滞胀将至（一）
滞胀将至（一）
从 一五一十部落最新文章
作者：谢国忠 | 评论(0) | 标签:通胀, 全球经济, 货币, 美元, 欧元, 中国股市
America's problem is over leverage. The solutions are (1) to spend less, save more, or (2) to inflate debts away. The Fed is pursuing the second option, I believe. It will keep short-term interest rate at 2% and inflation rate at 4% and encourage Americans to refinance their debts at short end. It effectively inflates away debts by 2% per annum. Credit market has blown up. Stock market is giving away a bit too. Bond market is the last piece to fall. Central banks of East Asian countries and Middle East oil exporters are holding up the bond market. They are the fools that the Fed is counting on to support the market while it inflates away the household debts. But, at some point, the central banks may wake up. The sharp correction of the bond market is the last piece in the repricing of financial assets in 2008.
Towards Stagflation
Stock markets around the world have collapsed. Many blame it on the US recession. That is not wrong; it is one factor. More important reason is the liquidity pool shrinking due to the capital losses at global banks. Stock markets were overvalued for a long time. But, bulls were arguing that too much money was chasing and markets could go higher regardless of valuation. Money creation happens when commercial banks borrow from central banks. This process depends on (1) central bank policy rate, (2) capital at commercial banks, and (3) risk appetite. When capital expands by one dollar at a bank, it can borrow $12 from central bank to lend out or buy financial assets. The global banks reported enormous profits in the past few years on the credit boom. They expanded their balance sheets aggressively, which injected enormous amounts of liquidity into the global financial system, which was the origin of the liquidity boom.
Now we know that the profits were an accounting illusion; the banks were booking capital gains on worthless papers. The reported losses today are just accounting for the overstated profits before. The fake profits led to excessive liquidity and overvalued asset prices. With less capital, the banks have to shrink their balance sheets by selling assets and giving the cash to central banks to repay debts. If global banks end up with $100 bn less capital despite capital injection, probably an underestimate, global liquidity contracts by $1.2 trillion. As the fake money vanishes, global asset prices will normalize too. This process cannot be reversed by central banks cutting interest rates.
I knew this liquidity problem would come and was waiting for an opportunity to make the call. Sensing a gathering storm, I wrote an article titled 'The Perfect Storm' calling for 20% correction of Hang Seng Index and sent it to South China Morning Post on Friday, Jan. 11. The SCMP couldn't print it on Monday, Jan 14, as I wished. I sent to the article to all the people on my emailing list (about 1,000 in total) at 2:30pm on that day, because I believed the market was ready to move. With 1,000 recipients, most of them investors, the article hit the market fair to everyone. The SCMP reprinted the article with a changed title of 'Eye of the Storm' on Thursday, Jan 17. I didn't long or short stocks in Hong Kong at the time and didn't inform any investor of my intension to write or send this article out before.
Hong Kong market is always vulnerable to fluctuation in global liquidity. It trades on the dream of 1.3 billion Chinese coming to buy but actually depends on international money. As global banks contract their balance sheets, Hong Kong market would be hit hard. When hedge funds short or long, they cause volatility but don't change fundamental market prices. When banks pull money out, asset prices must adjust to lower level of liquidity. In 1998, Hong Kong market crashed. Even though most blamed hedge funds, Japanese banks pulling out, due to capital losses at home, was the most important reason. History repeats itself now.
I want to emphasize that what is occurring is normalization. HIS was below 20,000 in August 2007 and then surged above 30,000 as retail investors poured in on the advice of newly minted 'share gods'. The current level is quite reasonable compared to the level one year ago. The PB ratio doesn't indicate a cheap market at all. The pain that market participants feel now is relative to the recent highs. Human psychology gives a big negative to a rollercoaster ride in money matter. Investors feel better about a flat market than one going up 100% and then dropping 50%. Two markets have the same ending, but feel very differently to investors. This is why there is a risk premium on volatility. An added risk to the Hong Kong market is the extent of margin trading. Many retail investors went into the market big in October 2007 with maximum margin borrowing. As the market comes down, margin calling would add selling pressure. And, the same investors pushed up luxury property market in Hong Kong, also with borrowed money. I am afraid that Hong Kong could suffer quite a bit in coming months with declining stock and property market.
