Both the US and Japan are now creating jobs. This will provide enough wage income to sustain the excesses of the world economy a bit longer. President George W Bush and Federal Reserve chairman Alan Greenspan have succeeded in doing what I once thought they could not do ? push a monetary string stiff as a drive shaft, linking free money to jobs.
Free money and profligate fiscal policy have also inflated financial assets and kept housing bubbles bulging. And low interest rates have made household debt mountains sustainable in the short term. The consumer has responded by spending tax refunds and borrowing some more. So demand has grown.
The missing link was always whether wage income ? the product of job creation and hourly rates ? would recover. Given pricing pressure from China and India, I thought it would not. Without the wage income link, the whole Bush-Greenspan strategy would ultimately have to fail. In the final analysis, more income is needed if households are to finance more borrowing and more consumption.
But now the jobs are there. And so too is a lot of other bullish stuff like US disposable income, which is rising nominally by more than 4%, excluding tax rebates. And on the supply side, US Inc is in massive cash surplus, with profits higher than at any time since 1994 and investment a historically low fraction of cashflow.
Even Japan is reinventing its old capital socialist model in the guise of reform. Corporate Japan never really rationalized its workforce as America has. So higher wage income can boost consumption and the top line of corporations. It fills capacity and raises capital formation, after years of under-investment. Of course, new jobs, coupled with lousy productivity, give corporate Japan higher fixed costs. But that works fine on the upside of the economic cycle.
This leaves Europe moving excruciatingly slowly towards reform. There are no new jobs, and there is no growth in wage income and no recovery. But that doesn?t belie the thesis that growth is set to be higher worldwide.
So we are set for a sharp strengthening in the economic cycle. But this new sweet spot will not last long ? maybe a year or so. That?s because serious bear market fundamentals will reassert themselves. This will happen as inflation kicks in. As sure as death, interest rates will rise and ultimately reach levels that will force households to cut their debt mountains and so burst the consumer bubble.
So what about the financial markets between now and then?
Investors will pay for a growth premium in expectation of a better return on assets and higher interest rates in fast-growing economies. The highest growth premium will be in the US. Furthermore, US consumers will continue to suck in imports and will not save enough. That means Asian central banks will keep on accumulating dollars and will invest them in US treasuries. So the dollar will perform for now, although its secular trend will be one of decline.
The great rise of commodity-based currencies and equity markets is over. Commodities are an old story with too many financial players crowded on the long side of the trade. That?s the sort of trade where the marginal news has to keep getting better for prices to motor. I don?t think this will happen.
On the demand side, the most commodity-intensive economy is China. It has a vast speculative bubble going on in a wide range of assets, commodities among them. Credit is being cut off for commodity speculation, real estate and many forms of investment. Distressed assets are appearing in the market. Anecdotal evidence abounds that Chinese companies are getting squeezed between higher input prices and something nasty happening on the demand side. The Chinese may well be only 20% of world commodity demand, but they could well be 100% of the panic sellers the day the bubble bursts.
Equity markets are strung out between higher interest rates and higher growth. For the moment, they will blow here and there on the breezes of worry.
Greenspan will prepare the ground for higher interest rates, but ultimately increase them little. Why would the world?s biggest blower of bubbles want to puncture them, just when he has succeeded in pumping bubble gas all the way down to the jobs market, so making real economic growth more durable?
So I reckon that equities are the financial asset of last resort. Bonds are finished. And when it becomes clear that short-term rates on cash will only inch up over the next year, investors will push equities to new highs.
