Semi-Annual Global Economic Update

Twice each year, in our March and September issues, we present an overview of the world economy for our readers. The March issue presents our own views, while the September issue is based on similar reviews that are released in September (e.g., by the IMF). For those of you who are reading this for the first time, let us assure you that our purpose is not to encourage market timing! Rather, our main objective is to provide early warning of any asset class overvaluations that seem substantial enough to warrant a short-term deviation from our model portfolios' asset allocation weights.

Our secondary objective is to provide you with a framework that can help reduce the information overload we all face, in the form of the deluge of statistics, daily market reports, and competing opinions we hear and read each day. To put it slightly differently, we are trying to help you cut through all the noise and focus on the key signals that provide the clearest indication about the likely direction of the global economy

At the outset, it is important to make clear the models and assumptions that underlie the conclusions we will reach in this article. Anybody trying to develop an estimate of what may happen in the future inevitably struggles with four questions. (1) What variables are important in determining the future outcomes that are the focus of my analysis? (2) How are these variables related to each other? (3) What are the likely future values for these variables? (4) How confident should I be in my answers to the first three questions

While psychological factors and investor behavior undoubtedly have an impact in the short-run, over longer periods of time trends in the real economy drive the returns on different asset classes. Our basic framework for analyzing the demand side of the global economy is the Economic Balance Equation. Most people are familiar with the concept of a corporate or household balance sheet, in which assets are by definition equal to the sum of liabilities plus net worth. The Economic Balance Equation is a similar tool for understanding the economy.

By definition, two economic accounts must always be equal. These are known as the "domestic balance" and the "current account balance." The domestic balance is equal to domestic savings less investment. It can be broken down further into a private sector balance (households plus businesses) and public sector balance. The private sector balance is equal to private savings less investment. Private savings equals total output (i.e., GDP) less private consumption (by households and businesses), while private investment includes business capital spending and inventory changes, as well as household fixed investment (e.g., in new houses). The public sector balance is equal to government spending (for both consumption and investment) less taxes. A negative balance, in either the private or public sector, stimulates total demand for goods and services; in contrast, a positive balance shows that savings are greater than investment, which reduces demand for goods and services. Negative and positive balances affect the supply of financial assets. A sector with a negative balance (that is, one that is investing more than it saves) issues financial claims (in the form of debt or equity) to raise funds. A sector with a positive balance either pays off its own claims or accumulates claims from others. For example, when a household spends more than it earns, it issues claims on its future earnings to other parties (e.g., it takes on credit card or mortgage debt). However, when it spends less than it earns, it either repays its debts, or invests in claims issued by others (e.g., purchasing bonds issued by a government that is running a deficit).

Now let's move to the current account, which tracks a country's relations with the rest of the world. When people refer to the "balance of payments" this is usually what they are talking about. The easiest way to understand the current account is to ask what happens when a nation's domestic savings are greater than its domestic investment. What happens to the surplus savings? They are invested in other countries, where domestic savings are less than domestic investment. So far, so good. But hold on, because things get a little trickier at this point.

Consider a world in which just two countries exist, that historically have had the same levels of domestic savings and investment. However, something changes, and next year the first country has relatively more domestic savings than investment, and the second country has just the opposite. As we have seen, the first country's surplus savings will flow to the second country. However, because the two countries have different currencies, the flow of savings from the surplus to the deficit country will mean that savers in the former will have to sell their currency to enable them to invest in the deficit country. In other words, on the foreign exchange market, the supply of the surplus country's currency will increase relative to the demand for it. As a result, its value will depreciate relative the value of the deficit country's currency. However, things don't stop there.

Consider what happens domestically if the price of one company's product falls relative to the price of a similar product made by a second company. Demand for the now cheaper product tends to increase, while demand for the now more expensive product tends to decrease. The same thing happens internationally when a change in exchange rates causes a change in the relative prices of goods produced by two countries. The country with the depreciating currency (that is, the country with surplus domestic savings) will see an increase in international demand for its (now relatively cheaper) goods and services, while just the opposite will happen in the country with the appreciating currency (that is, the currency with the domestic savings shortfall). To put it a bit more formally, a country with domestic savings greater than domestic investment by definition will have a positive balance on its "current account" which measures the value of its exports of goods and services less its imports of the same. Conversely, a country whose domestic investment is greater than its domestic savings will run a current account deficit.

An important point to keep in mind about the Economic Balance Equation is that it measures flows within a period, not the stocks of financial asset and liabilities that are affected by the flows. However, these stocks are the ultimate constraints on the system. For example, consider a country that attempts to stimulate demand growth by investing more than it saves (that is, whose private consumption spending, private investment spending, and government deficit adds up to more than 100% of its output). For a while, this strategy can work quite well. In fact, if other countries are willing to keep accumulating financial claims on the savings-short country, it can go on for many years. However, at some point, people in the savings surplus country will call a halt to the process, once the perceived risk of default by the savings-short country passes a certain point. In many cases, this point is reached once the ratio of the savings-short country's external debt to its GDP or to its export revenues rises above a certain "danger threshold.

At this point, the changes required to bring the system back into balance can be difficult and painful. In the short-term, a sharp reduction in savings exports from the savings-surplus country would cause a rise in its exchange rate, and a fall in the exchange rate of the savings-short country. As we have noted before, these would cause sharp changes in relative prices between the two countries. Unfortunately, if the structure of domestic demand is different in the two countries, this may not be sufficient to bring about the necessary changes in their respective current account balances. For example, suppose our savings-surplus country had focused its export industry on consumer electronics, which had caused a sharp reduction in the size of the savings-short country's domestic consumer electronics production capacity. Faced with an increase in the price of consumer electronics caused by the depreciation of their currency, people in the savings-short country might keep on buying them nonetheless, assuming their demand for them was relatively insensitive to price changes.

