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THE
SILENT DOLLAR CRASH & PARALLEL
INVESTMENT UNIVERSES
by Econotech
May 2, 2006
When Will the Mainstream Recognize the Silent Dollar Crash?
When measured in the price of gold, the dollar and U.S. financial assets
have already crashed. For example, relative to gold, as of Friday’s
close, since their last relative highs in June-July 2005, the U.S.
dollar index has declined 39%, the 10-year Treasury bond 43%, and the
S&P 500 31%. These declines have become free-fall in the last month
or so.
Yet as of now, the financial markets and mainstream media barely seem to
acknowledge this silent yet huge dollar crash, rather quite the
opposite. In terms of risk premia, credit spreads and volatility, global
financial markets continue to be more euphoric than at any time in the
past twenty years, as I pointed out on 3/24 link.
The IMF's April "World Economic Outlook" link
raised its global growth forecast for 2006 0.5% to 4.8%, which would be
the fourth straight year above 4%.
In the U.S., this complacency is perhaps mainly because the housing
market has not collapsed, though mortgage applications are down over 20%
from last summer, and inventories have built up to 5-6 months for single
family homes and 7 months for condos. Forward-looking indicators such as
NAHB home sales expectations and housing market index and the U of
Michigan home buying intentions are at their lowest levels in years.
There are numerous anecdotal news stories of previously hot real estate
markets slowing down, e.g. link.
As the IMF "Outlook" report notes, "the withdrawal of
equity from the housing market--which amounted to 7.5 percent of
household disposable income in the first three quarters of 2005,"
has been critical for the U.S. economy.
Since gold was money for millenia up until 35 years ago, it is still
possible that, should the real estate market decline accelerate, large
segments of the U.S. population may start to put two and two together
and finally realize what the core problem really is, rather than being
diverted into blaming various “others.” (See my 4/4 article link.)
Parallel Investment Universes That Have Not Yet Intersected
To me there appears to be three parallel investment universes. There is
the mainstream Wall Street world, where investor euphoria remains at a
20-year high, especially in terms of credit and emerging market spreads.
Then there is officialdom, represented by the G-7 recently handing to
the IMF the hot potato of trying to do something about the seemingly
intractable global economic imbalances, which imho will be a futile
effort without fundamental monetary/financial system reforms that as of
yet are not being even remotely considered.
Finally, there is the growing Internet world of wealth preservation
investors focused on gold and other commodities. (A few of these web
sites are listed in my links section.)
Unlike in the TMT equity bubble of the late 1990s, when the existence of
a bubble was at least open to debate on Wall Street, these parallel
universes have not intersected at all in this credit cycle.
Specifically, there is simply no acknowledgement on Wall Street as of
yet that the price of gold may be signaling a dramatically changed
financial situation.
To Wall Street, commodity inflation is directly linked to very strong
growth in emerging markets, especially that of China, which again has
been higher than expected, but it doesn’t go beyond that, to the role
of excess dollar credit as indicated by the price of gold, because it
can't, due to self interest.
The IMF has recently released two of its key periodic reports,
"World Economic Outlook" and "Global Financial Stability
Report." I may have missed it, but I do not recall the more than
doubling in the gold price over the past few years mentioned even once
in these otherwise authoritative and exhaustive reports, from which I
will quote liberally in the next few sections.
Rather than try to deal with the fact, it's as if the rise in gold
simply hasn't happened or has no meaning as far as Wall Street and the
global monetary authorities are concerned.
"Exogenous" Shocks are Endemic to Highly Leveraged
Speculative Finance Globalization
The IMF's April 2006 “Global Financial Stability Report” link
says “it is difficult to make a case that realistic economic
developments all by themselves could—at least over a 6–12 month time
horizon—seriously affect the global financial system in a systemic
way.”
But the IMF's new "Outlook" report also says "the
baseline forecast is for continued strong growth, although risks remain
slanted to the downside, the more so since key vulnerabilities—notably
the global imbalances—continue to increase."
The IMF "Stability" report notes that “sudden and negative
developments—such as military confrontation, major terrorist attacks,
a sharp fall in the supply of crude oil or other vital sources of
energy, and maybe, more realistically, a significant rise in
protectionism—could change the rational framework for global asset
allocation and trigger a disorderly unwinding of global imbalances.
