A surprising good Roach for a change.
Looks like his recent optimis has waffled.
What does that mean if anything?
morganstanley.com
Global: Fleeting Lessons
Stephen Roach (New York)
Confession time: I am still not ready to let go of 2005. I’ve gone through my annual ritual of trying to make sense of what went right and wrong on the global macro scene in the year just ended (see my 3 January dispatch, “The Lessons of 2005”). In the spirit of mark-to-market accountability, it was as dispassionate and honest an assessment as I could muster. But the catharsis that normally accompanies such an introspective endeavor is missing. As I look back, I still have a gnawing feeling in the pit of my stomach that 2005 was a year of suspended animation.
The year just ended most assuredly did not go according to my script. An unbalanced world turned out to be more stable than I had thought. And despite a wide array of serious shocks -- from hurricanes to spikes in energy prices -- the expansion was both resilient and durable. The broad consensus of investors, businesspeople, and policy makers has taken great comfort from this benign outcome -- hoping that a similar scenario is in the offing for 2006. A frothy start in the first few trading days of the new year underscores this hope. While I’ve learned never to say never, I must confess that I will be stunned if this year unfolds without a hitch.
It is quite possible that we’re being too analytical in attempting to discern why it all went so well on the global macro front in 2005. It may simply be that the stars were in near perfect alignment, enabling the world to buy an extra year of time. I think the odds are low that an unbalanced world economy will continue to draw support from such a favorable constellation of forces. Reversals are possible on three fronts -- the liquidity cycle, the US property market, or the dollar. Shifts in any one of these areas could well be enough to transform the global outcome from benign to malign. The interplay between these forces could be especially lethal.
A turn in the global liquidity cycle would be the most worrisome development. This will come about only through the conscious design of central banks. Yet that’s exactly what now seems to be under way. The world’s major central banks all seem focused on the same objective -- a normalization of policy rates. The Federal Reserve was first to embark on this campaign, and some 325 basis points later, America’s monetary authorities are signaling that their mission is just about accomplished. The ECB has just begun the march toward normalization, but with Euroland activity now on the rebound, there is reason to believe that additional progress will occur sooner rather than later. Even the Bank of Japan, which has gone to extraordinary measures with its zero interest rate policy for nearly seven years, is dropping strong hints that the first step toward normalization -- in its case, an end of “quantitative easing” -- is just around the corner.
This shift in monetary policy represents a sea change for the global liquidity cycle. Even if persistently low inflation allows central banks to stop short of taking their policies into the restrictive zone, the transition from extraordinary accommodation to neutrality is a big deal. That’s because it entails a meaningful increase in real short-term interest rates -- long the most powerful transmission mechanism of the impact of monetary policy on the real economy. In the case of the US, for example, the real federal funds rate (as calculated relative to core inflation) has already gone from “zero” to 2% in a span of 18 months -- a meaningful tightening by standards of the past. Moreover, it is important to remember that the impacts of such policy shifts typically hit with 12-18 month time lags. That means that the impacts of the current tightening cycle are only just now beginning to trickle into the system. The flat to microscopically inverted yield curve underscores the pressure on the liquidity cycle; banks, for example, are finding it far less attractive to provide new credit at lending rates that are at, or below, deposit rates. Moreover, as Andy Xie notes in today’s Forum, the recent deceleration of growth in Asian foreign exchange reserves may be an important early warning sign of a turn in the global liquidity cycle (see his 6 January dispatch, “Liquidity Receding”).
A post-bubble shakeout of the US housing market is a second factor that I believe would challenge the extrapolation mindset of momentum-driven financial markets. That’s because the ongoing support of the seemingly unflappable American consumer has been heavily dependent on the wealth creation of the Asset Economy. In that vein, a mere slowing in the rate of residential property appreciation would represent a significant headwind for a still income-short consumer. With annualized housing inflation still running at a 20% annual rate, or higher, in 40 major metropolitan areas in the US and with most gauges of national house price inflation now looking “toppy” at best, there is good reason to believe that a significant slowdown in the pace of asset appreciation is in the offing. At the same time, a shift in the liquidity cycle points to reductions in home equity extraction -- the monetization of property-based wealth creation. With interest rates on home equity loans having risen from 4% to 7% over the past 18 months, that’s hardly idle conjecture. Reflecting the impacts of higher energy prices, real consumption appears to have expanded at less than a 0.5% annual rate in 4Q05. Most believe this was an aberration that will be followed by a sharp bounceback in consumer demand in early 2006. If the housing market fades, any such rebound is likely to be fleeting.
The dollar is a third leg to this stool. Last year’s surprising rebound in the US currency short-circuited much of the market-based venting that normally drives a current account adjustment. In momentum-driven financial markets, currency trends and capital flows tend to be self-reinforcing. The more the dollar strengthened, the more confident foreign investors -- private and official -- became in US assets. It was the ultimate virtuous circle that then gave foreign investors little reason to seek concessions in the form of real interest rate adjustments that would provide compensation for taking currency risk. In the currency business, circles can quickly turn from virtuous to vicious -- especially for economies with massive current account deficits. With the dollar having been under renewed downward pressure over the past couple of months, and with Chinese and Korean authorities hinting in recent days at official shifts in foreign exchange reserve management practices, this is a risk to take seriously, in my view.
Nor should these potential adjustments be treated in isolation from one another. If, for example, the dollar goes and real interest rates are bid up in response, adjustments to the US housing market will undoubtedly be more severe. Under those circumstances, overly-indebted American consumers will then be squeezed by higher debt-servicing expenses. If, on the other hand, the US housing market simply falls under its own weight -- a distinct possibility given the major overhangs in property values in many segments of the nation -- the hit on wealth-dependent consumption and GDP growth could then be a major negative for the dollar. This is a point that Stephen Li Jen has been making for some time. And, of course, if the American consumer fades for any reason, the impacts on the rest of the world would be especially acute. With growth in internal private consumption remaining anemic in Asia and Europe, a loss of support from US-centric external demand could deal an especially harsh blow to the global economy. That’s when the pitfalls of a US-centric global economy come home to roost. Relative to sanguine expectations, the US economy could well be the weakest link in the global growth chain -- underscoring the possibility of another year of under-performance for dollar-denominated assets.
In the investment business, we always caution, “…past performance may not be indicative of future returns.” Yet the broad consensus of market participants seems intent to throw such caution to the wind in extrapolating the experience of 2005 into 2006. To the extent last year’s lessons are applicable this year, there would be good reason for optimism on the prognosis for the global economy and world financial markets. But the chances of ongoing support from the liquidity cycle, the US housing market, and the dollar are fading quickly. Stars rarely stay in perfect alignment for long. My advice: Don’t rework your life around last year’s lessons -- they stand a good chance of being far more fleeting than normal. And, now, I’ll let go of 2005. |
