Gravity Shifts to the East

I can’t recall any stockmarket correction being as calm as the one we’ve been experiencing. Although equities have been gyrating, the soothsayers have been soothing almost without exception.

The excuse for the correction '” firming interest rates '” hasn’t been enough to rattle the fundamentals of an international economy in pretty good shape. While the fundamentals are sound, the rest is market noise and excess being blown off.

My favourite international economist, Dr Neal Soss of Credit Suisse, is a good example. According to Soss, the stockmarket was set to come to terms with what the fixed interest market already knew: that the days of massive monetary stimulus were over; but the global economy continues to grow strongly.

With a background that includes two years as assistant to the former Federal Reserve chairman Paul Volcker and as a vice-president of the Federal Reserve of New York, Soss if well attuned to the interest rate cycle. He was hired by First Boston to fill the shoes of the venerable Dr Al Wojnilower when he retired as chief economist.

The New York-based Soss was the first economist I heard tell the China story. As guest speaker at an Australian Bureau of Agricultural and Resources Economics Outlook conference in the very early 1990s, Soss stressed the importance of the globalisation of the workforce as the most important economic factor in our economy. As Soss explained, the absorption of China’s and India’s workforces was the biggest event since the opening up of North America’s rich resources. (By comparison, the Australian stockmarket didn’t discover the story until late 2003, when the resources sector started to take off.)

Soss remains optimistic, convinced the China story has further to run. I caught up with him in New York late last month just as the correction was looming. As you can see in the accompanying video and transcript, his comments remain valid because they are based on fundamentals that aren’t changed by the occasional blast of speculative whimsy.

The reality of workforce globalisation (the China story by another name) is the major shift in economic power from the Atlantic to the Western Pacific. Soss notes that it is a massive shift that will take time to be absorbed, both in terms of geo-politics and economics.

Beyond what we had time for in the video interview, Soss was disappointed with the xenophobia and protectionism the United States has shown in blocking Dubai and Chinese takeovers of US ports and oil companies respectively. But he also believes that sort of reaction is predictable and emotionally understandable. More importantly, he believes it will be resolved in time.

Soss is insouciant about the US dollar’s performance, saying the world has no alternative reserve currency option as far as anyone can see. Rather than being a simple matter of the current account, he believes the greenback swings as a barometer of international order: when the world feels safe and secure, the greenback rises; when the sense of order is threatened, it falls.

What’s not being threatened at present is economic growth. The international monetary tightening remains about removing stimulus rather than applying the brakes.

The interview

Michael Pascoe: Is it time to worry when even the bears have turned optimistic?

Neal Soss: I don’t think so. There are times when everybody knows something and it turns out that what they know is in fact accurate. I don’t think it’s a surprise that the world economy is doing so very well at the moment. We’ve had a string of very easy money policies in all the major centres that’s been going on for some years. We have very easy fiscal policy in a number of the major centres '” that’s been going on for a number of years. We have still a very open broad acceptance of international trade, international capital flows and so forth and that’s all very stimulative backdrop, so why should we be all that surprised that it’s actually worked and given us a world economy that’s growing probably at the fastest pace in many decades '” arguably the fastest pace ever.

Have the capital markets priced that in or is there still room on the upside?

I think the capital markets are now starting to acknowledge something that the central banks have been hinting at '¦ beginning to act upon '¦ for some months '” maybe in the American case. some years now, which is that you don’t need as much stimulus when the world economy is doing so well as you needed before. So central banks are beginning to take some of that accommodation, liquidity, stimulus out of the system and financial markets around the world are beginning to adjust to that in the way that they always do. Interest rates are starting to move up across the board. Stock prices are starting to be more discriminating, shall we say. Markets are beginning to be a bit more herky-jerky, up days and down days and so forth, and all of that is also normal cyclical behaviour.

Herky jerky '¦ But is the trend still in place or have equity markets matured for a while?

Well let’s start with fixed income markets where I think it’s pretty clear that we are in the foothills at least of a bear market. A readjustment of interest rates to reflect the fact that the world economy, which had some real challenges let’s say four or five years ago, has emerged from those challenges to a period of robust growth. So you need higher interest rates. It’s a legitimate kind of market response; it’s a normal cyclical response. As interest rates move up it poses a challenge or a competitive asset allocation challenge to the equity markets. That doesn’t mean that you need a bear market in particular in stocks. It’s, I think, premature for that. Corporate profits on the whole are very good. Growth looks really to be persistent. The central banks are not looking to snuff out that growth. It’s not that inflation is such a problem that we’re looking for tight money. We’re just looking for money that’s less super-cheap than it had been. And against that backdrop, I would expect stockmarkets to go up but perhaps not quite as sharply as they had been doing earlier on.

The easy yards have been taken? It gets harder from here?

This phase in the American version of that is easy money has been made. And I always worry about a phase like that because if it’s so easy how come even I didn’t make it. But I think it is the case that the phase of the financial cycle in which flooding liquidity from the central banks dries up asset prices '” that phase is coming to an end.

You were the first economist to tell the China story. Are you confident that it’s still in place?

China has much further to run in my judgement. In the next couple of years, in a very direct kind of way, you’ve got the Beijing Olympics coming up as a focus for their energies. I think it’s fair to say that at least for some of the Asian countries, hosting the Olympics is sort of a rite of passage, it’s a first communion, it’s a graduation from college or whatever. Think about the Tokyo Olympics and then the Seoul Olympics and now up coming the Beijing Olympics, and I think it’s quite to be expected that that society will not deliberately at least allow itself to be embarrassed by an inadequate infrastructure, inadequate hotels, inadequate electrical capacity, inadequate airport and so forth, which means there’s an awful lot of investing to do to build that infrastructure so that they can be the showpiece to the world when their time comes in 2008.

So that’s a very strong forward dynamic in that economy. Beyond that, I think for legitimate reasons of their own it’s very much in their interest to reallocate some of the economic activity away from the coastal cities, which have been the main beneficiaries of this first generation of economic liberalisation, to reallocate that into the secondary and tertiary cities of the hinterland. But that, too, requires enormous investment in infrastructure and the like and that’s I think going to be a dynamic that will last long past the 2008 Olympics.

Is there a danger from US xenophobia about China or is it just the occasional politician rattling a can?

I think there’s a real risk to the established order. The way we think about the world economy '¦ the centre of gravity of the world economy for the longest time was the Atlantic. It was Europe and the United States and that was, when you thought about global GDP, if you’d sort of weighted the globe that way, there would be a big bulge on that side. Then along came Japan and that was an exception '” a very large exception but it didn’t really alter that perception that the world economy’s really about the US and Europe. That is now changing very rapidly. The centre of gravity of the world economy is moving very quickly into East and South Asia '” China and India, very specifically. These are just very large places and when they grow rapidly, on top of being absolutely large places, you get a very rapid shift in the ranking of global GDP and so forth and that takes some adjusting. That takes some getting used to, psychologically every bit as much as, and geopolitically every bit as much as in the narrow question of economics.