Global: Flash Points: Nasdaq, the Euro, and Oil
Stephen Roach (from Beijing)
World financial markets seem to be nearing an important flash point. With Nasdaq reeling and the euro in danger of freefall, a new disconnect has surfaced: How can the icon of America’s New Economy crumble while the dollar continues to rise? Surprisingly, the resolution may come through the oil price wild card.
The dollar, of course, has defied conventional macro logic as we know it -- it has continued to strengthen in the face of America’s record current-account deficit. Over the long haul, I do not believe this condition is sustainable: Something must and will give -- the current account via a US hard landing or the dollar. But to paraphrase Lord Keynes, in the long run, we’re all dead. And dollar bears have, indeed, died a thousand deaths in recent years, especially in 2000. Rest assured, we all seem to have cracked the code of the dollar’s Teflon-like immunity. Global capital flows continue to surge into dollar-denominated assets, both in the form of cross-border M&A activity and portfolio flows. As long as this trend continues, the dollar will stand tall -- irrespective of supposedly immutable laws of economics. When the flows stop, however, I suspect it will be a very different story altogether.
Scaling the flows gives some understanding of how defiant markets can be to the ironclad laws of economics. According to John Montgomery, our resident capital flow guru, net portfolio and direct investment inflows into the United States were about $190 billion in the first half of 2000, sufficient to have financed 90% of America’s staggering current account deficit over that interval. The portfolio piece of those inflows accounted for 75% of the total in the first half of this year. But there’s good reason to believe that the composition of these flows has shifted increasingly into direct investment in recent months. Completed cross-border M&A transactions into the US amounted to $68 billion in the first three quarters of this year, and the volume of announced deals hit a staggering $189 billion over this same period. Moreover, consistent with balance-of-payments accounting methodology, these flows are all stated on a "net" basis, subtracting out America’s overseas investment outflows. As such, the gross inflows from abroad into dollar-denominated assets run well in excess of the net inflows.
Why? It’s all about the New Economy, stupid. Dollar-denominated assets are perceived to be deserving of a permanent premium over assets of other nations. I have traveled the world in recent weeks, first to Europe and now to Asia. One conclusion comes through loud and clear: America is viewed around the world as sitting atop the pinnacle of a New-Economy mountain that other nations will never be able to climb. As I see it, the once sparkling brilliance of Nasdaq has personified all that was perfect about the global play into US assets, but now the bloom is off the rose. As Nasdaq fades, investors are coming to grips with the harsh reality that technology may turn out to be a cyclical business after all. This draws into question the mindless extrapolations of earnings growth that had long been embodied in bubble-like Nasdaq valuations. As those extrapolations come back down to earth -- and in my humble opinion, the journey may be far from over -- the notion of a permanent relative premium on dollar-denominated assets could be drawn into serious question.
As always, it will take a jolt from out of the blue to hammer that point home. I have no idea what that spark will be. But one possibility is starting to intrigue me -- a peaking of oil prices and a related rebound of the euro. Surging oil prices have, indeed, been a bonanza for the dollar. It was possibly the one event that took the dollar into its own bubble-like zone of overvaluation that was strikingly reminiscent of Nasdaq’s ascendancy last spring. The trashing of the euro is, of course, the corollary of this development. As soon as the oil price peaks -- and it always does -- this same dynamic could begin to spin rapidly in reverse. Enter Saddam Hussein -- an old actor from an old stage, who never seems to give up in his quest for attention and impact. By floating the possibility of pricing Iraqi oil in euros, he could well serve the purpose of galvanizing attention to the linkage between the oil price and the long-standing disequilibrium in foreign exchange markets. Stranger things have happened.
The strong dollar has been the linchpin of the virtuous circle. The American-led renaissance of world financial markets could not have happened without it. We all know that. To the extent that Nasdaq has personified all that was permanent about this virtuous circle, the two-way trade may be about to resume in world currency markets. It would undoubtedly take a peaking of oil prices to get there. In light of recent events in the Middle East, that event still seems to be off in the distance. But that day will come -- possibly sooner than we think. With it I suspect lies the fate of the dollar and, believe it or not, newfound glory for the euro. And redemption for the old macro.