These uncertainties, however, are difficult, if not impossible, to
quantify.” It also talks about avian flu in this manner.
Just because they can not be easily modeled, there is no reason to
consider these "exogenous” shock risks from "outside"
the global market system, rather they are endemic to the current version
of hyper speculative globalization, especially because the enormous use
of financial leverage gives less leeway for major problems.
No Let Up to Higher Energy Prices, While Oil Companies Maximize
Shareholder Value
In particular, the energy game continues to play out with no end in
sight. The April 29 FT lead headline says, “Bush woos Asian energy
allies to thwart Moscow.” Immediately after meeting with Bush,
China’s President flew to Saudi Arabia then Nigeria to sign major
deals, and of course China has close energy ties with Iran. Hedge funds
and other speculators are taking advantage of these very real energy
problems, making the situation worse, as Enron had done earlier (hyper
speculation nowadays almost always tends to be of the destabilizing herd
mentality type).
Chapter 2 of the IMF "Outlook" report says: "IMF staff
believes that the IEA’s [International Energy Agency] and OPEC’s
projections in the 1.2 mbd range for non-OPEC supply growth in 2006 may
be optimistic. Even if OPEC’s capacity increases by a projected 1 mbd,
spare capacity will likely continue to remain low, and consist mostly of
the heavy grades, for which refining capacity is limited."
It then makes the following key point: "The IEA estimates that
investment in the oil sector is probably 20 percent below what is needed
to meet projected demand over the medium to long term. In contrast,
oil-exporting countries and major oil companies argue that they are
investing as rapidly as is appropriate ... To date, oil corporations
appear to have used a large part of their profits to distribute to
shareholders, buy back shares, accumulate cash reserves, or acquire
other companies ... new investment, while significant in nominal terms,
may not be large in real terms."
I.e. according to the IMF, oil companies have been using their robust
cash flow to enhance "shareholder value," my term, not the
IMF's. How effectively energy companies invest their currently high
profits to actually increase energy supplies eventually will be a
critical test for the current version of speculative finance
globalization, far surpassing in importance the outrageous
"compensation" their CEOs have been granting themselves.
Why Aren't Non-Financial Corporations Investing Their Record
Cash Flows?
This behavior by energy companies is consistent with the more general
use of record profits and cash flows by corporate America in this
economic cycle. The IMF notes in Chapter 4 of the "Outlook,"
worldwide "the strong increase in profits has been used by
nonfinancial corporates to acquire financial assets—including a
substantial amount of liquid assets (“cash” for short) during
2003–04—or to repay debt, rather than to finance new capital
investments or to increase distributions to shareholders through
dividends."
"While higher profits explain part of the rise in NFCS
[non-financial corporate sector] excess saving in recent years, the
decline in nominal capital spending explains around three-quarters of
the increase in NFCS net lending since 2000 in the G-7 countries. Simply
put, firms have been investing a smaller share of their profits in
upgrading and expanding their capital stock."
Interestingly, the IMF also notes that "a closer examination
reveals that the increase in profits is mainly due to lower tax and
interest payments and, in some countries, to higher profits received
from foreign operations, rather than to a rise in gross operating
surplus."
Indeed, this economic cycle has seen profound shifts from previous ones.
Again, according to the IMF "Outlook," "capital is
flowing from emerging markets to industrial countries (notably the
United States), the opposite of what would be predicted by economic
theory." And, according to the IMF "Stability" report,
"the transfer of risk, at least in part, to the household sector
[from the corporate one] has somewhat changed the nature of moral hazard
from “too big to fail” for some key financial institutions to whole
market segments being “too important to fall.”"
Inflation Risks Still Exist
Btw, the IMF "Outlook" also notes "increased financial
investment in commodity markets," i.e. more hyper speculation by
hedge funds, etc., as one of the three "factors [that] are
contributing to the current upsurge" in commodity prices overall.
