12/12/2008: The beggar-thy-neighbor boomerang

It’s official. The National Bureau of Economic Research now says the US entered a recession a year ago, in December 2007. Thus, we already know that this is no average 10.7-month US downturn. If anything, this recession now seems to be accelerating, a full year after it began. In fact, it is shaping up to be the worst of its kind in at least 25 years. And not just for the US. Virtually every other big economy around the world is reeling, suffering from the same credit shock.

So this recession is a global one, with negative growth ahead for developed economies and a significant slowdown for emerging markets. How both large and small countries respond, singly and in concert, will tell us a lot about state of globalization today and the lessons learned, or not, from history.

The slowdown has not gone unnoticed. Governments everywhere have mobilized to combat it. They have bailed out their distressed financial industries and may support other crippled sectors, US car makers among the more prominent candidates right now. And massive fiscal stimulation packages are also in the works to revive investment, trade and employment globally.

Did we say everywhere? There is one developed country that is apparently unwilling to join the activists, and that is Germany.

To date, Chancellor Angela Merkel’s government has granted a mere 12 billion euros for recovery purposes, less than half the sums the UK and France have committed to fight their recessions. Germany’s reluctance is not due to lack of means: its debt and deficit situation is far sounder than in any other large developed country. Rather, Germany’s reluctance to spend its way out of recession has its origins in the policy of fiscal frugality that has been at the core of its export renaissance over the past decade.

But today’s recession challenges this kind of economic Darwinism. We are convinced that what got Germany back on track as an exporter won’t bring them further today. By relying on exports and not boosting its domestic demand, we think Germany is jeopardizing its own growth. Beyond that, they are also tacitly engaging in a beggar-thy–neighbor policy, whereby they look to prosper from the fiscal impulses provided by their trading partners at little cost to themselves. This is not unlikely to be warmly received by those same partners.

There is also one emerging market not entirely without reproach in matters of economic solidarity, and that is China. Yes, the recent 600 billion dollar stimulus package dwarves those of other nations. The US would have to spend roughly 2.4 trillion dollars to match it on a relative gross-domestic-product basis. And yes, domestic demand, both private consumption and public investments, are targeted in China’s package. But this should not obscure one missing element in China’s response to the global slowdown, its currency policy.

Roughly coinciding with the announcement of their fiscal stimulus program, the Chinese authorities seem to be reversing the appreciation trend of their currency against the dollar. Since 2005, the Chinese yuan has appreciated by 20% against the US dollar, which is still too low judging by the burgeoning China-US trade gap.

The undervalued Chinese yuan and China’s widening trade gap with the US are root causes of the current crisis. As their massive US dollar reserves grew, the Chinese were essentially buying US debt. This pushed US interest rates to very low levels, and this cheap credit swelled debt levels of both households and financial institutions in the US. And we now see the consequences of that bubble.

As with Germany, what fed China’s export success won’t bring them much further. US households have finally started to save. They are unlikely to buy up Chinese goods even if they are cheaper. In November, Chinese exports to the US shrank by 6.4% compared with a year ago. And even if US consumers were to revive their old spending patterns, in the end China might also appear to playing beggar-thy-neighbor. This could have truly dreadful consequences, since protectionism sentiment is no longer taboo in America. That is one road we really don’t want to take again (see Depression, Great).

We note with concern that Germany and China’s self-centered policies to date, though different in origin and implementation, are equally dangerous today. The recession is global. The solutions to mitigate it should also be global.

28/11/2008: Decouple is not just the people next door

In 2007, when the US subprime hemorrhage began, it looked like a case for local anesthesia. The market chattered about how the world would simply “decouple” from the ailing American economy and there was a massive investment migration as money exited the US market. Indeed, we saw a veritable feeding frenzy for emerging market assets among investors from developed countries.

But today it is clear that when the US economy shivers, the rest of the world still feels a chill. At the moment, nearly every country is in or near recession, and those who aren’t members of this growing club still feel rundown by the slowdown.

Markets corrected worldwide in 2008 with the tight choreography of synchronized swimmers diving for the bottom. So, we ask, what happened to decoupling? Is over? Did it ever really happen, or was it just a buzzword in the wind?

The word decoupling usually has two applications. It relates to economies, their growth and their business cycles. And it also refers to markets and their correlation, or lack of same.

