Ten Things I Think I Think

So financial markets continue their payroll week sturm und drang without delivering many signals of substance. Indeed, one could credibly argue that the payroll data itself is little more than noise these days, with most of the signal buried in the revisions.

Among the items sure to interest longer term investors is the recent announcements by the investment authority of Qatar and the managers of Japan's Kokusai bond fund that they have reduced their dollar weightings. While not 'actionable' news, it is nevertheless emblematic of what other long term dollar holders, particularly behemoths like CIC and SAMA, are likely to do in coming years.

In any event, days and weeks like this are a good time to sit back and think about long-term themes, some of which may or may not be reflected in current portfolio holdings. And so with apologies to Peter King, Macro Man presents his version of "Ten Things I Think I Think":

1) Global liquidity remains ample. While the August crisis was caused by an evaporation of microeconomic liquidity, macroeconomic liquidity remains plentiful, in Macro Man's view. Should the Fed and BOE follow through with the expected future rate cuts, liquidity conditions will improve even further. As noted a few weeks ago, the emerging world remains the primary provider of liquidity, via over-easy monetary policy and mercantilist currency policies. Macro Man has updated his monetary setting indicator; while developed-world monetary policy actually became slightly restrictive in Q2, global conditions eased thanks to EM countries. While conditions remain easy, the strategic outlook for risky assets is favourable.
2) Global inflation is likely to trend higher. Yes, the introduction of 2-3 billion Asian citizens into the global workforce has had significant disinflationary/deflationary consequences over the past decade. And it may well be the case that unit labour costs for manufactured goods remain flat to negative for years. But the enrichening of China and India will also cause a sustained growth in demand for finite resources, thereby pushing up overall input costs for many goods and services. While the Fed's core PCE deflator "target" may not capture this trend, Macro Man's TIPS position will.

3) Protectionism remains a threat. In any revolution, there are winners and losers. In the current economic revolution, among the losers are the Western manufacturing workers whose extra value added cannot compensate for the lower wages paid to workers in the developing world. Because the displaced workers live in democracies, their displacement will eventually feed through into the political process. This development appears to be close to reaching critical mass is places like the United States, which is encounteing the unfortunate combination of slowing growth and a forthcoming election.

4) There will be no credible intervention to weaken the euro any time soon. Europeans have their own brand of protectionism, which most often manifests itself via complaints about the level of the currency. The financial press is awash with stories about how Europe will try to push the euro (or at least the dollar) onto the agenda of the forthcoming G7 meeting. To put it bluntly, Macro Man expects that he has a better chance of being crowned the next Emperor of Japan than Europe does of getting the US to agree to prop up the dollar. Exactly what about the combination of slowing growth, a still-massive trade deficit, Treasury yields below Fed funds and a forthcoming election suggests that US policymakers will lift a finger to help out Europe, who have done relatively little to help the Yanks with China? Nothing.

5) FX reserve growth is still too big, and the consequences are coming home to roost. Books could be written about this subject, but Macro Man will keep his comments very brief. Quite simply, he believes that the economic benefits of reserve accumulation (maintaining "competitive" currencies to aid employment, discouraging speculation) are now substantially outweighed by the costs (the expense of sterlizing, the inflationary consequences of not sterlizing and/or tying one's currency to a sinking ship, expected future local-currency returns on the reserve assets.) The ultimate consequences of this are a) an increased focus on generating returns on reserve assets, and hence the sovereign wealth fund phenomenon, and b) ultimately, a decline in the rate of reserve accumulation.

6) Mrs. Watanabe will be around for a while. The yen may enjoy occasional bouts of strength, particularly against the dollar. But every time that Macro Man looks at Japan, he sees evidence that capital exportation is a growing, not a maturing, phenomenon. Sure, online margin FX punting might not always be as big as it is now. But the demand for foreign currency assets from Japan's households and institutions is very real and it is growing. Tying in with some fo the above themes, it will be very interesting indeed to see how that Japanese authorities react if/when USD/JPY drops to the erstwhile MOF "no fly zone" of 100-105, and if/when it rises to the US Congress "no fly zone" of 125-130.

