The Terrible Twins
Like many of you, I was glued watching the CNBC the last few nights and was amazed at how many are still looking at the wrong reasons why the markets are correcting. Some are still explaining that the US jobs data are still good and that a recession is not likely. The markets were already factoring in a 50 basis points cut end of January. Doing an additional 25 points a week earlier: is that sufficient?
Downward property prices and impending foreclosure won’t be helped by a 75 basis point cut. This is a correction which aggressive rate cuts won't help, the correction has to play itself out. It’s not just a US recession, neither is it US jobs situation which are killing the markets. If you cannot get to the right reasons, you will mis-read the markets.
If you have to put it down to one reason, it’s the implosion of credit bubble. If you want a secondary reason, it will be inflationary pressures due to the excessive money supply growth worldwide for the past 5 years – which are directly linked to the primary reason.
In Australia, the M3 money supply rose 20.7% from a year ago, Brazil's M3 +17%, Canada's M3 +12.9%, China's M2 +18.5%, the Euro zone's M3 +12.3%, Hong Kong's M3 +31.5%, India's M3 +21.5%, and the United States' M3 +15.8%, a 47-year high.
Under the leadership of Jean Trichet, the European Central Bank (ECB) has shifted far away from its monetarist roots and its original 4.5% growth target for Euro M3. Since Trichet was appointed in November 2003, the Euro M3 money supply has exploded from a 5% growth rate to an annualised 12.3% in October 2007, its fastest in history, lifting the Euro zone's inflation rate to a six-year high of 3.1%, and far above the ECB’s target of 2%.
By doing so, Trichet has immunised the Euro zone stock markets from record high oil prices with money supply. The ECB engineered an 11% Euro rally against the US dollar in 2007, by printing money at a bit slower pace than the Fed.
To use monetary policy to fine-tune economic activity or asset markets, or to gear it above a sustainable level will, in the long run, simply lead to rising inflation – not to faster economic growth. What we are seeing is a credit bubble being pricked. Hence, this is not just a market aberration that will correct itself swiftly. And - it is likely to take more than a few weeks to play out completely.
Not to blame just the ECB and the Fed, but most major central banks globally have been increasing annual money supply M3 at double digits since 2001. Initially it was to reflate the economies that were stricken with credit implosion issues.
The recovery of the global economy was hastened with the emergence of China and India, both as a low cost production centre and a huge additional group of global consumers.
The US central bank has pumped a lot of liquidity into the world economy over the last four years, as a result triggering a synchronised world-economic recovery. The ample liquidity, rise of BRIC, and globalisation trend caused all commodities to surge.
The US has to contend with lower growth compared to the rest of the world, hence explaining the underperformance of US equities relative to other developed markets and emerging markets for the past four years. The trade deficit, which the rest of the world had been financing, became the epicentre for the shift in economic paradigm. The world is not that keen to keep holding US assets as the new paradigm asserts itself. Oil trade resulted in huge surpluses for the oil rich nations. BRIC countries now have a solid economic and industrial framework to pull itself onto the global economic power platform. Currencies began to realign to the new competitive order.
As most commodities were priced in USD, the persistently weaker USD ignited a rally in commodity prices. Added to that, demand for commodities also kicked in with strong demand from China and India.
The Fed initially increased money supply for valid reason in 2001-2002. The last few years have been adding gasoline to fuel the inflationary fire. Now it looks like everything has come to a head. The imploding sub prime mess and credit contraction looks likely to be the catalyst for the unwinding of the upcoming inflationary mess.
Even though the US has been showing signs of recession and a sub prime mess is evolving into a consumer debt problem: inflation is still very much a lagging indicator. Thus the next few weeks will see more “inflationary fears” articles in the media mixed with “US recession” debates. Not exactly fun stuff for the rest of the world.
Inflation is a very slow cycle. The entire cycle takes anywhere from 12 to 16 quarters to work itself out of the data. Thus the weakness in the US may not be of much help to those robust countries trying to contain inflationary pressures on their own.
We have been through a long period of inflationary credit expansion but credit expansion is a self-limiting condition. Credit bubbles are merely the rediscovery by a new generation of the powers of leverage. Every credit bubble that ever existed has eventually deflated. Is this a credit bubble being pricked?
Sure looks like one. We have essentially already reached the limit of debt serviceability that brings the merry go round to an abrupt end. We are already seeing the tightening of credit standards, the refusal of banks to lend to one another, the frozen commercial paper, the bank runs, the redefinition of what constitutes a store of value, the rejection of financial alchemy, the debt defaults, the falling prices in the housing market, the lack of confidence. These are all hallmarks of a credit bubble bursting.
The US has basically exported inflation away from the US with the weak USD and settling for lower growth strategy, and now the problems lie more with Europe and emerging markets. Local currency will still be strong, and will have to remain strong to counter imported inflation. Production capacities have been enhanced already. The slowing US economy will hit hard in 2008.
Another key factor is the Baltic Dry Freight Index. The Index measures the cost of moving raw materials by sea in container ships. Many economists consider the index to be a good leading indicator of economic activity; when not many people are looking to move cargo, ships will be in less demand, causing a drop in the price that shippers can charge. Recent dramatic declines in the Baltic Index have reinforced views that the US is probably heading into recession. The index has lost nearly 40% since mid-November.
So we have the terrible twins: inflationary pressures still in the system and the credit bubble bursting. Not a pretty sight.
The coming weeks and months will see these things being played out:
· Occasional bad news about companies affected by CDOs related writedowns and bankruptcies by companies hit by higher credit cost or inability to refinance;
·Banks in the US coming to terms with worsening consumer loans;
·Fed dropping rates by 75 percentage points by February but failing to re-ignite the markets (this happened on Tuesday night);
·USD to lose 3%-5% in value in 1H2008;
·Commodities prices ease from their peaks but still stubbornly high;
·Real estate led correction hits Britain hard;
·Developed markets and emerging markets having to contend with inflation in goods and wages, plus coming to terms with a weaker US demand; and
·Some collateral damage in “good sectors” being sold down to help cover losses and redemptions in affected funds.
All said, the sooner we wring out the excesses due to the irresponsible money supply growth policies, the better. All markets will become attractive once they have fallen sufficiently. However, we have to wait for things to unfold from here. A good yardstick would be to monitor the financials in the US. Many are already trading below book value. We probably should see good value with another 5% lower from here. The catalyst which could bring about a buying platform should be a major purchase effected by a well regarded investor or institution, e.g. Warren Buffett. Are we there yet? Unfortunately, no.