In Chapter 3 of the "Outlook," the IMF makes another key
point: "globalization cannot be relied upon to keep a lid on
inflationary pressures in present circumstances. Strong global growth
and diminishing economic slack have reduced the restraining impact of
declining import prices on inflation, and with strong global growth
expected to continue, the primary risk is that a further upturn in
import prices could result in stronger inflationary pressures going
forward, particularly in countries that are well advanced in the
economic cycle. The possibility of further, partly
globalization-related, commodity price increases adds to these upside
risks from the external sector."
The Liquidity Risks in the Secondary Markets for Structured
Credit Products
The IMF "Stability" report notes liquidity risks.
Specifically, “credit derivative products have significantly enhanced
the “transferability” of credit risks by allowing for the increased
specificity of credit exposures, to meet different investor demands,
particularly in the “primary” risk transfer markets. However, once
transferred, secondary market liquidity risks and related contagion
effects remain, and may constitute the most significant stability risk
emanating from the structured credit markets.”
Again, “the potential for secondary [credit derivative] market
liquidity disruptions, often related to the homogeneity of market
participants in a particular segment and to gaps between real and
perceived liquidity, remains a stability concern.”
Concluding, “in the structured credit markets, we believe the risk of
liquidity disturbances is material. Whether and how these new risks
materialize, and the severity of their impact, will critically depend on
the degree to which the diversity of market participants increases, the
various structural frictions are reduced, and market surveillance is
improved.”
G-7-IMF Effort to Address Global Economic Imbalances Too Little
Too Late?
Roach at Morgan Stanley, who has for years focused on global economic
imbalances but whose call for a "new global [financial]
architecture" link
is probably too little too late imho, has just become more optimistic
today because he believes "the world is finally taking its
medicine--or at least considering the possibility of doing so" link.
At present I do not share Roach's new-found optimism. It has taken the
U.S. more than thirty years to get itself into its current
economic/financial situation, I believe that it will take a long time to
reverse it, capabilities and habits can not change over night. Given the
daunting arithmetic of the U.S. current account and fiscal deficit going
forward, and because profound, long-lasting structural changes to the
global economy have been made, I can not see any feasible size dollar
devaluation that would have a significant impact on the U.S. balance of
payments.
As for other views, Roach's colleague Xie is perhaps the only i-bank
macroeconomist, and MIT economics PhD, who routinely incorporates the
dominant role of global speculative finance in his core analysis of
global imbalances, e.g. "the global financial system is running the
global economy," link.
Gross at Pimco continues to point out the U.S. dollar risk, "need I
say more than to sell U.S. assets and buy Asian ones denominated in
their local currencies," link.
Some old-time continental European-trained economists, e.g. Richebächer,
Faber link,
have come from a more “sound money” tradition than their American
counterparts.
The mainstream academic international economists, while usually more
honest than Wall Street, also continue to have trouble coming to grips
with the key issues, saying for years that the current global imbalances
are unsustainable, but otherwise at a loss as to how this situation can
continue so long, let alone when it might change, again simply not
acknowledging what gold might be signaling, e.g., in recent separate
swipes at the global imbalances piñata by Eichengreen link,
Krugman, and Summers link,
and global inequality by Wolf (at the FT) and Krugman.
How Long Will China and Saudi Arabia Finance U.S. Twin Deficits,
Hence Its Military Policy?
As I said in my April 20 article link,
“to much of the world, the U.S. appears to be unilaterally, "pre-emptively"
embarked on policies which seem to have the effect, well-intended,
unintended or otherwise, of helping to destabilize key regions, such as
the Mideast, Iran, central Asia, North Korea, the former Soviet
republics, etc. East Asia and Saudi Arabia are in effect financing the
ability of the U.S. to pursue these unilateral policies by holding huge
amounts of very low-yielding U.S. debt securities which will most likely
significantly depreciate.
Stability in these key regions is critical to the paramount interest of
most of these Eurasian nations, economic development. In addition, most
of East and South Asia have huge internal infrastructure development
needs, on the order of $400 billion per year, which are not being met,
about equal to the amount it is adding to its forex reserves.
Thus, taking into account other costs and benefits (access to U.S.
market, technology, management, etc), how much longer will the rest of
the world finance U.S. military policy? How Iran is resolved might go
some way to resolving that question.”
