Sean is a London based economist and professional investor who publishes Dead Cats Bouncing, a leading markets analysis service that has established an impressive track record of astute and contrarian investment calls. He is a post-grad trained economist, CFA associate, with many years... More
A bearish frenzy has developed in the US dollar, and is probably the strongest consensus I've seen since the bullish stampede in oil futures crashed last Summer. With publicity hungry commentators from historian Niall Ferguson to journalists spinning lurid Chinese/Arab conspiracy theories weighing in with their economic insights, and hedge funds leveraging up aggressively again on the global carry trade using the dollar as a 'free' funding currency, it's time for a reality check. There is no alternative to the dollar as the global reserve currency for the foreseeable future; while the dollar's share of CB reserves has declined from 72% to just over 62% this decade, this is the result of the Euro's emergence, with the Yen still a paltry 3% of global forex holdings.
Total dollar holdings have steadily risen, and even this year, China has continued to accumulate dollar assets, while grumbling about US economic policy. It will be at least a decade before Yuan convertibility is a real prospect, and only then if China can radically overhaul its financial markets in the meantime, developing deep capital markets and hedging mechanisms and gradually opening its capital account. At the moment, even in Hong Kong, less than 2% of trade is conducted in Yuan. As for that complex proposed IMF basket currency, which dollar bears offer as a real alternative, call me when a Colombian drug smuggler is caught with a suitcase full of the things.
The structural nature of America's trade deficit has been demonstrated this year by the fact it still remained at 3% of GDP in Q2, in the depths of the recession (from 7% at the peak of the boom in 2007, when its funding was soaking up 70% of global excess reserves). In fact, the US hasn't run a trade surplus since the early 1990's recession, and that constant funding requirement places ongoing pressure on the dollar. I've commented at length on the dangers of current Fed policy, which does little to alleviate deflation in real assets while stoking hyperinflation in financial ones, and to the extent it is spiking commodity prices, undermining a real recovery. If it was down to me, I'd immediately place the $870bn in excess commercial bank reserves at the Fed at a negative interest rate (ie charge them for the privilege of parking their cash, as the Swedes have already done) and simultaneously hike rates by 50bps. This would correct the current dangerous distortion of the monetary base.
I wrote several times in 2008 on Japan's secular economic decline, determined by the developed world's worst demographic outlook. Over the next 20 years, the workforce will decline by 20%. Five years ago, the population was 127.7 million, today it marginally lower, but the composition has changed radically. In 2004, the population below the age of 15 was 17.7 million, and that population aged 65 and over was 24.9 million. Now, the population below the age of 15 has dropped 3.5% to 17.1 million, while the number of people older than 65 has increased 16% to 28.9 million. This devastating trend is set to accelerate over the next decade, with the working age population declining by 0.9% a year, implying a major drawdown of Japan's savings mountain, with adverse implications for the Yen and JGB yields. The household savings rate relative to disposable income has fallen to 2% from 14% in the early 1990's at the beginning of Japan's long decline, while government debt will probably hit 200% of GDP by next year. The country's birthrate has plummeted since the 1950s and has been below replacement level (2.1 births per woman in developed countries) for decades. Today it is at a mere 1.2 births. As a result, Japan now has the highest proportion of residents over the age of 65 in the world, and the health ministry estimates the country's population will decline by 25 percent by 2050, despite rising life spans.
By 2050, 40 percent of the population would be over 65. Where Japan has led, the rest of the developed world will soon follow with a steep drop in the global birthrate since the 1970's that has resulted in a rapidly aging population and workforce in Europe, Japan, and soon too in the US (which has been spared by Latin immigration). Not only does this have direct economic implications on household formation, demand for durable goods etc, but it has a cultural impact too, making a society more conservative and averse to risk-taking. It's a phenomenon that strikes me whenever I travel from youthful and dynamic London to cities in Europe like Vienna or Munich with a much older population on average, which are impressively prosperous but also stultifying. Globally, the world's birthrate looks set to drop below replacement level around 2040 (although population will still rise for some time after as longevity extends).
