The real force behind global market mayhem
Too much stuff to sell, too little demand
BY PHILLIP J. LONGMAN AND JACK EGAN
The doomsday scenario used to be the prospect of Soviet ICBMs streaking across the horizon toward U.S. cities. Fortunately, that never happened. But last week Americans learned the hard way of their vulnerability to a very different kind of Russian menace. New York and Washington are still standing, but the typical middle-class American's 401(k) is suffering collateral damage from the exploding Russian economy--and there's a good chance that more financial salvos are on the way, including a possible bear market (story, Page 50).
In one of its worst sell-offs of the decade, the Dow Jones industrial average plunged a heart-pounding 357 points last Thursday, and an additional 114 points Friday, resulting in a loss for the week of 5.6 percent. Since its peak of 9337.97 on July 17, the Dow has fallen 13.77 percent, the biggest setback since the bull market began in October 1990. Meanwhile, other markets around the world turned radioactive. Japan's plummeted 9 percent for the week, sinking to a 12-year low; Germany's bourse fell by 5.1 percent; emerging markets, from Eastern Europe to Latin America were also hammered.
The proximate cause for this global financial havoc was the ever worsening news out of Russia. Following Moscow's announcement on August 17 that it would both devalue the ruble and default on part of its huge foreign debt, the country has entered a dangerous new era of political and economic chaos that may well end with Russia's effective withdrawal from the global capitalistic order. The Russian stock market has for all intents and purposes ceased to function, and its banking system has virtually collapsed. Trading in the falling ruble was officially suspended last week, and consumer prices began rising sharply.
Why is all this so threatening to world markets? The Russian economy, after all, is only about the size of that of the Netherlands. But Russia is a Netherlands with 11,000 nuclear weapons. Moreover, while Russia accounts for only a small fraction of global trade, foreign investment in the nation is huge. The outside world's exposure to Russian debt and equities exceeds $200 billion. That exposure is mostly concentrated among German banks, but American banks have significant investments in Russia as well. The holding company for the Republic National Bank of New York, for example, disclosed last Thursday that losses on Russian investments will force it to write off $110 million in the third quarter, which will wipe out its earnings for the period.
The Russian meltdown is unnerving to investors because the case for the bull market has rested in part on the assumption that Russia, and emerging markets like it, would provide ever-expanding profit opportunities. Now that argument is being severely tested. Russia's combination of default and devaluation sets a dangerous precedent that other struggling countries may well follow. "The Russian default is a tremendous challenge to the world financial system," says Roger Kubarych, chief investment officer at Kaufman & Kubarych. "What country's population, facing the repayment of loans at a time when their economy is on its knees, wouldn't press for a similar solution?" There is now the very real prospect of a global debt crisis along the lines of what happened in Latin America in the 1970s--only larger, and far more complex.
Underscoring this fear is the continuing decline in world commodity prices. Perhaps the single most significant number to come out of last week's financial tumult wasn't the big drop in the Dow or other market indexes but the decline in the Commodity Research Bureau/Bridge Index, a broad measure of world commodity prices that hit its lowest level in 21 years. Though Russia has many deep institutional problems, the fundamental reason it is in much worse shape today than a year ago is the continuing decline in oil prices that began when Asian economies started to founder. Oil remains the leading indicator of the world economy's slide.
Commodity crunch. Commodities also represent the lion's share of exports from emerging markets. So as the prices of oil, copper, and grain continue to fall, it has a deflationary effect around the globe. Even a developed country like Canada is not immune. Last Thursday, Canada's central bank raised interest rates by a full percentage point in a bid to defend the Canadian dollar, which has reached an all-time low against the U.S. dollar. The main factor behind Canada's currency crisis is weakening demand for its exports of oil, forest products, and grain.
The decline in commodity prices is the result of twin forces. The Asian crisis has slowed economic activity over large swaths of the globe, reducing demand for raw materials. Meanwhile, as more and more economies stumble, they export more commodities in the hope of producing new revenue. Russia, for example, is currently flooding the world market with oil. The result of these twin forces is a downward economic spiral with no bottom in sight.
So far, the decline in commodity prices has been mostly good for the United States. Farmers have suffered from falling grain prices, but lower energy prices have helped quash inflation, reducing the need for the Federal Reserve to raise interest rates. But the key question is how far down can the rest of the world go before the U.S. economy is sucked under as well?
Throughout the postwar period, American recessions have always been preceded by rising interest rates and inflation. Since interest rates continue to fall, and there is no sign of inflation, many Wall Street analysts, most notably, Abbey Joseph Cohen, chief strategist at Goldman Sachs, remain optimistic. Cohen, the leading cheerleader of the current bull market, expects the Dow to climb back to 9300 by year's end. If the Fed drops interest rates soon, as is widely expected, and foreign investors continue to seek safe haven in the United States, the Dow is bound to stage at least a short-term rally.
But a growing minority of analysts now believe that the robust U.S. economy faces the prospect of recession caused not by inflation but deflation--that is, too little demand, not too much. The last time this happened was 1929. As more and more countries catch the Asian contagion, they cut back on government spending, often at the insistence of the International Monetary Fund and other lenders of last resort; at the same time, consumer spending shrivels as local currencies sink and imports become more expensive. In theory, countries enduring such austerity measures can export their way out of recession, but the problem lately is, who's left to buy their products?
Recently the answer has been U.S. consumers, who--until last week, anyway--were spending as though there were no tomorrow. But a well-established principle of economics known as the "wealth effect" suggests that they won't keep it up if their 401(k)'s continue to evaporate. That's the main reason Edward Yardeni, chief economist for Deutsche Bank Securities, is predicting a major bear market. "We're the only yuppies on the planet," he says. "The risk is that if the stock market keeps going down, the average person will get spooked and stop spending."
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