A modern fairytale

Time for a game. Which of the following is not like the others?

* Cinderella
* Hansel and Gretel
* The Princess and the Pea
* The boy king who survived a coup attempt and then ruled for 72 years
* Global decoupling: if the US slows significantly, it won’t matter to the rest of the world

The answer? They are all fairly tales except for the one about the boy king, who was in fact Le Roi du Soleil.

What started out as a generalized risk aversion event seems to have morphed into something peculiar to the USA. US stocks are trading the worst, the dollar is getting hit, and carry trades of every description are being re-established. The view that a US slowdown need not affect the rest of the world is quickly evolving into market gospel.

In Macro Man’s view, this is utter rubbish. He is cognizant that Chinese domestic demand remains robust, thus providing a crutch to the global economy that wasn’t there in the 1990’s. But the notion that domestic demand in Europe and Japan is sufficiently strong to pick up the slack appears to be flat-out wrong.

Now, an essay tackling this subject can either be very long or very short. And if Macro Man were a professional researcher with no other responsibilities, he would write the long-from version of the argument. However, he isn’t, so he won’t.

The short form version of the argument is as follows. The “strong”, “self-sustaining” domestic demand growth in Europe and Japan recently has still been well below the level of US domestic demand growth, despite the acute impact of the housing crunch in the second half of last year.

The notion that Europe and Japan are somehow not reliant on exports rings equally false. For most of the past several years, net exports have added substantially more to growth in Europe and Japan than in the US. Even with the recent substantial improvement in the US trade account, this remains the case over the past few quarters.

Sure, both of these countries can export to China, but you have to ask yourself whether Chinese import demand will accelerate or decelerate if export growth to the US slows.

For the time being, the market appears to want to sell dollars against most other currencies, both risky and “risk-free.” Macro Man is content to step aside and let the market have its way. However, he suspects that this situation will ultimately morph into a buying opportunity for the dollar, probably against the euro. Either US activity will recover, as Macro Man expects...or growth in the rest of the world will slow, which the market apparently does not expect. The time is not ripe yet to go short...but eventually, it will be.

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March 15, 2007 at 1:48 PM ×

"In Macro Man’s view, this [decoupling] is utter rubbish."

I knew you and Dr. Roubini would eventually find a point of agreement.

I am a bit more open to possibility of decoupling than either of you, though it is a bit of a stretch. Remember that differentials in population/ labor force growth mean that European domestic demand that is about 1% below US domestic demand is about the same thing relatively speaking in per capita terms. Though it certainly helps to have domestic demand in the big economy with the most population growth growing.

and i think you are leaving out one big engine of domestic demand globally -- the oil exporters. they are finally getting around to spending their windfall, big time. Dubai let the way, but others are catching up. the combination of lower oil prices and higher oil spending presumably explains the recent improvement in the european current account balance (I have been meaning to write about that). basically, if oil holds stable and oil spending picks up, the oil/ commodity exporters will support global demand for a while. right now, china and europe look to be the biggest direct beneficiaries.


Macro Man
March 15, 2007 at 2:54 PM ×

Interesting point. I hadn't really considered them. What do you make of the utter collapse of Middle Eastern stock markets over the past year? A sign of distress or a ring-fenced phenomenon affecting the pocket change of the oil sheikhs?

March 15, 2007 at 3:30 PM ×

a relatively ring fenced phenomenon -- a very small amount of the oil money (remember, most is still held offshore) started chasing a very small number of stocks (remember, most companies are still state owned, notably in the oil and gas sector), and with thin markets and a bit of day trading (one bank bragged you could bid for an IPO through its ATM network) you got a bit of a bubble --

the real action is in property and the growing budgets; domestic absorption rose dramatically in the gulf in 06 even tho the stock markets tanked. if and when the property bubble bursts and if and when every gulf state discovers it cannot be a financial/ transit/ tourist hub, well, things might look a bit different. but the bottom line is that with (06) spending on imports/ current account outflows at the equivalent of say $35 a barrel and oil at $60, the region has the capacity to spend more if it opts to almost no matter what (if i do the oil break even calculations in terms of fiscal budgets rather than from the balance of payments, the numbers are roughly similar). the governments just have to opt for smaller reserves/ investment funds and more current spending.


March 15, 2007 at 9:49 PM ×

The main disconnect, intellectually, is what you call the "real" economy. For currency and market mavens, it's the credit world. Hence the strong link between jurisdictional interest rates and currency strength, rather than currency following underlying physical world econ trends.

The credit economy is of course run by central banks, private banks, and elites of the political world. Asian currencies can stay weak if they say so - "take that."

Likewise equity markets are subject to the collective biases of a relative handful of world actors, and the astonishing rise of synchronised stock rises and falls is evidence.

Real world consumption and imports in the Mid East are strong as Dr. S points out, but I got ridiculed somewhat for pointing out the building boom in Dubai might be more than mere consumption recently. So while real world economics says its consumption rising, real world economists also say it won't last. Especially as so many assets of the Mid East are tied up with the US financial world, which is what is at risk today.

Dr Roubini may be wrong about the effects of the US on the real world economy to some degree, but he's dead on, as are you, about the intimate linkage in the parallel credit world of FX and stocks and bonds.

March 16, 2007 at 4:12 AM ×

John Authers, Investment editor
March 16, 2007

DR Doom is back. Henry Kaufman, the legendary chief economist for Salomon Brothers in the 1970s and 1980s, earned his nickname for gloomy (and usually correct) forecasts of higher inflation and interest rates.
Mr Kaufman gave a speech in Wall Street on Tuesday night. The timing was perfect. US stocks had just sold off savagely, and Asian markets were about to suffer the same fate. Within hours the selling hit Europe, leaving indices sharply down.
He had no words of reassurance. But he did have a clear diagnosis. The problem lies in the changing definition of liquidity.

After the war, liquidity was an "asset-based concept" - companies' cash on hand and so on. Now, Kaufman said, "firms and households alike often blur the distinction between liquidity and credit availability. Money matters, but credit counts".

Securitisation and improved technology, he said, stimulated risk appetites, "fostering the attitude that credit usually is available at reasonable prices". But risk-management models assume "constancy in fundamentals", and do not account for the market's changing structure.

Moreover, risk modelling is so profitable that it will spread, and become "in a word, riskier" because aggressive models make the most money. Meanwhile "the reliance on judgment and reason will be pushed aside".

The speech could have been a comment on this week. Traders realised they had extended too much credit - particularly to the sub-prime sector - and reduced leverage wherever they could. Hence the uniform sell-off.

Assets with little in common become almost perfectly correlated. Individuals and companies trade in and out of the stocks in the S&P500, and in and out of the US dollar and the yen.

But they were perfectly matched on Wednesday, with the S&P rising as the US dollar rose, and falling as it fell. As Dr Doom warns, reliance on judgment and reason have been pushed aside.