In this case, achieving the necessary adjustment in the current account would necessitate a substantial drop in total demand (income) in the savings-short country. In this case, purchases of consumer electronics would fall, not only because their price rose, but also because people simply no longer had the money to spend on them.

To put it differently, in this case, structural changes in the two countries' economies would make it difficult for the price mechanism (changes in the exchange rate) to bring about the necessary adjustments. The only alternative would be changes in aggregate demand, which is much more painful adjustment process. The important point here is that the savings-short country faces painful changes when it is told by its creditors that the party is over, and that the time has come to pay back some of its external debt. Turning a current account deficit into a current account surplus inescapably requires some combination of cuts in private spending and investment, and/or cuts in government budget deficits.

However, as we have noted, the changes in the savings-surplus country can be equally painful. If the savings-short country is to pay down its debt, the savings-surplus country has to become a savings-short country, and run a deficit on its current account. To do this, it will have to make difficult changes to increase domestic private consumption and/or investment spending, and/or to increase the size of its government deficit, while simultaneously reducing its exports and increasing its imports of goods and services.

This simple example sets the context for our overview of the current economic situation. First, let's briefly review how we got to where we are today. At the end of the 1990s, the world economy was heavily dependent on the United States as its main "growth engine." While the U.S. government budget was in surplus, its private sector balance was heavily in deficit, due to heavy corporate investment in information technology, and heavy consumer spending financed through a combination of debt accumulation and the spending of gains from rising equity values. When this bubble burst in 2001, and was followed later in the year by the 9/11 terrorist attacks, the world economy faced the stark prospect of a fall into a global recession that some worried might turn into a prolonged, Japan-style period of low growth and deflation. A de-facto three-part strategy was formulated to maintain global growth. In the United States, interest rate reductions and government fiscal policy were used to stimulate aggregate demand. In the Eurozone, it was hoped that aggressive structural reforms and government fiscal policy would have the same effect. Finally, to stimulate faster domestic demand growth in Japan, more aggressive structural reforms would be undertaken (to make the corporate sector more efficient, and to improve the banking system's credit quality) and a much looser monetary policy would be used to eliminate deflation.

The result was a "good news/bad news" story. The good news was that for the past three years, the world has avoided recession and deflation, principally because the U.S. government and consumers kept borrowing and spending, which helped to trigger a second source of demand growth: an investment boom in China. The bad news is that the original growth strategy was only partially implemented, and as a result the world economy today is probably even more dangerously unbalanced than it was in 2001.

In the United States, the corporate sector moved very aggressively to cut costs and strengthen its balance sheet. Much of this cost cutting reflected realization of the productivity improvements long promised by earlier investments in information technology. For example, the widespread deployment of Enterprise Resource and Planning (ERP) systems led to the elimination of many middle management jobs whose primary purpose had been the collection, aggregation, and analysis of internal corporate information. Many businesses were also able to cut costs by moving significant production operations to China and Southeast Asia, as information technology enabled the creation of globally integrated supply chains. However, in the household sector, the biggest story was not retrenchment, but continued spending, financed in no small part by the refinancing of home mortgages as interest rates fell. At the same time, the public sector saw an enormous and unprecedented shift in the fiscal balance, from a substantial surplus (1.3% of GDP in 2000) into a substantial deficit (negative 4.9% of GDP in 2004). With the sharp reduction in the private sector's balance, and with substantial military action inevitable after 9/11, the plain truth of the matter was that the U.S. government could not afford to have the global economy fall into what could easily become a prolonged deflationary recession. The net result of these changes in the private and public sector balances was a sharp increase in the United States' current account deficit. To varying degrees, the same current account story has played out elsewhere in the Anglosphere (i.e., Australia, Canada, New Zealand, the UK and the USA). For example, in the U.K., the public sector balance has fallen from 3.9% of GDP in 2000 to negative (3.0%) by 2004. The exception has been Canada, where higher initial external debt levels caused the country to take advantage of favorable conditions to run private, public and current account surpluses.

With the Anglosphere growing domestic demand faster than domestic production (as evidenced by its current account deficits), the main geographic beneficiary has been Asia. To understand why, we have to go back twenty years or so, and start with the broad outlines of the development strategy that many of these nations have been following. One of the most important challenges these countries face is how to maintain political stability in the face of rapidly growing populations. More specifically, the key challenge has been how to absorb large numbers of new workers into the labor force (due to both high historical birthrates and the shift out of agricultural employment) while at the same time meeting their expectations for a rising standard of living. Given that the "Latin American" approach to this challenge (characterized by protectionism, often-times inefficient import substitution investments by the public and private sectors, large current account deficits and heavy reliance on foreign bank loans) had proven relatively unsuccessful, the Asian countries largely copied a different approach that had been pioneered by post World War Two Japan.

The key elements of this development model were an emphasis on high levels of human capital (i.e., education), high domestic savings, smaller current account deficits (or even surpluses) and a focus on large export markets. Serving the latter offered a much bigger potential source of demand growth than relatively underdeveloped domestic markets. Equally as important, because they were much more competitive than import substitution, export markets would provide the stimulus for rapid increases in productivity (output per hour worked) and output. Finally, high productivity growth over time would be made possible by the combination of well-educated workers and increasing amounts of capital investment. In general, this Asian approach to economic development proved to be much more successful than the Latin American model. However, over the course of the 1990s its weaknesses began to show.