Surely, during all of 2007 and even the first quarter of 2008, decoupling was more than just a buzzword. It actually seemed to be happening. Remember, the US had already slowed considerably early in 2008, with only 0.9% annualized growth in the first quarter. At the same time, China registered another double-digit growth quarter, and other large emerging markets were also setting new growth records.

And back then, decoupling was not only an emerging market story. Germany also posted a whopping 5.2% annualized growth rate for the first quarter of 2008, and even Japan managed a strong 2.8%.

But as 2008 progressed, the local bleeding in the US spread globally, infecting the many countries exposed to the toxic US financial sector. Europe was especially hard hit. In early September, it became painfully clear that the US credit crunch would rock Europe just as hard as it was pounding the States. And with the US and Europe stumbling together into a deep recession, neither the emerging markets nor the commodity-exporting countries could not escape the global contagion.

So, for the first time since the early 1980s, we are experiencing a truly global recession, which could suggest that decoupling never took place. But in economics, as we often remark, correlation does not necessarily mean causality. Appearances can and do deceive.

We would argue that it was not the US recession that is leading the rest of the global economy to contract. What we are seeing instead are the consequences of a massive credit shock hitting both the US and the rest of the world at more or less the same time. Therefore, despite the business cycle being reset and synchronized globally, we think announcing the death of decoupling may be premature.

In terms of markets, the rest of the world hardly decoupled from the US in recent years. And this year, Wall Street still set the economic rhythm for stock markets worldwide early on. But as the financial crisis peaked, in late September and early October, we also saw Asian and European markets actually take the lead from Wall Street. So, while we again see a strong correlation between the US market and the markets of the rest of the world, causality is no longer quite as direct and rigid as it was only a couple of years ago.

We think investors would be mistaken to interpret today’s recoupled markets as a signal to avoid international diversification. We see this recoupling as a response to a once-in-a-lifetime global credit crisis. Despite the renewed correlation among international markets, we are convinced that an exposure abroad makes eminent good sense for many individual investors.

This is especially true for investors living in economies that rely on one or two specialized domestic sectors, or where the economy is highly commodity-dependent. Geographic diversification decreases their vulnerability to sharp movements in local markets and in its assets.

In a portfolio context, investing abroad is a good way to decrease volatility for the same expected return; or, alternatively, to increases the expected return for the same volatility. Decouple, we say, next door or even further afield. It’s good for you.

14/11/2008: The cheerless shine of gold

This should have been the perfect storm for gold. Between October 6th and October 10th, 2008 equity markets worldwide were falling at least by 15%. We were entering a weekend where the G7 and G20 would meet to discuss, how to find a solution to the unwinding financial crisis. There was no certainty at all that there would be a solution. Financial intermediaries on both side of the Atlantic were getting under major stress and the broad public was questioning the overall stability and viability of the financial system going forward. One obvious rational reaction in such a stressful environment should have been to buy the safe haven par excellence: gold.

But on October 10th, the same day where people were queuing in front of gold and coin retailers in London to buy bullion, gold fell from 913 to 850 US dollar an ounce. There are other paradoxes happening on the gold market. On October 27th, the news agency Dow Jones reported that a 24 karat pure one ounce bar of gold had attracted 12 bids, the highest being at 835 US dollar. Meanwhile, an ounce gold was selling at 729 US dollar on the spot market. How come that on the one hand there seems to be quite obviously a huge demand for physical gold, while on the other hand at the same time the gold price is falling?

One explanation might be that while they are obviously a large demand of gold, there might be an even larger supply of it. But why would anyone sell gold in such troubled times? Gold is liquid, i.e. quite easy to sell, but it is of course not a complete equivalent to cash. During a financial crisis, like the one we just experienced, cash is of course short everywhere, when it comes to fulfill some counterparty obligations or margin calls, therefore a large number of market participants need to get rid of their assets and this includes gold. So despite being considered as a “safe” asset, the volatility of gold within the last two months was roughly amounting to two third of the extremely volatile US stock market.

