It seems the older investment pros are throwing up their hands in frustration of late ... if not in disbelief. To wit: China's Shanghai Exchange equity market had risen 212% year-over-year (before a recent correction); the Canadian dollar at one point soared 30% against the USD since early February of this year; the exchange reserves of Russia (the pariah of the 90s as we remember) is up 65% from year ago levels to $447 billion (Nov. 2), milk powder prices have rocketed 155% yearover- year; it is reckoned that 2 million mortgages in the US will go into default over the next 12 months; and, according to some far-seeing observers, perhaps as much as $500 billion will be written off in the latest bout of Wall Street overindulgence.
All of the above are infrequent occurrences at best, yet equity markets seem to feel relatively unthreatened. Which is a funny thing. None of the above trends -- to name only a few -- are indicators of either sustainability or the sought-after rosy scenario.
In the real world, analysts certainly cannot be faulted for thinking that trends are not playing out intuitively ... excepting the fall of the US dollar perhaps. (We will come back to this topic.) If anything, many tried and true investment constructs seem to be totally worthless at this time ... if anything, a liability. As such, we empathize with the recent lament quoted on this page.
What is it that is so fundamentally different today? What forces are throwing the fundamental, value-seeking analyst into the carnivores' den of financial brinkmanship? What confluence of trends is working to convince investors that there never need be consequences for inflationary excesses?
We point to at least 6 modern-day phenomena that are acting to deny the inevitable. But perhaps, not too much longer.
What Can We Trust?
Frankly, we expect that the answer is not much. At this time banks don't even trust each other. And, that is a sorry state, to say the least, as there is supposedly honor even among thieves. However, what will surely provide some perspective is a longterm view and a bit of "ole time" theory.
The fact is this: A massive world-wide financial bubble is playing out. Very probably it is in its latter stages, although we can't be totally doctrinaire on this. Yet, no serious theorist can deny that such phenomena as soaring international reserve assets (growing at a pace of 25% per annum and more), widening external imbalances, reciprocal savings and investment excesses, gaping wealth skews and other related trends are not symptomatic of an extreme bubble.
Classical economists have always had a ready definition with which to identify such bubbles. Modern-day central bankers may protest that this is not possible, yet, all boom/bust cycles have had the same basic five ingredients.
- A large expansion in debt relative to income, either driving an overconsumption or an overinvestment binge.
- A heavy reliance on capital gains for income and reported profits.
- A sharply higher participation level in the stock market (marketable items of some kind that can be readily borrowed against, usually securities) either directly or indirectly.
- Crucially, a misreading of underlying credit and inflation trends.
- A "great new world" impulse, usually represented by a technological shift of some kind. (IT, the telephone and the automobile were impulses contributing to past booms.) In short, today, the impulse is the combination of globalization and securitization wrapped in the celebration of financial innovation and aided by "valuefree" capital and manipulated currencies.
Various symptoms of the above include: 1. Credit & debt growing faster than savings (or vice versa); 2. Chronic external account imbalances; 3. Enormous shifts on the household balance sheet; 4. Widening income and wealth skews, both at the country and international level; and 5. Gross distortions in the input/output structure of economies.
As you will note, however, there is a twist. These last five conditions apply to both surplus and deficit countries. The excesses of this current bubble have unfolded in a uniquely modern form, the effect of which is to make the current financial balloon a global hydra ... more virulent and deceivingly unsustainable than before. The present financial bubble is more complex, involving reciprocal deformations.
What we are witnessing today involves countries in semiparasitic, semi-symbiotic relationships, effectively enabling each other's different version of "inflation" disease. What we have today is the same as all booms ... but in a differing and critical way. How is it different and why do the "old hands" feel so perplexed? We next turn to our six reasons.
#1. Reciprocal Parasites in an Globalized Age
The fact that a world-wide credit boom has occurred during a liberalizing era of world trade and investment, has served to cause the manifestations of its inflationary effects to be very different. This has led to misinterpretation -- this being a key hallmark of all boom/bust cycles. A massive explosion in currency reserves -- more notably, the skew, within this phenomenon -- has its counterpart. The excesses of individual countries come in offsetting pairs -- the unprecedented surplus countering the record-sized deficit. Today, a debt-stimulated overconsumption boom in one country will result in a reciprocal "over-capacity" (the malinvestment) in another country.
A bubble therefore is not localized to one country as has been the usual manifestation in the past, but rather is global in reach. This makes it more complex and easy to misread the underlying inflationary forces. That is indeed what is happening. The boom in foreign currency reserves of some emerging market countries, as shown in Figure #1, are not natural phenomenon, but rather a symptom of a runaway global bubble. Its bursting will have global implications ... albeit different ones for different countries.
