Another Wall of Money on Its Way
Monetary easing has continued with the world’s major central banks printing high powered money without inhibitions. The Fed has just signaled that US short term interest rates will remain where they are in near zero territory until 2014. Move across the Atlantic and it is the same story. The ECB with its Long Term Refinancing Operation (LITRO) has opened the floodgates. We now know that no matter what the Germans say, the ECB will print whatever is necessary to avoid Italian and Spanish defaults. Not to be left out, the Bank of England has embraced another round of quantitative easing. And China is making noises that easing will come if the Chinese economy as expected slows further.
In my opinion, equity investors cannot ignore this wave of money. The brave will try to ride the wave, hoping they will know when to get off. In the current lexicon, the risk-on trade will prove irresistible. To short against the world’s central banks seems like a losing strategy. And the world’s central banks have set short term interest rates at zero thus punishing anyone unwilling to take risk and ride the wave. Real rates are negative except in Japan. Bernanke might worry about deflation risks but for investors inflation is the reality. But at the same time, risk-on is a very risky strategy for investors. Investors are being manipulated by the world’s central banks, most of which by the way secretly or not so secretly want to see their own currencies depreciate. Unfortunately, the major economies, by becoming reliant on money creation, are drinking salt water to quench their thirst. All this monetary creation will not end well nor will the excessive and growing loads of government debt.
The world’s central banks in full public view are debasing their currencies. And the markets and the financial media are cheering. In 1971 Richard Nixon severed the final link with gold. Under the Bretton Woods System or “Gold Standard Lite” as I prefer to think of it, the United States had to sell gold to other countries at $35 dollars per ounce. To do this it was required that the US maintain its financial discipline. But LBJ’s “guns and butter” in the sixties made that impossible. The US was unable to maintain the necessary financial discipline and the Gold Standard Lite had to go.
The results since have been horrible. Since 1971, inflation has risen in virtually all major countries, booms and busts have occurred around the world with increasing frequency. Governments have taken on huge debt loads as politicians sensed there was nothing to restrain them from caving into their electorates’ insatiable demands for more services and entitlements. And yes the financial sector got inordinately rich riding the booms and getting bailed out of each bust.
Some More Thoughts on the Euro
People are tired of reading about the euro. I am tired of writing about the Euro. But the euro problem does not go away. I have three comments that I would like to make in this at this time.
First, in the age of the classical gold standard, i.e. 1879-1914, the world didn’t need a euro. All major currencies were freely convertible into gold at fixed rates that were not expected to change. Capital flowed freely around the globe as there were no capital controls. Many countries, including the United States, didn’t even have a central bank. No money mischief. Gold was really the world’s and Europe’s currency.
Second, in nineteenth century America and in theory still the America of today, the market not the Federal government provided the fiscal discipline for the member states. The states defaulted from time to time. That was the way it was. If the states were bad, the markets punished them and nobody bailed them out. But now one hears lecture after lecture, particularly from the Germans, that discipline must be imposed politically from the center (Brussels). Europeans don’t trust markets. At last, Greece is apparently defaulting. Why didn’t they just let Greece default in the first place?
Third, as I have written before, talk of the ECB becoming undercapitalized because of the expansion of its balance sheet with questionable Greek, Italian, Spanish, or Portuguese paper is misplaced. Agreed the ECB’s purchase of questionable debt is a misallocation of resources. But the ECB, as is the Fed and every other central bank, is nothing more than a Department of Fiat Money Creation. It doesn’t matter what the ECB’s balance sheet looks like so long as it can create euros out of thin air. When is the world going to wake up? Since 1971 all the world’s currencies are backed by nothing except the willingness of their users to accept them as money. They are certainly not backed by the balance sheets of central banks. Who ever said to themselves “I can relax about my money because the Fed has such a great balance sheet.” There are plenty of reasons for the markets to lose confidence in the ECB and the Fed but their balance sheets are not one of them. Their balance sheets are irrelevant. If the markets were to lose confidence in the central banks because of their balance sheets, it would show how the markets have fundamentally misunderstood what Richard Nixon did on August 15, 1971. From my point of view, the markets in losing confidence would finally be doing the right thing but for the wrong reason.