As well as inflationary labor shortages, a shrinking and aging workforce also translates into a loss of innovation and entrepreneurial activity that's not easily replaced. Older workers tend to be more conservative and less risk-taking by nature, and additionally when a growing share of a country's gross domestic product must go to support retirees, that crowds out investment in new ventures. As a homogeneous and chauvinistic society, the Japanese have resisted one rapid action to boost population, which is opening up their doors to more immigrants. Indeed, as unemployment has risen in the current downturn the Japanese have done the exact opposite, sending some foreign workers home. Japan's population problems are already so acute that it would take a massive influx of many millions of foreign workers to make much difference, and that's politically very unlikely. At some point, the markets will realize that the Yen sub 90 to the USD and 10 year bond yields at 1.3% are economic anomalies in the context of Japan's deteriorating fundamentals, and sell both aggressively.
With Hilary Clinton as Eva Peron singing 'Don't cry for me Obama'? One of the most remarkable economic reversals over the last decade has been the impressive macroeconomic discipline shown by leading emerging markets from Brazil to India, while developed nations such as the UK and US have become increasingly reckless and profligate. While the former have been steadily re-rated by investors leading to a huge secular bull market in emerging market equities and bonds, the latter have yet to pay the price for their growing fiscal irresponsibility. Argentina's troubled history in recent decades leads many to forget just how prosperous and advanced the country was a century ago; in fact, it was one of the ten richest countries in the world on a per capita basis until the 1930's. Any analysis of the country's stunning decline into inflation and dictatorship a few decades later must begin with the role of an entrenched economic elite who pursued their narrow interests regardless of the national cost. Rather than investment bankers, Argentina had an elite of a few thousand landowners who equally dominated the economy via agricultural exports. The pursuit of naked self-interest by these 'oligarchs' led to an increasingly unbalanced economy that underinvested in education and infrastructure and was dominated by inefficient monopolies protected by political patrons. That effort to protect the status quo at all costs via a captive political system led to the failure of attempts to modernize the economy and income inequalities growing to a destabilizing extreme. Effectively Argentina metamorphosed from a productive to a rentier economy, with a small elite redistributing stagnant national income to their short-term advantage, with the rising frustration of the wider population eventually bought off with the printing presses. Sound even vaguely familiar?
America's strongest remaining economic advantage has been its ability to reallocate capital and talent to the 'new thing', the innovative business models and technologies that can transform broader economic productivity and generate new wealth. That depends on both social mobility and an effective reallocation of capital and people from dying to rising industries, what Austrian economist Joseph Schumpeter termed 'creative destruction'. Regulatory and political capture by entrenched elites runs counter to both, and helps explain the unhealthy domination of the US economy by the finance and healthcare industries over the past decade, whose political lobbying and funding dwarfs any other sector. An economy riven by narrow vested interests seeking to direct public policy and profit from public funds becomes one saddled with perverse economic incentives that undermine the purging and renewal process that is central to capitalism.
The end result is secular decline, imperceptible at first, but eventually leading to a crisis of confidence in a nation's currency and its debt obligations. The Soviet Union began an irretrievable decline from the late 1960's, caused by slumping productivity as real energy costs soared but also political capture by the military-industrial elite, as Kremlin factions competing recklessly to divert resources to their political constituencies. At one stage in the 1970's, the USSR was simultaneously producing five different battle tanks from four different decades, simply because military lobbyists in Moscow could work the system to obtain funding. Every Soviet leader from Khrushchev to Gorbachev attempted to control runaway military spending, but they were too weak to overcome entrenched interests until the whole shoddy edifice collapsed.
Early this year, I advocated building exposure to long-term inflation hedges such as TIPS and resource equities, because they were radically mispriced as investors fled in fear of a sustained deflationary environment. That strategy played out well, and TIPS are now implying around 2% CPI inflation over the next decade, or broadly in line with experience in the last. We face a tug of war between inflationary and deflationary forces in coming years, and key to the outcome will be the scale of excess liquidity (ie a rising money-to- GDP ratio) and how swiftly it is drained from the system in a recovery. Currently, the huge expansion of central bank balance sheets hasn't translated into higher credit via the banking system and therefore a broadening of money. In other words, the velocity of money remains very subdued as banks focus on deleveraging (with the exception of China). This can be seen by the remarkable 6% of GDP parked at the Fed as reserves by US commercial banks, and similar bank risk aversion is evident in the UK and Europe.
