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The only certainty in life is change

"Change your thoughts and change your world" - Norman Vincent Peale

We all know the saying that the only certainty in life is change. Curve balls are generally curve balls because of an individual's preconceived ideas. In the investment world one can get caught in exactly the same trap.

After the market crash in 1998, it required skills, patience and conviction to look through the crisis that was unfolding at the time to invest your money in resource producers. These were old-economy stocks that were, and still are, highly geared to global growth and industrial production.

At the time it was much easier (especially for the new era fund manager) to stick to what you knew and what you were comfortable with. Change is good as long as you remain realistic. If IT stocks trade on 100 multiples for two years it becomes easy to convince yourself that it could be justified!

Historically low interest rates have become the order of the day, pumping huge liquidity into the pockets of consumers and asset gatherers. This has made us somewhat complacent in terms of what the outcome would be if interest rates were to rise to normal levels, being real rates of around 1% to 1.5%.

From the attached graph it is clear that low interest rates have been a key driving factor behind market rallies during the last few years. Looking at the comparison between global interest rates, economic growth rates and market movements, the conclusions are logical, but still interesting. 

In the attached graph global real interest rates are measured by adding a third of each of the repo rates of Japan, US and Euroland. This might sound a bit simplistic, which it is, but in terms of a global liquidity source these three remain dominant.

Global growth bottomed in the beginning of 2002, exactly two years after interest rates peaked. Equity markets have responded to the liquidity-induced growth cycle, with the Morgan Stanley World Index and the Morgan Stanley Emerging Market Index bottoming at the same time as global growth.

Global real interest rates are still at extremely low levels, and should remain supportive of global growth as things stand at the moment. It is for this exact reason that the market got hammered recently, when the Fed started giving signals that they are as clueless about the future as anyone else.

Bear in mind that the Fed has changed chairman as well and the market is also uncertain as to his response to changing economic variables. For example, would he respond to rising inflation, while grappling with slowing growth or would he be willing to sacrifice price instability for full employment.

Uncertainty creates volatility. China is sending very clear signals that they are planning to clamp down on over-investment and excess demand and we would not be surprised to see further interest rate hikes. This sent shivers down the spines of even the most optimistic commodity bulls. 

If one uses labour market growth and productivity growth as a measure of trend growth for the US economy, it is clear that actual year-on-year growth has already slowed down to trend levels.

Further monetary policy tightening is more likely to come from Europe and Japan, which could be further bad news for equity market performance. The flip side of the coin is of course non-monetary policy liquidity in the form of central bank reserves.

This capital, especially Asian savings, has become increasingly more mobile, and could be the sustaining factor for global growth and asset accumulation. The question is whether Emerging Asia is now the Japan of the 70's and 80's?  It certainly has that feel to it, but so did it in 1997!

The world has changed since 10 years ago, but market reactions tend to remain constant. Global equity markets tend to react negatively to slowing growth. The developed world is likely to experience a US led slowdown leading into 2007.

Emerging market growth is holding up well, but globalization has sucked them in and a global slowdown is likely to dent emerging market growth as well. How bad it will be, or how deep the trough, remains to be seen.

Their resilience and that of their central banks will be tested in coming years, which could change economic theory as we know it.