#2. What's Awry? Lots of "Value-Free" Capital
Not all capital today is driven by the motive of investment returns alone. Increasingly, "value-free" capital is exerting a bigger footprint. For example, that China would accrue such a large US dollar horde of over $800 million (according to estimates of RGE Monitor) even as the US dollar is falling against other major world currencies, is not explainable in terms of portfolio theory. No doubt, China has its strategic reasons. These, however, may be geopolitical. Overall, international reserve assets are now approaching the $6 trillion mark, not counting the growing influence of sovereign wealth funds (SWF). Some of this money has no problem consorting with investment opportunities in "non-aligned" countries. The net effect in short? Seen in the whole, value-free capital distorts markets. That has certainly been the case in the US in recent years, where it can be argued that longer-term interest rates have been artificially suppressed, not to mention a host of other deformations around the world.
#3. The Bulge Bracket Financial Behemoths
Let's not forget that the financial industry of today is not the same of 10 and 20 years ago. It is the elephant in the room ... actually more likely "the dead moose in the room." It is not the small town bank that might have lent your grandfather a loan for a tractor 50 years ago. Today, it's more likely to be financing 3 sides of a hedge fund's $100 million spread position. Actually, this industry in its many guises has become so large, it can hardly serve the interests of its customers (seen in the aggregate). This industry's own need for return-on-investment (ROI) competes with that of its clients.
In recent years, profits of the financial sector have attained levels representing over a third of corporate profits in some countries and unprecedented shares of national incomes. Much of this growth has come from capital markets. Overall, it's the equivalent to the fox being in the hen house. There is only a finite amount of potential real-ROI to be spread around. Of course, not all clients will realize this.
Crucially, a few "bulge bracket" firms have come to dominate key financial sectors. Derivatives and asset-backed paper production are two notable examples. (For example, according to the recent 2Q Comptroller of the Currency report, only 5 banks account for 97.2% of derivative contracts. See Figure #2.) When troubles hit and demand from real armslength customers vaporizes for any such instrument or other assets, this cozy club can choose to play marbles amongst themselves. "You bid up my paper, I'll bid up yours." Real "price discovery" in the financial world will be frustrated if the rank and file keeps its calm decorum. Markets today are no longer freeflowing "price discovery" mechanisms. After all, underlying security market values are only a fraction (no more than 10% to 15% in our estimation) of the financial position value of all listed and over-the counter investment vehicles. Truly, the whole financial system is dependent upon wags dogging the tail. That can produce considerable market movements that are not at all intuitive.
#4. Consensus Values
Like their politicians, democratic societies tend to deserve the financial markets that they get. After all, financial markets express the values of society. Analysts may argue that "fundamentals" and "historical benchmarks" set the valuation envelope for asset market levels and trends. Yes, historical statistics have their uses, but frankly, they tell us little about the secondary and tertiary conditions that gave rise to them in the first place. For example, the average dividend yield of the S&P 500 over the 20 years between 1940 and 1960 cannot be directly compared to the average yield that existed during the 2 decades between 1987 and 2007. (Respectively, 5.27% and 2.24%, the former more than twice the latter.) These statistics embrace many differences, most significantly two different societies -- two sets of values and beliefs. In this comparison, the former society was a risk-averse, industrious, post-war society with modest expectations that couldn't be more different than the over-indebted, over-inured household of today. As another illustration, Figure #3 shows the changing value of labor income versus stock market capital.
Though few Wall Street-friendly scholars have written seriously on this topic in many decades, (a la Max Weber, R. H. Tawney) market trends do connect to beliefs, personal values and such things as religion. (Who would not agree that a reclusive group of Jesuits -- all having taken a vow of chastity -- would not put a different value upon the common stock of the makers of Cialis than the Mustang Ranch Investment Club?) In today's milieu, where everybody is a victim of something (no personal accountability) correct spelling is optional, and "make your own reality" ideology prevails, the same liberties will infuse financial market valuations, credit agency ratings and home value assessments. As such, no one can be called to task for bad mortgages and Wall Street et al (lobbyists and politicians in tow) can manufacture fictitious returns ad infinitum. That also distorts market norms ... especially so for old hands stuck with outmoded market values and theories.
#5. A Widening Wealth Skew
The IMF's recent World Economic Outlook (WEO, Sept. 2007) outlines the latest update on the world's ever-widening income and wealth skew. Though hot debates rage on this topic, it would not be outrageous to posit that today's global wealth skew may be the most extreme since the late stages of the past Roman Empire. At the very least, it is a fact that the majority of the world's fungible capital is in the hands of an ever smaller number of owners or managers. Given the advanced state of commoditization and securitization today, that suggests that the manifestation of a rush to "wealth preservation" will be different than perhaps only 20 years ago. Before the final deflationary liquidation occurs, we could first witness a massive "velocity inflation" as the world's (relatively) wealthy or its captains of capital make an investment mix shift to tangible assets.
