Outlook for World Economy and Major Financial Markets

April 23^rd to 30^th, 2012

IAIP hosted Dr. Michael Ivanovitch, President MSI Global Inc, in number of cities in India starting with New Delhi on April 23^rd followed by Bangalore on April 25^th, Chennai on April 27^th and finally Mumbai on April 30^th. Rooted with factual economic data Dr. Ivanovitch made insightful presentation on the Outlook for World Economy and Major Financial Markets.  He described, in detail, the present economic situation and how it is likely to evolve in the US, Euro zone and in various Emerging market economies in Latin America, Asia Pacific, Middle East and Africa. The data and questions were thought provoking and exposed the fallacy of popular views and stories. The event was well attended and highly appreciated by both members and non members of the society. This event qualified for 1.5 CE credit hours.

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Starting with the US economy, Michael showed that there is an output gap of 1.5% (Actual GDP growth rate at 1.5% vis-à-vis Potential GDP growth rate at 3%. Also, the unemployment rate is 8.2% vis-à-vis the full employment rate of 5-6%). ISM indexes for the service sector and manufacturing sector are above the boom-bust line. Savings rate is at 3%. The commercial banking system’s excess reserves ballooned from a monthly average of $1.5 billion in April 2011 to a monthly average of $1.5 trillion in April 2012. This high level of “Excess reserves” reflects that US banks are still not lending out to businesses and consumers. Credit is not flowing to businesses and consumers. Instead, US banks are lending to the US government. The Fed’s monetary base increased from $2500 billion in April 2011 to $2825 billion in April 2012. Over the past year, M0 is up 6%. Therefore, firstly, the key question in the US economy is when the Fed will withdraw this stimulus.

Secondly, the bond market is not reacting in the US. Current 10 year Treasury bond yield is at 2% when the Inflation is at 3%, and Federal funds rate of 0.1% is below the Target rate of 0.25%. Clearly, the bond market is working with a doom scenario. However, the current 10 year Treasury yield will increase when good economic data comes up.

Finally, the recent increase in profit margins of US businesses should not be expected to continue in the future. This is a transient cyclical thing because unit labor costs decreased due to a weak labor market.

The data on the Euro zone vis-à-vis other developed countries, rejects the popularly expressed view by the business media that the Euro zone would break up.  The “structural budget deficit” for the Euro zone (at -6.3%) is much lower compared to many developed economies: USA (-10.7%), UK (-10.4%), Japan (-7.8%) and France (-7.1%).  Furthermore, “the public debt (i.e. the government debt) as a percentage of GDP” for the Euro zone (at 98%) is lower in comparison to many developed countries: US (99%) and Japan (200%).  Moreover, as a percentage of the global currency reserves,  the currency Euro has increased from 0% to 30%, whereas the USD has decreased from 75% to 60% in the same time period. In addition, as per the Maastricht treaty, which is the law, the ECB cannot be a lender of last resort. Therefore, the ECB cannot print money to save individual members. ECB is a supranational entity. Therefore, ECB is the only genuinely “independent” central bank in the whole world. ECB targets inflation in the range of 0%-2%. The Euro “real short term interest rate” is 0.25%. Therefore, as per Taylor’s rule, the Euro zone has an expansionary monetary policy. Hence, the Euro is overvalued at present, but in light of all of the above supporting data, Michael suggested to buy Euro at every dip. The Euro is emerging as a strong alternative to the US dollar.

China wants a different composition of its growth (moving away from exports and moving towards growth due to domestic consumption and domestic investments). Clearly, China is seeking growth based on domestic demand.  Real GDP growth rate is at 10% with the targeted inflation at 3%. Presently, China is holding its currency down.

Japan is an example of a country that lost control of its domestic economy because Japan based its economy on exports. China is trying to avoid this. The Japanese Yen moving up will be a big blow to Japan’s export led economy.

In India, inflation is a big problem. The actual inflation is at 10% vis-à-vis the RBI’s comfort zone of 4-8%. India needs structural reforms to combat inflation. As an example, allowing more FDI in Retail is a structural reform.

Brazil is a recession-proof economy because of its big and diversified commodity exports.

From the data on various currencies worldwide, Michael concluded that the Asian countries were buying Euro and gold with their excess US Dollar currency reserves.  He first pointed to the identity that “World’s Balance of Payments = 0”. The data on “current account” positions shows that East Asia is a capital exporter. [Jan 2012: Current account deficits of $473.4 billion in US and $45.1 billion in Euro zone vis-à-vis Current account surplus of $446.3 billion in East Asia].  Secondly, the data comparing the “change in US dollar currency reserves over the last 12 months” to the “change in holdings of US Treasuries over the last 12 months”, shows that for every Asian country (with the exception of Singapore and South Korea), the “change in USD currency reserves” figure is positive and much higher than the “change in holdings of US Treasuries” figure, which is also positive. However, for Singapore and South Korea that stood out as exceptions, the opposite holds true. This shows that Singapore and South Korea are manipulating their currencies. Most importantly, the data begs the question: Where are the remaining US Dollar currency reserves of the rest of Asian countries going? The answer: into buying Euro and gold.

The recent spectacular rise in the price of gold is a clear vote of no confidence in political and economic governance.  The world economy is facing increasing geopolitical risks. For example, how events unfold in Iran will have a huge impact on oil prices. If Israel attacks Iran, oil prices will rise up drastically.

In conclusion, Michael suggested that Equities and Commodities should be the preferred asset classes. Also, it would be better to stay out of Fixed Income because it is highly likely to experience serious downward corrections.

About the Speaker:

Dr. Michael Ivanovitch is the Founder and President of MSI Global Inc (www.msiglobal.com) a New York based company dedicated to research on world economy, geopolitics and investment strategy. Dr. Ivanovitch has also served as a Senior Economist at the Organization for Economic Cooperation and Development (OECD) in Paris, and as an international economist at the Federal Reserve Bank of New York. He has also taught at the Columbia Graduate School of Business, INSEAD and HEC (the two top-rated business schools in Europe). Dr. Ivanovitch holds a Ph.D. (economics), M.Phil. and M.B.A. from Columbia, and a European law degree.

Contribution by:  Manan Agrawal, CFA; IAIP Volunteer