Is 2006 a top down year?

Year 2005 challenged the received wisdom that basic economic logic is irrefutable. Despite a growing trade deficit underpinned by a mismatch between domestic savings and investment coupled with a large budget gap, the US dollar appreciated sharply against other currencies.

Europe's GDP growth trailed behind the US but the European markets outperformed the US equity markets by a mile. The US's benchmark Standard and Poor's index rose by less than 4 per cent over the year compared with average gains of 20-30 per cent in major European markets.

Some of these apparent conundrums can be explained by the fact that a number of short-term, specific micro factors dictated the direction of asset markets. These overrode the logic of more "top down" macro theories.

The Homeland Investment Act, effective in 2005, for instance, which allowed US companies to repatriate their profits to their home market at concessional tax rates, induced large inflows into the US economy and propped up the dollar.

The US Fed's decision to raise policy interest rates continuously did not stymie growth, either, and opened up a huge arbitrage window for capital that sought higher yields.

In Europe, relentless cost cutting by European companies spurred the equity markets, despite weak macro numbers. Rising unemployment shifted bargaining power towards the corporate sector and enabled firms to make painful cuts in wages. Workers put in longer hours and these together led to large margin gains, which offset the drag on the top line that sedate GDP growth implied.

Year 2006, on the other hand, promises to be one in which top down theories come back into play. Over the last few weeks, the dollar has shed quite a bit of its gains against other currencies.

From average trading levels of over 120 yens to the dollar in early December, the dollar has now moved to a sub-115 zone versus the Japanese currency. Ditto for the euro-dollar rate. My sense is that this trend will continue, and a couple of brief rallies notwithstanding, the greenback is headed for a sharp fall in 2006. Why?

For one, the global foreign exchange markets are beginning to realise that contrary to expectations in early 2005, the US trade or current deficit is showing no sign of stabilising either in absolute terms or as percentage of GDP.

My colleague Robert Lind, ABN-AMRO Bank's chief US economist, has estimated if current trends were to persist, the US current account deficit will move up to 10 per cent of GDP.

This persistent deterioration in the current account cannot be explained by cyclical factors alone. A couple of critical structural factors are at work here. Import penetration in the US has risen sharply. Robert has constructed an index of imports relative to domestic demand.

From a level of 100 in the first quarter of 1995 (that Robert has taken as the base), the index rose to a level of 150 in 2005. In short, imports service 50 per cent more of domestic demand than they did in 1995. US exporters, on the other hand, are struggling to maintain market share and data show for the past decade, US exports have consistently grown more slowly than the US export markets, which implies dwindling market share.

The trigger for a sell-off in the dollar could come from the Chinese, who seem to be growing increasingly wary of its strategy of holding its reserves in dollar assets (China is estimated to hold over 75 per cent of its $600 billion plus reserves in US dollars).

Recently, China's foreign exchange regulator, SAFE (State Administration of Foreign Exchange), hinted at the possibility of altering its reserve management strategy. Its objective, it claimed, was "to improve the currency structure and asset structure of our foreign exchange reserves, and to continue to expand the investment area of reserves".

The mirror image of a declining dollar is, of course, appreciating currencies in other regions and the rupee (despite the somewhat vocal concerns of overvaluation and un-competitiveness) etc seems to be set on a rising course this year.

In fact, the falling dollar will induce a switch in asset allocations and money pulled out of US equities (on fears of currency losses) could well find its way into emerging markets like India. Thus, purely from the perspective of liquidity flows, one can continue to be bullish on the Indian market.

Europe seems all set to come out of the doldrums and in 2006, GDP growth in the region might begin to catch up with equity market performance. As that happens and labour demand picks up, margin enhancements from things like wage cuts will wane.

However, a significant margin squeeze is unlikely and the combination of higher employment, growing consumer confidence and business investment should drive top line. European equities are likely to sustain their bull run in 2006, but this time move in tandem with GDP growth.

For the world as a whole, growth is unlikely to decelerate much. A slowdown in the US is likely (rising policy rates will have to impact on the economy at some point) but a rising European economy should compensate for it.

That shouldn't be too bad for things like industrial commodities whose prices depend on global demand. We should start getting used to the idea of living with a weaker dollar. That in turn could give commodity prices a boost since commodities traditionally are seen as a hedge against the greenback.

The missing bit of the jigsaw puzzle is, of course, what happens to China this year. If economic logic indeed, triumphs, the persistent over-investment in the Chinese economy should result in a growth slowdown. One doesn't see that happening though, at least in the first half of 2006. China's defiance of the dictates of economics will continue.