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Davos '08: US Economy Casts a Long, Dark Shadow

Antonia Oprita,|Associate Web Producer
Wednesday, 23 Jan 2008 | 10:17 AM ET

The most talked about person in Davos won't be there, but at least he's also given the crowd a lot to talk about.

Federal Reserve Board Chairman Ben Bernanke testifies on Capitol Hill in Washington, Wednesday, Feb. 14, 2007, before the Senate Banking Committee hearing on monetary policy. (AP Photo/Dennis Cook)
Dennis Cook
Federal Reserve Board Chairman Ben Bernanke testifies on Capitol Hill in Washington, Wednesday, Feb. 14, 2007, before the Senate Banking Committee hearing on monetary policy. (AP Photo/Dennis Cook)

That's Fed Chairman Ben Bernanke and the impact of his dramatic three-quarters of one percent cut in the federal funds rate Tuesday, a step taken, as the Fed put it in a statement, "in view of a weakening of the economic outlook and increasing downside risks to growth."

So, among the 2,500 participants from 88 countries that will crowd the hotels, conference centers and restaurants of the Swiss resort, the recurrent questions will be whether America stops "sneezing?" And if it doesn't, how bad a cold will the world get?

World's heavyweights -- from JPMorgan Chase Chairman & CEO Jamie Dimon to European Commission President Jose Manuel Barroso to European Central Bank President Jean-Claude Trichet -- will try to answer just that.

Judging by the global selloff in stocks this January, many market watchers and economists believe a U.S. recession is at least imminent. Pessimists say it already started -- probably in December 2007 -- and the market is heading into bear territory.

"They could have waited for another week but looked at the market conditions and decided to do it now," said Dimitry Fleming, an analyst at ING Bank in Amsterdam, of the Fed's surprise move. "If the US economy is on track for recession, I don't think the cut will do much."

Trichet Slams The Door

For the time being, at least, it hasn't. The Fed's dramatic policy move has yet to matched by central bankers in Europe. In fact, Trichet Wednesday appeared to rule out any rate cut.

"In demanding times of significant market correction and turbulences, it is the responsibility of the central bank to solidly anchor inflation expectations to avoid additional volatility in already highly volatile markets," Trichet said, according to Reuters.

Prior to the US rate cut, some had already written off the Fed's policy as being too little, too late to help the economy. The US stock market's dramatic decline, some say, indicates investors believe the recession has already started but the problems of the credit crunch are far from over.

Reaction From Davos
Some of the best known business and political leaders are watching the markets from the World Economic Forum in Davos, Switzerland, reports CNBC's Maria Bartiromo.

"We don’t know if the economy will pull us out of the financial crisis, or the financial crisis will weigh down on the economy," Karen Olney, head for European equity strategy told CNBC. "We have to wait for a few months."

The Fed's latest cut begged the question about whether there had been any "decoupling" between the US and Europe and what European policymakers could do to sustain growth in the face of weakened demand from the U.S.

Fleming said he expects the Bank of England to cut interest rates at its meeting Feb. 7, but not the European Central Bank, which meets the same day.

Rainer Singer, fixed-income analyst at Erste Bank in Vienna, echoed that view, saying it "is too early for the ECB to cut interest rates", given the inflation backdrop there.

Trichet, who will appear at Davos this year, made his comments during testimony to members of the European Parliament, where he said the danger of price rises was still elevated and that the duty of the central bank was to make sure inflation was in check.

Decoupling Theory Tested

So where can one take refuge from a U.S. recession? Until not long ago, many voices were hailing the "decoupling," where the rest of the world is able to carry on more-or-less unscathed, while the US economy is struggling.

The theory was that emerging markets such as those in Asia, notably China and India, as well as the euro zone and Eastern Europe, would be able to continue enjoying quite strong economic growth because their dependence of the U.S. consumer had declined.

It now seems to be more like wishful thinking, though, judging by the by duplicative reaction of European and Asian stock markets, which have moved in tandem with Wall Street during most of the market turmoil that started in August 2007.

"I never thought we did decouple,” Kevin Gaynor, head of economic and interest rate research for RBS, told CNBC. "I think we are re-coupling and the ECB sees that, but they are in an inflation-targeting environment."

Indeed, the biggest economies in the euro zone are showing signs of fatigue. France's central bank said last week that the country's economy grew 0.4 percent in the last quarter of 2007, compared with a year ago,which was less than the 0.5 percent predicted previously.

Germany, the biggest of the euro zone economies, recorded economic growth of 2.5 percent last year after 2.9 percent in 2006, Data also showed private consumption was weak.

The first estimate of US GDP in the fourth quarter of 2007 is due out Jan. 30 with economists expecting an annualized growth rate of more than 2 percent. Nevertheless, many economists, if a recession has already underway, it began in December.

The continuing -- if no long escalating -- strength of the euro is likely to affect European exports to the US this year, further depressing growth.

"We will see some negative effect on exports in the first half," said Veronika Lammer, head of fixed income research at Erste Bank in Vienna.

"My main fear is that it could come to a credit crunch in the business sector,” Lammer added. But the effects of the liquidity squeeze is likely to calm down in the second quarter, by which time "a lot of bad news will be out," she added.

Emerging Markets at Risk

Emerging markets seemed to be the bright spot until not long ago.

The Euro sculpture is seen in front of the European Central Bank in Frankfurt, central Germany, Wednesday, Nov. 30, 2005, the day before a possible change of the main interest rate by the European Central Bank. (AP Photo/Michael Probst)
Michael Probst
The Euro sculpture is seen in front of the European Central Bank in Frankfurt, central Germany, Wednesday, Nov. 30, 2005, the day before a possible change of the main interest rate by the European Central Bank. (AP Photo/Michael Probst)

Many analysts had said they will not be affected that much by a U.S. slowdown, as some are rich in commodities. Most have the benefit of a cheap labor force to continue to sustain their exports and can rely on domestic demand and infrastructure projects to make up for a decline in U.S. demand.

But if they will have to deal with a full-blown U.S. recession, which then spread to Europe, emerging markets will not be able to cope. Around 30 percent of Asian exports are directed to the U.S. and Europe. And central banks will not be able to cut interest rates enoughto spur domestic demand in areas where high inflation is endemic.

Other risks loom for emerging markets, analysts say. Oxford Analytica, together with Aon Trade Credit Global, released a study on the vulnerability of emerging markets to the credit crunch.

Virtually all of them are at risk, although they are not likely to be affected to the same extent as the U.S., UK or Western Europe.

"It all depends on factors such as foreign debt and how much short-term debt they have to repay," said Jens Tholstrup, executive director at Oxford Analytica.

Investors have started to wake up to the realization that central banks may not be able to stop a U.S. recession from spreading, Tholstrup said, which does not bode well for Europe and other regions.

Inflation -- largely a result of high energy prices -- remains a concern just at a time when relaxed monetary policies are needed.

But these solutions, as well as the U.S. government's stimulus package, have been met with skepticism by global investors. Not that there isn't some room for optimism.

"In the short term, the markets are very fragile," said Singer. "But the outlook for recovery for the US economy has improved. It's a stabilizing factor."

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