Is the credit storm passing?

The pundits are already dismissing recent market volatility as a storm in a teacup and stressing that it's unlikely to herald a recession. But it's worth remembering that, unlike other recent financial crises, this one has its roots planted firmly in the 'real' economy.

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Of course, there's still plenty to worry about. Who knows where the next hedge fund blow-up is going to emerge? Or where we'll find toxic subprime paper washing up next?

Yet already the pundits are gearing up with their storm in a teacup' dismissals of the recent havoc.

But we wouldnt crack open the champagne just yet

Gerard Baker, writing in The Times today, reckons that there's little chance of a recession arising from this particular bout of market volatility.

"In the past 20 years," he says, "there have tended to be far more financial panics than economic slumps there is no inevitable connection between a financial market mess, such as the one we have now, and a necessarily unpleasant consequence" for the real' economy.

It's a fair point. The stock market pile-up of 1987 was largely confined to the markets, and in the end, it was blamed on black box trading systems - not too dissimilar to the computerised quants' taking some of the blame for the recent correction. And the aftermath of September 11th 2001 was again - in economic terms - fairly benign, despite obvious concerns of financial disaster at the time.

Of course, 20 years isn't really a terribly long period from which to draw conclusions about history. And also, given the tiny number of financial crises that have happened in that time, you've got to look at the underlying circumstances behind each individual event. You can't just generalise from each one.

For example, if you took the last 100 years as a reference point, you might conclude that Western Europe was long overdue another big war - after all, there were two in the first 50 years of the century, so why not the last 50?

As we've noted above, neither 1987 nor 2001 ended up being particularly significant in economic terms. The trouble is, this time the economic backdrop is a lot more worrying. Let's forget, for a moment, all the problems in the arcane realms of structured finance. Even if derivatives never existed, the slump in the US housing market would be a problem.

Rising house prices have been propping up consumption in America. Consumption is the most important part of the US economy. Now that house prices are falling because there are too many houses, and not enough people who can afford to buy them, especially now consumption is running into problems too. Wal-Mart, Home Depot and Macy's have already warned of disappointing outlooks.

But in the meantime, the subprime derivatives crisis has blown up rather dramatically, and the spotlight has thus fallen on the financial' economy, rather than the real' economy. But this problem has its roots in the real' economy. Lending standards got too slack, house prices got out of touch with reality, and people borrowed and spent too much. Now that process is reversing.

The optimists point to solid employment data in the US as being evidence of a fundamentally' sound economy. But this ignores the fact that employment is a lagging indicator. You don't lose your job while everything's OK. You lose your job after the downturn has begun something that nearly 2,000 unfortunate staff at Capital One's GreenPoint mortgage unit have recently found out. The financial services provider is shutting down the business, after becoming the latest casualty of the US housing problems.

It's not the first and it won't be the last. The markets are praying that the real' economy will bail them out but it's the real' economy that got them into trouble in the first place.

Turning to the wider markets

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In London, the FTSE 100 gave up early gains - which saw it climb as high as 6,163 - at 6,078 yesterday, a 14-point gain. Property stocks including British Land, Land Securities and housebuilder Persimmon were among the day's heaviest fallers whilst miners including BHP Billiton and Kazakhmys dominated the risers. For a full market report, see: London market close.

On the Continent, the Paris CAC-40 was 35 points higher, at 5,399, and the Frankfurt DAX-30 was up 29 points to 7,407.

After a weak morning, signs that the liquidity crisis is easing sparked a late rally on Wall Street. The Dow Jones added 42 points to end the day at 13,121. The tech-heavy Nasdaq was up 3 points at 2,508. And the S&P 500 was a fraction of a point lower, at 1,445.

Asian stocks continued to post strong gains today as they pulled back last week's losses. The Nikkei was 168 points higher, at 15,901, and the Hang Seng was up 96 points to 21,691.

Reports that Hurricane Dean would miss oil production in the Gulf of Mexico saw the price of crude oil dip to $70.77 this morning. In London, Brent spot was at $68.71.

Having risen $2 yesterday as the dollar weakened, spot gold had edged up further to $658.00 this morning. And silver was up to $11.74.

In the currency markets, sterling had weakened this morning as investors pared back carry trade positions. The pound had fallen to 1.9783 against the dollar and 1.4678 against the euro. And the dollar was at 0.7417 against the euro and 114.29 against the Japanese yen.

And in London this morning, housebuilder Persimmon announced a 9.8% increase in first half-profits. Net income was £196.6m compared to £179.1m over the same period last year. The company's purchase of Westbury has allowed it to negotiate better terms from suppliers, whilst office closures have also increased margins. Persimmon chairman John White played down the effect of rising interest rates on housebuilders, saying such was the undersupply of housing that 'unless interest rate rises affect job prospects, there'll still be demand.'

And our recommended articles for today...

The only worthwhile way to diversify - By diversifying across asset classes, investors like to believe that they won't suffer too much when the bad times come. But then the recent bad times inflicted losses across portfolios, says Merryn Somerset Webb. For a far better place to put your cash, read: The only worthwhile way to diversify

Will the crisis on Wall Street spread to Main Street?- Markets may have settled back down again, but it will be at least two months before we know the full extent of the fallout, says Jeremy Batstone. He reveals the likelihood of a full-blown economic crisis - and what would-be bargain hunters should do now: Will the crisis on Wall Street spread to Main Street?


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