Today's Outside the Box is a very interesting piece written by Louis-Vincent Gave and the team at GaveKal entitled "Part 2: So What Should We Worry About?" His article is a follow up to an earlier one that he wrote on why he, and the rest of the GaveKal team, had been bullish on the markets a couple of months ago. This letter is to answer the question "what could go wrong" with their previous outlook in light of the recent market climate.
For those of you unfamiliar with GaveKal, the firm was started in the late 1990s in London by Charles Gave, Louis-Vincent Gave and Anatole Kaletsky. GaveKal is a research firm, focusing on macro economics and tactical asset allocation for institutional clients around the world. Louis-Vincent is the CEO of GaveKal where he contributes frequently to the research and was the main author of their books Our Brave New World and The End is Not Nigh.
Let me make a quick remark regarding the latter of his 2 books. The End is Not Nigh has just recently been released and I highly recommend it as a good read. It is a great example of a book that presents a positive view of not just the markets but of the developing world as well. You can purchase the book directly from their website (www.gavekal.com) or through Amazon.
I trust that you will enjoy this week's Outside the Box from the always thought-provoking Louis-Vincent Gave.
John Mauldin, Editor
Outside the Box
Part 2: So What Should We Worry About?
At the beginning of April, we published a report entitled Part 1: Why We Remain Bullish. In that report we returned to some of the key themes we have presented in our research in recent years, namely a) the positive changes that our underpinning global economic growth, and b) the continued undervaluation of equities. We also introduced a new reason to be bullish: the rapid recovery following the brutal sell-off of late February-early March. Indeed, if financial markets were as precariously positioned, and as overleveraged, as the bears would have us believe, then a sell-off of the magnitude of late February should have led to a more sustained drawdown. Instead, the fact that the markets rallied sharply - and have since made new highs almost everywhere - points to the possibility that too many investors remained underexposed to equities.
Of course, a situation is never so good that a bearish argument can't be entertained. And since we wrote that paper, equity markets have rallied very sharply and now seem somewhat overbought. So with all that in mind, a growing number of clients are now asking us what would make us change our stubbornly bullish stance; in other words, what could derail the exciting investments environment in which we currently live? Needless to say, these kinds of questions allow our imagination to run wild. Undoubtedly, our reader will have his own potential nightmare scenario (something involving Iran and nuclear weapons? Terrorism? An earthquake in Japan which, like Kobe, triggers massive capital repatriation? Growing trade tensions with China?...). In the following pages, we review what we think could potentially disrupt the current benign investment environment.
1- Where Do Recessions Come From?
The main theme of our book, Our Brave New World, is that the economic cycle has become a lot tamer than in the past. But "tamer" does not mean that it has disappeared. A fact which begs the question of what drives the economic cycle in the first place? Is it:
- Excessive capital spending by eager companies who tend to overextend themselves and put in additional capacity at the top of the cycle - capacity which then has to be written off (the late 1990s tech boom comes to mind)?
- Intervention from governments, which all of a sudden lowers the returns on invested capital for entrepreneurs? This intervention can take many forms (protectionism, increases in regulation, increases in taxes, punitively high interest rates...). Once again, the late 1990s boom and bust comes to mind (with high interest rates from the Fed, government intervention against Microsoft, taxation of 3G mobile telephony across Europe...).
Investors of a more bullish disposition will tend to focus on the second explanation for recessions. Investors of a more bearish disposition will tend to see businesses as clumsy behemoths likely to invest at the worst possible times, thereby plaguing their shareholders with lousy returns. Either way, any argument that "things are going to get worse from here" has to start with the premise that either a) our system has terrible excesses to work through, or b) governments around the world are about to turn gold into lead (as they have done so often in the past).
2- So Where Are the Excesses?
Wicksell, a Swedish economist of the late XIXth century, had a very powerful intuition; he believed that economic cycles could be explained by the divergences between what he called "natural interest rates" and "market interest rates". If market rates were too low (i.e. money was too cheap), it led to a boom centered on excess capital spending, excess borrowing and excess consumption. In time, this boom eventually led market rates to rise above natural rates. This change in the price of money eventually brought about a bust. The bust would then lead market rates to fall below the level of the natural rates... and the party could start again.
Now it is undeniable that interest rates, all around the world, have in recent years been very low; and this for a host of reason that we reviewed in our last Quarterly Strategy Chart Book. But this state of affairs begs two questions. Namely:
- Are market rates set to move above natural rates, thereby triggering a correction? Frankly, right now, this seems unlikely.
