Bernanke and the Butterfly January 26, 2008
Health Warning:
I’ve been trying to think laterally lately – I’m on a 16 hour flight from Hong Kong to New York so I have enough time and there is little else to do. So I began dreaming up the controversial, the contrarian even the conspiratory. So now I’ve warned you, I’m not lambasting any group or ideology, just putting it out there as something tangential, which is designed to provoke thought, and nothing more. While this is perhaps the least accurate and perhaps most irrelevant thing I’ve conceptualized, it has been by far the most enjoyable to write. You may need to apply a Da Vinci Code-like imagination for this one, I hope you enjoy reading (please forgive my disjointed flow, repetitiveness and poor editing – I needed to get this out quickly as we’re in an environment where ideas are fast becoming dated!).
It started in Berlin
It is said that, by the fleeting power of consequence, a butterfly flapping its wings can, over time, conceivably create a hurricane on the other side of the World. The notion that something small can have huge repercussions in shaping something big is a powerful concept: we’ve come to call this “The Butterfly Effect”. Indeed, as one looks back over one’s lifetime, it causes one to wonder how things began, what were the proverbial butterfly-flutters that sparked the changes?
Could it be that, what started as just a glint in Gorbachov’s eye, evolved into Perestroika which, with the cooperation of far-sighted Western Leaders, led to perhaps the most captivating single political event of my lifetime: the fall of the Berlin Wall? The most daunting symbol of the Iron Curtain was destroyed and, with it, this book-marked the beginning of the end of The Cold War.
The Cold War was a World War, The Third World War, in many respects. This was not just about a couple of titanic superpowers engaged in an Arms Race for the sake of flexing their military muscles. For instance, over time, the repercussions of The Cold War snaked their way through the entire global economic system. Whether you were a city boy in London, a peasant farmer in Afghanistan or a government official in Korea, The Cold War was a true World War in the sense that it entrenched deep political divisions throughout the World and seemed to polarize the entire population of the Planet. Previously allied states, which shared prosperous and harmonious histories, were suddenly not on speaking terms and giving each other the Cold War Shoulder. The Barriers went up not just physically but culturally as well – in many instances even within countries and occasionally (as was the case in Berlin) the butterfly effects of fear, misunderstanding and animosity segregated neighborhoods within the same town and even families.
While the politicians and bureaucrats were in global gridlock, economic activity was always going to be constricted to a level significantly below its potential. The progression of raising global living standards suffered as a consequence and, as we are often made aware of, it was the people at the bottom of the pyramid, throughout the World, who probably had to bear the brunt of the distress. While occasionally appearing deceptively inactive to the masses, this latent war was, indeed, a silent killer in so much as is held back the rate of promotion of: more constructive symbiotic international politicking, free cross-border trade and so the obvious benefits of a well-lubricated global and international economic system, a phenomenon which we’ve come to know today as “globalization”.
Where am I going, what has this got to do with Investing?
Well, let’s just take one tiny step back…
The Dawn of a New Era
1987 saw the introduction of a bright, new Federal Reserve Chairman called Alan Greenspan, who immediately bolstered his credentials as a crisis manager during the great market crash in the latter half of that year. While this may have been (so far!) the most dramatic market correction of my lifetime, Greenspan stepped up to the plate to manage the situation. By making sure that the Financial System could still operate, despite the cataclysmic losses incurred by many, confidence was swiftly assured and the financial markets got back to doing what they do best: promoting ideas, sponsoring ingenious entrepreneurialism and occasionally letting poor companies fall, “creative creation with creative destruction”, I like to call it. This was central banking at its best and, here, Greenspan was at his most effective.
During the three decades after the 1989 collapse of The Iron Curtain, the global economy has experienced unprecedented growth and remarkably benign inflation – albeit with a few hiccups along the way. But let us get one thing straight: while Greenspan deserves enormous credit for his management of the economy during the late 80’s, he did not bring down The Iron Curtain – the timing of the end of the Cold War was coincidental to the beginning of his tenure!
