The IMF’s recent forecast for global growth this year suggested a soft landing for the world economy as growth subsides a little from 5% to 4.3%. But it reckoned that financial market conditions would tighten and global imbalances had deepened, increasing vulnerability to shocks. But it seemed relatively sanguine about the prospects of a gradual adjustment to tighter credit and higher costs.
I cannot be so optimistic. Global liquidity is tightening and risk appetite for global financial assets is set to fall. Disinflation (particularly in the US) is at an end and interest rates are on the rise. That will start to destroy wealth.
The first stage will be in the financial assets of those emerging markets that are most dependent on commodity and energy imports and on foreign capital, such as the Philippines and Turkey. Rising real interest rates are also going to burst the Anglo-Saxon property bubble. Further on, high commodity prices and rising interest rates will eventually slow growth. Then those economies that depend heavily on commodity exports, such as Russia, will suffer. So will resource-based economies such as Australia. And there is a significant danger of a financial sector bust in over-indebted economies such as the US.
The end of cheap money
The era of cheap money to borrow and spend that has lasted for more than 20 years is over. Global liquidity will contract and burst many of the credit bubbles that cheap money has spawned. It may play out over a very long period, but it will puncture excesses as far apart as the China commodity cycle, emerging-market debt, Anglo-Saxon housing, US consumer debt and financial sector leverage.
Global inflationary forces, such as oil and commodities, will put pressure on US prices more than on those of Europe and Japan because the US has the weakest currency.
The US economy only achieved disinflation over the past decade because cheapening imports contained the impact of an inflationary and unproductive service sector.
The Fed’s reaction ought to be to drop its “measured pace” language and increase short-term interest rates significantly. It probably won’t, so the bond market will do the job by continuing to push up long-term rates.
The first-stage losers from tightening liquidity will be the emerging-market debt of countries that are net importers of high-priced energy and commodities and have not done enough to correct their dependence on foreign capital. Among the primary victims are the central European countries, and high debtors such as Ecuador and the Philippines.
In the rich (OECD) countries, the big loser will be the most unproductive borrower, the housing market, to be followed shortly by the consumer. And I suspect that hidden in the outrageous growth of financial sector leverage is a big bankruptcy. That will kick the remaining life out of the financial sector boom.
High prices are the best cure for high prices – especially for energy and commodities. They will cause demand for oil and industrial materials eventually to contract and for supply to expand. As that happens, global economic activity will also feel the pinch of both tighter liquidity and higher inflation.
That will be when the China bubble bursts. As global growth falls, so will commodity prices and, with them, the fortunes of many of today’s safe-haven trades in emerging markets. That will be the time when commodity currencies lose their safe-haven status too.
Equity markets might hang in there doing little for a while, but ultimately they will be victims of rising inflation and interest rates that warrant much lower P/E ratios and, later, falling earnings as growth slows.
Euro attractions
What are the real safe havens? Gold is an obvious insurance against rising financial sector systemic risk. The contraction of dollar liquidity is a replacement process whereby the euro achieves a bigger share. The euro area will benefit from the dividend (ample liquidity and lower interest rates) of assuming part of the dollar’s reserve-currency role.
The globalized private sector, whose transaction and asset demand for dollars dwarfs the holdings and flows of central banks, will move to the euro first. Later, so will the central banks. European fixed-income assets
have to be winners. Also, because Europe and Japan will develop better and more self-sustaining recoveries than the US over the next few years, their equities should outperform.
The imbalances of relatively fast growth since the downturn of 2001 have been expressed in a huge US current account deficit, record property prices, high oil prices and yet weak consumer demand in Europe and Japan. Now with inflation returning and real interest rates rising, these imbalances will unwind. The process will be painful. The IMF’s optimistic forecasts are at peril.