The A-share market has been correcting due to the widening price gap between Shanghai and Hong Kong for the same stocks. On Jan. 22, Petro China, for example, closed at HK$9.61 in Hong Kong and Rmb26.18 in Shanghai, i.e., PetroChina sold for 193% more in Shanghai than Hong Kong. This big and widening gap is undermining the confidence of speculators in Shanghai. Despite the correction, Shanghai market is still 100% overvalued, I believe. However, after the first quarter correction, many pundits in China would come up with other reasons to cheer speculators up. The most important argument is that China is different. As for the price gap, they would ask investors to walk straight ahead, don't look around ('一直朝前走，不要朝两边看'). China has 1.3 billion people. Probably tens of millions are credulous. As long as the pundits could get these people to believe them, the bubble can continue through the Olympics. The current correction is just turbulence on the rooftop. Coming to the ground may happen after the Olympics.
Financial markets have become so large that their movements can affect real economies. Hence, governments and central banks have to respond to market turbulence. In a way, they have become market's hostages. The Fed responded to the crash in Asian stock markets on Jan 22 by cutting interest rate by 75 bps to prevent a similar crash on Wall Street. The US Federal Government has already outlined a fiscal package of $145 bn, mostly tax rebates for households and businesses. Even though these measures are significant, they are not enough to stop the recession or the bear market. Instead, the US policies are pushing its economy towards stagflation (say, 2% GDP growth rate and 4% inflation rate) for two to three years. Through the currency market, it could spread stagflation to Europe. Emerging economies may have good growth (say, 6-6.5% annual growth rate compared to 7.5% in the past three years) but may also have high inflation. In summary, the biggest investment decision for next two years is how to cope with rising inflation and slowing growth. In particular, investors should be aware of the risk of rising bond yields or falling bond prices.
As the late economist Milton Friedman argued that inflation was always a monetary phenomenon. In the end, price is equal to money supply divided by goods and services sold times money velocity. The last variable is how fast money turns over each year. Economists usually assume that the velocity doesn't change, as human behavior should be stable over the time horizon of one year or two. That is correct for developed economies but not for developing economies. In China, for example, money velocity could change substantially. Hence, even without policy change, mere sentiment change could cause inflation or deflation. Another complication is the competition between asset market and real economy for money. As governments don't include asset prices in CPI basket, money increase could inflate asset prices first. The resulting outcome-high asset price and low inflation would seem wonderful for everyone. High asset prices make people richer, while low inflation sustains living standard for people at bottom of the society. The essence of economics is 'no free lunch'. The paradise of high and rising asset price and low inflation is just temporary. Eventually, high asset price will trigger more demand, which would cause inflation. As inflation expectation surges, people don't want to hold money, which increases money velocity and, hence, rapidly pushes up inflation.
The Fed cut interest rate to 1% and kept it there for a long time after the NASDAQ burst and '9-11'. That was the origin of the subsequent asset bubbles around the world and today's credit crisis. The Wall Street created financial products like subprime to entice Americans into buying properties that they couldn't afford. The extra demand pushed up property price, and rising price momentum attracted speculators. The market snowballed on the new demand and, for a time, looked unstoppable. The Wall Street invented more and more products to turn asset inflation into cash for consumers to spend, which increased inflationary pressure and forced the Fed to hike interest rate. The high interest rate caused the property bubble to burst and the subsequent unwinding of all those funny credit products.
Lowering interest rate couldn't reverse the unwinding dynamic. The low Fed policy rate wouldn't increase money demand like before. Global banks are bleeding capital. They have to preserve 8% capital in turns of their asset size. If they lose one dollar of capital, they must shrink their asset size by twelve dollars. All the banks have reported about $100 bn in losses relating to subprime. Ceteris paribus, their asset size should be $1.2 trillion smaller. There may well be $100 bn more losses to come from subprime, credit card and car loans. The balance sheet shrinkage of the global banking system is unstoppable. Also, it shouldn't be stopped. The banks became too large on false profits. What we are seeing is normalization. Of course, as the balance sheet of the global banking system normalizes, asset prices around the world would normalize also. The Fed is fighting a phony war. There is no need to fight it. It is market force at work. Despite all the talks about panic selling, asset prices are only getting close to fair value.
