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To: Rarebird who wrote (38197)	8/2/1999 8:48:00 AM
From: Crimson Ghost	Respond to of 116753

Morgan Stanley's Steve Roach bearish on US financial assets, bullish on inflation. Global: Still Coming to Grips with Global Healing Stephen Roach (from Hong Kong) World financial markets have come a long way in accepting the reality of global healing. Global bond markets have corrected. Equity cyclicals have rallied. And now the dollar has turned. Is there more to come? My guess is there is. It all started with the great bond market correction of 1999. The 30-year US Treasury bond — the world's "riskless" asset — provides the cleanest read on how investors played the global crisis. When yields on long Treasuries hit a record low of 4.72% in early October 1998, investors had become convinced that a secular deflation was at hand. The world was perceived to be sliding into an abyss of crisis and ever-deepening recession. The inflationary premium that was embedded in the long end of the Treasury yield curve was flashing expectations of a CPI that was expected to average just 0.6% over the next decade. At that point in time, it was a one-way bet in world financial markets: Interest rates were thought to stay down forever, and the US dollar was the asset of choice — the only safe haven in an increasingly treacherous climate. Global healing has changed all of that. In the past three months, we have raised growth estimates in 15 countries that we have under coverage. That has been sufficient to take our above-consensus 1999 estimate of world GDP growth from 2.0% to 2.7%. And there has been a three-step response in world financial markets. First, came the bond market correction. As investors came to grips with a world on the mend, they abandoned the deflation play of late 1998; the inflationary premium in the US bond market rose by 150 bps (from 60 bp to 210 bp), sufficient to explain all of the increase in nominal long-term interest rates in the United States. Second, equity cyclicals surged, especially in April when early warning signs first became evident that the pace of activity in the global economy was about to improve. The third and most recent phase involves the dollar. Throughout the first half of 1999, the US economy was the only real growth story in the industrial world. Now, with clear signs of Europe on the rebound, and even Japan on the mend (at least temporarily), perceived growth differentials are shifting away from the US economy. That dims the attractiveness of the dollar as a safe-haven play, especially against the backdrop of America's gaping current-account deficit. The resulting currency diversification play is part and parcel of global healing. All of these developments are characteristics of what we have called "post-crisis normalization." While this sounds like medical jargon, it is intended to convey the impression of an important shift in financial markets that matches up nicely with the global economy's transition from crisis to recovery. In the depths of the crisis, financial markets were priced for deflation, ever-deepening global recession, and central banks that would forever remain predisposed toward monetary easing. In a post-crisis climate, all of these assumptions get unwound. Markets re-price financial assets for conditions and risks prevailing before the crisis hit — a climate characterized by moderate growth, low inflation, and solid earnings. This is the so-called return to pre-crisis norms that has driven our own out-of-consensus calls on bonds, the Fed, equity cyclicals, and more recently the dollar. But I fear that the story doesn't end here. Key in this regard is to look beyond normalization and ponder the possibility of an even more cyclical outcome, which would take investors full circle from last year's deflation bet to more of a classic late-cycle inflation bet. Cyclically advanced economies, like the United States, would be the first to migrate into this aspect of the global healing scenario. In the case of a fully employed and rapidly growing US economy, that spells a cyclical pickup in inflation. Commodity prices and purchasing managers' sentiment are already flashing such an outcome. The recent decline in the dollar is also hinting in that direction. Long dormant labor cost pressures have been the missing piece to this puzzle; the June Employment Cost Index suggests that piece may have been found. A cyclical case for inflation suggests that the Fed will have to do more than restore short-term interest rates to pre-crisis settings. The US central bank may actually have to fight a little bit of cyclical inflation to boot — an outcome that few seem willing to contemplate. Global healing allows pre-crisis fundamentals to come back into play. Seemingly dysfunctional economies are now in the process of becoming functional again. The once discredited rules of the old macro — especially the linkage between economic growth and inflation — are suddenly starting to work again. For financial markets that now look priced for just the first whiffs of inflation and interest rate normalization, there still seems to be denial over the full ramifications of global healing. That puts all the more pressure on overvalued equity markets.