December, 2005 Quarterly Warning Indicators Update

By Tom Coyne
Editor,
The Index Investor

We are the first to admit that the performance of the global economy and most financial markets in 2005 was a pleasant, and rather (for us at least) an unexpected surprise. But then again, so was the performance of the U.S. equity market in 1999. To make a long story short, rather than seeing the beginning of a correction, 2005 saw a further expansion of the imbalances that plague the global economy. The world remained overly dependent on U.S. consumption, and, ultimately, on the growing bubble in U.S. house prices that was financing it.

It also remained overly dependent on Chinese investment, and the continuing lack of credit skills and discipline displayed by that country's (state owned) banking system (did they go to a U.S. mortgage bankers course?). To be sure, there were further analyses presented in 2005 that tried to make the case that “this time it's different.” Some suggested that the de facto existence of a “Bretton Woods II” arrangement, whereby Asian countries would continue to finance the U.S. current account deficit in order to ensure continued markets for their exports, which drive their own economic growth and help ensure their political stability (see “The Revived Bretton Woods System: Alive and Well” by Dooley, Folkerts-Landau, and Garber). Others suggested that, if the U.S. expected to increase its share of world output in the years ahead, perhaps its large current account deficit could be justified (see “The U.S. Current Account Deficit: a Re-Examination of the Role of Private Saving” by Charles Engel).

Still, in our opinion, the analyses on the other side of the argument - that an adjustment of global imbalances is inevitable, and it will be a painful one - still seem more compelling (see, for example, “Will the Bretton Woods II Regime Unravel Soon?” by Roubini and Stetser, and “Is the U.S. Current Account Deficit Sustainable?” by Sebastian Edwards).

To be sure, there have recently been some positive developments. The Japanese economy is showing more vitality than it has in years. However, it is still heavily dependent on exports, including a large proportion of capital goods that are dependent on Chinese demand. And it is still among the fastest aging of the world's developed countries, which must eventually have a negative impact on economic vitality. Similarly, the Eurozone appears, once again, to be making tentative moves toward reforms that could increase domestic efficiency and demand. Yet it too remains very dependent on exports for overall economic growth.

Absent faster growth in domestic demand in Japan and the Eurozone, the world economy remains heavily dependent on the United States and China. Over the last quarter of 2005, it became increasingly apparent that strains in the latter are growing more severe. The shooting of protesting Chinese villagers in Shanwei by Chinese security forces marked the first time since Tiananmen Square in 1989 that this had happened. As has often been the case, the apparent cause of the protest was the seizure of farmers' land for industrial development (in this case, a power project) without compensation being paid. Earlier in 2005, the Chinese government admitted that around 75,000 similar demonstrations had been recorded in the country in recent years.

Apparently, money is allocated to compensate people for the loss of their land, but it ends up being siphoned off by corruption at various levels of government, to the point that little or nothing is left for its intended beneficiaries. On the other hand, growth continues unabated, financed with a mounting pyramid of bad loans to many projects of questionable economic viability. Such growth is necessary to provide jobs and rising incomes to the increasing number of workers leaving the land for the cities, and their promise of rising standards of living. Externally, the accumulation of such projects leads to oversupply and declining prices in many industries, along with substantial job losses at competitors located in developed countries. It is, to put it simply, an explosive mixture.

Clearly, China needs to keep growing to maintain what remains of its political stability. To do so, it will probably remain quite willing to continue recycling its export earnings to finance the U.S. current account deficit. But the key point is this: China cannot bear this burden alone. Indeed, the surpluses of all the Asian countries together are insufficient to the financing task. Continued financing of the U.S. current account deficit by investors in other developed countries (e.g., Europe and the U.K.) are also needed to keep the current “Bretton Woods II” system afloat. The real question, and the ultimate uncertainty, is when these investors will decide that they've had enough, and stop the music.

And then what happens? Sebastian Edwards' paper concludes that a substantial decline in global GDP is inevitable, in addition to a sharp depreciation of the U.S. dollar. In the past, we have noted our conclusion that this could easily trigger widespread deflation, which in turn would stimulate move by the United States to reflate. This belief is based on analysis that shows the political benefits that such a renewed period of inflation would have. As described by Doepke and Schneider in their paper “Real Effects of Inflation Through the Redistribution of Nominal Wealth”, “the middle class would gain at the cost of the rich and the poor. In addition, inflation would favor the young over the old, and hurt foreigners” who now hold large amounts of fixed rate U.S. dollar denominated debt. The authors conclude that “financial innovation and foreign borrowing have recently increased the potential welfare gains from inflation, to the point that these gains are now substantially larger than conventional estimates.”

