``I cannot find a single convincing argument that tells me that astrologers won’t do better than economists…The problem is the arrogance of these economists, they’re making people rely on theories that have not worked, do not work, and are really dangerous.” Nassim Nicholas Taleb
If you look at today’s prevailing sentiment, especially from those within the US, the perception is that the global financial realm looks likely headed for a meltdown. This leaves investors the Hobson’s choice of running to the hills for cover or burying one’s money under the ground.
Of course, such sentiment has been bolstered by falling asset prices, which if we borrow George Soro’s “reflexivity theory” basically means irrational beliefs or convictions reinforced by market actions can help shape reality- or that market trends have the tendency of molding fundamentals than the other way around.
In the US signs of a deepening economic slowdown, tighter access to credit, rising cost of money, declining collateral prices, forcible liquidations, rising bankruptcies and foreclosures, the seeming paucity of capital, diminishing consumer spending, decreasing business spending, falling corporate profits and a continuing gridlock in the global financial system compounded by high food and energy costs have combined to impinge on the country’s socio-ecosystem.
And the inference is that trade, finance, credit and labor linkages, aside from unpredictable tide of capital flows, effects from intertwined currency regimes and consumer sentiment channels in a more intensified and interlinked world raises the risks of a contagion-a global recession or even a world depression. (The latter has been a popular topic searched at my blog. Besides, google search shows 3,020,000 links, compared to world recession of 546,000-meaning a surge of topical resource materials)
Meanwhile, emerging markets former darlings of global investors predicated on economic growth outperformance appears to have now been consumed by the conflagration of soaring food and fuel prices or mainstream’s definition of “inflation”.
So, from the chain of linkages shown above, the world “recouples”.
Add to this dimension is that since globalization has so far bolstered the faltering US economy via the underlying strength of the global economy fed by the transmission link of dollar links and currency pegs, manifested through via the export and financial assets channels; thus, a softening of the ex-US economic growth tends ricochet back to the US economy, reinforcing a vicious countercyclical trends around the world.
Shrinking US Deficits Mean Lower Liquidity and Higher Risks
Figure 1: Gavekal: Shrinking Global Liquidity via US Trade Deficit (HT: John Maudlin)
As we have pointed out previously pointed out in Global Financial Markets: US Sneezes, World Catches Cold!, the slackening of the non-petroleum trade deficits (largely indicative of slowing demand growth in the US) have been replaced by a surge in petroleum imports (oil imports now comprises almost 50% of total), which makes the overall deficit marginally lower but still significant see figure 1.
However, the recent decline in Oil and commodity prices seem indicative of two important dynamics: one global economic growth could be in decline (see Philippine Economy: World Financial Markets Allude To Diminishing Risks of Inflation) and second, diminishing trade or current account deficits have translated to reduced US dollar based liquidity circulating throughout the world financial system.
Since most of the world transactions remain anchored to the US dollar the US current account deficit functions as the world’s working capital. Hence the decline in the trade or current account deficits leads a contraction of liquidity in the global marketplace and a potential dollar squeeze that leads to a financial crisis somewhere.
Figure 2: Economagic: US Current Account, S&P 500 and US Dollar Index
Figure 2 from the Economagic shows that in the past, significant improvements in the US current account (see blue circles) have coincided with a recession, weakening equity price values and a rallying US dollar trade weighted index.
We have been seeing many of these factors in motion-recession still unofficial, faltering US equity benchmarks, global credit crunch, and consolidation of trade weighted US dollar index-as the current account balance deficits have markedly improved.
So the point is global liquidity have been greatly impacted by the ongoing deleveraging process in some of the major developed economies and the pronounced transfer of wealth from oil consumers and oil producers which can equally be seen as a transfer of wealth from the private sector to the public sector (which likewise adds to the tightening). Thus, the risk environment remains elevated for MOST of the world’s financial markets.
But When The Parasite Is Removed, The Host Will Thrive.
It can also be said that we can’t disagree with the analysis that the world risks transiting into a recession, considering that OECD economies constitute nearly 2/3 of GDP (nzherald.co.nz).
But then again, given the high levels of risk aversion and the impact from contracting liquidity, we can’t also read too much of the aggregate as representative of all the parts, lest be engaged in the fallacy of division- what must be true of a whole must also be true of its constituents, because of the following:
1. There are inherent nuances in the risks profiles of every nation due to the idiosyncratic political, economic and financial/capital markets structure or in the policy directions by respective authorities, see table 1.
Table 1 Economist: Country Risks Scores
This from the Economist (underscore mine),
``The credit crunch continues to depress ratings in the developed world. While the emerging world largely dodged the subprime bullet, it is beginning to feel the impact of the credit crunch and the slowdown in the OECD. Inflation is also having an adverse effect on emerging market risk scores. Inflationary pressures are in part due to high fuel and food costs, but also sometimes reflect overheating and capacity constraints. Central banks are generally behind the curve in tightening monetary policy and will have to raise interest rates aggressively to rein in inflation. This will create strains for companies and households which have borrowed heavily in the boom years, particularly if output growth slows.”
