MacroVision – our annual deep dive into the burning issues in the markets and the global economy – offered nothing but optimism for 2007. Risks were banished to the distant tails of the probability spectrum, with the all-powerful liquidity cycle expected to cushion all but the most wrenching of shocks. Sure, markets will correct from time to time, but the MacroVision crowd felt any such downdrafts should be ignored. Dips were thought to be buying opportunities – whether for commodities, equities, credit, or emerging markets. The endgame was nowhere in the realm of possibility. Out-of-consensus views were presented with low conviction. MacroVision 2007 focused on three topics – liquidity, commodities, and protectionism.
MacroVision is a unique two-step process. On the first day, we conduct a series of thematically-driven workshops for our worldwide team of economists and strategists. On the second day, we bring a broad cross-section of our clients into the debate – representing multiple constituencies from the institutional investor base (fixed income, equities, and currencies), corporates, government officials, and a scattering of overseas participants. We start out with a broader menu of content choices on the first day and then narrow the debate for the client sessions. The trick in our approach is what we call “macro triangulation” – the examination of each topic by 2-3 distinctly different groups of individuals. We have been conducting this exercise with our internal teams for over a dozen years, and this is the sixth year we have added the client piece to the equation. I know of nothing like it in our business. The magic of MacroVision comes alive in our synthesis sessions, where we compare and contrast the insights and market conclusions that arise from multiple groups probing the same issue or problem from very different angles.
Global economic trends: liquidity
There can be no mistaking the dominance of the liquidity cycle in nearly all of our discussions. It was viewed as the ultimate buffer of the macro system – a cushion that was likely to remain very much in place over the one-year time horizon we were contemplating. The reason – persistent low inflation. Barring a major upside breakout to inflation, our own team, as well as our clients, saw only limited interest rate pressures in 2007.
The upside to policy rates was judged as minimal – with the Federal Reserve expected to hold the funds rate steady at 5.25%. The Bank of Japan’s stunning reversal on its normalization-based policy approach was viewed as lending further support to this conclusion. That was thought to be great news for global carry trades that were providing support for a wide range of risky assets – from corporate credit to emerging market debt. Under a baseline scenario of only modest monetary tightening for 2007, along with expectations of only limited pressures at the long end of yield curves, the MacroVision crowd came up with a very bullish prognosis for world financial markets. Given the ample stock of liquidity that is currently sloshing around the system and the related conclusion that a wrenching withdrawal of liquidity should be assigned a low probability, there was more optimism than I have ever encountered in one of these conferences. Absent a major turn in the global liquidity cycle, went the argument, bullish market outcomes were viewed as largely foolproof.
We all agreed that liquidity is one of the most mentioned, but least understood, constructs in the financial market debate today. Sure, it’s everywhere, but what really is it? In our internal strategizing, we broke down the liquidity story into two distinctly different sessions – one focused on metrics and the other on implications. This reflects our collective view that this debate needs to be better grounded in an empirically verifiable construct. Only then can we tell if, and when, the liquidity cycle is likely to turn.
Despite our noble intentions, we did not come up with a unique definition of a measurable gauge of global liquidity. We recognized that there are both quantity and price dimensions to the story – with the former including a combined measure of money and credit, derivatives, and foreign exchange reserves and the latter a hybrid measure of inflation-adjusted policy rates and spreads – both within yield curves as well as across borders and between assets. We also felt that price metrics were more appropriate barometers of liquidity in developed markets, whereas quantity metrics might be more applicable in emerging markets. The trick, of course, is to put all these diverse pieces together in the form of a single gauge of global liquidity. For us, this is work in progress. But that conclusion, in and of itself, points to a powerful insight into the state of the global liquidity cycle: In a world of incremental shifts in the inflationary underpinnings of monetary policy and asset prices, macro conclusions on liquidity are likely to be more subjective than objective.
