Prepare for a sudden swing to pessimism

This article from The Times of UK, argues that growth in both Europe and USA is headed lower. It also identifies the problem in current market dynamics. A excellent read.

The problem in America is the other way round. The Federal Reserve understands economic reality but the markets refuse to believe it. There is a widespread view on Wall Street that the US economy is growing strongly and has shaken off the effects of 5 per cent interest rates and the soaring oil price. It is now clear, however, that the post-Katrina rebound that boosted first-quarter growth figures was just that — a one-off bounce lasting a month or two. Last Friday, the University of Michigan consumer confidence survery revealed the biggest decline in consumer expectations in its 30-year record, the US trade figures showed an abrupt slowdown in imports and retail sales figures suggested that higher petrol prices were now crowding out virtually all consumption growth.

Between them, these statistics paint a clear picture of the US economy slowing down. This slowdown should not lead to outright recession because the Federal Reserve Board will eventually cut interest rates to support the US housing market and revive consumer demand. For the time being, however, the bias in US monetary policy must remain towards monetary tightening, since inflation is creeping upwards, commodity prices are flying and the markets refuse to believe that a slowdown is on the way.

Once investors accept the slowdown story, commodity prices will collapse, inflation will stabilise and the Fed will be free to consider a policy of stimulating US demand. But this will be impossible as long as the world puts its faith in ebullient stock markets and metal prices, rather than the sober message from economic statistics. In the end, reality will prevail over expectations. But first investors and businesses should prepare to ride a psychological roller-coaster from over-optimism to pessimism and then back again.