Global: The MacroVision Debate
by Stephen Roach (New York)
Feb 2, 2004
<And I might add, the collective wisdom in both instances was as tightly bunched on the muddle-through scenario as any consensus view I have seen in years.>
<As I see it, however, this venting is increasingly likely to morph into a long overdue realignment in real interest rates.>
I’ve long said you can’t do global macro just by reading the Financial Times in your office in New York. And so I spend much of my time traveling the world in search of in-depth insights that can only be gleaned from first-hand observations. I tend to shy away from the global conference circuit, but I make a few exceptions — a couple of key gatherings each year in China, the World Economic Forum in Davos, and our own MacroVision. Last week, I laid out my observations from Davos (see my January 26 essay, “The Davos Debate”). In what follows, I present the findings from this year’s just-completed MacroVision. Having gone through these two intense drills in the past 10 days, the global debate takes on heightened clarity. I wish I could say the same for the outcome.
Our MacroVision exercise is an outgrowth of a global “offsite” I have hosted for Morgan Stanley’s macro team over the past dozen years. Our market strategists, economists, and credit analysts come together from all over the world to probe the issues that we think will be key in driving world financial markets in the year ahead. Over the years, we have developed a unique structure to this collective effort: From an initial list of some 150 suggestions, we narrow our debate down to five key issues. We then ask three subgroups of our macro team to conduct independent brainstorming sessions on each of these issues — essentially enabling us to triangulate our debate. We conclude with a “grand synthesis” session, where we attempt to reconcile the differences that have emerged in these discussions. Then, literally the next day, we invite a focus group of clients to challenge our findings. By this time, we’ve culled our list down to three issues, and we ask subgroups of our team and clients to go through the drill again. It’s a bit of a high-wire act — no pre-set agenda and slick presentation packets — but it’s an extraordinary opportunity for all of us to engage in a real-time debate on global macro.
This year, our MacroVision exercise was framed around three topics:
* Reckoning with Rates
* China and India: Lightning Rods of Globalization
* Europe: Breakout or Breakdown?
In getting to the point of selecting these issues, we probed a number of critical macro building blocks — namely, global imbalances, the potential for serial asset bubbles, the risks of inflation, and the perils of an ever-mounting moral hazard dilemma stemming from aggressive global policy stimulus. But the group eventually came to the important conclusion that these were longer-tailed issues that were unlikely to have actionable impacts on world financial markets in the next 12 months. For some of us, this was a bitter pill to swallow. That was especially the case for me — having droned on endlessly about the ever-mounting perils of an unbalanced US-centric world. But the collective wisdom of our assembled group counseled patience — imbalances eventually matter, they concluded, but not for the moment. Instead, they argued that we needed to explore other possible tipping points that might have greater impact on the near-term debate.
So what did we find as we dove into this agenda? The interest-rate conundrum obviously took on a new urgency in the immediate aftermath of the Federal Reserve’s recent adjustment in the language of its policy statement. Obviously, great ambiguity remains as to when the Fed may begin to renormalize its policy rate. However, with the FOMC now stating that it “believes that it can be patient in removing its policy accommodation” rather than continuing to stress that such an easy stance “can be maintained for a considerable period,” there is good reason to take this subtle change as the first stage of an exit strategy. The good news is that fixed-income markets are reasonably well prepared for the eventual Fed tightening that this language shift might be signaling; there was a general consensus that a 50 bp Fed tightening would push yields on 10-year Treasuries up to around 5% by year-end 2004. In assessing the risks to this consensus prognosis, our group was certainly concerned about an upside breakout to yields reminiscent of 1994 — heretofore the worst year in modern bond market history. Any back-up at the long end, however, was expected to be contained by subdued inflation; moreover, there was broad agreement that in the event of the unexpected possibility of a shortfall in US economic growth, there could be a significant flattening in the yield curve. But several also pointed out that the more painful trade could actually be a drop in yields — an outcome that would expose the lingering perils of a serious asset-liability mismatch.
But there was far more to this discussion than the rate outlook, per se. What concerned us most was the sensitivity of a highly levered US economy to the possibility of rising interest rates. Given our inability to assess the degree of leverage in the system, we didn’t take this concern lightly. In light of America’s role as the sole engine of an extremely unbalanced world economy, we viewed this as a key global risk factor. In this vein, a key concern is that the means of venting of global imbalances might shift from currency adjustments to a long-overdue realignment of real interest rates. So far, America has been lucky in that its current-account adjustment has mainly been transmitted through a weaker dollar. History suggests that luck could be about to run out, as real interest rates in the US get pushed higher by foreign investors seeking some form of compensation for taking currency risk. For an asset-based, highly levered US economy, we viewed such a possibility as a major risk factor in 2004 — especially for the overly indebted and income-short American consumer. In assessing the possibility of a financial accident that might arise from such a development, our focus turned to the European banks and insurance companies, still among the weaker links in the global intermediation chain. The related point was also made that central bank tightening cycles almost always wreak havoc on one major asset class. Few felt this time would be different.
