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Eric Kraus, Nikitsky Russia Fund / CIS - THE DECLINE OF THE WEST – 7 November 2007
Verily, we live in interesting times. Strategists – in particular – feel a bit like rabbits on the first day of the hunt. As the volatility in markets continues, we live in constant fear of issuing a brave call –hitting the “send” button – then promptly being made total fools of as the market spins back into crisis mode. Perhaps we should learn to live with it – any given call will almost certainly be “right” at some time over the next 30 days (and stopped clocks tell the right time far more frequently than do most strategists at global investment banks)!
Credit Markets - The Fire This Time
Quite extraordinarily, a clutch of sober, senior and very, very serious Wall Street bankers has been allowed to create a Frankenstein’s monster which now threatens the global financial market with massive destruction. This monster was built upon a foundation which any school child should have known to be hopelessly unstable – extention of unlimited, inadequately collateralized credit to individuals clearly unable to repay.
The US credit market is in even worse shape than is commonly acknowledged. Large segments of it are now broadly insolvent. There is a single theme underlying the entire debacle – the US mortgage market, both Prime and Sub Prime. Forgive the colourful language, but the “cancer of bad housing loans” has infiltrated itself so widely throughout the financial body as to imperil not just the housing market itself, but also the corporate high yield debt market (via CLOs), the vitally important municipal bonds market (thanks to the near bankrupt monoline bond insurers) and the banking system itself. The bank regulators have been badly discredited – the rating agencies shown to be criminally negligent. We will almost certainly see the failure of one or more major financial institutions before the carnage abates.
A series of bailout operations by the Federal Reserve is now both vitally necessary and very much to be expected.
Once Fooled – Twice Shy
Rather than actually doing something to support its currency, the US Treasury Department has long reassured itself that global investors would continue to throw good money after bad, thanks to their “deep faith in US debt markets – the world’s deepest and most liquid; if so, this faith has been ill rewarded as a wave of CDO defaults blows dozens of European and Japanese institutions out of the water; presumably, they shall henceforth take a slightly more jaundiced view.
Yes, liquidity is cool, but fundamentals still count! Similarly, while the UST is not yet pricing in any default risk, the currency in which it is denominated has proved a bad bet. Ironically, the undoubtedly shallow and illiquid Russian bond markets have proved a far, far safer bet…while recently, there was a brief bout of mark to market damage, there have been no credit events; and investors face the comforting prospect of receiving both full interest and principal in fine. Global Macros and Mayhem Those who cling to the memory of the economic primacy of Atlantic Alliance have taken to reminding us of the Japanese Bubble predicting that history shall repeat itself and China’s secular rise will prove equally unsustainable... “Bollocks!” we say. Like China, Japan grew fast based upon an authoritarian, exportdriven politico economic model with massive, state sponsored investment in Capex. Beyond that, both countries are Asian, and Westerners can easily confuse Chinese and Japanese tour groups the similarity ends there.
Vitally, Japan was a fairly old country with a modestly sized population, at least relative to that of China. Thus, as Japan’s GDP per capita reached the levels of the industrialized West, the rate of growth naturally levelled off. Undoubtedly, this same phenomenon would occur in China, the day its 1.5 billion people attained a European standard of living. Needless to say, by that (very hypothetical) point, its economy would dwarf that of Europe and America combined! We do not expect to see this happen due to the limited global resources available to subtend industrial growth, and expect to see an increasingly brutal competition for resources develop first. That, fortunately, is for a subsequent issue, and in the near term, we expect to see China reshape the post war global politico economic montage far faster than would have seemed conceivable ten years ago.
The Dollar - Regime Change
Our safest trading call remains our longstanding dollar short – the EUR has just broken our first target – $1.45, first suggested in 2004 with patience, all things come. Disturbingly, the devaluation is occurring much faster than we had thought possible – the USD has weakened by almost 4 big figures, from 1.415 to 1.4540, in the week since we started drafting this issue. Whilst a gradual, orderly decline in the dollar is in everyone’s interest (the Americans’ most of all), a sudden collapse could be calamitous. Everyone – in particular, every central bank – has some skin in this game, and presumably, will wish to ensure at worst an orderly demise of the world’s erstwhile reserve currency.
Mistakes, however, can happen and powerful, poorly understood forces are at work; a disorderly unwind with a panicked sale of US assets, soaring US treasury yields, disruption of trade flows and possibly, of dollar based commodities markets would not be a happy event for anyone involved. As owners of dollar assets take an increasingly devastating hit to their net worth, we are seeing panicked sellers – foreign private entities are net sellers, as are an increasing number of sovereigns. The Bank of America estimated this week that the US outflows of funds into foreign bonds and equities are likely to reach $290bn this year. Are currency controls next?
As an interesting corollary, according to Chris Granville’s Trusted Sources, the G7 finance ministers spent an inordinate amount of time agonizing about the new sovereign wealth funds. It is quite extraordinary that the deficit countries expect the rising economic powers to continue accumulating constantly depreciating currency, simply to help support the deficit spending of the governments in question – spending often directly inimical to their own interests. Instead, they are now planning to actually do something with their money in a striking reversion of the classical roles, buying productive assets in the industrialized world.
The King is Dead!
We live in troubled times. “Faith based” economic mismanagement, with its convenient belief in the ultimate sustainability of a model whereby the world at large will forever finance the mushrooming US trade and budgetary deficits, has effectively killed the dollar as a store of value – this, coupled while the secular rise of Asia and the newly industrialized economies, has sharply decreased at least the relative weight of the US economy. Fundamentally, we are facing not just another bout of financial volatility – we are experiencing the economic equivalent of “regime change”. The fundamental tenets of the post war global economy are quickly becoming obsolete: both the US dollar as the ultimate anchor against which all other assets are valued, and the overwhelming primacy of the American economy (indeed, of the West, as a bloc) have been fatally tainted. Those who chose to ignore these shifts do so at their own peril
Accelerate Me Up Scotty!
What we find truly extraordinary is the accelerating rate at which this shift is occurring. T&B is on the record predicting a dollar at 1.45/Euro and $100 –oil, but certainly, at the beginning of this year, we would never have foreseen either event occurring in 2007!. Thus, as the world accelerates into the vortex of a generalized global catastrophe the contours of which we can only vaguely apprehend (see appendix II – The Fire THIS Time) not only is the rate of change accelerating, but the rate of acceleration is itself accelerating – second and third derivatives come into play.
A Bull In A Candy Store
Global markets are currently both frightening and elating. Given the self organizing nature of market economies, as the old system crumbles, a new meta stable system will certainly emerge – what is less clear is whether this will be a smooth, continuous process. We can only guess at the contours of this new system. Certainly, it will be multipolar, probably with a strong regional flavour. Given the absence of any obvious substitute for the US dollar, there will likely be a series of systems built around various stores of value: an Asian currency system, the Euro, perhaps systems anchored by the value of ounces of gold, even bushels of wheat and barrels of oil. Bridges will quickly form between the various components of this balkanized system.
Now, more than ever before in living memory, investors must remain intellectually flexible, ready to abandon long held preferences and practices at a moment’s notice. Old reflexes can be dangerously maladaptive in a new world – as just one example, international investors who retreated to the perceived safety of US treasury bills at the beginning of this year (much less, to “high grade” US debt securities) have suffered a substantial erosion of their wealth. Russian rouble bonds – widely seen as high risk assets – have proved to be infinitely safer than Investment grade CDOs. More controversially, Russian bank debt may turn out to be far safer than the paper of some of the major Western Investment banks.
Oil prices are now driven by a combination of fundamental supply / demand factors and financial drivers – in particular, long only US investment funds which have recently been buying protection against $100 oil – leading the investment banks to hedge their exposure by going long the underlying
Acceleration of Change - A brief History of Time
A man born in 1700 would have likely died in a world which had seen only very limited change. Economic relationships were fixed and regulated by long tradition, society was stable and predictable, the majority of men lived on the land, worked as their fathers had, and expected their children to inherit a world largely unchanged from the one they knew. Likewise politics: empires rose and fell slowly, over centuries. France had risen to become the preeminent European state by the early 18th Century; she remained so for some two hundred years. The seeds for the rise of what was to become National Germany were planted during the Napoleonic wars; the resultant tree grew disruptively into the middle of the 20th century
The Turkish Empire declined for some 250 years before finally giving up the ghost, playing its part in the bloody onset to the century just ended. The old Europe was inwards looking. Given the huge costs and relative uncertainty of transportation, until the middle of the 19th century the impact of trade was very limited – primarily based upon the importation of luxury goods from Asia and precious metals from the Americas. The agrarian societies of Asia and the Americas were tradition bound, intellectually immobile, and inward looking; they were little affected by the technological change which was transforming the West. Europe’s undisputed pre eminence was due as much to a pragmatic and positivist intellectual approach as to her superior technology. The conquest of Mexico by a handful of Spanish adventurers was repeated throughout the Americas, resulting in a continent divided into a series of agrarian, hierarchical Catholic societies with deeply inflexible class structures, a conservative outlook, and widespread poverty.
Following the classic colonialist model, these countries were exploited for their commodities and kept as captive markets for excess industrial production, first by Spain, later by the United States (The Monroe Doctrine) The first experiments with left wing revolution failed, both due to external pressure and to the maladaptive nature of the classical Marxist model; most Latam economies thus remained essentially feudal until recently, when a fundamental shift in global trading patterns allowed new experiments in alternative growth models . Likewise Asia, where despite a rich and complex high culture and substantial scientific achievement, Asian societies were loath to embrace technology – i.e. the pragmatic application of knowledge. Having invented gunpowder and early artillery, the Chinese themselves had no workable guns to fend off European raiders.