Does this speak against an investment in gold? Not necessarily. Despite its current high volatility, gold might nevertheless give you a good protection of value during those troubled times. Moreover, given the huge debt and money creation of the governments around the globe to mitigate the unfolding global recession, inflation expectations might significantly increase in the longer run. This also pleads in favor of gold. This said gold investors have to be disciplined. Gold has a tendency to create an emotional bonding with the investor, who would say: “it is the safest part of my portfolio; therefore I will never sell it”. This attitude could lead to big underperformances. After having traded above 600 US dollar an ounce in 1980 it took gold twenty six years to reach this level again. Hence a prudent investor buying gold must have a clear price target and also a stop loss and not be apprehensive to sell gold should it break through the stop loss.

31/10/2008: Is that the sound of a bubble in the making?

The back-story is well known now. Even Alan Greenspan, former maestro and current scapegoat for the financial crisis, seems at last to acknowledge it. To fend off a recession after the tech bubble burst in 2000, excessively lax US monetary policy led straight to two even bigger bubbles, in house prices and their next of kin, the credit markets.

The bursting of these two bubbles, in the US and elsewhere, has had profound consequences that are not yet behind us. Not least, it has pushed the US and Europe to the brink of deep and prolonged recessions that we expect them to enter next year.

And again, as in 2001, the question now is how to avoid or at least mitigate the effects of a recession.

This time, monetary policy may not work. Despite deep cuts to interest rates, the Fed has been unable to stave off a serious credit crunch. In fact, virtually all the world’s major central banks are now on the rate-easing path. But with commercial banks and other lenders focusing on reducing their own debt and replenishing their own balance sheets, liquidity remains frozen and money is still not finding its way to the public.

With credit channels for businesses and private borrowers still blocked, governments will probably have to turn to fiscal policy measures next. Here again the US paved the way, starting last spring with a 150 billion US dollar impulse program, mostly in form of tax rebates. Another fiscal program is currently being prepared. Other countries, most notably the UK and France, are now considering similar measures. The recently-scorned ideas of John Maynard Keynes are back, alive and kicking, much to the chagrin of many economists.

But how will the US government pay for its high-ticket interventions? The answer is simple: it will just increase its debt. Today, everyone’s chasing the safest and most liquid paper, which is government debt, especially from the US. With roughly a 3.5% yield on 10-year US Treasury paper, financing its budget deficit has become especially cheap for the US government. So far, so good. There is nothing wrong with profiting from good financing conditions.

But is this also a good deal for the investor? Here, we are far less certain. Once the financial crisis begins to fade, the risk premium on asset classes like equities or corporate bonds will fall. Investors might suddenly become nervous about the towering deficit and debt-to-GDP ratio accumulating in the US. And this realization might lead them to exit the US government bond market as fast as they entered it. This would turn today’s favorable picture on its head and lead to sharply higher interest rates and lower bond prices.

Some economists would cite Japan as proof that low interest rates are not inherently incompatible with an extremely high government debt-to-GDP ratio (now estimated to be around 180% in Japan). But almost all of Japan’s government debt is financed domestically, while a large chunk of US debt is held abroad. And here lurks a huge risk, in our opinion.

Having financed US corporate debt during the tech bubble and then US consumer debt during the housing bubble, we wonder if the rest of the world will line up to finance US government debt. If enough former backers sit this round out, we just might end up with a big, nasty US Treasury bubble.

“Fool me once shame on you, fool me twice shame on me.” Being fooled a third time invites the question, are we investors, or masochists? We think fiscal policy measures may prove to be a bit more problematic against this recession than some government economists seem to acknowledge.

17/10/2008: Ignore fundamentals and they will seek revenge

This is a basic rule of investing. It has been recently once again proven right. This time it was in the foreign exchange market.

During the last five years at least foreign exchange markets were dominated by a practice called “carry trade”. Carry trade consists of borrowing funds in a low- interest rate currency and investing the proceeds in a high- interest rate currency. For example taking a mortgage in the Swiss Franc characterized by a very low interest rate and buying real estate in another country whose interest rates are higher. The yield difference between the two countries or the two currencies represents a gain if the exchange rate does not move to such an extent that it will erase the interest rate differential. If such a strategy is broadly adopted, as was the case in the last couple of years, then the price value of the low-yielding currency will decline and the price value of the high-yielding currency will go up.

This sounds like a money-spinner but, as we all (should) know, there is no such thing as a free lunch, or a perpetual profit maker. So where is the flaw in this practice?

