Morgan Stanley reviews 2004 and previews 2005

Some insights from Morgan Stanley from the past few days.

Chief economist Stephen Roach looks back at 2004 and forward to 2005. As usual, he focuses on the global rebalancing theme. Some of his conclusions:

Adjustments in foreign exchange rates -- basically the decline in the US dollar -- is likely to usher in adjustments in other asset prices -- principally bond prices -- that would provide a more decisive impetus to global rebalancing.

Foreign buying of long-term US securities have allowed US interest rates to stay low. He doubts that they can stay low, noting: "There comes a point when private foreign portfolio investors demand to be compensated for taking outsized currency risk, and that compensation normally takes the form of higher real interest rates."

Foreign central banks may start to baulk at continuing to support the US currency. "There also comes a point when the offset from official capital inflows becomes politically and economically untenable," he wrote, addding that "it perpetuates trade imbalances, thereby raising protectionist risks, and it also leads to a loss of control over the domestic money supply, thereby stoking inflationary pressures".

US consumption has remained resilient. Sub-par income growth has been offset by increases in wealth -- most recently, that from property markets. If interest rates rise, "the long-awaited capitulation of the American consumer could well be at hand".

China has managed to cool its economy. Further downside is likely to be limited. Reform, especially of its currency regime, may be the main challenge for China in 2005.

Roach's colleague, Andy Xie, thinks that the US dollar's movement is the key to the performance of the global economy and financial assets.

When the dollar bottoms, I believe it will signal the peaking of all risk assets globally (e.g., Shanghai property, commodities, and emerging market debt). When the dollar bottoms will determine how 2005 pans out for financial investors. If the weak dollar drags through the whole year, 2005 would turn out to be similar to 2004 with risk assets remaining grossly overvalued and the global economy strong.

If the dollar reaches a convincing bottom in 2005, major reversals in asset markets could follow. The overvaluation of commodities and emerging market debt and stocks, for example, could correct quickly. A sharp slowdown in the emerging economies as well as the global economy would follow.

For my own review and outlook for 2004 and 2005, see "Stormy 2004 makes way for challenging 2005".