While much of the symbolism was occurring in Berlin, the economic effects were not only felt in Germany (or the US or USSR for that matter), indeed, there were far-reaching implications all over the World. The Barriers came down almost overnight, and so, with it, came the reversal of all the economic potential which had been held back in restraint during decades of political stalemates and frictional, trade-less stand-offs. The fall of The Iron Curtain opened the proverbial floodgate for free trade and it was here that the seeds of Globalization were sown.
The Evolution of Globalization
As we entered the 1990’s, the World seemed destined for a new era of prosperity and growth and nothing was going to stop us. I was only 13 years old when Greenspan began his tenure as the Chairman of the Fed and I was more interested in skateboards when The Iron Curtain came down, so you’ll excuse me if my recollection is a bit hazy. But, whether one agrees with my perception of the effects of these historic events or not, one cannot deny this: the build-up of tension as a result from The Cold War was a forceful, yet gradual, tectonic process. When that ended it was (relatively) very sudden and that released the pressure-valve on international and cross-border economic activity which was the precursor to the amazing growth and benign inflation that we have been experiencing for the past two decades. I’m not saying that central bankers did not have their role to play in the 1990’s, I’m just saying they were sailing with a significant tailwind. Times were good, and, as they say, a rising tide lifts all boats – this was the birth of globalization. There were massive global economic, sociological and political forces at play all working in the same direction: an unprecedented display of global economic harmony which would dwarf the reach and power of any single nation or institution and, in particular, any single person – even Greenspan. This was the dawn of inflation-free growth (everything is relative, of course!).
But this was just the foundation, just the beginning. Throw in the greatest gleaming innovation of this era a little something called, The Internet, and mix it with the backdrop of post Cold War optimism and you have globalization on steroids. And in many senses the stock market rally we experienced in the first half of the 90’s was entirely justified. There was genuine reason to believe we were in a new era, “this time it was different”.
Fantastic! The Global Economy had a double whammy, we had our cake and, by golly, we were eating it. Not one, but two massive forces working: demographically, socially, politically and economically to simultaneously elevate business and innovation and GROWTH higher while pushing poverty, unemployment and INFLATION lower. Yes I’m simplifying a lot, to get my point across about the change in sentiment, but at times it almost seemed that, no matter who or where you were in the World, life was getting better – for businesses, workers and consumers alike. But wait, just when we thought things were too good to be true, welcome the third contributor to the party: the emergence of the Emerging Market Economies – especially the BRICs and China-related economies. Suddenly, a new era of optimism and healthy growth gave way to a feeding frenzy among consumers and a spiral of euphoric optimism among the financial think tanks, business leaders and media pundits. Not only that, we all co-habit what is commonly regarded as “The Global Village”, synergies could be worked within the system. Cue: the massive Labor Arbitrage between the consumers (The Western Economies) and the producers (the then Emerging Market Economies – especially Asia).
The tidal wave of products, services, materials, opportunities flowing out of Asia was, not only contributing greatly to global growth, it too enhanced the tailwind of disinflation that Globalization was already providing. Not only were these (now three) phenomena a gigantic influence on the supply side of the equation, the surge of optimism and the spawn of an easy monetary policy style (“The Greenspan Put”, as it had come to be known), stoked confidence in The West to hysteric consumption patterns. By the turn of the century, we had grown intoxicated on our own potent cocktail of inflation-risk-free growth to the point that Greenspan himself (now, widely dubbed by the growing band of investment groupies and media junkies as “The Maestro”) called for an end to the “irrational exuberance” of asset price inflation. Alas, that was the last we ever saw of Greenspan’s attempts to diffuse bubbles and asset prices.
Credit Only Where it is Due
Greenspan deserves only a fraction of the credit he gets for keeping inflation under control and stimulating growth for the past twenty years. It is quite likely that low inflation, globalization and higher growth would have presided irrespective of who was at the helm of the Central Bank for the last quarter of a century. In fact, by over-use of the Greenspan Put, our “Maestro” encouraged confidence to give way to complacency.
