Global: Reflation Trade?
Stephen Roach (New York)
March 14, 2003
Morgan Stanley
What should we make of the financial market pyrotechnics of 13 March?
Are they simply a reflection of a long overdue dead-cat bounce of
oversold equity markets? Or is this the start of something bigger -- a
sustained reversal of stocks, bonds, and currencies that has reflation trade
written all over it?
Having flirted with this idea once before, I must confess to being a bit
gun-shy (see my 16 December 2002 dispatch, “The Reflation Trade”). At
the time, I argued that investors still seemed inclined to believe that the
past was prologue for what was ahead. In that context, the time-honored
combination of policy stimulus and a resolution of the war in Iraq were
likely to be seen as the stuff of an imminent economic revival. With
forward-looking financial markets probably quick to figure that out, I
reckoned that the reflation trade seemed like a reasonable bet late last
year. It worked brilliantly for the first two weeks in January, leading me
to believe I had finally mastered the art of trading. But it has failed
miserably since. The lesson for me is painfully obvious -- stick to
economics and leave the trading to the pros. (For the ins and outs of the
latest incarnation of this trade, Barton Biggs’ latest piece, “A Triple
Bottom?” is a must read).
I am far more comfortable in weighing in on the economics of reflation.
To me, it boils down to whether you believe that the war -- and its
ultimate resolution -- will alter the macro endgame. The optimist would
look to the Gulf War of 1991 and argue in the affirmative. Equity markets
basically rallied when the first missiles hit Baghdad, and they never really
looked back. Consumer confidence rebounded and economic recovery
eventually followed. Given the policy stimulus in the pipeline, my gut tells
me that most investors remain enamored of this line of reasoning. It’s just
a question of getting over the war. The pessimist would argue that 2003 is
not 1991. After all, it’s a post-bubble, US-centric world fraught with
imbalances and vulnerabilities. Can war and peace really change all that?
I guess my biases are pretty transparent at this point. I continue to believe
that the US and a US-centric world economy had plenty on its plate long
before Iraq showed up on the screen. America’s anemic recovery has
been a by-product of stiff post-bubble headwinds brought about by
excesses of the late 1990s that have yet to be purged -- namely, record
lows of national saving, a record current account deficit, and record highs
of private sector indebtedness. Policy traction remains relatively elusive in
that climate -- not just because of the lingering excesses of the boom but
also because the US economy is lacking in its traditional sources of
pent-up demand for cars, homes, and capital expenditures. Nor does the
global economy have an alternative engine of growth. Europe and Japan
are back on the brink of recessions of their own, and the trade-dependent
economies of Asia can’t help but reel from weaker conditions in the
industrial world.
In my opinion, a war in Iraq -- to say nothing of the peace that eventually
follows -- seems highly unlikely to wipe this slate clean. To the contrary, I
continue to worry that the risks remain very much skewed toward
renewed recession and toward the intensification of deflationary
pressures that such an outcome would spawn. Sluggish growth and oil
shocks are a lethal combination that almost always culminates in
recession in the United States. The recent data flow is especially
worrisome in that regard. February’s sharp declines in employment and
retail sales follow a pattern painfully reminiscent of the shock-induced
recessions that have occurred since the early 1970s. And rest assured --
if the US goes back into recession, the global economy will be quick to
follow. That’s the inescapable price that a US-centric world must
eventually pay.
All this underscores the distinct possibility of a second recession in three
years. But there’s a new twist in the current climate: With inflation
exceedingly low at the onset of the first of these two downturns -- 1.3%
in the industrial world in 2000 and 2.1% in the US -- a series of cyclical
blows takes on new meaning. By definition, recessions are deflationary
events. When they hit low inflation economies repeatedly, the endgame of
outright deflation is far more likely -- precisely the opposite of the
outcome implied by the reflation trade. Unlike the stagflationary oil
shocks of the 1970s, I continue to fear that this one will be more
deflationary.
The trick for investors, of course, is to translate all of this back into the
financial markets. The key question is always the same: What macro
outcome are the markets discounting? If markets are priced for the worst
at that final moment of capitulation, then it doesn’t take much to trigger a
reversal. As Barton Biggs always reminds me, the bad news just has to
get less bad. To a certain extent, that’s what appeared to happen on 13
March. In the face of international pressure, the Bush Administration
flinched on the launch date of America’s invasion of Iraq. That hardly
represents a fundamental shift in the White House’s stance toward
Saddam Hussein. It simply suggests that the war may start a little bit later
than previously expected. Suddenly, the bad news doesn’t seem all that
immediate or threatening. For financial markets, this could certainly be
construed as the functional equivalent of an “eleventh-hour” reprieve.
But the basic question remains: As financial markets breath a collective
sigh of relief, is there further scope to reprice for a more constructive
macro outcome? If asset prices were discounting full-blown recession
and deflation, that might be a possibility. But, in my opinion, that does not
appear to be the case. US equity prices, for example, appear to be
discounting nothing worse than a subpar growth climate over the next
18-24 months. I press our strategists repeatedly on this, and they concede
that another recession is not in the price and would, therefore, come as a
huge disappointment. At the same time, it does not appear that deflation is
in the price. That’s certainly the verdict that can be imputed from the long
end of the Treasury market. For example, the spread between the yield
on the cash 10-year and its TIPS real interest rate equivalent currently
stands at about 200 bp. This is a good proxy for the inflationary premium
embedded at the long end of the yield curve. And it is currently more than
three times the 60 bp spread that was prevailing back in late 1998, when
crisis-induced deflationary fears were running rampant. In other words,
the recent darkening of investor sentiment stopped well short of pricing in
a worst-case macro outcome. That, alone, could well be a limiting factor
on the upside -- unless investors are prepared to bet on a far more
vigorous recovery in growth and inflation.
With the prospects of war still extremely high, I suspect there’s a good
deal more of such volatility ahead. But I continue to believe there’s far
more to the macro conundrum than this bout of geopolitical angst. A
lopsided world had plenty on its plate before Iraq, and is likely to face
many of the same pitfalls post Iraq. That, more than anything else, should
ground the reflation trade in a still tough reality. |
