We want to make three main points that speak to the survivability of the current credit crisis. Yes, the financial edifices are still tremoring and there is a high probability that major financial bankruptcies and bailouts still lie ahead. Yet, it is a timely question. Prior to a year ago, there were very few brave souls that had the chutzpah to stop dancing, let alone predict the likelihood of a crisis such as occurred. This is now all too clear in retrospect. In contrast, today there are no shortages of prescient forecasters who are willing to predict that the "bottom is not yet." But here, an important perspective is missing for portfolio managers inside the Bubble Bloc as we will point out.
Admittedly, we weren't much better at forecasting the systemic financial infarctions of the past year, having been early in stating our belief that unfolding financial bubbles were not sustainable. We certainly expected an impending disruption to the long-running hegemony of the financial sector. But when? (See Global Spin, "The End of Financialization ... Maybe?", August 15, 2005.) That was 3 years ago -- 2 years premature, but certainly besting Franklin D. Roosevelt's predictions of systemic demise another 60 years earlier.
As it was, the accumulation of global financial pressures finally erupted, causing sudden shearing along global economic fault lines. It takes at least two sides for there to be any shearing. We hazard the opinion that the world's economic power distribution will not be the same going forward. Yet, at the same time, the foundation for the next global boom is being set up even now.
Let's first sum up our 3 basis points. It stands and remains the Age of Global Capital. Despite the enormous capital incapacitations of the many loose-playing financial institutions of late, it is worth recalling that it is an increasingly global world. That may seem a redundant statement, except that this perspective is generally not yet reflected in Occidental capital markets. How so? The Occidental world still may think that their own realities (cataclysmically pessimistic in terms of psychology and perception these days) are representative of the entire world. No ... certainly not any longer. They are now on the descending side of the shear line.
In recent years, China, Brazil and many other emergent countries have proven themselves to be much more sensible and sustainable with respect to economic policy than America, UK, Spain, Ireland, Australia ... etc. For sake of easy reference, we will call the former group the Hard Bloc (i.e. low-financialization, low debt, tendency toward external surplus bloc) and the latter cohort, as already dubbed, the Bubble Bloc. Admittedly, these are somewhat extreme caricatures, but you'll understand the differentiation that we are wishing to make. While the heft of the Hard Bloc in terms of global GDP-share, may not yet dominate the high-income ranks, they certainly have reigned supreme in terms of world savings supply and labor-driven wealth (as opposed to the financial wealth alchemy that has openly become accepted policy in greater parts of the Occidental world). The point here is that the recent woes of the Occidental world, while grim, neither heralds a global meltdown nor a long-term economic winter worldwide. Assuredly, there will be different realities for the two blocs, but taken on weighted average, hopefully no long economic winter.
For now, a global economic slowdown is surely in tow (a Global Intermission, in our terminology) with at least one more brutal phase ahead, but likely nothing more severe than experienced in the post-war period. The rest of the world is no longer the caboose to the US. There are now more locomotives.
In due time there will emerge the next world boom, that being our second point. It would occur with the backdrop of a much more balanced and coordinated world. The large players that heretofore thought that global coordination was a good thing but mostly only for others, have been discredited and have lost power. In reality, the financial adjustments of the past year, essentially signifies the "recognition" stage -- the sudden earthquake resulting from a long build-up of pressures along fracture lines -- of the global economic power shifts that have already occurred. Despite the sophist arguments to the contrary -- mostly from Wall Street -- any country that runs large, chronic external deficits and becomes reliant upon borrowing the savings of others, eventually will lose its relative economic position. This recognition holds significant implications for global investment policy for the upside of the next global economic cycle.
Finally, now that the greatest saga of financial malfeasance since the 1920s is far enough along in its unwinding, we can begin to ponder the nature of the next global upturn that awaits on the other side of the dark chasm of current financial disturbances. Here, our central scenario would place a high probability on a global infrastructure boom/bubble emerging longer-term. Several factors suggest that it could be the biggest yet. But, the salient point is that the transitioning phase between now and that next global boom could stand to turn conventional wisdom upon its head with respect to investment policy ... at least for those portfolio managers living in the Bubble Bloc.
Financial Tempest in Western Teapot
Looking at Figure #1 on the front page, one would not get the sense that the world is in a deleveraging mode, which according to popular consensus, is supposedly the case. Though the financial pipes began to freeze up around the mid-point of 2007, overall world securities and financial position value continued to power up on a per-capita basis. (We define financial position value as including the notional amounts of both listed and over-the-counter derivatives.) For the year, total financial position values per-capita (measured over the world population base) grew by a third, expanding USD $31,500 to near $124,000 for every man, woman and child on earth. The increase in this position value alone is estimated as equivalent to 4X global per-capita income in 2007.
