THE INSIDERS: Bubblenomics

By bne IntelliNews November 10, 2010

Timothy Ash of The Royal Bank of Scotland -

Having been on the road for much of the past month, herein are some brief broader market observations from afar.

First, in the US I was struck by just how depressed the US economy is (for the first time through this crisis it really felt deflated and depressed), only matched by the paucity of the US policymaking debate more generally. The mood music in the run-up to the mid-term elections was all about bashing foreigners, and the Chinese in particular, with little more circumspection in terms of the problems nearer to home. It left me with a real concern that the Chinese will never be able to deliver enough nominal (or real) revaluation to call off the attack dogs in Congress, and especially given the Chinese' own clicking electoral clock in the run-up to the 2012 leadership change and rising nationalism in China itself.

I would thus argue that there is a real danger that the US leads us into a new era of trade protectionism/wars; imagine a protectionist bill being tabled in Congress over the next year - few politicians would feel able to vote against such a bill, given the likely closely fought contest in 2012. The danger is that the cosy market consensus that the Chinese will just give the US enough nominal forex appreciation (as in the past) to bite/buy off the political class in the US, could prove misguided. The political mood in the US seems to have decisively changed with the advent of the Tea Party. As one sage investor commented, the US should be arguing about trade access into China, not the level of the Chinese yuan.

Second, there is real antagonism and frustration across emerging markets, and indeed in many developed markets, with the paucity of US policy, and the fact that the US has reached too readily for another bout of quantitative easing (so-called QE2), as some last gasp tonic (making the Federal Reserve look like a bunch of quacks) for its inability and unwillingness to address deeper seated structural reforms at home.

The US needs a period of balance sheet adjustment and cleansing, and QE2 is seen as a huge gamble not only for the US, but also for emerging markets and the broader global economy. QE2 is seen as having little real positive impact on the US economy, as even with currently low policy rates at the micro level, credit risk is perceived to be too high for both consumers and suppliers of credit to transact. I doubt this will change, which leaves us just with the impact of the weaker US dollar, as with little use for more dollars at home, the greenbacks just look to head for the exits. Against this backdrop, I doubt that it will provide much of a pick-me-up in the short term, as the US' problems rest more at home; it is interesting how Germany is proving more than able to compete with a strong euro, which should tell US policymakers something. For emerging market policymakers, this is leaving them with the unpalatable choice of following the US and further easing or delaying the normalisation in monetary policy - cutting rates to reduce the carry - or resorting to capital controls, which in most cases runs right against their basic instincts. Policymakers feel acutely uncomfortable with the sheer weight of capital inflows (see the next point below), and managing these "hot" inflows is proving hugely challenging; there is some "hope" that the structural shift to emerging markets will mean that these inflows prove sticky this time, but this hope seems based more on wishful thinking than any firmer footing. The US is building a huge amount of resentment abroad at present with its conduct of monetary policy; on the road, I heard few complaints about the Chinese, but near universal frustration with the US.

Third, everyone is exactly the same way positioned for QE2. QE1 was the path-finder, it showed the way that with the US printing money (let's call it for what it is), cash would flood into real assets (commodities, property in Asia), bonds and emerging markets, with some even ending up in US equities. This leaves me hugely concerned that once there is the slightest hint of recovery and/or inflation in the US, bondholders will get crippled, and this will probably take most other assets down with it. True, there is scant hope of growth and inflation anytime soon in the US, but the mere whiff of it could well leave a lot of blood on the floor.

Fourth, yields and spreads are being driven to levels across emerging markets that probably are not justified by the fundamentals, but this is a technical rally - a wall of cash chasing or being funnelled into a limited range of investable assets. We are seeing capital and resource misallocation; this is also probably encouraging inappropriate and sub-optimal policymaking. Alongside resorting to capital controls, some governments are probably being encouraged, for example, to run looser fiscal policies than would normally be appropriate, as they can fund deficits easily and cheaply at present, and are not being driven to undertake more far-reaching fiscal reform; herein, we would include Turkey, as well as Russia, Hungary and even Poland.

Fifth, we are in bubble territory, we all know it - it feels like a bubble, it smells like a bubble and it probably is - but we all assume and hope that we can get out before the other guy, and before it bursts and all ends in tears. This is rarely the case. The warnings are already there.

Timothy Ash is Head of Emerging Markets Research for The Royal Bank of Scotland

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