Monetary policy has been astonishingly loose for most of the past decade, in response to a series of financial panics starting with the 1998 LTCM/Russia meltdown, proceeding via the IT bubble bursting in 2000, and now the systemic banking crisis of 2008. Ironically, like a doctor feeding an addict's drug habit with ever higher dosage, the response to each crisis has precipitated the next. Between 1996 and 2009, nominal GDP in USD for the top five global economies grew 60%, but narrow money (M0) grew 230% and broad money (M2) 210%. Much of the excess leaked into a fast sequence of speculative bubbles from Internet stocks to Florida condos and oil futures.You can picture the current monetary situation like a dam, with a lake of fresh money rising even higher, held back only by weak supply (and indeed demand) for credit.
When that dam breaks, and credit growth resumes, even at much lower levels than seen in recent years, the inflationary risks become substantial. There is now intense political pressure on banks to lend, as a quid pro quo for their generous taxpayer funded bailouts. When looking at inflation, it is a mistake to consider it simply in terms of narrow CPI statistics (which are in any case arbitrary in their calculation. Volatile asset inflation has been a characteristic of the last decade precisely because the real economy hasn't been able to absorb the flood of money issuing from central banks and amplified by a secular rise in bank leverage until last year's crash. Historically, a big rise in money supply takes 1-2 years to inflate asset prices. However, given the unique nature of quantitative easing which involves creating money to directly buy assets such as bonds from institutions, thus providing fresh capital which they can re-invest into riskier assets, the lag this time has been a matter of months rather than years, and is being reflected in the relentless rally in equities.
After a stunning six-month rally in equities, commodities and corporate bonds, we are reaching a critical juncture for markets, which have swung from despondency to euphoria since March. Incoming data have moved the investment debate from whether a recovery is imminent to how strong and durable it will prove. I said back on March 10th that: 'Equities are now cheaper than for several decades on a cyclically adjusted earnings basis (and versus bonds) and stand at an extreme oversold level only seen a few times in the last century' The depression/deflation panic was clearly misplaced and I predicted a 40-50% trough to peak rally as deflation fears abated. Indeed 10 year inflation expectations in the TIPS market had jumped back to near 2% by June, driving the first leg of the risk asset rally. The six leading global economies this time around have applied 300% more fiscal stimulus and 500% more much monetary stimulus relative to GDP as occurred in the 1930's, and that was always going to be hugely reflationary.
Key factors that turned a hoped-for recovery in 1930 into the disaster of the Great Depression were a sharp hike in interest rates in October 1931 and a decline in the overall price level of 10% per year in 1931 and 1932. History isn't going to repeat and indeed the Bernanke Fed is loathe to risk tightening policy before any recovery is self-sustaining as reflected in capacity utilization climbing to at least 75-80% (ie not before end 2010 if markets don't force their hand). In fact, reflating asset markets was a crucial objective of public policy as much as avoiding CPI deflation, as balance sheets were so dangerously stretched in the US and Europe, and it has proved successful. Three factors have proved supportive of the ongoing risk asset rally in recent weeks.
Firstly, not only is the cycle bottoming earlier than seemed likely back in March, but the recovery is increasingly synchronized on a global scale (with Q3 marking the inflection point for the US and UK, and Europe already modestly rebounding as are the key Asian exporters). Secondly, central banks from the Fed to BOE, far from removing the punch bowl of monetary stimulus, are raiding the drinks cabinet for any leftover monetary hooch they can thrown into the mix to keep the party going. Thirdly, 10 year government bonds have sold off modestly so far, supported by a natural bid from commercial banks seeking to flatter their capital ratios, and central bank's own buying as well as still declining CPI inflation.
However, a number of risks loom large in coming months to unnerve complacent sentiment.
Last Summer, as the mania gripping commodity markets peaked, I warned repeatedly that the climactic move represented the biggest speculative bubble since Nasdaq in 2000, and went short accordingly. I wrote back on 26 May 2008 in It's the oil price, stupid, but for how long more?, that:
Peak Oil is not at hand but peak speculation in oil may well be. Given the weight of resource stocks in key global indices (and earnings), it will be interesting to see how markets react to a looming reversal in oil; some pretty brutal sector rotation would certainly result and the dollar would resume its stalled rally.
