Remeber the Fundamentals
[Update added below as well I have incorporated some further points which clarify my argument]
Volatility and risk aversion seems to be on the rise in financial markets around the world. So, what are we seeing here? Is this the crash and burn scenario some has been calling for a while. On that note, let us stop by Roubini' s blog to see what he has in store for us ... in short; a US recession is coming in 2007.
This hard landing will certainly be, at a minumum, a painful growth recession and, much more likely, a much more ugly outright recession. Greenspan says this recession may start in Q4. As long as the debate is now on the timing of this recession (frankly it matters very little whether it starts in Q2, Q3 or Q4) rather than its likelihood, the debate about the US business cycle outlook would have made a significant progress from the increasingly unlikely consensus about a soft landing. More and more respected analysts are now discussing the timing of the US recession rather than trying to defend the soft landing case that is melting by the day faster than the Arctic ice cap.
And interestingly enough Munchau from Eurointelligence also seems to be on the wagon in his recent call we are in for a crash more so than a correction.
This is a market crash, make no mistake. There are those who talk about a technical correction, an intermezzo. Don't believe a word. If this was merely yet another period of exuberance in equity markets, as happens from time to time, I would not be greatly worried. But this time is different. There are several factors coming together.
So folks, brace yourselves for the downturn! Well, I wonder whether we couldn't say something to differentiate a bit or at least try to look at the fundamentals. First of all, let me get one thing out the way. I still don't think that the US is heading for a certain crash. I may be right in my call or wrong, this is not really the issue. However, what we do need to realize is that the idea of de-coupling is really not feasible, I mean that much I think Roubini has right. Of course, this is not a black and white argument but if the US consumer takes a beating and begins to seriously wind down consumption then it will have marked consequences for export dependant economies. At least we need to realize that the usual suspects in terms of for example the Eurozone countries (most notably Germany) Japan will have much more difficulties de-coupling from a US slowdown than for example India where growth is driven much more by consumption. China is of course a conundrum as ever but the structural trade relationship with the US means that China won't be able to de-couple entirely. The Economist of course seems to think otherwise in general terms relating to the idea of de-coupling but I just do not see the fundamentals pointing to for example a sustained process of de-coupling in Japan and in Germany/Italy which essentially would mean that these economies reverted to a growth path driven much more by consumption than is currently the case. However this couclusion needs differentiation ... let us begin with the basic conceptualization.
As such, it all comes down to the US economy and whether the global economy can continue to rely on the US to run ever more on excess demand to supply and thus withhold the trade deficit. I mean, if we peel it down to the most basic fundamentals I still think this is the salient point in terms of the global economy and the macroeconomic balances. However, sometimes we can also make things too simple. On thing here is of course the fact that some parts of the world already seem to have 'decoupled' as it were from the US. This notably include for example India and Brazil. So Germany could perhaps achieve some kind of de-coupling from the US if it managed to 'couple on' to other economies but still the net effect of a US slowdown would be felt in Germany I think. In Japan, China is of course very important and as such I also suspect the transmission mechanism from a US slowdown to be somewhat indirect but still it would be felt.
On that note, I was struck by some of the things Munchau wrote in his piece linked above. First of all, he notes how the global exchange rates are out of 'kilter' which accordingly will have two consequences. Firstly, the fairly tale of the US economy is coming to an end which in turn will prompt investors and even central banks to shift Dollar portfolios into Euro portfolios. Ok, full stop. Let us try to examine what this means in terms of the fundamentals of the global economy ... for starters such a prediction clearly assumes that Eurozone de-coupling is possible since such a move from Dollars into Euros would cause a marked appreciation of the Euro. Now, how would the Italian and German economy respond to such a shift and indeed the ECB? In short, I do not see the economic fundamentals for such a shift. Secondly, Munchau notes the Yen and how the Euro and Yen are misaligned with the Yen being undervalued. The carry trade will unwind as Munchau notes and the Yen will close the gap to the Euro accordingly.
Take note here that such an exhange rate correction between the three major currencies of the world would coincide quite nicely with a recession in the US economy and de-coupling from the Eurozone and Japan. However, we really need to think the fundamentals of the Eurozone economies and Japan's economy in order to understand why suddenly the Euro quite simply cannot take up the slack from the Dollar which is to say to bear the burden of a sharp depreciation of the Dollar associated with a crash of the US economy. Remember also that this would have de-facto consequences for nominal interest rate levels and crucially interest rate differentials. One question is especially pertinent in this case and we need to ask to what extent the ECB or the BOJ can continue to tighten at the same as the Fed holds or perhaps even finds it necesseary to loosen the monetary grip. I do not see this as a probable scenario and as such I see a structural limit as to how far the Dollar can fall relative to the Euro and accordingly, I also think that recent debacle on the Yen and the BOJ's need to raise rates misses the point by a mile in terms of what is really going on in Japan's economy.
