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China’s reserves and purchases of US treasuries Annualized monthly change ($bn) |
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We enter the year to a deafening beat of bullishness. The long rally since the lows of March last year has brought US and European equity prices back to 70% of their peak in March 2000. Optimism rules and the consensus is for further upside in 2004.
By mid-year, though, I reckon the message will have changed. Why will this happen?
First, globalization is continuing to destroy corporate pricing power in the US and Europe. Deflationary forces will persist. Indeed, I don’t expect the Federal Reserve or the European Central Bank to raise rates this year.
Second, the consumer debt bubble in the the US, the UK and Australia is set to burst. So central bank liquidity injections will deliver diminishing returns. Global economic expansion will disappoint and, with it, corporate profit growth.
Third, the dollar will continue to weaken as foreign funding of US deficits declines, threatening to drive up US treasury yields and destroy the equity rally. Rising geopolitical risk will keep oil prices up and send gold higher.
The Iraqi hangover A year ago I forecast that the US would win the Iraq war and lose the peace. I’d hoped that the capture of Saddam marked a turning point for the better, but it doesn’t look like it. He was never the main locus of Iraqi resistance to the occupation and western influence. Terrorism will continue, because opposition to the occupation is deep-set, rooted in divisions between Sunni and Shiite Muslims and Kurdish separatism, as well as Arab nationalism. The US administration’s policy still lacks understanding of these forces and any open-mindedness in allowing Iraqi independence so that Saddam’s arrest could be turned into broad benefits for Iraqis.
On the debt bubble front the US consumer will not follow through as the market expects because households will lose wealth as house prices drop and jobs will go as globalization squeezes the service sector.
The recovery stories in Europe and Japan are hype – the two great economic jellyfish of the world will neither sink nor swim. But it will take the markets a while to wise up to the realization that global growth will disappoint.
The dollar crisis is already unfolding as the euro races towards $1.30. That will export deflation to the euro area and Japan. From Europe and Japan, deflation will be re-exported to the US, as US export markets for its services evaporate and, with them, demand for its financial assets.
The Bush administration is taking the world closer to protectionism and digging holes to bury the US system of alliances.
The decay of the world’s vital alliances requires immediate political leadership, not populism. The optimists assume that the targets of such policies, many of which are major investors in US financial assets, will interpret US policy benignly. But for the process to stay under control, the victims must not retaliate. I doubt that the world will be so kind.
The easiest way to strike back is to do something else with your international reserves than finance the Bush administration, or to take reciprocal measures that accelerate the slide towards protectionism and dearth of international cooperation.
Already, disputes are building up in international trade. And it seems that China’s huge dollar reserves are not being recycled into US treasuries at the same level, laying the burden of recycling firmly on the Japanese, who continue to intervene in currency markets at record levels to stem the rise of the yen.
Perverse effects Ironically, things that would make the world go better might perversely still make financial markets go worse. A great US or global recovery would tighten global liquidity by sucking more money into the real economy and out of the financial one. And if the US job market takes off, enough income will be generated to postpone the reckoning for household debt and house prices. But the ensuing growth cycle will force up interest rates and destroy the excess liquidity that financial asset prices currently float on. Equity markets will sell off.
So you should expect the gold price to head on up as most of the major currencies are debased in value by their governments and central bankers, as well as because of rising geopolitical risk. Other commodities will follow, until there is evidence that global growth is heading south or that China is going to need fewer commodities. The oil price is not going to come down. Indeed it could rise further as Russia and the Middle East are now lost to US influence and China has shifted energy demand permanently higher.
Finally, expect the euro to keep rising. The logic of that is a conservative policy from the ECB, no external deficit and no institutional framework to deal with a strong currency. The euro area is independently wealthy, sick and stable – widows like that take forever to die.