In the graph, you'll notice that for reference purposes is also included the trend line for arable land per capita. It is a useful way of presenting a grounded perspective on the fanciful flights of global finance in this global Age of Capital. By the end of 2007, speculative and hedging-type derivative position values had risen to 5 times the underlying securities values in the world. In no case, did either securities value (debt or equity) nor overall financial positions value, decline in 2007 viewed in US dollars. Nor, will this likely be the case in 2008 though it may be a close call ... especially so if the US dollar rises substantially.
This specter serves to introduce three important perspectives. Firstly, a point often forgotten, (excuse this basic primer) that the world remains binary when it comes to wealth. There are always two sides to every transaction, a buyer and a seller, a debit for every credit, and debtor for every creditor. The lopsided and pessimistic din of the media at present -- the daily barrage of bad economic statistics and earnings reports -- now sensationalizes the losses and write-offs. These are indeed sensational for the financial sectors (some $600 billion to-date and counting). But what is entirely overlooked is the other side of the binary equation.
Somebody sold the over-priced homes that others bought and now are being foreclosed upon. Someone received the proceeds from the original sales of the mortgage-backed or other asset-backed securities that ended up written off to the tune of tens of billions. Where did this money go? It is still there, if not in the form of money, but another asset of some type. And, as Figure #1 shows, asset values were (are) still rising in volume, though surely yet vulnerable to possible mark-downs in valuation. So while the thin capital veneer of the leveraged financial system (mainly in the Bubble Bloc) is now taking a shellacking of fearsome proportions, the larger global perspective suggests that there is sufficient means for recapitalization. To an extent, this has already been underway, thanks to the investments of the Sovereign Wealth Funds (SWFs) and other institutional and strategic investors.
According to the various sources listed for Figure #1, the total underlying securities value of the world (denominated in US dollars) amounted to $140.6 trillion at year-end 2007. In relative terms, this value would be equivalent to 2.5X annual world GDP. These values do no include bank deposits and other forms of money. The most apocalyptic of forecasters -- probably the most well-known is Nouriel Roubini of RGE Monitor, who has been eerily accurate with his prognostications to date -- estimate total losses and costs of the current crisis as high as $2 trillion and more. That is a huge number ... certainly the biggest historically in absolute terms. Viewed from a broader perspective then, losses of this size would amount to as much as 1.5 to 2% of the total world value of financial securities. Again, this is not an inconsequential figure. But, we hazard to guess that it is survivable ... assuming that the world's collective monetary authorities of both Bubble and Hard Blocs have similar vested interests.
Some of the biggest banking busts in the past have cost in the order of 10% to 20% of respective country GDP (according to the studies of the International Monetary Fund). No doubt, these crises were terrible and financially fatal for individual financial players. Nevertheless, they were survivable. (After all, we're still here and globalization continues!) Should the next global boom end up with even higher world debt levels and deeper, more uniform, malinvestment, it may well end up in a total, global systemic melt-down. At this point, given that the inter-country wealth skew remains pronounced and that imbalances were complimentary (huge surpluses mirrored by deep deficits), it provides some potential fodder for the next growth engine driving global economic recovery ... at least in the Hard Bloc.
Of course, all of this might sound as so much heresy in North America, as here the crisis feels the worst ... the emotions on Wall Street frenetic and frantic. There seems to be no comparable precedent for the financial devastation being sustained since at least the Dirty Thirties of the last century. But this perspective again ignores global realities, revealing a bit of Bubble Bloc narcissism. Consider this comparative: Back during the Asian crisis of 1997-1998, an Indonesia citizen would have been tempted to draw the same apocalyptic inference for the rest of the world. (Comparatively, Indonesia's population is not grossly smaller than that of the US -- 228 million versus 305 million, respectively.) Even while Indonesia's GDP cratered by more than 20% between 1997 and 1998 (the stock market collapsing over 70% in 15 months), to conclude that the sky was falling upon the whole world, would have been incorrect. The same perspective now applies in reverse, though the comparative metrics of the illustration are surely of a different scope. But, the example is apt.
The financial disasters of the Bubble Bloc world (specifically the United States) while bound to have knock-on effects for the entire world, are no longer the only determinant for world-wide economies and financial markets. A power shift has occurred, and further such phases in that direction likely still lie ahead, but not all in one eruption.