Instablogs are Seeking Alpha's free blogging platform customized for finance, with instant set up and exposure to millions of readers interested in the financial markets. Publish your own instablog in minutes.
Dollar Bear Trade Looks Dangerously Crowded...
A bearish frenzy has developed in the US dollar, and is probably the strongest consensus I've seen since the bullish stampede in oil futures crashed last Summer. With publicity hungry commentators from historian Niall Ferguson to journalists spinning lurid Chinese/Arab conspiracy theories weighing in with their economic insights, and hedge funds leveraging up aggressively again on the global carry trade using the dollar as a 'free' funding currency, it's time for a reality check. There is no alternative to the dollar as the global reserve currency for the foreseeable future; while the dollar's share of CB reserves has declined from 72% to just over 62% this decade, this is the result of the Euro's emergence, with the Yen still a paltry 3% of global forex holdings.
Total dollar holdings have steadily risen, and even this year, China has continued to accumulate dollar assets, while grumbling about US economic policy. It will be at least a decade before Yuan convertibility is a real prospect, and only then if China can radically overhaul its financial markets in the meantime, developing deep capital markets and hedging mechanisms and gradually opening its capital account. At the moment, even in Hong Kong, less than 2% of trade is conducted in Yuan. As for that complex proposed IMF basket currency, which dollar bears offer as a real alternative, call me when a Colombian drug smuggler is caught with a suitcase full of the things.
The structural nature of America's trade deficit has been demonstrated this year by the fact it still remained at 3% of GDP in Q2, in the depths of the recession (from 7% at the peak of the boom in 2007, when its funding was soaking up 70% of global excess reserves). In fact, the US hasn't run a trade surplus since the early 1990's recession, and that constant funding requirement places ongoing pressure on the dollar. I've commented at length on the dangers of current Fed policy, which does little to alleviate deflation in real assets while stoking hyperinflation in financial ones, and to the extent it is spiking commodity prices, undermining a real recovery. If it was down to me, I'd immediately place the $870bn in excess commercial bank reserves at the Fed at a negative interest rate (ie charge them for the privilege of parking their cash, as the Swedes have already done) and simultaneously hike rates by 50bps. This would correct the current dangerous distortion of the monetary base.
More »Japan: Who will Switch the Lights Off?
I wrote several times in 2008 on Japan's secular economic decline, determined by the developed world's worst demographic outlook. Over the next 20 years, the workforce will decline by 20%. Five years ago, the population was 127.7 million, today it marginally lower, but the composition has changed radically. In 2004, the population below the age of 15 was 17.7 million, and that population aged 65 and over was 24.9 million. Now, the population below the age of 15 has dropped 3.5% to 17.1 million, while the number of people older than 65 has increased 16% to 28.9 million. This devastating trend is set to accelerate over the next decade, with the working age population declining by 0.9% a year, implying a major drawdown of Japan's savings mountain, with adverse implications for the Yen and JGB yields. The household savings rate relative to disposable income has fallen to 2% from 14% in the early 1990's at the beginning of Japan's long decline, while government debt will probably hit 200% of GDP by next year. The country's birthrate has plummeted since the 1950s and has been below replacement level (2.1 births per woman in developed countries) for decades. Today it is at a mere 1.2 births. As a result, Japan now has the highest proportion of residents over the age of 65 in the world, and the health ministry estimates the country's population will decline by 25 percent by 2050, despite rising life spans.
By 2050, 40 percent of the population would be over 65. Where Japan has led, the rest of the developed world will soon follow with a steep drop in the global birthrate since the 1970's that has resulted in a rapidly aging population and workforce in Europe, Japan, and soon too in the US (which has been spared by Latin immigration). Not only does this have direct economic implications on household formation, demand for durable goods etc, but it has a cultural impact too, making a society more conservative and averse to risk-taking. It's a phenomenon that strikes me whenever I travel from youthful and dynamic London to cities in Europe like Vienna or Munich with a much older population on average, which are impressively prosperous but also stultifying. Globally, the world's birthrate looks set to drop below replacement level around 2040 (although population will still rise for some time after as longevity extends).