#6: Institutionally Speaking
When Asian currencies went into a tailspin in the late 1990s, the Western world was quick to blame Asia's problems on cronyism and corruption. But how to define these conditions and can they be identified? The problem is that it becomes invisible when it is institutionalized. And that may be the case today in many countries, especially in North America. The fact that "corporate ethics" has been such a growth business for consultants and the funding of many new chairs and programs in this new "discipline" at universities this past decade or so, is the very proof of the underlying disease.
But good corporate ethics or so-called "innovation" shouldn't be confused for truthful reporting. Money makes the world go round and a lot of vigorish will make it spin dizzily. We needn't say more. Only a few short years after the debacle of Enron, we will soon enough find out again how much corporate malfeasance has been mixed into this current bubble. In the case of the financial sector, we will finally understand how such an unsustainable asset boom was made to appear as reality for so long.
There are our 6 reasons ... 6 steps to reality (or retirement!). Not a complete list by any means, they together suggest that the amplitude of irrationality and financial bubbles will experience greater extremes today. However, all these shifts have not cancelled the business cycle, nor indefinitely delinked underlying income from asset value ... far less insulating the investor from the sure phases of crowd psychology.
End of Bubble: US Dollar Soon Again Attractive
Looking past the detail and the noise, we wager that a world-wide bubble is in its last stages. To this point, a massive credit inflation has infected virtually every investment class ... to the farthest corners on earth. This, unsurprisingly, is not readily identified by most analysts. Once inflationary forces have percolated for a long period of time, it is no longer possible to separate cause from effect. The original inflationary impetus to the boom has been long lost into a myriad of channels which loop back upon themselves. After a while, the results of the original impetus become the base upon which even more excesses are validated.
How can we deduce that the global bubble is in its last stages? Frankly, we can't time this precisely, however, we can be reasonably sure that a number of bells have rung. Firstly, the great global "non-bank" credit machine has lost its engine. It is dead in the water as of the sudden "credit revulsion" of this past summer. It can no longer navigate its own destiny. It may sputter and burp for a while, but the clock is ticking. Only the momentum of "bullishness" and "never say die" optimism has kept the financial ship moving forward ... for now.
Next, the world's largest economy is headed into shallow waters. It is unrealistic to believe that the rest-of-world economy can decouple from the US... at least not quickly. Much evidence argues that this is improbable. If anything, every country is over-exposed to its own variant -- or counterpart -- to the global bubble as never before. For example, China today is more export-oriented than previously, as less of its economic output is directed to domestic consumption. Conversely, the overextended consumer, in countries such as the US (also Ireland and Spain, for example) has become even more dependent upon debt as household savings have collapsed.
What's the solution? According to central banks, the sure short-term sinecure to today's imbalances and untenable valuations is "more" -- namely, more excesses, more debt for the indebted and more surpluses for the surplus countries. The road of least resistance to this outcome is lower interest rates in the US, and a continuing tight-link to the US dollar by China and the major oil exporters. But, this can only continue for a short time at best. It won't be long until Europe spoils the party as its economy comes under downward pressure. They will not be as beholden to China as America (they don't need China's surplus!) and they will not appreciate the "beggar thy neighbor" policies of a profligate US whose currency is in a death dive.
Today we see evidence of panicked investment capital. Some of it is trapped inside the deflating world of structured finance. Other parts are trying to escape depreciating currencies and money. At present, a reactive reverberation has been to move into areas that were "hot" already ... emerging markets, China, commodities ... etc. (See Figure #4) That is all fine if the world can indeed decouple from an economic downturn in America. But, that has long odds.
Our long-running forecast that the US dollar would fall to at least 1.45 to the euro is finally reality. That brings no joy. But, will it fall further? Possibly. A final capitulation phase could surprise as to how deep it may fall. (In fact, anything is possible in financial markets, witness the inanity of the Canadian dollar hitting 1.10 as its guardian, the Bank of Canada, remains toothless.)
Yet, we are inclined to look for the US dollar bottom. Likely it is near. The rest of the world (ROW) looking upon America is still mesmerized by the American Way ... reputedly the land of the brave and the free ... the Super Slurpee ... this vast dynamo of a beautiful country. Deep down, most foreign investors continue to believe that America is a safe bet for the long-term. Is the US going through a bit of slow-down ... a bit of currency trashing? Yes, of course. It is deserved. But economic adjustments will now occur, feeding through to other world economies. Gradually, the trade (non-energy) deficit will shrink. Once foreign equity markets begin declining significantly in anticipation of a slowing global economy and the USD has put in a bottom, it is possible that a torrent of foreign-invested portfolio capital will return to the US. Some estimates put the value of this foreign investment at over $1.5 trillion (and rising as the US dollar falls.)
From our perch in Canada, the next few months likely present the lowest risk buying opportunity of US dollars in at least a century. US "large-cap" companies with significant overseas operations are also attractive on a relative global basis as these are best able to weather an economic slowdown. America will survive for a few years longer.
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