Thursday, 23 March 2017
Last updated 8 hours ago
Sep 22 2007 | 11:35am ET
Russell Napier, Analyst at CLSA
You are sitting in the best seats in the house and watching one of the most important changes in world history. Perhaps it can be labelled “market turmoil” or “deteriorating fundamentals,” but make no mistake that these are convenient labels for the manifestations of a great global structural shift. For those who slog it out in the investment trenches, such market turmoil is a result of deteriorating credit quality in the United States, which is the beginning and not the end of the story.
This credit quality deterioration is merely a result of the current shift away from a period when global financial markets danced to an American tune. While such a transition is often talked about, its pace is now accelerating and causing profits and losses daily for market practitioners. If all you see from the trenches is market turmoil and deteriorating fundamentals, then you are tomorrow’s cannon fodder. So what is the current market turmoil telling us about how global financial markets work today and how they will work tomorrow?
There are still those who believe that movements of U.S. short-term interest rates are the most important factor for global markets, but this is an illusion. Ostensibly, the U.S. monetary policy has produced over a decade of high economic growth and low inflation. Ostensibly, the actions of the Federal Reserves in exercising the so-called “Greenspan put” have reduced risks for investors. Of course neither of these options would have been possible had it not been for a lack of growth or inflation in Japan. Neither of these options would have been possible had it not been for the decision of Japanese, Chinese and Asian politicians to prevent an undue appreciation in their currencies relative to the U.S. dollar. This currency policy has forced the Asian authorities to buy hundreds of billions of dollars worth of U.S. agency and Federal debt and finance U.S. growth at remarkably low rates of interest. Japan’s economic lethargy has kept global inflation lower than it would otherwise have been. These are crucial ingredients in America’s post 1992 economic success.
Those who speculate daily on the next twist and turn of the Yen often talk in the same breath about how the financial markets in the world are correlated with the U.S. markets. While such a relationship cannot currently be disputed, the future of the relationship is being questioned by current market activity. If a unique combination of events in Asia has permitted the apparent U.S. economic miracle to emerge then it is a change in Asia which threatens the United States rather than vice versa.
It is fundamental changes in Asia that are undermining the outlook for the United States. It is improving fundamentals in the east which are bringing an end to the apparent economic renaissance in the United States and the recent market turmoil is a reflection of this fundamental shift. It is important to recognize this structural shift behind such turmoil as it will mean that global markets will not have to slavishly follow U.S. markets. So a decline in credit quality in the United States is not a good reason to dump non-U.S. financial assets. It is quite the reverse.
So what is the practical day-to-day mechanism through which this structural shift is taking place? Throughout 2005, I was researching my book, Anatomy of The Bear: Lessons From Wall Street’s Four Great Bottoms. To this end, I delved deep into the pages of the Wall Street Journal, analyzing over 70,000 articles published over the past one hundred years. The book focuses on 1921, 1932, 1949 and 1982 and how contemporary commentators failed or succeeded in recognizing the greatest buying opportunities. While there were many tactical considerations which proved useful in identifying these great buying opportunities, it was clear that there was only one strategic issue to focus on: inflation. U.S. equities have become very cheap in periods of deflation or when there was a real prospect of deflation. If one also looks at periods when U.S. equities have become expensive, this has occurred when investors have believed in a permanency of low inflation and high levels of economic and, hence, corporate earnings growth. It has been changes in the general price level which have been the most important factor driving returns for investors in financial markets. Investors in equities derive the majority of their return from rising valuations and history suggests that it is the changing outlook for inflation which plays the crucial role in determining market valuations. Neither deflation nor low inflation has ever proved permanent and thus an investor’s periodic belief in such permanency has produced mis-priced equities. We are living through such a period when a new economy was foreseen which would bring a permanency to the high-growth and low-inflation scenario. This belief in the permanency of this combination reached its zenith in 2000 when valuations for U.S. equities reached all time highs.
In the past seven years the permanency of low inflation and high growth has been disturbed by the corporate profits collapse from 2000-2002 and the subsequent remarkable rebound. A strong rebound in inflation since 2002 has also been somewhat unsettling. While valuations of U.S. equities have declined as a result, history suggests that this is the beginning of a valuation decline which will increasingly be driven by rising inflation. It is these inflation changes, driven by changes in Asia, which are now being signalled by the recent market turmoil. It will be the economic success of Asia and the likely ratcheting up in global inflationary pressures which will grind down the valuations of U.S. equities.
Across Asia, under-geared consumers and under-geared corporations are poised to consume and invest. While a pick-up in both is inevitable, we have been waiting almost a decade for the catalyst to bring such a boom to life. It is probable that the re-capitalization of the Chinese banking system is such a catalyst. The foreign capital pouring into this banking system heralds the birth of consumer credit in China and a world that will never be the same again.
For more than 20 years we have lived with the certainty that China will produce disinflationary forces for the world. Remarkably, the economic transformation of China has happened against a background of over-production rather than over-consumption. The failure of consumption to keep up with production has sent Chinese goods spewing across the planet and thus depressing prices. The birth of consumer credit in China can change all that just in the way it changed the United States in the roaring twenties. This time the global ramifications are much larger as the world is much more dependent on inexpensive Chinese products than it ever was on inexpensive U.S. products.
With Chinese consumers given access to consumer credit there will now be periods, as in most other economies, when demand outstrips supply and results in inflation. The first availability of consumer credit is very likely to produce a boom in consumption and thus such an inflationary period. While this rise in inflation undermines the basis for high U.S. equity valuations it is just the catalyst which Asian consumers need to start spending. The legacy of deflation, which has impacted most of Asia at some stage in the past decade, will pass and with it a greater proclivity to borrow, spend and invest. This economic resurgence in Asia will finally pull back the curtains on the new reality which has been hidden for more than a decade. This reality is the that the world is living through a similar structural shift which was witnessed with the decline of the United Kingdom and the rise of the United States in the post World War I era. The current market turmoil is pricing tremors issuing from the shift towards Asia and not the US as leading global markets. Again, you are sitting in the best seats in the house and watching one of the most important changes in our history.
Russell Napier is a consultant with CLSA Asia-Pacific Markets writing on issues affecting global equity markets. He is also the author of Anatomy of the Bear.