28/01/2011: Deconstructing bubbles before they pop

We have a love-hate relationship with asset price bubbles. After each one bursts, from tulip bulbs to credit default swaps, we are wounded but wiser. Or are we? Not only do we mourn the passing of steroid-stoked markets, we set off in search of the next one. And if somebody tries to let the air out of a nascent bubble, as we see today in several emerging economies, we cry foul.

Given what investors have been through over the past two decades or so, it is unsurprising that they worry a lot about bubbles and their consequences. Thus, one question I am often asked by clients is: “Do you think that such-and-such is in a bubble?” You can take you pick for “such-and-such” from a list that includes gold and commodities more generally, specific real estate markets like Switzerland’s, emerging market equities or government bonds. It seems that there are plenty of assets to worry about.

Let’s look at what makes an asset bubble. In his classic and still rewarding 1978 study, "Manias, Panics, and Crashes – A History of Financial Crisis," the economic historian Charles P. Kindleberger developed an elaborated model of financial bubbles. In this task, he drew heavily on a rather unorthodox economist, Hyman Minsky, who has enjoyed renewed interest in the wake of our latest financial crisis.

The Kindleberger-Minsky model requires the presence of three essential ingredients to declare a bubble has formed: excessive price increases, extreme levels of liquidity and credit activity to fuel the price increases, and, finally, a narrative, a story that inspires investors to throw money at assets that are based more on fantasy than on facts.

Wherever the three elements assemble, a bubble may well be in the making. Since the bottom of the markets, back in March 2009, many assets have enjoyed robust price increase, which in some case would point a developing effervescence, a bubbly formation. But let’s remember this run started from deeply depressed levels after the 2008 crash.

Liquidity certainly has been ballooned lately, as governments mint new money to support their still besieged economies, so this element of the Kindleberger-Minsky model is emphatically oh hand. But here, too, context is key. Credit activity in most developed economies continues to struggle against the outgoing tide of deleveraging. In many emerging markets, though, as well as in the European economies that have recovered faster—Switzerland, Germany, the Benelux and the Scandinavians, for example—credit indicators need a careful and fresh reassessment.

The narratives that have fed bubble over the centuries often look nakedly naïve in the rear-view mirror of history. While many financial and even non-financial assets and markets have experienced bubbles, from the infamous tulip bulbs in 17th century Holland to the soaring dot.com(edy) stocks at the beginning of this century, bubble narratives combine two basic threads: supply-phobia, or fear of shortages, and unfettered fantasies about potential profits. “If every mouse-click on our website leads to a USD 10 purchase….”

The first story line, shortages, usually relates to commodities: “What if the Chinese were to buy the entire world’s gold?” and to real estate: “What if all US retirees buy Miami condos?” The second is either related to a new, yet-to-mature technology—in the past hundred years, railways, cars, electronics, the Internet—or to the potential riches of exotic markets like those promoted by the Dutch East India Company, the British South Sea Company, the French Mississippi Company in the 18th century. Or, just fifteen years ago, the Southeast Asian Tigers before their crisis.

Today, those tigers want to change their stripes. They have learned the nasty lesson of burst bubbles: when they collapse, everyone gets soaked. No wonder, then, that many emerging markets, having been touted as hot investments, are now trying to cool the frenzy by restricting the domestic credit activity.

Yet some observers regard this commendable foresight an act of economic betrayal that will damage emerging economies. We wonder why they disparage such sober policies. Many of us, it seems, still have to learn that healthy, sustainable economic growth is not fed by bubbles.

21/01/2011: Upbeat smoke signals but little real fire in the US economy

Since mid-November a nearly nonstop stream of good news from the US economy has led some observers to conclude that a sustainable recovery has finally taken hold. We are not among them.

Most recent leading and concurrent economic indicators suggest stronger-than-anticipated cyclical momentum in the US. We agree there has been real strength in the recent data, which has led WMR to revise our overall US growth forecast upwards for this year. But despite all the good news, we are still unconvinced about the sustainability of this “recovery.”

The struggling US labor market casts the biggest shadow on any celebration. December’s non-farm payroll report may have been the only major statistic below expectations, but we think it’s probably the most telling measure of the US economy’s prospects. The high unemployment rate hasn’t budged, and given the jobless recovery that followed 2001’s shallow recession, we don’t expect a significant improvement during 2011.

A second source of gloom comes from the US housing market. While we have seen some signs that the steep price correction—let’s speak plainly: the crash—has finally ended, recent data suggests the slide may be poised to resume. A new report from the Federal Reserve Bank of Dallas (*) paints a grim picture, offering the judgment that US house prices are still overvalued by almost 25%.