The debate over China and India was more about politics than economics. Few disputed the efficiency dividend of the rapidly expanding global labor arbitrage and its resulting boost to purchasing power in the high-cost developed world. But there was clear recognition that the offshoring of goods and now services could be a contentious political issue, especially for a hiring-short developed world that is now entering an election cycle. The outcome, in our view, hinged on the implicit contract between Asia and the United States — a trade-off between American demand for Asian-made products and Asian demand for US Treasuries. Lacking in domestic demand, Asia needs undervalued currencies to sell cheap goods to America and the rest of the world. Similarly, a highly levered, asset-based US economy needs low interest rates to keep the music playing. As long as Asia keeps buying US bonds, US interest-rate risk will be capped. It’s in the world’s best interest to maintain this “bonds for goods” contract indefinitely.
Accordingly, we probed the possibility that this contract might be broken — not by economics but by politics. For starters, there is good reason to worry about Asia being saturated with dollar holdings; after all, as of November 2003, Japan and China collectively held $669.3 billion of US Treasuries, representing 44% of total foreign holdings — up from 27% in 1994. We discussed a number of possible political shocks that might destabilize this mutually advantageous arrangement. The leading candidate was thought to be an American protectionist assault on China. Far-fetched as that might seem, all it would take would be a pre-election growth disappointment in the US economy that leads to an increase in unemployment; in that event, the Bush Administration might well endorse the bipartisan legislation that has already been proposed in the Congress to raise tariffs sharply on all Chinese products sold in the US. Were that to occur, the dollar would undoubtedly weaken sharply, foreign appetite for bonds could dry up — especially from the Chinese — and US real interest rates would soar.
Our discussions on Europe were both predictable and surprising — but they also ended on a highly political note. With the euro surging, it’s easy these days to worry about another downside surprise to a still sluggish European economy. Interestingly enough, however, our group felt financial markets had largely discounted those risks. As a consequence, we were more inclined to play Europe as an upside surprise, reflecting the possibilities that the ECB becomes more flexible and that European consumers begin to benefit from the wealth creation spurred by economic integration. This somewhat surprising optimism was tempered by political risks — the internal fracture within Europe in the aftermath of the now-failed Growth and Stability Pact and the external pressures that Europe might bring to bear on Asia if the dollar’s adjustment continues to be manifested mainly in the form of a stronger euro.
The real challenge in an exercise such as MacroVision comes when we take a look at the potential interplay between these three key macro risk factors. Both of our groups — Morgan Stanley’s macro team and our focus group of clients — were largely convinced that an unbalanced world would somehow find a way to buy more time and “muddle through” between now and the US presidential election on November 2. “The authorities wouldn’t dare allow anything to get in the way,” was the typical observation. In that important respect, MacroVision sentiment was no different from that which I had encountered in Davos a week earlier. And I might add, the collective wisdom in both instances was as tightly bunched on the muddle-through scenario as any consensus view I have seen in years.
That’s where I personally have the biggest problem with the verdict of this groupthink. In my view, a world beset with unprecedented imbalances is powder keg that could be ignited easily by the slightest of sparks. Sure, it’s in everyone’s best interest to hold this tenuous equilibrium together during the all-important US election campaign. But do politicians and politically sensitive policy officials actually have that power? That’s where I part company with the deeply held convictions of consensus thinking. MacroVision came to the conclusion that a seriously unbalanced and highly levered world was likely to stay the course of a benign rebalancing, largely driven by currency adjustments. As I see it, however, this venting is increasingly likely to morph into a long overdue realignment in real interest rates. Equity and extended property markets would be highly vulnerable to such a possibility. So would a highly levered financial system. Yet the MacroVision consensus, as well as the Davos crowd, feels strongly that these were fears for another day. I have my doubts. In my view, the real interest-rate wild card remains the biggest threat to the muddle-through case for the US and for an unbalanced global economy.
Byron Wien joined us for the MacroVision wrap-up. After hearing the conclusions, he offered some sage advice: “The consensus always opts for the muddle through. But it almost never works out that way.” To me, the economics and politics of an unbalanced world paint a far more precarious picture than that which emerged from the MacroVision debate. |