Current Economic Trends
The Global Intermission as we call it, has begun ... and, frankly, there is no telling yet how long it may last. What is known is this: It has definitely moved to the second stage and is now embarking on the third. The chill economic winds (different but related to the credit crisis) that began in North America, are clearly impacting the economic climate virtually everywhere. The fanciful "global decoupling" notion is now being firmly debunked in situ, as it always was theoretically. Economies are slowing virtually everywhere, in response to the demand effects of credit-induced revulsions.
Clearly, the second phase of the intermission has mostly impacted Europe and the major commodity producing countries. As such, the rally of the US dollar recently against the euro pretty well signals the next phase and third phase of the Global Intermission. The chill winds of economic recession having already blown through most of Europe, sets up the type of bad relative conditions which make the conditions still besetting the US economy and its financial systems look less worse by comparison.
Now that the euro is in retreat -- even if only temporarily -- it serves to funnel the chill winds directly towards Asia. As the Chinese yuan and other yuan-peggers are now experiencing rising competitive pressures with the eurocountry bloc, this introduces the latest phase of trade impedance. Earlier, when the growth rate of America's imports with the Asian manufacturing countries slowed, the soaring euro provided a welcome release valve. This kept the Asian export juggernaut rolling ... albeit already slowing in pace. As such, no wonder that the Chinese yuan has weakened against the US dollar of late. This trend, if it continues, could threaten to unleash a mountain of speculative capital which has been betting on the opposite trend ... a rising yuan. All of this signals that a world economic slowdown is still on a downhill spur, meaning that commodity prices (and the Canadian dollar as well as other commodity-linked currencies) still have some way to fall.
The Boom on the Other Side
Yet, even while this great saga of global trade imbalances and financial excess has hit its constraints and is now reversing, some early signs of opportunity are already in view. Consider that Chinese equities have now already fallen by more than 60% from the "bubble peak." This decline has continued despite plummeting commodities prices. The relationship of commodities prices and China's stock market has now gone full circle. At one point, rising commodities were taken as evidence of a buoyant China and hardly as reason for caution, despite the fact that rising energy and food prices were highly punitive for individual Chinese households. Now even declining commodities prices are providing no cushion to Chinese stock markets and outlook. An opportunity is in the making here. But, likely not before the widely-held belief that commodities prices can only rise (thanks to a booming China and other rapidly-growing and relatively populous countries), is firmly dashed. That, too, has started to happen.
The Global Scenarios the Morning After
To recall, in August 2007, following the first credit meltdown phase, we proposed four scenarios (See Global Spin, September 2007 issue, entitled Next Scenario: "Minsky, Mini, Minor or More?") As part of the base-line scenario, we had attached a 40% probability to the prospect of a Mini Minsky occurring with strongly inflationary sideeffects. A Mini Minsky encompassed the idea that a controlled phase of credit revulsion and deleveraging would occur. A full Minsky would have comprised an uncontrolled, panicked meltdown, far outrunning the severity of the global financial chill of the late 1920s and early 1930s.
The probabilities and scenarios proposed last August have run their course and fulfilled their usefulness. A new vista of global scenarios is in sight. We propose three: 1. Turning Japanese, I Really Think So -- a long, low-growth environment with a slow take-off and rising government indebtedness overall; 2. Global Infrastructure Cycle -- this being marked by high infrastructure spending across the globe, stagflation in the Bubble Bloc and modestly warm growth in Rest-of-World (ROW); and, lastly 3: Emergence of a global Inflationary Infrastructure Boom. In short, we'll call them Global Purgatory; New World and Global Boom, respectively. Actually, while each of these could be the main ending scenario over the next 5 years or so, it is more likely that they unfold in sequence. As we outlined in the table on this page, it is the schism -- the different experiences expected on each side of the shear line -- that is most important for investment policy, we think.
