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Relentless optimism reigns among investors

Larry Elliott and Jonathan Watts

It may have been the biggest fall since 9/11 but few people seem very worried by it.

DOMINIC ROSSI, head of global equities at Threadneedle Investment Services, summed up the City of London's insouciant mood after the biggest tremor in global markets since 9/11: "Nothing has happened over the past 48 hours that affects our view of the world and the positive outlook for equity markets."

The falls in stock markets were not a reaction to any economic event, he insisted. China was steaming ahead, in spite of Tuesday's drop of almost 9 per cent in the Shanghai stock market. "In short, the macroeconomic backdrop remains favourable," he said.

With Wall Street recouping some of Tuesday's 415-point loss in early trading on Wednesday, the markets were on Wednesday night reassuring themselves that February 2007 was more October 1987 than October 1929. A minor correction in an upward trend; nothing more. Ben Bernanke, chairman of the U.S. Federal Reserve, helped calm markets by telling Congress that the bank still predicted moderate growth.

Not everybody sees it that way. For many years, Stephen Roach, head of global economics at Morgan Stanley, was the bear's bear, who could always find the cloud to any silver lining. Last April, he recanted and said he was now more optimistic about the outlook. On Tuesday, just before Wall Street nose-dived, he had second thoughts. "After four fat years, convictions are deep that nothing can derail a Teflon-like global economy. Investors, policymakers and politicians have now succumbed to a dangerous complacency. That's the time to worry the most," he said.

Although some in the markets see Morgan Stanley's Dr. Doom as a good contrary indicator, the undimmed confidence in the financial markets goes deeper than that. Firstly, the global economy has been growing rapidly, with the past four years seeing the strongest growth for more than three decades. The big developing countries — especially China and India — have been instrumental in underpinning growth.

Cheap goods

Secondly, the arrival of the market economy in China, Russia, and India has meant the West has been able to plug into low-cost sources of production. Cheap manufactured goods and services from China and India have put downward pressure on inflation and interest rates. For a time, the west has been in the happy position of having it all: high levels of growth together with modest increases in the cost of living and low borrowing costs. In those circumstances, investors have been able to take advantage of the manifold opportunities presented by the liberalisation of capital markets. The vast amounts of liquidity pumped into the global economy after 9/11 have given investors the financial means to make massive bets and the state of the global economy has reassured them that these bets are all one way.

The events of the past 48 hours have suggested that this is not necessarily always the case. Central banks have been issuing warnings for some time that markets are not fully priced for risk, and to ram home the point that strong global growth and soaring asset prices pose a threat to low inflation they have been pushing up interest rates as well.

But until this week, the warnings have been blithely ignored by the markets. Now the hunt is on to explain the sudden spasm.

Despite being the source of the crash, most analysts believe there is little reason to panic about a slump in the Chinese economy, although there are signs of a bubble in some sectors. Prices of houses, art, and stocks have surged thanks to a huge inflow of capital and a miserly banking system, where the returns on most deposits are 0 per cent.

But most China-based analysts believe the share price fall is a market adjustment, after a year of spectacular gains, rather than evidence of fundamental weakness. It was sparked by a government initiative to dampen speculation and investigate brokerages. Ahead of a politically sensitive Communist party congress later this year and the Beijing Olympics in 2008, the government will do everything in its power to ensure that the economy maintains its spectacular 10 per cent growth rate.

The links to overseas stock markets are overstated, according to several analysts, who point out that strict capital controls imposed by the government in Beijing prohibit foreign investors from buying Chinese stocks and make it difficult for Chinese investors to buy overseas shares. As proof of the disconnect, Stephen Green, a senior economist with Standard Chartered Bank, noted that Shanghai and Shenzhen stock exchanges ended Wednesday up 3.9 per cent and 3.8 per cent respectively, recovering about half of the previous day's losses, while the entire of the rest of Asia fell.

A slowdown in the U.S. is a much bigger threat and was underlined by news of a sharp fall in sales of new homes and a downward revision to growth in the final quarter of last year. The Economist Intelligence Unit said it had "long been concerned that financial market participants, particularly equities investors in the U.S., have not fully taken into account the ongoing slowdown, even if it is not as sharp as originally feared. The economic prospects in the U.S. have not justified the gains seen until recently on Wall Street, and any resulting correction would have implications for world financial markets in general. In particular, it could result in massive selling in emerging market assets, as seen last May and June. Most emerging markets look well overbought." —

© Guardian Newspapers Limited 2007

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