Well, that is all water under the bridge, as they say, it is history. We find ourselves in a brave new World. The economies commonly referred to as the BRICs are no longer emerging they have emerged into titans, consuming, reforming and growing on a scale and pace never seen since the emergence of the great American economy, nearly a century ago. Never-more is this exemplified than in our observation of the Middle Kingdom of Asia. While China contributes greatly to global economic GDP growth, the sheer volume of production, pace of change and the stage of its development cycle, means that China is no longer a deflationary influence on Global prices. The tailwind for the policy makers and central bankers in The West has gone, in fact the tailwind may now have given way to a headwind – the BRICs are, if anything, exerting inflationary influence on the Global Village (see Morgan Stanley’s piece on this from a few weeks back). The job of a central banker is now more difficult now than it has been since Volcker, in my opinion. This was always going to be a difficult transitional stage of the cycle to manage, but it was not made any easier by the ill-disciplined policies of our central bankers during the “Wonder Years”, which started just after the fall of The Iron Curtain. Due to a bubble-happy predecessor, our current Fed Chairman, Ben Bernanke, faces, not only external inflationary forces, but the consequences of the last bubble(s), a Sub Prime Crisis and, apparently, a precipitous decay in economic growth rate and consumer confidence. A butterfly flapped its wings in 1987 but now, two decades later, it caused a hurricane all over the World.
Blame Only Where it is Due
People talk about the current Fed being behind the curve. I agree, the Fed is behind the curve, because the Fed simply has no choice. Pause for a moment to imagine the consequences of a dramatic pre-emptive (or “ahead of the curve” , as some call it) cut in the Fed Funds Rate, only then to be confronted with economic data showing a “head-fake” for imminent recession and, instead, sparking an inflationary super-spike at the expense of the US? They would likely have the humiliating task of needing to raise rates dramatically directly after they had just over-zealously slashed them. The credibility of the Federal Reserve would evaporate. While the probabilities of this may be lower, the risks to the economy and the Fed (confidence/credibility) are far higher. No, Bernanke’s hands are tied, he must wait either for significantly slower growth to be baked into the cake or for problems in the banking system to reach an obvious risk-equilibrium before he can take action, or risk destroying the last threads of credibility that the Central Bank still has. Gentle Ben has been handed the unenviable task of weaning a complacent market off the Greenspan Put in a, now “high-inflation-risk” part of the globalization cycle, and there is zero margin for error. He’s not perfect, but, so far, he has done little wrong, given the information available at hand at the time. It’s worth reminding ourselves that it is not the Fed’s job to prevent recession, it is to manage long term inflation (and therefore present inflation expectations) and nurture long term employment and with it economic growth. I hear talk of recession now as if it were something we should never have to experience, ever. Perhaps this was Greenspan’s vision, a safety net for failing, weak and inefficient businesses. Nobody should be allowed to suffer the consequences of the natural business cycle. But yet this form of Financial Socialism has a tendency to expunge the natural existence of, what I call, the “darwinistic alpha” normally prevalent in a purer capitalist system, thus the notion of “creative creation with creative destruction”, becomes compromised.
The demise of the dollar is another of the many factors creating a real problem for Gentle Ben. Every time he even considers adopting Greenspan-esque policies, like a pre-emptive move to slash rates, this leads to another down-leg in the dollar, not only against other currencies, but against commodities, in particular oil. Many manufacturing and service industries, in which American businesses used to indulge, simply cannot compete with their foreign counterparts who, despite their groundbreaking growth, are still enjoying a healthy labor arbitrage gap. Consumers have entered an age of complacent indebtedness, induced by a fatal courtship of irrational consumption and irresponsible lending – which started at the top, at the Federal Reserve. This is never more apparent than the predicament of the modern mortgage market. As a result, the consumption-based economy in the US is now highly influenced by the price of imports. A weaker dollar has significantly more inflationary influence than it had in a more balanced economy with, say, a saving cushion or less onerous deficit. This is not the same “pleasant” wage-induced inflation one experiences in a country basking in the glory of organic growth. This is painful inflation, real disposable income is falling, we’re getting poorer. Additionally, as commodities like oil are priced in US dollars, this has direct inflationary follow-thru on the cost of living – in the form of higher fuel prices and everything else that goes along with expensive petroleum. In the same way that a bloke with a hangover is more sensitive to loud noises or a chap in a Californian china shop is more aware of earth tremors, a highly leveraged household is more sensitive to inflationary swings and (more importantly) more likely to react with volatile inflationary expectations. The inflationary threat is not a fabrication, it is real. The Fed must tread carefully.