As I put it in my 3/24 article link,
"especially if the geopolitical stuff below, such as in the Mideast
or friction with China, starts to really go against the U.S., and a
Eurasian "balancing coalition" starts to form, around national
and energy security issues, against the sole U.S. "superpower"
hegemon, then "feedback loops" with the above areas could
accelerate. E.g. having to raise interest rates, which would further
jeopardize the real estate market, thus consumer spending, thus capex
spending, starting a downward spiral in the dollar."
How Much Longer the Golden Age of Goldman Sachs?
There needs to be some very creative thinking on how to solve these huge
issues, and to date there isn’t, as far as I can see. Instead, the
market euphoria that I noted in my March 24 Economic/Financial Monitor link
has continued, especially in the commodity and emerging markets.
“The Economist” has two puff pieces on Goldman Sachs in its current
issue. The lead says, “The average pay-packet of its 24,000 staff last
year was $520,000—and that includes a lot of assistants and
secretaries.” Even with such high “compensation,” return on equity
is near 40%.
Meanwhile, the recent first quarter U.S. employment cost index again
confirms that the rest of the population has been going nowhere for the
past five years. (Inflation as defined by the Fed would be if real wages
ever went up merely in line with productivity, rather than everything
that Goldman trades currently going parabolic.)
Goldman makes much of its money in proprietary trading, i.e.
speculating. Despite the cover's sub-head, "Goldman Sachs and the
culture of risk," the leader says, "If the much vaunted
systems do not work, then the central banks will have to step in (as the
Federal Reserve did with LTCM)." Why, what risk culture is that?
U.S. Goes from High-Tech Leader to Global Hyper Speculator
In the late 1990s, the U.S. “brand image” was built on high-tech
leadership and productivity, which presumably was why the rest of the
world would be willing to finance ever larger U.S. twin deficits. Now
look at the ongoing troubles of Intel and Microsoft. Notwithstanding the
huge success of Google, E-Bay and a few others, mainly oriented to media
and advertising, tech investing generally has been reduced nowadays to
playing short-term product and inventory/capacity cycles, e.g. fiber
optic/telecom lately.
(Former technology hedge fund manager Kessler trotted out a version of
his “margin surplus” views from his "Running Money" book
once again recently in WSJ op-ed, no surprise there, the Silicon Valley
slice-and-dice horizontal asset-light outsourcing business model
certainly has helped hedge funds and venture capitalists. Such a
cost-cutting model is also favored by the Wal-Marts of the world, whose
merchant mentality simply has very little conception of the true costs
of real innovation, readily apparent in books on that company.
Prestowitz has a more accurate view of what such a model has meant for
the U.S. in his "Three Billion New Capitalists," soon in
paperback, which incidentally is one of the very few mainstream books to
mention the effects of the dollar's role as reserve currency, also see
the "Curse of the Dollar" section in my 4/20 article.)
Emerging Market Growth Drives Financial System, Not Vice Versa
In the past five years, the Goldman's of the world have greatly
benefited from the extraordinary growth of China, India and the rest of
the developing world helping to drive the world economy, rather than the
other way. China’s development has been heavily dependent on huge
foreign direct investment (FDI), not speculative “hot money,” the
latter still might be its undoing (as it was in the so-called Asian
Financial Crisis of 1997-98), especially given China's inadequate
financial/corporate governance systems. China President Hu recently
visited Microsoft and Boeing, not Wall Street.
The global speculative financial system “free rides” on this real
growth, it doesn’t create it, as is commonly thought in the U.S. The
sooner corporate America realizes this the better, since despite all its
problems, it is a main repository of critical technology and know-how
needed to help solve the world's most pressing issues, such as
sustainable energy development.
The rest of the world knows what really drives growth, even while it
continues to play along, for now, with the U.S. dominated hyper
speculative monetary/financial system. The central banks of Sweden and
others now seem to be looking to diversify out of this game.
I'm not a libertarian, but I recommend the April 25 and Feb 15 speeches
by Rep. Ron Paul, "What the Price of Gold is Telling Us," link
and "The End of Dollar Hegemony" link.
Paul is one of the very few principled politicians seemingly left in
Washington. Hopefully someone with a little more clout will finally
figure out what he has before it’s too late, but I’m not holding my
breath waiting.
© 2006 Econotech
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