Andy Xie of Morgan Stanley writes
Summary and Investment Conclusion
The monetary bubble that the Fed has created post-tech burst has created property and commodity inflation (mainly in food and oil). I anticipate the cost-push inflation will spread to general inflation in the coming months, which may shake the bond market.
I believe the global economy is headed toward either mild deflation or stagflation. If central banks cut interest rates in 2005 in response to slowing growth — an outcome of the oil shock — the global economy may be headed toward stagflation. If central banks focus on price stability and, hence, do not cut interest rate in 2005 despite slowing growth, the global economy could be headed toward low growth and low inflation with deflation in certain periods and some sectors.
My expectation is along Andy Xie’s one, but twofold, dividing the world into a US-Dollar and a Euro zone.
The US Federal Reserve Bank (Fed) under Greenspan is likely NOT to focus on price stability. The propaganda “core CPI” inflation measurement (without “volatile” food and oil prices) will show only low US inflation rates.
Next year the Fed will decrease its interest rate again, because the US economy will be in stagnation or in another recession. Low Fed interest rates will lead to a new round of money creation (cheap credit => increasing amount of money chasing a constant amount of goods => higher prices => inflation) and intensify the inflationary process. The US money expansion will also fuel inflation in Asia where currencies are bound to the value of the US Dollar. Through more expansive imports from Asia to the US the inflation spiral will accelerate.
This will have the desired effect of decreasing the cosmic US debt in real, inflation corrected, terms, but in effect will be a heavy additional tax for the US consumer. This is the stagflation scenario.
The European Central Bank is hawkish on inflation. It will most likely not decrease its interest rate, but may allow or engineer a further rise of the Euro against the US Dollar. This will shield the Euro market from increases in Dollar denominated commodity (oil) prices, i.e. inflation, but will hurt its exports.
Inflationary pressure in the Euro zone will be much less than in the US, but low local demand and sluggish exports will take their toll.
(The Euro economies will try to increase their exports into countries that are blessed with higher income through higher commodity prices, i.e. the Middle East and Russia. This puts their economic interest in opposition to strategic US interests.)
Real wages will decrease, as desired, not through inflation, but through negotiated working hours increases. This is Andy Xie’s deflationary scenario.
Economic analysis is unsound in quantifying effects in time. The above scenario may unfold in 2005 to 2008, but possible shocks like a massive oil supply disruption, a litigious US election or a severe correction in the stock markets through derivative failures (Fannie Mae?) will likely accelerate the process.
My medium term investment conclusion:
Short: US Dollar, US Treasuries, high tech, housing and retail related stocks;
Long: Euros, Gold, commodities (oil, food), stocks related to water, food and commodity production;
These are just my € 0.02. If you add your equivalent in the comments, we may all become rich.