The core problems seemed to be the mechanism chosen for allocating high domestic savings to investment projects, and the way that foreign exchange rates were managed. In the case of the former, most Asian countries heavily relied on the banking system to allocate savings, and had relatively underdeveloped domestic bond and equity markets. At the same time, these countries' bank regulatory capabilities did not keep pace with the growth of their banking systems. In retrospect, the results were predictable: growing amounts of relatively inefficient investment (e.g., lending for property speculation, or for inefficient, "me-too" export projects), growing reliance by banks on external funding (e.g., U.S. dollar denominated deposits from foreign banks), and growing numbers of non-performing loans. However, while these problems were developing, pressures were slowly building up in the foreign exchange markets, where strong export performance had led to inflows of foreign capital. With exchange rates essentially pegged to the U.S. dollar (to help export competitiveness), these foreign capital inflows resulted in increases in the domestic money supply, which led to increases in both domestic asset prices and domestic prices (and remember that the latter reduces export competitiveness). In 1997, this Asian development model broke down in many countries. Growing doubts about the creditworthiness of domestic banks and the competitiveness of exports led to growing capital outflows. In addition, exchange rate depreciation increased the value of countries' dollar denominated foreign debt relative to both their export earnings and GDP. As this crisis spread beyond Thailand (where it first appeared), more and more countries were forced to dramatically slow the growth of their economies (and increase the risk of political unrest) to get the situation back under control.

The sharp setback experienced by the Asian countries seven years ago had a number of consequences. First, the contraction in domestic demand (and particularly in investment) moved their private sector balances into very strong surpluses, which has caused their current accounts to also move into surplus. Investment in these countries (except for China, as described below) has yet to return to its pre-crisis level. Second, the shock changed the way in which the U.S. dollars (and other foreign currencies) earned from export sales are managed. Rather than having foreign exchange risk born by the private sector (in this case, by holding foreign currency denominated assets, or, to put it differently, by exporting surplus savings), this function has shifted to the public sector. Specifically, the central banks of many Asian countries now hold substantial foreign exchange reserves that are invested in U.S. government debt obligations. This has been the genesis of one of the key dynamics at work in the global economy today: domestic U.S. demand is greater than domestic production, with much of the difference made up by imports from Asia. This results in a large current account deficit (and the accumulation of more and more dollar denominated external debt) which is being financed by the reserve accumulations of Asian central banks.

Arguably, the tremendous stimulus to global demand growth provided by the Anglosphere has afforded the Eurozone (and, to a lesser extent, Japan) the luxury of being able to lag in their implementation of the global growth strategy. Despite some progress, the Eurozone countries have generally failed to enact the structural reforms (e.g., deregulation, privatization, etc.) needed to increase their productivity and domestic growth capacity. The region's productivity growth rates still lag behind the rates found in most Asian and Anglosphere countries. As a result, the increase in the Eurozone's exports and government deficits (e.g., the latter increased from negative 0.9% of GDP in 2000 to negative 2.9% of GDP by 2004) has not led to appreciable increases in private consumption and domestic spending. Moreover, the relatively anemic growth that was achieved rather quickly fed through to price increases (i.e., jumps in inflation) rather than increases in output. As the European Central Bank (ECB) sees its primary mandate to be the control of inflation, this has led to a far more cautious monetary policy (i.e., relatively higher interest rates) than in the United States. Over the past year, this situation has deteriorated, as many private investors' increasing worries about the United States' rapidly growing external debt have caused them to shift funds into Euro-denominated assets. The resulting appreciation of the Euro/U.S. dollar exchange rate has caused the Eurozone's exports, and hence the region's overall growth, to weaken from their already unimpressive levels.

All of these trends can be seen in the International Monetary Fund's latest forecast for how the Economic Balance Equation is expected to turn out in 2005 in various regions of the world:

This table tells a very interesting and very important story. Let's start with the second column. While the war against Islamic extremists dominates the headlines, the longer-term story is the emergence of three different economic groupings in the global economy, and their divergent strategies and performance. The smallest of these is the Eurozone, which accounts for 16% of global Gross Domestic Product (i.e., total world demand). Relative to other regions of the world its growth is expected to be slow in 2005. Its demand stimulus is coming from its exports (as evidenced by its slightly positive current account surplus) and public sector fiscal policy (as evidenced by its negative public sector balance).

The two largest groupings are the Anglosphere and Asia. Both now account for about 27% of world GDP. This number for Asia includes only China, Japan, South Korea, Hong Kong, Singapore, Taiwan, Indonesia, Malaysia, Philippines and Thailand. If the countries of South Asia (e.g., India and Pakistan) are also included, Asian GDP is larger than that of the Anglosphere. As you can see, while growth rates have been higher in Asia and the Anglosphere than in the Eurozone, the strategies employed have been different, but complimentary. As we have noted, the Anglosphere countries have tended to grow domestic demand faster than domestic output, with the difference coming from the Asian countries which have done just the opposite.

The good news is that despite its uneven implementation, the strategy that was put in place in 2001 has thus far kept the world from falling into a global (and possibly deflationary) recession. The bad news is that the current approach remains very unbalanced, which means that beneath the surface, pressures for change continue to build up. Hence the critical questions are how much longer the current system can continue, and what is most likely to replace it when it reaches its inevitable end.
While there is no shortage of candidates when it comes to fault lines that could set of an earthquake in the global economy, we will look at six of the most likely candidates in rough order of the possible time to their impact: (1) a major new terrorist attack; (2) rising oil prices; (3) falls in housing market values; (4) a sharp economic slowdown in China; (5) cessation of Asian countries' financing of the U.S. (and Anglosphere's) current account deficits; and (6) Eurozone and Anglosphere governments' efforts to address the potential public sector costs of aging populations.

