Five Factors for Five More Years
An interesting contest is currently taking place across the global financial sphere. It is a discussion worth tuning in to, for both investors and financial practioners. After all, both are dependent upon the same phenomena, even though the shares of the pie may shift periodically.
On one side, a number of respected financial analysts are staggered by the continuing financialization boom, the widening international savings imbalances and apparent lackadaisical complacency. Such respected luminaries as Larry Summers, Joseph Stiglitz and notable others have been sounding alarums -- whether for shorter or longer periods. In their view, the price of risk has blown sky high, equating the investment heroics of today's investors and hedge funds to "picking up pennies in front of a steamroller." Present trends are unsustainable and unprecedented, they claim.
On the other side is a greater majority who thinks that the good times and mega-bonuses for investment bankers and other financial croupiers will roll on for yet quite a while. Apparently, to this group, nothing on the horizon portends any change to present warp speeds. Given the world's rapidly globalizing workforce and the enormous inventiveness of the globe's financial industry -- which also is the biggest profit earner in the world -- that kind of optimism, of course, is inclined to find a heavy constituency. Amongst this group, sustainability is a question for the next year, not 2007.
Who's right? Maybe both groups. The key will be timing. As this year opens, clearly, the irrepressible weight of money and burgeoning financial asset and paper generation worldwide is cowing the naysayers. Even "causal-thinking" theorists no longer risk venturing any sobering forecasts. One by one, they have lost their courage.
Yet, there is a paradoxical thing: The broad consensus does agree that there are indeed a number of unsustainable trends at play -- in fact, even very reckless developments. So what's the key difference? One group looks at remarkable developments of the past five years and concludes that the momentum of the financial steamroller is just too impressive to counter. The other group simply gapes in awe that such sojourns into uncharted waters, could continue yet one year longer.
Time will tell who is right. For the sake of illustration, let's concede for now the case being argued by the majority -- that the global financialization boom can continue unmolested for one more year. In fact, we'll go a few better. Just what would have to happen over the next 5 years to continue the remarkable developments of the last five? Could the unparalleled financial boom last another 5 years?
Let's briefly review just 5 of the unprecedented developments of the last 5 years -- end-2001 to end-2006. We will simply assume that "tomorrow will be as yesterday."
1. Five More Rungs Up on the Financial Ladder. Firstly, a reference point that is near and dear to all. The 1st chart on the front page shows the extent of the rise in financial asset value around the world. According to McKinsey Global Institute, global financial assets have risen from USD $91 trillion at end-2001 to $140 trillion at end-2005. Roughly updating this number to end-2006, would now place this figure above $150 trillion. In short, over the past 5 years, financial assets have grown approximately by $60 trillion. That's a rise of +65%, or equivalent to the value of over 150% of global GDP annually. Indeed this development was remarkable. But can it continue at this pace of expansion for 5 years more?
Assuming 5% nominal growth in world economic output per annum and the same rate of expansion in financial intensity (plus other assumptions), the world would produce roughly another $120 trillion worth. Such a boost in financial assets would represent 10 times the entire value of assets that existed in 1980. Is it possible?
2. Sources of High Propensity to Consume. It goes without saying that the last 5 years have witnessed a bipolar world with respect to savings and net cross-border capital flows. Consider the shift between just two sets of the world's players -- its leading economy and some still mostly developing ones, namely Asia and the oil exporting nations. The 2nd chart on the front page shows the significance of this shift over recent years. The correlated offset is the US current account deficit. The earlier referenced McKinsey report estimates that the US absorbed 85% of global capital flows in 2005.
Looking ahead 5 years, let's make just one supposition, and that with respect to China. Were this country's trade surplus (up 8x since 2001) and currency reserves to grow at the same pace as the last 5 years, we must expect its reserves to blow through $2 trillion and its trade surplus to almost equal the size of the entire US trade deficit today. Can it happen? Maybe, but relative demand for the US dollar can be expected to change quite substantially.
3. Anglo Savings Adjustments. The USCD reported this past week that the US household saving rate for all of 2006 was 1%, the worst in 73 years. It was old news. To be sure, this is a heavily embattled statistic. Assuming that the deterioration of this savings rate (gross or net, pre- or post-taxes, take your pick) continues apace in Canada and the US, in 5 years the deficit will be plumbing near -5%. In the meantime, the US wealth skew has been widening, too. So if that trend were to continue also, (as it must), we should expect that the median household will have a savings deficit of near 10% and the Gini coefficient of all North America slipping to levels below most of South America and Mexico. A January 2007 report from the Center for American Progress concludes "that all the gains made in financial security among middle class families in the 1990s had disappeared by the early this century."
4. Fuel for Speculative Investment Leverage. The "carry trade" is again the topic of the month, and not surprisingly. Cheap "low-yield" money remains on tap in the world, fostering leverage and marked effects on currency trends. The biggest source of monetary effluvia of course has been Japan. Other currencies are also involved as finance currencies -- the Swiss franc and others. All is well, as long as Japan et al continues to maintain low interest rates and can tolerate stimulating its exports without any inflation flare-ups. One more assumption is necessary for this to continue -- that the yen will be allowed to fall indefinitely.
According to the estimates of Tim Lee of Pi Economics (Source: RGE Monitor) about $1 trillion of private money (not including the actions of the official sector) is involved in the carry trade and is betting that the yen will continue to weaken further. In real terms, the yen has already fallen lower than prior to the last liquidity spike in the yen which occurred back in 1998 (the very nadir of the Asian Crisis). For this source of cheap funds to continue plying speculative investors for the next 5 years, what must we expect? Our back-of-the envelope estimates: A total yencarry trade of near $2 trillion and a yen at 200 to the USD (adj. real terms). Manufacturers in North America and Europe (even China) will be screaming. Actually, the Europeans are bringing up this very issue at the upcoming G7 this month in Essen.
5. The Silent OTC Colossus. Over-the-counter (OTC) derivatives growth in recent years is the stuff of fairy tales. At last count, the Bank of International Settlements (BIS) estimates a total nominal value for these instruments of $369.9 trillion. That's up $72.2 trillion in just 6 months to June 30, 2006. Over the period 2001 to end-2006, its likely that this lucrative financial sector will have expanded in nominal value by over $325 trillion, a near quadruple (equivalent to 7x annual world GDP today). Another 5 years at the same rate? $1,700 trillion.
Conclusions. We have briefly reviewed just 5 "New Millennia" developments. Can they all together continue apace for another 5 years? Then how about just one more year? Of course, a lot more is riding on that last answer than may be thought for at least two reasons -- the effects of asymmetry and exponential momentum.
The "five factors for five more years" we have reviewed must continue their expansion apace just to keep the rock from falling upon Sisyphus. A condition of acceleration is required just to maintain the status quo.
Will everything continue as before for one more year? The strongest consensus on Wall Street in a long time right now says yes. Will domestic and global equity markets achieve 10% to 20% returns this year as in 2006? Maybe so. The most important factor, however, is risk. If anything, right now, we are cowed by the high risks ... not the "high-5" Wall Street cheerleaders.