The Least Likely Outcome?
Stephen Roach (New York)
Feb 3, 2003
<<The slow cure resolves nothing and, if anything, produces more pressures that can only be vented in the fat tails. The majority of the participants in MacroVision endorsed the muddle-through of the slow cure. To me, that may well be the least likely outcome for 2003.>>
Investors are understandably gun-shy these days. So are economists, analysts, and market strategists. Bear markets tend do that -- especially this one. The hope is that the worst is over. But there are few willing to bet that a meaningful resurgence in the global economy is now at hand. Markets are now discounting a slow cure. The downside has been ruled out -- but so has the upside. Therein lie the risks.
That, in my view, was the over-arching conclusion that follows from our annual MacroVision exercise -- two days of intense discussions on the economic and market outlook that Morgan Stanley’s global macro team conducts each year. We have gone through this exercise now for 11 years -- bringing our far-flung team together in an effort to probe and challenge our collective thinking. We assemble market strategists from all major asset classes -- fixed income, equities, and currencies -- along with our global team of economists and credit analysts. We make every effort to wipe the slate clean and start with a fresh sheet of paper in attempting to gauge the fundamental forces that we believe will be key in shaping economies and markets around the world. As was the case last year, we closed with a new twist to this effort -- bringing a cross-divisional “focus group” of clients into the debate in an effort to stress-test our conclusions. It’s an exhausting effort, but I know of no better way to force us out of our comfort zone.
In keeping with the thematic style that has always driven the Morgan Stanley macro culture, we spent a good deal of time identifying the major forces that we believe will be decisive in shaping the economic and market outlook for 2003. Three such forces were at the top of our list -- the first being “Post-Bubble Valuation and the Asset-Liability Mismatch.” The debate here hinged on what type of valuation metrics were appropriate, as mean-reverting markets established new norms in the aftermath of the biggest bubble of them all. We recognized from the start that that mounting tensions between the fixed liabilities of pension obligations and reduced post-bubble return expectations on the asset side of the equation would have a critical impact on the investment implications that would follow. Many believed that the resolution of the asset-liability mismatch entailed nothing less than a fundamental challenge to the equity culture, itself. At a minimum, new strategies were needed on the now depressed asset side of the equation in order to hit the fixed-liability bogey. The resulting quest for return was thought to shy away from the asset that had done the most damage -- traditional equities -- and focus more on higher-return potentials in emerging markets. Others felt social contracts would have to be rewritten -- that companies would have no choice other than to walk away from their obligations to fund worker retirement. By default, that would leave the government as the defined-benefit provider of last resort -- raising tough implications for budget deficits and sovereign bond markets.
Not surprisingly, we also focused on the topic of deflation -- but with a twist. The concept we probed was “Deflation: Made in China?” By framing the debate in this fashion, we forced ourselves to link the biggest risk to markets and economies -- deflation -- with the most powerful force now emerging on the global scene -- China. Our basic conclusion was that while China was not to blame for the world’s deflationary perils, there was a good chance that the world wouldn’t see it that way. Deflation was thought to be mainly an outgrowth of a now seemingly chronic deficiency of aggregate demand in the industrial world. Against this backdrop, the China factor became a classic supply-side shock that would lower relative prices of tradable goods rather than push down the aggregate price level in the industrial world. For China’s trading partners, this was viewed as a boon to consumer purchasing power -- not as a tipping point for global deflation. Nevertheless, concerns were expressed that the industrial world would not take kindly to a loss of market share, and there were increasing worries that protectionist actions would be taken against China. At the same time, there was considerable doubt that China would abandon its mercantilist strategy of export-led growth -- especially since the awakening of the Chinese consumer was perceived as a distant development, at best. As a result, there was little sympathy for the view that China would revalue its currency in response to market-share concerns raised elsewhere in the world. China could not be counted on to provide the resolution of deflationary forces. The burden of that fix would have to fall, instead, on the industrial world.
