Don't heed the doom mongers


WHAT a year. In March storm clouds were everywhere. We had a war in Iraq, a worsening situation in the Middle East, oil price worries and international terrorism.

The stock market was down for the fourth year in a row and many expected the US economy - the one bright spot around the globe - to slow significantly.

Six months later, the world is a happier place. Saddam Hussein has been removed. Stock markets have recovered and are now well up on the year to date. Private investors, who didn't want to know about the stock market earlier in the year, have ventured back. And far from slowing down, the US economy has gone from strength to strength.

Economic confidence has bounced back like a superball. Since June, US growth was 7% - a spectacular rate for the world's biggest economy and one that would be impressive even for an emerging market.

As you might expect of an economy that is the global engine for growth, the US is pulling Japan with it. After a decadelong gloom, the Japanese economy and stock market are coming back to life. And the recent miserable level of growth in Europe seems about to pick up.

Can this go on, or will confidence crack at the first sign of trouble, taking markets back down in the lift?

The biggest worries are the huge deficits in the US. This year the US will import more than $500bn more than it exports. This is an enormous figure and vast by historic standards. And the amount the US government has to borrow to finance its spending is also extraordinarily high, at around $450bn.

As with individuals, it's fine for governments to spend more than they earn over a short period, but not for ever.

The US can carry on spending money as long as it can find someone to borrow from. Currently, most comes from Asian governments.

With exports booming, the central banks of Japan, China, and Taiwan have been huge buyers of US currency and their dollar reserves have risen sharply.

Together these central banks now have reserves of $1.3trillion. This is around half of the world's total currency reserves.

The crunch comes if these Asian governments stop buying dollars. Then US interest rates would be forced up in order to attract buyers of dollars or the US would be forced to stop borrowing.

Either way it would be bad news as both would force US consumers to rein in spending. Result? The world's global engine would slow.

Happily, this seems unlikely. In the short term, Asian governments should continue to show a strong appetite for dollars. This keeps their currencies low, makes their exports competitive and supports US consumer spending, much of it on their exports.

The US is also an attractive place for foreigners to invest and do business and this also supports the dollar.

Nonetheless, the deficits cannot continue. We are likely to see more flexible exchange rates in the world's biggest economies and this should mean, over time, a gradual weakening of the dollar.

Lower US government spending should slow the growth in the budget deficit. A weaker dollar will restrain US imports, whilst making their exports more competitive.

Demand is also unlikely to continue-to grow at its recent pace and interest rates will eventually rise from their current remarkably low levels. So if you own dollars or US bonds, expect them to reduce in value.

Given time, Asia and Europe will take up the slack as their economies recover.

Over the longer term we expect a re-balancing of global growth away from the US and towards the rest of the world, against a background of healthy global growth and strong share markets.

So while these deficits exist, the correction of them does not mean a problem for the global economy.

It may not all be plain sailing ahead. But the doom mongers are wrong. No tropical storm awaits us.

Richard Turnill is Chief Economist at Merrill Lynch Investment Managers.

Don't heed the doom mongers

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