With the obvious exception of Japan, the first non European nation to defeat a major world power in 1905, and despite brief moments in the sun for the likes of Argentina and Brazil as one or another commodity came into demand, this situation remained essentially unchanged until the 1960s. Trade in vital commodities, in particular oil, was almost entirely controlled by companies domiciled in the industrialized West; the commodity exporters mined for their resources were essentially passive price takers. Indeed, seen from Europe, the emerging world seemed primitive and comical · lazy, happy natives lying in the sun eating fruit impoverished, tradition bound societies obviously inferior to the civilized and prosperous industrial world of Europe and its English speaking offshoots.
The Dragons Resume Smoking
This seemingly immutable divide between the industrialized nations and the third world began to erode with the rise of the Asian Dragons. First a resurgent Japan, rising from the ashes to undergo radical modernization and industrialization, transformed itself from a primarily agrarian backwater into a first world country. By the 1970s, Korea, Taiwan and Singapore – authoritarian, centralized states hell bent upon transformation in a single generation, became serious players. Other Asian states sought to emulate their more successful neighbours. Yet the true tipping point was the rise of China growth which has been extraordinarily fast for the past two decades, but given the extremely low baseline, it is only in the past few years that it has belatedly been recognized as being one of the world’s most important economies (number one in terms of the gross volume of GDP growth, impact on global prices for consumer goods, as well as effects upon commodity –prices
The sheer size of the Chinese economy is by now daunting. A decade ago, China was strictly the appanage of Asian strategists – no one else much cared. It is now inconceivable that a global strategy piece should be drafted without giving pride of place to China! Equally, as a working hypothesis, the limited effect of the subprime crisis on global markets can be explained by the resilience of the Chinese and Indian markets. If this decoupling can be sustained, it will accelerate the Eastward shift in the global centre of economic gravity.
Future Shock - 220V
History does not repeat itself…Historians repeat themselves! The single greatest danger to the investor is to indulge his apparently inborn tendency towards intellectual conservatism – the belief that things will always be as they are today. Perhaps a useful trait in a stable, predictable world, it becomes a crippling impediment to adaptation during times of rapid change. Even for those at least vaguely cognizant of the major events surrounding them, there is a huge resistance to accepting the implications of these events – i.e. the disruption of tried and true traditional models.
One of the best examples was the behaviour of the oil analysts. From 1998 until about a year ago, thanks to their highly sophisticated (if increasingly irrelevant) supply/demand models, almost to a man they warned of the impending collapse of crude prices back to its “long term average” of, say, $25. In the meantime, oil prices have surged some 900%– intellectual conservatism in action! It is not that the analysts are fools – simply, their finely honed mathematical models, which had proved so useful in the past, offered a comfortably “scientific” means of extrapolating present trends into the future. The hugely inconvenient fact that an elephant – China – had entered into the elevator was simply ignored; in fact, this single factor has itself outweighed all of the other changes measured by the models. More recently, commodities analysts have fallen victim to the same fallacy, predicting a collapse in commodities prices due to an incipient US recession – the fact that Chindia has replaced the US as the primary source of incremental commodities demand has apparently been missed
In Summary T&B believes that the current financial crisis and shift in global growth patterns is not merely a fluctuation within a relative continuum – nor even a cyclical function; instead, it falls within a fundamental discontinuum; our basic assumptions are now that: The centre of economic gravity is shifting away from the G7 – it will not return in our lifetimes. As a result of the economic shift, the global political / diplomatic context will see a radical change. For the first time in modern history, the world will be deprived of a single reference currency against which all others can fluctuate. A multi currency system including not just classical currencies but also ounces of gold and perhaps bushels of wheat / barrels of oil will have to fill the gap. Increasing prosperity may prove to be not a factor for peace, but rather, for a dangerous exacerbation of conflict, as increasingly wealthy emerging nations compete with the old G7 countries for scarce resources
Asia’s New Asian Millennium
As we have noted previously, one of the most interesting aspects of the current crisis is that it will test our fundamental financial thesis – that growth in the emergings is now selfsustaining, and that the centre of economic gravity has shifted from New York/London to Beijing/Bombay. While it is too early to arrive at any final judgments, T&B has clearly won the first round. While the short term volatility in financial markets remains primarily driven by events on Wall Street, the real economies of Emerging Asia have not yet suffered any damage. Thus, as G7 equities have stagnated, Asian indices have boomed, both on surging liquidity as well as on signs of accelerating economic growth. As of this writing, the economic fundamentals have been decoupling smartly. As the US faces a housing recession, Japan is threatened with a renewal of deflation, and Europe struggles to avoid being sucked into the credit withdrawal vortex. Chinese GDP has just printed at 11.5%. Singapore, India, Korea, even the Philippines and Indonesia are showing unexpectedly rapid growth. Russia is likely to come in well above 7.5%. Selected commodity prices are on a rampage –
Prices for oil, iron ore, as well as fertilizers, agriculturals, shipping (Baltic Dry Index) and most base metals suggest a continuation of rapid demand growth. Again, whilst US imports of consumer goods are trending down, the real test is what will happen when US demand is hit by recession. As the value of the dollar plunges, and the credit squeeze hits, US consumers will be obliged to begin saving, thus decreasing the demand for imports. We continue to expect this to primarily affect those countries most dependent upon sale of high value goods – Japan, Korea, and Taiwan, rather than those who fill up the shelves of the Wal Marts of this world – China, Vietnam, Thailand, etc. Nevertheless, to some extent, all will be faced with the need to find alternative markets in the Asia Pacific region, and especially, to stimulate their own internal demand. If they succeed, then a new era will be upon us; if not, then the transformation will be delayed until the next cyclical trough.
In any event, financial markets are increasingly discounting a decoupling. For the first time, average P/E ratios in the emerging markets are higher than those in the Atlantic countries…not surprising, given that emerging GDP growth rates are three times those in the G7, while fiscal policy has been far more virtuous in the major emerging markets than in their developed peers. George Bush and the Fall of the West Economics There are those who view history as a purely mechanistic process, with the rise and fall of great empires pre ordained. In this view, statesmen are seen as mere actors, playing their roles in a tragedy not of their own conception. A contrary view, one espoused by our favourite modern historian, AJP Taylor, is that much of history is due to blind chance – the stumblings of men across an unlit stage. Whether or not the relative decline of the American Empire became a certainty on the day after its greatest triumph – the fall of the Berlin Wall – is purely speculative, but unipolar global political systems have reliably proved labile, providing a compelling target for all of those outside the charmed circle.
Diplomacy aside, simple economic determinism – the secular rise of China and the other Asian powers – is now inexorably diluting out the economic primacy of the West. What should be clear is that the election of George Bush in a rigged Florida election (albeit, confirmed 4 years later in a poll widely viewed as relatively free and fair) sharply accelerated this process. The election of what is now widely seen as the worst US administration in living memory, as well as the catastrophic failure of a finely honed system of checks and balances to restrain the Presidential ability to make mischief, has a price. As was briefly the case during the late Reagan presidency, great empires may well fly for some time on autopilot – they do not fly well with a chimp at the controls! It would have been extraordinary had a Bush regime which has proved so extravagantly incompetent in its foreign and domestic policies failed to do its bit to cripple the US economy. From the purely domestic standpoint, crony capitalism has flourished, while the increasing propensity to live beyond one’s means has masked a precipitous decline in social mobility – once the mainstay of the American credo.
Relatively unconcerned with US domestic issues, T&B will focus instead upon the international implications. The dangerous combination of gross incompetence and extraordinary arrogance characterizing Bush’ international diplomacy has also marked US economic policy: “deficits don’t matter” was the credo – ‘faith based’ economics the theology. Early in the Bush presidency, so as to brush away the inconvenient strictures imposed by economic reality, the new administration deliberately appointed compliant and ideologically pure non economists to key economic policy positions. O’Neill and Snow could be reliably counted upon to countenance whatever policies suited the Neocon ideologues. Thus, in a grotesque expansion of Reagonomics, they convinced themselves that military spending could be driven to levels reminiscent of the late USSR, while taxes (at least for the wealthy) could be slashed; this would result not in massive deficits, but in a balanced Federal budget – because they wished it to be thus. This childlike faith extended to the general populace which briefly enjoyed the delights of cheap credit, disavings, and home equity extraction. The laws of gravity are now extracting their brutal revenge.
The Kindness of Strangers
The US budget balance, briefly in surplus under Clinton (an almost unheard of feat for the old, industrialized democracies),has swung into deep structural deficit; whilst the extent of this shift was temporarily masked by the enhanced tax revenues generated by a burst of credit fuelled economic growth, it will be seriously exacerbated by the coming downturn, and will require substantial, pro cyclical tax hikes in a recessionary environment (in turn, requiring the Fed to run an extremely accommodative monetary policy). A recent study by the US Congress put the potential cost of the wars in Iraq and Afghanistan at as much as $2.7 trillion (under a moderately pessimistic scenario, and including compounded interest). The fundamental problem is not the deficit per se (other countries run larger ones as a proportion of their GDP) but rather the fact that, given US dissavings unlike Japan, France or Italy (but very much like Turkey and Estonia) the deficit must be financed entirely by foreigners. Those foreigners who have rushed to do so are now taking a nasty hit on their dollar holdings – presumably, they will now be increasingly disinclined to provide further financing. Funding the US deficit could thus prove to be a far stickier undertaking than in the past.
