Global Cooling

Kudos to Douglas A. Dachille, Chief Executive Officer of First Principles Capital Management, who, during a segment on Bloomberg television today, lambasted Fed Chairman Bernanke, Congress and the Administration over their apparent eagerness to provide some form of quick fiscal stimulus to the economy.  Mr. Dachille, insightfully, compared the use of fiscal stimulus by the government with the use of steroids in baseball; both practices implemented with the goal of performance enhancement beyond what could occur naturally.

We find ourselves at a point in time where the capital markets are telling us that our economy is teetering and will likely fall victim to a recession.  As with all markets, there is a natural ebb and flow.  The primary danger here exists, not so much with normal market adjustments but, rather, with the potential for our politicians to tinker mightily with the controls at their disposal.  Stimulus can almost always be interpreted as an inflationary measure.  With the dollar at its current low level, and with commodity prices at their currently high levels, stimulus may mean playing with fire.  To a politician, though, it means getting re-elected in the near term and, honestly, who cares about the long term.

Jumping ahead to 2007 and 2008, it looks as if the new foreign investor, namely the Sovereign Wealth Funds, learned a little bit from their overly aggressive oriental cohorts and have significantly wised up in their purchases of US assets.  Rather than buying golf courses and real estate, these new financial behemoths are taking significant ownership stakes in our financial institutions. Citigroup, Merrill Lynch and Morgan Stanley highlight the list of top tier firms who have sought large investments from these funds in the wake of a credit crisis spurred by the subprime debacle.  
 
These investments are much different than those we witnessed twenty years ago and they will prove far more difficult to unwind.  We must remember that the United States has long since ceased operations as a manufacturing country; we are now a nation of service industries.  What are the SWF’s buying?  They are buying huge stakes in some of our premier service companies.  Like it or not, it looks as if we have taken on a set of new partners that are likely to be with us for a very long time.  

This is yet another example of the shortcomings of a weak dollar policy.

The US has been the main culprit behind the destabilising global imbalances of recent years. America’s massive current account deficit absorbs about 75 per cent of the world’s surplus saving. Most believe that a weaker US dollar is the best cure for these imbalances. Yet a broad measure of the US dollar has dropped 23 per cent since February 2002 in real terms, with only minimal impact on America’s gaping external imbalance. Dollar bears argue that more currency depreciation is needed. Protectionists insist that China - which has the largest bilateral trade imbalance with the US - should bear a disproportionate share of the next downleg in the US dollar.

America’s aversion toward saving did not appear out of thin air. Waves of asset appreciation - first equities and, more recently, residential property - convinced citizens that a new era was at hand. Reinforced by a monstrous bubble of cheap credit, there was little perceived need to save the old-fashioned way - out of income. Assets became the preferred vehicle of choice.

With one bubble begetting another, America’s imbalances rose to epic proportions. Despite generally subpar income generation, private consumption soared to a record 72 per cent of real gross domestic product in 2007. Household debt hit a record 133 per cent of disposable personal income. And income-based measures of personal saving moved back into negative territory in late 2007.

None of these trends is sustainable. It is only a question of when they give way and what it takes to spark a long overdue rebalancing. A sharp decline in asset prices is necessary to rebalance the US economy. It is the only realistic hope to shift the mix of saving away from asset appreciation back to that supported by income generation. That could entail as much as a 20-30 per cent decline in overall US housing prices and a related deflating of the bubble of cheap and easy credit.

Those trends now appear to be under way. Reflecting an outsize imbalance between supply and demand for new homes, residential property prices fell 6 per cent in the year ending October 2007 for 20 major metropolitan areas in the US, according to the S&P Case-Shiller Index. Most likely, this foretells a broader downturn in nationwide home prices in 2008 that could continue into 2009. Meanwhile, courtesy of the subprime crisis, the credit bubble has popped - ending the cut-rate funding that fuelled the housing bubble.

As home prices move into a protracted period of decline, consumers will finally recognise the perils of bubble-distorted saving strategies. Financially battered households will respond by rebuilding income-based saving balances. That means the consumption share of gross domestic product will fall and the US economy will most likely tumble into recession.

America’s shift back to income-supported saving will be a pivotal development for the rest of the world. As consumption slows and household saving rises in the US, the need to import surplus saving from abroad will diminish. Demand for foreign capital will recede - leading to a reduction of both the US current-account and trade deficits. The global economy will emerge bruised, but much better balanced.

Washington policymakers and politicians need to stand back and let this adjustment play out. Yet the US body politic is panicking in response - underwriting massive liquidity injections that produce another asset bubble and proposing fiscal pump-priming that would depress domestic saving even further. Such actions can only compound the problems that got America into this mess in the first place.

