Looking to 2005

This week’s Buttonwood column in The Economist is typically bearish about the prospects for the financial markets in 2005, but more than typically explicit about why:

As Christmas is fast approaching and this is the final Buttonwood of the year (and the last by this columnist), readers will perhaps forgive the sentimental segue into the rather less Christmassy topic of financial markets, where the questions on Buttonwood’s mind are: how can risky assets the world over be as expensive as they are? And are they likely to stay that way?

…To the question of how much compensation investors should receive for investing in risky assets, Buttonwood has no pat answer. In 2002, it is clear, they were generously compensated. In December 2004, equally clearly, the rewards are too meagre.

But just how meagre? To be sure, the world has proved remarkably resilient in the face of war in the Middle East, the threat of terror, a high oil price, recently rising interest rates in America and a shaky dollar. Growth has been robust; indeed, according to the International Monetary Fund, this latest recovery in the world economy has been the strongest in 40 years. Corporate profits have been growing at record levels in most rich countries. So, it should perhaps come as little surprise that corporate default rates have dropped precipitously and equities have been putting in a decent performance (though they have struggled a bit this year compared with last).

And yet it does come as a bit of a surprise to this columnist. Financial markets, after all, are meant to be forward-looking, and, barring a miracle—admittedly a possibility not to be dismissed lightly at this time of year—the prospects for the world economy look decidedly gloomy.

The focus of Buttonwood’s pessimism (and that of many economists) is the US’s high and rapidly rising levels of debt. The worry is that if US interest rates to rise for some reason (such as because of a slowdown in capital inflows to the US, or a rise in inflation) then all of that debt will become quite burdensome on consumers and firms, leading to a rapid slowdown in economic activity. Is this what awaits us in 2005?