Waiting for the Global Financial Drama

The script is

complete. The dress rehearsal has been held. But the curtain has yet to go up

on the first night of the Great Global Asset Price Collapse.

Markets have recovered

some composure after the last two days of February. The steep drops can now be

described as a correction, not a collapse. But the payback from sustained

overindulgence still awaits. That is not to argue that every index from Dow

Jones to Topix via silver futures and Singapore property is going to

suffer the same fate. There are elements of the local as well as the global in

every national market. But make no mistake: the global liquidity bonanza is the

pre-condition for almost every asset market excess.

Don’t read too much

into the fact that the recent wobble spread from China. The Chinese market remains

among the most closed in the world. What the 9 percent Shanghai shock did was simply remind

investors in other markets of how much they had risen in the past year. The

Asian ones to suffer most, in addition to China

and India, were those which

have risen most steeply in recent months -- Malaysia

and Singapore.

Whatever the macro economic and corporate outlook, profit-taking was overdue.

Indeed Asian markets including Korea

and Thailand, Malaysia and Singapore look relatively less

vulnerable to sustained declines than most.

Top of the worry

list remains Mumbai. So it is no surprise to find that it has now fallen 12

percent from its high last month, and with lots more to come. Not only had the

market risen fourfold since 2003 but the macro conditions in India are abysmal, with inflation

at over 6 percent, the current account deteriorating sharply, bank lending

excessive and, to cap it all, the government has just raised the tax on

dividends.

Shanghai has better macro-economics to support it for

the time being and the rise of the past year has been driven by an abundance of

cash not credit to punters. But China’s

investors are notoriously skittish and could well defeat any government efforts

to stem price falls. Price earnings ratios are even higher than in India

and profit growth looks likely to disappoint.

The rest of the

world need not worry itself with either Mumbai or Shanghai, both primarily driven by local

factors. Falls of even 50 percent would cause barely a ripple elsewhere. The

world has plenty of other issues to worry about and the recent correction has

pointed at the two major ones but without coming to a definitive conclusion as

to if and when they will hit.

The first is the US

consumer. Has the bonanza of the real estate cash-out come to an end? House

prices have finally begun to slip and interest rates show no signs of falling –

though real rates remain well below historical norms. Companies in the US, as almost

everywhere, are cash-rich but showing little desire to increase investment –

and household incomes are barely rising faster than inflation. Two things will

happen when the US

consumer-led boom stalls. Most obviously, imports will tend to fall, with a

consequent knock-on effect for Asian exporters, China more than most because of the

Chinese economy’s exposure to US-bound exports. Contrary to some current

belief, it will not be question of the world catching cold when China sneezes, but of China

catching a cold from the US.

Quite how much

damage that will do to China’s

own growth rate remains to be seen but given that China

(and India)

have been growing at unsustainably high rates, the downward shift could be severe.

It will anyway be accompanied by a politically driven continued gradual

appreciation of the yuan against the dollar which will squeeze Chinese

corporate revenues and profits – and also those of US

retailers like Wal-Mart which source heavily from China.

That brings up the

secondary impact of the US

consumer retreat: the narrowing of the current account deficit, which would

reduce the pace of global liquidity creation. Growth of base money has been

fuelled by a 15 percent plus increase in global reserve assets, still mostly

held in dollars.

A weak US

economy would have the secondary effect of causing most currencies, particularly

the Asian ones which are conspicuously cheap (headed by the yen) to rise. In

turn this would further contract the local liquidity expansion effects of the US deficit. The

impact would be particularly felt by China, for whom the trade surplus

is a key to over-rapid credit growth.

It would likely be

less marked in countries such as Malaysia

and Taiwan.

Both seem candidates for currency appreciation and reduced current account

surpluses. But the liquidity expansion effect of their huge current surpluses

has been significantly offset by capital outflows, while China has had large net capital

inflow in addition to its current surplus.

Apart from the US consumer, the other global party pooper will

be Japan.