First and foremost, one needs to acknowledge that interest rates are usually a reflection of inflation expectations. The countries, which are seen as having a low inflation track like Switzerland or Japan enjoy usually comparatively low interest rates and conversely countries with a less optimal inflation track, like Australia or New Zealand have comparatively higher interest rates. According to the purchasing power parity, low inflation countries will see in the long run their currencies strengthen against higher inflation countries. In fact over a period of 20 years the Swiss Franc and the Japanese Yen have clearly appreciated against almost all other currencies in the world.

Second, a low interest rate is also a reflection of the fact that a country is seen as safe and stable. This explains why usually developed countries have lower interest rates than emerging markets and have in the long run currencies, which are more stable.

Despite these fundamental explanations, why in the long run low yielding currencies tend to appreciate against high yielding currencies carry trades enjoyed the investors’ favor of investors in the last couple of years, reflecting their robust risk appetite. The exchange rate between the Japanese yen and the Australian dollar, which encompasses one of the more favored carry trades – sell the former and buy the latter – was almost mimicking the evolution of the Standard & Poor’s 500 equity index. Therefore there was a close relationship between successful carry trading and equity performance, one gauge of overall market sentiment.

Like every other risky strategy carry trades have been hit hard by the ongoing financial crisis to the extent that we consider them to be over by now. Over the last month alone the high yielding and once favored Australian dollar lost more than 40% against the low yielding and once despised Japanese yen.

In our view, carry trades are now clearly out of fashion on the currency market and it is not yet clear which new theme will drive the market over the medium run. Meanwhile, and at least as long as the crisis last we low- yielding, safe-haven currencies like the Japanese yen and the Swiss franc over higher- yielding currencies, like the euro, the British pound or the Australian dollar.

03/10/2008: On the road to inflation or deflation?

Government debt is soaring as the US and Europe scramble to rescue distressed financial institutions. Central banks worldwide are pumping liquidity into markets and lowering their interest rates. Classical economic theory argues that these actions should pave the way for a surge in inflation pressures ahead. But is it really so?

Economic textbooks generally take the view that two government actions can be counted on to fan the flames of inflation––printing more money or increasing government debt. While few economists would dispute this thesis, there can be exceptional circumstances that defy it, and this is what we now are seeing.

Money is created from two sources: a central bank, like the US Fed, and financial institutions, like commercial banks. When the central bank wants to create money, it simply prints it and then buys something with it, such as government debt. The “new” money goes to the seller of the government debt, who in turn buys something or saves it.

At some point, this freshly created money lands in a bank’s accounts. The bank will lend most of this money to someone, who will buy something with it; at some point the money will land in another bank account; that bank will lend most of the money to someone else; and the cycle continues.

In a smoothly functioning financial system, one unit of central bank money, or base money, thus creates multiple units of money in the real economy. How much it creates depends on the reserve requirements of banks that stipulate the proportion of deposits that must keep at the central bank rather than lent. It also depends on interest rate levels and on the willingness of banks to lend.

In today’s dysfunctional financial markets, the willingness to lend has abruptly vanished, especially in the US. This means that the Fed can print money, but these funds will not find their way to the public via loans and will therefore have no affect on demand, prices, and inflation.

After the Japanese real estate and stock markets collapsed in 1990, the Bank of Japan and the Japanese government confronted a situation similar to what the US and to a lesser extent Europe now face. Despite years of central bank interest rates at zero percent and government debt that ballooned to more than 150% of GDP, Japan actually experienced more than ten years of deflation, that is, declining prices, because banks drastically reduced lending and deleveraged, that is, they removed debt from their balance sheets.

Both inflation and deflation hurt equities, but inflation is obviously the lesser of the two evils as the Great Depression of the 1930s and Japan in the 1990s both confirm. Bonds, especially the safest ones, tend to perform well in a deflationary environment; so does currency, even if its returns are low. Commodities, on the other hand, do well in times of rising inflation and less well when deflation prevails.

Thus, the view that money creation automatically feeds inflation does not neatly apply in the current situation. The environment is more complex this time around, which means that making the right investment decisions will be absolutely crucial to your portfolio once the worst of the current crisis is behind us.

19/09/2008: How do financial crisis end?

Like forest fires, there are essentially two ways of dealing with financial crises. The first is to do nothing. Let the fire burn itself out. The second way is to send in the fire fighters.