- Have the low market rates fostered an environment of excessive risk taking and capacity expansion which now need to be purged?
This last question opens up a debate in which, once again, we are reluctant to get involved (see The End is Not Nigh). Indeed, on the one hand, it is easy to argue that excesses have taken place in the US homebuilding and subprime lending space (excesses which are now being purged). On the other, it is also easy to argue that, unlike previous cycles, excesses in capital spending by Western companies have completely failed to materialize. In fact, in recent years, for reasons reviewed in our books, capital spending across most of the OECD has been extremely tame. So tame, in fact, that a brutal collapse in capital spending now appears highly unlikely (the opposite is probably to be expected).
The debate is thus simple: have the excesses of recent years been so large as to now trigger a recession and a genuine bear market? And if so, where have those excesses taken place?
3- Excesses in Visible, and Hidden Places
The crux of the thesis of our latest book, The End is Not Nigh, is simple and goes something like this: a) Asian central banks continue to manipulate their currencies and prevent them from finding a fair value against either the US$ or the Euro; b) this manipulation triggers an accumulation in central bank reserves which, in turn, leads to low real rates around the world; c) the combination of low global real rates and low Asian exchange rates amounts to a subsidy for Asian production and Western consumption; d) in the US, the subsidy has by and large been captured by individual consumers; e) meanwhile, in Europe, the subsidy has been cashed in by governments whose debt has skyrocketed; f) we see little reason why, in the near future, the subsidy should be removed; but g) if it were removed, the US would most likely encounter a consumer recession (not the end of the world); while h) Europe could go through a debt crisis (far more problematic).
So with this in mind, we will not bore our reader with an umpteenth discussion on US real estate, the state of the subprime industry, the overleveraged US consumer, etc... Nor will we bore our reader with another description on how things could go horribly wrong for Europe. Instead, we will focus on what we believe are interesting developments currently unfolding in Asia.
It is no mystery that, in the past few quarters, the Fed has been tightening monetary policy and restraining the amount of money it puts into the system. So much so that the growth of the US monetary base is now close to record lows.
With the Fed putting in less money into the system, the weakest players no longer get easy cash and start going belly-up. This time around, it has been subprime lenders and over-extended home-builders. So far, so good.
As the Fed puts less US$s into the system, and as the US economy slows somewhat, the US consumer (very naturally) starts to push less money abroad; the US trade balance improves.
And as the US trade deficit improves, we should expect the growth of reserves held at the Fed for foreign central banks to start decelerating fast. After all, if the US starts to export less US$, then it follows that foreign central banks should have less US$ to deposit. Though interestingly, this has simply not been happening lately. Instead, we have been confronted with an odd environment wherein:
- The Fed has been actively withdrawing US$ from the system.
- The US consumer is pushing a smaller number of US$ abroad.
- Foreign central banks are bringing back to the Fed an ever-growing number of US$.
This, of course, begs the question of where the foreigners are getting these excess US$ in the first place. And here, we find two possible explanations (there may be others that we have not considered - if so, please let us know).
Explanation #1: Foreigners are unhappy with holding US assets and are selling the US aggressively, receiving US$, and turning in those US$ to their domestic central banks (in exchange for Yen, RMB, Rubles, Rupees, Dinars, etc...). We find this explanation unsatisfying for a) it conflicts with the TICS data and b) seems highly unlikely when the NYSE, Russell & DJIA keep on hitting fresh all-time highs.
Explanation #2: As in the late 1970s (when European banks lent money en masse to Latin America) and the mid 1990s (when Asian corporates borrowed US$ extensively from Asian banks to finance a continent-wide construction and capital spending boom), we are seeing a very large creation (through bank credits) of US$ outside of the US. For example, when GaveKal staff members go to Beijing to buy real estate (and participate in the RMB appreciation) that they finance with US$ mortgages, we see US$ creation outside of the Fed's control. This, of course, might help explain why China's reserve growth has outpaced China's trade surplus & FDI inflows so consistently in recent years:
Or, in other words, why a country like China has been able to save so much more than it has earned? We must realize that, behind a large part of the growth in central bank reserves lies not "earned US$" but "borrowed US$". And these "borrowed US$" may, one day, need to be repaid (in 1983-85 and 1997- 2001, the need to repay previously borrowed US$ led to a true short-squeeze on the US$ and the greenback reached silly values).