Where Now?
As I’ve already mentioned, the BRICs have gone from exerting a deflationary tailwind to an inflationary minefield for Western Central Bankers. What is perhaps more relevant, this inflation-gust was an entirely justifiable and natural part of the cyclical process of a maturing globalization phenomenon – that is, I think this could (and should) have been predicted and, therefore managed earlier in the development phase of the globalization cycle. Bernanke has little to gain by preemptively slashing rates to within a whisker of zero and saying. “See? I told you so…” as the inflation (or worse, stagflation) counterpunch liquidates the economy before our eyes. Like some unfortunate circus chimpanzee, he is forced to walk the tightrope act that has been laid before him, and, consequently, the Fed frequently comes across as though it is dithering or being indecisive. You think they don’t know this? They do, they simply have no choice.
Everyone needs a scapegoat even me (especially me!), but I think there is a general feeling of disdain towards the US economic predicament, the Fed and, in particular Ben Bernanke, which is overblown. I’d hesitate before underestimating the dexterity of the US economy, the power and speed of American entrepreneurialism and also the creativity and intelligence of staff at the current Federal Reserve. I still have a bit of faith in you Ben, thousands wouldn’t, but the challenges you’ve been presented with are so daunting it is quite staggering.
As a side note, I do believe that, given the “choice” of inflation over deflation, the Fed has to and will try to choose inflation or risk a prolonged, Japan-style slump. The reason is quite straight forward: Central Banks have the tools and a proven track record for fighting inflation, but not deflation – Bernanke himself alluded to this in great style, the best cure is prevention. Never-the-less, while the current Fed has a chairman has a great reputation as a deflation fighter/preventer/historian, he has yet to prove his inflation-fighting credentials. Inviting inflation, therefore, is a bit like playing with fire. Perhaps, then, with high deficits, a Greenspan-ized consumer balance sheet and with the acceptance that the US was always going to choose inflation risk over deflation risk, we could argue that Bernanke may be the wrong man for the job. But, like I said, I think the Fed, as an institution (it’s not all about Bernanke), has had very little choice in it’s actions thus far, or rather, there was a very fine line of actions that the Fed could have taken. I’ll admit, Bernanke’s communication-style is decidedly…errrmmm…“different”, but, while they may have walked gingerly, they have not put much of a foot wrong – at least as far as their collective decision-making is concerned … SO FAR!
So please, go easy on Bernanke, he’s not the most eloquent man on the Earth, he may not even be the best man for the job, but perhaps one day good fortune will grant him the opportunity to stand face-to-face with his predecessor and say, in the famous lyrics of Alanis Morrisette: “…I’m just here to remind you, of the mess you left when you went away…”
To Couple or Not to Couple – That is The Question
So to the next great debate: Asia and the Great Decoupling Thesis. Firstly, we need to define decoupling, there are two types:
- The decoupling of the financial markets – commonly (and therefore narrow-mindedly) measured solely on the performance of equity markets.
- The decoupling of the economies – commonly (and therefore narrow-mindedly) measured solely on national GDP growth figures.
The two definitions, it seems, are used interchangeably when best it suits the prognosticator. The “experts” who point to the fact that the Shanghai Index is up more than the S&P, in the face of eroding export growth as a sure sign that we have already dispelled the coupling myth are hopelessly misguided. You may talk about out-performance or volatility in this context, but this is not even correct to show the relative out-performance of one equity market over another as conclusive evidence of decoupling at work. Finally, even in our frictionless and wonderfully lubricated Global Economic Machine, there is always a significant lag to the reaction of one economy to another, especially when looking at the coupling of GDP growth, but it is even true when observing the coupling of the financial markets. This is an essential consideration when observing relatively closed markets like China or even India – to an extent. Hong Kong is, after all, 8,000 miles from New York (according to my “Skymap” on this Cathay Pacific flight!), so, one can imagine, it takes a while for the “butterfly flap” on foreclosed home in Florida to be heard on a Chinese semiconductor assembly-line in Guandong. My views on this are known, I cannot put it any clearer than Paul Donovan of UBS’s global economic research team:
“…export growth is going to slow in every major economy in the World [including China] and that has growth implications…”
UBS revised their forecast for global growth for 2008 down again from 4.3% to 3.6%, compared to what we’ve been used, to that is pittance.
