Oct 27, 2000 Global: Flash Points: Nasdaq, the Euro, and Oil Stephen Roach (from Beijing)

World financial markets seem to be nearing an important flash point. With Nasdaq reeling and the euro in danger of freefall, a new disconnect has surfaced: How can the icon of AmericaBs New Economy crumble while the dollar continues to rise? Surprisingly, the resolution may come through the oil price wild card.

The dollar, of course, has defied conventional macro logic as we know it -- it has continued to strengthen in the face of AmericaBs record current-account deficit. Over the long haul, I do not believe this condition is sustainable: Something must and will give -- the current account via a US hard landing or the dollar. But to paraphrase Lord Keynes, in the long run, weBre all dead. And dollar bears have, indeed, died a thousand deaths in recent years, especially in 2000. Rest assured, we all seem to have cracked the code of the dollarBs Teflon-like immunity. Global capital flows continue to surge into dollar-denominated assets, both in the form of cross-border M&A activity and portfolio flows. As long as this trend continues, the dollar will stand tall -- irrespective of supposedly immutable laws of economics. When the flows stop, however, I suspect it will be a very different story altogether.

Scaling the flows gives some understanding of how defiant markets can be to the ironclad laws of economics. According to John Montgomery, our resident capital flow guru, net portfolio and direct investment inflows into the United States were about $190 billion in the first half of 2000, sufficient to have financed 90% of AmericaBs staggering current account deficit over that interval. The portfolio piece of those inflows accounted for 75% of the total in the first half of this year. But thereBs good reason to believe that the composition of these flows has shifted increasingly into direct investment in recent months. Completed cross-border M&A transactions into the US amounted to $68 billion in the first three quarters of this year, and the volume of announced deals hit a staggering $189 billion over this same period. Moreover, consistent with balance-of-payments accounting methodology, these flows are all stated on a "net" basis, subtracting out AmericaBs overseas investment outflows. As such, the gross inflows from abroad into dollar-denominated assets run well in excess of the net inflows.

Why? ItBs all about the New Economy, stupid. Dollar-denominated assets are perceived to be deserving of a permanent premium over assets of other nations. I have traveled the world in recent weeks, first to Europe and now to Asia. One conclusion comes through loud and clear: America is viewed around the world as sitting atop the pinnacle of a New-Economy mountain that other nations will never be able to climb. As I see it, the once sparkling brilliance of Nasdaq has personified all that was perfect about the global play into US assets, but now the bloom is off the rose. As Nasdaq fades, investors are coming to grips with the harsh reality that technology may turn out to be a cyclical business after all. This draws into question the mindless extrapolations of earnings growth that had long been embodied in bubble-like Nasdaq valuations. As those extrapolations come back down to earth -- and in my humble opinion, the journey may be far from over -- the notion of a permanent relative premium on dollar-denominated assets could be drawn into serious question.

As always, it will take a jolt from out of the blue to hammer that point home. I have no idea what that spark will be. But one possibility is starting to intrigue me -- a peaking of oil prices and a related rebound of the euro. Surging oil prices have, indeed, been a bonanza for the dollar. It was possibly the one event that took the dollar into its own bubble-like zone of overvaluation that was strikingly reminiscent of NasdaqBs ascendancy last spring. The trashing of the euro is, of course, the corollary of this development. As soon as the oil price peaks -- and it always does -- this same dynamic could begin to spin rapidly in reverse. Enter Saddam Hussein -- an old actor from an old stage, who never seems to give up in his quest for attention and impact. By floating the possibility of pricing Iraqi oil in euros, he could well serve the purpose of galvanizing attention to the linkage between the oil price and the long-standing disequilibrium in foreign exchange markets. Stranger things have happened.

The strong dollar has been the linchpin of the virtuous circle. The American-led renaissance of world financial markets could not have happened without it. We all know that. To the extent that Nasdaq has personified all that was permanent about this virtuous circle, the two-way trade may be about to resume in world currency markets. It would undoubtedly take a peaking of oil prices to get there. In light of recent events in the Middle East, that event still seems to be off in the distance. But that day will come -- possibly sooner than we think. With it I suspect lies the fate of the dollar and, believe it or not, newfound glory for the euro. And redemption for the old macro.

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-- Martin Thompson (mthom1927@aol.com), October 27, 2000

Answers

It may not be that far off, the EU and the euro may need iraq's intervention more than iraq needs euros. Common need makes strange bedfellows.

-- Lee Blocher (cblocher@northernway.net), October 27, 2000.