Monday, July 04, 2005

Stephen Roach turns "bullish" ...sort of...


My newfound optimism on the bond market is a case a point. My call on US interest rates has long been framed in the context of a classic current account adjustment -- a shift from deficit back toward balance that, for most nations, is invariably accompanied by the combination of a weaker currency and higher real interest rates. I still believe such an endgame eventually awaits the United States -- leaving me an unrepentant bond bear. But I now expect something else to happen first -- namely, a China slowdown brought about by a marked deceleration of growth in its fixed investment and export sectors. With these two sectors collectively accounting for 80% of Chinese GDP and currently growing at a 30% y-o-y rate, a China slowdown arises from the confluence of internal policies aimed at the excesses of China’s property bubble and external protectionist pressures taking dead aim on Chinese exports. If I’m right, this will lead to a deceleration of pan-Asian GDP growth and a sharp fall-off in commodity prices -- both bond-bullish developments.

At the same time, I would stress the transitory nature of this constructive conclusion on the bond market. To the extent the China slowdown is but a temporary detour for a high-growth Chinese economy, reductions in interest rates are likely to be relatively short-lived -- perhaps lasting only a year or so. Moreover, during the hiatus of lower interest rates, the asset-dependent American consumer could well take advantage of yet another blow-off in an already bubbly housing market -- leading to another spending binge, ever greater extensions of debt, reduced national saving, and a further widening of the current-account deficit. As China comes out of this cyclical downshift, the US current-account deficit could well re-emerge as the dominant force shaping world financial markets -- possibly with an even sharper adjustment than might have otherwise been the case. That might be reason enough to shift back to a more bearish assessment of the bond market -- albeit from lower levels of longer-term rates than previously thought.

Unlike my rethinking of the interest rate outlook, there are no strings attached to my newfound optimism on Europe. I continue to feel that the angst over Europe’s political disappointments is obscuring the meaningful progress being made on structural reforms. The failure of the EU constitutional referenda in France and Holland, in conjunction with the acrimonious ending to the recent European summit, does not undermine the case for structural change, in my view. Labor market rigidities are improving at the margin -- underscored by progress in Germany, where shortened workweeks are being abolished, labor unions are losing their industry-wide bargaining power, and the rapid growth of part-time and temporary workers is creating a more flexible workforce. Equally encouraging, in my view, is Corporate Europe’s recent push into IT-enabled capital spending -- a belated but nevertheless encouraging catch-up to the trend first established by the US in the late 1990s. Finally, it is important to note the flurry of corporate restructuring activity now evident in Old Europe, especially in Germany. What emerges out of all this is an encouraging case for European productivity improvement after a decade of anemic performance. Ironically, the recent political setbacks may serve the unintended, but positive, role of clearing the decks for more heavy lifting on the structural reform front.

Ah, those French. "Old Europe" as Rumsfeld called it, is certainly in better shape than many Americans thought.

(HT: New Economist)

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