As adults, we don't believe in Santa Claus but, strange to say, a large number of adults such as central bankers, economists and financial experts seem to believe in Goldilocks, the popular name given to the hoped for, soft landing of the US economy not too hot, not too cold!
The history of investment markets is that they swing from one extreme to another. Markets become too dear, then eventually fail and continue to fail until they become too cheap. Markets that have become too cheap after time become attractive and are bought and bought until they become too dear again, and so it goes on. Economies also go from boom to bust and back again. The Goldilocks concept however, asks us to believe that an economy or a market can go from being too dear or too cheap to being just right not too dear, not too cheap and stay there. That is the soft landing they talk about.
US soft landing: will the dominos continue to fall?
It has been calculated that the US housing market and auto market, both of which are in recession, represent about 9% of American GDP. It is argued, therefore, that if only 9% of the economy is in recession it need not be a source of alarm because the other 91% is OK. What an enticing argument, that two such key elements of the US economy can be ring-fenced and the rest of the economy continue unscathed. The real world isn't like that because there are things called dominos. When one domino, such as the housing market falls, sadly other dominos in close proximity, are hit and in turn fall which, in turn, hits the next domino, etc., etc.. It's almost impossible to insulate one falling domino from its neighbours. (For more on this, see: The US housing market and domino economics.)
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Wolfgang Mnchau wrote in the Financial Times on 3rd January under the headline "The good the bad and the ugly scenarios for the year ahead". His three scenarios for the US economy for 2007 are a soft landing; a hard landing, economic growth between 0% and 1%; or recession.
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A soft landing he explains is the scenario on which the world's central banks and governments have based their current policies and would see the US growth falling to an annual rate of about 2%. Such an outcome would allow the eurozone and Japan to continue to grow as would many of the emerging markets. It presumes that the slowdown in the US housing market will only have a limited impact upon the US economy.
If what we at RHAM expect should happen, and the deterioration in the US housing market continues, then Goldilocks is dead, leaving only scenario two or three.
US soft landing: recession more likely
Wolfgang Mnchau is in the hard landing camp as the most likely alternative to Goldilocks although some economists, one of whom is Nouriel Roubini, Chairman of RGE Monitor, are firmly in the recession camp where we similarly place ourselves. If that recession is to take place in 2007 then the stock market has to be lower by then than it is now because once a US recession has been confirmed, the stock market should already be at its lows. Even a hard landing will be very damaging for the stock markets.
Without using the word domino, Wolfgang Mnchau does follow that train of thought, pointing out that consumers would have to stop spending and start saving and that some mortgage banks will get into difficulty dominos, dominos. In scenario three, he says that several mechanisms will carry the shock of a US recession around the world economy more dominos. The bigger the economic downturn, if linked to a weak dollar will probably trigger an outbreak of protectionist pressures not just in the US but also in Europe the dominos continue.
US soft landing: will 2007 be a year of transition
Merrill Lynch on the 8th December in their publication Economic Focus' written by their North American Economist, David Rosenberg, covers a lot of the points detailed in this conclusion. What is interesting, is Merrill Lynch's view of 2007, which he calls a year of transition. He says that their optimistic view is that the economy will settle into a soft landing in 2007. He goes on to say "Our concern, however, is a soft landing is fully priced into equity and credit markets at a time when our proprietary model suggests that the chance of a hard-landing is almost, but not quite, as high as a chance of a soft one. We would be more comfortable forecasting a soft landing if we believed the economy was in the early or middle part of the business cycle. Unfortunately this cycle appears to be getting long in the tooth; imbalances have built up, savings rates are depleted, and the goods and labour markets are pressing against potential." David Rosenberg hopes a soft landing will occur but he is cautious. We would like to ask him, off the record, about his personal view because, reading between the lines of what he writes, we think that he is in the camp of scenario two or three and not genuinely in the scenario one camp.
This coming year could have massive consequences for the unwary. We would bet that the famous saying "In economics the majority are always wrong" will prevail; that Goldilocks will prove to be a fairytale and that markets will continue to travel from one extreme to the other, which really means that many of them can only go one way and that is down. The Goldilocks economy may be a fairytale but the three bears may turn out to be very real!
By John Robson & Andrew Selsby at RH Asset Management Limited, as published in the Onassis Newsletter, a fortnightly newsletter that gives insight into the investment markets.
For more from RHAM, visit https://www.rhasset.co.uk/