Don’t Get Too Excited About the US Economic Rebound
The just released 4Q2012 GDP numbers have been taken as underwhelming by the markets. The numbers should have been no surprise. Consumer spending is roughly seventy percent of the US economy. Consumers have not finished their deleveraging from the massive debts incurred over recent years. Personal income as of November is up 3.9% yoy. The CPI-U as of November was up 3.4% yoy. Do the math. Net of inflation consumer income has gone nowhere. The recent spurt of consumer spending was apparently financed by a drop in the personal savings rate to 3.5%. Housing, a major locomotive for past recoveries, continues to meander along the bottom thanks to excess inventories, foreclosures, and lagging consumer incomes. Seasonal adjustment problems may have served to inflate some of the monthly indicators for the quarter and may have provided an overoptimistic tone.
Looking ahead, it is almost a certainty Europe will have a sharp recession. China in turn is slowing down although the picture there is murky as ever. (Statisticians have their problems with seasonally adjusting China as well since the lunar Chinese New Year came very early this year. Chinese consumer spending normally surges before Chinese New Year. It is quite possible that recent Chinese numbers were overstated.) The point is that US exports don’t have a bright near term future. Nor does the outlook for spending for the states which are busy cutting back essential services in order to pay their outrageous pension obligations. Nor does the outlook for consumer spending look healthy with limp personal income growth and high unemployment still prevailing.
So where’s the strength coming from?
Iran—the Black Swan on the Horizon
The impression I am getting from reading geopolitical and military assessments from various sources is that, while there is no question about the US ability to prevail militarily, Iran does have the ability to shut down the Straits of Hormuz for a time. Neutralizing Iran’s military and knocking out its nuclear program would probably be a multi-month, multitrillion dollar operation.
I have no idea how to incorporate a possible war with Iran into an investment strategy although out of the money puts might be one way. A war with Iran would no doubt be extremely negative for the markets at least in the initial phases. I would make the following points:
1. It has been said that the greatest threat to American military supremacy is the American budget deficit. The fact is America in its current fiscal state cannot afford an expensive war and budget realities have already forced military cutbacks. The US federal government is looking at unchecked fiscal deficits, a growing Federal debt load and at least one hundred trillion dollars of unfunded entitlements. We are all Greeks now, Richard Nixon might have said. Most gestimates are that an attack on Iran would indeed be expensive. Various estimates have been made of the true cost of the wars in Iraq and Afghanistan and one reads numbers like three to four trillion dollars. Iran has substantial military assets in place to shut down the Straits of Hormuz and defend against air attacks. Iran may not be a pushover like Iraq. And the possibility of the war expanding including a major assault on US ally Israel cannot be discarded. With the US budget deficit running at close to 10 percent of GDP, adding another trillion or two or more for a war is something the US cannot afford. Of course national security takes precedence over fiscal bean counting. But investors will have to live with the consequences.
2. Supposedly China gets 50 percent of its oil through the Straits of Hormuz and Japan 75 percent. India faces a similar situation. Iran produces some four million barrels of oil a day. A shutdown of the Straits of Hormuz is no academic exercise for China, India or Japan or for the oil and gas exporters through the Persian Gulf. These would include Iran, Iraq, Kuwait, Qatar, Bahrain and the UAE. Supposedly some 17 million barrels of oil per day more through the Straits of Hormuz. Sure, alternative routes and alternative suppliers will be eventually found. But the near term disruption would bring an enormous shock to the already shaky world economy.
3. Should a war with Iran become necessary, investors can expect that the American Administration would find this a convenient opportunity to indulge its propensity to raise taxes by imposing special “patriotic taxes” on the “rich.”