Again, gross incompetence and the conscious decision to see the world as it should be, rather than as it is, has a price. Payback time is at hand. While there is reason to hope that the coming US recession will be relatively mild, it is also likely to be prolonged, and to provide a convenient historic milestone marking the secular decline in US economic preponderance, at least in relative terms. This will be accompanied by a substantial decline in living standards as wealth is destroyed and the dollar loses much of its value. Eventually, the weak dollar will lead to a rebalancing of the trade deficit, consumers will be compelled to save enough to fund the US deficit, and (after an overshoot) the dollar will find a floor. The US may well avoid slipping into absolute decline, but in economics, as in politics, the era of absolute American pre eminence is over. It is not coming back. Fear and loathing in the Capital Markets Given the boom in Asian markets, the collapsing dollar, and the resultant run up in commodity prices any half competent international asset manager should currently be shooting the lights out – if he had the courage to short credit indices, then he is an absolute hero. And yet – speaking to our peers in Europe and Asia – T&B has encountered a generous dose of fear, mixed in with the greed.
Against Economic Calvinism - Von Sacher Masoch
The Greatest of the “Austrian” Economists? – Each day it seems, T&B reads yet another tirade demanding that terrible punishment be visited upon those who got caught in compromising positions under the influence of copious liquidity. The saintly Greenspan has been revealed as nothing more than the Devil’s accomplice, and his host of followers – soft, pink and fat – are to be scourged and shrived to save their immortal souls. One indignant columnist demands that “millionaire investors” who took advantage of the leverage on offer should be made to pay – the Fed should tighten rates to support the currency (shades of 1929…), the US Treasury should allow the commercial paper market to implode, the ECB should let banks go bankrupt, SIVs collapse, financial markets should fail, all so that a chastened human race should turn away from sin, living according to the words of the gospel – sober, frugal…and very, very poor. Some of T&B’s favourite macroeconomic pundits aside, the current crisis sweeping through global capital markets is not the end of the world as we know it. Properly managed it will not bring the global (or even the US ) economy to a screeching, grinding halt; it will not cause a collapse in all asset prices, nor create global hyperinflation sending gold prices into the 5 digits.
The dollar will not lose all (perhaps most…but not “all”) of its value. For once, the central banks, both European and American, have done precisely what they should have done – maintaining an adequate level of liquidity to prevent the seizing up of credit markets. Even the much maligned ‘super SIV plan’ – if successful – is an absolute godsend. The total meltdown in a one trillion dollar market for commercial paper is a recipe for disaster – not for recession, but rather, for outright depression. Central banks were not designed as vehicles for divine retribution, but rather, as institutions devoted to maintaining the viability of their financial systems, without which the real economy fails, disrupting the lives of millions of ordinary people. Markets have no magic. They make mistakes. They blow bubbles which collapse, and the collapse can cause huge and durable destruction of value. The economic masochism which demands that the culpable pay for their misdeeds is somewhere between misguided and insane. It is akin to suggesting that no one should have tried to extinguish the fires at Chernobyl after the operator’s intellectual curiosity led to a loss of control over the reactor. In fact, the guilt parties had already been irradiated. It was the neighbours who were at risk.
The moral hazard argument is vacuous for the simple reason that no one is ever going to do the same awesomely stupid things again – they will do other equally stupid things but not the same ones. No amount of punishment for the culpable will prevent future folly. Future bubbles will be blown in new and unexpected places – like dictators, successful bankers will always imagine themselves immune from the punishments meted out to their predecessors3. After the debt crisis of the 1980s, the global banks stopped sovereign lending, never to resume. The US S&L crisis put an end to the S&Ls. Following the tech wreck the problem shifted elsewhere – internet IPOs ceased to be a problem. CDOs were invented. 3 Mr. O’Neals $161. golden handshake suggests that they are correct…. Letting the financial system collapse to warn bankers against doing silly things is like shooting fallen dictators to make sure that no one does it again. The nature of man is that he sees death all around him, yet does not believe that he himself shall die. An endless supply of dictators will always be available…and of risk tolerant bankers too. Each feels sure that he will be the exception to every rule. By all means shoot a few of each, pour encourager les autres, but never believe that this will prevent future mistakes.
Thus the era of the adjustable subprime loan with a teaser rate, of commercial paper based on worthless assets supposedly rendered viable by their short term structure and of collateralized debt obligations of dubious provenance etc. is gone. Dead as the dodo. They are not coming back. The banks which engaged in ill advised lending are taking massive write downs – Merrill’s initially reported $8bn loss was impressive even by recent standards – it now it looks like that may have been just the tip of the iceberg. Hundreds of smaller mortgage lenders now sleep in a watery grave. Some two million Americans will lose their homes, and somewhere between 2 7 trillion (yes, that’s trillion) will be wiped off the US real estate market. Guillotines are being set up in the lobbys of US investment banks, with their presidents the first to step onto the escalator…ergo, punishment is not in short supply.
Global Turbulence – Blowback for the Empire Iran Mohammad Mosaddeq – Or why do they hate us so?
Amazingly, Condoleezza Rice, perhaps the most incompetent Secretary of State in American history, has just declared that Iran is the “greatest security threat facing the United States.” While the reasons for this obsession · perhaps nothing more than an attempt to deflect domestic attention from their hugely successful efforts to “liberate” Afghanistan and Iraq – are not entirely clear, the statement itself is obvious nonsense. As we have remarked previously, the greatest threat is Pakistan – and the sorcerer’s apprentices in Washington have predictably succeeded in fouling up the single most dangerous foreign policy dossier on the planet. By putting all of their chips on Musharraf, the Bush regime repeated the US errors in the runup to the eminently predictable overthrow of the Shah of Iran – finding themselves totally cut off from the moderate opposition, and thus, from any of the potential successors. As a result, they were unable to switch mounts, and when a new leader swept aside the Shah’s rotten edifice, it was of course the one most inimical to their interests – the Ayatollah Khomeini. Predictably, the US foreign policy establishment cajoled, bribed and prodded Musharraf into initiating a suicidal policy – a hugely unpopular war against the radical, Taliban aligned tribes in Pakistan’s border regions.
Given the unmitigated hatred with which the US is viewed in most of the Islamic world, not excluding Pakistan (according to the Pew Survey, only Palestine and Turkey are more anti American), an alliance with Washington was the kiss of death. Having failed in a desperate, last minute attempt to slip in a more compliant politician in Musharraf’s steed, Washington is now reduced to watching passively as Musharraf ignores his erstwhile masters, declaring martial law, and throwing his country into something looking dangerously like civil war. In Eastern Pakistan, military units are reportedly defecting to the rebels; elsewhere, a political free for all is underway. Most terrifyingly, the world at large is now faced with a high cost, if low likelihood danger of a Taliban style state armed to the teeth with REAL nuclear tipped missiles, not with the Iranian variety – potential, hypothetical, someday nuclear weapons – but real ones, fully tested and ready to fire. Those 40 Virgins awaiting martyrs in Heaven should be getting ready for some heavy there’s likely to be something of a virgin shortage soon. Meanwhile, back in Teheran The Pakistan story aside, to everyone except perhaps the folk in Washington, it should be obvious that, rather than being the threatened party, in recent years it has been the United States to have posed the greatest threat to Iran’s security, first planning and supporting a coup that replaced the populist government of Mosaddeq with a puppet dictator beholden to the US4, then sponsoring the slaughter of millions of Iranians in the Iraq Iran war.
Regarding the first, in cahoots with a United Kingdom irate that the Iranians should presume to exert ownership over the massive oil deposits conveniently situated beneath their soil, the CIA engineered the 1953 coup against Mohammad Mosaddeq, installing a corrupt, brutal and widely hated puppet regime under a tame Shah. When this regime was finally overthrown in a popular uprising led by the Ayatollah Khomeini (an uprising which included not only the religious fundamentalists, but also virtually that entire segment of the Iranian bourgeoisie not personally related to the corrupt and brutal Rezi family – i.e. the bazaris) it was only to be expected that they vented their spleen on the erstwhile (neo ) colonial power – the United States. The US embassy was occupied and its staff held hostage in a major humiliation which spelled the death knell for the Carter presidency. Before rolling their eyes, readers who suspect T&B lacks in balance would do well to run a Google search on “Iran, Mosaddeq, 1953” – the CIA management of the coup, and the participation of the UK, has been amply documented, including by US academic sources based upon documents released by the CIA under the Freedom of Information act.
No self respecting imperial powers can countenance slights of this sort, and the US extracted terrible revenge by encouraging a proxy war – Iraq’s decade long war against Iran. This sponsorship included substantial technical assistance in the manufacture of chemical warfare agents, used with terrible effect against Iranian civilian populations. Before ending in stalemate, this war left millions dead on both sides. Iranian foreign policy, perhaps including the development of nuclear capabilities, is presumably aimed at preventing any repeat of these calamities. When When all Else Fails – try Diplomacy! The limitations on America’s international reach are being laid bare by the Iranian situation. With the Iraq debacle, the US has become belatedly aware of the need to work via international institutions. Alas for Washington, the UN Security Council includes Russia and China, both of whom have important ties with Iran; whilst neither is comfortable with the notion of a –nuclear armed Iran, they are even more concerned with maintaining their ability to protect their own interests and to retain an independent foreign policy – neither is willing to become a tail wagged by the NATO dog.
Likewise the other Caspian states, which will have to live with Iran as a major regional power. Even India, despite maximum pressure from Washington, has announced its intentions to go ahead with the building of a pipeline to bring Iranian gas across Pakistan; new sources of energy are indispensable for the continuation of the Indian economic miracle. Britain, already mired in both Afghanistan and Iraq thanks to a childlike faith in Bush, seems disinclined to open up a third front. Only France has surprised by aligning itself with Washington – Foreign Minister Bernard Kouchner, a political amateur more at ease in the heady world of NGOs than at the Quai d’Orsay, made a fool of himself by appearing to threaten military intervention in Iran, before being silenced by an irate Sarkozy. Big wind, loud Thunder – No rain? Despite almost weekly warnings of the imminence of an American attack on Iran, generally backed up by some intelligence regarding one or more US carrier groups cruising about in the Gulf, T&B has long predicted that the US would limit itself to bellicose language, empty sanctions, and moral outrage – refraining from an actual military strike against Iran. This was based upon the assumption that, after an almost unbroken series of foreign policy failures, the Bush regime would be loath to start yet another unwinnable war – one having potential consequences far greater even than those of its current Eastern stalemates.
