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Tuesday, July 19, 2005:

This is without a doubt a very interesting point of view regarding Boris Vian's L'Ecume des jours (Foam of the Daze) with the financial market:

I found this on the (what I think is) the conservative financial website of the world famous Morgan Stanley organization. Anyway I am always amazed how Boris Vian, who not only travels through different cultures, but as well to financial markets. Enjoy!

I got this from the website : http://www.morganstanley.com/GEFdata/digests/20050628-tue.html

Froth on the Daydream

by Joachim Fels
Morgan Stanley
June 28, 2005

Is your stack of books to read on your summer vacation already complete? If not, I suggest you add the classic L’Ecume des jours by Boris Vian, a French jazz writer, trumpet player, inventor and poet who died of a heart attack at the age of 39 in 1959 while watching a preview of a film based on another of his novels. (Reportedly, he did not approve of the film version.) In the preface to L’Ecume des jours, Vian says that “the story is absolutely true because I invented it from beginning to end.” Re-reading the story 25 years after I first read it, I still believe he is right.

Froth on the Daydream was the title of the first English translation of L’Ecume des jours, but later translations have appeared as Mood Indigo (named after the classic piece by Duke Ellington, whom Vian admired) and Foam of the Daze. It is a melancholic and surrealistic story in which handsome and wealthy young Colin falls in love with beautiful Chloe. Soon after their wedding, Chloe falls ill: a water lily is growing in her right lung, threatening to kill her. The only cure the doctor can think of is to de-hydrate Chloe and surround her with plenty of beautiful flowers to discourage the one growing inside her. The flowers cost a fortune and Colin’s inherited wealth evaporates quickly, so he has to take up work. Eventually he finds a job where he has to give people advance notice about terrible things that are going to happen to them the next day -– a job that does not make him very popular with the recipients. Alas, the water lily keeps growing and Chloe’s health deteriorates rapidly. One day, as Colin ploughs through the list of recipients of bad news, “he looked at the next name on the list and saw that it was his own. He threw down his helmet and walked slowly home with his heart heavy as lead for he knew that by tomorrow Chloe would be dead”.

What does all this have to do with financial markets? Nothing, of course. Except perhaps that the title reminds me of the surrealistic froth we are currently seeing in many asset classes, and of the daydreams that many investors and consumers harbour about ever-rising asset prices and eternal wealth enhancement. And, thinking of my own job and my dire forecasts of US stagflation and of widening political and economic fractures in the euro area, I can imagine how Colin felt about his bad-news-delivery job even before the worst of all news hit him. Maybe, like Colin, I should wear a helmet while going about my job.

Bonds, commodities, and property are on fire. US 10-year Treasury yields are back below 4%, Bund yields are eyeing 3%, oil prices just made a new all-time high and gold is back in favour. House prices look bubbly in many countries and especially in the US (see Steve Roach’s From Bubble to Bubble June 24, 2005). High yield corporate spreads and emerging market spreads have tightening again following the spring sell-off. Froth as far as the eye can see…

As I see it, the driver behind these simultaneous rallies across asset classes and across countries remains the unprecedented amount of excess liquidity, created over the past several years by central banks that have kept real short-term interest rates at or below zero. Thus, as I have pointed out before, the answer to Alan Greenspan’s bond yield conundrum, and to the wider conundrum of simultaneous rallies in virtually all asset classes, is with the Chairman’s policies, together with those of his counterparts at other central banks. Extremely low short-term interest rates have encouraged the global carry trade, executed by banks, proliferating hedge funds and private equity firms, corporations and individual property investors.

It is easy for central banks to warn against excessive risk-taking in their glossy financial stability reports (you may also wish to add the ECB’s June 2005 Financial Stability Review to your summer reading stack): However, they usually forget to mention the crucial role of monetary policy in encouraging and underwriting these activities. True, the Fed has raised interest rates from 1% to 3% over the past year, thus reducing the stimulus, and the money markets are priced for another two or three quarter-point rate increase until year-end. But even so, US real interest rates are still very low and other central banks around the globe are either already easing monetary policy further, like the Swedish Riksbank last week, or are moving in that direction, like the Bank of England or the ECB.

