Our 22nd annual Lyford Cay investment conference was notable for lack of controversy and deep conviction on major investment themes. It was as if the assembled crowd were watching the world and the markets go by in slow motion.
There was the usual hand-wringing over fat-tailed concerns — especially credit risks, the dollar, and politics. But there was a nearly universal belief that an increasingly elastic and globalized world could cope with almost anything except the most extreme of disruptions.
The experience of the last four years certainly lends support to such hope. Despite all the angst over global imbalances, soaring oil prices, housing bubbles, and spread markets, the global economy never really skipped a beat. Instead, world GDP growth soared at a 4.9% average annual rate over the 2003-06 period — the strongest four-year burst of global growth since the early 1970s.
As the resident “Doubting Thomas,” my latest strain of cautious comments was received by the Lyford crowd with understandable indifference. The US housing downturn was not thought to be a particularly big deal, and even if it were, conviction was deep that there were plenty of alternative sources of growth — either at home or abroad — that could easily fill most of the void.
We did a fair amount of interactive polling at this year’s conference in order to deepen our understanding of the macro assumptions held by the investors in attendance.
Three conclusions jumped off the page: First, inflation was not perceived to be a major risk. Fully 45% of the group thought the core CPI would recede from its latest reading of 2.9% in September 2006 into the 2.4% to 2.8% zone over the next 12 months; another 30% felt core inflation would hold around current levels. That left only about a quarter of those in attendance with some inflation concerns, but most of that segment anticipated risk in the 3.1% to 3.5% range.
In other words, those banking on a relatively sanguine outlook for core inflation outweighed those looking for deterioration by a factor of three to one. Nor was there much concern about the possibility of sharp further upward increases in oil prices. Fully 64% of the Lyford crowd expected WTI-based oil prices to hold in a $40 to $60 range, with more leaning toward the lower half of that range than the upper half. The tail on the oil price was skewed slightly to the upside, with 6% of the group fearing a breakout above $80 while no one thought oil would drop below $40 per barrel over the next 12 months.
Second, there was little concern over the interest rate outlook over the next year — very much consistent with the generally optimistic prognosis for inflation. The Federal Reserve was viewed as more likely to ease than tighten over this time horizon, with nearly 40% of the investors in attendance looking for the federal funds rate to fall from its current level of 5.25% into the 4.5% to 5.0% zone over the next year and another 10% thinking it could drop below 4.5%. Conversely, 6% thought the Fed would hike the overnight lending rate into the 5.5% to 6.0% zone, whereas just 3% feared a funds rate in excess of 6%.
The biggest chunk of the Lyford crowd — fully 42% of them — thought the Fed would basically stay on hold and keep its policy rate in the 5.0% to 5.5% zone. In terms of the long end of the yield curve, there were a few more investors who thought rates would drift up rather than decline: Nearly 35% of the group expected yields on 10-year Treasuries to move up into the 5.0% to 5.5% range, and another 6% thought long rates could rise above 5.5%; by contrast, about 30% thought long rates could be slightly lower.
When the expectations of long-term interest rates are combined with the Fed policy bet, the Lyford consensus is very much in the camp that the inversion of the US Treasury yield curve is likely to come to an end at some point during the next 12 months. In their collective view, the possibility of a back-up at the long end should generally outweigh expected moves toward policy accommodation at the short end.
Third, we attempted to measure investment sentiment on the prospective state of the US business cycle by asking the assembled crowd where they thought the unemployment rate was headed over the next 12 months. Fully 77% of the group thought it was headed higher, whereas only 17% thought it could drift a bit lower.
Of those looking for an upside drift in US joblessness, the majority thought any increases would be relatively modest, confined in the 4.5% to 4.9% range. This is broadly consistent with an opening up of thin margins of labor market slack that might result from a modest downturn in real GDP growth to the 2.5% to 2.75% range over the next 12 months.
The scenario that emerges from our polling of the macro sentiment of the Lyford crowd is the quintessential soft landing — a modest slowdown that leads to an equally modest easing of underlying inflationary pressures and a concomitant tilt toward easier Fed policy. A slight updrift in bond yields was the only real anomalous result of this exercise.
