Is the End Nigh?

There has been a significant change in perceptions of the investment climate. Many have now recognized that far from slipping into a recession, the world’s biggest economy is accelerating. Rather than the prospect of lower interest rates, in the US, for the first time in a year, our warning that the Federal Reserve may still need to raise rates is increasingly becoming mainstream.

After the interest rate adjustment, which is well under-way, stronger US growth is likely to prove positive for the global economy and especially for the emerging markets. The driver has changed. Previously, investors were eager to buy emerging markets, other higher risk assets and put on carry-trade type strategies on ideas that a Fed rate cut was just around the corner.

Going forward, the return to trend growth in the US may still be supportive of the same investment themes. Many countries of course still depend on the US to absorb their excess production. Stronger US demand will likely offset the impact of higher interest rates.

US 10-year yields have risen about 20 bp over the past week and a little more than 50 bp over the past month. Some observers are concluding that the old Greenspan conundrum is finally resolved. Remember his conundrum. Why would long-term bond yields remain so low even as the FOMC was persistently gradually raising interest rates?

Believing that the rise in US yields now resolves the conundrum may lead to a more pessimistic outlook. After all it would follow then that the rise in US interest rates significantly alters the underlying incentive structure and that it will spur the market to price risk more accordingly with models that officials seem to refer to when they talk about the market’s mis-pricing of risk.

There is an alternative view. It begins with Federal Reserve Chairman Bernanke’s explanation of Greenspans’ conundrum. Bernanke’s view placed an emphasis not on a US-centric narrative or even a policy-centric narrative. Rather he discussed the implications of what he called surplus savings. Many countries savings, especially that of east Asia and oil producers, are in excess of what the domestic capital markets can readily absorb. The US, and to a much lesser extent Europe, absorbs those savings.

Of course, record corporate profits not just in the US, but in Europe, Japan and many emerging market countries as well, allow capital expenditures to be financed from retained earnings to a large extent and that may have helped reduce a source of demand for capital. At the same time, the record corporate earnings often have translated to greater tax revenue and help reduce government borrowing costs. This has, for example, produced a smaller than expected US budget deficit.

The conventional explanation of the rise in global liquidity and the low levels of asset market volatility tend to understand it in the context of a weakening US dollar under the weight of a large current account deficit, prompting intervention by many countries, which in turn boosts their broad measures of money supply. The rise in US interest rates and the strengthening of the US dollar in recent weeks, means under this rubric, that there is less need for intervention and therefore that may dampen liquidity. This would offer a more pessimistic outlook for investment portfolios.

Following Bernnake and the surplus savings explanatory model would suggest that while financial markets are prone to these kind of spasms, the underlying investment drivers remain the same. Those rapidly developing Asian economies and the petrodollar rich oil producers continue to generate excess savings far in excess of financial assets domestically available. In addition, several countries recently, including China and Brazil, are easing restrictions on domestic purchases of foreign assets.

Conventional wisdom had emphasized the shock of the hundreds of millions of Chinese and Indian workers entering the world economy and theoretically at least depressing wages. The surplus savings hypothesis emphasizes the savings of these same countries being integrated to the global pool of capital.

In addition, the rapid growth of monetary aggregates is not limited to those countries that have been rapidly accumulating reserves. The ECB, for example, which has not intervened in the foreign exchange market since 2000, is wrestling with the fact that the pace of its money supply growth is nearly twice the pace that prevailed prior to the beginning of the rate hiking cycle in December 2005. The US has stopped publishing M3, but the broad measure of money supply MZM has been rising at more than a 12% annualized pace for the last few months.

Ultimately, investors have to decide, has the investment climate changed. The preliminary answer offered here is yes because US growth expectations have increased and the market no longer expects the Fed to cut rates this year. However, stronger US growth is not a negative, but rather a positive for the world economy. Ironically, many of the same investments that did well with the prospect of a US rate cut may still derive support from a stronger US economy.

This analysis and the constructive outlook it offers is not a substitute for disciplined risk management.
Is the End Nigh? Is the End Nigh? Reviewed by magonomics on June 08, 2007 Rating: 5
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