Tuesday, April 04, 2006

Are markets are currently dismissing downside growth risks?

I'm a bear. While it's true that people tend to see only what they want to see, I find it hard for a bull to miss the downside risk that Stephen Roach sees. As he is 'Chief Economist' and 'Director of Global Economic Analysis' Morgan Stanley, he is someone who knows what he's talking about.

"As the housing bubble continues to deflate and equity extraction from property fades, I continue to believe that income-constrained American consumers will prune discretionary spending -- putting the risks to overall consumption growth on the downside of the 3% average pace recorded over these two quarters. China could well be a second source of deceleration over the course of this year, as the government makes a downpayment on its avowed rebalancing away from exports and fixed investment toward private consumption. Rising protectionist risks could well provide a third source of deceleration -- operating not just through the seemingly all-powerful Chinese export dynamic but also through the currency and interest rate implications of a US current account adjustment."

"Financial markets are currently dismissing downside growth risks leaning the other way -- betting more on the upside of the global momentum play or, at worst, believing that any deceleration in the pace of world activity is likely to be minimal. That’s certainly the message to take from the recent sharp back-up in real interest rates, as well as the latest surge in metals prices -- precious and industrials, alike. Central banks have reinforced this pro-growth cyclical play by sending signals that they remain very focused on the traditional closed-economy linkage between rapid growth and inflation. In my view, that leaves markets increasingly exposed on the other flank to the possibility of a downside growth surprise. If those risks play out, bonds could rally and equities could sag on growth concerns."

"The biggest risk, however, is that it doesn’t take all that much to turn the global liquidity cycle. For their part, the world’s major central banks are all on the tightening side of the monetary equation for the first time in 15 years. The Federal Reserve has already gone a long way down the road toward policy neutrality, and there are those who argue that it may already have entered the restrictive zone (see Joachim Fels and Manoj Pradhan’s 28 March dispatch, “The Supernatural Fed”). Nor should we underestimate the potential impacts of the sea change in Japanese monetary policy now under way -- the shift away from quantitative easing that has already commenced and a possibly sooner-than-expected ending of the BOJ’s zero-interest-rate policy this summer (see Takehiro Sato’s 28 March dispatch, “Earlier and Smaller”). If the turn in the global liquidity cycle reinforces a downshift in global growth, financial markets could be especially vulnerable. Recent action in some of the more exotic corners of the markets may well be providing a hint of how that vulnerability might spread. An unwinding of carry trades in Iceland and New Zealand, corrections in Middle Eastern equity markets, and very recent pullbacks in commodity-linked currencies (i.e., Canada and Australia) could well be canaries in a much bigger coal mine. Even the big equity markets in the US, Europe, and Japan have looked a bit toppy in recent days as yields on long-dated US Treasuries close in on the 5% threshold. "

"The global economy has just come off a very hot and increasingly synchronous burst of growth. Momentum-driven financial markets are betting this trend will continue. However, there is good reason to suspect that the ever-fickle pendulum of global growth is now about to swing the other way. If that turns out to be the case, increasingly myopic markets could reverse course in a flash."

His commentary is one of the many reasons I am bearish about the outlook for 2nd half of 2006.


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