A View from the Trenches, September 8th, 2009: "The beginning of the '10s depression?"
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With Labor Day over, perhaps it has never been so clear that a new
phase in the capital markets story is being written. What are we
talking about? As I mentioned earlier, I am currently writing a small
research note describing a formal framework to analyze this story. In
the meantime, let’s borrow an approach from another science, namely
Biology. If my memory doesn’t fail, biologists cannot tell you what
“life” is, but they can describe a living being. Thus, while we wait
for a formal definition of the new phase, let’s describe the different
dynamics taking place in the markets. Let’s see…
With the first half of 2009 earnings releases behind, there is this
much certainty: There has not been any revenue growth so far and
results were acceptable thanks to cost cutting and the refinancing of
short-term in favor of longer term maturities. Without revenue growth,
unemployment will remain high and consumption weak. This obviously
impacts the housing market and may lead to further loan losses. These
concerns have merit, of course.
In addition, given the steady fiscal deficits, monetary easing
cannot stop, no matter what Bernanke and friends will tell you. Risky
assets have been (and continue to be) transferred from the private to
the public sector. They were (and continue to be) risky for a reason:
an important percentage of them were/are underwater or in default. The
final balance sheets to hold them were those of the central banks. They
were transferred from financial institutions to governments and from
governments to central banks. Therefore, their corresponding currencies
(the liability side of this equation) should be worth less than before
this exercise took place. But when you sell a devalued currency, you
must actually buy another one, unless you want to invest it in a
non-financial asset. The exchange away from currencies and into
non-financial assets began in earnest on March 18th of this year. At
this stage, the expected productivity from these non-financial assets
is thought to have matched their respective price appreciation. But
given the continuation (the immortality) of fiscal deficits worldwide,
it is clear that the devaluation of currencies will remain in full
force. Therefore, it begs the question of what currencies we are left
to invest in. The central bankers know this well and to thwart any
movement, they will exchange, swap, their respective assets to deceive
us. That is what has been happening since on August 18th, the People’s
Bank of China started to restrict credit expansion and unload, at the
same time, agency debt in exchange of Treasuries. The market took note
of it and decided to start buying gold.
After the Jackson Hole conference in August, it seems that there is
a silent agreement to strengthen the Chinese currency. The unwanted
consequence is the becoming of the USD into a carry currency. Can a
carry currency be a reserve currency at the same time? Only in those
countries where money has a history of being debased (i.e. Latin
America, etc.) at a higher speed. The concern therefore shifts from the
US to emerging markets. Emerging markets have slowly, over the past
years become more and more dependent of Chinese consumption. There is
nothing new here. Perhaps the new paradigm however is that while in the
past, US would lead the way, driving China and emerging markets
indirectly, it may now be China that leads the way, driving emerging
markets, dollar bloc currencies and the US simultaneously, in parallel.
I call this a paradigm, because it is not a reality, yet. But the
markets want to believe in that story, and we cannot fight the market.
What do we mean by “China” leading the way out? We mean that China’s
growth would be the key driver behind the “needed” increase in demand.
Politicians and a great majority of economists believe we need an
increase in demand, because deflation is considered something negative.
We can’t blame them; they’ve been educated under the Keynesian truth,
where the pricing system is not considered an essential mechanism to
transmit demand/supply signals, but a blurry reflection of “animal
What is the bottom line here?
The asset swaps among central banks can and will
continue, particularly among developed nations and with more difficulty,
between developed and emerging nations (here is where the IMF regains its lost
shine). An alternative way is to use an indirect approach, where China holds US
assets, for instance, and emerging markets’ central banks hold Chinese assets.
This has actually started.
On March 30th, for instance, the central bank of Argentina entered into
a 70BN Yuan currency swap with China. There are only two possible
outcomes: Inflation or deflation, which means we will be denied the
benefit of price stability. I (and the markets too) am inclined to
believe inflation will be the outcome. With inflation, we will continue
to see high unemployment and more defaults. The bomb has not been
defused and the explosion has only been delayed.
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