The Federal Government has sprung to action to stimulate the economy. The White House has already outlined a stimulus of $145 bn, mostly in tax rebates for households and businesses. A similar package in 2002 did have a meaningful impact at ending the recession. Americans have shown again and again that, when given money, they will spend it. I wouldn't bet against it this time. The US economy is already in recession. The stimulus money could be released in spring and the economy may stabilize by third quarter. While fiscal stimulus may support the economy in the short term, it only complicates matters overtime. America's problem is spending too much, not too little. Recession is a solution, not problem for the US economy. All that fighting against it is counterproductive in the long run.
The US has a growth culture. It is usually a good. The belief in growth incentivizes ordinary people to become entrepreneurs. The productive activities of the entrepreneurs boost economic growth. Optimism can be self-fulfilling. On the other hand, economic pessimism can be self-fulfilling too. Financial investors must judge first if a country is optimistic or pessimistic before making investments. In pessimistic countries, investors should buy bonds or stocks with high dividends. In optimistic countries, investors should buy growth companies.
The dark side of the growth culture is the tendency to over-stimulate. What is occurring now in the US is payback for excessive expenditure in the past. After the NASDAQ burst in 2000, the Fed under Mr. Greenspan cut interest rate to 1%. The Wall Street invented new products for households to borrow to spend. The low interest rate caused Americans to overspend with rising trade deficit as a byproduct. The current downturn is really to offset the borrowed growth in the past. Market is fair in that regard. However, policymakers view the downturn as unacceptable and must deploy stimulus to fight it. Market punishes people for taking unrealistic actions. The consequences for the monetary and fiscal stimuli in the US are high inflation and weak dollar.
There will be more stimulating measures to come. The Federal Government may initiate another and bigger stimulus package late in 2008. The stimulating measures may decrease short-term pain by stretching out the adjustment process. But, its cost is high inflation. Some argue that the weakening economy should bring down inflation. I doubt it. Inflation is global today. With rising food and energy prices and weakening dollar, the US is importing inflation. Further, the productivity slowdown will partly offset the disinflationary effect of weakening demand. The stimulating policies by the Fed and the Federal Government will exacerbate the situation, mainly by keeping the dollar weaker and for longer than otherwise. In the early 1980s, the US had a tight monetary policy and loose fiscal policy. It led to a strong dollar despite rising trade deficit. Now, it is loose monetary and fiscal policy. The outcome is shrinking trade deficit and weak dollar. Both are inflationary. The US economy may have 4% inflation and 2% GDP growth rate for two to three years.
The stagflation scenario in the US will infect other economies. Euro-zone, in particular, is quite vulnerable. The ECB keeps a tight monetary policy because the Euro-zone faces rising inflationary pressure due to rising commodity prices and rapid money growth. Euro has become an alternative reserve currency to the dollar. As global central banks switch some of their reserves into Euro, they inject the liquidity that the Fed has released into the Euro zone. The ECB has stayed firm despite the recent financial turmoil, because the underlying economy is still strong. However, by mid-2008, it should become apparent that the Euro-zone is heading for a downturn. The growth engines like Germany in the Euro-zone are export-led. Euro's strength is hurting them. Euro may gain further in the first half of 2008. It will eventually shut down Euro-zone's growth engine. The ECB may be forced to cut interest rate late in 2008. Euro would weaken then. It then removes the main dis-inflationary force in the Euro-zone. Euro-zone may well experience inflation higher than growth rate for two years also. The stagflation in the Euro-zone may be less severe than in the US. Still, it has major implications for bond investors.