On that basis, the MacroVision assessment of the state of global liquidity gives an unequivocal green light for financial markers and for increasingly asset-dependent economies around the world. We don’t believe in the “coincidence of fundamentals” that would justify rock-bottom spreads in a variety of very different risky asset classes. Nor do we think it’s an accident that such a powerful risk appetite would occur at the same time that volatility has plunged in traditional equity, bond, and currency markets. These are all very visible manifestations of the powerful correlations of a liquidity-driven risk-extension trade – by far the most awesome force at work in world financial markets today. The MacroVision consensus was convinced that this was likely to remain the operative outcome over the course of this year.
Global economic trends: commodities
There was broad agreement on the other two topics as well – commodities and protectionism. The MacroVision consensus viewed the commodity super-cycle as largely intact and felt fears of protectionism were overblown. Our discussions were quick to unmask the most important assumption that both of these debates had in common – a bet on the irreversible mega-trend of globalisation. This was identical to the conclusion that came out of our Lyford Cay discussions a couple of months ago. With nothing likely to stop globalisation, went the argument, the MacroVision consensus was virtually unanimous in conceding that there was no risk of protectionism currently embedded in the price of financial assets. In that case, of course, an adverse shift in trade policies could deal the markets a very serious blow.
Globalisation was also viewed as the glue that would push commodity prices to higher highs and even push predictable dips to higher lows – validating the basic premises of the ever-popular super-cycle. Differentiation was stressed, however, as we probed deeper into the commodity story. The group believed that an important mix shift could occur over the next year, with gains moving away from oil and other hard commodities such as metals into the softer agricultural commodities. Corn and water came up as the most interesting soft commodity plays – the former for its connections to alternative sources of energy (i.e., ethanol) and the latter as a potential bottleneck to globalisation.
The MacroVision consensus has a pretty good track record. In last year’s sessions, both our internal and client groups were on the right side of a generally bullish bond market, while our client consensus was very accurate in its prognoses of oil prices and US equities. While both groups nailed the further deterioration in the US current account deficit, they missed the understandably tricky currency connections – failing to appreciate the strength of the euro and the weakness of the yen. But the MacroVision 2006 consensus was spot on in picking the best-performing asset class – emerging market equities.
Looking out over 2007, both our internal and client groups are in fairly tight agreement. Interest rates – both short and long – as well as currencies and oil prices are expected to remain in relatively narrow ranges, and a modest widening in credit spreads is anticipated. But, as noted above, the staying power of the all-powerful liquidity cycle is expected to contain any damage. This is viewed as a distinct positive for equities – especially the outlook for US stocks. Indeed, almost half the clients picked the S&P 500 as the best-performing asset over the next 12 months – nearly double the second choice, emerging-market equities. In this instance, our clients were far more optimistic than our internal macro practitioners – who looked for the US market to fluctuate around present levels.
Global economic trends: protectionism
I remain very much on the other side of most of these bets but have to concede the power of the liquidity-driven conclusion to many of the arguments – especially in light of the low-inflation conclusion that remains central to my own baseline case for the world. Even so, I fear the MacroVision and the market consensus is far too sanguine on the globalisation debate – presuming that market forces can forever continue to trump political pressures. As I have stressed for several months, I suspect a pro-labor shift to the political Left in many major countries of the developed world is likely to be a much bigger deal than most suspect. Don’t get me wrong: I would not characterize my baseline macro view as an anti-globalisation bet. I just think the political factor is likely to be increasingly important in translating this into a two-way debate – a risky possibility for markets that have made a one-way bet on globalisation.
At the same time, I also believe that China is serious in its current cooling-off campaign. I expect it to be surprisingly successful in slowing down an overheated – and commodity-intensive – investment sector. If I’m right, that could prove to have far more challenging implications for the demand side of the commodity super-cycle than most expect.
In the end, the excesses of the liquidity cycle remain the rising tide that lifts all boats. As I conceded recently, absent a meaningful turn in the liquidity cycle, I suspect the markets will continue to trade away from the stresses and strains implied by my global rebalancing call (see my 16 January dispatch, “The Growth Machine”). In the parlance of MacroVision 2007, my concerns have all but been banished to the remote confines on the ever-distant tail of the markets’ probability distribution. All alone in a foolproof macro climate – a crotchety bear could hardly ask for more.
By Stephen Roach, global economist at Morgan Stanley, as first published on Morgan Stanley’s Global Economic Forum