A major terrorist attack might take many forms; however, the one that seems both relatively probable and the most worrisome to us is an incident that would slow or stop the operation of the ports of Los Angeles/Long Beach or Seattle/Tacoma. These are the two major West Coast ports through which the majority of Asia's exports enter the United States. An attack which severely disrupted these ports would have serious consequences for the two economic groups which up to now have been keeping the global economy out of recession.

This year’s rise in oil prices is another major threat to the global economy. While far smaller than the large hikes in 1973 and 1979 (which raised oil prices by 252% and 179%, versus the most recent 29% increase), it nonetheless has a twofold negative impact on oil importing countries. First, an oil price rise functions as a tax that directly reduces the money that can be spent on other forms of consumption and investment. Second, if oil price increases lead to higher inflation, they may also cause central banks to raise interest rates, which would further reduce consumption and investment spending. The taxation effect of oil price increases is particularly pronounced in Asia, which is far less efficient in its use of oil (e.g., energy used per dollar of GDP produced) than the Eurozone or Anglosphere countries. With respect to interest rates, the Asian Development Bank recently noted that "consumer credit expansion has been strong [in recent years in many countries] leading to higher household indebtedness. [The combination of ] lower real incomes due to higher oil prices and higher interest rates would significantly raise the debt servicing burden of households, possibly leading to a substantial rise in default rates in some countries. At the same time, business investment would suffer a setback."

Besides the direct impact of the oil price rise on growth, there remains the important question as to how the producing countries will invest their increased oil revenues. A decision to invest them in the Euro, Pound or the Yen, instead of the U.S. dollar could have serious consequences. Further appreciation of the Euro versus the USD would further reduce the Eurozone's already weak growth. Given its current account deficit, appreciation of the U.K. pound would also be less than helpful, while appreciation of the Yen would severely hurt Japan's already fragile and export-dependent growth. But how likely is it that oil prices will remain high?

In its September World Economic Outlook, the IMF notes that the most recent run-up in oil prices was caused by both demand and supply side factors. "Perhaps most important, as the global economic recovery has taken hold over the past year…both the level and the growth in the global demand for oil have consistently outpaced expectations." On the supply side, recent years have seen no major new discoveries of large oil reservoirs that can be exploited at low cost. During the same period, relatively low oil prices have held back development of oil supplies that while plentiful are much more expensive to recover (e.g., Canada tar sands and Venezuelan heavy oil deposits). That has led to the current condition in which demand and supply are finely balanced, with the latter subject to not-inconsiderable political risks (e.g., in Iraq, Saudi Arabia, Russia and Venezuela). As the IMF notes, "while proven reserves remain plentiful, the key issue in the global oil market appears to be low excess production capacity and the adequacy of existing capacity expansion projects relative to the potential increase in global demand."

So how likely is it that the current high oil prices will continue? One argument says that with so many other factors likely to slow down the world economy over the next year, the current price rise will likely be short lived. Another argument is that higher prices will lead to both demand reduction (e.g., the fall in sales of sport utility vehicles in the United States) and supply increases, due to more intensive exploration efforts, and the introduction of new technologies (e.g., not only for exploiting marginal deposits, but also for getting much more oil out of existing reservoirs). A third argument notes that the recent run-up in oil prices will only speed the transition to the hydrogen economy that is now well underway (e.g., witness the number of hybrid and fuel cell vehicles and power plants now nearing commercialization). On the other hand, given the political and economic uncertainties associated with new capacity development, no less an authority than David O'Reilly, the Chairman of ChevronTexaco has warned (in an interview with the Financial Times) that "there is the potential for an underlying shift in the value of the oil price. It is possible that we are at the same place that we were in the late 1970s."

Even if it is not sustained, the recent increase in oil prices could still be sufficient to cause other negative reactions in the world economy, particularly if it triggers a rise in inflation that forces an increase in interest rates. The undeniable fact is that the household sector is probably the biggest weak point in the global economy today because of the amount of debt on its balance sheet. Both the Bank for International Settlements (BIS) and the IMF have recently examined different aspects of this problem. In June, the BIS published a new study titled "The Macroeconomic Implications of Rising Household Debt." It noted that, following financial system liberalization, "household borrowing has grown considerably in many countries over the past two decades, both in absolute terms and relative to household incomes." Like others, the study notes that most of this increase has been in the form of mortgage debt associated with investment in residential property. It also notes that rising property values have helped to hold up private consumption expenditures in many countries since 2001.

However, the BIS study also notes that the rise in household sector debt "has raised concerns about…the possible implications for the financial system and the macroeconomy if it is not sustainable. While household debt has increased relative to both income and household assets in most countries, the interest cover or debt service ratio of households does not show a clear upward trend. The increase in household indebtedness has been offset by the decline in borrowing rates, so that on average, households are not devoting any greater share of their incomes to debt service than in the past. However, debt service is close to historical highs in some countries. With interest rates at historically low levels, debt service costs will rise further as rates increase when the interest rate cycle turns." The study notes that the impact on private consumption should be most severe in those countries where a substantial percentage of mortgage debt carries variable rather than fixed rates. These countries include Australia, Ireland, Spain, Sweden, Switzerland, and the U.K.

