By Ian Harwood, FT | 30 June 2008
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In the early years of this century, moreover, the Fed acted aggressively to head off what it perceived to be the very real threat of outright consumer price deflation. And this year, of course, the Fed has acted swiftly to pump liquidity into a banking system threatened by the bursting of the housing and credit bubbles. In this latter regard, the US has been extremely fortunate to have had at the Fed’s helm an economist who cut his academic teeth analysing how the collapse of the US banking system in the early 1930s had played the key role in transforming a not untypical recession into the Great Depression.
The fact the Fed is doing its utmost to keep the US financial and economic show on the road, however, doesn’t ensure there will be any early end to the economic downturn. Indeed, there is good reason to be very cautious. At present it is the beleaguered US housing market which is receiving the most attention. Any erstwhile optimists have long since abandoned hope of any early recovery. And it is generally accepted that the adjustment of activity, sales and prices to previous excesses will be a long drawn-out affair.
The US consumer, moreover, is looking increasingly vulnerable. Not only is the fragile housing market likely to have adverse spill-over effects upon households’ propensity to borrow and spend, but banks are becoming more and more reluctant to lend. Consumer spending is also likely to be progressively undermined by record inflation-adjusted energy prices and contracting employment. Ever since the mid-1990s US consumer spending has surprised by its vigour, year after year. Now the stage is set for the opposite to happen.
The US quarterly flow of fund statistics, moreover, reveal that the non-financial corporate sector remained in substantial deficit during Q1 2008, rendering it vulnerable to the credit crunch which the latest Fed bank lending survey signals has fast-intensified. As for corporate profits, one of the most overlooked developments of the recent past has been the weakness suffered by the whole economy, or NIPA measure of non-financial profits. This actually fell in 2007, for the first time since 2001.
If you believe— as I do— that profits are a key driver of the business cycle, this decline in whole economy profits goes a long way towards explaining why business confidence, investment and employment progressively weakened. There is, moreover, no reason to expect the downward pressure on profits to ease. And weakness of whole economy profits in the late 1990s gave early warning of the similar fate which lay in store for the more closely-watched S&P profit measure.
Against such a downbeat economic backdrop, core inflation promises to remain well-behaved, sky-high commodity prices notwithstanding. Corporate earnings, however, look extremely vulnerable, as does Wall Street. In such circumstances, a strategy of overweighting government bonds and underweighting equities seems wise.
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Normxxx
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