I think the expansion of China is a juggernaut with momentum which is both hard to express in these words and clearly hard for the government to contain. There is little doubt in my mind that China will eventually evolve into a major economic power which will effectively see it decouple from the trajectories of Western Economies, but I think not yet. There is some chance that China will decouple from the US today, but it is far from as inevitable as the average Chinese equity salesperson would have you believe. China’s export-centric growth (not GDP composition) and export-centric employment will suffer as, one by one, manufacturing-related industries are called on their, already razor-thin, profit margins. This would be a direct decoupling, but lately I’ve been thinking, what about indirect decoupling or decoupling through the back door? Not margin depreciation directly from top line erosion via export weakness, but through the credit markets and cost of capital – have you witnessed the state of the Asian Credit Markets today? How many CDSs, that were trading only a couple of months ago, are simply nowhere to be seen now? How many US dollars worth of Asian deals have been pulled in the past 6 weeks alone? This is an indirect consequence of the Mortgage Meltdown we are seeing in The West. I’ve not even spoken about the consequences for participants of the great carry trade, perhaps that’s for another discussion.
Assumptions to The Coupling Theory
So, looking at the coupling of the financial markets now for a change (not the respective economies, as I normally do), let’s say, for arguments sake, that it is probable that the Asian Markets will not decouple from the US, as measured by the equity market trends – we’ll give it a 55% probability. And we’ll give quite a high probability to decoupling of the Asian markets if the US continues to follow a bear market trend – say, 35%. Surprising perhaps, but I think it’s certainly, a closer call than many think. But, instinctively, as a mathematically-minded chap, and under my moral obligation as an investor, I am compelled to address all probabilities and all outcomes. You will notice that the above probabilities do not add up to 1, there is another possibility: that China decouples from the US, but in a way which nobody expects. What if the US markets show resilience and the Shanghai Indices continues to deteriorate? What if the Fed continues to get it just right and, while we may dip into a quarter of near-zero or negative growth, this, by definition, would not necessarily herald a bone-crushing recession. What if we somehow work through the woes of Sub Prime and the US economy resumes a sure footing? What if the dollar snaps back to 1.30? What if, as history has shown, by contagion, European suffers a far harsher fate than their counterparts across the Atlantic? Is it inconceivable that under the brutality of a global slowdown, dollar-denominated assets – including US equities – may be considered as a safe haven among investors?
That’s all very well, I hear you say, but that is only one side of the equation, the thought of Chinese shares trading down while US stocks remain supported is unfathomable. Well, that is a fair point, which is why I only attach 10% to this outcome. But 10% makes it still significant, in my eyes. The argument for the sustainability of Chinese growth (and thus equity valuations) is argued on many levels, all of them accurate, let’s categorize some of them into 5 general theses:
Thesis 1: China is a closed economy. The central government effectively has a strong hand in controlling everything, including Chinese asset prices like land and equity prices. So, one cannot apply normal free-market assumptions to the valuation of asset prices, the trajectory of growth, the risks of non-performing loans, or even basic consumption patterns.
Thesis 2: stability is King – super-high growth is a perfect distraction for achieving courageous and ambitious (and frequently controversial) long term objectives. While there are huge social and economic imbalances within China, these are dwarfed by the phenomenal economic growth and overall rate of increase in living standards China has cultivated. The opportunity for prosperity has distracted questioning (political) movements from gaining traction. China’s vision is extremely far-sighted and its goals are long term. China has shown that it is perfectly capable of enduring, or even engineering, short term corrections for the pursuit of stability and achieving long term objectives.
Thesis 3: even in a consumption-led global recession, China will engineer a great transition. With huge economic surpluses and internal social and economic imbalances, China will shift its export-centric, manufacturing labor-base to embark on a massive infrastructure boom. This will smooth over any effects of a global slowdown within China.