However, even those countries where fixed rate mortgages predominate may also be affected by rising rates. In these countries, a high percentage of mortgage debt has been securitized by the originating banks (i.e., mortgages have been packaged and resold as some type of mortgage backed bond), and sold to institutional investors, like pension funds. So when interest rates rise, these institutions' holdings of mortgage backed securities will decline in value. However, it may be the case that these institutions have taken steps to hedge their exposure to this risk by purchasing interest rate derivatives (essentially insurance contracts that payoff when rates rise). However, the capital losses caused by rising interest rates don't disappear -- in this case, they are simply shifted to whoever it was that sold the derivative contract to the pension fund. And therein lies one of the biggest (if unacknowledged) risks facing the financial system: the creditworthiness of the parties who are left holding this risk. If enough of these turn out to be weaker than expected (i.e., unable to make the payments called for under the derivative contracts they have sold), it will undoubtedly be a nasty shock to the economy. Unfortunately, we suspect that more than a few highly leveraged hedge funds have been boosting their returns by selling interest rate derivatives. So we won't be surprised if the "derivatives credit shock" eventually occurs if rates keep rising.

A closely related question is whether house prices have become seriously overvalued in some countries. If this is the case, then a substantial fall in house values could make any economic downturn that happens much deeper and more prolonged. In its September World Economic Outlook, the International Monetary Fund analyzed this issue. Like others who have also explored it (e.g., see the September 11, 2004 issue of "The Economist"), the IMF came to a worrying conclusion. The IMF began by constructing a model that attempts to explain the increase in house prices across a sample of 18 countries over the 1971 - 2003 period. Over this period, house prices have grown at a real rate of 1.75% per year, with a standard deviation of 7.0% (Note: assuming constant 4:1 leverage, this equates to real growth of 7.0% per year). However, there are significant country-to-country variations within this average. For example, average real house price growth has been higher in the UK and Australia than in Canada, the United States, and New Zealand. It has also varied widely within the Eurozone, with average growth in Spain, Ireland and the Netherlands much higher than in other countries.

As one would expect, the study's authors found that the growth rate of house prices was affected by economic fundamentals, including population growth, real income growth, interest rates, and the growth of credit. While there was a low contemporaneous correlation between changes in stock prices and changes in house prices, this was not true over time, as changes in stock prices tended to lead changes in house prices. The IMF also found that the growth in house prices had a high degree of serial correlation (coefficient of .5); in other words, there was a high probability that a positive change in one year would be followed by a positive change the next year. However, over longer periods, the "growth rate of real house prices also showed fundamental reversion: if house prices are out of line with income, there is a gradual tendency for this misalignment to be corrected (by about 15 percent every year)." The IMF also found that changes in house prices were increasingly correlated across countries (the recent average correlation equals .4), and that changes in global GDP growth had a surprisingly large impact. However, the extent to which this was due to permanent linkages (e.g., the globalization of trade and financial markets) versus the recent dominant role of the United States (in driving world GDP growth) remains open to debate. It is also interesting to note that the same phenomenon has been observed in the global commercial property market. In essence, even a diversified property portfolio will still contain quite a strong exposure to a single risk factor: global GDP growth.

A particularly interesting aspect of the IMF study is the extent to which its model explains the growth in house prices between 1997 and 2003 across different countries. Any house price growth in excess of that predicted by the model suggests the presence of speculative price increases not warranted by changes in demographic and economic fundamentals. On this measure, the greatest indicators of speculative excess were found in Ireland, the UK, Spain, and Australia. Worryingly, these are also countries where floating rate mortgage debt predominates. As the IMF notes, in these countries "there is a danger that higher interest rates could trigger a large downward adjustment of house prices, with…severe consequences for [real GDP growth]." The IMF study concludes "the strength of the housing market has played an important role in supporting [global GDP growth]…. By the same token, the outlook for the housing market will play a key role in shaping the extent and nature of [the global economy] going forward.… Just as the upswing in house prices has been mostly a global phenomenon, it is likely that any downturn would also be highly synchronized, with corresponding implications for global economic activity. In particular, higher global interest rates will result in a slowdown in house prices, the extent of which will differ across countries."

As we noted in our March 2004 Economic Update, China has played a very important role in world economic growth since 2001. In effect, it has become the engine driving growth in Asia. China’ growing exports to the United States have triggered a sharp increase in domestic investment as well as strong export growth (and further domestic investment) in the many Asian countries that supply China with raw materials and intermediate goods. In our March 2004 issue, we also noted the many risks to the continuation of strong Chinese growth, and the potentially severe consequences for the world economy of a sharp slowdown in China. In this September's World Economic Outlook, the IMF also addressed this issue.

The IMF study notes that "China's economic growth has been marked by periods of cyclical surges in economic activity and inflation, followed by periods of retrenchment. In the 1980s, two cycles ended with hard landings characterized by sharp slowdowns in growth. These periods were often influenced by political changes and typically began with an early relaxation of monetary and fiscal policies to support state-owned enterprises, leading to a significant increase in inflation. The authorities eventually responded with a heavy reliance on direct controls and other administrative measures. Inflation was quickly brought under control, but growth slowed sharply…This general pattern was [again] repeated in the 1991-1997 cycle. In 1992, an easing in monetary and fiscal policies led to an investment boom with real GDP growth exceeding 14 percent and an acceleration in inflation. Early attempts at tightening policies hit state-owned enterprises hard, prompting a relaxation of policies. This easing, and a devaluation of the official exchange rate, resulted in inflation rising to a peak of over 24 percent in 1994. The authorities eventually achieved a soft-landing of the economy, with inflation in the single digits by 1996 and only a modest slowdown in growth. Factors contributing to this included structural reforms to increase the market orientation of the economy, the buildup of excess capacity that put downward pressure on prices, and a tightening of monetary policy."