So what we need to understand here I think is the following. Certainly, the US is slowing and indeed has been slowing since Q3 2006. The next question then becomes, will this be a recession, a hard landing, or a soft landing. The difference between these three scenarios is of course a lot about semantics but still Roubini for example is pretty sure as you can see above that this will be a recession and so is Munchau it seems. Of course, also the recent rise in volatility in financial markets and subsequent slump in equity prices will only weigh heavier on the general pessimitic outlook. However, what I want to argue is that the imbalances and fundamentals of the global economy will persist. Where does it leave the US economy and forecast for 2007 then? Well, I won't make any call on this since it would be like tossing a coin I think but I do think that the slowdown is continuing. Of course, the bursting of an equity bubble as well as a mortgage bubble as mused by Munchau would push the arrow further towards a US recession. However, what I do want to emphasize is that before we go out and hail the crash of the US economy, the Dollar, and the rise of Japan and Europe to take up the baton we need to consider the flipside of such a call and thus remember the fundamentals.
Morgan Stanley's Global Economic Forum has a slew of notes which deal with the recent market wobbles and how to interpret them. I will begin with Stephen Jen who, as myself, points to the need to look at the fundamentals.
This is an uncertain environment; many things can indeed go wrong in the global economy and we could see discrete price changes in the financial markets. But my own view remains structurally constructive, as I believe that global economic fundamentals will remain positive and the risky asset prices, in general, should continue to be biased to the upside, even though some previously over-valued markets may not recover. After the dust settles, risk-taking will fully recover, I expect.
The sell-off in the sub-prime mortgage market and in some over-valued emerging equity markets is a healthy development, in my view, as it reflects valuation adjustments toward levels better aligned with the economic fundamentals. While further portfolio adjustments may lead to continued volatility in the financial markets for some time, my structural outlook for the global financial markets remains positive. Global liquidity is abundant and the global economy robust. Exchange rates will continue to be driven by cyclical factors, and ‘greed’, not ‘fear’, will dominate in the not-too-distant future. However, the dollar should stay on its back foot as long as the US is in its soft patch.
Ultimately, the real US/global economic fundamentals will drive financial prices and risk-taking, in my view. The latest round of risk-reduction is, by and large, healthy. I maintain a structurally constructive outlook on risky assets, based on the opinion that the global economy will remain benign and the global liquidity conditions favorable.
Note especially Jen's analysis on the Dollar versus the Euro ... he makes a lot of sense here in my opinion. Of course citing the ones who agree with me is way too easy. As such Ted Wieseman and David Greenlaw have review of the latest data coming out of the US economy and indeed it does paint a pessimistic picture of the US economy in the short term. An interesting point is also the inflation and how its apparent resilience does not indicate the Fed is going to be generous with a downward move.
With our current +2.2% 1Q GDP estimate, we seem now to be into our fourth straight quarter of sub-par growth, and yet inflation refuses to budge, remaining stubbornly near the cycle high and above the Fed’s comfort zone, making any near-term easing in rates unlikely. After a +0.25% reading for the core PCE price index in January (just barely rounding up to +0.3%) after two straight +0.1% outcomes, the annual rate reaccelerated, ticking up to +2.3% from +2.2% in December. This was just below the cycle high of +2.4% seen in August and September and actually higher than the +2.0% recorded last March before the start of the current period of below-trend growth.
Incidentally, this is also the message you get when you actually ask central bankers although I think they would be wise not to climb to high up in the ivory tower, especially at the ECB and the BOJ. It also seems as if I have perhaps wronged Munchau since he, in his recent note, which deals with the German export dependency explicitly notes how he does not support the 'decoupling scenario'. However, I just do not see how some kind of major portfolio diversification into Euros at the same times as an unwind of the carry trade can happen unless something fundamentally changes in the global economy. In Germany's case this is of course a whee bit more complicated since a slowing US in itself might be somehow weathered if Germany can leverage other export markets. That being said I fully agree with Munchau when he points to the increasing structural shift in Germany's economy towards export dependency ... the question of why this is of course remains as the proverbial 1 million dollar question.