Which took us to the heart of the debate and the third major theme of our discussions, “Policy Traction and the Geopolitical Wildcard.” Policy traction, of course, is where the rubber meets the road on the great deflation conundrum. Few were sympathetic to my argument that aggressive policy stimulus would fall largely on deaf ears -- that post-bubble and increasingly deflation-prone economies would have little to show for the recent and prospective stimulus of monetary and fiscal policies. Instead, a modest degree of traction was expected to take hold. As such, endorsement of the “reflation trade” was nearly universal -- once the cloud of geopolitical uncertainty lifts. Commodity currencies in Australian and Canada seemed likely to be beneficiaries of such a trade, as were higher yielding emerging market bonds. All this certainly dovetails with my own discussions with investors. In fact, rarely have I seem such widespread agreement on a likely market move. Ultimately, that left most of our MacroVision participants very uneasy about the post-Iraq market outlook. Since few believed that policy traction would be powerful enough in and of itself to provide a major lift to the global economy, there were concerns that any reflationary bounce would be short-lived and, therefore, subject to a quick reversal. Such a possibility was thus thought to up the ante on the policy fix, putting ever-greater emphasis on fiscal remedies rather than monetary stimulus. Consequently, a likely rally in equities was viewed by many as a selling opportunity. With monetary easing likely to intensify in Europe, there was some interest in European bonds. In the end, the possibility of a quick reversal to the reflation trade left most convinced that they needed to be “long” volatility. “It’s a ‘fat-tailed’ world” quickly became the mantra of MacroVision 2003.
Alas, there’s always a twist. The guidelines we use in this exercise are designed to uncover the key out-of-consensus forces that we believe will have an impact on financial markets in the year ahead. It’s always tempting to play the double contrarian and attempt to outsmart the group by focusing on what was left out. Japan and Europe come to mind, as does the dollar, inflation, and gold. Maybe those oversights will come back to haunt us. But as we probed the global macro, the other issues seem to pale in comparison relative to the ones we singled out.
But there’s more to macro than gamesmanship. What I always find to be most important after our annual pow-wows is the grand synthesis -- an attempt to pull these seemingly disparate forces together in the form of a broader and more coherent picture of the macro landscape. This year, the scenario that emerges is a modestly upbeat view of the world -- call it the slow cure. Policy measures are expected to be successful in staving off global deflation, although a muted form of policy traction is expected to deliver relatively limited impetus to the real side of the industrial world economy. It’s a world that remains effectively trapped in a US-centric growth dynamic; Japan and Europe are expected to remain sluggish, at best, and China’s impact is thought to come more from the supply side than the demand side. As a result, pricing leverage is expected to remain tough to come by -- although many are hopeful that a modest pickup in inflation might be evident in 2004. However, that would still insure single-digit returns in most major equity markets, thereby putting heightened tension on an already problematic asset-liability mismatch. To close that gap, investors are expected to go further out on the risk curve.
The problem with this scenario, in my mind, it that it finesses the big issue -- the impacts of mounting global imbalances. The more the world remains locked in a US-centric growth dynamic, the greater the disparity between nations with current-account deficits (mainly the United States) and those with surpluses (mainly Asia and, to a lesser extent, Europe). That puts tremendous pressure on relative asset prices, with price concessions likely for dollar-denominated assets -- not just in currency markets but also in stocks and bonds. But I also believe this scenario fails to pick up on the geopolitical risk factors -- especially the possible interplay between Iraq and China. It’s not a stretch, in my view, to worry about destabilizing global impacts from both countries. The US-Iraqi war has to go almost perfectly in order to avoid postwar backlash between America and the Islamic world and even between America and some of her allies. At the same time, the China factor is not exactly a source of stability for the world trading system. A protectionist backlash looms increasingly likely, in my view. All this spells further pitfalls on the road to globalization -- making it all the less likely that the world will be able to stay the course of the slow cure.
Yet ever-defensive investors continue to bank on the slow cure as their central case. I guess it’s the siren song of mean reversion. However, unlike the past when that mean was basically an average of thin tails, today’s mean is an average of much fatter tails. That’s a difference worth underscoring. To me, it makes better sense for investors to focus on the binary possibilities of fat tails -- the chances that the world will turn out to be considerably better or much worse than the muddle-through scenario. While I remain predisposed toward the downside, if I’m wrong, I suspect that policy traction will lead to a more extreme breakout to the upside. The slow cure resolves nothing and, if anything, produces more pressures that can only be vented in the fat tails. The majority of the participants in MacroVision endorsed the muddle-through of the slow cure. To me, that may well be the least likely outcome for 2003. |