And What if we’re Wrong? We could be wrong. Perhaps a fatally wounded but still dangerous hard core Neocon faction centred around Cheney – its dreams of empire shattered and faced with imminent political oblivion – will lash out, counting on a wartime patriotic reflex to save its fortunes… one last roll of the dice. More sinister yet, perhaps not content to saddle the next U.S. administration with unwinnable wars in Iraq and Afghanistan, they would simply like to add one more to the pile. Given the progressive shift towards an imperial presidency and the utter failure of legislative oversight, they could just conceivably get away with it. The diplomatic implications of such insanity would fall outside of our remit. It could Arroz Sin Leche – Rice in Moscow Miss Rice’ trip to Moscow was a predictable debacle. Along with US Defense Secretary Gates, Rice had been dispatched to attempt gain Russian cooperation on the Iraq dossier. In a wonderful example of the anachronistic nature of American diplomacy, no sooner had she landed than she was gratuitously antagonizing her hosts by publicly interfering in Russian domestic affairs, meeting with a gathering of anti Putin dissidents.
Tacit any discussions of the advisability of gratuitously antagonizing your hosts when on a visit to plead for diplomatic assistance, the meeting provided at least one delightful moment. A St. Petersburg woman got up to tell Rice that, given the fact that America had lost the moral high ground, rather than seeking to act alone, the US should join forces with the European Union in bringing pressure on Russian administration. Rice was predictably furious, snapping back that the United States has not forfeited one bit of its moral standing! The funny part is that she was undoubtedly sincere in her cluelessness. Surely, she must be one of the very few passport holding Americans to be unaware of their extraordinary loss of international prestige over the past 7 years. Certainly –destabilizing the Middle East, paving the way for an unstoppable fundamentalist wave – indeed could, just conceivably, provide the spark for a true war of –civilizations
Islam vs. the West.
Clearly, Iran would strike back against US and other Western interests throughout the region, and the survival of pro Western Arab governments would be more a matter of luck than of planning. It seems unlikely that Russia the major power in the Caspian – or China, dangerously dependent upon oil imports, would stand by passively. Although an armed confrontation falls within the realm of political fantasy, Russia and China would be driven further into a hard, anti Western military alliance. Iraq and Lebanon would explode. Iran damaged but not occupied would dig in and race to build a bomb as a matter vital to national survival. Turkey – already furious at the Americans for having ignored their warnings of what would happen if they invaded Iraq – would find itself with another war zone along its sensitive Eastern border. Their patience could snap. Oil and Money For financial markets, given the importance of Iran and the region for the global petroleum trade, this would be a catastrophe scenario.
It is difficult to predict the reaction of erstwhile friendly Arab governments, and especially, of the Arab street, to yet another invasion of an Islamic country by Western Crusaders, with the perceived backing of Israel. Certainly, there is a real danger of a repeat of the 1973 oil embargo which plunged the world into a deep recession (at a time when dependency on imported oil was far lower than today). Even if one or more Middle Eastern states did not halt its oil exports and OPEC refrained from slashing quotas out of solidarity, and further assuming that the Iranians could not successfully imperil Gulf oil shipments (now that the Revolutionary Guard is armed with supersonic torpedoes, this is a risky assumption) the withdrawal of 3.5M bbd of Iranian oil, along with the perceived threat of a disruption of Middle Eastern supplies, would send an already tightly balanced oil market into panic mode – oil prices would likely surge above $200/bbl, tipping an already fragile global economy into meltdown mode
Those who would scoff at our typically alarmist commentary are referred back to our predictions of the possible consequences of the Iraq invasion, including the fatal destabilization of Iraq, the export of fundamentalism and terrorism, as well as radicalization of Turkey likely How to trade it, if it happens: Massive longs in oil and gold, spot and futures. Initially, long USD and Yen, then quick reversal to short USD, Yen. Short equities. Long G7 treasuries. Long Russian Roubles and commodity currencies. Extreme case portfolio – long canned food, firearms, land in New Zealand. Global Markets – How to Trade ‘em The ultimate binary Trade Short term trends in financial markets are driven not by rational expectations, but rather, by the alternation between fear and greed. Ordinarily, market participants oscillate back and forth between these two fundamental emotions, – most unusually, we are now encountering an unprecedented combination of the two, with the savviest investors simultaneously elated and terrified. Whilst, over the longer run, markets are remarkably rational, the amount of short term idiocy one must endure to get a piece of the “long run” is really quite extraordinary. At present, global markets are almost totally binary. On any given day, depending in particular upon whether or not yet another global investment bank has just announced that some new horror has been found lurking in its basement, our screens are either blood red or the emerald of a well tended lawn – financial risk either gets put on or taken off, wholesale and indiscriminately.
Do You Really Want To Be Rich?
As emotions go, fear is far stronger than greed. Risk is asymmetric, and men fear losing what they have far more than they hunger after new acquisitions. Thus, in times of rapid change and stress, like generals constantly fighting the last war, investors retreat back into the familiar; as often as not, this proves to be a fatal error. In 1999, when T&B was hawking Russian sovereign bonds for a major European bank, prudent investors gave us short shrift. One German institution listened politely before showing us the door they were not going to risk their investor’s hard earned money on speculative Russian assets, and instead, were building carefully hedged positions in safe, high grade US securities with attractive spreads. We have just learned that this same institution is faced with imminent bankruptcy if a buyer cannot be found. As always at times of fundamental change, the psychological adaptation is lagging the reality – analogous to the situation at the beginning of Russia’s extraordinary resurgence from 1999, relatively simple and hugely lucrative investment opportunities are available to those possessed of the requisite psychological flexibility needed to jettison tried and true reflexes and to adapt to the new reality.
As the centre of global growth shifts towards the emerging economies and away from the old industrialized countries at a rate unprecedented in human history, the economic equivalent of “regime change” is sending the emerging markets ballistic. Meanwhile, the world’s erstwhile reference currency is plunging, while defaults in that ultimate store of value – US investment grade credit – have triggered an avalanche of downgrades and defaults, posing a real threat to financial stability. Investors who withdrew into the safety of safe, predictable assets, the US dollar and highgrade credit, are facing severe losses. Those who invested in blue chip equities have fared only a bit better; while, in dollar terms, US equity indices are holding up very decently given the carnage in the debt markets, expressed in terms of Euros (or, as Mark Faber likes to repeat, in ounces of gold, or bushels of wheat) they are once again underperforming their global peers.
Revenge of the Old Economy
Even that damned fool Jim Rogers cannot be wrong about everything (though he remains psychologically unable to acknowledge that he was totally wrong about Russia; had anyone been insane enough to follow his advice, his apocalyptic predictions and implicit recommendation to go short Russia at the beginning of this decade would have provided a fast track to bankruptcy…) as regards commodities (as well as for the continued decline of the dollar and of the Baltic markets) he happens to be right. Alongside the emerging Asian markets trade, the commodities trades and their offshoots are perhaps the fundamental opportunities of our new century.
As industrialization spreads, and hundreds of millions of people are drawn into the consumer sector, the demand for energy, base metals and food will increase inexorably; as they run into hard supply constraints, economic and diplomatic relations will be profoundly disrupted (as will the fundamental survivability of planet Earth). While the latter half of the twentieth century was characterized by a seemingly inexorable fall in commodity prices with a shift towards the service economy and economic growth based on the production of intangibles. Now, thanks to the emergence of Asia, the “Old Economy” has reclaimed pride of place. The fact that a trade is “fundamental” does NOT, of course, mean that it is unidirectional; given the weight of speculative money, fierce corrections are to be expected. In the near term, except for specialized commodities futures players, we would steer clear of the futures markets; in particular, almost all are now in contango rather than backwardation, i.e. forward premia cause a negative carry at each rollover (perhaps precious metals are the exception; long dated gold futures have acceptable volatility, and as long as the dollar continues to tank, gold is an excellent hedge.)
Agricultural Prices - Malthus Come Home! Dinner's On The Table!
In a wonderfully ironic inversion of the classic roles, the “developed” countries are now major suppliers of agricultural commodities to the “emergings”, upon whom they are – in turn increasingly dependent for imports of manufactured goods! The explosive growth in energy prices has been squeezing the global economy for most of the decade food prices are now joining the party. As the Asian countries get richer, they are enjoying a huge increase in their consumption of foodstuffs, moving up the value chain towards higher protein diets. Unfortunately, this comes in parallel with declining local food production due to the paving over of agricultural land, desertification, inadequate water supplies, pollution, and damage due to poor land management practices.
This is already providing a boon for the agricultural exporters, Brazil and Argentina, but also for the old industrialized countries – Europe, Canada, Australia / NZ, and the United States. Already, the EU is winding down the set aside program which formerly paid farmers to not grow crops. Alas, it is not easy to get exposure to food inflation as a pure play. Fertilizer companies provide one good alternative, infrastructure another. In terms of geopolitics, in the absence of sudden disruptions, it is just possible that price action will allow a gradual accommodation, while better agricultural technology helps to avoid severe deficits. If, on the other hand, there is a serious disruption to current production, e.g. a severe drought caused by the rapid loss of the Himalayan glacier flow which irrigates both India and China, then expect a free for all as the Asian tigers forage the world over for desperately needed food…at best, this will play havoc with pricing – at worst,… Extreme case portfolio – canned food, firearms and land on –Jupiter.