More darkness gathers from the savings behavior of US households. In the immediate aftermath of the financial crisis, the US saving rate rose but lately it has started to drop again. Let’s remember: the US private sector is still overly indebted. The inevitable deleveraging process it faces, with asphyxiating consequences on growth, is merely being delayed.

Last but not least, the most recent jolt of fiscal stimulus will at best have only a neutral effect on the economy. After all, it only supports the overly stretched public deficit for another year, and it does so through heavy use of the printing press to create fresh money. We still think the US government is just paving the way for new problems ahead. One obvious consequence would be high inflation but an even worse prospect would be a critical reassessment of US credit quality. Last week, both Moody’s and Standard & Poor’s warned that a triple-A rating for the US cannot be regarded as eternal.

The very mixed picture we have of the US economy has led us to increase our US growth outlook for 2011 but, indeed, to lower it for 2012. This sums up our skepticism about whether the current recovery has legs.

What should investors make out of this? We believe that more cheering cyclical surprises over the next couple of months should fuel the bullish sentiment on the US equity market. Given attractive valuations and the positive technical picture, we think enough factors are in place to recommend increasing exposure to US stocks. However, we would firmly mark a date in our calendars to reassess the situation six months from now.

(*) DiMartino Booth, Danielle and David Luttrell (2010): “The Fallacy of a Pain-Free Path to a Healthy Housing Market,” Federal Reserve Bank of Dallas Economic Letters, December 2010

14/01/2011: The Turkish Gambit

With Europe’s worrisome sovereign debt crisis, America’s troubling quantitative easing experiments and China’s challenge to cool its surging economy without freezing it solid, there are plenty of big economic stories unfolding right now. This means smaller but no less interesting news items are sometimes overlooked.
One such blip was the decision by the Central Bank of Turkey, the CBRT, to cut its interest rates last December. Looking at Turkey’s overall economic situation, it’s difficult to find strong arguments for or against this move. The Turkish economy is performing quite well, with growth down a bit from earlier unsustainably high levels, and inflation, while still above 7%, has not reaccelerated.
Such a placid environment might normally induce inertia in a central bank, but the rate-cutting decision itself was not very remarkable, hardly worth more than a passing nod of acknowledgment from observers. However, the reason given for it, as served up in the CBRT’S communiqué, really was rather astonishing: the rate cut was made to prevent the economy from overheating. No, you didn’t read that wrong: this strange statement was then reiterated by Erdem Basci, a deputy governor of the bank.
First, a short explanation: cutting interest rates to cool an economy down not only contradicts basic macroeconomic theory, more tellingly, it even violates common sense: if interests are trimmed, doesn’t this induce firms and households to borrow, and spend, more? And wouldn’t this in turn increase demand and therefore boost growth? Or did we miss something?
Yes, actually, we did. Like Brazil and several Southeast Asian emerging markets, Turkey has become a favored destination for vast inflows of international capital. Obviously, with interest rates are near zero in the US and the core of Europe, investors are seeking returns elsewhere, moving assets into regions that promise high yields. And when a country reduces yields, by cutting interest rates, this can have a dampening effect similar to introducing capital controls: lower rates should reduce the capital inflows and thus cool the economy down.
This is the reasoning but does it apply here? There are several caveats, in our view. The rate cut mostly just affects money-market instruments and the like. Yes, international investors who use these sorts of vehicles to invest in Turkey might now face less attractive opportunities. But those who are investing directly into the country, by buying bonds, equities or real estate, will not at all be deterred by a rate cut from the central bank.
Moreover, while the rate cut may reduce international capital inflows into Turkey, it should also significantly boost domestic credit activity and consumer spending. It could even be said that this measure attempts to shift the engine of growth from international investments towards domestic consumption, which, in the longer run, may prove a far less sustainable growth model.
Finally, by cutting interest rates, the CBRT has substantially weakened the Turkish lira, which increases the price of imports. A large part of the Turkish current account deficit comes from energy imports, and with the weaker lira these imports just got more expensive. Hence, at least through this channel, the rate cut exacerbates the very problem it was meant to solve, since higher energy prices will drive up the current account deficit. To counter these inflationary effects, we note, the TCMB has raised reserve requirements for banks, constraining their ability to make loans.
If you are not living in Turkey, you might find this an interesting little story but might also ask why you should about the machinations of the Central Bank of Turkey. In fact, while Turkey might be the only country conducting a rather convoluted monetary policy at the moment, several others are thinking about similarly contradictory measures. In this respect, Turkey’s rate cut can be seen as just another skirmish at the fringes of a simmering currency war.

07/01/2011: Currency strength: a blessing or a curse?

Skating below 1.25 against the euro and under 0.95 versus the US dollar, the Swiss franc has never been stronger. Understandably, many worry the muscle-bound currency will hurt Swiss exporters. Is that inevitable? Should Switzerland join the troubled Eurozone and adopt the euro, as some Swiss politicians suggest?