Thesis 4: the Olympics effect cultivates domestic optimist which often makes markets trade up into the event, although, granted, there is often a bit of an “Olympic Hangover” in subsequent quarters.
Thesis 5: if anything overheating and inflation are growing concerns in China, China needs a more efficient method of fighting inflation than trying to directly control household goods with price caps. A significant revaluation of the Rmb is generally regarded as the most effective way of dealing with these problems.
This does not present the case for an imminent Chinese downside decouple in a very positive light. But, we’re in the realm of creative thinking here so let me just play devil’s advocate and ask: what if the markets act in a way that catches everybody off guard? Who was it that said that the markets try to make a fool of as many participants as possible? This would be a perfect opportunity to test the hypothesis.
Every Dollar has its Day
OK, let us start with the notion that the US dollar may indeed be oversold. We recognize that in a global recession the dollar is often a safe haven among its counterparts – especially if the Fed continues its deft tightrope walk and people regain confidence in their ability to steer the economy through the rough patch. I, for one, think that The Street underestimates the character and intelligence of the new Federal Reserve, under Ben Bernanke. Sentiment may turn the corner as the market sees the proverbial light a the end of the tunnel: that the challenges facing the US economy will eventually be overcome.
Foreign exchange is, after all, a relative value game; if you think Europe and Japan (the next biggest economies and consumers on the planet) are immune from a US recession, think again. If anything the existing growth-famine and deflationary tendencies of Japan and the still onerous labor laws and fractional politics in Europe would make these, highly US-centric, US-exporting, economies perhaps more susceptible to a global consumption recession than anybody else! European and Japanese policy makers would have no choice but to take measures which risk devaluing their respective currencies relative to the dollar (in the case of Japan perhaps directly so with intervention) – it’s worth noting that the housing markets in parts of Europe are considered to be just as overvalued as the US (especially now, after a painful correction in The States) and unemployment in Europe is considerably higher. Japan is perhaps the only economy of size which has experienced pathetically anemic growth over the past decade, the fragility of Japan’s recovery is there for all to see. These economies are far from “healthy” or “robust” in my opinion, so it is indeed quite possible for the Euro and Yen to fall against the dollar in 2008.
As investors develop a taste for dollar-denominated assets once more, it is not inconceivable that the yen-dollar carry trade and petro-dollar virtuous cycle are picked up with renewed vigor. We may observe the widespread purchase of treasuries, the foreign acquisition of American property and large strategic equity stakes in US bell-weathers …hang on, are we not seeing this already? Sovereign Wealth Funds are not in the game of bottom-ticking markets, but they have an uncanny ability to make impressive long-term returns on assets they purchase. Suddenly, the risk-reward profile of owning an American stock may not be as bad as its foreign counterparts. We cannot rule out the possibility that the US may sneeze and the rest of the World will catch a cold, which may result in US equities outperforming, or even rising, certainly in dollar-neutral terms, while other markets, even China, are left languishing.
The Conspiracy Theory
China is trying to achieve something unique, something that we’ve never seen before. Kenny, our new Chinese Analyst, and I do not even know what to call it: Leninist Capitalism, Merchantilist Corporatism. I dunno, who cares. It is working – that is all that matters. But one thing I’m sure of, Chinese bureaucrats are acutely aware of the role capitalism can play, even in a rigidly centralized political system, both from the perspective of creative creation (entrepreneurialism, innovation, efficiencies) and creative destruction (most notably in the financial markets). Is it therefore inconceivable that China could encourage, nay even engineer the induction of, a pause or a correction? We know they are openly encouraging a slowdown of growth. The measures they have taken in the real estate markets and banking reserve requirements point directly to an attempt to slow the economy. When government officials, who are normally very careful in choosing their words with respect to the financial system, unexpectedly warn about the effects of falling equity prices on retail investors – are they actually trying to tell us something? When high-level officials announce just this week that they will take assertive measures to ensure a more “effective” equity market during a global market correction, it makes you wonder – are we missing something?
