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
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
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
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
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
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
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
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.
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.
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