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What today is fundamental and what is sideshow?

These are very confusing times internationally, where few people wish to commit themselves to a definite view. Will there be a US recession, an emerging market decoupling, a further twist to the global banking crisis, a further relentless rise in oil prices?

Even more animated are the debates as to whether there will be a deepening bull market or a bear market in equities shortly. The answer in both instances seems to turn on the stage of the existing global bubble in emerging equities and commodities.

The bull crowd concentrates on first taking the bubble to maturity, preferring to focus on the rise and rise ahead of us in equity asset prices, with all kinds of clever warnings to jump ship in time eventually.

The bears accelerate through the forming bubble, focusing on how it will end, inevitably in tears.

Globally, there have been financial market bubbles every decade, in US equities in the 1960s, in gold in the 1970s, in Japanese equities in the 1980s, in US and Asian equities in the 1990s, in housing throughout and now in this decade in emerging equities and commodities.

South Africa's experience has been far more limited. The 1960s saw a great equity exuberance (ending in the crash of 1969), and there was the gold-driven asset spike of 1980. Our 30-year political stagnation detour ended in 1994, and from 2003 we have taken off on afterburner in line with the latest emerging bubble globally.

So, analytically, how is one supposed to handle such confusion? Well, it would be helpful not to exclusively focus on the financial symptoms. These are but the accompanying results of deeper phenomena.

What is driving global events?

In financial markets the conviction is deep that it is the central banks. Their periodic policy easing and tightening are for many people the full explanation behind all financial excesses we can observe, central banks sitting astride fiat (paper) currencies, ultimately driven by the choices of their democratic (or autocratic) societies and governments.

Perhaps key central banks are important, but is there a bigger force we should accord pride of place, which central banks in turn have to pay homage?

Certainly Greenspan in his memoirs gives the impression of being rarely in charge, forever responding to events rather than controlling and shaping them. There is a crucial difference.

Two episodes stand out in Greenspan's US experience these past twenty years. Firstly, the sensation that inflation was on a long-term down trend which came as a pleasant surprise (tailwind) to central bankers, originating globally. And secondly the surprising technology wave and productivity gain in the US, further deepening the disinflation experience.

In neither instance were central banks the originators of these phenomena. Greater primordial forces were at work. The one involves absorbing huge numbers of additional production factors (mainly labour and forced savings and the rapid capital formation it makes possible). The other concerns technical progress (translating into global productivity gains).

So how should we visualize the global condition and the financial excesses within it? Where does it take us next?

There have been two great institutional renewals globally this past century, their true roots stretching far back in time, for centuries really, encompassing all of the modern West's long ascendancy.

Firstly, Europe engaged in yet another internal death struggle during WW1 and again in WW2. These were merely the latest of a series of massive modernizing upheavals, preceded in foregoing centuries by the reformation and generations of continental-wide contests whose ultimate outcome was the vesting and consolidation of a mature, established liberal order. In this latest joust it was capitalist democracy that won out decisively. It was a feat completed before our time.

Secondly, the non-Western world regained its freedom and/or prevented colonization and responded successfully to Western expansion in protracted resistance struggles. This effort straddled many generations, notably our own.

Japan, China, Russia, Turkey, Iran, Afghanistan and Thailand are examples of countries that successfully resisted Western colonizing, taking between 30 and 300 years to formulate successful responses to Western expansion.

Most of the rest of the world was overwhelmed between 1500 and 1900 by Western expansion. Freedom was regained only slowly in stages, America being the earliest example in the late 1700s, followed by most of Latin America in the 1800s. Other English-speaking settler countries followed in the early 1900s. The rest of Asia, all of Africa and the Middle East followed only after WW2 and then in rapid succession.

In these two great historic 20th century movements, the central phenomenon that won out worldwide was market capitalism. To a lesser degree, the Anglo-Saxon tradition of democracy was imperfectly taken over to varying degrees or not at all.

Today we aren't as yet living in a mature, uniform, global democracy. Instead, centrally-directed authority in many instances continues to hold sway.

In contrast, technological advances are global and central to all economic advances.

Social tendencies today are nearly universal and mostly Western in origin, though a billion-strong Muslim society continues successfully to adhere to its own conventions, and the more underdeveloped parts of Africa, Asia and Latin America have yet to join the global mainstream.

