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Global: Beyond the Fix
Stephen Roach (New York)
While there are plenty of problems on the macro scene these days,
there’s still great confidence in the ability of the Authorities to resolve
them. At least that was one of the key conclusions I took away from our
annual global investment conference held this past week in Nassau.
Spurred on by the significant rally in global equity markets over the
past month, the assembled investors were looking to invest in the more
tranquil environment that would be evident once the policy fix took
hold.
As usual, we did a fair amount of polling of the assembled group to
measure their sentiment. They were unmistakably optimistic on the
prognosis for the US equity market. Not only did the majority believe
that stocks would rally at least another 10% between now and year-end
2002, but by a margin of nearly two to one they looked for a minimum
of an additional 10% increase in 2003. And, borrowing a page out of
the script of the late 1990s, it was thought to be a good-old-fashioned
tech-led rally. This was a group that had grown tired of the low-return
defensive strategies of the past couple of years. The time for more
aggressive plays was finally thought to be at hand.
Consistent with this optimistic assessment of the stock market, the
majority of the assembled investors looked for sustained, albeit
modest, recovery in the US economy. The majority felt that real GDP
would increase by at least 2.5% in 2003. They listened politely to my
case for the double dip, but in the end most – but not all – rejected it.
The group was confused on the outlook for the bond market. On the
first day of the conference, I was stunned to find that the bulls (looking
for yields on a 10-year Treasury to hit 3% between now and the end of
2003) outnumbered the bears (a 5% target on the 10-year) by a little
less than two to one. On the last day of the conference, however, it was
basically a toss-up between these two opposing camps. Some of the
bond bulls had obviously changed their minds or gone home early.
These summary results of the polls we conducted do not do the
richness of the debate much justice. There was considerable give and
take in the macro sessions that shed a good deal of light on the
tensions bearing down on financial markets. For example, there were a
number of investors who were very vocal in expressing sympathy to my
case for deflation. But they viewed this potential risk as more of an
imperative for public policy than as a lethal doomsday scenario. The
implicit message: Bad things happen only to others, but not to the
United States. The operative presumption was that the Authorities would
rise to the occasion and do whatever it takes to prevent deflation from
getting out of hand. They were, however, quite vague on the "whatever
it takes" part of this premise. Most of the investors at our conference
were simply willing to give the benefit of the doubt to the coming policy
ploy. They then wanted to take it to the next stage, choosing the
beneficiaries of America’s coming reflationary gambit.
This gets to one of the key point we have actively been debating at
Morgan Stanley – whether deflation is actually in the price, or not.
Barton Biggs continues to believe it is (see his essay "Of Double Dips
and Deflation" in the November 13 issue of Investment Perspectives).
And I continue to maintain that it is not, citing the so-called TIPS
spread of 160 bp – a real-time measure of the inflationary premium
embedded at the long end of the Treasury yield curve – in support of
my case. After all, this same spread got down briefly to 60 bp in late
1998, when a crisis-induced "seizing up" of world financial markets led
to something much closer to a full-blown deflation scare. By that metric
the bond market is still 100 bp away from pricing in another deflation
scare. Needless to say, what’s in the market is critical in assessing the
fallout from a further intensification of deflationary pressures. To the
extent that I’m right, there’s considerably more downside to the
earnings profile that would shape equities, to say nothing of the
downside to the inflationary premium that drives bond yields. To the
extent Barton’s right, it’s hard to conceive of any bad news that might
rattle the markets. I took some comfort from one of the most
out-of-consensus calls of any of the assembled investors – that yields
on 10-year Treasuries would pierce the 3% threshold. His view was
rather lonely, but as it was the view of one of the world’s leading bond
market experts, it was one you didn’t dismiss lightly.
China finally made it to center stage this year. I have been pushing the
bull case for China consistently at this conference over the last three
years. The response has been lukewarm, at best – an interesting story
but one filled with innumerable short-term risks (i.e., banks, rising
unemployment, and still too many unprofitable companies) and an
all-too-distant long-term payoff. This year, China was ubiquitous –
present in virtually all aspects of our discussions. China’s deflationary
influence was stressed by many as a powerful depressant on profit
margins of western industry. China was also perceived to be
unstoppable in any market-share battles in Asia or the broader global
arena. In our session entitled "Search for Growth," no one wanted to
consider Europe, Japan, or anywhere else in the world as a potential
replacement for the stalled American growth engine. China was thought
to be the only viable candidate.
Several of the assembled investors also were quick to dismiss the claim
that – growth or not – it’s impossible to make money in China. Three
options were most favored – China’s fast-growth utility companies, its
resource companies, and an increasingly wide array of Western
companies that now benefit from China-based outsourcing strategies.
The investors grilled our China economist, Andy Xie, on the legalities of
making money in China – especially taking earnings of foreign
subsidiaries out of China. When Andy noted that China reported $28
billion in foreign investment outflows in 2001, the doubters started to
flinch. Over cocktails, I had several investors come up to me and ask to
sign up for my next trip to China.
China’s ascendancy at this year’s conference was indicative of the
ultimate paradox that came out of the debate – the notion that the
Authorities actually have the answer in an increasingly deflationary
world. Not only is China a growing source of macro tension in the world
from the standpoint of pricing and market share, but its impacts tend to
overwhelm the traditional stabilization policies of other major
economies in the world. Many investors at our conference expressed
similar concerns with respect to other forces at play in the US – namely
the diminished returns of the "refi cycle" to boost personal
consumption, deteriorating fiscal conditions at the state and local level
as a significant offset to federal budgetary stimulus, a credit crunch that
is intensifying for small- and medium-sized businesses, the prospects
of another round of layoffs, and the impacts of low nominal interest
rates on the retirement earnings of the elderly. Meanwhile, there was
also concern over mounting tensions in the international arena –
especially with respect to the potential for a major crisis in Brazil in early
2003, to say nothing of an outbreak of protectionist sentiment if the
dollar finally cracks, as I suspect. Yet in their bullishness on US
equities, the assembled investors were either dismissing these concerns
or presuming that the Authorities are clever enough to sidestep them. I
continue to have my doubts on both counts.
On the final night of the conference, several of the participants asked
me what I had learned over the three days of intense give and take. I
offered three observations: First, US investors are becoming less
parochial and are now paying more attention to global forces (i.e.,
China). Second, investors are utterly convinced that policy can fix
anything that ails America – from deflation and asset bubbles to
asset-liability mismatches and geopolitical threats (i.e., Iraq and
terrorism). Third, denial has yet to crack with respect to the potential
interplay between the first two points – between a US-centric world and
America’s post-bubble hangover. If America saves the day by achieving
policy traction, then the imbalances of a US centric world can only
become more precarious. Conversely, if the US continues to list toward
deflation and double dip, financial markets are leaning precisely the
wrong way. In my view, the consensus at our annual investor conference
didn’t seem to grasp the enormity of a world in disequilibrium. Could
the curse of Lyford Cay strike again? |