The last quarter of 2005 has also seen a number of worrying developments in the category of “uncertain but potentially very significant” issues. Iran's nuclear program seems to be a lot further along than anyone had realized; some estimates suggest uranium enrichment facilities will reach a critical stage of development around March 2006. Given the radical pronouncements of Iranian president Mahmoud Ahmadinejad, we suspect that a crisis of some sort could occur around this date. This crisis may be complemented by Deputy Al Quaeda head Ayman al-Zawahiri's apparent call on his organization in late 2005 to focus their efforts on the world's oil infrastructure. Given the lack of slack in the world oil market today (amply demonstrated by Hurricane Katrina), any disruption would further increase prices and take even more steam out of a global economy already slowing due to interest rate rises throughout 2005 by the U.S. Federal Reserve and more recently by the European Central Bank.

Finally, in yet another “unpredictable but very likely significant” development, we note recent indications from Indonesia and Turkey that H5N1 avian influenza may be increasing its capability for human-to-human transmission. There are two critical uncertainties here. The first is whether and when H5N1 will develop into a full-fledged global pandemic. The second is how severe will be that pandemic's effects. The U.S. Congressional Budget Office recently produced an analysis of this second question. It based its “severe pandemic” scenario on assumptions it believes reflect the impact of the 1918 pandemic: 30% of the population would become infected, and 2.5% of infected population would die. Up to now, the death rate for people infected with H5N1 has been higher than this; however, implicit in the CBO's analysis is the assumption (also made by other researchers) that there is a trade-off between an influenza strain's transmissibility and its deadliness. As the former increases, the latter declines. It remains to be seen whether that is indeed the case with H5N1. Assuming the CBO's severe pandemic scenario develops, it concludes “it would produce a short-run impact on the worldwide economy similar in depth and duration to that of an average post-war recession in the United States. However, it also notes “there is little evidence available to use to determine which theoretical prediction best describes the long-term impact of an influenza pandemic.”

On balance, our fundamental view of the world remains the same as those discussed in our March, June, and September 2005 economic outlooks. While we may continue to muddle through for some time, the day of economic reckoning seems inevitable, and will be more severe the longer imbalances grow larger without a substantial adjustment occurring. Neither we nor anyone else can conclusively forecast which asset classes will do best in future years. Our best estimate today is that real equity returns will be substantially lower than those in recent years. Due to the likely depreciation of the dollar (except, perhaps, in the case of a severe bird flu pandemic or wider Middle East war), for U.S. investors, foreign bonds seem likely to do relatively well. On the other hand, for non-U.S. investors U.S. bonds are likely to disappoint. If one assumes a return to high inflation at some point in the future, then inflation hedges like timber and commodities should do well. Both, however, should suffer in the short term as real economic demand declines. There is also an important question about the extent to which speculative activity has driven the price of commodity index funds in particular above reasonable valuation levels.

Domestic commercial property will also provide, to some degree, a hedge against the eventual inflation we expect, but is likely to suffer in the intervening economic downturn. Again, for U.S. investors, foreign commercial property looks potentially attractive, given our estimate of future dollar depreciation. Historically, this asset class has provided higher returns than foreign currency bonds, without too much additional risk. On the other hand, looking to the future, foreign commercial property may not perform as well as foreign government bonds in a worldwide economic downturn.

With the exception of Australia, real return bonds today present a clear dilemma. Real yields are at extremely low levels, reflecting the imbalance between high global saving and low global investment demand. Neither a global recession nor a global influenza pandemic (which, by reducing the size of the labor force, would potentially increase the return to labor, and reduce the return to capital) would improve this situation. On balance, given a choice, we would underweight real return bonds today relative to their target portfolio weights, while favoring intermediate term nominal return government bonds.

Equity market neutral - our proxy for investments in uncorrelated alpha strategies - is also problematic, given our outlook. We are of an age that understands the meaning of the old saying “don't confuse investment skill with a bull market.” We don't believe that many of today's hedge funds will perform well if our downside scenario comes to pass. So we wouldn't be overweighting EMN either. Finally, the equity volatility asset class presents yet another dilemma. In a largely uneventful market, it earned negative returns for U.S. investors, and slightly positive ones for those foreign investors who benefited from the U.S. dollars unexpected appreciation (thanks to the Federal Reserve's raising rates faster than those in other countries). Still, its role in a portfolio is not to be a source of steady returns. Rather, its role is to provide a cushion that protects capital against a sudden drop in multiple markets. It is, in essence, crisis insurance, along with domestic and foreign currency government bonds. For that reason, investors who can access it should keep it in their portfolios (sadly, there are, as yet, no retail index funds available that invest in this asset class).

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