September 5, 2008 | posted by Michael Baxter in Markets, US economy, global economy |

Not an awful lot happened yesterday that you couldn’t have spotted a mile off. In fact some of the economic data out yesterday was actually quite good. But markets crashed all the same.

You can’t pin yesterday’s big sell off on any one piece of news specifically. But it appears truth has dawned on the markets. Until the last few days there had been a certain amount of smugness related to the US economy. Wasn’t the Fed clever, it cut interest rates and went all dove-like, whereas the silly old ECB and Bank of England banged on about inflation, displaying all the plumage of hawks.

Then, sure enough, the US sees a big economic boost in the second quarter, the Eurozone contracts, and the UK now appears to be on course to be the first G7 member to hit recession. And that just goes to prove how right the Fed has been, went the argument. If only the ECB had acted more precipitately then everything would be all right.

Funnily enough though, the ECB’s team of rate setters are not so dumb after all. They had actually thought of that already. The inflationary pressures in Europe are no worse than in the US, it wasn’t that the ECB were just insensitive fools, rather they had good reason for their caution. And that is the truth that is slowly dawning on markets. All of a sudden, markets have woken up to the thought that the US is not firing on all cylinders again  – that the boom isn’t back on. The penny has dropped that the Q2 growth spurt seen in the US was down to one offs – things such as a massive tax credit dished out by the government, and the effect of a lower dollar increasing exports, before the economies of the United State’s trading partners suffer.

But now, the Eurozone and UK are both slowing, and the dollar is back up again. Suddenly it is understood, the US can not expect its export boom to continue.

In yesterday’s FT, John Authers was talking about a smile effect. The smile is supposed to represent the curve of the chart showing the course of the dollar. If the US economy suffers a hard landing, the rest of the world also suffers, and the dollar stays quite high. If, on the other hand, the US economy has a soft landing, then the world is now sufficiently de-coupled from the US that it can carry on growing. Paradoxically, this is the worst case scenario for the dollar. If, on the other hand, the US has the gentlest of slowdowns, and then goes back to boom, the dollar soon recovers. You can imagine then a kind of curve with the low point in the middle – sort of smile shaped.

Until recently, some believed the bad economic news from the US was in the past, and that this explained why the dollar was doing so well. But that feeling seems to have changed. Now it is felt that actually the US economy has lots of bad news ahead, and that the dollar has recovered, not because the US economy is strong, but because it is so weak the rest of the developed world could be sent into recession too.

But it is not just the developed world. The Hang Seng is now down 10 per cent from the beginning of August, the Chinese CSI index is down by nearer 20 per cent.

Yet, yesterday’s economic news itself was not all bad. Sure, the latest job data from the US was worrying, with a 15,000 rise in the number of American’s claiming unemployment benefit for the first time to 444,000. Data from ADP suggested the private sector lost 33,000 jobs in August.

On the other hand, productivity in the second quarter was revised upwards to an impressive 4.3 per cent. Consider that for a moment. The US workforce produced 4.4 per cent more per unit of labour. That is really quite impressive.

The latest data from the Institute of Supply management suggested the services sector expanded in August.

Meanwhile, Wal Mart revealed a 3 per cent rise in like for like sales in August.

So, really, the economic data was ambiguous.

Markets instead were spooked by comments from those in the know. The man at the Fed from Dallas, mentioned the word anemic when he was talking about growth, while the Fed president at San Francisco talked about the credit crunch deepening, But it was the Beige book from the Fed that told the really sorry tale. “Consumers” said the book, were focusing on “food, staples and essential items.” Luxury items, it appears, are off the menu. The Beige suggested much weaker quarters ahead, but above it slipped in one of those words markets hate. It talked about stagflation.

But then, even those comments were not surprising. The only real surprise is that markets were surprised in the first place. Japan’s lousy decade, the period known as the lost decade, was in part caused because it took banks and policy makers too long to face up to the truth. That is why Alistair Darling comments about the economy should be welcomed. The sooner the rest can face up to reality, the sooner the recovery can begin.