Japan is already in recession. But, its inflation is unlikely to rise. Declining population makes Japan a special economy. It behaves like a superconductor in globalization; whatever happens elsewhere passes through Japan without a trace. Japan's only significance is as the funding source for carry trades. When speculators feel bullish about global growth, they borrow yen at 0.5% interest rate and buy other currencies like Euro or Aussi Dollar that gives higher interest rate. When they feel bearish, they unwind the trades. Yen value fluctuates with the sentiment about the world economy. The most important indicator for this risk appetite is Euro-yen. It rose from about 100 four years ago to the peak of nearly 170 last year. It is now at 155, still indicating pretty high risk appetite in the global financial market.
Emerging economies already experience high and rising inflation. China and India already have inflation rate stuck between 5-10%. The growth rate in the emerging economies is still strong. They have been growing at 7.5% in the past four years. They may grow between 6-6.5% in 2008, slowing down from the breakneck speed before but still high by historical standard. The main reason for the decoupling between emerging and developed economies is their high foreign exchange reserves. Though their exports will slow in 2008, they still have plenty of money to support their investments. It is still too early to see if their inflation rate would be higher than their GDP growth rate. My hunch is that it won't happen in 2008. However, after the dollar bottoms in 2009, they may also enter a mild form of stagflation. The economic decoupling doesn't extend to financial decoupling. There is so much international money in their stock markets that they will come down on shrinking global liquidity.
The above analysis is giving some colors to the inflation problem in the global economy. The bottom line is that central banks released too much money during low inflation period. The money went into asset markets and caused inflation there. Central banks refused to accept asset inflation as a consequence of their policy and kept monetary policy loose. Strong asset markets caused strong demand growth and overtime inflation. As central banks tightened against inflation, asset prices came down. In response to the demand weakness from asset deflation, central banks are reluctant to decrease money supply to contain inflation. Hence, the money that they released before will become inflation. Yesterday's asset inflation has become today's CPI inflation.
Bond yields around the world are quite low despite high inflation, because investors believe that weakening demand would bring down inflation. They are probably wrong. When the stagflation scenario becomes apparent, bond yields could spark up sharply. Bonds will become worth buying then. They should hold cash despite the low and declining short-term interest rates. Investors who take more risks than buying bonds could look at gold.
从 一五一十部落最新文章
作者：谢国忠 | 评论(0) | 标签:通胀, 全球经济, 货币, 美元, 欧元, 中国股市
America's problem is over leverage. The solutions are (1) to spend less, save more, or (2) to inflate debts away. The Fed is pursuing the second option, I believe. It will keep short-term interest rate at 2% and inflation rate at 4% and encourage Americans to refinance their debts at short end. It effectively inflates away debts by 2% per annum. Credit market has blown up. Stock market is giving away a bit too. Bond market is the last piece to fall. Central banks of East Asian countries and Middle East oil exporters are holding up the bond market. They are the fools that the Fed is counting on to support the market while it inflates away the household debts. But, at some point, the central banks may wake up. The sharp correction of the bond market is the last piece in the repricing of financial assets in 2008.
Towards Stagflation
Stock markets around the world have collapsed. Many blame it on the US recession. That is not wrong; it is one factor. More important reason is the liquidity pool shrinking due to the capital losses at global banks. Stock markets were overvalued for a long time. But, bulls were arguing that too much money was chasing and markets could go higher regardless of valuation. Money creation happens when commercial banks borrow from central banks. This process depends on (1) central bank policy rate, (2) capital at commercial banks, and (3) risk appetite. When capital expands by one dollar at a bank, it can borrow $12 from central bank to lend out or buy financial assets. The global banks reported enormous profits in the past few years on the credit boom. They expanded their balance sheets aggressively, which injected enormous amounts of liquidity into the global financial system, which was the origin of the liquidity boom.
Now we know that the profits were an accounting illusion; the banks were booking capital gains on worthless papers. The reported losses today are just accounting for the overstated profits before. The fake profits led to excessive liquidity and overvalued asset prices. With less capital, the banks have to shrink their balance sheets by selling assets and giving the cash to central banks to repay debts. If global banks end up with $100 bn less capital despite capital injection, probably an underestimate, global liquidity contracts by $1.2 trillion. As the fake money vanishes, global asset prices will normalize too. This process cannot be reversed by central banks cutting interest rates.