Verily, we live in interesting times. Strategists – in particular – feel a bit like rabbits on the first day of the hunt. As the volatility in markets continues, we live in constant fear of issuing a brave call –hitting the “send” button – then promptly being made total fools of as the market spins back into crisis mode. Perhaps we should learn to live with it – any given call will almost certainly be “right” at some time over the next 30 days (and stopped clocks tell the right time far more frequently than do most strategists at global investment banks)!
Credit Markets - The Fire This Time
Quite extraordinarily, a clutch of sober, senior and very, very serious Wall Street bankers has been allowed to create a Frankenstein’s monster which now threatens the global financial market with massive destruction. This monster was built upon a foundation which any school child should have known to be hopelessly unstable – extention of unlimited, inadequately collateralized credit to individuals clearly unable to repay.
The US credit market is in even worse shape than is commonly acknowledged. Large segments of it are now broadly insolvent. There is a single theme underlying the entire debacle – the US mortgage market, both Prime and Sub Prime. Forgive the colourful language, but the “cancer of bad housing loans” has infiltrated itself so widely throughout the financial body as to imperil not just the housing market itself, but also the corporate high yield debt market (via CLOs), the vitally important municipal bonds market (thanks to the near bankrupt monoline bond insurers) and the banking system itself. The bank regulators have been badly discredited – the rating agencies shown to be criminally negligent. We will almost certainly see the failure of one or more major financial institutions before the carnage abates.
A series of bailout operations by the Federal Reserve is now both vitally necessary and very much to be expected.
Once Fooled – Twice Shy
Rather than actually doing something to support its currency, the US Treasury Department has long reassured itself that global investors would continue to throw good money after bad, thanks to their “deep faith in US debt markets – the world’s deepest and most liquid; if so, this faith has been ill rewarded as a wave of CDO defaults blows dozens of European and Japanese institutions out of the water; presumably, they shall henceforth take a slightly more jaundiced view.
Yes, liquidity is cool, but fundamentals still count! Similarly, while the UST is not yet pricing in any default risk, the currency in which it is denominated has proved a bad bet. Ironically, the undoubtedly shallow and illiquid Russian bond markets have proved a far, far safer bet…while recently, there was a brief bout of mark to market damage, there have been no credit events; and investors face the comforting prospect of receiving both full interest and principal in fine. Global Macros and Mayhem Those who cling to the memory of the economic primacy of Atlantic Alliance have taken to reminding us of the Japanese Bubble predicting that history shall repeat itself and China’s secular rise will prove equally unsustainable... “Bollocks!” we say. Like China, Japan grew fast based upon an authoritarian, exportdriven politico economic model with massive, state sponsored investment in Capex. Beyond that, both countries are Asian, and Westerners can easily confuse Chinese and Japanese tour groups the similarity ends there.
Vitally, Japan was a fairly old country with a modestly sized population, at least relative to that of China. Thus, as Japan’s GDP per capita reached the levels of the industrialized West, the rate of growth naturally levelled off. Undoubtedly, this same phenomenon would occur in China, the day its 1.5 billion people attained a European standard of living. Needless to say, by that (very hypothetical) point, its economy would dwarf that of Europe and America combined! We do not expect to see this happen due to the limited global resources available to subtend industrial growth, and expect to see an increasingly brutal competition for resources develop first. That, fortunately, is for a subsequent issue, and in the near term, we expect to see China reshape the post war global politico economic montage far faster than would have seemed conceivable ten years ago.
The Dollar - Regime Change
Our safest trading call remains our longstanding dollar short – the EUR has just broken our first target – $1.45, first suggested in 2004 with patience, all things come. Disturbingly, the devaluation is occurring much faster than we had thought possible – the USD has weakened by almost 4 big figures, from 1.415 to 1.4540, in the week since we started drafting this issue. Whilst a gradual, orderly decline in the dollar is in everyone’s interest (the Americans’ most of all), a sudden collapse could be calamitous. Everyone – in particular, every central bank – has some skin in this game, and presumably, will wish to ensure at worst an orderly demise of the world’s erstwhile reserve currency.
Mistakes, however, can happen and powerful, poorly understood forces are at work; a disorderly unwind with a panicked sale of US assets, soaring US treasury yields, disruption of trade flows and possibly, of dollar based commodities markets would not be a happy event for anyone involved. As owners of dollar assets take an increasingly devastating hit to their net worth, we are seeing panicked sellers – foreign private entities are net sellers, as are an increasing number of sovereigns. The Bank of America estimated this week that the US outflows of funds into foreign bonds and equities are likely to reach $290bn this year. Are currency controls next?
As an interesting corollary, according to Chris Granville’s Trusted Sources, the G7 finance ministers spent an inordinate amount of time agonizing about the new sovereign wealth funds. It is quite extraordinary that the deficit countries expect the rising economic powers to continue accumulating constantly depreciating currency, simply to help support the deficit spending of the governments in question – spending often directly inimical to their own interests. Instead, they are now planning to actually do something with their money in a striking reversion of the classical roles, buying productive assets in the industrialized world.
The King is Dead!
We live in troubled times. “Faith based” economic mismanagement, with its convenient belief in the ultimate sustainability of a model whereby the world at large will forever finance the mushrooming US trade and budgetary deficits, has effectively killed the dollar as a store of value – this, coupled while the secular rise of Asia and the newly industrialized economies, has sharply decreased at least the relative weight of the US economy. Fundamentally, we are facing not just another bout of financial volatility – we are experiencing the economic equivalent of “regime change”. The fundamental tenets of the post war global economy are quickly becoming obsolete: both the US dollar as the ultimate anchor against which all other assets are valued, and the overwhelming primacy of the American economy (indeed, of the West, as a bloc) have been fatally tainted. Those who chose to ignore these shifts do so at their own peril
Accelerate Me Up Scotty!
What we find truly extraordinary is the accelerating rate at which this shift is occurring. T&B is on the record predicting a dollar at 1.45/Euro and $100 –oil, but certainly, at the beginning of this year, we would never have foreseen either event occurring in 2007!. Thus, as the world accelerates into the vortex of a generalized global catastrophe the contours of which we can only vaguely apprehend (see appendix II – The Fire THIS Time) not only is the rate of change accelerating, but the rate of acceleration is itself accelerating – second and third derivatives come into play.
A Bull In A Candy Store
Global markets are currently both frightening and elating. Given the self organizing nature of market economies, as the old system crumbles, a new meta stable system will certainly emerge – what is less clear is whether this will be a smooth, continuous process. We can only guess at the contours of this new system. Certainly, it will be multipolar, probably with a strong regional flavour. Given the absence of any obvious substitute for the US dollar, there will likely be a series of systems built around various stores of value: an Asian currency system, the Euro, perhaps systems anchored by the value of ounces of gold, even bushels of wheat and barrels of oil. Bridges will quickly form between the various components of this balkanized system.
Now, more than ever before in living memory, investors must remain intellectually flexible, ready to abandon long held preferences and practices at a moment’s notice. Old reflexes can be dangerously maladaptive in a new world – as just one example, international investors who retreated to the perceived safety of US treasury bills at the beginning of this year (much less, to “high grade” US debt securities) have suffered a substantial erosion of their wealth. Russian rouble bonds – widely seen as high risk assets – have proved to be infinitely safer than Investment grade CDOs. More controversially, Russian bank debt may turn out to be far safer than the paper of some of the major Western Investment banks.
Oil prices are now driven by a combination of fundamental supply / demand factors and financial drivers – in particular, long only US investment funds which have recently been buying protection against $100 oil – leading the investment banks to hedge their exposure by going long the underlying
Acceleration of Change - A brief History of Time
A man born in 1700 would have likely died in a world which had seen only very limited change. Economic relationships were fixed and regulated by long tradition, society was stable and predictable, the majority of men lived on the land, worked as their fathers had, and expected their children to inherit a world largely unchanged from the one they knew. Likewise politics: empires rose and fell slowly, over centuries. France had risen to become the preeminent European state by the early 18th Century; she remained so for some two hundred years. The seeds for the rise of what was to become National Germany were planted during the Napoleonic wars; the resultant tree grew disruptively into the middle of the 20th century
The Turkish Empire declined for some 250 years before finally giving up the ghost, playing its part in the bloody onset to the century just ended. The old Europe was inwards looking. Given the huge costs and relative uncertainty of transportation, until the middle of the 19th century the impact of trade was very limited – primarily based upon the importation of luxury goods from Asia and precious metals from the Americas. The agrarian societies of Asia and the Americas were tradition bound, intellectually immobile, and inward looking; they were little affected by the technological change which was transforming the West. Europe’s undisputed pre eminence was due as much to a pragmatic and positivist intellectual approach as to her superior technology. The conquest of Mexico by a handful of Spanish adventurers was repeated throughout the Americas, resulting in a continent divided into a series of agrarian, hierarchical Catholic societies with deeply inflexible class structures, a conservative outlook, and widespread poverty.
Following the classic colonialist model, these countries were exploited for their commodities and kept as captive markets for excess industrial production, first by Spain, later by the United States (The Monroe Doctrine) The first experiments with left wing revolution failed, both due to external pressure and to the maladaptive nature of the classical Marxist model; most Latam economies thus remained essentially feudal until recently, when a fundamental shift in global trading patterns allowed new experiments in alternative growth models . Likewise Asia, where despite a rich and complex high culture and substantial scientific achievement, Asian societies were loath to embrace technology – i.e. the pragmatic application of knowledge. Having invented gunpowder and early artillery, the Chinese themselves had no workable guns to fend off European raiders.