"However, this episode is directly linked to the key current problems in China's financial sector, as the rapid pace of credit growth [bank lending] in 1992-1996 contributed to the weakness of the financial sector today…Many of the non-performing loans in the banking system date from this period…The current cycle (2002-2004) bears some of the characteristics of the previous overheating cycles, such as high GDP growth, rapid credit growth, and high investment rates…The authorities moved to tighten monetary policies beginning in mid-2003…However, investment has remained high, and inflation has increased. In the current circumstances, a soft-landing, which would maintain underlying growth momentum, appears achievable. However, this will require taking into account the lessons learned from previous cycles. In addition to the early action to rein in credit and investment growth already undertaken by the [Chinese] authorities, these include the consistent implementation of monetary tightening actions to contain inflation and mitigate the non-performing loans problem and introducing greater interest rate liberalization and hard budget constraints for state-owned enterprises to support the effectiveness of monetary policy. In the near term, it will also be important to avoid the tendency seen in earlier cycles to loosen policies prematurely."

In light of this, Chinese President Hu Jintao's recent launch of a new campaign to rid the Chinese Communist Party (CCP) of corruption strikes us as a critically important indicator of what may lie ahead. As we noted in March 2004, letting the already very high level of party corruption continue unchecked seemed sure to lead to a political crisis at some point. However, given the importance of rapid economic growth to the CCP's perceived legitimacy, we do not see how Hu Jintao can simultaneously undertake both an economic slowdown and aggressive anti-corruption campaign. In short, we think the odds of an eventual hard landing in China have recently gotten higher.

If there is a silver lining in this, it would seem to be its impact on any thoughts that Asian countries (including China) may have about the continued wisdom (at least in the short term) of their current policy of funding the U.S. current account deficit, and, therefore, their own export sales. Falling Chinese domestic demand would increase the relative importance of exports to the U.S., and thus their incentives to keep accumulating U.S. Treasury Bonds in their central banks. There have always been two schools of thought on this issue. One has been forcefully argued in a series of papers by Dooley, Folkerts-Landau and Garber, who see the symbiotic relationship between Asia and the United States as relatively stable new Bretton Woods System. According to this view, the system of de facto fixed exchange rates versus the dollar will lead to the rapid development of Asian economies, and eventually faster domestic demand growth. This in turn will enable them to gradually reduce the size of their current account surpluses, while enabling the United States to repay its external obligations to them by running current account surpluses. To put it another way, in contrast to our earlier framework of a world consisting of three main economic groupings (i.e., the Eurozone, Asia, and the Anglosphere), this view posits that for all practical purposes Asia and the United States are today functioning as a single currency bloc.

The opposing view has been well stated by Barry Eichengreen, in his paper "Global Imbalances and the Lessons of Bretton Woods." He argues that the combination of four factors will soon bring an end to the current system. First, the current system for "sterilizing" the impact of large dollar inflows into Asian countries (e.g., eliminating their tendency to increase the domestic money supply) does not work perfectly. Over time, this will manifest itself in rising inflation that undermines external competitiveness and/or unsustainable increases in asset prices (e.g., in property and equity markets) that undermine financial systems. Second, this process will accelerated by inflows from international investors who are tempted to speculate on the eventual appreciation of Asian currencies versus the U.S. dollar. Third, as Asian central banks gradually lose confidence in the commitment of the United States government to maintaining the value of the nominal return bonds they hold (e.g., as evidenced by increasing inflation in the United States), they will reach a "tipping point" at which the expected losses on their foreign exchange reserves begin to outweigh the expected value of the future benefits produced by exports to the United States. Finally, when that point is reached, the Euro provides a ready alternative reserve currency into which they can shift their reserves.

Another excellent paper arguing that the current system cannot go on much longer is "The U.S. as a Net Debtor: The Sustainability of the U.S. External Imbalances" by Roubini and Setser. In essence, they argue that in the absence of policy changes, the size of the U.S. current account deficit will exceed the Asian countries' ability to finance it within the next three to four years. A related paper, "The Transpacific Imbalance: An East Asian Perspective" by Wha Lee, McKibbin and Park uses econometric analysis to make a key point: plausible changes in U.S. dollar/Asian currency exchange rates won't significantly reduce the U.S. current account deficit. Changes in the U.S. private and public sector balances will also be needed.

On balance, we think that in the short term the Asian countries will continue to purchase U.S. Treasury Bonds and fund their own export sales to the United States. First, given the current uncertainties surrounding the Eurozone Stability and Growth Pact (which in theory ensures fiscal stability, but which countries have recently violated without being sanctioned), how the expansion of the European Union will work out (including the fate of the proposed European Constitution), and the Eurozone's relatively weak domestic demand growth (and hence the size of the potential market for Asian exports), we question the extent to which Asian central banks at this point view the Euro as a viable alternative to the U.S. dollar. Second, by gradually switching their Treasury Bond holdings into Treasury Inflation Protected Securities, Asian central banks now have the opportunity to hedge at least a portion of their valuation risk (undoubtedly, this is one of the reasons we have seen such a large increase in TIPS issuance). Third, as we have noted, given the uncertainties about future domestic demand growth in China, there are strong incentives to keep financing exports to the United States. Finally, as we noted in March 2004, we need to keep in mind the long-term national security strategy of the biggest kid on the Asian block. Chinese leaders have made no secret of their ambition to replace the United States and the dominant player in Asia, and, indeed, to compete with the U.S. as equals on the global stage. Given the wide disparities between the two nation's military power, other means must be found to weaken the United States. It doesn't require a large mental leap to see how encouraging the United States to keep living beyond its means and accumulating (inflation protected) U.S. foreign debt in Asian hands contributes to the achievement of this long-term goal.