7) Commodity prices are likely to trend higher over the coming years. This touches on the point made in the inflation "thing." Given liquidity, demand, and supply conditions, Macro Man would not be surprised to see oil over $100 and gold over $1000 by the end of the decade.

8) The US yield curve should continue to steepen. Macro Man thinks that the Fed blew it by cutting 0.50%, and has set the stage for a new bubble of dollar weakness and commodity strength. Dollar reflation and an inflation target that ignores inflation are a recipe for a steeper curve. Of course, if Macro Man is wrong about the US and it falls into recession, that should also be a recipe for a steeper curve. What would cause the curve to flatten would be a muddle-though US economy and a Fed that reclaims the high ground against inflation. That may well happen....in a few months. In the meantime, Macro Man is looking to put on a 2-10 steepener somewhere around 40 bps.
9) US equities will underperform the world over a multi-year horizon. Most of Macro Man's equity ideas have come in the US market, since that is what he knows best. Yet under the surface, he is pretty sure of one thing: that America's share of the world's economic pie is going to shrink over the next few decades. This shouldn't be anything controversial: how realistic is it for 5% of the world's population to have 27% of the world's economic output and 40% of the world's equity market capitalization ad infinitum? Not very.
While US markets have underperformed the ROTW for most of this decade, on the basis of the last 20 years' history, the party could just be getting started. The chart below shows the ratio of MSCI World with the SPX; note how far the ratio fell during the 1990's, when American growth was more or less the only game in town. Now that it isn't, it may be reasonable to expect that ratio to climb back closer to levels prevailing in the late 80's and early 90's. Macro Man will look to introduce this theme into his portfolio in the future.
10) Non-market things I think I think:
a) Macro Man loves traditional autumn weather....but hates the short days that come with it. He is a big-time sufferer of SAD
b) Ireland were dreadful in the Rugby World Cup, to Macro Man's chagrin. South Africa is the team that's impressed him most (well, other than the Argies....)
c) Microsoft Vista has gotten a lot of stick, but Macro Man just bought a new Vista machine and he loves it
d) Macro Man has been to at least a dozen lunches/dinners revolving around China over the last couple of year.....and not one has served Chinese food. Why is it that business lunches are often conducted over Japanese food, but almost never over Chinese?

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James
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October 3, 2007 at 12:15 PM ×

I for one would like to see if non US equities can rally after everyone drops there dollar pegs. Growth as is it right now is as much about inflation as anything else. 200 nations all doing there best zimbabwe impression

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t
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October 3, 2007 at 12:22 PM ×

All of which, pretty much, are $ -ve.
Perhaps we can foresee a similar slo-mo capital flight out of the US as we have in Japan.

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Macro Man
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October 3, 2007 at 12:53 PM ×

t, I think we're already seeing it...which is why the US current account deficit has been funded pretty much exclusively via the CBs these days.

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t
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October 3, 2007 at 1:01 PM ×

agreed, which makes short dollar a no-brainer based on principal depreciation.

To take the point further, I suppose I mean that the dollar will also become a funding currency par excellance in the same way as then yen, but even bigger, as dollar borrowings are subsidised.

In which case the risky asset boom / inflation / liquidity / dollar anti-bubble is going to get to (even more) ridiculous proportions.

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"Cassandra"
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October 3, 2007 at 1:02 PM ×

You're flying macro high for someone who's trades are often more tactical in nature. I generally agree with most of your sentiments, but let me add a few:

Liquidity remains ample, but the will to lend amongst dedicated systemic lenders at previously prevailing spreads and terms HAS waned dramatically. Liquidity is the sum of what's out there already, and the possible multipliers thereof. What's out there already in private and official hands will perhaps put a floor on asset prices, other things the same, BUT once prudential religion is burnished upon lenders in a Jimmy Stewart kind of "Financial Ghosts of Xmas Past", authorities may find it hard to rekindle the speculative animal spirits of bank lenders and leveraged buyers of securitised yield plays.