With the obvious exception of Japan, the first non European nation to defeat a major world power in 1905, and despite brief moments in the sun for the likes of Argentina and Brazil as one or another commodity came into demand, this situation remained essentially unchanged until the 1960s. Trade in vital commodities, in particular oil, was almost entirely controlled by companies domiciled in the industrialized West; the commodity exporters mined for their resources were essentially passive price takers. Indeed, seen from Europe, the emerging world seemed primitive and comical · lazy, happy natives lying in the sun eating fruit impoverished, tradition bound societies obviously inferior to the civilized and prosperous industrial world of Europe and its English speaking offshoots.
The Dragons Resume Smoking
This seemingly immutable divide between the industrialized nations and the third world began to erode with the rise of the Asian Dragons. First a resurgent Japan, rising from the ashes to undergo radical modernization and industrialization, transformed itself from a primarily agrarian backwater into a first world country. By the 1970s, Korea, Taiwan and Singapore – authoritarian, centralized states hell bent upon transformation in a single generation, became serious players. Other Asian states sought to emulate their more successful neighbours. Yet the true tipping point was the rise of China growth which has been extraordinarily fast for the past two decades, but given the extremely low baseline, it is only in the past few years that it has belatedly been recognized as being one of the world’s most important economies (number one in terms of the gross volume of GDP growth, impact on global prices for consumer goods, as well as effects upon commodity –prices
The sheer size of the Chinese economy is by now daunting. A decade ago, China was strictly the appanage of Asian strategists – no one else much cared. It is now inconceivable that a global strategy piece should be drafted without giving pride of place to China! Equally, as a working hypothesis, the limited effect of the subprime crisis on global markets can be explained by the resilience of the Chinese and Indian markets. If this decoupling can be sustained, it will accelerate the Eastward shift in the global centre of economic gravity.
Future Shock - 220V
History does not repeat itself…Historians repeat themselves! The single greatest danger to the investor is to indulge his apparently inborn tendency towards intellectual conservatism – the belief that things will always be as they are today. Perhaps a useful trait in a stable, predictable world, it becomes a crippling impediment to adaptation during times of rapid change. Even for those at least vaguely cognizant of the major events surrounding them, there is a huge resistance to accepting the implications of these events – i.e. the disruption of tried and true traditional models.
One of the best examples was the behaviour of the oil analysts. From 1998 until about a year ago, thanks to their highly sophisticated (if increasingly irrelevant) supply/demand models, almost to a man they warned of the impending collapse of crude prices back to its “long term average” of, say, $25. In the meantime, oil prices have surged some 900%– intellectual conservatism in action! It is not that the analysts are fools – simply, their finely honed mathematical models, which had proved so useful in the past, offered a comfortably “scientific” means of extrapolating present trends into the future. The hugely inconvenient fact that an elephant – China – had entered into the elevator was simply ignored; in fact, this single factor has itself outweighed all of the other changes measured by the models. More recently, commodities analysts have fallen victim to the same fallacy, predicting a collapse in commodities prices due to an incipient US recession – the fact that Chindia has replaced the US as the primary source of incremental commodities demand has apparently been missed
In Summary T&B believes that the current financial crisis and shift in global growth patterns is not merely a fluctuation within a relative continuum – nor even a cyclical function; instead, it falls within a fundamental discontinuum; our basic assumptions are now that: The centre of economic gravity is shifting away from the G7 – it will not return in our lifetimes. As a result of the economic shift, the global political / diplomatic context will see a radical change. For the first time in modern history, the world will be deprived of a single reference currency against which all others can fluctuate. A multi currency system including not just classical currencies but also ounces of gold and perhaps bushels of wheat / barrels of oil will have to fill the gap. Increasing prosperity may prove to be not a factor for peace, but rather, for a dangerous exacerbation of conflict, as increasingly wealthy emerging nations compete with the old G7 countries for scarce resources
Asia’s New Asian Millennium
As we have noted previously, one of the most interesting aspects of the current crisis is that it will test our fundamental financial thesis – that growth in the emergings is now selfsustaining, and that the centre of economic gravity has shifted from New York/London to Beijing/Bombay. While it is too early to arrive at any final judgments, T&B has clearly won the first round. While the short term volatility in financial markets remains primarily driven by events on Wall Street, the real economies of Emerging Asia have not yet suffered any damage. Thus, as G7 equities have stagnated, Asian indices have boomed, both on surging liquidity as well as on signs of accelerating economic growth. As of this writing, the economic fundamentals have been decoupling smartly. As the US faces a housing recession, Japan is threatened with a renewal of deflation, and Europe struggles to avoid being sucked into the credit withdrawal vortex. Chinese GDP has just printed at 11.5%. Singapore, India, Korea, even the Philippines and Indonesia are showing unexpectedly rapid growth. Russia is likely to come in well above 7.5%. Selected commodity prices are on a rampage –
Prices for oil, iron ore, as well as fertilizers, agriculturals, shipping (Baltic Dry Index) and most base metals suggest a continuation of rapid demand growth. Again, whilst US imports of consumer goods are trending down, the real test is what will happen when US demand is hit by recession. As the value of the dollar plunges, and the credit squeeze hits, US consumers will be obliged to begin saving, thus decreasing the demand for imports. We continue to expect this to primarily affect those countries most dependent upon sale of high value goods – Japan, Korea, and Taiwan, rather than those who fill up the shelves of the Wal Marts of this world – China, Vietnam, Thailand, etc. Nevertheless, to some extent, all will be faced with the need to find alternative markets in the Asia Pacific region, and especially, to stimulate their own internal demand. If they succeed, then a new era will be upon us; if not, then the transformation will be delayed until the next cyclical trough.
In any event, financial markets are increasingly discounting a decoupling. For the first time, average P/E ratios in the emerging markets are higher than those in the Atlantic countries…not surprising, given that emerging GDP growth rates are three times those in the G7, while fiscal policy has been far more virtuous in the major emerging markets than in their developed peers. George Bush and the Fall of the West Economics There are those who view history as a purely mechanistic process, with the rise and fall of great empires pre ordained. In this view, statesmen are seen as mere actors, playing their roles in a tragedy not of their own conception. A contrary view, one espoused by our favourite modern historian, AJP Taylor, is that much of history is due to blind chance – the stumblings of men across an unlit stage. Whether or not the relative decline of the American Empire became a certainty on the day after its greatest triumph – the fall of the Berlin Wall – is purely speculative, but unipolar global political systems have reliably proved labile, providing a compelling target for all of those outside the charmed circle.
Diplomacy aside, simple economic determinism – the secular rise of China and the other Asian powers – is now inexorably diluting out the economic primacy of the West. What should be clear is that the election of George Bush in a rigged Florida election (albeit, confirmed 4 years later in a poll widely viewed as relatively free and fair) sharply accelerated this process. The election of what is now widely seen as the worst US administration in living memory, as well as the catastrophic failure of a finely honed system of checks and balances to restrain the Presidential ability to make mischief, has a price. As was briefly the case during the late Reagan presidency, great empires may well fly for some time on autopilot – they do not fly well with a chimp at the controls! It would have been extraordinary had a Bush regime which has proved so extravagantly incompetent in its foreign and domestic policies failed to do its bit to cripple the US economy. From the purely domestic standpoint, crony capitalism has flourished, while the increasing propensity to live beyond one’s means has masked a precipitous decline in social mobility – once the mainstay of the American credo.
Relatively unconcerned with US domestic issues, T&B will focus instead upon the international implications. The dangerous combination of gross incompetence and extraordinary arrogance characterizing Bush’ international diplomacy has also marked US economic policy: “deficits don’t matter” was the credo – ‘faith based’ economics the theology. Early in the Bush presidency, so as to brush away the inconvenient strictures imposed by economic reality, the new administration deliberately appointed compliant and ideologically pure non economists to key economic policy positions. O’Neill and Snow could be reliably counted upon to countenance whatever policies suited the Neocon ideologues. Thus, in a grotesque expansion of Reagonomics, they convinced themselves that military spending could be driven to levels reminiscent of the late USSR, while taxes (at least for the wealthy) could be slashed; this would result not in massive deficits, but in a balanced Federal budget – because they wished it to be thus. This childlike faith extended to the general populace which briefly enjoyed the delights of cheap credit, disavings, and home equity extraction. The laws of gravity are now extracting their brutal revenge.
The Kindness of Strangers
The US budget balance, briefly in surplus under Clinton (an almost unheard of feat for the old, industrialized democracies),has swung into deep structural deficit; whilst the extent of this shift was temporarily masked by the enhanced tax revenues generated by a burst of credit fuelled economic growth, it will be seriously exacerbated by the coming downturn, and will require substantial, pro cyclical tax hikes in a recessionary environment (in turn, requiring the Fed to run an extremely accommodative monetary policy). A recent study by the US Congress put the potential cost of the wars in Iraq and Afghanistan at as much as $2.7 trillion (under a moderately pessimistic scenario, and including compounded interest). The fundamental problem is not the deficit per se (other countries run larger ones as a proportion of their GDP) but rather the fact that, given US dissavings unlike Japan, France or Italy (but very much like Turkey and Estonia) the deficit must be financed entirely by foreigners. Those foreigners who have rushed to do so are now taking a nasty hit on their dollar holdings – presumably, they will now be increasingly disinclined to provide further financing. Funding the US deficit could thus prove to be a far stickier undertaking than in the past.