More »As well as inflationary labor shortages, a shrinking and aging workforce also translates into a loss of innovation and entrepreneurial activity that's not easily replaced. Older workers tend to be more conservative and less risk-taking by nature, and additionally when a growing share of a country's gross domestic product must go to support retirees, that crowds out investment in new ventures. As a homogeneous and chauvinistic society, the Japanese have resisted one rapid action to boost population, which is opening up their doors to more immigrants. Indeed, as unemployment has risen in the current downturn the Japanese have done the exact opposite, sending some foreign workers home. Japan's population problems are already so acute that it would take a massive influx of many millions of foreign workers to make much difference, and that's politically very unlikely. At some point, the markets will realize that the Yen sub 90 to the USD and 10 year bond yields at 1.3% are economic anomalies in the context of Japan's deteriorating fundamentals, and sell both aggressively.
America as Argentina?
With Hilary Clinton as Eva Peron singing 'Don't cry for me Obama'? One of the most remarkable economic reversals over the last decade has been the impressive macroeconomic discipline shown by leading emerging markets from Brazil to India, while developed nations such as the UK and US have become increasingly reckless and profligate. While the former have been steadily re-rated by investors leading to a huge secular bull market in emerging market equities and bonds, the latter have yet to pay the price for their growing fiscal irresponsibility. Argentina's troubled history in recent decades leads many to forget just how prosperous and advanced the country was a century ago; in fact, it was one of the ten richest countries in the world on a per capita basis until the 1930's. Any analysis of the country's stunning decline into inflation and dictatorship a few decades later must begin with the role of an entrenched economic elite who pursued their narrow interests regardless of the national cost. Rather than investment bankers, Argentina had an elite of a few thousand landowners who equally dominated the economy via agricultural exports. The pursuit of naked self-interest by these 'oligarchs' led to an increasingly unbalanced economy that underinvested in education and infrastructure and was dominated by inefficient monopolies protected by political patrons. That effort to protect the status quo at all costs via a captive political system led to the failure of attempts to modernize the economy and income inequalities growing to a destabilizing extreme.
Effectively Argentina metamorphosed from a productive to a rentier economy, with a small elite redistributing stagnant national income to their short-term advantage, with the rising frustration of the wider population eventually bought off with the printing presses. Sound even vaguely familiar?
America's strongest remaining economic advantage has been its ability to reallocate capital and talent to the 'new thing', the innovative business models and technologies that can transform broader economic productivity and generate new wealth. That depends on both social mobility and an effective reallocation of capital and people from dying to rising industries, what Austrian economist Joseph Schumpeter termed 'creative destruction'. Regulatory and political capture by entrenched elites runs counter to both, and helps explain the unhealthy domination of the US economy by the finance and healthcare industries over the past decade, whose political lobbying and funding dwarfs any other sector. An economy riven by narrow vested interests seeking to direct public policy and profit from public funds becomes one saddled with perverse economic incentives that undermine the purging and renewal process that is central to capitalism.
The end result is secular decline, imperceptible at first, but eventually leading to a crisis of confidence in a nation's currency and its debt obligations. The Soviet Union began an irretrievable decline from the late 1960's, caused by slumping productivity as real energy costs soared but also political capture by the military-industrial elite, as Kremlin factions competing recklessly to divert resources to their political constituencies. At one stage in the 1970's, the USSR was simultaneously producing five different battle tanks from four different decades, simply because military lobbyists in Moscow could work the system to obtain funding. Every Soviet leader from Khrushchev to Gorbachev attempted to control runaway military spending, but they were too weak to overcome entrenched interests until the whole shoddy edifice collapsed.
More »Inflation or Deflation?
Early this year, I advocated building exposure to long-term inflation hedges such as TIPS and resource equities, because they were radically mispriced as investors fled in fear of a sustained deflationary environment. That strategy played out well, and TIPS are now implying around 2% CPI inflation over the next decade, or broadly in line with experience in the last. We face a tug of war between inflationary and deflationary forces in coming years, and key to the outcome will be the scale of excess liquidity (ie a rising money-to- GDP ratio) and how swiftly it is drained from the system in a recovery. Currently, the huge expansion of central bank balance sheets hasn't translated into higher credit via the banking system and therefore a broadening of money. In other words, the velocity of money remains very subdued as banks focus on deleveraging (with the exception of China). This can be seen by the remarkable 6% of GDP parked at the Fed as reserves by US commercial banks, and similar bank risk aversion is evident in the UK and Europe.
