When 2006 began, all eyes in global equity markets were glued to the Federal Reserve. The U.S. central bank has always been a pivotal player in international financial markets, and foreign central banks and international investors are always keenly attuned to changes in U.S. monetary policy.
Although the U.S. economy may account for a smaller chunk of global GDP — because the rest of the world is growing faster than the U.S. economy — in other ways the U.S. has gained dramatically in importance in recent years. Thus, U.S. imports have more than doubled over the past decade, and account for around 18 percent of the world’s total exports. The U.S. continues to provide the bulk of global demand growth, on which many emerging economies, as well as export-dependent Japan and Western Europe, vitally depend.
Equally important, the U.S. has become a major supplier of capital via its yawning trade gap. In 1996, its trade deficit measured around $180 billion. It has now widened to around $850 billion. America is spewing an equivalent of nearly 1.5 percent of global GDP annually into the world financial system.
It can be plausibly argued that the rapid development of China’s industrial base would have been impossible without America’s willingness to run up massive current account deficits, the equivalent of 6.5 percent of its total GDP. Similarly, other Asian Tigers would not have been able to recover so strongly from the 1997-1998 regional financial crisis had it not been for the outflow of U.S. dollars, which allowed central banks around the region to build up huge speculator-proof hard currency reserves.
World stock markets had a spectacular 2005, which followed on the heels of a very strong 2004 as well. Emerging markets, as measured by the dollar-denominated MSCI index, gained nearly 40 percent of their value during the year. The Tokyo market rose by a similar margin when measured in yen. Europe also posted a strong performance, gaining around 25 percent in local currency terms.
But Wall Street provided a stark exception in 2005. The Dow Jones Industrial Average was flat, while the technology-dominated Nasdaq Composite index posted a very slight gain.
Why 2006 Was Much Better
The reason for America’s underperformance was not lack of growth — the U.S. economy was humming along nicely — but rather concern about the Fed. The central bank began raising its interest rates back in mid-2004, and was adding 0.25 percentage points with clockwork regularity after every Federal Open Market Committee meeting. The question troubling Wall Street was simple: How high would the rates go?
The rest of the world was also wary. The Fed provided plenty of liquidity for the rest of the global economy to enjoy heady growth, but was it now determined to take away the punchbowl?
It was no idle question. Global market indices were highly sensitive to every actual or perceived step by the Fed. Markets rose en masse in the first four months of the year, as Fed Chairman Alan Greenspan was preparing to retire, on hopes that the new regime would be more lenient. But in May, after the Fed hiked its rate yet again, investors became concerned that Ben Bernanke, the new broom at the Fed, would need to sweep even harder to establish his inflation-fighting credentials and might sin on the side of excessive tightness. Investors were spooked, and global stock markets plummeted. Some previously hot emerging markets, such as Turkey, Russia and Brazil, were swamped by bears, losing 20 percent to 25 percent in a matter of days.
But the Fed did pause at mid-year, after 17 straight interest-rate increases which pushed its Fed funds target rate from 1 percent to 5.25 percent during the previous 24 months. By mid-November, most markets around the world, even the hardest-hit ones, regained their May highs, and the Dow, having risen around 15 percent trough to peak, shot past the 12,000 mark during October.
A Goldilocks Economy