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Currencies: Beyond This Oil Shock
Stephen L. Jen (London)
It’s never too early to look for the next turning point. Brent traded at US$10.40 a barrel in the beginning of 1999, peaked at US$37.40 in September 2000, and is now trading at around US$31.20. A key part of the global slowdown story is high oil prices. But could we see oil prices plummeting below US$20 a barrel in 2001? We believe that the probability of this scenario is higher than many think. Oil prices are high, and are likely to stay high for several months longer. But if the world is to slow in 2001, why should oil prices stay high?
Factors to track. When the world slows, oil prices should fall. While the qualitative aspect of this scenario should not be contentious, we believe that it is important to track the key factors that will determine how sharply and when oil prices could fall.
Factor 1. Decelerating global demand. Oil prices tend to be very pro-cyclical, in light of the relatively slow response of OPEC in adjusting its output. Though OPEC has pushed up its production target by more than 3.2 mbpd (million barrels per day), it did so incrementally, and at a pace that was substantially slower than the rate of acceleration in global demand. When the world economy decelerates in 2001, as we project, we also expect OPEC to take belated action. Based on our forecast of global growth of 4.9% in 2000 and 3.9% in 2001, global demand for oil could be less than 78 mbpd in 2001. This would reflect a year-on-year growth rate of oil demand that is back on par with the trend growth rate in the 1990s of around 1.3-1.5%, rather than the exceptional 4% witnessed in 2000.
Factor 2. "Exogenous" factors may force OPEC to raise output further. If oil prices continue to be supported by the "exogenous" factors, such as the Middle East Crisis and a cold winter, the pressure from the global community for OPEC to raise its output would persist. In fact, we think OPEC is likely to raise its production target again when it meets on November 12. The point here is that OPEC will be pressured to increase its production even if the reasons for high oil prices lie somewhere else (pipeline capacity, tanker capacity, refinery capacity, etc.). But when these other constraints are alleviated, there will likely be a large excess supply of crude oil.
Factor 3. OPEC must cut output in early-2001 to avoid a price collapse. As suggested above, crude oil supply may not be the binding constraint any more. But convincing OPEC to cut production in 2001 may be even more difficult than squeezing more output out of them now. Historically, OPEC has had much more difficulties in agreeing on production cuts than production increases. The Centre for Global Energy Studies (CGES) believes that if OPEC fails to cut oil production in 2001, ceteris paribus, oil prices could plummet to US$12 a barrel by 2001Q4. Alternatively, an output cut of about 2.0 mbpd would be needed to stabilise prices within the US$22-28 band.
My thoughts.
Point 1. Low oil prices will be positive for emerging markets. The oil shock hits countries that are more oil-intensive harder than the less oil-intensive countries. Since developing countries are about twice as oil-intensive as developed countries, this type of tightening imposes on the former a heavier burden in slowing down the world economy. Lower oil prices next year could be more positive for emerging markets than for developed economies.
Point 2. Externality and the "free rider" problem. There is another aspect of the relationship between the oil shock and interest rates. Oil is different from labour. Central banks are now held accountable for high oil prices. In practice, there could be a "free-rider" problem where central banks could try to wait for others to tighten first. Not only could the US have been a "free-rider," NJA countries have also been free riders.
Point 3. Resurgence of the inflation/deflation debate. Could the world flirt with deflation again next year, as growth decelerates? After the winter season, when oil prices plummet, global price pressures should abate. Asset markets could find a floor. The talk of a negative terms-of-trade shock undermining Asia’s recovery should go out of fashion as well. Also, the Fed by then would have the asset market adjustment it wanted through the oil shock.
Bottom line. In the absence of aggressive cuts from OPEC, oil prices could plummet in 2001H1. Emerging markets and countries with dovish central banks should benefit. |
