A new eight pound gorilla?

That was our first impression when we saw the impact the Chinese stock market correction had on other markets around the world. The more interesting observation, however, was the fact that it was not only developing countries that were impacted. Europe and the U.S. were also hit by this correction which brings to mind two important points. That economic integration on a global scale, better known as the global village project, is alive and kicking and that China is rapidly becoming the new eight pound gorilla on the block, despite the fact that its market capitalization as a percentage of the world capitalization is only slightly above 6% if we include Hong Kong. That's still way below the colossal 34% share that the U.S. commands. Nevertheless, we don't see much reason for worry as we subscribe to Greenspan's view that occasional corrections can have a cleansing and beneficial effect on markets. This is particularly true for markets that, by their very nature, are prone to speculative bubbles.

Tamed or not? Part 2

The Fed's insistence on maintaining a tightening bias after applying the brakes on rate hikes paid off yesterday with the release of higher than expected core inflation figures. A stark reminder that the inflation threat is still very real and could easily flare up in the event that oil prices rise or that the economy shows signs of overheating considering the tight labor market and close to full capacity utilization. We nevertheless are leaning more towards the scenario where inflation will be contained by the unfolding economic deceleration. Potholes remain on the horizon in the form of a potential rise in defaults, a reversal in commodity prices or an unwinding of the numerous carry trades and other hedge fund strategies......stay tuned!!!

Japan waking up...

The BOJ's quarter point rate hike to 0.5% came as no surprise considering the stronger than expected fourth quarter GDP results. Policymakers in Japan find themselves in a similar boat as the Fed in that the direction to take in terms of interest rates remains blurry. The decision to tighten did however come as a welcome development for currencies as it let out pressure on the yen which had been accumulating due to the widening divergence in rates with the US and Europe. The direction that the economy is taking remains unclear given the recent mixed bag of indicators suggesting on the one hand, with weak consumer spending and low prices, that the recovery is delicate and, on the other hand, with growing business confidence and stronger GDP figures a more sanguine environment. The combination of ongoing reforms, rising export demand particularly from neighbors, reassurance that the US economy is not about to collapse
and growing overall optimism by both consumers and businesses should help keep Japan afloat for the rest of the year. The current environment also pretty much guarantees that we will not be seeing any further tightening for some time to come. Japan is, after all, still recovering from its deflationary cycle. They are not completely out of the woods yet!

Tamed or not?

Bernanke's upbeat report on the economy and Fed policy seem to be backed by the latest figures which suggest that inflation is under control. The Fed nevertheless maintains its tightening bias until further notice with Bernanke noting that his optimistic scenario is conditional on gasoline prices remaining under control and that we see less strain on capacity utilization. Oil may remain at current levels or even drop a little but certainly not as much as 30% as suggested by Sandford C. Bernstein & Co. Their wild predictions are nothing new, we heard the same story back in 2005. One thing is for sure though, we wont be seeing Fed action any time soon. They will be holding steady for at least the next couple of months unless there is a material change in the environment. We maintain our scenario of a soft lading type of deceleration for the US in 2007.

So what's up with interest rates?

Seems like no end in sight to the economic expansion of the last couple of years. Normally, at this stage of the recovery we should be observing a marked surge in interest rates but things may indeed be a little different this time around. The structural changes in the global economy, most notably the emergence of China and, to a lesser extent, India have led to a surplus in liquidity looking for a place to park. With financial markets still at a relatively rudimentary stage in developing countries, a large chunk of this cash has found its way into the sophisticated markets of developed countries such as the US. This in turn has helped keep interest rates at unusually low levels, leading to a soft landing in the housing market and providing continued growth in corporate earnings. According to a recent businessweek article, the low interest rate environment is here to stay, at least for the next 10 to 20 years which is the estimated amount of time it will take these new emerging countries to develop their financial markets sufficiently. There is a caveat though in the form of greater volatility and a greater risk of default as lending conditions tend to be less restrictive. Unlike the great "new" economy deception which led to the market collapse in 2001, the theory behind low interest rates really does seem to hold, and this time around, things may well be different!