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*** Stephen Roach (6-14-04) ***


Global: Escape Act

Stephen Roach (New York)
June 14, 2004

We hold two major conferences each year for global investors — one in America (technically offshore) and another in Europe. I have been to most of them — nearly 20 years of the American strain and now 10 installments of the Euro effort. For me, these gatherings have become important milestones in gauging the subtleties of the investment climate — not just in identifying the common ground of a diverse group of some 45 institutional investors but also in uncovering the areas of greatest opportunity and concern.

Our just-completed European conference was one of the more fascinating efforts of the lot. You wouldn't know it from the consensus of this group. Our polling told us that the collective wisdom of these investors was based on a relatively benign macro scenario — a reversion to trend GDP growth in the developed world, a soft landing in China, single-digit earnings growth in most major markets, an inflation scare but no inflation, and the onset of a normalization in monetary policy.

The group was modestly bullish on equities and bearish on bonds. Cash was actually the favored asset class of 22% of those in the room — the highest I can ever remember at one of these conferences. Currency risk was not a concern, and this European crowd had little interest in even talking about Europe. From a global asset allocation point of view, they liked Japan and their home European markets the most, and the US the least.

As always, it was the tails of the risk distribution that shed the greatest insights into what was really on the minds of this crowd. As I saw it, concern was rife in the air for these fully invested bears. At the end of the conference, we broke the group down into several discussion groups, with an aim toward uncovering the out-of-consensus insights they thought might actually pan out. The risks were very much skewed to the downside — a bust in China, surging oil prices, and a full-blown resurgence of the US wage-price cycle were at the top of the list. The optimists focused on the possibility of a Bush landslide in the upcoming US presidential elections and the chance that the financial sector — an industry that was universally scorned in our polling — actually performs surprisingly well in a monetary tightening cycle.

As these conferences have grown in stature over the years, we have detected a certain amount of gaming in our sampling of investor sentiment. Would you give away your best idea in a room filled with your competitive peers? And, of course, these investors have long learned to play the curse of consensus thinking —whether the curse surfaces at Lyford Cay or Eden Roc. Don't get me wrong, the discussions in our plenary sessions are often electric. But in terms of actionable investment opportunities, I have long found the side conversations to be especially valuable. This year was no exception. At the end of this conference, my luncheon companion whispered out of earshot of the rest of the crowd, "I just feel it — the big pop is coming. It'll be hard to escape this extraordinary build-up of macro tensions without serious adjustments in major asset classes. It's time to take big positions ahead of time."

Of course, there's always the risk that you hear what you want to hear at conferences like this. Needless to say, I have been on this kick over mounting structural imbalances for longer than I care to remember. The idea that the time is coming when macro tensions are about to be released was music to my ears. In my framework, global rebalancing is the functional equivalent of an escape act — the means by which an unbalanced world vents its structural imbalances. For investors, the escape act goes a step further — where to hide, what to avoid, and what to take advantage of.

Over the course of this conference, we focused the discussion on two key aspects of this escape act — central bank exit strategies and the coming landing of the Chinese economy. While "house views" have never been our thing at Morgan Stanley, our macro team of strategists and economists shares the view that these are likely to be among the biggest issues in 2004. The trick is in getting the timing and degree of these two adjustments right.

For the session on central banks, we were fortunate to have the legendary Hans Tietmeyer, former president of the Deutsche Bundesbank, as a special guest participant. He didn't pull any punches. In assessing the current state of monetary policy and the complications of the exit strategy, he was quick to warn of the perils of excess stimulus. In offering advice on how to remove the unusual accommodation, he stressed two preferences — "sooner rather than later" and "gradual rather than bold." And he was quite direct in expressing the view that central banks now need to take account of developments in asset markets in setting monetary policy. On that latter count, he was very much in agreement with Ottmar Issing of the ECB, who has been the leading champion of this view in the circle of active central bankers.

Hans Tietmeyer went out of his way to venture into perhaps the most delicate and important aspect of monetary policy — political independence. Fiercely independent in his own right, he maintained that central banks should not even be located in the same city as the seat of government. The monetary authorities need to be removed totally from the political debate. In this vein, he was clearly worried about the political pressures currently bearing down on America's Federal Reserve in this election year. He framed his concerns in the context of a simple but powerful counter-factual example: He was reasonably certain that if there were not an election looming in the US, the decisions to tighten would have already been made. Some of the most difficult moments in economic history have been accompanied by the politicization of central banking. As I saw it, Hans Tietmeyer was sounding the alarm in that regard.

