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Global Macro Investment
For Presentation at Yale University on October 22, 2003
Dr. Joe Zhou
[email protected]
Interplay Between Financial Market and Economic Fundamental:
With Application to $$$ and Economy
When I analyze a particular financial market, I find it useful to make a
distinction between the financial side and the real side as if the two sides could
be separated. The economic fundamental is the real side. The real side is different
for different financial market. The real sides of the commodity market, the equity
market, the bond market and the foreign exchange market are inter-related but
they are intrinsically different in structural details. In the case of an individual
stock, the fundamental or the real side includes the company’s balance sheet and
operating performance, its competitors, among other things.
It is crucial to study the interplay between the financial side and the real
side. Most investors understand intuitively that there is a positive association
between the financial market and the economic fundamentals. For example, a
positive surprise in a company’s performance is usually associated with a rise in
the stock price; a positive shock in a country’s performance is usually associated
with an appreciation of the country’s currency. However, it does not make us
rich to only understand the positive association between the real and financial
sides.
For those investors who possess only public information, it is far more
important to understand and to measure the feedback and dynamic relationship
between the real side and the financial side. At the early stage of an upward
trend in an asset price, there is an asymmetric sensitivity of the asset price with
respect to the fundamental news. This asymmetric response to news is consistent
with an old saying referring to a bull market in stocks, which says that good
news is good news and no news is good news. Certainly at this stage, the
feedback from the real side to the financial side is positive and dramatic. Having
observed the asymmetric price action, the uninformed investors (which includes
the majority of capital market participants) can derive certain perceptions about
future price dynamics that affect the demand for the asset, creating a tendency
for the asset price to trend. A trend can materialize if the underlying
fundamentals are better off with the help of a firming asset price.
In most cases, other things being equal, there is also a positive feedback
from the financial side to the real side, thus helping asset price to trend. The
amount of time for the reverse feedback to work varies with different capital
markets. In my opinion, for the reverse feedback to work, the FX market needs
more time than the bond market, and the bond market needs more time than the
equity market. For example, as part of a foreign exchange move, foreign capital
flow into a country lowers the cost of capital for the country, thus improving the
country’s macroeconomic fundamentals. When there is a two-way feedback
relationship between the real and financial side, a momentum is set in motion in
both the real and financial side, creating great investment opportunities. At the
end of an upward price trend, there is an opposite and asymmetric price
sensitivity with respect to fundamental news. In this case, good news may not be
good news and bad news is really bad.
By focusing on the interdependence between the real side and the
financial side, it is interesting to see what has happened and what might happen
to the US economy and the Dollar. What has happened on the real side? On the real
side, the US economy has deteriorated and is much weaker than the official GDP
numbers suggested. For example, without the dramatic increase in government
spending, the GDP numbers would have been negative. There is simply not
enough quality in the US GDP number that attracts domestic and foreign
investment. In addition, the US balance of payments situation is getting worse by
the day: in fact, the US has to sell 1.5 billion dollars of assets each and every day
to finance the current account deficit.
In response to the gloomy employment picture, the US fiscal and
monetary policies are geared at stimulating the aggregate demand, which would
put the US government and private entities further into debt. So far, the economy
has not responded to the fiscal and monetary policies. And there is not much
room for further maneuver on either policy front.
What has happened on the financial side? Since the technology bubble burst,
the major global equity markets have declined significantly and so have the
global bond yields. Although the US dollar has depreciated only modestly, the
Dollar’s fall has been enough to generate a perception that there is greater risk
for holding dollar assets, and that to put it mildly, there is no visibility in the
Dollar’s long-term trend.
If the weak or risky Dollar perception holds, the risk premium on all US
assets should increase relative to the rest of the world, thus raising the cost of
capital for doing business in the United States even in the absence of actual
capital outflow. The increase in the cost of capital is negative for the real
economy. A 1% increase in the cost of capital could drive many firms out of
business and lowers the standard of living for millions of Americans. Therefore,
the perception of a weak or risky Dollar would then negatively affect the real
economy.
When compared to emerging markets or even to Europe, the US assets are
traded at higher valuations (say in Price/Earnings or Price/Book terms) or
equivalently speaking, the US assets command lower risk premium. Thus, US
businesses enjoy lower cost of capital from global capital markets. The reasons
are many, including the fact that the United States provides the most visible
business environment and the most freedom for capital movement. Like human
beings, freedom for capital is valuable. Other important reasons include the faith
that global investors have on the future of the US currency. The fact that the risk
premium has not narrowed between US and the rest of world goes to show that
the US stock and bond markets have not responded to the weak or risky Dollar
perception, if indeed such perception exists as suggested by investor surveys and
actual exchange rate movements.
So far, the weaker Dollar has not raised the cost of capital in the United
States relative to the rest of the world. Until that happens, there is little chance
that a currency crisis would occur. Why has the weak or risky Dollar perception
not affected the cost of capital in the United States, thus avoiding a currency
crisis?
There are at least two reasons. First, the Dollar is the main reserve
currency in the world in the sense that governments hold it without requiring a
risk premium. Second, China has been taking in huge amount of dollar in order
to peg its exchange rate, and Japan has intervened in the FX market by buying
the Dollar in order to manage the Dollar-Yen exchange rates. The actions of these
governments have helped to lower the cost of capital in the United States.
The Chinese and Japanese central bank actions in support of the Dollar
serve to slow down the fall of the Dollar. The conditions for a weak Dollar
remain intact: (1) The United States government, company and individuals get
deeper into debt, which require external financing; and (2) Judging from the
yield curve, the expected returns on all US financial assets are very low.
Someday, foreigners would demand meaningful returns for holding US assets,
and in the process of doing so, they would have to face the necessary
consequence that their Dollar portfolio may not be worth much at all.