Friday, July 02, 2004
To everyone's expectations and no one's surprise, the Fed hiked its target Fed Funds interest rate by 25 basis points to 1.25%. It made it clear this was still accomodative, and that since the upside and downside risks to the economy are roughly equal, it can afford to remove its policy accomodation at a measured pace subject to the proviso that it would act to the extent needed to ensure price stability.
The Fed is still taking on a highly accomodative stance of monetary policy because, in my opinion, it knows that with the twin deficits (trade deficit and budget deficit) and private sector and household indebtedness at record levels, any sharp increase in interest rates would be detrimental. In this current era of low pricing leverage, muted wage growth and high levels of indebtedness, the Fed does not want to take unncessary chances. Still, the Fed can clearly see inflationary clouds looming on the horizon, thus it gave itself a certain leeway of departing from a measured pace of policy normalization if there is evidence of widespread inflationary pressures.
Still, no matter how the Fed skillfully engineers itself out of the current period of historically high levels of policy accomodation, the fact remains that there are massive dislocations and imbalances present in the US and world economy today. In the period 1995-2002, the US accounted for a full 98% of the cumulative increase in world GDP as measured on a purchasing power parity basis. The huge trade deficit, currently at 5.1% of GDP, is testimony to the dependence of global economic traction on the US consumer, which is already overly indebted. Thus far, Asia and Europe have yet to generate a consistent and significant source of domestic demand, relying instead on weak currency policies and extraordinary amounts of intervention to maintain their export-led growth dynamics. The lopsided global economy is in serious need of rebalancing. Indeed, I foresee that this rebalancing will severly impact financial markets for the rest of the decade. As demographic forces start to put a permanent crimp on domestic demand in Europe and Japan, as a coming slowdown in the Chinese economy creates ripple effects on the region (notably Japan, Taiwan and Hong Kong) which depend greatly on Chinese import demand, and as multiple asset bubbles in the US finally meet their day of reckoning, putting the final lid on the over-exuberant US consumer, it is not hard to envisage multiple storm fronts coverging simultaneously on the economic horizon. Our game plan must thus be one of extreme caution.
If I have a single call to make, it would be the resumption of the secular bear market in equities and bonds starting latest by mid 2005. In reality, the time frame may turn out to be much shorter.
The short term bull run in global equity markets, notably emerging markets, is in its final stages. Traders should begin taking profits off the table. With the Fed decision and Iraqi handover out of the way, markets should now turn their focus to earnings reports. While I believe that the next round of earnings will be okay, I am not too sure going into the 3rd and 4th quarter. Already there are signs of inventory buildup in tech companies and lowered guidance from retailers such as Wal Mart suggest that the US consumer is finally beginning to show signs of fatigue in this post-stimulus period. While technical indicators based on price and volume are still looking good and point towards a possible continuation of the rally, sentiment indicators are suggesting that it is late in the rally and it would be prudent to take some winnings off the table.
The 22-year period of disinflation came to a screeching halt on June 30 when the Fed raised rates for the first time in 4 long years. Although the tide will now start to shift towards inflation, the change will take place over a long time, over multiple economic cycles. This will be a period that is generally good for commodities and precious metals, and not so good for stocks and bonds. But note that it will not be one direction either up or down; there will be twist and turns along the way and the entire scenerio will take years to play itself out.
The Fed is still taking on a highly accomodative stance of monetary policy because, in my opinion, it knows that with the twin deficits (trade deficit and budget deficit) and private sector and household indebtedness at record levels, any sharp increase in interest rates would be detrimental. In this current era of low pricing leverage, muted wage growth and high levels of indebtedness, the Fed does not want to take unncessary chances. Still, the Fed can clearly see inflationary clouds looming on the horizon, thus it gave itself a certain leeway of departing from a measured pace of policy normalization if there is evidence of widespread inflationary pressures.
Still, no matter how the Fed skillfully engineers itself out of the current period of historically high levels of policy accomodation, the fact remains that there are massive dislocations and imbalances present in the US and world economy today. In the period 1995-2002, the US accounted for a full 98% of the cumulative increase in world GDP as measured on a purchasing power parity basis. The huge trade deficit, currently at 5.1% of GDP, is testimony to the dependence of global economic traction on the US consumer, which is already overly indebted. Thus far, Asia and Europe have yet to generate a consistent and significant source of domestic demand, relying instead on weak currency policies and extraordinary amounts of intervention to maintain their export-led growth dynamics. The lopsided global economy is in serious need of rebalancing. Indeed, I foresee that this rebalancing will severly impact financial markets for the rest of the decade. As demographic forces start to put a permanent crimp on domestic demand in Europe and Japan, as a coming slowdown in the Chinese economy creates ripple effects on the region (notably Japan, Taiwan and Hong Kong) which depend greatly on Chinese import demand, and as multiple asset bubbles in the US finally meet their day of reckoning, putting the final lid on the over-exuberant US consumer, it is not hard to envisage multiple storm fronts coverging simultaneously on the economic horizon. Our game plan must thus be one of extreme caution.
If I have a single call to make, it would be the resumption of the secular bear market in equities and bonds starting latest by mid 2005. In reality, the time frame may turn out to be much shorter.
The short term bull run in global equity markets, notably emerging markets, is in its final stages. Traders should begin taking profits off the table. With the Fed decision and Iraqi handover out of the way, markets should now turn their focus to earnings reports. While I believe that the next round of earnings will be okay, I am not too sure going into the 3rd and 4th quarter. Already there are signs of inventory buildup in tech companies and lowered guidance from retailers such as Wal Mart suggest that the US consumer is finally beginning to show signs of fatigue in this post-stimulus period. While technical indicators based on price and volume are still looking good and point towards a possible continuation of the rally, sentiment indicators are suggesting that it is late in the rally and it would be prudent to take some winnings off the table.
The 22-year period of disinflation came to a screeching halt on June 30 when the Fed raised rates for the first time in 4 long years. Although the tide will now start to shift towards inflation, the change will take place over a long time, over multiple economic cycles. This will be a period that is generally good for commodities and precious metals, and not so good for stocks and bonds. But note that it will not be one direction either up or down; there will be twist and turns along the way and the entire scenerio will take years to play itself out.