By contrast, you would have thought a benign growth, inflation, and Fed policy outlook might have provided a modestly constructive climate for long rates. One development that might square this circle is a possible decline in the dollar. With 40% of the group looking for the yen-dollar cross rate to move below 115 over the next 12 months — nearly double the 22% anticipating further dollar strength — some concession on real rates could well be part and parcel of America’s long overdue current account adjustment.
With Asian central banks speaking increasingly of the need for reserve diversification out of dollars, a modest currency-driven boost to longer-term US interest rates is not out of the question. But even in this case, the worst-case expectations of a back-up in long rates — roughly in the 50 to 100 basis point range — is hardly the stuff of a dollar collapse and a wrenching current-account adjustment.
We did our best to stress-test this sanguine macro prognosis. I made a compelling case for the coming China slowdown and its important implications for the overdone commodity bet. The response was a great big yawn, with far more interest in a presentation of secular constraints on the supply side brilliantly articulated by my debating adversary, Wiktor Bielski, our European metals and mining analyst.
Professor Niall Ferguson, who wowed the European version of this conference last June with his concerns over the fate of two globalizations — the one that came to a sickening end in the early 20th century and the current strain with many eerie parallels — grabbed the Lyford crowd with his “paradox of the newspaper.” Shouldn’t we make more of an effort, he argued, to reconcile the sickening content of the news section with the sanguine stories of the business section? “Nonsense,” said the Lyford crowd. Geopolitical angst paled in comparison to the main event — globalization.
A rapidly accelerating pace of cross-border integration of economies and markets should not be seen as a risk — even as pro-labor Democrats stormed the US Congress. Instead, it was viewed as a one-way street to ever-greater prosperity by poor and rich countries, alike. Globalization was the glue that cemented the unflinching enthusiasm over BRICs and commodities that permeated our discussions at Lyford Cay this year.
Instead, Niall Ferguson was seen as typical of the alarmists that I always seem to invite to this conference. There was actually a request by one of the more seasoned investors to dispense altogether with an outside speaker next year, and instead offer a screening of “Mary Poppins.” There was the usual hand-wringing over the credit explosion, as well as related angst over the explosion of credit derivatives, LBOs, and the levered loan market.
But no one made a case why these trends couldn’t continue — especially in the context of the relatively benign interest rate climate that most were expecting. Derivatives were not be feared, went the all-too-familiar refrain — they were the new “killer ap” of financial markets that slices up risk and distributes it widely to the masses. With built-in shock absorbers like that, why worry?
Over the years, I have learned to read the Lyford consensus very carefully — and with great respect. Of course, we have the inside joke of the fabled “curse of Lyford Cay” — i.e., that the strongest held view of the group usually turns out to be wrong. Sometimes that turns out to be the case — the most recent such example was the dollar’s rebound in 2005 when, at the end of 2004, almost all of the crowd was lined up on the side of the boat that thought it would continue to decline. But far more often than not, the debate at this conference gets right to the heart of the major issues the markets are grappling with.
Like most groups, the crowd is heavily influenced by recent trends. The US stock market has been on a tear in recent months, and the economy seems to be holding up just fine — at least so far — in the face of the bursting of another asset bubble. The election has come and gone, and while the outcome was a shocker to most, there were few concerns that shifting political winds might derail this Teflon-like scenario.
In the end, the Lyford macro view all boiled down to a very simple observation: Liquidity was everywhere — holding the system together, keeping many of the assembled investors heavily involved in spread markets and unlikely to challenge the widely recognized excesses of the credit cycle. As has been their wont, central banks were widely presumed to ride to the rescue in the event of any major disturbance in the credit cycle.
In a low inflation world, this was not viewed as a moral hazard — but prudent management by the most powerful stewards of the global economy and world financial markets. Literally nothing seemed to faze the Lyford crowd in November 2006. Did someone say Mary Poppins?