China-bashers in the US Congress also need to stand down. America does not have a China problem - it has a multilateral trade deficit with over 40 countries. The China bilateral imbalance may be the biggest contributor to the overall US trade imbalance but, in large part, this is a result of supply-chain decisions by US multinationals.

By focusing incorrectly on the dollar and putting pressure on the Chinese currency, Congress would only shift China’s portion of the US trade deficit elsewhere - most likely to a higher-cost producer. That would be the same as a tax hike on American workers. If the US returns to income-based saving in the aftermath of the bursting of housing and credit bubbles, its multilateral trade deficit will narrow and the Chinese bilateral imbalance will shrink.

It is going to be a very painful process to break the addiction to asset-led behaviour. No one wants recessions, asset deflation and rising unemployment. But this has always been the potential endgame of a bubble-prone US economy. The longer America puts off this reckoning, the steeper the ultimate price of adjustment. Tough as it is, the only sensible way out is to let markets lead the way. That is what the long overdue bursting of America’s asset and credit bubbles is all about.

The writer is chairman of Morgan Stanley Asia

This is just another example of how loose people can be when carrying someone else’s purse.  Is it just coincidence that our taxes are due by April 15th, and we vote in national elections in November, six months apart?  I wonder how politicians would feel were we to move elections to the 16th of April?

This story from the Washington Post is worth a read:
http://www.washingtonpost.com/wp-dyn/content/article/2008/01/03/AR2008010304163.html

The table below represents an estimate as to where certain commodities and other items would be priced today were their values 100% correlated with inflation.  This is by no means an attempt to place a fair value on any of the items but, rather, to simply serve as an indication of where prices are relative to inflation, as measured by CPI.  There is a good deal of sticker shock in the air when discussing commodity prices, as previously mentioned, perhaps this segment of the market is only just now catching up.  This rings especially true when compared with the S&P and Home Prices.

A weak currency, sooner or later, hurts at home. 

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Feb Crude Oil traded to $100/bbl for a short period of time today.  Feb Gold traded to $864.50.  Beans, Wheat, Corn, Copper and most every other physical commodity you can think of have been on a tear for some time now.  In listening to the popular financial programs on radio, television and the internet, the same questions are posed over and over;  Why?  What’s driving these markets?  Is it a demand or a supply issue?  Is it China, or Pakistan or civil unrest in Nigeria?

The why, of course, is not the most important question.  What really matters, in the short run, is whether any of us are on the right side of these markets.  As for the long term, the true question to be answered is whether or not we are seeing permanent structural changes in the pricing of these commodities. 

Let’s take gold as an example.  Today’s high trade broke through the old record set in January of 1980, twenty eight years ago.  While $860 strikes one as quite high, consider the purchasing power of $1.00 in 1980 as compared to today.  The Consumer Price Index stood at 100 for the average of the 1982-1984 period.  If we use this as a starting point, Gold closed the month of January 1984 at a level of $373.80.  The CPI as of November 2007 was 210.177, more than double the 1984 figure; another way to look at this is that your purchasing power has fallen in half over the past 24 years.  By my calculations, Gold should be fairly priced at $785.64 to match inflation.  $860 doesn’t sound nearly so high when put into that context.  Crude oil is a bit more out of whack than gold with an inflation adjusted fair value somewhere around $63.00.  What this tells us is that we have had the good fortune of vast supplies of raw commodities available to us at extremely cheap levels for many, many years now.  These price shocks may have been a long time coming.

What this inflation argument fails to account for are specific changes in the supply and demand aspects of each individual market.  However, considering that most of the commodity markets seem to have been rallying in unison, one would doubt that individual market dynamics are the driving factor.   What is likely is that our domestic financial markets and international trading systems have been supplying liquidity, in the form of dollars, to the global system for so long, and at such a high rate, that we have undermined the old pricing system leaving ourselves vulnerable to any significant supply/demand imbalances.  In short, we have printed too much money.  Since May 2003, crude is up about 288% on a dollar basis, but up only 183% when priced in Euros.  (continuous futures contracts, crude / euroFX) 

To be sure, there are a myriad of factors that come together to determine the price of a given commodity.  “Price Discovery” is, in fact, one of the most important functions of an exchange or marketplace.  The Farm Bill and the Energy Bill and the many other bills and acts passed by our country and others, along with weather, demographics, etc, and etc., all play a very significant role in pricing any commodity.  It is the baseline price though, that is in peril of migrating upwards at this point in time.