Could the same thing happen today? Frankly there is little to suggest that the appetite for borrowing in US$ outside of the US is waning. If anything, the appetite, and ability, to borrow in US$ is stronger than ever. Whether it is US private equity firms buying assets around the world, companies financing their capital spending in US$, or individuals (mostly around Asia and the Middle East), borrowing US$ to finance real estate purchases, the propensity for borrowing in US$ seems very solid.
4- A System That Works For Everyone
In other words, as we write, the system seems to be working for everyone. The World is seeing restrained liquidity growth in the US (helping the Fed cool down activity in an economy that was starting to heat up too much), and liquidity growth outside of the US is fuelling a global boom such as we have never seen before (around the world today, only two economies are today experiencing a recession: Lebanon and Zimbabwe). In time, the excess liquidity created outside of the US flows back into central bank's coffers, and foreign central banks, in a bid to prevent their currencies from rising, end up being forced buyers of US Treasuries, German Bunds, UK Gilts, etc.... In other words, we live in a world whereby:
- 1. Central banks (mostly in Asia and the Middle-East) want to control the level of their currencies against the US$.
2. This encourages the private sector to borrow US$ and buy assets in those countries. This leads to a big increase in monetary aggregates (Singapore M3 is up 23% YoY, HK is up 17% YoY...), which in turn fuels a surge in economic growth and asset prices.
3. Asian & Middle-Eastern central banks end up with the excess US$ created. The central banks mostly redeploy that excess money into fixed income instruments around the world.
4. This "forced buying" of bonds everywhere (see Of Bonds and Zombies) helps to keep real interest rates low around the World (see page 2). In turn, this makes risk-taking a very attractive proposition. Most asset prices move higher around the world...
5- Milton Friedman's Rule
So what could change this cosy, and highly beneficial, arrangement? The answer, we believe, has to be inflation. Indeed, Milton Friedman once said that, "a central bank can control its exchange rate, it can control its interest rates, and it can control its money supply/inflation. But it can't control all three at the same time."
In Asia, policymakers have been very happy to control exchange rates and interest rates and let money supply growth rip. And as long as there is no inflation, it is highly unlikely that we will see a marked change in Asian monetary policies. However, should inflation start to accelerate, will Asian policymakers be able to remain as relaxed about money growth?
This means that the question of inflation across Asia is now more important than ever..., and incidentally, it seems that in a number of countries, inflation in recent months has indeed been picking up slightly.
6- Is Inflation in Asia a Threat?
Over the past few years, we have repeatedly highlighted that we did not believe that inflation was a sustained threat for Asia. This belief rests on two pillars:
- China is allowing the rest of Asia to industrialize on the cheap: One of the research themes we have constantly hammered in recent years is that, while the important macro development of the past ten years was the marriage of expensive machines (from Japan, Europe, North America...) with cheap labour (mostly in China, but also in Mexico, India, Poland etc...), the story of the next ten will be the marriage of very cheap labour (from Vietnam, Indonesia...) with very cheap machines (from Korea, China...).
The fact that China is now a net exporter of machinery and equipment leads us to believe that the cost of manufactured goods will only continue to collapse. The industrialists who today complain about the "China price" will soon have to meet the "Indonesia price" or the "Vietnam price"... China today is allowing the rest of the third world to industrialize, rapidly, and on the cheap.
- Distribution costs should continue to plummet: The other theme on which we have been pounding the table for quite some time (see The Bullish Growth in China's Road Infrastructure, The Asian Infrastructure Boom Continues...) is that Asia today is going through an unprecedented infrastructure spending boom. For example, in China, as the feverish pace of road construction continues to accelerate, we will soon reach a point whereby 90% of the Chinese population will live within a one hour drive of a motorway. Needless to say, this can only mean that distribution costs across China will now plummet. The creation of the US interstate highway system in the 1950s allowed companies such as Wal-Mart, P&G, Gillette, McDonald's and others to distribute their goods and services at ever falling prices. Why should it be any different around Asia?
So putting the above two structural trends together, why should we worry about inflation? Because in recent quarters, a new trend has emerged: rising food prices.
In Asia, a significant percentage of consumer spending is still based on "surviving" (a fact which, incidentally, might explain the highest differences in savings rates...poor people need to save, while the rich don't, as they have the option of moderating their lifestyles).
