by Stuart Burns
An article in the FT calls out the risk of a bubble in American assets as a result of a possible flood of emerging market funds flowing into the economy. The article draws similarities between the situation today and that of the mid-1990s leading up to the Dot Com bubble and the late-1990s stock market boom.
The problem, according to the line of thinking, is the world is awash with too much savings and distorted exchange rates leading to negative returns in some locations, encouraging a flight of capital into secure high-growth locations like the U.S. World savings were just under a quarter of gross world product last year, matching 2007's all-time high ratio.
But in 2007, the world's baseline real interest rate - the inflation-adjusted yield of U.S. 10-year Treasuries - was just under its long-run average of about 2.5%. By 2012, the real 10-year Treasury yield was minus 0.5%. Even this year, the real yield on 10-year U.S. Treasuries is only +0.5%, yet most emerging markets have overvalued currencies, making investment in undervalued exchange rate economies especially attractive.
So what does it all mean for us? According to the article, the OECD's measure of relative unit labor costs has the U.S. undervalued by 15%, the eurozone by 10%, Japan by more than 20% and Britain by nearly 20% - all relative to the 1973-2012 post-Bretton-Woods average. These advanced countries have three-fifths of the world's GDP, and as all exchange rates must come to a balance, that means emerging markets' exchange rates must be overvalued. The article suggests U.S. real exchange rate at its lowest since the Second World War, and its private and public borrowing now constrained.
The story in Europe is mixed. Southern states like Spain and Greece have gone through a form of internal devaluation, but northern states like Germany are enjoying an export boom of their own aided by an undervalued Euro. Nevertheless, Europe as a whole has limited upside potential to encourage an inward flow of investment.
When it comes to growth, the U.S. is the world's most positive story, the FT believes; and its firms are highly profitable, aided by undervaluation. Assuming federal budget disputes get resolved by late-winter, growth should accelerate to more than 3% from next spring onwards.
This is hardly boom-time by late-1990s standards, but relatively restrained growth may postpone interest rate hikes, possibly also bond yields. Burgeoning energy output is cutting energy costs, enhancing undervaluation. It is hard to see, the paper says, how the dollar can avoid rising fast: inflation, already minimal, should be contained or even lowered.
All Comes Down to China
The other big change from the late 1990s concerns China. China was protected from the Asia Crisis by 30% undervaluation in 1997-98 - but is 30% overvalued now, according to Lombard Street Research's estimates quoted by the FT. Reforms announced recently included removal over the next few years of controls on private capital outflows. Chinese annual savings are about one-quarter of world savings. Its private investors are likely to prefer U.S. real assets to almost anything else the world has to offer.
What impact such inflows into U.S. assets would have all point to bubble potential and the possibility the Fed may have a painful choice between encouraging growth and checking fresh bubbles.