As usual in economics, a seemingly self-evident truth grows shaky when exposed to a bit of critical thinking. Consider this paradox: since the breakup of the Bretton Woods system in the early 1970s, the developed economies with fundamentally weak currencies have not been the export champs. That race has been won by countries whose currencies have appreciated quite dramatically versus their competitors: Japan, Germany and Switzerland.

These three countries still have sound industrial bases. They thrive by exporting “things,” high-value-added manufactured goods like sophisticated machinery, expensive cars, advanced electronics and high-end watches. At the other end of the scale, countries with currencies that have weakened over the past forty years – the US, the UK, France and Italy – have seen their industrial bases crumble.

How can we explain this? No doubt, a strengthening currency poses a stiff challenge to the competiveness of domestic industries. But that in itself turns out to be positive. After all, it encourages innovation, tight cost controls and an emphasis on high quality that cheaper imitators can’t replicate. In the long run, this recipe supports the survival of a country’s industrial base far better than the “no-brainer” strategy of chasing price competitiveness by devaluating the domestic currency.

Does this mean that Swiss exporters can blithely ignore the strengthening of the franc? Here again the answer is not simple. For one thing, it depends on timing. The prospect, say, in ten years’ time, of a Swiss franc at parity with the euro and around 0.50 against the US dollar should not be an insurmountable challenge for Swiss industry. But hitting such levels a year from now would surely be disastrous.

Given that neither the euro, swooning from the European sovereign debt crisis, nor the US dollar, awash in QE2 liquidity, are very attractive right now, we think the Swiss National Bank will be severely challenged to keep the franc from massively and brutally appreciating in the near future.

01/01/2011: The economic trilemmas that will shape 2011

Much of the world can be grouped into three economic blocs: the US, the Eurozone and the Emerging Markets. Each bloc faces some very hard and very urgent choices that will shape our world in 2011.
The problems at hand lend themselves rather neatly to the logical form of the trilemma. While a dilemma is an either/or situation, in a trilemma only two of three available options can possibly apply at any given time. One option must be sacrificed. To illustrate, consider the mordant trilemma that made the rounds in the former Soviet Union: you could be a party member, or intelligent, or honest. Obviously, ran the joke, you could not be all three at once!
We see a trio of problems shaping economic developments in 2011, and below we explain the costly trade-offs they will inevitably entail. First, the three trilemmas:
• Emerging Markets and to a lesser extent the European Monetary Union: unrestrained capital flows, a fixed exchange rate, and independent central banks.
• The Eurozone: a supranational entity (the EU) made up of sovereign nation states that practice democracy and share a common currency.
• America: the conflicting aims of running a trade surplus and balanced budget with buoyant consumers.
In each trilemma, one element has to give way, and this choice will tell the economic story in 2011.

The Emerging Markets trilemma
Textbook economics calls this the "impossible monetary trinity:" an independent monetary policy, freely moving international capital flows and a pegged exchange rate. Only two of these conditions can prevail at the same time. How emerging markets respond to this trilemma will be one of the biggest economic stories of 2011, and beyond.
It is not surprising that the first official to use the term “currency war” was Brazil’s Finance Minister, Guido Mantega. After their financial crisis of the late 1990s, many countries in Asia and other emerging markets pegged their currencies to the US dollar. Staggered by bouts of high inflation, overheated economies, current account deficits and currency crashes, they understandably sought some form of monetary stability.
The dollar peg, later called “Bretton Woods II,” was quite successful. Emerging market currencies grew steadily cheaper when in fact they should have appreciated. They enjoyed strong exports and healthy current account surpluses, building up vast foreign exchange reserves. China alone has managed to increase its foreign exchange reserves to a whopping USD 2.6 trillion.
At first, Bretton Woods II seemed to deliver the best of all possible worlds to both the emerging markets and the US. The emerging markets exported and saved; America got the cheap goods and credit it craved to finance its consumption and housing booms.
But the model was inherently unsustainable, as the recent financial crisis made clear. By binding their exchange rates to the US dollar, emerging markets lack their own independent monetary policies. This was not an issue as long as US monetary policy was stable. But with the Fed first slashing interest rates to zero and then launching its quantitative easing programs – effectively printing money – many emerging markets are now wedded to a monetary policy that is far too expansive for their economies.
Overheated economies, inflation surges and asset bubbles – especially in real estate – are the ugly potential consequences that emerging markets now fear because of their forced adherence to America’s loose monetary policy. Emerging markets face a stark and difficult choice: Either they abandon the dollar peg and see their currencies appreciate sharply, or they maintain the peg and await an inevitable jump in inflation.
One strategy to counter an inflation surge would be capital controls to limit funds entering the asset markets of these countries, something that Brazil has recently implemented. By preventing surplus US liquidity from flooding into their economies, emerging markets can at least soften the choice between currency appreciation and inflation. However, history has shown that capital controls are difficult to maintain if goods and services still move freely.

