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If you’re looking for an omen for the year ahead, you couldn’t ask for a better start to 2010. Stock markets are bouncing higher, Asian and European manufacturers are showing strong growth, and U.S. factories are providing hints of recovery.

Could it be that optimism is coming back into fashion? John Maynard Keynes, the British economist, coined the term “animal spirits” to describe the fragile sense of optimism that is needed to fuel economic growth.

This confidence vanished after the collapse of Bear Stearns and Lehman Brothers Holdings Inc., but following the stock market’s remarkable resurgence in recent months and an encouraging round of recent economic reports, animal spirits are back in fashion.

A return of optimism is undoubtedly a good thing. Pessimism creates a vortex in which people are unwilling to invest or to buy. This leads to layoffs, which leads to even more gloom.

Animal spirits may not be enough to produce growth by themselves, but positive psychology is an essential element of any recovery. Only if people feel confidence in the future will they buy things or build things, which leads to more sales and eventually more jobs.

Call it the skyscraper effect. Animal spirits are what drive developers in countries with no shortage of land to make a statement by building needlessly tall buildings — like the Burj Khalifa, the world’s tallest skyscraper, which officially opened in Dubai yesterday.

Only a month ago, the Burj Khalifa was the world’s tallest free-standing metaphor. Editorial writers pointed to it as a symbol of the wretched excesses that led to Dubai’s recent brush with financial disaster.

But these days, following a bailout of Dubai by its neighbour, Abu Dhabi, the skyscraper is being held up as a symbol of Dubai’s unstoppable optimism — the same optimism that has allowed the emirate to establish itself as a financial and trading centre even though it doesn’t have much in the way of natural resources.

Like the Burj Khalifa, the global economy can be viewed either as an artificially supported and overbuilt tower or as a wise investment with a bright future. It’s all a matter of psychology –and, right now at least, the market is dwelling on the positive viewpoint.

The tilt to optimism got confirmation yesterday from a survey of purchasing managers at U.S. manufacturers. The Institute for Supply Management index, which measures manufacturing activity, registered its highest reading in December since April 2006.

The good news came on top of positive reports on Asian and European manufacturing. In response, the Dow industrials hit a 15-month high, oil prices surged above US$81 a barrel and Canadian and world stock markets posted gains.

So what’s not to like? Paul Krugman, the Nobel prizewinning economist and Princeton University professor, believes that the spate of good news is the result of two factors –massive government stimulus and the natural tendency of manufacturers during a slump to report a onetime increase in production after they run through the inventories they built up in better times.

Krugman calculates that there is a one-third chance the United States will slip back into recession during the second half of this year as the effects of stimulus money fade away. He draws comparisons to the United States in 1937 and Japan in 1996, when authorities declared victory over recession too soon and withdrew support too early.

Capital Economics, a London-based economics consultancy, isn’t feeling the animal spirits either. It notes that the S&P 500 is nearly 40% more expensive in relation to its earnings than its long-term average. It predicts that the stock market will end 2010 lower than it is now, while 10-year treasury yields head back down to 2.5%.

Investors should use these downbeat assessments to temper their own animal spirits. But it’s worth noting that the experts have been wrong in calling just about every aspect of the recent economy.

Stephen King and Stuart Green of HSBC Global Research have compared consensus forecasts for 2007, 2008 and 2009 against reality and found that the forecasts have consistently been off by large amounts. “It is time, we believe, for all economists, ourselves included, to eat a large slice of humble pie.”

Animal spirits may have a bigger effect than forecasters foresee. If so, the best places to indulge in them could be by investing in emerging markets and commodity producers.

King and Green predict the GDPs of emerging nations will grow at more than a 6% clip over the next couple of years, while the developed world barely manages 2%. They also argue Chinese demand will provide a firm foundation for commodity prices no matter what happens in the developed world.

Both emerging markets stocks and commodity producers offer a smart way to bet on animal spirits during the next few months — even if the animal in question turns out to be more of a tortoise than a hare.

source:http://www.canada.com/business/fp/Animal+spirits+back+fashion/2405758/story.html

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