Hamish McRae: Why the world's markets shrug off fears over global trade imbalances

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The Independent Online

There is a strange mismatch between the concern of the world of officialdom and the exuberance of the world of the markets. Which is right?

The official world, that of finance ministries and central banks, is worried. You can catch that concern from last weekend's meeting of the G7 finance ministers in Washington. The prime concern was about global imbalances, particularly the under-valuation of the Chinese yuan and other Asian currencies against the dollar but also naturally high oil prices and their effect in exacerbating these imbalances. Both the G7 and the IMF called for an orderly devaluation of the dollar.

You can spin this in a number of different ways. The US declared it was very satisfied by the meetings since they pointed the finger at China and its policy on the yuan. The Chinese, unsurprisingly, said they were being responsible, unlike the US, and argued that if any currency needed to be monitored by the IMF it should be the dollar.

The general argument that the adjustment needed everyone to shift was well put by Rodrigo de Rato, the managing director of the IMF. In the run-up to the G7 meeting he had called for an orderly decline in the dollar as one element of a co-ordinated strategy to rebalance the global economy. Other elements would include a lowered US budget deficit and increased US savings, alongside greater domestic demand in Europe, Japan, emerging markets and in the oil-exporting countries.

Now when the world's main finance ministries and central banks call for a gradual devaluation of a currency so important as the dollar you might imagine the markets would do it for them. And why make it gradual? If the dollar is about to fall you make money by kicking it on the way down. If everyone knows that the present exchange rate is unsustainable - and a current account deficit of some 6 per cent of GDP takes a lot to finance - why are people still putting money into the dollar? It is kinda stoopid.

Indeed, I was with some hedge fund people yesterday who pointed out that you could get a much higher rate of interest on Chinese debt than you could on American. So it ought to make sense to buy the former: not only would you get a higher running return but you would also almost certainly make a profit on the currency too. The switch out of the dollar is, or at least ought to be, a no-brainer.

Yet the dollar holds up, more or less. Apocalypse not now - but when the decline starts in earnest you would expect it to be very disruptive. The IMF may call for an orderly decline but financial markets are not good at doing orderly.

Indeed the markets, viewed as a whole, seem utterly unworried about the US deficit, the dollar or indeed US financial conditions in general. There is a good argument to be made that their exuberance is rational.

This is well made by Mike Lenhoff at Brewin Dolphin. In a recent paper he pointed out that the long climb of US interest rates was drawing to its close (first graph) and it will stop increasing rates at 5 per cent. So that drag on the US markets will come to an end. Meanwhile, US shares have become good value vis-à-vis those of other major markets as the market has moved up less than others and US company earnings have been strong. So the relative forward price/earnings ratio has improved over the past three years. There are dangers of course, including the present rise in bond yields but his conclusion is that US share prices represent good value.

Investors seem to agree for not only have global markets done pretty well but there is a general perception worldwide that the markets have some way to run. That leads to those twin vital questions. How long does the present strong global expansion last? And what ends it?

They are of course unanswerable but I do think some sensible points can be made. Take the second question first. We know that the end will have something to do with these global imbalances, in particular those between the US and Asia. We know that at some stage these will need to be corrected and the chances are that this will happen in a messy way. There is a huge amount of global liquidity about and that is supporting the markets at the moment. But liquidity can be destroyed when confidence collapses. It is silly to try to predict the detail but we can see the outline.

So when? Well, have a look at the final graph. It shows the US leading indicator and it gives a crude feel for the movement of general economic activity. You can see how it was very low at the beginning of the 1990s, had a mid-cycle dip, collapsed after the popping of the internet bubble in 2000, recovered and is, currently, signally a mid-cycle pause.

This growth phase has lasted a long as the 1990s one, which would suggest it should go on a bit longer. But the 1990s cycle was artificially extended by the internet mania, running on perhaps a couple of years longer than it might otherwise have done. And the funds pushed into the markets after 2000 by the central banks are arguably responsible for the house price boom in many countries, which has been sustaining the present US (and UK) expansions.

So this growth phase may be shorter than the previous one. What we don't have yet is the frothy feel of the late 1980s or the late 1990s. There is an intellectual signal of trouble ahead, articulated by people such as Mr de Rato. But there isn't a gutsy signal and until we get that - real exuberance followed by real panic - things can run on.

You see, it takes some external emotional factor to tip global markets. We had one with the millennium. While the 1990s' boom continued all was fine. But come the millennium we woke up and thought, hey, this isn't really sensible.

My private theory is that the UK trigger was that party in the Dome. We saw our political leaders making prats of themselves and realised it was time to call time. At any rate, that exactly coincided with the peak of share prices in the UK, though the American market ran on for another three months or so.

So what is the trigger next time? Try this. Sir Martin Sorrell, the adman, was talking about this to my colleague Jeremy Warner the other day. He reckoned it would be the end of the George W Bush presidency. That sort of feels right. So some time around the end of 2008 it might be time to sit things out.

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