I knew this liquidity problem would come and was waiting for an opportunity to make the call. Sensing a gathering storm, I wrote an article titled 'The Perfect Storm' calling for 20% correction of Hang Seng Index and sent it to South China Morning Post on Friday, Jan. 11. The SCMP couldn't print it on Monday, Jan 14, as I wished. I sent to the article to all the people on my emailing list (about 1,000 in total) at 2:30pm on that day, because I believed the market was ready to move. With 1,000 recipients, most of them investors, the article hit the market fair to everyone. The SCMP reprinted the article with a changed title of 'Eye of the Storm' on Thursday, Jan 17. I didn't long or short stocks in Hong Kong at the time and didn't inform any investor of my intension to write or send this article out before.
Hong Kong market is always vulnerable to fluctuation in global liquidity. It trades on the dream of 1.3 billion Chinese coming to buy but actually depends on international money. As global banks contract their balance sheets, Hong Kong market would be hit hard. When hedge funds short or long, they cause volatility but don't change fundamental market prices. When banks pull money out, asset prices must adjust to lower level of liquidity. In 1998, Hong Kong market crashed. Even though most blamed hedge funds, Japanese banks pulling out, due to capital losses at home, was the most important reason. History repeats itself now.
I want to emphasize that what is occurring is normalization. HIS was below 20,000 in August 2007 and then surged above 30,000 as retail investors poured in on the advice of newly minted 'share gods'. The current level is quite reasonable compared to the level one year ago. The PB ratio doesn't indicate a cheap market at all. The pain that market participants feel now is relative to the recent highs. Human psychology gives a big negative to a rollercoaster ride in money matter. Investors feel better about a flat market than one going up 100% and then dropping 50%. Two markets have the same ending, but feel very differently to investors. This is why there is a risk premium on volatility. An added risk to the Hong Kong market is the extent of margin trading. Many retail investors went into the market big in October 2007 with maximum margin borrowing. As the market comes down, margin calling would add selling pressure. And, the same investors pushed up luxury property market in Hong Kong, also with borrowed money. I am afraid that Hong Kong could suffer quite a bit in coming months with declining stock and property market.
The A-share market has been correcting due to the widening price gap between Shanghai and Hong Kong for the same stocks. On Jan. 22, Petro China, for example, closed at HK$9.61 in Hong Kong and Rmb26.18 in Shanghai, i.e., PetroChina sold for 193% more in Shanghai than Hong Kong. This big and widening gap is undermining the confidence of speculators in Shanghai. Despite the correction, Shanghai market is still 100% overvalued, I believe. However, after the first quarter correction, many pundits in China would come up with other reasons to cheer speculators up. The most important argument is that China is different. As for the price gap, they would ask investors to walk straight ahead, don't look around ('一直朝前走，不要朝两边看'). China has 1.3 billion people. Probably tens of millions are credulous. As long as the pundits could get these people to believe them, the bubble can continue through the Olympics. The current correction is just turbulence on the rooftop. Coming to the ground may happen after the Olympics.
Financial markets have become so large that their movements can affect real economies. Hence, governments and central banks have to respond to market turbulence. In a way, they have become market's hostages. The Fed responded to the crash in Asian stock markets on Jan 22 by cutting interest rate by 75 bps to prevent a similar crash on Wall Street. The US Federal Government has already outlined a fiscal package of $145 bn, mostly tax rebates for households and businesses. Even though these measures are significant, they are not enough to stop the recession or the bear market. Instead, the US policies are pushing its economy towards stagflation (say, 2% GDP growth rate and 4% inflation rate) for two to three years. Through the currency market, it could spread stagflation to Europe. Emerging economies may have good growth (say, 6-6.5% annual growth rate compared to 7.5% in the past three years) but may also have high inflation. In summary, the biggest investment decision for next two years is how to cope with rising inflation and slowing growth. In particular, investors should be aware of the risk of rising bond yields or falling bond prices.