Of course, this brings us to the major factor driving the long-term tendency of the United States current account to remain in deficit: the growing pressure on the public sector balance caused by the costs associated with an aging population. We covered this topic in depth in our May 2004 issue. Here, we will simply say that if developed countries in the Eurozone and Anglosphere do not find better ways to control rising health care costs and the costs of national "pay as you go" pension plans, it is hard to see how their public sector balances can avoid going into (or remaining in) substantial deficits. This is especially true of the Eurozone, where efforts at reform have been more limited, and where productivity growth has been lower than in the Anglosphere countries. In point of fact, the latter actually offer some rather good examples of what could be done to address the problem. In comparison to other countries, Australia seems to have been particularly successful at addressing these twin threats to the public sector balance (not that an Australian would ever brag about this, mind you!). On the healthcare front, the country has put in place a healthcare system that provides a basic level of universal coverage paid for with public funds, complimented by optional additional coverage that is paid for via private insurance. In effect, Australia has separated "healthcare" into two goods: one a universally available, tax financed necessity, and the other a privately paid for luxury item. In addition, the Australian system stimulates efficiency on the supply side by encouraging competition between private providers of healthcare services. The results are indeed impressive: both Australia's healthcare outcomes and its healthcare spending as a percentage of GDP compare quite favorably with most other developed countries.

On the pensions front, Australia has already implemented what strikes us as the long-term solution other countries must eventually adopt. It has two parts. First, everyone must contribute a certain percentage of earnings to a defined contribution pension plan (known as a "superannuation plan" in Australia). Upon retirement, the balance in this plan must be used to purchase a life annuity. Second, the state also provides a means-tested benefit to ensure that everyone will have at least a minimum level of retirement income. However, because of the mandatory superannuation plans, the ultimate cost to the public sector of these means-tested "top up" payments is not expected to be onerous. Frankly, we think it is time to stop referring to Australia as "the lucky country," and start calling it "the smart country" instead. Unfortunately, much as they might agree with this sentiment in private, no Australian will ever agree to it in public!

More broadly, as the IMF notes in its September World Economic Outlook, "the policies to tackle the impact of demographic change [i.e., aging] will inevitably involve difficult tradeoffs, will take time to agree and implement, and will need to be phased in to allow people sufficient time to adjust their behavior. This is most clearly true in pension reforms - which affect the welfare of the elderly and threaten benefits that people believe they are entitled to - but also of healthcare. Therefore, while the full impact of demographic change will not be felt in most countries for a number of years, the process of planning a response should not be delayed. This is particularly true for advanced countries where reforms to pension and health care systems will become increasingly difficult to implement as the population ages. Policymakers therefore need to take advantage of the current strong global economic rebound to advance the reform agenda before the window of opportunity begins to close."

What, then, are the implications of these various risk factors for the future of the global economy? Perhaps the best way to look at this is to define what needs to go right in order for global growth to continue at its current healthy rate. The following table sums up the assumptions that underlie any optimistic forecast about the future:

While some of these outcomes seem more likely than others, the joint probability that all of them, or indeed, even most of them will come to pass seems rather low. It thus seems reasonable to conclude that we are most likely looking at some rather rough water ahead.

More specifically, we believe that the most likely scenario is a global growth slowdown that could easily trigger a period of deflation because of (1) the continuing surplus capacity in many industries; (2) the high level of leverage in the household sector; and (3) the substantial amounts of "hidden leverage" and potential for a deflationary debt implosion implied by the growth of hedge funds and the size of the worlds' derivatives markets (e.g., swaps, options, and futures). Along these lines, we note the recent publication of two recent working papers by the Board of Governors of the U.S. Federal Reserve: "Monetary Policy at the Zero Bound" by Bernanke, Reinhart and Sack, and "The Scope of Monetary Policy Actions Authorized by the Federal Reserve Act" by Small and Clouse. Both directly focus on the policy options open to the Federal Reserve in a period deflation.

As we have said before, we do not believe that any deflation could politically be allowed to persist for long. Governments in the Eurozone and Anglosphere could not simply sit idly by while real returns to bondholders skyrocket and middle class voters are destroyed by rising real debt burdens and unemployment. It therefore seems likely that any period of global deflation would not last long before the Eurozone and Anglosphere governments very aggressively attempted a coordinated reflation. In sum, while in the short term it seems that the current, relatively benign global economic environment can continue for a while longer (perhaps a year or two), our most likely medium term scenario is for a relatively severe global recession that will be followed by an aggressive, coordinated attempt at reflation. In contrast, our most dangerous scenario is one in which initial attempts at reflation fail, and we are stuck in a highly damaging deflationary period for a longer period of time.

Up to now, we have only looked at the demand side of the global economy. However, as we noted at the outset, real returns on financial assets result from the interaction of demand supply in the real economy. So it is to the supply side that we now turn. The first problem you confront in this area is the fact that supply side data are harder to observe, are noisy (that is, they are measured less precisely than demand side data) and usually only appear with a lag. For example, while unemployment data are collected, they don't include people who have stopped looking for work. Nor do they explicitly show the percentage of people who could do much more than they are in their current jobs (a condition known as "underemployment"). Finally, unemployment alone doesn't tell you much about the relative quality of the workers involved -- they make no distinction between an unemployed computer programmer and an unemployed ditch digger. Data on the capital side of the supply equation are just as problematic. For example, capacity utilization data tells you precious little about the nature of unused capacity -- under what conditions would it again be put into use, and how likely are those to occur (e.g., now that China has emerged as a major supplier in many industries)?