In OECD countries (where the median family tends to spend less than 10% of its income on food), changes in food prices do not matter much. But in countries such as China, (where the median urban family spends around 30% of its income on food), rising food prices should have an immediate impact on disposable incomes (after all, one can hardly postpone one's food purchases because "prices are too high").
With its strong support of ethanol, the US administration decided to intervene in the markets (maybe to give farmers a subsidy that would have been hard to offer under WTO rules?). Unfortunately, this intervention could end up suffering from the law of unintended consequences. Indeed, if higher food prices start pushing inflation rates higher around Asia, then it is hard to believe that Asian policymakers will not step in to do something about it.
And this desire to do "something about rising food prices" would be triggered by both practical and political impulses. Indeed, in a country like China, while the government no longer is communist in practice, the leadership still subscribes to a Marxist view of History. And in the Marxist dialectic, big turning points are not the results of an individual's action, but are instead the result of economic forces. Applying this Marxist grid to recent history, most Chinese leaders believe that the Tian An Men revolt was a direct consequence of the high inflation, and rapidly rising food prices, prevalent in the late 1980s. As such, it is unlikely that they will allow inflation to accelerate much from here... So what can they do?
7- The Indian Example
As it turns out, this is exactly the question with which Indian policymakers have had to deal. Since 2004, inflation in India has accelerated from around 3% to over 6%; unsurprisingly, the Indian central bank has reacted by raising rates repeatedly to where they stand today: 7.75%.
Now it is obvious to any casual visitor that India has not embarked on the same kind of infrastructure spending plan as other countries, most notably China. As a result, the recent wave of growth has created tremendous bottlenecks and hence inflation. Nevertheless, whatever the cause of India's inflation may be, it is interesting to note that, so far, the central bank's repeated interest rate increases have only had a muted impact on prices, a fact which may explain why the central bank now seems to be changing policy.
Indeed, last week, and against most observers' expectations, the Indian central bank did not raise rates at its meeting. Instead, it seems that the authorities are allowing the currency to rise and hopefully thereby absorb some of the country's inflationary pressures (linked to energy and higher food prices). In recent weeks, the rupee has shot higher and now stands at a post-Asian crisis high.
And interestingly, the local market is loving it. While Indian stocks had been sucking wind year to date, the central bank's apparent policy shift (from higher interest rates to higher exchange rates) has triggered a very sharp rally:
This of course is an interesting turn of events and we would not be surprised if Asian central banks were to study developments in India carefully over the coming quarters. After all, India is blazing a path that a number of Asian countries may yet decide to follow.
One could argue that a change in monetary policy in Asia could end up being a "triple whammy" for Western economies. It would mean that:
- Asian central banks would export less capital into our bond markets and this would likely lead to a drift higher in real rates around the world.
- Asian exchange rates would move sharply higher, which in turn would likely mean higher import prices in the US and Europe.
- As Asian exchange rates start to move higher, Asia's private savers would likely start repatriating capital, further amplifying exchange rate and interest rate movements. This would also likely lead to collapses in monetary aggregates in the Europe and the US.
There are, of course, a lot of "ifs" in the above scenario. For a start, it is absolutely not a given that Asian central banks will change their monetary policies and the current status quo could easily persist for a number of quarters, if not years. Secondly, it is also not a given that rising Asian currencies would trigger a bond market meltdown; there are other forces at work which could also explain the low level of real rates. Thirdly, a serious rise in Asian currencies could actually spur global growth even further (after all, the current uptick in global markets was given a serious jumpstart by the RMB's de-pegging two summers ago).
As we highlighted in "Part 1: Why We Remain Bullish," we are not worried about valuations. And we are also not worried about "excess leverage" in the system, or the threat of a "private equity bubble". We also do not fear an 'economic meltdown" or a brutal end to the "Yen carry-trade" (which we did fear in the Spring of 2006). Instead, if we had to have one concern, it would have to be a possible change of monetary policy across Asia and the impact that this would have on real rates around the world. As we view things, the only reason Asian central banks would change their policies is if food prices continued to increase (in that respect, owning some soft commodities--a hedge against rising real rates--makes sense to us; as does owning Asian currencies). Interestingly, such a turn of events seems to be unfolding in India, yet no one seems to care. Monitoring changes in Asian inflation, monetary policies and exchange rates could prove more important than ever.
Your thinking that there are a few things to be worried about in the 2nd half of '07 analyst,