Lays it out succiently.
May 27, 2006
AsiaTimes
RISKY BUSINESS
Liquidity contraction feeds bloodbath
By Jephraim P Gundzik
A global asset market correction has begun. This correction has been inordinately brutal on what were once the world's highest-flying stock and bond markets. The sudden downdraft in global asset markets appears to have been triggered by higher-than-expected US inflation.
However, rapidly contracting global liquidity is the real culprit. The contraction of global liquidity will accelerate over the next six months, which could push currently favored markets down a further 25-35% - at least.
The bloodbath in emerging market assets since mid-May has been remarkable - very few saw it coming. In the past three
months many of the world's largest investors in emerging market assets, even some so-called market gurus, have been beating the drum for continued strong price advances.
Curiously, none of these heavyweights has emerged from their bunkers yet. Hopefully they're extremely busy trying to understand why equity markets in Korea, Thailand and the Philippines dropped by 10% and those in India and Indonesia by 15% in the past two weeks.
Seemingly unstoppable equity markets in Latin America and emerging Europe have not been immune to this setback. Stocks in Mexico and Brazil have lost an average 12% of their value, while losses in Russia and Turkey are near 20%.
Emerging market bonds have been another casualty of the global asset market downdraft, with sector-wide indices losing about 15%. This downdraft, which has also ensnared asset markets in developed countries, has wiped out hundreds of billions of dollars of investor equity.
Many blame the world-wide correction in emerging and developed asset markets on mildly worse-than-expected US inflation data. However, the underlying cause of this rout has been contracting global liquidity, to which falling stock and bond markets worldwide are contributing.
Global liquidity will continue to contract as monetary conditions in Japan, the EU and the US tighten in the months ahead, feeding an extended correction in global asset values.
Central bank tightening in Japan and the EU
The end of quantitative easing in Japan is the most important factor draining global liquidity. Since 2003, the Bank of Japan has flooded the country's banking system with excess liquidity.
Rather than being used to finance domestic investment, these funds have been lent by Japanese banks to foreign investors in the form of interest and currency swaps. Attracted by strong momentum and the potential for high returns, these exceedingly cheap yen loans have been primarily used to finance investment in wide array of emerging market assets.
The flow of yen liquidity into emerging market assets produced spectacular returns in 2005 despite broadly deteriorating political, social and economic conditions in many countries. Widespread disavowal of this deterioration encouraged continued strong investment flows into emerging market assets in the first four months of 2006. But at the same time, the Bank of Japan was plotting the end of quantitative easing.
In March 2006, Governor Toshihiko Fukui announced that the quantitative easing policy would be scuttled by the beginning of June. Many analysts were left pondering whether this meant an increase in Japan's dormant official interest rate was imminent.
Meanwhile, this column warned that a small upward move in interest rates would be inconsequential compared to the enormous negative impact Japan's rapidly ebbing liquidity would have on emerging market assets.
By draining liquidity from the banking system, the Bank of Japan has made it increasingly expensive for investors to roll over their yen loans, almost all of which carry tenors of one year or less. This, combined with sinking emerging market asset values and yen appreciation will force more investors to liquidate investments overlying ultra-cheap yen loans. Liquidation means selling, and selling means further downward pressure on emerging market assets.
Liquidity is also tightening in the EU, where recent inflation data has shown an unsettling rise in core prices. Rapidly rising energy prices, very strong credit growth and accelerating economic growth are feeding the increase. The European Central Bank (ECB)is widely expected to increase official interest rates at its next meeting on June 8; the main question is by how much.
The ECB may depart from the ridiculously gradualist approach to monetary policy tightening engineered by the US Federal Reserve over the past two years, pushing official interest rates up by 50 basis points.
Even if rates are only increased by 25 basis points, the door to further rate hikes will be unmistakably open. By the end of 2006, official interest rates in the EU will be near 3.5%, an increase of 100 basis points from current levels. Higher than expected official interest rates in the EU will encourage euro appreciation.
Market-driven tightening in the US
Liquidity in the US will also tighten over the next six months - with or without the Fed's guidance. Though core inflation measures in the US have remained inexplicably docile in the past six months, broad measures of inflation, such as the consumer price index, have clearly moved higher. Inflation expectations in the US have also shifted higher, as evidenced by the 60 basis point increase in long-term US Treasury yields since the beginning of 2006. Where there's smoke, there's fire.
After nearly two years, the Fed's timid pursuit of monetary policy tightening has only recently pushed official interest rates to a so-called neutral level where Fed officials judge policy to neither inhibit nor encourage economic growth. In other words, this gradualist approach to monetary policy tightening has encouraged higher rates of real economic growth than are compatible with core inflation rates below 2%. Once economists believed that stable inflation in the US was compatible with real economic growth of around 3%.
Since the fourth quarter of 2003, real quarterly GDP growth in the US has been between 3.6% and 4.7%, measured by comparing quarterly GDP to the same quarter the previous year. Only in the fourth quarter of 2005, following the devastating hurricanes along the US gulf coast, did quarterly GDP growth dip toward 3%. Quarterly GDP growth reaccelerated in the first quarter of 2006 to 3.6% compared to the same quarter in 2005.
This prolonged period of above-trend economic growth, coupled with relentlessly rising energy prices will feed higher core inflation in the US. This higher core inflation is bound to appear within the next three months, especially as summer begins and US energy demand grows. Once core inflation begins to rise, it will be very difficult to reverse, as will the accompanying market-directed surge in long-term US interest rates.
Higher energy prices and long-term US interest rates will do much of the Fed's lost work in the past two years to slow US economic growth. In fact, US economic growth will probably fall toward 2% in the second half of 2006. But the Fed, vacillating between indicators showing an abrupt economic slowdown and others showing rising inflation - in other words, stagflation - will remain firmly on its back foot, adding to market-driven upward pressure on long-term US interest rates.
Alternatively, the Fed may take strong action and begin to raise official US interest rates in 50 basis point increments. Either way, long-term interest rates in the US are headed higher than expected. In addition to an accelerating sell-off in the bond market, US equities are also poised for a swoon. Falling asset prices around the world will act to further tighten already diminishing global liquidity.
There's more potential bad news, though. A sharp decline in US stocks and bonds may begin to shake foreign investors, who hold over US$6 trillion worth of these assets. Foreign capital flight from the US, which has probably already begun, could prompt the devaluation of the dollar and a prolonged period of global economic weakness. With liquidity fast tightening in the world's largest economies, emerging market assets could well be poised for their worst performance in more than a decade. |
