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A man delivers drinks in the Little Tokyo district of Los Angeles on July 27. The US labour market has added jobs at a steady clip in the past year despite efforts by the Federal Reserve to cool the economy, raising both optimism among investors for the prospects of a soft landing and concern among analysts that the fight against inflation will continue. Photo: AP
Opinion
Macroscope
by Anthony Rowley
Macroscope
by Anthony Rowley

Deluded investors’ hopes of a soft landing for global economy betray their irrational exuberance

  • The split between the reality on the ground and the way in which it is perceived by investors and market analysts seems to be growing ever wider
  • The IMF and others are warning about the continuing risk of a hard landing, yet investors are still on a stock-buying frenzy
Anthony Rowley
Anthony Rowley
Why you can trust SCMP
The distance between Wall Street in New York and Pennsylvania Avenue in Washington where the International Monetary Fund (IMF) is headquartered is less than 400km, and yet the two are poles apart right now on the issue of whether the global economy can make a soft landing.

Investors on Wall Street and those elsewhere appear eager to declare victory over inflation and rising interest rates even as the IMF and others are signalling that the worst could be yet to come on both fronts.

The decision by Fitch Ratings this week to strip the United States of its AAA sovereign credit rating might provide a wake-up call for investors as to where financial markets are heading, but as likely as not the narrative of optimism will continue to prevail until a crash comes.
The impact of monetary tightening is highly uncertain. Milton Friedman noted 50 years ago the lag between monetary policy actions and the response of inflation, and that it takes time for the full impact to be felt. So, why all rush to declare victory at this early stage?

It has long been assumed that financial markets have a nose for where the economy is heading, yet they seem to have lost their sense of smell. This is likely to be because investors have become “passive” in entrusting money to asset managers who in turn entrust it to “passive” investment vehicles which they do not control.

Traders work on the floor of the New York Stock Exchange on August 2. The Dow Jones Index fell more than 300 points in trading following the news that Fitch had downgraded the US economy to AA+ from AAA. Photo: AFP
It could also be because of the fact that huge inflows of pension fund contributions and other savings continue to pour into the bloated asset management industry, regardless of how well these funds are managed and how overvalued much of the global equity market has become.

Whatever the reason, the dichotomy between the economic and financial situation on the ground and the way in which it is perceived by investors and market analysts seems to grow ever wider. It is market practitioners and not IMF officials who inhabit the “ivory towers” nowadays.

Even so, the IMF has to be diplomatic. It needs to avoid being seen as second-guessing the US Federal Reserve on monetary policy, and it also cannot afford to challenge the equally nearby White House, whose occupant is heading into an election next year.

But there is an unmistakable and dangerous dichotomy between the message that investors are sending by their frenzied stock-buying actions and what the IMF and other analysts and officials are saying about the continuing risk of an economic and financial hard landing.

Talk of a soft landing for the US economy is still just hope

As The New York Times noted recently, soft landing optimism could be premature. Confidence, it noted, was voiced in 1989, 2000 and 2007 that economic hard landings could be avoided, but each time the US economy plunged into recession, unemployment shot up, businesses closed and growth reversed.
The S&P 500 stock index has risen by about 20 per cent this year. This is understandable perhaps as a knee-jerk reaction to the ending of the Covid-19 emergency and to what many people perceive to be victory in the battle against inflation and rising interest rates.

The IMF is challenging what former US Fed chairman Alan Greenspan famously referred to as “irrational exuberance” in the stock market. It said in a blog published on July 27 that inflation remains a “risk confronting financial markets”.

“Central banks may keep interest rates higher for longer than currently priced,” it warned, adding that “given investors’ benign inflation outlook and growing expectations for a soft landing, this could increase financial stability risks and weigh on growth”. Rarely can such a mildly phrased message have contained such powerful implications for the global economy and financial system.

A man checks discount prices at a clothing store in Istanbul on August 3. According to data released by the Turkish Statistical Institute, Turkey’s official inflation rate stood at 47.83 per cent in July, but an independent group of researchers calculated it at 122.88 per cent. Photo: EPA-EFE
Much of what else was in the blog was also a sotto voce warning of impending crisis. Investors, it suggested, are probably over-optimistic about disinflation and the chances of a soft landing. Core inflation remains “sticky”, suggesting the monster has not yet been tamed. History cautions against declaring victory too soon and central banks must remain vigilant.
What people don’t seem to get is that it is not just inflation and interest rates that matter but the way in which lenders and borrowers are reacting to these developments. Credit is tightening, debt distress is growing and it is only a matter of time before economic growth and financial system stability suffer.

Despite these growing signs of a pending recession and economic hard landing, the central narrative among market participants is one of a benign soft landing, where inflation returns to target relatively quickly, with only a modest slowdown in economic growth, as the IMF noted.

Once markets realise how bad the economy is, things will get worse

Perhaps it would be better if the IMF was more explicit in its message rather than disguising its meaning in a manner intended to alert but not alarm markets.

Re-written to reflect the true situation, the blog might have read like this: “Listen up. The Fed is determined at all costs to avoid easing policy too soon as it did in the days of Paul Volcker, and interest rates are not going to fall any time soon, so be aware and beware.

“Debt is at high levels in corporate household and government sectors in the US and other advanced economies, as well as in emerging markets. The pain is only just beginning as rates will stay higher for longer. If you think the worst is over, you are wrong.” It’s time to start telling it like it is.

Anthony Rowley is a veteran journalist specialising in Asian economic and financial affairs

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