2005: Inflation Scare or China Shock?
Over the past two years, commodities and risky assets,1 especially emerging market bonds and stocks, have been the star performers in global asset markets. Oil and copper prices have virtually doubled and global equity markets are up around 50 per cent, reversing about half of their post-bubble crash.
Meanwhile, emerging market and high-yields bonds have also posted total returns close to 50 per cent. Can these trends continue in 2005?
Perhaps through the first quarter, but beyond that it seems unlikely. The big question is whether they fall victim to a serious inflationary scare or another deflationary shock as China’s spectacular investment boom turns into an ugly bust.
In the first case, (much) higher short-term interest rates, a poor year for bonds with bursts of volatility in the equity and credit markets, and growing risks to house prices may lie in store.
In the second, commodity plays, together with emerging market bonds and stocks, look most at risk, but developed equity markets may also suffer, at least until oil prices really come down.
Meanwhile, high-grade bonds, especially in Europe, wouldbecome the safe haven. We see this second scenario as the more likely endgame for 2005.
What Goes Up?
Since early 2003, the Bush tax cuts, a spectacular recovery in corporate finances and China’s epic investment boom have helped power one of the strongest global recoveries in 40 years. Not surprisingly there was a corresponding rebound in investor risk appetite from a 30-year low in late 2002. Fears of a global growth slowdown caused a setback last summer, but a late-cycle burst of global demand, mostly in China but including a pick-up in US employment growth, pushed risk appetite higher again in late 2004 (see chart 1, below).
The economic cycle has thus supported risk appetite for most of the past two years. But risk appetite up-cycles seldom last much more than two years, and risk appetite tends to trend down when global growth is slowing or global central banks are tightening. So far, we have had a little of both, but not too much of either. A hard landing for Chinese fixed investment would give us too much of the former, while a real inflation scare would ensure too much of the latter. The recovery in risk appetite looks to be living on borrowed time.
What Goes Down?
Over the past two decades, inflation has all but vanished in the developed world. But precisely because inflation is so low, abundant liquidity and low interest rates fuel fears that the current cyclical up-tick is also the start of a new secular up-trend for inflation. During such episodes, bonds and stocks often perform poorly at the same time, as bond yields rise and earnings multiples shrink. An unlikely historical parallel plays to that concern.
The past four years, as it turns out, look a lot like the early 1960s. The beginning of each decade (i.e. 1961–1964 and 2001–2004) saw a surge in US productivity that was not accompanied by rising labour costs.
Inflation was steady, but corporate profits rose sharply and the profit share reached very high levels (see charts 2 and 3, right). Moreover, interest rates were low compared to growth in the mid- 1960s, just as now, although back then it was more the case for bond yields, whereas today it is especially true for overnight rates.
During the second half of the 1960s, excess liquidity and strong economic growth led to sharply rising unit labour costs, as hiring and wages picked up and productivity fell. Consequently, inflation surged, monetary policy was tightened significantly (the Fed funds rate peaked at 9.15 per cent in 1969), and both bonds and stocks performed poorly.
Could we be in for a re-run of that scenario, starting in 2005? Presumably not, if the Fed remains vigilant against rising unit labour costs and inflation. However, if firms start hiring more aggressively and China booms on, inflation could become a much more serious concern. If the Fed does not step up to the plate, inflation expectations and bond yields will rise sharply. And if they do, short rates will rise more quickly than expected until risk appetite and global growth go into sharp reverse.
Forever Blowing Bubbles
Excess capacity has been the defining economic characteristic of the past decade. A succession of investment-led booms and asset market bubbles (in Japan, Asia and technology) created excess demand and mild inflation, followed by massive excess capacity, credit problems and deficient demand, once the boom broke. In each of these bubbles, today’s excess demand was the result of building tomorrow’s excess supply.
This seems to be happening in China now, with excess investment taking place in property, cement, steel, chemicals, apparel, some technology sectors and perhaps even cars. Since 1997 real fixed investment has soared by 170 per cent versus about 60 per cent over the corresponding periods of the Japanese and US investment booms of the 1980s and 1990s.
Meanwhile, some posttech bubble over-supply still remains in developed markets. Capacity utilisation is still below its historical average in the United States, Japan and Europe. Excess capacity in labour markets also persists: the OECD unemployment rate, at 6.8 per cent, is half a percentage point higher than it was four years ago, and the workforce participation rate in the United States has fallen from 67.5 per cent to 65.9 per cent.
New labour supply from China, India and Russia, which is more accessible today than it was in the 1960s, makes an acute labour shortage unlikely anytime soon.
In our view, a hard landing in Chinese investment is very likely in 2005. That would put disinflationary pressure on base metals and apparels, as well as some technology goods like flat-panel televisions. A Chinese investment bust would negatively affect other emerging countries, especially those that benefited directly from China’s boom. Commodity prices, including those of steel and oil, would probably fall substantially.
A few years ago, the primary threat to the world economy, recognised by both central banks and firms, was the possibility of underproduction and deflation, rather than excess demand and inflation. A Chinese bust could rekindle those fears.
Looking for Better Value
In contrast to the 1960s, today’s environment of supply-led growth means that the 1990s’ legacy – the looming potential for a disinflationary shock – is ever-present. Paradoxically, trends normally thought of as inflationary (e.g. excess liquidity, rising budget deficits and high commodity prices) are today more likely to be the harbinger of another investment bust and period of deflation for internationally traded goods. The risk of over-zealous tightening in response to a cyclical uptick in inflation is obvious.
A disinflationary shock in 2005 could become a deflationary scare in 2006. Expectations of tighter monetary policy in the US, Japan and China would abruptly end. Big winners in 2004 in terms of asset returns – commodities, emerging market assets, and perhaps lowgrade credit – would suffer most.
Without the threat of outright deflation, damage from a milder disinflation could be limited to emerging markets and commodities, and might even eventually prove supportive of those developed world equity sectors that would benefit from lower commodity prices. In our view, this is the most likely scenario for 2005 – a soft landing of sorts.
Indeed, that scenario would probably be better for global equity markets and risky assets in the longer run than one prompting much higher interest rates in 2005. We still expect global equity markets and risky asset markets to perform well through 2007–2008, but feel that, one way or another, an inflation scare or a Chinese bust will give investors a better entry point.
JAMES SWEENEY
CREDIT SUISSE FIRST BOSTON
1 Risky assets include developed and emerging equities, and low-grade corporate and sovereign debt. Safe assets include high-grade sovereign and corporate debt. Risk appetite tracks the volatility-adjusted relative
performance of the two groups. The index rises when risky assets outperform.
Entry Filed under: Asset Management