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Portfolio managers seem to be quite optimistic for 2007, whatever asset class theyÆre in. When everyone is so confident, is the consensus in for a bushwhacking? Here are five risks û and five reasons why 2007 should still be a good year.
Risk 1: The big enchilada: avian flu. This falls under the æall bets are offÆ category that would also include terrorism, war in the Middle East and other surprises unrelated to financial markets. Avian flu is the scariest: the extreme case (the Black Death) completely upended global demographics. Pension and insurance managers can throw away their actuarial assumptions. Who knows what buy side would survive?
Risk 2: The opacity of the derivatives market. No single hedge fund seems likely to derail the markets as LTCM did in 1998, but itÆs hard to tell to what extent a series of credit defaults or surprise interest-rate moves could cripple an investment bank at the heart of numerous structured-products transactions. If this possibility were remote, it would be reassuring to see some hard data that says so.
Risk 3: If thereÆs to be a dollar crisis, it wonÆt come because Asian central banks decide to stop buying the greenback: theyÆre too embedded in AmericaÆs trade deficit, and they are too committed to pursuing liquidity and stability. But petrodollars arenÆt, and nor are these massive oil-fuelled portfolios transparent. For all we know, these portfolios are invested purely to enrich families or cronies, with unknown degrees of professionalism and risk management.
Risk 4: Protectionism. The DemocratsÆ takeover of the United States Congress, the worldwide failure to secure the Doha trade round, backlashes by crusty Leninists in China, faltering reform under JapanÆs new prime minister, the European UnionÆs flagging solidarity with would-be members. Protectionism is on the rise around the world; proponents of the free exchange of goods across borders are on the defensive. Portfolio capital isnÆt under direct threat but which financial markets will suffer if the arteries of commerce are clogged up?
Risk 5: The least likely risk to be realised in 2007 could be the most likely to materialise in some form over the next generation: political unrest in China. The sources of tension are many: the environment, growing inequality, among provinces and between provinces and the centre. What happens during an economic recession if one or more of these spills out of control? And what if the authorities prefer to channel civil unrest against foreign interests, or even into overseas adventures? For optimists, prosperity should one day lead to political reform that allows the nation to cope with its challenges, but such a shift may not succeed until the majority of the population consists of middle-class urbanites û a prospect that is 30-40 years away. A continued push for economic reform and market-based practices is the best policy against any disaster but itÆs not clear how far Beijing is prepared to let this go.
Despite these scary possibilities, the positive scenarios seem more likely to hold sway in 2007. Here are five reasons why.
Reason 1: The world is becoming less reliant on the US consumer to drive economic growth. This reflects growing domestic demand elsewhere, and also implies the US current account deficit may finally begin to shrink û gradually, thanks to cheap dollars, high oil prices and the end to paper wealth based on housing prices.
Reason 2: Speaking of which, the US housing market is not going to crash. That is, it is not going to suffer a Great Depression-era national collapse in housing prices by 30%, which is what it would take to dent triple-A rated agency mortgage-backed securities. The market will slow down, it will cause pain to US consumers, and it will slow worldwide exports, but it wonÆt tip the world into recession.
Reason 3: Asia and America are ever more interdependent. Tensions are inevitable but China and the US are not headed for a new Cold War. The recent visit to Beijing by US Treasury secretary Paulson and Federal Reserve chairman Bernanke was criticised for American æobsessionÆ with China and its trade position û often by the same pundits who criticised the US for ignoring Asia. Jaw jaw is preferable to war war, to paraphrase Churchill, and right now thereÆs plenty of jaw jaw. Flashpoints such as Taiwan and North Korea can be managed and contained. Big-power rivalry will show up more in places like Africa as China and the West offer providers of natural resources differing visions of trade and growth, but the potential excesses in competition should be muted by the bigger framework of cooperation and consultation.
Reason 4: Central banks seem to know what theyÆre doing. They are staking out their views and letting market players trade around them. Transparency, consistency and independence seem to be working. And the central banks are well aware of the sensitivities in trying to remove liquidity from the market, particularly regarding the yen carry trade; they will move, but prudently. Liquidity will continue to drive asset prices.
Reason 5: The two big themes since 1989, globalisation and technology, continue to drive productivity, growth and human genius. They cause a lot of pain and disruption, but the net impact is positive û tremendously so. Globalisation and technology are outcomes of liberalism and the free flow of capital, goods, people and ideas. Those freedoms must be fought for every day, but they endure because they reflect the essential optimism and hope in our common humanity. And with that, AsianInvestor wishes you a merry Christmas and a happy new year.
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