In the economic sphere market capitalism proved triumphant except for some struggling socialist enclaves (Cuba, North Korea) and dysfunctional states (Zimbabwe). One should, however, allow for the different stages of industrial development that many emerging countries find themselves in (and the accompanying stage of market capitalism applicable to them).

Such technical, social and economic universalism created the reality of what we came to recognize as globalization, which nearly all political systems have found difficult to resist.

It proved to be central to the effort of transforming the European condition into a universal liberal order. Competing political systems such as communism (in Russia, Eastern Europe and China) eventually also gave way, at least in their economic and social organisation.

So, too, has state socialism in the many ex-Western colonies in most of Asia and Africa, though state guidance has remained a feature in some of these countries as rapid economic development became the objective. Latin America continues to struggle with some aspects of its Iberian heritage.

Just as the UK was the industrial role model for the US and much of Europe that followed it, mostly emphasizing liberal economic policies, so Japan adapted these Western ways to its own circumstances and in turn became an early economic model for many developing countries that came after it.

Japan as an extremely poor and backward country chose to modernize rapidly in a very specific and un-Western way. It became producer-oriented, determined to catch up with the industrialized West as soon as possible in order to safeguard its freedom.

In the process, Japan actually lost its way militarily, became totally devastated, and by a remarkable set of circumstances was allowed to revive. Something similar happened to Germany.

Other Asian countries to a greater or lesser degree modeled themselves economically on Japan or the early Western industrialization effort.

Others choose industrializing Russia as their model, only relatively recently changing horses as that model imploded. When the switch came to market capitalism these past 30 years, the impact was stupendous, with the greater productivity of market processes translating in much faster economic growth.

Why put such emphasis on these historic processes?

This is the Mother Lode. The fundamental process. Much else has flowed from it, especially financially. 

Today, technical, social, economic and financial globalization is unlocking enormous labour and productivity additions via the global market place, creating the ability to lift living standards rapidly everywhere while suppressing inflation, interest rates and risk premiums.

In the process, huge financial surpluses are being generated and re-allocated around the world. It has created massive balance of payments imbalances but has also boosted financial markets with the consequent enormous investable surpluses (liquidity).

These phenomena in turn have given rise to serial asset market explosions, thinking of the equity bull runs of the 1980s, the 1990s and 2000s. Central bank activity has been more by the way of corrective interventions in response to crises along the way.

Even so, internal mistakes were made, thinking US macro-policy in the 1960s and 1970s, the OPEC energy disruption of the 1970s, Japan's excesses of the 1980s, Europe's mistakes of the 1970s and its imperfect absorption of Eastern Europe in the 1990s, and Russia's implosion.

The Third World debt explosion of the 1980s reflected internal weaknesses in many such developing regions, especially in Latin America, that became exposed once non-sustainable recycled petro-Dollar loans encountered rising US interest rates and Dollar.

The Asian contagion of 1997-1998 reflected institutional weaknesses in Asia. These were exposed by a wave of incoming capital generated in the 1990s US asset boom.

The 1987, 1990, 1998, 2000, 2001-2003 and 2007 Fed interventions (all of them vintage Greenspan, with only 2007 so far being Bernanke's) were all in response to crisis conditions, at a time that inflation was trending down longer term.

What today is fundamental and what is sideshow?

We remain globally in the full flood of catch-up industrializing growth, especially in Asia (China, India, Singapore, Korea, Taiwan, Malaysia but also Indonesia, Vietnam, Pakistan, Bangladesh and others).

In other countries, such as Germany and Japan, there is relative underperformance, under-consumption and excess saving. In yet others (OPEC oil producers and other commodity producers such as Chile, Brazil and Russia) huge export gains can't all be absorbed, creating yet more excess savings.  

In all these instances investable surpluses are generated that need to be allocated around the world. In the case of the US, such incoming capital has been mostly invested in US Treasury bonds. In other countries it has been invested in direct investment, government bonds and increasingly in equities.

Meanwhile strong income growth, a culture of high consumption and low-savings-from-income allowed the US to expand its imports, running a current account deficit equivalent to a large part of the producer surpluses being generated elsewhere in the world.