In fact, an ECB rate cut of up to 50 basis points as early as September looks increasingly likely to me, unless the economic data suggest a meaningful rebound in growth by then. I don’t think the slight improvement in the June German Ifo index released this morning qualifies as such. To be sure, the euro area is not suffering from a lack of monetary stimulus: credit growth is strong and property prices in many countries are rising rapidly. However, the ECB is increasingly being pushed into the role of a scapegoat for Europe’s structural ills and the Council may decide that cutting interest rates is the only way to play the ball back into the governments’ court. To justify a cut, the ECB could point to the recent retreat of market-based inflation expectations, and it could interpret the move as a signal for consumers and businesses to spend more. But the deeper motivation for a rate reduction, in my view, would be to deflect the criticism that the ECB is not doing enough to support economic growth. Without such a move, governments might be able to win public support for a change in the ECB’s mandate or at least for a political
(re-)definition of the price stability goal. Faced with such implicit threats, a rate cut may be seen by the ECB Council as the lesser evil.

Thus, taking a global perspective it seems that, despite the Fed’s continuing tightening campaign, liquidity springs eternal, creating more and more froth in financial markets. As I already pointed out two years ago, central banks have long become prisoners of their past (monetary easing) deeds: once the genie called liquidity is out of the bottle, it is virtually impossible to get it back in again, except for the high price of a serious financial and economic recession caused by aggressive interest rate increases (see my notes Bubble Trouble August 27, 2003, and Too Much Debt September 4, 2003). Make no mistake: no central banker on this globe is willing to pay this price. Hence the party will go on. Or won’t it?

If global liquidity remains abundant as aggressive monetary tightening around the globe is unlikely, what else could make the froth turn into frost? One possibility is that bubbles burst or deflate on their own when they become too large. However, while I can see this happening in individual markets, it is difficult to envisage a spontaneous and simultaneous bursting of bubbles in all markets as long as there is plenty of liquidity around. Moreover, to the extent that a bursting bubble in one market, say the housing market, led to systemic risks and/or to recession risks, central banks would likely respond by easing monetary conditions further, thus helping to pump up asset prices elsewhere. Thus, a spontaneous correction of the global financial bubble out of the blue looks unlikely to me. Rather, I think the biggest risk to elevated asset prices comes from either a significant slowing of global economic growth or from an unanticipated acceleration of inflation, or from a combination of the two.

I won’t belabour the first risk – a significant slowing of global economic growth – here as Steve Roach, our Global Chief Economist, has laid it out succinctly in his recent pieces. I agree with him that such a slowdown would either start in China, where the authorities are trying to clamp down on the property bubble, or in the US, where a savings-deficient and asset-dependent consumer looks stretched. Near term, high oil prices are the most likely trigger for a slowdown, but longer term I worry most about what I think will be a protracted slowing of US productivity growth. If global growth slows significantly, risky asset classes such as high yield, emerging markets, and equities should suffer most. Government bonds would be supported, especially if the Fed stopped tightening and markets would start to factor in the possibility of a Fed easing.

The second risk – an unanticipated acceleration of inflation especially in the US – worries me even more than the first one. Why? Because I think markets are wholly unprepared for such an outcome. While real bond yields are already very low, suggesting than bond investors anticipate slow growth, the recent decline in market-based inflation expectations implies that a pick-up in inflation would genuinely surprise markets. Such a pick-up in US inflation could result from the combination of rising oil prices and slowing productivity growth. The latter would put further upward pressure on unit labour costs, which are an important determinant of prices in the service sector. To be sure, globalisation makes it difficult to see any significant inflation pressures developing in manufactured goods. However domestically produced services account for a much larger chunk of the consumer basket than manufactured goods, and that’s where the productivity slowdown should lead to rising inflation pressures.

My main scenario remains a combination of the two scare stories described above: a combination of economic slowdown and rising inflation pressure, a.k.a. stagflation (see my note Stagflation October 4, 2004). As the experience of the 1970s teaches us, stagflation is bad for virtually all asset classes. Or, to go back to L’Ecume des jours, it resembles the water lily growing in Chloe’s chest: when it blossoms, all is lost.


Tosh // 10:37 PM

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