Again, gross incompetence and the conscious decision to see the world as it should be, rather than as it is, has a price. Payback time is at hand. While there is reason to hope that the coming US recession will be relatively mild, it is also likely to be prolonged, and to provide a convenient historic milestone marking the secular decline in US economic preponderance, at least in relative terms. This will be accompanied by a substantial decline in living standards as wealth is destroyed and the dollar loses much of its value. Eventually, the weak dollar will lead to a rebalancing of the trade deficit, consumers will be compelled to save enough to fund the US deficit, and (after an overshoot) the dollar will find a floor. The US may well avoid slipping into absolute decline, but in economics, as in politics, the era of absolute American pre eminence is over. It is not coming back. Fear and loathing in the Capital Markets Given the boom in Asian markets, the collapsing dollar, and the resultant run up in commodity prices any half competent international asset manager should currently be shooting the lights out – if he had the courage to short credit indices, then he is an absolute hero. And yet – speaking to our peers in Europe and Asia – T&B has encountered a generous dose of fear, mixed in with the greed.
Against Economic Calvinism - Von Sacher Masoch
The Greatest of the “Austrian” Economists? – Each day it seems, T&B reads yet another tirade demanding that terrible punishment be visited upon those who got caught in compromising positions under the influence of copious liquidity. The saintly Greenspan has been revealed as nothing more than the Devil’s accomplice, and his host of followers – soft, pink and fat – are to be scourged and shrived to save their immortal souls. One indignant columnist demands that “millionaire investors” who took advantage of the leverage on offer should be made to pay – the Fed should tighten rates to support the currency (shades of 1929…), the US Treasury should allow the commercial paper market to implode, the ECB should let banks go bankrupt, SIVs collapse, financial markets should fail, all so that a chastened human race should turn away from sin, living according to the words of the gospel – sober, frugal…and very, very poor. Some of T&B’s favourite macroeconomic pundits aside, the current crisis sweeping through global capital markets is not the end of the world as we know it. Properly managed it will not bring the global (or even the US ) economy to a screeching, grinding halt; it will not cause a collapse in all asset prices, nor create global hyperinflation sending gold prices into the 5 digits.
The dollar will not lose all (perhaps most…but not “all”) of its value. For once, the central banks, both European and American, have done precisely what they should have done – maintaining an adequate level of liquidity to prevent the seizing up of credit markets. Even the much maligned ‘super SIV plan’ – if successful – is an absolute godsend. The total meltdown in a one trillion dollar market for commercial paper is a recipe for disaster – not for recession, but rather, for outright depression. Central banks were not designed as vehicles for divine retribution, but rather, as institutions devoted to maintaining the viability of their financial systems, without which the real economy fails, disrupting the lives of millions of ordinary people. Markets have no magic. They make mistakes. They blow bubbles which collapse, and the collapse can cause huge and durable destruction of value. The economic masochism which demands that the culpable pay for their misdeeds is somewhere between misguided and insane. It is akin to suggesting that no one should have tried to extinguish the fires at Chernobyl after the operator’s intellectual curiosity led to a loss of control over the reactor. In fact, the guilt parties had already been irradiated. It was the neighbours who were at risk.
The moral hazard argument is vacuous for the simple reason that no one is ever going to do the same awesomely stupid things again – they will do other equally stupid things but not the same ones. No amount of punishment for the culpable will prevent future folly. Future bubbles will be blown in new and unexpected places – like dictators, successful bankers will always imagine themselves immune from the punishments meted out to their predecessors3. After the debt crisis of the 1980s, the global banks stopped sovereign lending, never to resume. The US S&L crisis put an end to the S&Ls. Following the tech wreck the problem shifted elsewhere – internet IPOs ceased to be a problem. CDOs were invented. 3 Mr. O’Neals $161. golden handshake suggests that they are correct…. Letting the financial system collapse to warn bankers against doing silly things is like shooting fallen dictators to make sure that no one does it again. The nature of man is that he sees death all around him, yet does not believe that he himself shall die. An endless supply of dictators will always be available…and of risk tolerant bankers too. Each feels sure that he will be the exception to every rule. By all means shoot a few of each, pour encourager les autres, but never believe that this will prevent future mistakes.
Thus the era of the adjustable subprime loan with a teaser rate, of commercial paper based on worthless assets supposedly rendered viable by their short term structure and of collateralized debt obligations of dubious provenance etc. is gone. Dead as the dodo. They are not coming back. The banks which engaged in ill advised lending are taking massive write downs – Merrill’s initially reported $8bn loss was impressive even by recent standards – it now it looks like that may have been just the tip of the iceberg. Hundreds of smaller mortgage lenders now sleep in a watery grave. Some two million Americans will lose their homes, and somewhere between 2 7 trillion (yes, that’s trillion) will be wiped off the US real estate market. Guillotines are being set up in the lobbys of US investment banks, with their presidents the first to step onto the escalator…ergo, punishment is not in short supply.
Global Turbulence – Blowback for the Empire Iran Mohammad Mosaddeq – Or why do they hate us so?
Amazingly, Condoleezza Rice, perhaps the most incompetent Secretary of State in American history, has just declared that Iran is the “greatest security threat facing the United States.” While the reasons for this obsession · perhaps nothing more than an attempt to deflect domestic attention from their hugely successful efforts to “liberate” Afghanistan and Iraq – are not entirely clear, the statement itself is obvious nonsense. As we have remarked previously, the greatest threat is Pakistan – and the sorcerer’s apprentices in Washington have predictably succeeded in fouling up the single most dangerous foreign policy dossier on the planet. By putting all of their chips on Musharraf, the Bush regime repeated the US errors in the runup to the eminently predictable overthrow of the Shah of Iran – finding themselves totally cut off from the moderate opposition, and thus, from any of the potential successors. As a result, they were unable to switch mounts, and when a new leader swept aside the Shah’s rotten edifice, it was of course the one most inimical to their interests – the Ayatollah Khomeini. Predictably, the US foreign policy establishment cajoled, bribed and prodded Musharraf into initiating a suicidal policy – a hugely unpopular war against the radical, Taliban aligned tribes in Pakistan’s border regions.
Given the unmitigated hatred with which the US is viewed in most of the Islamic world, not excluding Pakistan (according to the Pew Survey, only Palestine and Turkey are more anti American), an alliance with Washington was the kiss of death. Having failed in a desperate, last minute attempt to slip in a more compliant politician in Musharraf’s steed, Washington is now reduced to watching passively as Musharraf ignores his erstwhile masters, declaring martial law, and throwing his country into something looking dangerously like civil war. In Eastern Pakistan, military units are reportedly defecting to the rebels; elsewhere, a political free for all is underway. Most terrifyingly, the world at large is now faced with a high cost, if low likelihood danger of a Taliban style state armed to the teeth with REAL nuclear tipped missiles, not with the Iranian variety – potential, hypothetical, someday nuclear weapons – but real ones, fully tested and ready to fire. Those 40 Virgins awaiting martyrs in Heaven should be getting ready for some heavy there’s likely to be something of a virgin shortage soon. Meanwhile, back in Teheran The Pakistan story aside, to everyone except perhaps the folk in Washington, it should be obvious that, rather than being the threatened party, in recent years it has been the United States to have posed the greatest threat to Iran’s security, first planning and supporting a coup that replaced the populist government of Mosaddeq with a puppet dictator beholden to the US4, then sponsoring the slaughter of millions of Iranians in the Iraq Iran war.
Regarding the first, in cahoots with a United Kingdom irate that the Iranians should presume to exert ownership over the massive oil deposits conveniently situated beneath their soil, the CIA engineered the 1953 coup against Mohammad Mosaddeq, installing a corrupt, brutal and widely hated puppet regime under a tame Shah. When this regime was finally overthrown in a popular uprising led by the Ayatollah Khomeini (an uprising which included not only the religious fundamentalists, but also virtually that entire segment of the Iranian bourgeoisie not personally related to the corrupt and brutal Rezi family – i.e. the bazaris) it was only to be expected that they vented their spleen on the erstwhile (neo ) colonial power – the United States. The US embassy was occupied and its staff held hostage in a major humiliation which spelled the death knell for the Carter presidency. Before rolling their eyes, readers who suspect T&B lacks in balance would do well to run a Google search on “Iran, Mosaddeq, 1953” – the CIA management of the coup, and the participation of the UK, has been amply documented, including by US academic sources based upon documents released by the CIA under the Freedom of Information act.
No self respecting imperial powers can countenance slights of this sort, and the US extracted terrible revenge by encouraging a proxy war – Iraq’s decade long war against Iran. This sponsorship included substantial technical assistance in the manufacture of chemical warfare agents, used with terrible effect against Iranian civilian populations. Before ending in stalemate, this war left millions dead on both sides. Iranian foreign policy, perhaps including the development of nuclear capabilities, is presumably aimed at preventing any repeat of these calamities. When When all Else Fails – try Diplomacy! The limitations on America’s international reach are being laid bare by the Iranian situation. With the Iraq debacle, the US has become belatedly aware of the need to work via international institutions. Alas for Washington, the UN Security Council includes Russia and China, both of whom have important ties with Iran; whilst neither is comfortable with the notion of a –nuclear armed Iran, they are even more concerned with maintaining their ability to protect their own interests and to retain an independent foreign policy – neither is willing to become a tail wagged by the NATO dog.
Likewise the other Caspian states, which will have to live with Iran as a major regional power. Even India, despite maximum pressure from Washington, has announced its intentions to go ahead with the building of a pipeline to bring Iranian gas across Pakistan; new sources of energy are indispensable for the continuation of the Indian economic miracle. Britain, already mired in both Afghanistan and Iraq thanks to a childlike faith in Bush, seems disinclined to open up a third front. Only France has surprised by aligning itself with Washington – Foreign Minister Bernard Kouchner, a political amateur more at ease in the heady world of NGOs than at the Quai d’Orsay, made a fool of himself by appearing to threaten military intervention in Iran, before being silenced by an irate Sarkozy. Big wind, loud Thunder – No rain? Despite almost weekly warnings of the imminence of an American attack on Iran, generally backed up by some intelligence regarding one or more US carrier groups cruising about in the Gulf, T&B has long predicted that the US would limit itself to bellicose language, empty sanctions, and moral outrage – refraining from an actual military strike against Iran. This was based upon the assumption that, after an almost unbroken series of foreign policy failures, the Bush regime would be loath to start yet another unwinnable war – one having potential consequences far greater even than those of its current Eastern stalemates.
