With just days to go until the end of the first half of 2008 Wall Street analysts are suddenly waking up to the realization that life for financial firms is still bad, is getting worse and that any thought of a recovery in the second half of the year is looking problematic. This continued weakness in the financial system of the world’s biggest economy is going to have further implications for business, even in the Gulf States where record high oil prices have so far insulated economies from the global downturn.
The writing is on the wall everywhere you look. The IMF is forecasting no growth in the US economy this year with 3.5 per cent inflation. Bond insurers saw their credit ratings slashed last week and will now have to report huge losses. And financial analysts are warning of further substantial write-offs at Merrill Lynch and Citigroup, while question marks over the long term future of Lehman Brothers remain after the departure of top management.
At the root of the problem is the deteriorating US housing market which is not realistically expected to bottom out until the end of 2009. Until that time, and probably for a fairly long period afterwards, there will be a drip feed of bad news as firms try to get the market to adjust slowly downwards to the ongoing destruction of capital.
The big risk, of course, in such an adjustment by capital markets is that markets decide to suddenly re-price risk with a crash, and overshoot on the downside. So far Wall Street has remained remarkably buoyant against a background of swelling bad news, and has confined its discounting of bad times to the financial and property sectors.
But as the financial crisis continues – and typically three years is the length of such a period of market deterioration – then more and more sectors of the US economy will be affected. Car sales, for example, are already well down. Surveys show that consumer confidence is falling away as fears about potential job losses and recession mount. Indeed, as firms actually do fire more and more staff in the second half of 2008 the decline in consumer spending will get worse.
What will this slowdown or recession in the world’s biggest economy mean on the other side of the world for the Gulf State? Is this the foot coming off the accelerator of the global economy? Will oil prices tumble as US consumers cut back on traveling and buy less Chinese products?
For business analysts in the Gulf the difficulty is the same as for their compatriots on Wall Street, there is a major issue of time lags. If you hit a man on his leg his reflex reaction is quick. But if you slow the US economy this is more like putting the breaks on an oil tanker – it takes a long time to stop.
There is a whole pipeline of orders between the US shop selling a Chinese made pair of shoes and the manufacturer producing it in China, for example. But just like investment banks are now suffering as much from the fall in ongoing business as sub-prime write-offs, the inexorable economic slowdown will eventually have an impact on oil demand.
But at the same time the Gulf States are likely to benefit from the offsetting impact of emergency measures designed to keep the US economy afloat. This year we have already seen the effect of seven interest rate cuts by the Federal Reserve on local inflation rates because of the dollar peg. If the financial crisis continues, as I think it almost certainly will do then the next stage will be a major correction on Wall Street for equity and credit markets.
The dilemma for the Federal Reserve will then be acute: will it risk higher inflation by further cutting interest rates? Or hold fast and bankrupt some financial institutions and cause a systemic financial collapse? Put like that there is only one choice, and that will be to lower interest rates again and suffer the inflationary consequences. Interest rates rises will be discussed but never implemented for the same reasons. And the US might end up with a decade of zero growth like Japan in the 1990s.
Where does this leave the Gulf States? Probably still with high oil prices and even lower interest rates, and that will allow the real estate boom to rage onwards and keep inflation very high. Eventually the US economy will most likely recover sufficiently to allow the inflation genie to be put back into the bottle, as Fed chairman Paul Volcker did in the early 1980s. But it is very hard to see how any rational policy maker could attempt this in the middle of what many observers characterize as the worst financial crisis since the Second World War.
For it is the loose monetary policy of the Federal Reserve in response to the US housing crisis and its financial counterpart the sub-prime crisis that has fanned oil prices higher and ratcheted up the economic boom in the Middle East with low interest rates, and until there is a decisive change in that policy stance the region will continue to enjoy its best economic growth since the 1970s.
Even a serious geopolitical event would only serve to spike oil prices higher and further undermine the Fed’s ability to reset interest rates to the level needed to deliver stable prices. For the time being the US economic slowdown remains a positive for the Gulf States, and only a much deeper economic recession will seriously dampen oil prices and impact regional prosperity.
