In the wake of the discount rate cut by the Federal Reserve on 17 August, Asian stock markets staged an impressive recovery last week. Just as drug addicts deprived of their daily shot when they run out of money treat themselves with more than one shot when they find some money, investors have grabbed Asian stocks with both hands and more. This hunger for Asian stocks will result in indigestion, eventually. Some historical perspective would help investors.
In the 1990s, China exported deflation to the rest of the world by becoming the centre for global manufacturing. The West, trying to opportunistically lower inflation, welcomed it. Import prices came down dramatically everywhere. The declining price of crude oil added its own deflationary weight to this mix. That is why, when the technology, media and telecom bubble melted in the US and Europe, central bankers’ fears were about deflation. They eased aggressively—some early, some late—and they kept rates low for long. They were willing to take the risk of allowing some inflation back into the system. Soon, the pendulum began to swing the other way.
Crude oil prices began to rise from a combination of war, political tensions in West Asia, rising demand and supply discipline. Strong global growth revived prices of industrial metals, which boomed. With each year of strong growth, capacity utilization edged up globally and all raw material prices began to climb. China thus began to export inflation, indirectly. It is about to do so more directly now that its inflation rate has climbed to nearly 6% from around 1% a year ago.
The US, which had put monetary policy on hold in 2006 but was keeping its finger on the trigger for another rate hike, has been forced to take its hand off the trigger because Wall Street has just sent a bill to the Main Street and policymakers are paying up. Politicians would see to it that they pay a lot more. In America, capitalists have rigged the system effectively in their favour. David Walker, the comptroller general of the country, warns darkly of the threat of the US going the way of the Roman Empire. Perhaps I am digressing.
Even as the central bank is busy providing liquidity and cutting interest rates, inflation ghosts are not about to disappear soon. Commodity prices have resumed their uptrend. Wheat prices are at a 20-year high and crude oil is firmly ensconced above $70 per barrel. Monetary policy contradictions might soon reappear in the US. That is what happened in 1987. After the infamous October 1987 crash, the federal funds rate was lowered from 7.25% to 6.5% by February 1988. Soon, within six months, the rate was rising. In the middle of the super-bull market between 1982 and 1999, the S&P 500 delivered a princely annual return of just over 4% from September 1987 to end-1994. Adjusted for inflation, the real returns were actually negative.
Asia fared little better. Between October 1987 and December 1990, the Hang Seng index returned -30.0%, the Singapore Straits Times index, -15.0% and Taiwan weighted index, -33.0%. Only Korea’s KOSPI gave positive 40.0% returns. With the exception of Japan, Asian stocks began to rally in 1991, up to end-1993. But, that was because it was preceded by a three-year drought. After a five-year feast of returns, famine awaits Asian investors, as not just the US but China, too, will be complicating matters for them.
In China, monetary policymakers had to put on hold even token attempts at tightening on seeing the inflation rate climb to 5.6% because the US had successfully exported its structured finance and alphabetical viruses all over the globe. Initially, we were told that Chinese banks were not infected. Mea culpa followed reluctantly last week. It is just the first instalment of confessions.
So, China held back from tightening monetary policy and came up with a clever plan to export its stock price bubble. It allowed its residents to buy foreign shares, including H-shares in Hong Kong. The Hang Seng index, at one stage, had surged 3,000 points from the intraday low on 17 August to an intraday high on Tuesday (21 August) morning. This was insanity at its best (or, worst?).
Economic theory has taught us that developed countries would export technology and capital while developing countries would export raw material and consumer goods. Instead, the US exported its housing bubble and consequent troubles to the other (China) and the other is now exporting its bubble to Hong Kong and, through that, to the rest of Asia and the world. It would be soon exporting its inflation as well.
When economic policy in two of the world’s biggest economies is geared towards propping up asset prices and ponzi schemes, the end result would likely be disastrous. It would not hurt investors to be afraid.
V. Anantha Nageswaran is head, investment research, Bank Julius Baer & Co. Ltd in Singapore.These are his personal views and do not represent those of his employer. Your comments are welcome at firstname.lastname@example.org