In the blink of a summer's eye, the psychology in America has changed totally. People suddenly don't know what to think about the economy, their investments, or their future. Before July, the U.S. had economic nirvana. Now confusion reigns. Volatility dominates markets. Hedge funds blow up. Deflation looms. The Asian contagion spreads. Russia defaults. The dollar plummets. CEOs worry. And Washington fiddles with impeachment. Yet the economy still feels pretty strong. So what is really going on out there?
Blame it on the fog--not the weather, but a surprising confluence of events that is masking the true fundamentals of the global economy, making life uncertain and people anxious. Is the U.S. heading for serious economic trouble? Maybe. But it's also possible that the current gloom is overblown, that Asia is beginning to find its legs, and that the impending U.S. slowdown will be a soft landing instead of a hard thud. There are five murky situations to watch that will determine whether the global economy slides into a synchronized recession or bottoms out and begins to grow again.
-- The yen turnaround. The yen soared an amazing 20% against the dollar in the space of three days, reversing its long slide. A stronger yen is a tonic for Asia's malaise, making Pacific Rim exports more competitive, taking the heat off China to devalue, and boosting the buying power of Japanese consumers. A lower dollar also cuts the cost of oil to Asia and provides U.S. multinationals with a profits fillip. But is the yen rebound real or a technical unwinding of highly leveraged hedge-fund positions? Will the dollar shoot back up to 130, 140, or even 150 yen by Christmas? Stay tuned.
-- The Japanese bank bailout. One of the longest-running soap operas appears to be ending. The politicians are throwing $600 billion into the rescue, equivalent to nearly all of Japan's bad loans. If it works, liquidity would start flowing, and businesses would begin growing again, pulling in imports. But is the deal for real? Eight years of shadow plays and false starts feed the skepticism. This time, it could be different. Stay tuned.
-- Monetary policy. The Federal Reserve recently cut U.S. short-term interest rates by a grudging 25 basis points when the shaky markets expected 50. Then the German Bundesbank flip-flopped on easing, finally saying "Nein." With economic growth falling around the globe, lower interest rates are critical. But the U.S. and Europe can't agree on a coordinated easing. Yet piecemeal, interest rates are being cut--in Britain, Canada, Spain, China, Japan, Ireland, and Portugal. This stealth wave of rate cuts could put a floor under the recession. But is it enough? And will Fed Chairman Alan Greenspan, so unnerved by market developments ("I've never seen anything like this"), take U.S. rates down by another 75 basis points sooner rather than later? Stay tuned.
-- The LTCM bailout. Nothing surprised the markets more than the sudden near-death of this hedge fund. Under the unseeing eyes of the public, regulators, investors, and Washington politicians, Long-Term Capital Management borrowed huge sums from clueless banks and leveraged its capital to unheard of levels before it crashed and burned, threatening the entire financial system. Are the big banks and Wall Street investment firms now so wounded they will stop lending, thereby strangling the U.S. economy? Stay tuned.
-- The Asian contagion. Conventional wisdom holds that Asia is in freefall. But there are signs that emerging markets may be bottoming out. Trade surpluses for Indonesia, Thailand, Korea, and Malaysia are soaring. Interest rates are falling sharply. Stock markets, including Hong Kong's, are up 15% to 20%. Is this the turn? Are lower rates and a rising yen reliquefying Asia, reversing its decline? Stay tuned.
The greatest hopes and worst fears of economists are seldom realized. That is likely to be the case once again.