3 Global Scenarios for the Next 5 Years -- 2008 – 2013
|Global P||Hard Bloc |
(Global Weight 1/3)
|Sub P||Bubble Bloc |
(Global Weight 2/3s)
|#1 Global Purgatory |
Turning Japanese, I Really Think So
(3 to 18 months.)
|35%||Growth slow-down, likely mild but with some possible short economic recessions mainly due to knock-on effects of Bubble Bloc slowdown. External surpluses will be turned inward, supporting demand and infrastructure spending. Commodity and energy price declines act to ameliorate impact on household spending. Equity markets likely to hit bottom here first.||5%||Period of asset deflation (real estate mainly), long period of low economic growth (18 months at least) and crippled financial system. Rise in government debt (min. 30% to 40% as % of GDP in the case of the US). Unpre-cedented interventions continuing. More bail-outs. A truncated Japan experience in the US, but without as deep impact on equities. Low to negative real interest rates at the outset.||50%|
|#2. New World |
Global Infrastructure Cycle
(18 months to 4 years horizon.)
|45%||Household spending continues to rise as % of GDP, infrastructure spending strengthens further. GDP growth returns to 75% to 85% of peak of recent years. Commodity and energy prices again rise gradually across the entire spectrum, further igniting alternate energy and resource spending. Inflations returns to above the average of past 5 years. Strong stock markets driven by earnings.||65%||Continuing elements of Purgatory and stagflation, but economies stabilizing and growing at plus 2.5%, driven by government spending, infrastructure, supply-side emphasis, exports and rising incomes relative to household debt growth. Modest stock market growth (5%-7% per annum) ending with 2.0 % real rates, above average inflation levels.||35%|
|#3. Global Boom |
Inflationary Infrastructure Boom
|20%||Intensification of Scenario #2. Contributes to overall "velocity inflation" environment as financializing Hard Bloc (with rising real incomes relative to Bubble Bloc) increases demands for resources and energy.||30%||Higher inflation than Scenario #2, low real-rates, continuing government deficits contribute to "crack up boom" (velocity inflation) environment. Higher stock market returns (+ 10% per annum) zero % real rates, above 5% GDP, strong commodity and precious metal prices.||15%|
Scenario #1 presumes that the entire world will need to first expiate some venal economic/ financial sins before supple global growth can be re-primed. This will require more purging time in the flames (a lot more for the Bubble Bloc) and the governments giving much alms to the gods of direct stimulus. The latter two scenarios presume that a global recovery again builds but with differing outcomes -- namely, varying degrees of monetary and inflationary malfeasance.
Judging from our choice of the Rexford Tugwell quote on the front page, we may have already shown our preference for scenarios #2 and #3. In reality, much fertilizing manure will be required in all 3 scenarios for the Bubble Bloc. Dr. Tugwell was a colorful policymaker during the Hoover government of the early 1930s ... the time that the New Deal was birthed. Being the agricultural minister during part of that period, he borrowed somewhat steamingly from the farmyard. He likened some of the stimulative spending policies of the Hoover Administration as being so much exrementitious bovine waste being applied to the top of trees, rather than to their roots. Suffice it to be said that there was a lot of manure spread around throughout the New Deal. Some of it did get to the roots. The same challenge presents itself again for the US today.
As summarized in the table, fully 70% of the probability range anticipates more than simple survival of the world financial system. Significantly, an early re-ignition of inflationary pressures is also highly likely on the back of a developing global infrastructure boom.
Why an Infrastructure Boom?
If bubbles have been proliferating in serial fashion in recent years, what could be nominated as the trigger for the next one? Given that recent financial bubbles have centered upon assets (real estate most recently and securities in the late 1990s), it behooves policymakers to try to generate some income inflation. While that may prove detrimental to corporate earnings (as a share of national income), it is the perfect sinecure for debt-strapped, mortgage-heavy consumers in the Bubble Bloc countries. Figure #2 on the front page shows that the long-running and rising trend of financial wealth gains versus income. There is room for modest reversal at least at the regional level, if not global. Rising incomes and above-average inflation can effectively lower the carry cost of historical debts relative to income. We reason that the most effective way to boost household incomes in stagflation-prone Bubble Bloc countries, is government spending directed towards public infrastructure as well as tax incentives to promote energy sustainability. In the case of the US, a country which has underinvested in public infrastructure for several decades, this would be popular policy.
As for the Rest-of-World, demand for infrastructure is far from satiated, especially so for groups of fast-growing, financializing countries. While our analysis here is hardly comprehensive, the point we make is that infrastructure spending stands to be a popular outlet for policy stimulus as well as satiating real demand for such services. All of which points to the likely early re-emergence of inflationary pressures along with an investment preference for real earnings and real assets (equities, commodities, and precious metals). But, we are getting ahead of ourselves.