Whether led by a change of heart by Japanese institutions or by fear replacing

greed in the hearts of investment bankers and hedge fund gamblers, the huge

outflow of yen will come to a halt. Indeed, for many with leveraged positions

in the carry-trade it will be dramatically reversed.

The importance of a

sudden rise in the yen, back to say 105 to the US dollar, would not be so much

on its trade surplus or domestic profit, which is super-competitive at current

low exchange rates. It is the sudden increase in the exchange-rate cost of

borrowing Japanese savings. That will mean a sharp pullback in the global

liquidity expansion by which Japanese savers have been financing consumer booms

in the US, UK, Australia,

New Zealand etc and driving interest rates in sickly emerging markets such as

the Philippines

to rock bottom levels.

Quite how fast all

this happens is impossible to tell, if only because of the opaque nature of the

credit derivatives business and the sheer size of currency hedging books. But

once markets get a whiff of trouble, rout could follow and take some big

institutions and funds down with it. There was a hint of panic this week even

though the US consumer’s

retreat is not yet a sure bet in the near term, and Japan’s

weak-willed central bank has appeared to extend the life of the yen carry trade

and by implication the Taiwan

dollar and Swiss franc equivalents (both have been unnaturally weak despite

huge current account surpluses).

So what does this

say to investors? Will it take commodity markets down with stock markets as

demand stalls simultaneously with the contraction in liquidity? Some impact in

inevitable at least on base metals such as copper. But the overall impact on

commodities may well be modest as investments in new production have lagged

demand and new mines come on stream only slowly. Food commodity prices will be

kept under upward pressure by demand from ethanol and biodiesel plants. Precious

metals may even benefit as investors seek refuge from currencies as well as

stocks.

But don’t rush out

and buy Australia.

Australian consumption and property prices are likely to suffer badly as the

cost of sustaining its huge current account deficit increases just as commodity

markets falter. Avoid the Aussie and NZ dollars which have been buoyed up by

the carry trade.

The euro will

probably get even stronger against the US dollar as the ECB keeps monetary

policy quite tight even as the US

heads for recession. But it has already risen so steeply since its nadir five years

ago that a major new move seems unlikely. Ditto the Canadian dollar, which

would also suffer from a commodity decline.

The currency action

is going to be mostly in Asia and the yen will

be the key. The NT dollar will not be far behind and may well strengthen

against the yuan as well as the US dollar. Ditto the ringgit. Further

appreciation against the US dollar is likely for the won, Singapore dollar and baht, but

having led the way in Asian currency appreciation they will now likely lag.

So what does this

scenario do for Asian stock, property and bond markets? Clearly exporters’

margins will be squeezed by weak US

demand, a possibly faltering China

and by currency appreciation. Reduced global liquidity should put upward

pressure on interest rates but commodity-driven inflation is falling and

stronger currencies will deter authorities from raising rates. So bond markets

may be quite stable (except for the weaker countries like the Philippines and Indonesia). Stock markets can

expect to suffer broadly but domestically-oriented issues including banks in

most of Asia should not be badly hurt. (China and India excepted)

Indeed, Taiwan and Japan may well see repatriated

funds invested in the property market. Hong Kong’s property market should also

benefit from a weak currency vis-à-vis China.

As for Wall Street, the

end of the consumer and property booms will see some horrendous casualties in

the credit sector, retail and real estate. But some boring old manufacturing

outfits would do really well out of a declining dollar and continued, if

slower, growth in foreign markets, especially in Asia.

Perhaps the

overriding question is not what the trend is going to be but how fast it will

happen and hence how destabilizing. The impact of interest rate and currency adjustments

has so far been gradual and un-alarming. If continued there will be no crisis

but a slow but sure shift to a new trade and market equilibrium.

However, experience

suggests that after such a long period of monetary expansion there will be a

catharsis, not as severe as the 1997 Asian crisis but on a scale that spans the

whole globe.