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Against the tide: No end in sight for the credit crunch

Global liquidity is set to keep contracting and inflation will keep on increasing despite a growth slowdown. There is a serious risk of global recession in 2008.

In the third quarter of 2007, credit markets were hit everywhere as the sub-prime loans crisis in the US went global. The cost of securitized debt rose sharply and banks became fearful of lending to each other. As a result, interbank rates moved out sharply from the policy rates set by central banks. The resulting credit squeeze forced central banks to flood markets with extra liquidity and in the case of the Federal Reserve to cut its funds rate by 50 basis points.

Despite this, global equity markets were relatively resilient. Indeed, they rose 0.5% in the quarter, and the S&P 500 index appreciated by 1.6%, outperforming Europe and Japan for the first time in many a quarter, as those equity markets fell sharply, by 3.4% and 7.5% respectively. Emerging market equities, after suffering a drop following the initial credit squeeze in August, rallied hugely to end up 11.8%.

More chapters

It’s my view that the rally in equities might continue for a while, led by consensus expectations of lower central bank interest rates and the avoidance of global economic recession. But I am much less sanguine than the consensus on a one-year view. There are further chapters in the global liquidity contraction to come, coupled with rising inflationary pressures and the serious risk of global recession in 2008.

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