Stephen Roach of Morgan Stanley - June 24, 2002
Global: The Trees or the Forest?
Stephen Roach
Financial markets are supposed to be a huge forward-looking discounting machine. Yet nothing could be further from the truth these days. Our strategists remain focused on whether this is the time to catch that proverbial knife in midair and play a tradable rally in an oversold equity market. Our economists are hard at work in scrutinizing weekly chain store reports and jobless claims in an effort to discern the underlying fundamentals of aggregate demand. Meanwhile, tectonic shifts are occurring in the macro climate. A turn in the dollar, another crisis in Latin America, whiffs of deflation, and increasingly impotent central banks all speak of an engineless global economy that casts financial market risk in a very different light. The forest has never looked more different from the trees.
I’ll leave the short-term calls to the traders. But my macro lens continues to see the movie of the 1990s running in reverse. America was the world’s bubble and now it has popped. Equities led on the upside and were the first to go on the downside. And the real economy has followed with predictable lags. The first shoe to fall was the capacity overhang of earnings-battered businesses. Next to come should be the spending excesses of saving-short and overextended consumers. A US economy that drew increasing support from the extremes of financial asset appreciation is now returning to the much tougher basics of income-driven fundamentals. At the same time, a long overdue US current-account adjustment is under way -- a multi-year process that should ultimately force a US-centric world to come up with a new recipe for global growth. Try as they might, policy makers can’t alter the endgame. The new realities of this post-bubble era are likely to remain with us for some time to come.
The unwinding of the dollar bubble has equally profound implications. The interplay between currency markets and other asset prices is turning many of the rules of engagement in financial markets inside out. In recent times of turmoil -- for example, the Asian financial crisis, the demise of Long-Term Capital Management, and the popping of the Nasdaq bubble -- dollar strength cushioned the blow in the broader equity and bond markets. It was symptomatic of a Teflon-like US economy that was able to ward off the impact of even the toughest of body blows. Shielded by the ultimate in virtuous circles, a US-centric global economy had little to fear.
A weak dollar denies investors the cover they had grown accustomed to. It also unmasks new fault lines in the global economy. That puts today’s rapidly spreading Latin American currency crisis in a very different light. This, of course, was the contagion that was never supposed to happen again. The tragedy of Argentina was widely thought to be a country-specific problem that had little or no bearing on the rest of the region. But now Brazil, the largest economy in the region, has seen a wholesale markdown of its currency and bonds that is every bit as bad as that which occurred in the depths of the crisis three and a half years ago. Nor are other Latin economies being spared this contagion. From Uruguay to Mexico, virtually all of the region’s currencies are now lurching to the downside.
Consequently, this year’s 7.9% decline in the trade-weighted value of the dollar (as measured against the broadest basket of America’s trading partners) takes on new meaning. In a post-bubble world, "buy America" is suddenly seen as a risky alternative. In retrospect, this shouldn’t be all that surprising. Just as it was when Nasdaq was rocketing toward 5000, the world has overdone the dollar play. As Joe Quinlan has noted, foreign investors appear to have reached historical saturation points with respect to their holdings of dollar-denominated assets (see his 21 June dispatch, "Saturation of Foreign Holdings of US Assets"). For example, at the end of 1Q02, foreign holdings of US Treasuries totaled $1.25 trillion, close to the previous record of $1.3 trillion hit in 1998; that’s equivalent to 35.7% of outstanding marketable Treasury securities. At the same time, foreign ownership of US equities rose to a near record high of $1.75 trillion in March 2002 -- equivalent to nearly 13% of the value of outstanding corporate stocks. Such saturation, against the backdrop of America’s massive current account deficit, puts an engineless world on notice: Unlike the case in earlier crises, there is no refuge in the once proud safe-haven status of the dollar.
A rapidly spreading Latin currency crisis, in conjunction with a weaker dollar and what I believe is an increasingly fragile recovery in the global economy, changes everything for the world’s major central banks. Financial markets had been virtually unanimous at the start of this year in looking for the monetary authorities to take back the extraordinary rate cuts that had been put in place in the immediate aftermath of the terrorist attacks on 11 September. This "recalibration" is standard operating procedure for central banks once the impacts of any shock wear off. Once a post-shock economy is able to stand on its own, a return to pre-shock interest rates is usually in order. It’s just a question of when.
But it may be different this time. That’s because the world is a more deflationary place than it was pre-September 11. US inflation has fallen to a 48-year low of a 0.45% annual rate in the past two quarters (as measured by the broad GDP chain-weighted price index). At the same time, Asian deflationary pressures have intensified. As Andy Xie notes, the newly-industrialized Asian economies (Korea, Taiwan, Singapore, and Hong Kong) have lowered their real export prices by 41% over the past decade. Yet, that’s nothing when compared with the rapidly emerging "China factor" -- the intensification of deflationary pressures from the largest and fastest-growing economy in the region. That’s underscored by the reemergence of outright deflation in China late last year -- a decline that has persisted to this very day, with the Chinese CPI running 1.1% below its year-earlier level through May 2002.
At the same time, there is good reason to question the final demand follow-through to the US inventory dynamic. In my opinion, earnings-battered Corporate America remains very much focused on cost cutting, likely to take further actions that would continue to restrain capital spending and hiring. The macro feedback effects of such restraint should intensify pressure on the US economy’s income-generating capacity -- spreading macro vulnerability to the heretofore resilient American consumer. This, of course, underscores the possibility of the double dip or the anemic recovery, either of which would prolong America’s deflationary perils.
Against this backdrop, why would central banks tighten at all over the foreseeable future? Recently, our US team pushed out its view of an August Fed tightening. For what it’s worth, as a card-carrying double dipper, I wouldn’t be surprised if the next move of the Federal Reserve was to ease. Indeed, I would currently ascribe as much as a 40% probability to just such a policy adjustment -- roughly consistent with the same probability that I would now pace on the dreaded double dip between now and the end of this year. In my view, the combination of a rapidly spreading Latin currency crisis, heightened geopolitical tensions, and another sharp downdraft in US equity markets reinforces the possibility of such a Fed surprise. For many of the same reasons, but with the added complication of a strengthening euro, I also find it hard to believe that the European Central Bank will tighten in this climate. That conclusion stands in contrast with our official view that still calls for an ECB tightening on 4 July.
All this represents a rude awakening for the once proud Federal Reserve. Yet it didn’t have to end this way. Alan Greenspan was well ahead of the curve in December 1996 when he pondered the perils of "irrational exuberance." But by failing to follow through on this warning and then by adding fuel to the mania through his steadfast support of the "new economy," the great moral-hazard play was on with a vengeance. Few could resist -- long-term investors and speculators alike. Sadly, the rest is now history. But it’s a history that could well have more painful lessons to offer -- those of central banks that end up "pushing on a string" in the aftermath of an asset bubble. Just as the Bank of Japan has had to struggle with this painful reality over the past decade, the Fed may find it exceedingly difficult to gain policy traction in the years ahead. And so the era of the omnipotent central banker may have drawn to a close.
In the meantime, the state of play in world financial markets is shaping up as the mirror image of the 1990s. The fall of the once mighty dollar and a whiff of deflation have the potential to turn the world inside out. Engaging in hand-to-hand combat over the weekly gyrations in the markets and the economy does this debate a real disservice, in my view. There are far bigger issues to face up to. You can’t tell the new forest by looking at the old trees.
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