Thus the one region's excess consumption and imports created a shortfall that needed funding and it was equivalent to the other region's excess export and savings that needed to be invested.

Other countries following America's example are Australia, New Zealand, South Africa, Spain, India.

Many other emerging countries have been subjected to capital inflows, whether they needed or wanted such inflows or not, with some of these inflows neutralized in their rising foreign reserves.

What we have seen over the last four years is that the rapid growth of Asian industrialisers, the massive windfalls accruing to commodity producers, rapid company earnings growth worldwide, and low inflation and interest rates globally have given rise to often explosive increases in equity markets.

The very size of these equity price increases has in many places engendered a great psychological exuberance (an emotional optimism, in which a healthy sense of skepticism and realism tends to be temporarily suspended). Its presence is taken as proof of an asset bubble forming.

Yet the underlying relationship between actual earnings and asset prices has only become excessive so far in China and to a far lesser extent in India. In many other equity markets, more modest valuations continue to apply, despite the great price gains of recent years.

Despite cyclical activity remaining a reality, and the relentless growth and high global resource utilization putting upward pressure on inflation and interest rates, the essence of what we are watching (global developmental catch-up) is continuing mostly unchallenged.

Rapid industrialization can be observed in a large swath of countries, some leading the growth process, others being intermediate conduits and yet others as mere suppliers (commodity producers).

Even with cyclical weakness observable in the US, and relative domestic underperformance in Japan and Europe, the world remains very much growth oriented. Its source is the great supply additions and catch-up phenomena driving most of Asia and also observable elsewhere in the world, a huge incomplete work impatiently in progress.

These realities suggest ongoing investable global surpluses for some time to come. At the same time, the US role as receptacle for most of these funds is temporarily changing, as the US is taking a pit stop, slowing its growth, cutting interest rates, weakening the Dollar, increasing its saving balances and improving its net exports, thereby reducing its current account deficit.

This condition doesn't seem to be cutting unduly into global growth, not least because many emerging countries are now maintaining robust internal demand engines, especially their fixed investment (infrastructure) efforts and to a lesser extent their household consumption booms.

China, India, Russia, the Middle East, Eastern Europe and Latin America have now EACH 10-year infrastructure efforts of $1 trillion apiece underway, in addition to which Australasia and Africa also have ambitious infrastructure expansions. The significance of this for global growth sustainability is perhaps something we too easily lose track of in the greater context of things.

US weakness, lower US rates and a weaker US Dollar are also boosting commodity price prospects and are reducing bond yields. Together, the growth outlook and the lowered interest rate outlook are boosting equity prospects, none more so than in emerging markets where the growth is most rapid, with temporary disenchantment with US assets and the Dollar further encouraging asset diversification.

With less global appetite for US bonds, and growing appetite for commodities and emerging equities, the global bull markets in these assets seem to be set to intensify, possibly to the point of exuberance (bubble conditions).

Such conditions usually don't come into being overnight. Going by recent decades and global phenomena, bubbles can take up to ten years to mature.

The remarkable news may be that with the commodity and emerging equity take-offs only dating from 2002-2003, with the global growth outlook hardly impaired (if evolving), and with asset valuations as yet hardly challenging (except in some instances), there could be an extensive period of years still ahead in which this latest asset price development will get the full opportunity to flower.

Full bubble characteristics may only be achieved with price-earning multiples in the 30-100 range. On that score further doublings in price/earnings multiples in many emerging countries may still lie ahead before irrational exuberance finally flames out once again.

As to China, the gambling instincts of its population, and the intractable contradictions of its government?s economic policies are probably such that new Asian and global standards for market excess could be achieved before 80%-90% price adjustment is encountered (as it has regularly on past occasions).

Is all of this frightening?

Any excessive speed is frightening to rational people, especially older, more mature ones with reduced reflexes and much experience of what can go wrong.

But these are unlikely to be the ones in the driving seat. Instead, mostly inexperienced, young, immature elements will be doing the driving on their way to their first major financial lesson in life, which probably no amount of warning will prevent them from incurring eventually. That, too, is a major historic characteristic of market capitalism.

A sure thing. It remains one of life's great constants.           

Cees Bruggemans is Chief Economist of First National Bank. Visit his website www.fnb.co.za/economics and register for his free e-mail articles.