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Marcuard's Market update by GaveKal Dragonomics
By Charles Gave
Back in 1947, war was over but a ruined European economy needed full-scale reconstruction. The US government was in the driver’s seat and a remarkable generation of public servants rose to the occasion. Their macroeconomic challenge lay in the beggar-thy-neighbour dynamic racking the continent. A systemic shortage of capital meant that the more go-ahead European economies were struggling to fund external deficits being run with their neighbours, while the most badly off could not import the capital needed to rebuild their ruined infrastructure.
My history lesson has a modern day point, but first consider how the US authorities responded to this dilemma back in the late 1940s:
1) The current account deficit of all European economies was backstopped through funds provided under an economic plan championed by US Secretary of State George Marshall.
2) Any nation that chose a protectionist path would be cut off from fund disbursements made under the Marshall Plan.
3) To ameliorate structural problems, the newly formed Bretton Woods institutions stepped up. The International Monetary Fund eased funding crises, while the World Bank offered long-term capital in a world bereft of long-term savings.
The result was a fairly swift European recovery made possible by local currencies seeing a sharp decline in both long- and short-rates. In the early 1950s a European risk premium was warranted by the very real possibility of Communists taking power in France or Italy, or Russian tanks rolling into Berlin. Yet by 1965, the situation had greatly stabilized such that German long-rates had declined to US levels.
The result was outperformance by European longer duration assets like growth-stocks and real estate. Hence, viewed simply in financial terms, the impact of the Marshall Plan was to facilitate a sustained decline in the cost of money, leading to a long period of capital formation and growth.
Now fast forward to the 21st century. In the last two decades the world’s most important emerging economic region has seen two great crisis periods, which in large part stemmed from vagaries associated with the global reserve currency, the US dollar. In 1998, all Asian economies were settling their external accounts in the US currency. Hence, when there were excess dollars, Asia boomed and when there were not enough dollars, Asia faced a bust. As such, the region was really a warrant on the US dollar.
Then came the 2008-09 crisis, which produced a spectacular and instant collapse in Asian imports and exports due only to the US dollar funding squeeze that followed Lehman Brothers’ collapse. As a result, the People’s Bank of China sought to strike a new bargain with its regional counterparts, with a pitch that went something like this:
“In future we should all stop settling accounts in US dollars, and instead do so in our local currencies. We will extend renminbi swaps if you need them, and so, in fact, we will underwrite your current account deficit. The proviso is that you must buy Chinese capital goods. Moreover, let’s establish our own version of the IMF and the World Bank, which we will fund and oversee so that is supports all of our liquidity needs.”
This is, of course, the bargain that the US offered Europe in the 1950s. As I look at the way China is wooing its neighbours through its Belt and Road strategy and other economic and financial linkages, the approach looks like a remarkably effective “copy-and-paste” operation.
Let’s assume that Beijing’s big plan works like Marshall’s did for Europe 70 years ago. What should follow is a sharp fall in Asian risk premiums. As such, the big question that will determine the size and scope of the next Asian bull market will be: what is the appropriate risk premium for Russian or Emerging Asian bonds versus their Chinese equivalents?
Consider that 10-year bonds in Indonesia currently yield 7.8%, in India 7.2% and in Russia 8%. China, meanwhile, is at 3.7 %, which leaves plenty of room for the kind of convergence observed in Europe in the 1960s.
But it also means that economic volatility in Asia should collapse (no more dollar crises). The market impact should be a huge rerating of high-quality growth stocks and lower bond yields. The odd thing, as I see it, is the continued belief in the US dollar’s might as an axiom of Asian investing. Ironically, I see evidence of this “peak dollar” moment in Chinese firms acting to resume US dollar debt in the expectation that its value will likely decline over time versus the renminbi.
The reality is that the US dollar is much less important today than it was ten years ago, but much more important than it will be five years hence. Buy long-dated assets in Asia.
