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The Macroeconomic Outlook at Mid Year 2004William R. Thomson
If this were a normal economic cycle, we would be at the sweet spot of a spreading global upturn, with increased capital spending on top of revived consumer expenditures requiring a modest upturn in interest rates to sustain a balanced upturn. And, we would be wondering how much the stock market might appreciate in the following twelve months, always being aware that the first year of a new Presidency tends to be the most difficult but offset with knowledge that years ending in 5 were the only ones that never failed to be winners in the twentieth century. Indeed, that is the way Wall Street still tries to spin it to the public. But the reality, as we all know, is vastly different. This upturn is not a healthy one: the excesses of the bubble era were never properly purged, they were transferred to the housing market, to China, and the whole of the financial system has become dangerously addicted to debt and the leveraged carry trade. All these factors are in the process of change. Geopolitical background We are facing an increasingly unstable geopolitical scene - especially in the Middle East and with respect to the availability of oil. There are elements here reminiscent of the end of the Shah's regime in 1979, and all that entailed for the oil markets. I might also note in passing that relations between the Bush administration and Iran are deteriorating again. Iran is keeping its options open about Iraq in the months ahead. Al Qaeda claims, whilst the CIA demurs, that they have access to nuclear weapons. The CIA says that, at best, they have a dirty bomb. So we can all sleep soundly at night knowing that organisation's track record! To stir the pot just a little more, relations between China and Taiwan might, just might, be heading for a major confrontation. With the US stretched in the Middle East other players might just decide to settle some scores if the big boy on the block becomes over-extended. This is not a prediction, just the sort of risk factor that must be borne in mind in assessing today's market valuations. The effect of oil prices Oil prices at $40 barrel obviously carry a hefty risk premium over the supply/demand balance in normal times. The market is willing to pay this premium as insurance against a reduction in oil flows from potential damage to the oil infrastructure or blockage of the shipping lanes. The possibilities of something going wrong cannot be estimated on any reasonable criteria but, if they do go wrong, then oil could spike much higher, say $60 or more. Indeed, to reach the $40 they reached in 1980 in real terms they would have to reach $100 a barrel. Now western economies are less than half as energy intensive as they were in 1980 so today's prices are an inconvenience but only likely to damp growth slightly - say 0.5 percent - over what they would have been otherwise. The higher prices go the more impact there will be and the impact will not be uniformly spread. Asia, with its industrialisation, is very much more energy intensive. Higher oil prices would have a real cooling effect. Déjà vu - or back to the 70s Today's overall macroeconomic conditions have more and more uncanny resemblances with the stagflationary 1970s but with greatly enhanced geopolitical concerns and with far greater systemic financial leverage. In other words, the dangers, political and economic, are far greater this time. In 1971-3 we had wage and price controls, the end of the Bretton Woods system, recession-induced budget deficits and Arthur Burns, the supposed wise man of the time at the Fed, pumping up the money supply alongside artificially low interest rates. Except for wage and price controls it all sounds so very familiar. The result of this policy was a pre-election boom with Nixon being re-elected, despite the looming Watergate scandal. Oil prices exploded before the election but got a turbo-charge from the 1973 Middle East war and the resulting embargo. The world was then set on an extremely volatile and stagflationary period with subnormal growth rates and double digit inflation rates leading eventually to the Iranian oil crisis, the appointment of Paul Volker and the election of Thatcher and Reagan. So where are we today? The Money supply M3 has been growing at 11.8 percent since February and over 8 percent since December. Now obviously, that rate could be reversed but it is interesting to note that it is similar to the rate set in 1972-3 which led to the 9+ percent inflation in 1974-80. The Fed funds rate is presently 1% and will undoubtedly be raised on 30 June. My guess is Greenspan will raise it the minimum 25 basis points, since he does not want to be accused of sinking another Bush's chances of re-election. However, the Fed is already way behind the curve. In May, even the lamentable CPI, which badly measures the prices of things we do not consume and fails to measure the prices of things we do consume - that just happen to be increasing in price - increased by 0.6 percent a 7.2 percent annualised rate. The much delayed, and presumably massaged, PPI figure came in at 0.8 percent - almost a double digit annualised rate. So despite the best spin efforts of Wall Street and the Administration, commodity and oil price inflation is coming back. What is missing at this point for a full 1970s scenario in the US is sustained wage inflation, largely because the job market is not at healthy as painted. (Labour force participation is under 66 percent and well below the level when Bush took office. It is almost 75 percent in the UK.) If the US job figures prove to be real, which I doubt, then wage inflation will follow. With the oil threats and the Fed behind the curve, the bond markets are still vulnerable. If bonds are vulnerable, then so are equities. An external event could trigger massive problems in derivatives. There are very real concerns about the mortgage agencies Fannie Mae and Freddie Mac with their huge opaque derivatives books. Greenspan and Snow seem to have been getting their denials in first. Not my fault, guv! China et al I have not mentioned the problem of China. Whilst we are in the beginnings of the greatest development success story since the United States was opened up 130 years ago, it is virtually impossible to imagine that there will not be hiccups along the way. There certainly were in the case of the US and, indeed, Japan and the rest of Asia. China could be approaching such a point. There is a bubble in Beijing and Shanghai and the government is concerned to rein in the over exuberant economy in and has been taking administrative measures, rather than fiscal and monetary ones, to slow the economy to a sustainable rate. My guess is they will keep increasing the pressure until they get results. That could mean a slowing of the economy from its present rate of 11 percent or more to one of 5 percent at the bottom. Whilst that might seem modest, it could be worse, and it would certainly feel like a cold draft with a real impact on the East Asian region which has come increasingly dependent on China. What is the net impact of all this uncertainty? In the short run, probably an increased liquidity preference, and increased volatility as markets try and adjust to a further unwinding of the leveraged carry trade. Diversification will almost always play dividends, liquidity a chance to take advantage of opportunities that arise. But it is a time for caution and insurance. It goes without saying, gold has a place in portfolios as insurance at this time. Harking back to the 1970s, gold increased from $40 to $800 during that period. At the peak, the Dow Jones and the price of an ounce of gold briefly kissed at parity. Twenty fours years on gold is still below $400 an ounce and the Dow is over 10,000. The past is rarely prologue for the future but, when faced with today's threats, that seems like cheap insurance. William R. Thomson Bill Thomson is Chairman of the Siam Recovery Fund and advises governments and several asset management companies and institutions in Asia. He was formerly Vice President of a major international bank in Asia and is a former US Treasury official. He writes widely and we really appreciate his words of wisdom at 321gold. 321gold Inc |
