yardeni is back / intresting summary on t current situation ; it is neither black nor white , it is grey......global vs usa , cdos and chinese growth

Insight: Global boom faces first major stress test

By Dr Ed Yardeni, president of Yardeni Research

Published: July 31 2007 18:32 | Last updated: July 31 2007 18:32

The global economy is in the midst of the greatest boom of all times. It started when the cold war ended, leading to an unprecedented period of free trade. It really took off after China joined the World Trade Organisation on December 11, 2001.

Never before have so many people around the world experienced such a rapid increase in their standards of living and wealth. The previous great global boom occurred during the 1950s and 1960s and benefited about 300m people as Japan and Europe were rebuilt following the devastation of the second world war, and the US retooled from a wartime to a peacetime economy. The rest of the world was mostly left out of this postwar boom. Now, at least 3bn people are benefiting from globalisation – the rapid integration of national markets for goods and services, capital, and labour through free trade.

If we are experiencing the greatest global boom, aren’t we also witnessing the greatest global bubble of all times in almost all asset classes? Booms always stimulate speculative bubbles caused by a combination of easy credit and irrational exuberance. In the past, when these bubbles burst they often triggered a chain reaction of events that converted the booms into busts. So, is our present global prosperity just a cyclical phenomenon – the consequence of liquidity-inflated bubbles, which may be starting to burst? I don’t think so. I think it will be sustained for many years as globalisation continues to increase the wealth of nations, which should absorb the shock waves when bubbles inevitably burst along the way, as some are doing right now.

The Organisation for Economic Co-operation and Development’s industrial production index is up 10 per cent since the end of 2001. A broader index, which includes six big emerging economies, is up a whopping 30 per cent since then. Clearly, the emerging economies have emerged and continue to do so. Their growth has been fuelled by exports as free trade has proliferated. Of course, a significant portion of this trade has been in commodities. In turn, OECD economies and corporate profits have been boosted by the boom in their capital goods exports to emerging countries.

The OECD core consumer price inflation rate has remained remarkably stable at between 1 and 2 per cent since 2003. That’s because all those relatively scarce commodities have been converted into a glut of consumer goods. Manufacturers can’t raise their prices because of global competition. So they’ve been buying capital equipment to boost their productivity, which has mostly offset rising materials costs and maintained high profitability. If inflation remains subdued in spite of such cost pressures, then central banks are not likely to raise interest rates to levels that cause a global recession, which historically has been the main cause of boom/bust cycles.

The clear and present danger for the global boom is a credit crunch. “Tranche warfare” has broken out in the capital markets. Over the past couple of years, Wall Street’s alchemists discovered how to convert junk mortgages, bonds, and loans into AAA credits by packaging them as CDOs for the bonds and CLOs for the loans. These credit pools are divided into frontline tranches of pawns that defended the kings and queens. The pawns are getting killed by rising foreclosures in the subprime mortgage market, leaving the better credits exposed. Suddenly, private equity firms and their bankers can’t refinance their bridge loans using these pools. The market for “covenant-lite” bonds and loans has seized up.

This is really the first big stress test of the global boom. We are about to find out how much of it has been driven by financial alchemy. We are also about to find out the extent to which the global economy still depends on the US, and the extent to which the global economy has become more important to the US. In my opinion, the world economy has become less US-centric, and the global boom will help the US to overcome its severe housing recession without an economy-wide recession. I also expect that the bursting of the alchemy bubble in the credit markets won’t seriously disrupt the global boom. The enormous wealth of nations created by globalisation should act as a powerful shock absorber.

Copyright The Financial Times Limited 2007