Storm clouds are gathering, but the storm will probably not last very long. While financial stocks have suffered a correction, most equity markets are robust thanks to corporate profits. Companies continue to reap the benefits of globalization. At the same time, workers and consumers enjoy rates of unemployment that are either very low, as in the United States, the United Kingdom and Japan, or falling rapidly, as in Continental Europe, where labor markets have also become more flexible in recent years.
Also, commodity traders are betting against their moodier colleagues on the bond side, who seem to be pricing in at least a mild recession by pushing yields on secure two-year government bonds to ultralow levels. High oil prices of more than $90 per barrel have not led to doom and gloom for the Western world. Many believe they simply reflect ever-stronger import demand from the likes of China and India.
In this case, the United States, Western Europe and Japan should be able to piggyback on the revival of post-socialist Eurasia by exporting ever more goods and services to the growing number of consumers in the world’s most dynamic region. More and more consumers in areas ranging from Poland to China and India are now rich enough to afford Western consumer goods, and brand-conscious enough to finally buy the imported originals rather than domestic fakes.
Alternatively, if oil prices fall back instead, Western consumers would benefit nicely from having to pay less for their gas and heating oil. This would also reduce the risk of a serious economic downturn. The truth could well lie in between these two scenarios this year, with a modest easing of oil prices helping Western consumers, and buoyant exports to Asia, Eastern Europe and the oil countries putting a smile on the faces of Western exporters.
The real concern for the global economy in 2008 will continue to be fallout from the U.S. mortgage crisis. For many countries, the current corrections in real-estate markets are a normal feature of the business cycle. But the present U.S. situation is different in a way that accentuates the short-term risks as well as the long-term recovery prospects.
In the past, mortgage lenders took deposits from customers and lent the money to home buyers. Nowadays, and more so in the United States than elsewhere, mortgage lenders and other financial institutions higher up the value chain often take bundles of mortgage loans, repackage them and sell them as tradable securities to investors. If homeowners default on their mortgages, the resulting loss mostly hits those investors who bought the mortgage-backed bonds, and the financial institutions that had agreed to back up such mortgage bonds if need be.
In the nonsecuritized past, such losses typically hit balance sheets only over a longer time, as financial institutions gradually raised their loan-default provisions. Because the new mortgage-backed securities are tradable, their prices can swing much more suddenly. The expectation of future mortgage defaults can drive away buyers and drive down prices rapidly.
That’s what we saw in recent weeks. Investors seeking to secure their positions before end-of-year reporting shunned mortgage-backed paper. The result is that the securities are barely traded. Prices for them, if they can be found at all, reflect outsize risk premiums and huge discounts for a lack of liquidity that, taken together, seem to exceed guesses about how bad the ultimate mortgage-related losses will really be. Some top-rated securities backed by mortgage loans are trading 25 percent below their face value; the bottom-rated securities lost 80 percent of their value last year.
If the worst-case scenario reflected in current prices does not fully materialize this spring, when many subprime rates are due to reset, the market could come back to life. If so, this would lighten the burden on financial institutions around the world holding such paper. Once the bad news is flushed out, forward-looking markets can recover quite nicely. With just a little luck, global financial tensions, and the risk of a protracted credit crunch, could ease some time this spring.
The fact that financial losses from the mortgage crisis are more front-loaded than they used to be means that the worst could be over sooner than usual. Come May, money and credit markets may have regained some composure, and the global economy could be heading for a sunnier summer after a cold winter.