2. Protectionism. The threat is significantlyt under-estimated. The least systemically disrupting answer to this threat is for the US to harmonise its energy and consumption taxes to OECD norms. This allows BWII to breathe for another day. The CA deficit would at a minimum halve in very short order, and though some would complain, the system would live to fight another day, and the US and EU would again be fighting on the same the neo-mercantilist battle.

3. US Equity underperformance. I am not an equity bull, but this is the weakest of your 10 points. And you haven't said in what terms US equities underperform...local ccy or USD? Here, you need to examine what US equities (you mentioned cap in yests post, where the USD will be, and what the actual global linkages will be vs. the Economists rosey version of "The World Can Withstand A Stonking US Recession". Within the OEX Top 100 representing the lions share of US market capitalisation, the avg non-US sales % is roughly half. These are global enterprises. Moreover, most foreign non-EMs bear similar if not greater overseas proprtions. So who's exposed and under what scenarios? Weakening USD and mild softening, but continued robust growth outside the US combined with no protectionism might allow USS midcaps and small caps to underperrform until the J-curve effects upon trade kick in. But is this likely? Large caps however will outperform small , and likely keep pace with global non-US large caps, each suffering from US softness, offset by non-US robustness. In local CCY terms its a wash then, but in USD terms, non-US might outperform, but if it reduces to this, you needn't express a short-dollar view so cumbersomely.

Finally, as to the non-market things I think,

- Will the gazillion sq feet of retail being built out at White City be another Canary Wharf, being a visionary idea right in the long run, but getting deep-sixed and changing owners several times before the vision is proved a success?

- Why do the English eat baked beans for breakfast? Is there perhaps some connection between this and their banking troubles?

- Why are there not more physical goods arbs in the UK between the US? Shipping is cheap, and while there is VAT to contend with the spread are large? Are all the specs preoccupied with front-running Russians in South Kensington and St. Chelskyberg real estate?

- What demons possessed highway engineers in the UK to pursue the round-a-bout, and put them seemingly everywhere thhey are not needed? It's very name gives a clue as to the directness of the round-a-bout as an answer to traffic problems.

- IS there any city or town south of Watford that is as maddeningly inaccessible, ugly or irrelevant as Andover? Also, in my long resiidency in the UK, why did no one every tell me that Canterbury is amongst the grimmest of places?

- The OFT should investigate or someone should be told of the most obvious price-fixing arrangement betweeen Costa[lot]'s Coffee and Starbucks. No wonder England is a land Tea drinkers!

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Anonymous
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October 3, 2007 at 1:36 PM ×

macroman --

nice post, very "macro" --

I half expected a link to my blog when you wrote "that books could have been written" about reserve accumulation; there is a new ECB paper out as well that seems to make similar points.

t -- one problem with the dollar as a funding currency in some global macro sense is that the uS doesn't have a current account surplus for its housewives (or hedge funds) to lend out to the world; any dollar borrowed from the US to lend to the rest of the world is a dollar the US itself is borrowing from the rest of the world. I think that ultimately makes it a central bank demand for $ arbritrage kind of play ...

and for non-market things I think:

Is the city really going to grow fast enough to occupy all the new construction visible from the south bank of the thames? The cranes of Dubai and Shanghai seem to have a bit of competition ... there is a lot more construction going on in London than New York from the look of things. I probably should have known that, but somehow didn't.

bsetser

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Macro Man
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October 3, 2007 at 2:33 PM ×

C, ironically enough I think the US equity underperformance, in dollar terms, is the strongest of the points when looked at from a longer term perspective. Us nominal GDP growth will be well below that of the world nominal GDP growth, which should bear some relation to relative domestically-generated profits. And while the biggest US companies are multinationals, I'd expect that an outcome of protectionism to be a more adverse operating environment for those firms in the fullness of time (i.e, over 10-20 years.)

I, too, struggle with the roundabouts, which are used instead of stop signs.

