The latest bout of global market turbulence should be viewed from that perspective. Financial-market volatility fell to record low levels earlier this year, signaling investors had become too complacent. While trouble had been brewing in the U.S. housing market for several months, many investors were willing to overlook it, instead holding on to the belief that in an environment of easy money and strong world growth, no problem could be serious enough to derail the global bull market for stocks.
However, with the crisis of confidence in the U.S. credit market over the past few weeks, assumptions underlying the big trends of this decade are being questioned. Emerging markets have been the asset class of choice this decade, rising by nearly 300 percent from the October 2002 lows, due to rapidly improving economic fundamentals, including rising foreign-exchange surpluses and falling inflationary expectations. But in the past month, as foreigners have pulled more money from emerging stock markets than in any other decline, old fears have resurfaced about how these markets are doomed to rise and fall with American mood swings.
The important questions for investors, then, are: does the credit crisis have the potential to become a full-fledged systemic shock that breaks the back of the U.S. economy, and, if that happens, what are the implications for growth in the emerging markets? Given the key role the U.S. housing market has played in the current economic cycle, it seems unlikely that the unwinding of such a massive credit cycle will have no macroeconomic follow-through.
The best-case scenario for the U.S. economy is subpar economic growth. However, it should be able to avoid a recession due to the strength of corporate balance sheets. After all, corporations in the U.S. are flush with cash, have little leverage and—most important—overseas sales account for an increasing share of their earnings. But the fate of the global economic expansion will more likely be determined by whether the world’s most powerful growth engine—China—continues to barrel ahead.
This year, for the first time in modern history, China is set to contribute more to global growth than the United States. To be sure, the U.S. is still the largest importer of Chinese products, and as a result, there remains the possibility of broader economic contagion from a weak U.S. economy. However, the share of Chinese exports that go to the U.S. has fallen to less than 30 percent from more than 40 percent at the beginning of the decade. Furthermore, the contribution of the U.S. in the global economy has dropped to below 30 percent.
One positive unintended consequence of any Fed easing might be that while economic growth in the United States and the rest of the world has increasingly decoupled, monetary policies remain synchronized. Despite an improving economic profile that warrants stronger currencies in developing countries, China and many of its peers are not keen to let their exchange rates appreciate too rapidly against the U.S. dollar. These countries will be forced to run even more accommodative monetary policies if the Fed cuts rates, as they don’t want their currencies to rise against the dollar. The relatively low interest rates will boost domestic demand and offset some of the negative impact from weak U.S. growth.
The current scene is starting to look a lot like 1997 and 1998, but in reverse. Back then, emerging markets were in crisis, and at times sharp falls in their stock markets and currencies caused short-term hiccups in the United States as well. But it did not stop the underlying U.S. bull market, which continued on the back of a tech-driven productivity boom and inflows of foreign capital. Now the U.S. is in financial trouble, but the uptrend in emerging markets seems likely to persist, as strength in domestic investment spending and rising productivity keeps growth humming in China, as was the case with the U.S. in the late 1990s.
Just like a decade ago, the upshot of major financial dislocation is that the world may become excessively dependent on the spending of one economic superpower to keep growing. In 1997, that power was the United States. Today, it is China. If the parallel to the late 1990s does indeed play out in the reverse, then the volatility of the past few weeks was just another twist to the otherwise unchanged tale that this decade belongs to emerging markets.