And What if we’re Wrong? We could be wrong. Perhaps a fatally wounded but still dangerous hard core Neocon faction centred around Cheney – its dreams of empire shattered and faced with imminent political oblivion – will lash out, counting on a wartime patriotic reflex to save its fortunes… one last roll of the dice. More sinister yet, perhaps not content to saddle the next U.S. administration with unwinnable wars in Iraq and Afghanistan, they would simply like to add one more to the pile. Given the progressive shift towards an imperial presidency and the utter failure of legislative oversight, they could just conceivably get away with it. The diplomatic implications of such insanity would fall outside of our remit. It could Arroz Sin Leche – Rice in Moscow Miss Rice’ trip to Moscow was a predictable debacle. Along with US Defense Secretary Gates, Rice had been dispatched to attempt gain Russian cooperation on the Iraq dossier. In a wonderful example of the anachronistic nature of American diplomacy, no sooner had she landed than she was gratuitously antagonizing her hosts by publicly interfering in Russian domestic affairs, meeting with a gathering of anti Putin dissidents.
Tacit any discussions of the advisability of gratuitously antagonizing your hosts when on a visit to plead for diplomatic assistance, the meeting provided at least one delightful moment. A St. Petersburg woman got up to tell Rice that, given the fact that America had lost the moral high ground, rather than seeking to act alone, the US should join forces with the European Union in bringing pressure on Russian administration. Rice was predictably furious, snapping back that the United States has not forfeited one bit of its moral standing! The funny part is that she was undoubtedly sincere in her cluelessness. Surely, she must be one of the very few passport holding Americans to be unaware of their extraordinary loss of international prestige over the past 7 years. Certainly –destabilizing the Middle East, paving the way for an unstoppable fundamentalist wave – indeed could, just conceivably, provide the spark for a true war of –civilizations
Islam vs. the West.
Clearly, Iran would strike back against US and other Western interests throughout the region, and the survival of pro Western Arab governments would be more a matter of luck than of planning. It seems unlikely that Russia the major power in the Caspian – or China, dangerously dependent upon oil imports, would stand by passively. Although an armed confrontation falls within the realm of political fantasy, Russia and China would be driven further into a hard, anti Western military alliance. Iraq and Lebanon would explode. Iran damaged but not occupied would dig in and race to build a bomb as a matter vital to national survival. Turkey – already furious at the Americans for having ignored their warnings of what would happen if they invaded Iraq – would find itself with another war zone along its sensitive Eastern border. Their patience could snap. Oil and Money For financial markets, given the importance of Iran and the region for the global petroleum trade, this would be a catastrophe scenario.
It is difficult to predict the reaction of erstwhile friendly Arab governments, and especially, of the Arab street, to yet another invasion of an Islamic country by Western Crusaders, with the perceived backing of Israel. Certainly, there is a real danger of a repeat of the 1973 oil embargo which plunged the world into a deep recession (at a time when dependency on imported oil was far lower than today). Even if one or more Middle Eastern states did not halt its oil exports and OPEC refrained from slashing quotas out of solidarity, and further assuming that the Iranians could not successfully imperil Gulf oil shipments (now that the Revolutionary Guard is armed with supersonic torpedoes, this is a risky assumption) the withdrawal of 3.5M bbd of Iranian oil, along with the perceived threat of a disruption of Middle Eastern supplies, would send an already tightly balanced oil market into panic mode – oil prices would likely surge above $200/bbl, tipping an already fragile global economy into meltdown mode
Those who would scoff at our typically alarmist commentary are referred back to our predictions of the possible consequences of the Iraq invasion, including the fatal destabilization of Iraq, the export of fundamentalism and terrorism, as well as radicalization of Turkey likely How to trade it, if it happens: Massive longs in oil and gold, spot and futures. Initially, long USD and Yen, then quick reversal to short USD, Yen. Short equities. Long G7 treasuries. Long Russian Roubles and commodity currencies. Extreme case portfolio – long canned food, firearms, land in New Zealand. Global Markets – How to Trade ‘em The ultimate binary Trade Short term trends in financial markets are driven not by rational expectations, but rather, by the alternation between fear and greed. Ordinarily, market participants oscillate back and forth between these two fundamental emotions, – most unusually, we are now encountering an unprecedented combination of the two, with the savviest investors simultaneously elated and terrified. Whilst, over the longer run, markets are remarkably rational, the amount of short term idiocy one must endure to get a piece of the “long run” is really quite extraordinary. At present, global markets are almost totally binary. On any given day, depending in particular upon whether or not yet another global investment bank has just announced that some new horror has been found lurking in its basement, our screens are either blood red or the emerald of a well tended lawn – financial risk either gets put on or taken off, wholesale and indiscriminately.
Do You Really Want To Be Rich?
As emotions go, fear is far stronger than greed. Risk is asymmetric, and men fear losing what they have far more than they hunger after new acquisitions. Thus, in times of rapid change and stress, like generals constantly fighting the last war, investors retreat back into the familiar; as often as not, this proves to be a fatal error. In 1999, when T&B was hawking Russian sovereign bonds for a major European bank, prudent investors gave us short shrift. One German institution listened politely before showing us the door they were not going to risk their investor’s hard earned money on speculative Russian assets, and instead, were building carefully hedged positions in safe, high grade US securities with attractive spreads. We have just learned that this same institution is faced with imminent bankruptcy if a buyer cannot be found. As always at times of fundamental change, the psychological adaptation is lagging the reality – analogous to the situation at the beginning of Russia’s extraordinary resurgence from 1999, relatively simple and hugely lucrative investment opportunities are available to those possessed of the requisite psychological flexibility needed to jettison tried and true reflexes and to adapt to the new reality.
As the centre of global growth shifts towards the emerging economies and away from the old industrialized countries at a rate unprecedented in human history, the economic equivalent of “regime change” is sending the emerging markets ballistic. Meanwhile, the world’s erstwhile reference currency is plunging, while defaults in that ultimate store of value – US investment grade credit – have triggered an avalanche of downgrades and defaults, posing a real threat to financial stability. Investors who withdrew into the safety of safe, predictable assets, the US dollar and highgrade credit, are facing severe losses. Those who invested in blue chip equities have fared only a bit better; while, in dollar terms, US equity indices are holding up very decently given the carnage in the debt markets, expressed in terms of Euros (or, as Mark Faber likes to repeat, in ounces of gold, or bushels of wheat) they are once again underperforming their global peers.
Revenge of the Old Economy
Even that damned fool Jim Rogers cannot be wrong about everything (though he remains psychologically unable to acknowledge that he was totally wrong about Russia; had anyone been insane enough to follow his advice, his apocalyptic predictions and implicit recommendation to go short Russia at the beginning of this decade would have provided a fast track to bankruptcy…) as regards commodities (as well as for the continued decline of the dollar and of the Baltic markets) he happens to be right. Alongside the emerging Asian markets trade, the commodities trades and their offshoots are perhaps the fundamental opportunities of our new century.
As industrialization spreads, and hundreds of millions of people are drawn into the consumer sector, the demand for energy, base metals and food will increase inexorably; as they run into hard supply constraints, economic and diplomatic relations will be profoundly disrupted (as will the fundamental survivability of planet Earth). While the latter half of the twentieth century was characterized by a seemingly inexorable fall in commodity prices with a shift towards the service economy and economic growth based on the production of intangibles. Now, thanks to the emergence of Asia, the “Old Economy” has reclaimed pride of place. The fact that a trade is “fundamental” does NOT, of course, mean that it is unidirectional; given the weight of speculative money, fierce corrections are to be expected. In the near term, except for specialized commodities futures players, we would steer clear of the futures markets; in particular, almost all are now in contango rather than backwardation, i.e. forward premia cause a negative carry at each rollover (perhaps precious metals are the exception; long dated gold futures have acceptable volatility, and as long as the dollar continues to tank, gold is an excellent hedge.)
Agricultural Prices - Malthus Come Home! Dinner's On The Table!
In a wonderfully ironic inversion of the classic roles, the “developed” countries are now major suppliers of agricultural commodities to the “emergings”, upon whom they are – in turn increasingly dependent for imports of manufactured goods! The explosive growth in energy prices has been squeezing the global economy for most of the decade food prices are now joining the party. As the Asian countries get richer, they are enjoying a huge increase in their consumption of foodstuffs, moving up the value chain towards higher protein diets. Unfortunately, this comes in parallel with declining local food production due to the paving over of agricultural land, desertification, inadequate water supplies, pollution, and damage due to poor land management practices.
This is already providing a boon for the agricultural exporters, Brazil and Argentina, but also for the old industrialized countries – Europe, Canada, Australia / NZ, and the United States. Already, the EU is winding down the set aside program which formerly paid farmers to not grow crops. Alas, it is not easy to get exposure to food inflation as a pure play. Fertilizer companies provide one good alternative, infrastructure another. In terms of geopolitics, in the absence of sudden disruptions, it is just possible that price action will allow a gradual accommodation, while better agricultural technology helps to avoid severe deficits. If, on the other hand, there is a serious disruption to current production, e.g. a severe drought caused by the rapid loss of the Himalayan glacier flow which irrigates both India and China, then expect a free for all as the Asian tigers forage the world over for desperately needed food…at best, this will play havoc with pricing – at worst,… Extreme case portfolio – canned food, firearms and land on –Jupiter.
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