September has not been kind to Japan. Prime Minister Shinzo Abe resigned after less than a year in office. The economy contracted in the second quarter. Its corporations are beginning to cut back on capital spending after having vigorously added to capacity in the last three to four years. Households have steadfastly refused to boost spending as labour incomes have stagnated or even regressed. Japan looks set to travel back into the 1990s with higher public spending to stimulate demand, low interest rates and a weak currency.
The clouds that have gathered over Japan’s economy have implications for global rebalancing of demand. At the beginning of the year, it was expected that both Japan and Eurozone would be able to assume the mantle of growth, allowing the American economic and import growth to moderate and the current account deficit to come down. Those hopes are about to be dashed now. Japan’s slide is all too evident. In Eurozone, while data are yet to reveal a convincing turn for the worse, growth forecasts are being revised down.
The baton passes back to the US. As it did in 1998 and then again in 2001-02, would America reflate its own economy for the sake of keeping global growth going? If it chooses to do so by lowering interest rates aggressively, the Federal Reserve would be encouraging American households to take on more debt when the expansion of household balance sheets in the last several years has been the cause of the current troubles in the global financial and credit markets.
If American households oblige, then the current account deficit that has shown signs of stabilizing at least as a ratio of GDP, would start to expand again, nominally, and as a share of GDP. It currently stands at slightly below $800 billion. It would exceed a trillion US dollars, then.
The American dollar would begin to depreciate against other currencies at an accelerated pace. Other countries may not acquiesce readily. Currency wars loom large. Further, an expansion of America’s current account deficit would require that other countries remain willing to accumulate dollar reserves on top of the vast pile that they are holding, and that, too, when the US dollar enters into an accelerated depreciation mode. It would also require China to continue to travel down its current disastrous path of economic management of relying on export-led growth, which, in turn, requires a competitive exchange rate, low interest rates and hence tolerance of an already bloated equity and property markets. With trepidation, they are trying to reverse this in agonizingly slow motion. China pushed up interest rates on Friday, while the Federal Reserve is under pressure to ease on Tuesday.
Globally, a successful reflation of the US economy through lower interest rates would entail a permanently high price for crude oil—more than $70 per barrel—and further increases in the price of food, as both income and substitution effects (biofuels) ensure tight demand-supply balance of foodgrains. The price of wheat scaled an unprecedented $9 per bushel last week.
Successful economic reflation in the US would permanently let the inflation genie out of the bottle and that would see central banks scramble to resume their interest rate tightening campaign soon. That is what at least the Federal Reserve did in 1987. Interest rates came down from October 1987 up to February 1988, and began to rise thereafter. Unsurprisingly, stock markets slumped. From the beginning of October 1987 and up to the end of 1990, the S&P 500 stock index lost 6% of its value cumulatively. Most Asian indices did worse.
If all of this sounds too difficult to imagine, then let us visualize the other scenario—the American consumer refuses to play ball with the Federal Reserve even if the latter slashed interest rates aggressively. Then, all the liquidity created by the Federal Reserve would have to find its way somewhere.
Now the belief is that emerging market equities would fit the bill. That is why even as the West grappled with the failure of a mortgage lender in the UK, most Asian bourses scaled new highs. But if the American consumer does not grab the bait of low interest rates and spends again, then the Asian macro-economic story would run into rough weather with adverse consequences for corporate earnings.
Further, while capital inflows could be positive for equities and real estate for a while, it would cause the already bloated emerging currencies to appreciate further and cause overheating in the economy. Central banks would have to resort to a combination of orthodox and unorthodox tightening measures. The initial surge in valuation would prove to be unsustainable.
Therefore, regardless of whether America succeeds in reflating its economy or not, the consequences are uncertain and mostly adverse for emerging market equities. Valuations do not reflect these risks currently and offer investors an opportunity to exit with their gains intact.
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