Earlier this month noted investor Marc Faber warned in his monthly report of a possible QE 2 inspired "crack-up boom" in the US and word economy. His argument was that more money printing by the Federal Reserve would cause a temporary boost to the US economy, which would in turn fuel massive speculative bubbles in commodities and emerging markets. Faber thought this scenario could play out over the next 6-12 months but would end in economic tears.
With the recent surge in commodities, we may be in the early stages of Faber's crack up boom. Almost every commodity, be it industrial, agricultural, or energy related, have all increased dramatically since late August 2010 as investors pile out of increasingly worthless dollars and into hard assets. The numbers are alarming: year to date cotton is up 86.5%, palladium up 65.7%, silver 54.5%, coffee 48%, lumber 34%, corn 28%, gold 25%, wheat 23%, and soybeans 20%. Even more troubling is the fact that most of these moves occurred in only the last few months as the anticipation of QE2 started to grow stronger.
Along with strong commodity prices, emerging markets have enjoyed a huge run-up as investors seek out bigger returns in high growth economies. According to EPFR, a firm which tracks fund flows, a total of $79.9 billion has flowed into emerging market equity funds year-to-date, putting the sector on track to beat last year's record $83.3 billion inflows. And remember these numbers just include fund flows. The Institute of International Finance has projected a staggering $825 billion dollars will go into emerging economies this year, up 30 percent from 2009. The large influx of capital into these markets has resulted in spectacular returns for emerging markets: Colombia (+57.9%), Peru (+49.2) and Thailand (+45.2%) just to name a few. As more and more hot money money races into these markets, real estate prices have also exploded in value. For example, in Hong Kong, real estate prices have increased by more than 50% since the beginning of 2009. This has Hong Kong's Chief Executive Donald Tsang concerned about the potential of a bubble. In a recent interview he noted:
Given their better growth prospects compared to the US and Europe, Asian economies are attracting huge amounts of excess liquidity in pursuit of higher yields. These money flows are creating upward pressure on exchange rates, consumer price inflation and asset prices in the region.
Brazil central bank President Henrique Meirelles also joined the chorus of Fed critics, saying
The quantitative easing creates excessive liquidity which overflows to countries like Brazil, and then we have to take measures to address that issue..It does create a problem.
In response to the Fed's never ending money printing, emerging markets have tried to stop or at least discourage speculative money from flowing into their economies. Some have tried capital controls, increasing taxes and interest rates in an attempt to prevent potential bubbles from forming. The problem is that the Federal Reserve, along with the BOJ and BOE, continue to print more money without any regard to the potential risks. Newsweek correctly describes the situation, saying
The latest round of QE raises the stakes enormously: pouring liquidity of this scale into booming economies is like drenching a fire with gasoline. The result will be even bigger asset bubbles or inflation or both.
This dynamic could lead to a worldwide bubble in emerging markets which will end much like the Asian financial crisis in 1997-1998, when some kind of catalyst (and you never know what it will be) caused all of this speculative money suddenly to flee developing markets. BA-Merrill Lynch analyst David Hauner warned how quickly investor perceptions can change, noting
[Emerging market] Flows are so strong that the market seems not to be concerned. But there are a lot of crowded positions at this stage. Investors will take any shocks badly.
If a global shock does occur, such as a sovereign default in Europe, it could precipitate a complete collapse of emerging markets since falling asset prices negatively impact growth prospects, reduce corporate investment, and disrupt the proper functioning of local capital markets (e.g. credit crunch). Asia's financial crisis showed the power of capital flows and how they can influence economic events.
You really have to wonder if the Fed's QE is being used as a blunt tool to force emerging markets like China to re-adjust their economies. QE 2 can be seen as the final US ultimatum to countries like China that if they fail to make the proper adjustments, they will face lethal asset bubbles, which will eventually implode their economies. All of these emerging markets (especially in Asia) follow the same export model of keeping their currencies artificially undervalued and interest rates low. With the benefit of cheap and abundant labor, they have been able to industrialize rapidly their economies and improve living standards at the expense of developed economies. Emerging markets run huge trade surpluses while advanced countries run up deficits and debt. To keep Western economies (mainly the US) consuming, surplus countries invest their foreign exchange reserves in US treasuries.
Furthermore, to prevent any currency appreciation, these surplus countries constantly intervene by selling their currency and buying dollars. Western economies have tried to convince developing countries of the benefits of boosting internal consumption and relying less on exports for growth. However, this has gone nowhere as we have seen with the failure of the G-20 to come up with any agreement on global imbalances. Quantitative easing, which has the full endorsement of the US government, is a way for the US to circumvent these intransigent developing countries when it comes to serious trade issues. There is strong evidence the Fed knows QE does not help the US economy because the money has all gone into emerging markets. Dallas Fed President Richard Fisher in a recent speech remarked:
In my darkest moments, I have begun to wonder if the monetary accommodation we have already engineered might even be working in the wrong places. The Treasury International Capital, or TIC, data released yesterday morning show that foreign interest in buying Treasuries remains robust. Yet, far too many of the large corporations I survey that are committing to fixed investment report that the most effective way to deploy cheap money raised in the current bond markets or in the form of loans from banks, beyond buying in stock or expanding dividends, is to invest it abroad where taxes are lower and governments are more eager to please.
So don't for a minute think the Fed does not understand what it is doing with its money printing program. However, emerging markets remain obstinate with regards to their trade policies. They keep selling their currencies, hoping this will beat the Federal Reserve in the great race to the bottom and protect their export advantage. As the bubbles get bigger and bigger, the time may come when it is too late for these economies to take steps to prevent the inevitable collapse.
Any possible fallout would have dire implications for the global economy because the majority of worldwide growth has been concentrated in developing economies, which were largely unaffected by the 2008-2009 financial crisis. Without continued growth in these countries, commodities will remain vulnerable to huge declines as the global economy starts to wilt back into recession. If Marc Faber is correct about the crack-up boom scenario, we could see the peak sometime in mid-to late 2011. In the meantime, the Fed- induced bubbles in commodities and emerging markets will continue to inflate, reaching egregious levels. However, at some point the euphoria will turn to panic and the bubbles will begin to collapse, bringing with it ruinous consequences. I wonder how the Fed will react to this...more money printing perhaps?
Disclosure: Long Gold, Stans Energy, and Allana Potash