Contagion, But What’s Catching?

In a word, fear. World financial markets, after 7 months of glassy-smooth sailing, have encountered some serious chop in recent weeks. Some pundits have claimed that markets are reawakening to the fact that risk is alive and well, after pricing it out of many assets during their last leg up. That’s not a bad way to look at it–we accept the idea that markets can overshoot in any direction, but we also believe that they self-correct with reasonable efficiency. We are also stubborn believers in cause and effect, and specifically the idea that the words and deeds of public officials can have a blunt impact on financial market behavior. So what’s behind the current downdraft? Our early assessment is that both market data and government actions have motivated a significant repricing of financial risk.

Market data continues to point to a huge divergence between healthy and unhealthy sectors of the economy–service industries appear to be doing quite well, manufacturing appears to be middling along, and residential industries are in pretty bad shape. A prevailing notion among bears is that the residential correction will undermine consumption and thereby lead to recession, but in our view, this balance sheet focus is too narrow, as real incomes continue to rise, and labor markets are tight overall. What matters going forward are cash flows relative to debt service and current consumption. It is disconcerting to us that leveraged U.S. consumers (and some marginal corporate debtors) are now in a similar position to that of many emerging markets in the mid to late 1990s. If the Bernanke Fed were to go on an ‘asset bubble pricking spree’ in the spirit of Alan Greenspan and Robert Shiller circa 1996, the domestic wreckage would be immense, and pose an even greater ‘pandemic’ threat to the world than ‘Asian Flu’ did in 1997. However, at this point, we believe that sector specific wreckage will remain sector specific, and that its roots lie in the overly easy period of Fed policy at the end of Greenspan’s tenure, and not an overly restrictive Fed under Bernanke. We expect the economy to remain in pretty good health overall in the coming year.

Among government actions, there are three of note. First, a leading culprit in the initial market downturn–which originated in Asia–was talk in China of imposing capital gains taxes on stock market holdings, in an effort to curb domestic retail speculation. Since capital gains taxes raise the required return on investment, they have a powerful and negative effect on asset prices (there is a countervailing pressure to hold on to appreciated assets, as those in favor of cap gains taxes love to point out, but this debate has received only limited academic attention, and recent research indicates that the longer term effect is indeed negative–something of a no-brainer, in our view). A second factor might have been Alan Greenspan’s claim to a Hong Kong business conference that there is roughly a 30% chance of recession this year as the current business cycle matures (we’re lumping Greenspan in with government because we speculate that few in Asia would know his name if not for his 20+ years at the Fed). And third, Congressional bluster over China is picking up intensity here at home again. Most recently, significant, across-the-board tariffs have been proposed as a competitive response. We’ve been down that road before with the Hawley-Smoot Tarriff Act of 1929, which marked the continuing demise of the first age of globalization, and a period that, as history clearly shows, did not end well. We should avoid making that kind of mistake again. If Congress sincerely wants to help our manufacturing base compete globally–and in our view, the loss of low end manufacturing employment is an important social concern–then politicians need to engage in a critical discourse about how expensive it has become to employ people in this country. That would require some self-critical reflection in Washington, indeed at all levels of government, which is something we don’t place a high probability on, unfortunately. As far as China and global trade go, it gives us some comfort that Treasury Secretary Paulson is currently the man at the margin.

Summing it up, what’s catching is simply fear, the other side of greed according to Wall Street wisdom–fears of recession, a global credit crunch, higher taxes on capital, increased barriers to trade, and so on. Our models are placing a low probability on the first two at present, and while higher taxes and trade barriers are an ever present risk in a modern democracy, we don’t expect any significant shifts on those prior to the 2008 elections.