Whether the problem is inflation or from spillover effects from credit crunch or a combo thereof, the different configurations and policy directions determines the disparate risk profiles of each nation. So it would be ridiculous to lump the Philippines in the same category with Zimbabwe or Iraq in as much as it would be ludicrous to classify the Philippines with that of Switzerland or Finland.
Thus, the different risk profiles will result to diverse outcomes relative to economic wellbeing or financial market performance.
2. Doomsayers could be overestimating the risks associated with the chain effects from global linkages while underestimating other variables such as domestic investment and consumption patterns aside from regionalization trends or policy levers available to authorities.
Figure 3: ADB: Emerging Asian Regionalism
For instance, while it is true that Asia remains sensitive to world trade, where 67.5% of exports represent final demand OUTSIDE of the integrated Asia, regionalization has not been CONFINED to simply trading channels but to other aspects such as tourism, equity markets and bond markets (e.g. Asian Bond Market Initiative), foreign direct investments, trade policy cooperation and macroeconomic links as shown in Figure 3.
In addition, learning from the Asian Financial Crisis of 1997, it is noteworthy to cite the region’s attempt to undertake insurance measures such as monetary cooperation like the Chiang Mai Initiative (CMI), or a resource pooling strategy consisting of bilateral currency swap arrangements to cushion potential recurrence of external shocks. Another is the Manila framework, “a regional surveillance mechanism to monitor economic development and issues that deserve attention by the participating members.” (ADB)
Next, in the perspective of policy leverage, the humongous currency reserves of China ($1.81 trillion as of June 2008- Bloomberg) and the rest of the emerging market rubric which accounts for 76% of the $4.9 trillion global reserves in 2007 (Michael Sesit-Bloomberg) allows for much leg room for domestic investment spending or stimulus.
Investment bank Merrill Lynch estimates that Emerging Markets are expected to pour a huge amount of these reserves into infrastructure expenditures as shown in Figure 4.
Figure 4: US Global Investors: Expected Share of EM Infrastructure expenditures
According to khl.com, ``Annual infrastructure spending in emerging markets (EM) - Africa, Middle East, Latin America, Eastern Europe and Asia - is expected to jump +80% over the next three years, according to financial management and advisory company Merrill Lynch.
``The company's latest forecast said EM infrastructure spending would rise from US$ 1.25 trillion to US$ 2.25 trillion annually over the next three years, thanks to more aggressive government spending programmes, fuelled by decades of under-investment in power, transportation, and water, and higher analyst estimates.” (highlight mine).
So while the much dreaded consumer goods and services inflation wanes in the following months, we can expect EM governments to address its policy leverage by renewing its focus to build internal productive capacity.
Here in the Philippines, infrastructure expenditures are expected to climb to $50 billion from 2007-2010 (chinapost.com).
From the investor's point of view, areas where such huge investment undertaking will take place should translate to massive growth potentials and outsized prospective returns.
3. As we have repeatedly been saying, the problem of systemic overleveraging and the attendant market prompted deleveraging process has been mostly an Anglo Saxon or US-Europe affair with very little or minimal exposure in Asia or in the Emerging Market economies see figure 5.
Figure 5: IMF Global Financial Stability Report Update: Bank Writedowns and Capital Raised
Figure 5 from IMF shows that writedowns far exceed capital raising activities mainly seen in the US. From the IMF, ``However, disclosed losses have thus far exceeded capital raised and banks face difficulties in maintaining earnings due to falling credit quality, declining fee income, high funding costs, and exposures to “monoline” and mortgage insurers.” (highlight mine)
Thus, it is essential to understand the distinction among countries baggaged by cyclical or by structural variables. This also means countries affected by countercyclical factors are likely to experience shorter term pain compared to the structurally impaired markets whose recovery are likely to be protracted due to the sizable market clearing process coming out of severe malinvestments.
So we can’t buy on the notion that the world will evolve towards absolute “convergence” based on financial market performance and or in the economic outlook in as much as we can’t expect total “divergence”.
Under today’s environment, economic and financial market performances will likely be discriminatory than a holistic episode as seen during the recent past.
To quote Peter Schiff of Euro Pacific Capital (emphasis mine), ``The world is over-reacting to our problems, almost to the extent that we are under-reacting. Investors are over-estimating the global consequences of the collapse of the American consumer. I have long argued that American consumers have been functioning as global economic parasites, feeding off the productivity of the rest of the world. When the parasite is removed, the host will thrive. While those who have loaned us money will finally recognize their losses, the truth (belatedly recognized) will set them free. Once they move on, the world will enjoy enhanced growth, as it reclaims the savings, resources and consumer goods previously sent to America on credit.”