The European trilemma
The age of globalization has given rise to complex political and economic challenges that often involve competing demands. The Eurozone is learning firsthand just what that means.
Harvard's Dani Rodrik has described the structural tensions facing the Eurozone as "the political trilemma of the world economy:" economic globalization, sovereign nation-states and political democracy. They cannot all flourish simultaneously. At least one element will have to give way. Like the emerging markets’ impossible monetary trinity, the political trilemma has a particularly strong impact on one region: the Eurozone.
Many of the Eurozone’s recent crises and tensions can be traced to clashes among these three elements. For example, many observers saw the recent strikes in France as a refusal to acknowledge that the French pension system is severely underfunded. And, incidentally, the funding situation will not improve much, even with the retirement age lifted to 62. But, I would argue, much of the anger triggered by raising the retirement age was because the change was imposed upon the population, without the usual lengthy debate that characterizes the French democratic process.
The early stages of the Irish crisis showed another facet of the trilemma. The Irish government initially refused any bailout from the European Union, fearing this would mean surrendering some of its hard-won sovereignty. The country’s ultra-low corporate tax rate came under especially harsh scrutiny from its Eurozone partners, and the government saw that accepting aid would seriously compromise its capacity to resist this pressure.
The fundamental clash of economic globalization, nation-states and democracy offers a neat framework for considering the future of the Eurozone. If nation-states were forced to give way, we would see a Federal Republic of Europe, that is, a democratic, integrated Europe with common fiscal, economic and social policies. If economic globalization – represented by the European Monetary Union as a supranational entity – were to give way, the Eurozone would break up, with all the disruption such a scenario would entail.
Finally, if democracy were to give way, we could see further integration imposed against the will of the people. The austerity measures being implemented in the heavily indebted countries at Europe's periphery, which are strongly opposed locally, can be seen as the prototypes of centralized political power. If the European Central Bank were to start printing money to mitigate the sovereign debt crisis, while at the same time fueling inflation fears in Germany, for example, this could also be seen as undermining democracy.
We see many examples of democracy giving way as the Eurozone attempts to muddle through, dealing with its systemic problems case by case. However, as Ambrose Evans-Pritchard wisely observed in The Telegraph, in the aftermath of the Greek crisis, “No democracy will immolate itself on the altar of monetary union for long.”

The American trilemma
The last of our three trilemmas that will shape 2011 is a super-sized American specialty: the Hollywood dream of a trade surplus, buoyant domestic consumers and a balanced government budget. It’s a big story and plenty of drama is guaranteed.
There are two ways to evaluate a country’s trade balance. The usual method subtracts the value of total imports from total exports. The less traditional approach subtracts the value of total consumption from total production. Applying the second measure, a country with a trade deficit lives beyond its means, consuming more than it produces. Sound familiar?
We can make a useful distinction here between the private sector and the government. This lets us reformulate America’s trilemma in even starker terms: If the private sector consumes more than it produces and the government does the same, a trade surplus is an accounting impossibility. There is simply no way around that cold fact.
Economists refer to America’s problem as the income-balance trilemma, but it may be better known as the tale of the twin deficits: a deeply negative trade balance and a government budget awash in red ink. These two black holes grew cavernous in the 1980s, when Ronald Reagan’s sharply higher government deficits were accompanied by a nose-diving trade balance.
The income-balance trilemma will affect the US in two profound ways in 2011, and beyond.
First, the noisy debate between Democrats and Republicans on whether fiscal stimulus can be achieved through government spending or via tax cuts will be rendered increasingly irrelevant. The towering US budget deficit can no longer be ignored in any serious economic discussion. Even if US consumers snap out of their coma, the budget deficit will still weigh heavily on America’s trade position.
Second, negotiations between the US and China on their bilateral trade relations are a dialogue of the deaf. The US insists that China let its currency appreciate, thus favoring the exports-minus- imports definition of the trade balance. Meanwhile, China points to America’s excessive consumption and low savings rate, using the production-minus-consumption definition. One is talking apples, the other oranges, so we see little hope for progress here.
The income-balance trilemma holds the key to America’s macroeconomic future. To return to growth, either its overly indebted consumers must resume living beyond their means, or public debt must massively expand. There is a third possibility that may comfort optimists: The country as a whole may finally acknowledge that austerity, both personal and public, although unhelpful to short-term growth, is the only possible way to achieve sustainable long-term growth and the much-desired trade surplus. That would truly be a Hollywood happy end.