As the late economist Milton Friedman argued that inflation was always a monetary phenomenon. In the end, price is equal to money supply divided by goods and services sold times money velocity. The last variable is how fast money turns over each year. Economists usually assume that the velocity doesn't change, as human behavior should be stable over the time horizon of one year or two. That is correct for developed economies but not for developing economies. In China, for example, money velocity could change substantially. Hence, even without policy change, mere sentiment change could cause inflation or deflation. Another complication is the competition between asset market and real economy for money. As governments don't include asset prices in CPI basket, money increase could inflate asset prices first. The resulting outcome-high asset price and low inflation would seem wonderful for everyone. High asset prices make people richer, while low inflation sustains living standard for people at bottom of the society. The essence of economics is 'no free lunch'. The paradise of high and rising asset price and low inflation is just temporary. Eventually, high asset price will trigger more demand, which would cause inflation. As inflation expectation surges, people don't want to hold money, which increases money velocity and, hence, rapidly pushes up inflation.
The Fed cut interest rate to 1% and kept it there for a long time after the NASDAQ burst and '9-11'. That was the origin of the subsequent asset bubbles around the world and today's credit crisis. The Wall Street created financial products like subprime to entice Americans into buying properties that they couldn't afford. The extra demand pushed up property price, and rising price momentum attracted speculators. The market snowballed on the new demand and, for a time, looked unstoppable. The Wall Street invented more and more products to turn asset inflation into cash for consumers to spend, which increased inflationary pressure and forced the Fed to hike interest rate. The high interest rate caused the property bubble to burst and the subsequent unwinding of all those funny credit products.
Lowering interest rate couldn't reverse the unwinding dynamic. The low Fed policy rate wouldn't increase money demand like before. Global banks are bleeding capital. They have to preserve 8% capital in turns of their asset size. If they lose one dollar of capital, they must shrink their asset size by twelve dollars. All the banks have reported about $100 bn in losses relating to subprime. Ceteris paribus, their asset size should be $1.2 trillion smaller. There may well be $100 bn more losses to come from subprime, credit card and car loans. The balance sheet shrinkage of the global banking system is unstoppable. Also, it shouldn't be stopped. The banks became too large on false profits. What we are seeing is normalization. Of course, as the balance sheet of the global banking system normalizes, asset prices around the world would normalize also. The Fed is fighting a phony war. There is no need to fight it. It is market force at work. Despite all the talks about panic selling, asset prices are only getting close to fair value.
The Federal Government has sprung to action to stimulate the economy. The White House has already outlined a stimulus of $145 bn, mostly in tax rebates for households and businesses. A similar package in 2002 did have a meaningful impact at ending the recession. Americans have shown again and again that, when given money, they will spend it. I wouldn't bet against it this time. The US economy is already in recession. The stimulus money could be released in spring and the economy may stabilize by third quarter. While fiscal stimulus may support the economy in the short term, it only complicates matters overtime. America's problem is spending too much, not too little. Recession is a solution, not problem for the US economy. All that fighting against it is counterproductive in the long run.
The US has a growth culture. It is usually a good. The belief in growth incentivizes ordinary people to become entrepreneurs. The productive activities of the entrepreneurs boost economic growth. Optimism can be self-fulfilling. On the other hand, economic pessimism can be self-fulfilling too. Financial investors must judge first if a country is optimistic or pessimistic before making investments. In pessimistic countries, investors should buy bonds or stocks with high dividends. In optimistic countries, investors should buy growth companies.
The dark side of the growth culture is the tendency to over-stimulate. What is occurring now in the US is payback for excessive expenditure in the past. After the NASDAQ burst in 2000, the Fed under Mr. Greenspan cut interest rate to 1%. The Wall Street invented new products for households to borrow to spend. The low interest rate caused Americans to overspend with rising trade deficit as a byproduct. The current downturn is really to offset the borrowed growth in the past. Market is fair in that regard. However, policymakers view the downturn as unacceptable and must deploy stimulus to fight it. Market punishes people for taking unrealistic actions. The consequences for the monetary and fiscal stimuli in the US are high inflation and weak dollar.
