It used to be said that when Wall Street caught a cold, London sneezed. These days, it’s more a case that when Wall Street is fed spicy food, Europe gets the runs. The hot spice came late last week from Federal Reserve chairman Alan Greenspan, who said that markets might be underestimating the degree of riskiness of equity investments, the FTSE 100 index is following the 132-point run of last Friday.
Greenspan is nothing if not consistent. Last year, he spoke of “irrational exuberance” in the equities markets. There usually follows a mini-crash after such comments, then the markets carry on over-inflating as they had before. With the London market off a good ten per cent in the immediate wake of Greenspan’s warning, we might wonder whether the run on equities is this time rather more permanent.
Much will depend on the resilience of the US economy. But the first observation to make is that the London market is no longer entitled to have a mind of its own. Wall Street has now behaved so extraordinarily that any substantial correction is bound to take Europe with it.
It is perhaps a little too cruel to say, as some do, that the London Stock Exchange exists to follow the movements of the Nikkei in the morning and Wall Street in the afternoon, but it is the case that the destiny of global markets has long been prescribed by that irrational exuberance in the US.
A new rationale may be coming to the US and it’s not only through the voice of Greenspan. His latest remarks follow hard on the heels of a report that US wholesale prices jumped by 1.1 per cent in September, the fastest rate in nine years. As an inflation indicator, that points to a further interest-rate hike when the Fed meets early next month, adding further weight to the school of correction in the equities markets.
But those are the headline points. Dig deeper and things begin to look even more alarming. A timely paper, published this week by global asset management company Phillips & Drew (P&D) and Cambridge professor Wynne Godley, claims that, unless policy towards the dollar and the US budget changes in a remarkable (and improbable) fashion, “the United States could easily become a new millennium version of Nineties Japan”.
The supporting argument goes that Wall Street’s overvaluation could now exceed 50 per cent, without which annual economic growth in the US might have been just two per cent, compared with the 3.5 per cent that it has averaged since 1995 – growth that has been unusually dependent on an unprecedented fall in private net savings brought about by the bull stock market.
A decade ago, Britain and Japan similarly experienced asset price bubbles, combined with sharply falling private savings. Both economies suffered horribly when those asset prices finally collapsed and savings rose to abnormally high levels. Contained within the US’s present means of growth are the seeds of that growth’s destruction – the excessive escalation of debt.
In order to maintain the US boom, domestic and corporate debt would have not only to rise, but rise at an exponential rate. Meanwhile, private savings would have to continue to fall to keep growth at even the modest 2.5 per cent that is widely predicted.
But the dependence of growth on falling savings and rising debt points to an implausible future. Either US households would have to devote nearly a quarter of their income to servicing debt, or the Wall Street bubble would have to inflate further, perhaps to asset overvaluations of more than 70 per cent.
The US’s retrenchment will come as private savings recover. But that implies an economy that contracts on average over the next five years, with unemployment eventually rising above 11 per cent. Tellingly, P&D assumes a knock-on effect to the rest of the world of a cut of one percentage point in average growth.
Can all this be avoided? Technically, yes it can. But it requires a massive policy U-turn on Capitol Hill. Maintaining growth of two per cent might require a 30 per cent fall in the dollar and “stellar” tax cuts – a policy revision unlikely even in the febrile atmosphere of presidential election campaigns.
The report concludes that it would be “nothing short of miraculous” if the US avoids the depressive forces of a huge bubble bursting on Wall Street. Over the past week, those depressive forces may have started to have their effect. We must learn to live with market volatility over the new millennium.
A couple of observations with regard to that volatility: Gartmore, the fund management arm of the NatWest, may be planning a management buy-out. You don’t organise an MBO on over-inflated asset values, so NatWest, under takeover siege from Bank of Scotland, must be entertaining the forthcoming market discount in values.
Secondly, Persil-to-Bird’s Eye Unilever is suing its institutional fund manager, Mercury Asset Management, for underperformance. Quite apart from the issues of companies of this size buying into an investment strategy and having contracts that make that strategy clear, it would be a shame if such an action encouraged fund managers to take unnecessary risks to chase performance or pushed them into further index-tracking exercises.
With the current volatility in equity markets, both courses of action could prove disastrous.
George Pitcher is a partner of issue management consultancy Luther Pendragon