In my experience, the goods arb is hampered by customs, which I am sure charge more than just VAT on imported goods.

Brad, I thought I had linked to you...but I see now that it was in a comment on another post. You're linked up now!

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t
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October 3, 2007 at 2:39 PM ×

"the uS doesn't have a current account surplus for its housewives (or hedge funds) to lend out to the world;"

Credit can be created at the stroke of a pen; in the face of a slowing economy borrowing will be made easier, reserve requirements can be eased (though not exactly onerous now); can not credit expand up to the capacity to borrow?
Why then the old-fashioned requirement of savings?

Please correct my likely misunderstanding.

re. Andover - how about Portsmouth, now there is no navy presence.

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Anonymous
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October 3, 2007 at 3:59 PM ×

why the old fashioned requirement for savings -- well, that probably takes more than a comment to address. But i think the general argument would be that this credit creation, absent savings to lend you, implies inflation ...

on a global basis, the account identities indicate that you have to save more than you invest (not create more credit with new fangled instruments) to finance the rest of the world. the big funding currencies now (JPY, CHF) both have current account surpluses. the US not so much -- it relies on inflows to cover a domestic savings shortage. i don't think that changes with new instruments.

the more interesting question is whether derivatives can let you take effectively leveraged positions with very small flows -- i think the answer is yes, but it going short the $ via a derivative requires someone that is willing to take the opposite side ...

bsetser

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Macro Man
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October 3, 2007 at 4:06 PM ×

..or think of it on a micro level. Northern Rock's business model involved heavy doses of credit creation layered on top of relatively little savings (its small deposit base), with the shortfall made up by the kindness of strangers (the interbank lending market.) It works great when it works. But when the strangers exhibit less kindness, it can all go horribly wrong rather quickly...

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t
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October 3, 2007 at 5:38 PM ×

...and yet the powers that be go out of their way to ensure that this type of credit creation from a small borrowing base continues, because they are scared ****less about the deflationary implications if it doesn't continue. Almost like a broker too scared to give its biggest client a margin call, lowering margin requirements when the client's trades are losing.

So as far as I can see, all means necessary will continue to be deployed to continue the NR borrow short lend long model. As a result the inverted pyramid of credit will continue to grow until people are unable to borrow any more.

I understand this implies inflation (de facto devaluation vs. assets).

As for savings being necessary to become a funding currency, I bow to your superior knowledge (inferior ignorance?) Brad. It would seem to predict, though, prolonged weakness in currencies that have current account surpluses, which seems perverse. I will spend more time trying to understand this.

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Anonymous
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October 3, 2007 at 7:24 PM ×

for all the hand-wringing about the $ , I remeber when there were 4$'s to the Pound during the 60's ....... time frames can make all arguments valid

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Macro Man
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October 3, 2007 at 7:51 PM ×

t, it might be useful to clarify terminology. Current account surplus countries will export capital (run capital account deficits) because of the identity of international accounts.

These days, the rate at which the capital account clears is the primary determinant of exchange rates.

One term in that equation is the attractiveness of borrowing in a curency to fund purchases in another currency. That decision may be made on the basis of very low interest rates (e.g. the yen) or of expected depreciation (e.g. the dollar.) Note that the current account does not play a role in that decision. However, because it represents the offset to the capital account, currencies like the yen tend to have a buffer that currencies like the dollar do not.

It's also important to remember that that current accounts represent a marginal savings rate, not the stock of savings. If the US repatriates some of its stock of foreign savings, it can fund its own current account deficit in the absence of foreigners. To a degree, that is what happened in 2001.

So...I guess the rule is that there are no permanent rules.

Anonymous, you are right about the GBP/USD rate....though its subsequent decline says a lot more about pre-Thatcher Britain than it does about the post-Kennedy USA.

And of course, investors' time horizons must be finite at the end of the day, for in the long run we are all dead!

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t
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October 3, 2007 at 9:47 PM ×

I appreciate the chalkboard, MM, Brad.
It is kind of you to share.

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