There will be more stimulating measures to come. The Federal Government may initiate another and bigger stimulus package late in 2008. The stimulating measures may decrease short-term pain by stretching out the adjustment process. But, its cost is high inflation. Some argue that the weakening economy should bring down inflation. I doubt it. Inflation is global today. With rising food and energy prices and weakening dollar, the US is importing inflation. Further, the productivity slowdown will partly offset the disinflationary effect of weakening demand. The stimulating policies by the Fed and the Federal Government will exacerbate the situation, mainly by keeping the dollar weaker and for longer than otherwise. In the early 1980s, the US had a tight monetary policy and loose fiscal policy. It led to a strong dollar despite rising trade deficit. Now, it is loose monetary and fiscal policy. The outcome is shrinking trade deficit and weak dollar. Both are inflationary. The US economy may have 4% inflation and 2% GDP growth rate for two to three years.
The stagflation scenario in the US will infect other economies. Euro-zone, in particular, is quite vulnerable. The ECB keeps a tight monetary policy because the Euro-zone faces rising inflationary pressure due to rising commodity prices and rapid money growth. Euro has become an alternative reserve currency to the dollar. As global central banks switch some of their reserves into Euro, they inject the liquidity that the Fed has released into the Euro zone. The ECB has stayed firm despite the recent financial turmoil, because the underlying economy is still strong. However, by mid-2008, it should become apparent that the Euro-zone is heading for a downturn. The growth engines like Germany in the Euro-zone are export-led. Euro's strength is hurting them. Euro may gain further in the first half of 2008. It will eventually shut down Euro-zone's growth engine. The ECB may be forced to cut interest rate late in 2008. Euro would weaken then. It then removes the main dis-inflationary force in the Euro-zone. Euro-zone may well experience inflation higher than growth rate for two years also. The stagflation in the Euro-zone may be less severe than in the US. Still, it has major implications for bond investors.
Japan is already in recession. But, its inflation is unlikely to rise. Declining population makes Japan a special economy. It behaves like a superconductor in globalization; whatever happens elsewhere passes through Japan without a trace. Japan's only significance is as the funding source for carry trades. When speculators feel bullish about global growth, they borrow yen at 0.5% interest rate and buy other currencies like Euro or Aussi Dollar that gives higher interest rate. When they feel bearish, they unwind the trades. Yen value fluctuates with the sentiment about the world economy. The most important indicator for this risk appetite is Euro-yen. It rose from about 100 four years ago to the peak of nearly 170 last year. It is now at 155, still indicating pretty high risk appetite in the global financial market.
Emerging economies already experience high and rising inflation. China and India already have inflation rate stuck between 5-10%. The growth rate in the emerging economies is still strong. They have been growing at 7.5% in the past four years. They may grow between 6-6.5% in 2008, slowing down from the breakneck speed before but still high by historical standard. The main reason for the decoupling between emerging and developed economies is their high foreign exchange reserves. Though their exports will slow in 2008, they still have plenty of money to support their investments. It is still too early to see if their inflation rate would be higher than their GDP growth rate. My hunch is that it won't happen in 2008. However, after the dollar bottoms in 2009, they may also enter a mild form of stagflation. The economic decoupling doesn't extend to financial decoupling. There is so much international money in their stock markets that they will come down on shrinking global liquidity.
The above analysis is giving some colors to the inflation problem in the global economy. The bottom line is that central banks released too much money during low inflation period. The money went into asset markets and caused inflation there. Central banks refused to accept asset inflation as a consequence of their policy and kept monetary policy loose. Strong asset markets caused strong demand growth and overtime inflation. As central banks tightened against inflation, asset prices came down. In response to the demand weakness from asset deflation, central banks are reluctant to decrease money supply to contain inflation. Hence, the money that they released before will become inflation. Yesterday's asset inflation has become today's CPI inflation.
Bond yields around the world are quite low despite high inflation, because investors believe that weakening demand would bring down inflation. They are probably wrong. When the stagflation scenario becomes apparent, bond yields could spark up sharply. Bonds will become worth buying then. They should hold cash despite the low and declining short-term interest rates. Investors who take more risks than buying bonds could look at gold.