Fortunately, there is a way around these problems: we can directly observe the result of the interaction of real supply with real demand conditions in the form of the real interest rate. Until recently, this was at best a noisy observation, as the real rate itself had to be inferred from current nominal rates interest and some estimate of future inflation. However following the widespread introduction of government real return bonds we can now directly observe real rates of interest. To be sure, this is still a bit of an uncertain measure. For example, it can be distorted a bit by factors unique to a specific bond market (e.g., if a real return bond issue is perceived to be somewhat illiquid, it will command a premium over the "true" real rate), or there may be some risk discount applied to government debt versus the "true" real rate for the overall economy. Still, these are relatively minor shortcomings, and the government real return bond yield is still an extremely useful measure of what is happening on the supply side of the economy.

So how should we interpret the current yield on real return bonds? Let's start with the basic concept behind the real rate of interest. It is the basic building block of the financial system, to which various risk premia are added to obtain expected returns on different asset classes. But what does it represent? It is the additional compensation that an investor should expect to receive in exchange for postponing consumption for one year. And how much should that compensation be? Logically, it should represent the additional output that can be produced by investing the saved capital rather than consuming it. This additional output equals the expected real growth rate of the economy, which we already know is a function of the increase in the labor force and the increase in labor productivity. Why should the real rate on government bonds proxy for this? Because the government can't sell its debt for very long if it is offering substantially lower risk adjusted real returns than those available from investing in the economy as a whole. As labor force and productivity growth rates vary somewhat across countries, so too should real interest rates.

However, all of the above statements assume that no unexpected surprises occur, which we know isn't the case. And when these happen, the observed real rate of interest (the yield on real return government bonds) can substantially diverge from its theoretical value (the rate of labor force growth times the rate of productivity growth). For example, a sharp increase in domestic demand could, all else being equal, cause the observed real return to exceed the theoretical one. This would be a clear sign of building inflationary pressures. On the other hand, a supply side shock could cause the opposite to happen. In this case, actual real rates would be below their theoretical values. In point of fact, this is exactly what seems to have happened over the past few years, due not only to the impact of information and communication technology, but also due to the entry into the world economy of China and India as major players in multiple industries.

So let's take a look at how big these real return gaps are today. The data in the following table are from the IMF, except for the Real Bond Yields, which are as of September 2004:

As you can see, with the exception of Canada and perhaps the U.K., inflation-linked government bond markets seem to be sending a clear signal that on balance, the greater risk we face is one of deflation, rather than inflation. An alternative interpretation of current real returns would be that our future productivity growth assumptions are too high (or, in the case of Canada, too low), and that the markets are in fact in equilibrium. While in some cases this interpretation seems somewhat reasonable (e.g., implying relatively low long-term productivity growth of around 1.80% per year in many regions), in Japan and the U.S. the implied productivity growth rates seem much too low. Hence, on balance we conclude that real interest rates are consistent with our view that deflation, rather than inflation, is the biggest risk we face today.

Unfortunately, when it comes to asset allocation, these scenarios do not at this point translate into clear signals that the time has come to implement short-term deviations from some of our model portfolios' long-term asset class weights. At the strategic level (what may happen, and why), our confidence in our estimate of possible future scenarios is reasonably high; unfortunately, when it comes to market timing, strategic insights are less useful than operational ones (how events will happen) and especially tactical ones (where and when events will happen). At the operational and tactical level, the number of possible outcomes grows exponentially. Because of this, at these levels of detail it becomes much, much harder to make forecasts with any degree of accuracy. Forecast confidence levels consequently decline. One need only think back to the late 1990s for a good example of this. While there were many people who were strategically right about the extreme overvaluation of the U.S. equity market, many of them also lost a lot of money hedging against a decline that didn't occur until 2001 (by which point quite a few previous hedgers had thrown in the towel). As always, market timing remains a very difficult game to play consistently well.

At this point, we believe the main implications of our economic outlook for different asset classes are as follows:

Finally, these are the key indicators we will be monitoring to help us determine what scenario is developing:

In sum, we are facing some of the most unsettled and uncertain circumstances in recent times in the global economy and financial markets. Sharp swings between inflation and deflation (and back to inflation again) may occur. Under these circumstances, ensuring proper portfolio diversification is more important than ever. Investors who have recently experienced unexpected gains in wealth confront a critical choice: they can either maintain their current asset allocations while raising their goals (e.g., shortening their time to retirement, increasing their target retirement income, or cutting future savings), or maintain their goals while shifting to a more conservative asset allocation (as the minimum required rate of return needed to achieve their current goals has fallen as a result of their unexpected gains). In light of the current uncertainties facing the global economy, the latter seems to be the much more prudent approach.

Conversely, people who have recently experienced an unexpected reduction in their wealth should not be taking on more risk (e.g., a more aggressive asset allocation policy) to achieve their goals. Rather, the more prudent course of action in this case is to adopt a more conservative set of goals (e.g., lengthening the time to retirement, increasing annual savings, or aiming for a lower level of post-retirement income).

Last but not least, investors who have a large lump sum of cash to invest should not do so all at once, but rather should slowly implement their asset allocation policy over time to minimize their risk of capital loss.

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