The world on the cusp

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By:
Clive Horwood
Published on:

Another record year for financial institutions suggests no end to the boom in global financial markets. But they may be ignoring underlying economic conditions that threaten global growth and might cause a severe correction in the global capital markets, says Clive Horwood.

World Economic Forum Special Report: Contents

Clive Horwood
Editor
Euromoney magazine

The world’s financial markets seem to have contracted a bad case of hubris. It’s easy to see why.

For the last five years, since the internet bubble burst, financial markets have been on a seemingly endless upward path. Economic conditions could hardly have been better: low inflation, robust growth and stability have been the order of the day.

This has created its own Goldilocks situation for the global capital markets and the banks that service them. Credit has boomed while default rates remain low. Low interest rates, large amounts of cash and the high risk appetite that stability generates has led to a spike in leverage, in turn fuelling an M&A boom that could yet surpass anything we have witnessed before. There has been huge innovation in the capital markets, notably in derivatives and the structured products they can help to create. Global stock markets and real estate prices have reached new heights, in large part propelled by the investment of trillions of petrodollars.

If you look at one of the leading indicators of the state of the financial markets – investment banks – you’ll find them in the rudest health.

Take the leader in the field, Goldman Sachs. In December it announced full-year results that had jaws hitting the floor. Overall revenues of $37 billion and earnings of $9.5 billion were enough to catch the eye. That’s what the biggest global bank Citigroup made in net income in the boom year of 1999. But what really stood out were the records: investment banking revenues ahead of the last high watermark in 2000; record net revenues across divisions such as fixed income, currencies and commodities, equities and asset management, not to mention principal investments.

Goldman’s CEO, Lloyd Blankfein, must have struggled to keep a straight face as he delivered the classic understatement: “We are very pleased with this year’s performance.”

Talk to most bank CEOs and they seem to think that these earnings levels can continue. They’re not concerned about a severe correction. This isn’t a bubble. It can last. The market has survived corrections in both 2005 and 2006 and can survive any more thrown its way.

We hope they are right. But these conditions cannot last indefinitely. So two questions arise – when will the downturn come, and how severe will it be?

Goldilocks was born of a marriage of convenience, between a US economy that wanted to spend and a Eurasian mentality that didn’t so much like to save as was plain thrifty.

On the following pages, a leading group of independent economists present the view that the state of global imbalance must come to an end soon, and with painful consequences. Do economic prospects boil down to a simple question of whether Americans will want to stop borrowing and spending before Eurasians stop wanting to save and lend? If, as they argue, the glut caused the spree, then the spree will end before the glut, and world growth must suffer. In fact, as Eurasians continue to save, Goldilocks is being sustained in the short term, with the inevitable consequence that when the downturn comes the landing will be that much harder and the recovery slower and more painful.

We hope they are wrong. Their view isn’t widely shared. Most bank analysts predict that 2007 will see some bumps along the way, including rising defaults and an increase in volatility. But those predicting that 2007 could see the first ever $100 billion leveraged buyout can hardly be expecting a severe downturn, can they?

Perhaps globalization really has worked its magic. Maybe risks are now sufficiently diversified that financial markets can withstand all but the severest shocks. It’s interesting to note that 30 of the world’s 100 largest companies are banks; and that of the 15 largest financial institutions, five come from the US, five from Europe and five from Asia. In the past few years, two new and hugely influential industries have risen on the back of the leveraged boom – hedge funds and private equity – and, as one of our economists says, “they are not about to roll over and play dead”.

Time will tell. We hope Euromoney’s readers, as well as the political, economic and business leaders at the World Economic Forum, will use this special report to challenge their assumptions and reflect on the challenges ahead. At the moment the attitude seems to be a strange collision of Harold Macmillan and Mr Micawber: “We’ve never had it so good” and “Something will turn up”.

But, make no mistake, the world is on the cusp. This looks and feels like a bubble. In the past, bubbles have always burst.

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