A Continuing Equity Conundrum
Almost all of the analysts that originally warned of the ultimate consequences of the profligate policies of the US (not to ignore the deliberate complicities of the surplus countries), of course now feel vindicated. Though we also shared these convictions from the beginning, we have not been nearly as pessimistic on equities (though we are also underweight at present). Considering the scale of carnage in the financial sector, it indeed seems remarkable that major stock markets have not fallen further ... to date only on the scale of 20% or so from peak to trough for Canada and the US. Why? There are some legitimate reasons, we believe.
To begin, major equity markets were not nearly as overvalued as before the stock market swoons of 2001-2003. The financial bubble was not centered in securities as it was previously. Also, the bond markets know that the necessary scale of stimulative policies, such as manure in tree tops, bail-outs and unprecedented interventions, will not be kind to the supply of fixed-income securities in the Bubble Bloc.
Given the high probability that a "Hard Bloc boom" environment again unfolds (also a form of what we have previously called "velocity inflation as in Scenario #3) in tandem with a global infrastructure cycle, the longer-term specter of above-average inflation again re-emerging after the current "Global Intermission" is high. Equities will fare better in such an environment as opposed to bonds.
The demand curve for equities is also shifting globally. For one, there are too many US fixed-income instruments in international hands that have been deflated mainly by way of a weak US dollar. An important structural factor to recall is that the levered side of the financial system (bank and nonbank) does not own a preponderously large portion of equities. The bulk of equity ownership these days is in stronger hands ... i.e. pension funds, or core mutual funds driven by automatic deposits and not levered global hedge funds or collapsing banks. Even if our Global Purgatory scenario were to last as long as Japan's in the 1990s, it is not likely that equities would decline deeply ... certainly not in the same measure as occurred there. Besides Japan's valuations having reached nose-bleed highs in the late 1980s, differences in their case included a condition of huge inter-corporate ownership, also a banking sector which had very large equity holdings. As real estate and other collateral values deflated, banks were forced to sell off equity holdings.
Back to America, in recent years, contrary to the usual pattern of high household investment in equities in late-stage bull markets, households had been lowering equity investment. The retail investor has been strangely absent in terms of a sentimental force, either optimistic or negative.
That is not to say that stock markets will not fall further in response to earnings declines or the duress of private equity firms disgorging their equity holdings. Yet, the case can be made that the major equity market averages this time will not succumb to deep declines.
Conclusions for Investment Policy
In conclusion, by the time that this global slowdown has bottomed and is again on the mend, international structures will have taken the biggest leaps of change since the late 1940s. Back then, it was fertile ground for international institutions (the World Bank, IMF, ... etc. all were launched).
The world then was attempting to set up a system that would forever more prevent another world war. This next round of revision with respect to globalism, will attempt to forever avoid another world-wide calamity as has been foisted upon the world by errant, high-income-country heavyweights.
The balances of global financial power are changing. No longer is the Occidental world the only player in the driver's seat. Therefore, the next boom will likely be as coordinated as never before ... a finely manipulated architecture with an objective of delivering booming wealth for all. All the same, the global wealth skew (intra-country, not inter-country) will probably become more extreme.
Looking ahead, given that the global economic slowdown has probably entered its last two stages, as its waves are now rolling through Asia, global stock markets (not necessarily all stock markets) are likely to begin anticipating the recovery phase. Which scenario will it be? We have outlined our favored scenario (#2) longer-term -- high infrastructure spending, solid global economic growth, above average inflation, and a return of real yields of plus-2.00% or so.
Actually, we expect global conditions to rotate through our proposed 3 scenarios, beginning where we are now -- Scenario #1: Global Purgatory. At this point, scenario #3 is still speculative and some ways off. The big question of the moment concerns the length of the preceding purgatory. Viewed globally -- not through the colored glasses of an observer in the Bubble Bloc -- the New World growth scenario should be underway by next year.
The "stock market conundrum" we have contemplated, should be expected to continue. Once the bond markets have adjusted to their new state in the Bubble Bloc (following the impact of the current "Global Intermission" stage), then higher bond yields will generate attractive coupon income. But not yet.
All the above argues a preparedness to move to heavily overweight global positions relative to domestic weightings in the Bubble Bloc world. Specifically attractive should be the Hard Bloc countries (i.e. including Brazil, China, India ... not sure about Russia just yet), "supply side" sectors everywhere, infrastructure sectors, commodities, gold and , interestingly, perhaps even Islamic financial products. With the infidels having massively blown their "al riba-based" financial system of late, the latter have proven more stable in the interim.
We'll let Dr. Tugwell have the last word: Expect much more fertilizer and a Global Purgatory that hopefully will be short.