Which approach is chosen will depend on what is at stake. If the forest fire does not threaten to spread to the big towns, then less dramatic measures are required. But if the fire is being helped along by strong winds and there is a suspicion that some arsonists are hoping to profit from cleared land close to the cities, then there is a lot more at stake. Fire-fighters will be called in from far and wide, and the state will use all measures at its disposal to put out the fire.

We have seen both approaches used in previous financial crises. The 1987 stock market crash, which was severe, did not spread, and therefore, doing almost nothing was the right thing to do. On the other hand, like in 1929, a financial crisis can lead to a Great Depression. In such a case, doing nothing could end up being very costly.

However, the fact that there is no universally applicable answer to which approach to take does not necessarily imply that there is not a certain set of rules which need to be applied to solve a crisis. In their seminal work on the Panic of 1907, the US economists Robert Brunner and Sean Carr emphasized how the failure of collective action could worsen and deepen a crisis.

In a nutshell, the Panic of 1907 was a financial crisis in the US, and especially in New York City, which was characterized by numerous runs on banks and other financial institutions. Back then, the Federal Reserve didn’t exist and therefore there wasn’t an obvious “lender of the last resort” – someone who could supply the fire fighters with unlimited amounts of water for their hosepipes. Therefore, there was also no obvious way to stop the crisis.

In this particular case it took the leadership of the legendary banker John Pierpont Morgan. He gathered around him a circle of influential New York bankers and forced them to form an association aimed at supporting the distressed financial institutions. Moreover, once this group was in place, there was a very strong commitment to draw a line in the sand and declare: “the trouble stops here”.

Lessons from past crises show that to solve them we must see rule-based action, clear communication, a credible leading coalition, collaboration of private and public forces in an internationally coordinated fashion, unless we want the crisis to run its own course.

The current crisis reached a threshold in late September, where letting it run its own course was no longer a viable option. Sooner (rather than later) the crisis is going to stop because the authorities are going to do what is necessary to stop it. This is likely to include a broad rescue plan from the US government and the monetary authorities.

21/08/2008: The dollar cycle

Until the summer break, the newspapers had been full of stories about the declining US dollar and predictions about its end as the world’s leading currency. This debate flares up whenever there is a sustained weakness in the dollar, as we have seen in recent years. It helps to take a longer-term view, though. These cycles are not new. The dollar suffered bouts of protracted weakness in the past, like in the late seventies and in the mid-nineties, only to stage strong recoveries.

Since the end of the Bretton Woods System of fixed exchange rates way back in 1973, the value of the dollar against other major currencies has been subject to large swings. Over the past two decades those swings lasted roughly fourteen years (seven years up and then seven years down). Since its peak against the Euro back in 2001 and until July, the dollar lost roughly 50%: seven years down. Now, over the last months it has gained almost 10% from its 1.60 peak.

Are the seven down years finally over? It is difficult to say. But one thing we do know is that currencies cannot forever drift away from one of their fundamental anchors: purchasing power parity. Purchasing power parity gives an indication of where the exchange rate should be to make the price of a basket of goods in the US the same as in another country. We knew, therefore, that the cheaper that a range of US assets, including Manhattan apartments, became relative to comparable assets elsewhere, the greater the bargain for foreign investors and the greater the likelihood that the dollar would snap back at some point. Based on our estimates, the purchasing power parity between the euro and the dollar is 1.27. This means that at current levels - 1.47 – the dollar is still more than 15% undervalued against the euro. This is no longer a big enough gap to make a bold forecast for a further substantial appreciation of the dollar, but it gives a sense of why a 1.60 exchange rate (which means the dollar was 25% too cheap) was not really sustainable.

What is currently driving the euro/dollar exchange rate is the ongoing weakness of the European economy. While every market participant has known for quite a while that the US economy is in pretty bad shape, the latest economic indicators out of Europe clearly surprised the market on the negative side. Moreover, this finally shattered the belief that Europe could decouple from the US. This initiated a trend for a stronger dollar, which is still not over, because we expect even more negative news from the European economies in the months ahead.

We, therefore, favor the dollar against the European currencies over the next couples of months. We believe that currency investors are likely to be well served by using moments of temporary greenback weakness, which might occur during this period, to build up dollar positions.