Source: The InfoFax – CLSA Asia-Pacific Markets, 15 September 2006
We have been periodically critical of Alan Greenspan during his period as Fed Chairman. But an opportunity to speak to him should never be passed over. At the Investors’ Forum on Thursday we were given that opportunity with a breakfast Q&A session. The subjects covered were broad ones. Here are a few of our highlights.
Mr Greenspan spoke in response to questions from the floor. He ranged over a wide range of subjects. Rather than report the questions and Mr Greenspan’s answers verbatim (and, in any case, we couldn’t type fast enough) we have aggregated his responses into a few key themes. What follows is true to Mr Greenspan’s comments; unusually for the Infofax, they are his opinions not always ours.
On the main drivers of the world economy
AG: There is a need to recognise a seminal event that no one noticed, the fall of the Berlin Wall. This has been recognised as important geopolitically, but its economic impact has been understated. The extent of the economic gloom revealed by the fall of the Wall caught everyone by surprise. It discredited central planning as an economic model.
In consequence there began major changes, most specifically in China. China had started to reform but the fall of the Berlin Wall accelerated the process. And in the last decade the move towards competitive markets has accelerated. It has resulted in a global decline in marginal labour costs. For example in Western Europe the possibility that production can move into the former eastern bloc has diluted trade union strength and moderated militancy. As a result wage inflation has started to flatten out.
These forces have created disinflation across the world economy which has been captured in sharply falling inflation and risk premia in both developed market and emerging market bond yields. In turn this has fed into equity markets. The period of disinflation has resulted in falling real rates that have led to housing booms in Anglo-Saxon economies.
However the adjustment pace of labour is approaching completion and therefore the period of disinflation that has caused asset prices to rise, to reflect the drop in real funding costs, is also approaching completion. Investing is therefore going to become more challenging than it has been in the last decade.
On the US housing market
AG: I have never seen anything like the current US housing cycle before. Turnover used to be relatively stable but from about ten years ago turnover began to accelerate. It began to drive the whole asset price structure upwards.
We now have a slowing down of that whole acceleration process. The level of mortgage rates is not really an issue, even now. However affordability has been squeezed because of the rise in property prices. We have not yet seen any decline in US house prices. It is hard to believe that we won’t but Australian and UK experience suggests that the adjustment process might not be all that difficult.
On China and India
AG: What is fascinating is that it is not democracy per se that is important but democracy with the protection of property rights. The irony is that China, a communist state, is doing this. There is no democracy in China whereas there is in India but India remains enamoured with Fabian socialism. There is an anticapitalist culture in government that makes it difficult to do business deals in a number of areas.
The Fabian tradition is being unwound but it is deeply ingrained. However it must be unwound if India is to exploit its advantages (for example its demographics are far more advantageous than those of ageing China).
For capitalism property rights are the end of the road. And most investors thank that capitalism is safer in China than India. It sounds ridiculous given their political heritages but it is true. However it cannot continue indefinitely. India’s bureaucracy has to dismantle itself and China has to become more liberal.
On China’s capital markets and currency
AG: It’s very evident dealing with regulators and the central bank in China that there is a cadre of very capable people who really understand how markets work in a way that is remarkable given that they were educated in a Marxist system. My impression is that reforms are moving forward however (interest) rates still can’t move as rapidly as they should.
The PBOC is sterilising its intervention but it is only being partially successful and currency intervention is contributing to rapid growth in its monetary base. The potential threat to stability that this implies is large. China’s economy is evolving rapidly and it needs flexibility in its financial and currency markets that it does not yet have.
On gold and commodity prices
AG: First of all separate gold from base metals. Base metals are going through a fairly broad inventory accumulation globally. This is the classic driver of industrial resource prices. It is likely to start to change because the inventory cycle is starting to change.
The gold price reflects something different. Gold is the ultimate means of payment in a fiat currency world. Gold is always acceptable. Its price is therefore driven by perceptions of geopolitical risk and it only needs a few people to move the price. This is the same factor that is driving the oil price. In other words the gold price has not been a measure of inflation risk. But it is a good representation of the tail of the curve of expectations of those people that are nervous about the future of the financial system.
On negative US savings
AG: We have an interesting dichotomy in the US. If you ask individual households they say that they are saving enough. They point to the capital gains on their investment plans and their 401ks and in fact if you add the value of these capital gains to current income you do end up with decent savings.
But the problem is that capital gains can’t finance new capital investment. The accumulation of new assets can only be financed from saving out of current income. And the liability side of households’ balance sheets is now increasing faster than the asset side in book value terms. The removal of equity from property has the effect of reducing the book value of household savings rates but is not seen as damaging by households. The issue is therefore going to relate to how quickly home equity extraction will slow as housing capital gains dwindle. There will then be a rising in saving out of current income and necessarily a fall in the growth of consumption. To date consumption is holding up better than I expected.
On hedge funds
AG: The combination of hedge funds and private equity finance has been a huge innovation in finance. Also everyone now uses the hedge fund investment procedure to identifying niches. These can only exist where there are pricing inefficiencies. So the hedge fund mentality has eliminated these efficiencies. And increasing market efficiency increases flexibility. Hedge funds are the way of the future.
Having said that, the number of junior partners that have left investment banking to go into hedge funds has created a surplus. And the law of supply and demand mean that when there is a surplus the price goes down.