Asia/Pacific: Seesawing into 2005
Andy Xie (Hong Kong)
In 2004, the global and Asian economies clocked up the highest growth rates in a decade, as the liquidity boom that drove financial markets up in 2003 transformed into demand via booming consumption in the US and strong investment in China. Financial markets, on the other hand, have seesawed as rising demand has soaked up liquidity.
At the beginning of 2004, I recommended a low-beta strategy for the year – the opposite to my recommendation for 2003. It was effective some of the time. The spasms in the US dollar periodically changed the risk appetite, rearranging liquidity in favor of or against high-beta assets. Financial markets overall seesawed a lot but ended where they started with the dollar down by about 5% and global equity up by 10% in dollar terms.
How the US deals with the dollar and how China manages its investment cycle will determine if the global economy or financial markets will have a soft landing in 2005. US policymakers’ talking down the dollar or China’s refusal to raise interest rates could prolong the global growth boom and the seesawing pattern of the global financial markets. However, a major crash may await the world in 2006.
If the US raises interest rates more quickly than expected and cuts the fiscal deficit and China raises mortgage interest rates to cool property speculation, the global economy still has a chance of a soft landing. Growth-sensitive or high-beta assets would underperform in such a scenario.
2004: Much Ado About Little
Pessimists and optimists had even shares of good days in 2004. What occurred in 2003 electrified the financial markets with the dollar down 15% and global equities up 35%. In 2004, the dollar was down by 5% and global equities were up by 10%. The extra return in equities for non-dollar investors compensated for the extra risk at best.
The real money was made in avoiding currency intervention by Asian central banks or listening to the US policymakers on the dollar’s direction. While the dollar index did not move much for the year, the big shifts took place with Asian intervention early in the year and the US jawboning late in the year. Astute investors who leveraged into these big moves can expect the fattest bonus checks this year.
Policy variables drove financial markets in 2004. China zigzagged in its policy on cooling excess investment. It took a tough stance on investment in the spring. The market took it seriously and lowered expectations about the renminbi, which caused a major correction in commodity and growth stocks and kept the dollar from falling. In the fall, easing started to dominate China’s rhetoric. The market reversed its expectations and began to believe that China wanted to prolong its investment boom. Commodity stocks made a comeback.
US policymakers immediately proceeded to beat down the dollar following the presidential election. It was the last big trade in the global financial markets. The weak dollar sentiment further inflated expectations of a Chinese renminbi revaluation, which renewed the inflow of speculative capital into China. The renewed liquidity boom post the US’s weak dollar policy was the real fuel prolonging China’s investment bubble.
2005: Same Issues Await Investors
China’s policy towards its investment cycle and the US’s policy towards its trade deficit will decide how the financial markets and global economy will unfold in 2005. The outcome could be binary. The most reasonable policy mix would be for China to raise mortgage rates to cool its investment bubble and the US to raise interest rates and taxes to tame its twin deficits. The combination would offer the best chance of a soft landing for the global economy.
If China and the US opt for policies to prolong the current trend, i.e., encouraging property speculation in China and consumption in the US, they may succeed in maintaining strong growth in the two economies. Strong currencies, on the other hand, would cast a dark shadow over the other economies. Europe and Japan are likely to disappoint. In Asia, strong currencies would affect Korea, Taiwan and Singapore significantly. It is even possible that some of these economies would experience recession. Hong Kong and Malaysia would likely benefit because of their currency pegs to the dollar.
Predicting a Soft Landing
We forecast that the global economy will grow 4.7% in 2004, 3.6% in 2005, and 4% in 2006, which fits the pattern of a soft landing. We forecast Asian GDP to grow by 7.1% in 2004, 5.9% in 2005, and 5.6% in 2006. The diverging trend we expect between the global and Asian economies in 2006 is mainly due to the prolonged effect of strong currencies on investment-heavy Asian economies and the extended period necessary for investment consolidation in China.
When it comes to forecasting, it is always difficult to predict a big change based on a concept. Tinkering at the margin usually dominates forecasting. In this regard, our forecasts for 2005 and 2006 fit the mold. Statistically, the best forecasting is ‘tomorrow is similar to today’, adjusting for mean reversion.
Turbulent Times Ahead
However, I think it is possible that 2005 will turn out to be an extreme year. Either there will be a bigger bubble than in 2004, mainly in China and the US, or a big downturn. A soft landing is usually wishful thinking. The global economy had a soft landing in 2001 by definition after the tech burst. But this happened because, I believe, the Fed ignited a property bubble that was bigger than the tech bubble, and this allowed the global economy to grow rapidly and so did not have to adjust for the tech bubble.
The liquidity bubble in the dollar block has been reignited since the fall with a combination of China’s pro-investment and the US’s pro-weak dollar rhetoric. The liquidity bubble has rekindled strong global demand. If we think about it, we realize it is all sentiment. But how can sentiment be so powerful? The main reason, I believe, is that the Fed funds rate is still lower than the inflation rate. Because the real borrowing cost is still negative, when speculative sentiment is revived, speculators’ demand for money ultimately comes from the Fed.
There is a good chance that 2005 will be similar to 2004. Say, for example, the US has a couple of bad job reports and oil prices continue to decline. The Fed would have the perfect excuse to stop raising interest rates for a few months. In addition, if the Chinese government forces downstream industries not to raise prices despite higher input prices, this would give China the excuse not to raise interest rates. The combination would keep liquidity strong in the dollar block, which would put pressure on other currencies to appreciate. The world would then look identical to that in 2004. Indeed, financial markets are betting on this scenario now.
On the other hand, some event could upset the applecart. There are two major candidates. First, supply could overwhelm demand in China’s property market. The Chinese economy or industries usually correct when oversupply brings down prices. It is an investment-prone economy. Its auto industry, for example, is correcting under such a scenario. When its property market corrects under the same force, this would have a major macro impact as its inventory or the value of buildings under construction is equal to one third of GDP in market value.
A sudden tumble in the US bond market is another candidate. Asian central banks, government agencies of oil exporting countries, and ethnic Chinese around the world are the principal holders of liquid US dollar assets. The first two blocks are unlikely to dump dollars suddenly as they are government agencies. The third one, however, could. Ethnic Chinese may hold as much as US$1 trillion in US fixed income assets (e.g., cash, bills and bonds). They are becoming increasingly nervous about US policy. When they panic, which happens often, and sell en masse, this could be expected to crush the US bond market.
Any other country following policies similar to those in the US would experience real bond yields of close to 10%. The unique status of the dollar has allowed the US to get away with low bond yields despite its weak dollar policy. When ethnic Chinese bail out of bonds, this would likely bring to an end the US policy of encouraging consumption at any cost. |
