Markets cheer a global slowdown as preferable to stagflation

Again, the impending decimation of global demand in the face of weak US spending is being interpreted as good news by market commentators with their noses pressed to currency rates. It is doubtless good news that inflation appears to be easing. If it does so in the Gulf, it could alleviate the uglier aspects of the boom, and if it does so among the biggest consumers of the Gulf's oil, it could underpin the boom. The problem remains, however, that the global economy now appears to be slowing in line with the US economy. So the sharp rally in the dollar is more about a retreat from risk than it is a reappraisal of growth prospects. It certainly does not mean that the financial crisis has no more woe to inflict. Commodity prices, while they have fallen sharply, remain historically high, imposing a significant drag on growth. And a rising dollar certainly doesn't do much to maintain the one thing helping the US economy right now - rising exports. Yet there are some analysts, mainly in the West, who perceive a bottom in the financial crisis having come with the bailouts of Fannie Mae and Freddie Mac, and who say that the growing likelihood of a global slowdown will result in sharply lower global commodities demand and slower inflation. This would seem an argument to return to bonds, which have been battered in recent weeks by inflation concerns. But analysts in Asia and the Middle East say they still see little sign that inflation is abating. Keep in mind that folks in these parts have so far been behind the curve in the Great Decoupling Debate - Asia does not after all appear to be immune to the West's slowdown, nor is it helping to cushion the global economy from the blow. No one is wrong or right here, really: the US slowdown has proved more severe than most people predicted, an outcome that even ardent decouplers warned would overwhelm the intraregional dynamism of emerging Asia. Still, if commodities demand in emerging markets does offset "demand destruction" in the West, decoupling may yet manifest itself as persistently high commodity prices and continued inflation. This would be an argument for buying emerging market stocks and other real assets, including real estate and commodities. It would be a relief to see either combination emerge as a clear trend: a global slowdown pulling inflation down with it and an easing of the credit crunch, or a continued credit crunch and emerging market-led inflation pushing up prices for real assets. Either one would mean an end to the stagflationary rut we're in that is eroding the value of all assets together. But I suspect that the shift has yet to come and that it is too early to look for either an end to inflation or a bottom in credit risk - even if credit default swaps have apparently declined. Like other financial crises, this one has yet to burn itself out. We have not seen the distressed assets being written off start to sell again. Once the US mortgage market starts to clear, once UK housing stops declining, or real estate in Australia improves, then it could be a sign the worst of the credit crunch has passed. Then, it will take some new engine of growth to pull the global economy forward. And usually, we only find out what that is after it's already underway. And just as often, it seems, these new engines become the next bubble. It was thus with tech, and again with the post 9/11 liquidity bubble. Some suggest that the so-called emerging markets, led by Chinaand India but including Russia, Brazil, Southeast Asia and the Gulf will emerge from the slowdown as the new engines of growth. This jibes with what I've been writing since the beginning of this blog: that what we are witnessing is the shuddering decline of the American-dominated global economic order and a shift of the balance towards the emerging world. This financial crisis is a paroxysm, not a death rattle. In the meantime, the retreat from risk means zero tolerance for financial legerdemain. So while assurances from regulators are appropriate, allegations of fraud among local property developers and lenders are likely to be punished with even more redemptions by foreign investors. It is important during this period not to equate falling stock prices with evidence of wrongdoing. Falling stock prices tend to lend urgency to allegations, but in this environment they prove absolutely nothing. That isn't to say the allegations are false, but a more meaningful indicator of whether smart money believes them to be true might be to track what happens with property prices and lending rates locally. Concerns about the creditworthiness of borrowers and the veracity of financial statements should raise risk premia, pushing up further interbank rates, bond yields and mortgage rates.