Up too went credit spreads on corporate bonds, especially the more daring stuff, as well as emerging-market debt and the price of insuring against default. And up went the yen, pushed lower these past few weeks by “carry traders” borrowing cheaply in Japan and lending for more elsewhere. No one yet knows whether this week's shudders mark a pause before prices glide serenely upwards again or the start of a proper tumble. One apparent cause of the Shanghai slide, a rumour of a planned tax on capital gains from shares, was denied. The market steadied there on February 28th, but fell again the next day. Markets in Europe and elsewhere in Asia were nervous, though Ben Bernanke, Mr Greenspan's successor at the Federal Reserve, seemed to have soothed Wall Street. Given that people still argue over the reasons for the crashes of 2000, 1987 and 1929, it would be premature, to say the least, to tie this week's events too closely to basic economic causes. Not made in China You can say, though, that the fall in the Chinese market may simply have been the jolt the markets needed to take a second look at the risks they have been taking. The natural starting point is the American economy. Long before it was confirmed on February 28th, the downward revision of fourth-quarter GDP growth, to 2.2% at an annual rate, was expected. And the economy appears to have begun the year sluggishly (although bad weather has made it harder than usual to tell). There had been signs that the bond markets had twigged, with Treasury yields falling in the past few weeks. Until this week, however, the markets for shares and many other things did not seem to have taken all this on board. Now, perhaps, they have. One sign that things are slowing down came in the form of those disappointing orders for durable goods, which fell by 7.8% in January, far more than expected even after stripping out surprisingly poor demand for aircraft. Granted, America's firms have been oddly reluctant to invest for a while, considering the cheapness of borrowing and the huge profits that have been pouring into their coffers, but this was shocking. That American companies are not confident of investing profitably is reflected in forecasts for annual profits growth, which have fallen into single figures after three and a half years in double-digit territory. Having chopped and diced the past few years' numbers and adjusted for changes to accounting rules, Albert Edwards, a market watcher at Dresdner Kleinwort, even reckons that the recent profits record of non-financial firms is no more impressive than in the mid-1990s. Bricks and dust A second and perhaps bigger source of concern is the housing market. The commonest view runs something like this. Yes, the housing market has slowed. Yes, the fall in residential investment has whacked the GDP figures, but the market seems to be settling down again. And consumer spending has gone along merrily. Just look at the fourth-quarter accounts: consumption was strong enough to explain the whole of the addition to GDP and more. This week the Conference Board's measure of consumer confidence hit a five-year high. So there is probably nothing to worry about. Well, perhaps. The stock of existing homes, relative to monthly demand, remains high and the backlog of new homes is rising. The housing glut is likely to weigh on prices and on building—and hence on the economy—for a while. It is hard to believe that consumer spending will be unaffected, once homeowners realise that their houses are no longer doing their saving for them simply by going up in price. At the risky, subprime end of the mortgage market, there are already signs of distress: defaults and foreclosures have been soaring. This week Freddie Mac, one of America's two giant quasi-governmental mortgage companies, said that it would curtail its purchases of those subprime loans most likely to go wrong. The subprime market is too small to have much aggregate effect, but credit terms are getting a little meaner for mainstream borrowers too. According to the Fed, 15% of banks reported tightening lending standards in the three months to January, the most since the early 1990s. How much should the rest of the world worry about America? It would be silly to claim that a slowing American economy would make no difference at all. But it is far from silly to observe that, on the evidence so far, the rest of the world is doing quite nicely. Indeed, in the fourth quarter of last year net trade made a handsome contribution to the gain in America's GDP, implying that foreigners pulled America along, rather than the other way around. In China, for instance, consumer spending is stronger than official figures suggest. Europe's economies, notably Germany's, look much less sleepy than they did a couple of years ago. Domestic demand is now the euro area's main engine, although some of the investment that makes up much of this is doubtless intended to produce goods for export. Signs of a tightening labour market in the euro zone (see article), though they vex the European Central Bank, may be no great worry if fatter wage packets can be combined with rising employment to feed consumer spending. In any case, an American slowdown is only to be expected. The markets (and perhaps Mr Bernanke) may have cursed Mr Greenspan for mentioning recession. In fact, he spoke a lot of sense. He did not say recession was likely. He merely noted the truth: that corporate America's profit margins “have begun to stabilise”, a sign that the economic cycle is entering its later stages. The cycle, in other words, has not been abolished. If this week has served as a reminder of that, so much the better. So much the better, too, if it has made investors stop and ask whether, at the returns on offer, it is wise to run after emerging-market shares, virtually any sort of corporate bond and the privilege of insuring lenders against the risk that goodness knows who will default on a loan. And if not? Then the next slip on the tightrope could be much nastier.