Monetary policy has been astonishingly loose for most of the past decade, in response to a series of financial panics starting with the 1998 LTCM/Russia meltdown, proceeding via the IT bubble bursting in 2000, and now the systemic banking crisis of 2008. Ironically, like a doctor feeding an addict's drug habit with ever higher dosage, the response to each crisis has precipitated the next. Between 1996 and 2009, nominal GDP in USD for the top five global economies grew 60%, but narrow money (M0) grew 230% and broad money (M2) 210%. Much of the excess leaked into a fast sequence of speculative bubbles from Internet stocks to Florida condos and oil futures. You can picture the current monetary situation like a dam, with a lake of fresh money rising even higher, held back only by weak supply (and indeed demand) for credit.
When that dam breaks, and credit growth resumes, even at much lower levels than seen in recent years, the inflationary risks become substantial. There is now intense political pressure on banks to lend, as a quid pro quo for their generous taxpayer funded bailouts. When looking at inflation, it is a mistake to consider it simply in terms of narrow CPI statistics (which are in any case arbitrary in their calculation. Volatile asset inflation has been a characteristic of the last decade precisely because the real economy hasn't been able to absorb the flood of money issuing from central banks and amplified by a secular rise in bank leverage until last year's crash. Historically, a big rise in money supply takes 1-2 years to inflate asset prices. However, given the unique nature of quantitative easing which involves creating money to directly buy assets such as bonds from institutions, thus providing fresh capital which they can re-invest into riskier assets, the lag this time has been a matter of months rather than years, and is being reflected in the relentless rally in equities.
More »Equities: As Good as it Gets?
After a stunning six-month rally in equities, commodities and corporate bonds, we are reaching a critical juncture for markets, which have swung from despondency to euphoria since March. Incoming data have moved the investment debate from whether a recovery is imminent to how strong and durable it will prove. I said back on March 10th that:
'Equities are now cheaper than for several decades on a cyclically adjusted earnings basis (and versus bonds) and stand at an extreme oversold level only seen a few times in the last century'
The depression/deflation panic was clearly misplaced and I predicted a 40-50% trough to peak rally as deflation fears abated. Indeed 10 year inflation expectations in the TIPS market had jumped back to near 2% by June, driving the first leg of the risk asset rally. The six leading global economies this time around have applied 300% more fiscal stimulus and 500% more much monetary stimulus relative to GDP as occurred in the 1930's, and that was always going to be hugely reflationary.
Key factors that turned a hoped-for recovery in 1930 into the disaster of the Great Depression were a sharp hike in interest rates in October 1931 and a decline in the overall price level of 10% per year in 1931 and 1932. History isn't going to repeat and indeed the Bernanke Fed is loathe to risk tightening policy before any recovery is self-sustaining as reflected in capacity utilization climbing to at least 75-80% (ie not before end 2010 if markets don't force their hand). In fact, reflating asset markets was a crucial objective of public policy as much as avoiding CPI deflation, as balance sheets were so dangerously stretched in the US and Europe, and it has proved successful. Three factors have proved supportive of the ongoing risk asset rally in recent weeks.
Firstly, not only is the cycle bottoming earlier than seemed likely back in March, but the recovery is increasingly synchronized on a global scale (with Q3 marking the inflection point for the US and UK, and Europe already modestly rebounding as are the key Asian exporters). Secondly, central banks from the Fed to BOE, far from removing the punch bowl of monetary stimulus, are raiding the drinks cabinet for any leftover monetary hooch they can thrown into the mix to keep the party going. Thirdly, 10 year government bonds have sold off modestly so far, supported by a natural bid from commercial banks seeking to flatter their capital ratios, and central bank's own buying as well as still declining CPI inflation.
However, a number of risks loom large in coming months to unnerve complacent sentiment.
More »CFTC Belatedly Discovers Speculative Oil Bubble...
Latest Followers
Posts by Ticker
Latest Comments
Most Commented
Posts by Themes
Instablogged Stocks
Latest Instablog Posts
-
1
-
2
-
3
-
4
-
5
See all Latest Instablog Posts »Top Instabloggers
-
1
-
2
-
3
-
4
-
5
See all Top Instabloggers » Top StockTalkers »