The Tietmeyer critique was not an exercise in abstract thinking. The US monetary policy debate has been turned inside out in recent days. Fed policy makers are now on the campaign trail to distance themselves from the previous "measured" tightening paradigm. That doesn't mean that a 50 bp move is now a done deal at the end of this month. It simply means that the US central bank is now uncomfortable with the rhetorical straightjacket of a measured normalization of monetary policy —a straightjacket, I might add, of its own design. .

More and more, this smacks of 1994 all over again. One of the savviest investors I know pulled me aside at the conference and reminded me of the great "Fed foil" at the time. A decade ago, a Fed that was eager to extricate itself from a zero real interest rate policy was quick to cite mounting inflationary concerns as justification for what turned into a 300 bp tightening in a 12-month period. The smoking gun back then was a 30% increase in commodity prices. Fast forward ten years and another 30% increase in commodity prices has suddenly gotten the Fed's attention. In a recent speech, Governor Don Kohn indicated that such pressures may have already pushed up core consumer inflation by as much as 0.5 percentage point over the past year (see "The Outlook for Inflation," June 4, 2004 posted on the Fed's website). This represents a major about-face from earlier observations of Fed Governor Ben Bernanke, who all but dismissed the impacts of commodity prices in driving underlying inflation (see "The Economic Outlook and Monetary Policy," April 22, 2004, also posted on the Fed's website).

A key lesson from 1994 looks increasingly relevant today: While the inflation scare back then turned out to be a false alarm, the Fed used the build up of inflationary fears in the markets as an excuse to normalize an overly stimulative monetary policy. With today's monetary policy stance far more accommodative than it was a decade ago — the real federal funds rate is in negative territory today rather than at zero as it was in late 1993 and early 1994 — the Fed should actually be far more eager to normalize its policy stance than it was back then.

Not surprisingly, Fed officials have gotten the message. They are now jumping all over the inflation scare in their efforts to convince markets to rethink the gradualism implied by the measured-tightening paradigm. Ironically, the case for another false alarm on the inflation front is even more compelling today than it was in 1994; that's because unit labor costs — the key determinant of inflation — are currently falling at a 1.3% annual rate rather than rising by 1.5% as they were a decade ago at the onset of the Fed tightening. My guess is that while the Fed shares this optimistic prognosis on the price front, they are so far behind the curve that they will now resort to anything in an effort to face up to the increasingly urgent imperatives of policy normalization.

Smelling such a possible Fed surprise, several investors at our just-completed European conference pushed me on how such a development might affect an unwinding of the notorious "carry trade." The concern was expressed that a 1% overnight lending rate, in conjunction with the rapid expansion of the derivatives market over the past ten years, may have led to a much larger bet on the steep yield curve than that which occurred in the early 1990s. The unprecedented bond market carnage of 1994 is ample testament to the perils of the carry trade. The investors who focused on this risk were frustrated that we didn't have better metrics of the scale and scope of such positions. So are we. But that also sounds like 1994 all over again — the big risk that no one can quantify. Over the 2004-05 interval, looming bond market perils appear to pose the most serious challenges for levered consumers and property markets — possibly even resulting in a new deflation scare.

Escaping the potential carnage of an unwinding of the carry trade was the biggest concern I detected at Eden Roc this year. Maybe that explains why cash suddenly loomed so attractive. Interestingly enough, there didn't seem to be much fear over China. The consensus of investors expressed considerable confidence in the Chinese government's ability to manage the downside in a fashion that would limit any collateral damage to the rest of Asia as well as in the broader global economy. During the course of the conference, the Chinese economic data flow — industrial output, bank lending, and investment activity — all pointed to the onset of a significant slowdown. While this is good news for China, it may well complicate the escape acts for Japan, Korea, Taiwan, and Germany — all countries that have had both a heavy dependency on Chinese export growth over the past year and a weak backstop in private domestic consumption. However, relative to investor concerns over the unwinding of the carry trade, China risks paled in comparison.

Gleaning macro insights from conferences is always tricky. But my experience tells me that European investors are among the most sophisticated macro thinkers in our business. This year at Eden Roc, there was a good deal of discussion about the accident-prone character of the global economy. At the same time, there was little indication that this assembled group of investors has done much, if anything, to prepare for such possibilities. To my thinking, that could well be emblematic of the biggest risk of all in world financial markets.

http://www.morganstanley.com/GEFdata/digests/20040614-mon.html