Monday, May 01, 2006

5/1 The Silent Dollar Crash and Parallel Investment Universes

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 0.6% to 4.9%, 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 and 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. Evidently the price of gold is one market signal that the so-called "free market" types would rather ignore.

"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 deficits going forward, and because profound, long-lasting structural changes to the global economy have been made, I can not see any feasible size dollar depreciation 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.

Also among the reputable mainstream economist bloggers, see Nouriel Roubini's May 1 post, "Is the US Dollar Reaching a Tipping-or Tripping-Point?" link along with various blog posts by his colleague, Brad Setser, at the same site link.

Gross at Pimco, the mega bond manager, 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. Richebacher, 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.

The outsourcing cost-cutting supply-chain business model is also favored by the Wal-Marts of the world, whose "stack 'em high" monopsonist link merchant mentality simply has very little conception of the real nature and true costs of development of new innovative products and services, 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.