If you subscribe to the notion that China cannot hinder the rise of share prices, it is a “free-market”, then you are in direct conflict with founding decoupling Thesis 1. Additionally, we know that, in the interests of long-term stability and long-term growth, we occasionally need to sacrifice the short term. A mountaineer does not stride to the peak of Everest in one long march, but rather rests, setting up camps, recharging and occasionally even descending before completing the next stage. Similarly, when managing overwhelming growth in the World’s most populous nation, even as a centrally-planned government operating in a capitalistic grass-roots economy, it is a naturally cyclical business. The role of the government may not be to fight the natural cycle, but rather to aid it, in both directions – creative creation and creative destruction.
By decoupling Thesis 2, we understand that long term growth and long term stability is the name of the game. So far, breakneck growth has been a timely distraction to the socio-economic imbalances and political problems this has surfaced. This imbalance can be addressed from both sides: firstly by allowing the asset prices of the relatively prosperous to correct (equities and coastal and city property prices), and also by building far-reaching infrastructure into impoverished areas. As the wealth gap closes, political stability may return to distant, fractional communities. While the wealthy have a certain amount of power, this is still China and this is still communism. Besides, I think if stocks rally 300% and then give back 50% of their gains their wining will fall on deaf ears – this may not be such a devastating outcome, in a communist country with a very high savings rate and comparatively little consumer leverage.
Recent Olympics have occurred in free-market economies and what we’ve often observed are periods of buoyant domestic economic optimism. To some degree this is understandable, but then only to be followed by an “Olympic Hangover” the following year. But by Thesis 1, China is not a free-market economy and can easily engineer a sustained growth trend even after the Olympics. But Thesis 1 also implies that China could theoretically also engineer a slowdown or even correction in financial markets during an Olympic year – that is; begin assertively slowing down the economy and resetting the cycle of asset prices before the Olympics. After all, not only is this compliant with Thesis 1, it also embraces Thesis 2. While Thesis 2 shows that distraction provides important protection for the government to employ controversial and highly ambitious macro reforms, what could be more distracting to a slowing economy than an exhibition of the largest, most impressive, sporting showcase known to man? OK, now let’s get this straight, I know this is far-fetched, but I’m not ambitious enough to say that China will use the Olympics as a screen of deception to go out and bash the market. I’m just saying that, just because it is an Olympic year, I would not bet on Chinese Economic Planners putting their entire economic commitment on hold. 2008 is a year like any other in this respect, and it could be a year we could see big changes, not all of them necessarily resulting in higher equity prices in Shanghai.
In Conclusion
Putting all this together: what’s to stop us seeing a large revaluation in the Rmb in 2008 (Thesis 5) as inflation risks rise and the Global Economy stalls. With its far-reaching, centralized control (Leninist Corporatism) China could “engineer” (Thesis 1) some creative cyclicality in the low-margin, export reliant manufacturing sector, straining under the heavy burden of over-capacity. China can transition its economy and hungry, swelling labor force quickly into an introverted infrastructure-driven economy for a while (Thesis 3). Perhaps even, by playing into the hands of the Olympic effect (Thesis 4) there will be more than enough distraction (Thesis 2) for the restless masses as it smooths-over the great transition (Thesis 3).
I’ve been quick to rebuke the Rmb hawks, but perhaps an aggressive Rmb action against inflation will be more of a gradualist approach than we think.
So, you see, we’ve turned the entire upside decoupling thesis on its head. But before I hear the creaking of cross-bows being drawn and I see arrowheads laced with poisonous accusations of conspiracy. I’ll shield myself with this admission: this is a far-fetched contrarian theory. But call me not a conspirator, for no conspirator of substance would assign a 10% probability to his theory. My point is only this: nothing is obvious – we are duty-bound to consider all possibilities. Especially a market which is now hell-bent on issuing harsh lessons and nasty surprises and perhaps next time we see a butterfly we might consider that no matter how much we think we know about Ben Bernanke, the Federal Reserve and Chinese Politics, not all is black and white.
There is only one secular trade I feel confident about: volatility of volatility is here. Buy volatility on the dips, take profit diligently on the spikes and take care!
