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August 20th, 2008
Ronald Reagan once said those are the nine scariest words in the English language. And he's starting to be proven right.
World markets have been watching with bated breath lately as the dynamic duo of Paulson-Bernanke has mounted the Hill (or has been mounted, as it were), on several occasions recently, soothing the markets, politicians, and public with calming words about liquidity, regulation, and "bottoms." Even the POTUS (that's President of the United States) has made a few well-rehearsed remarks about the economy, energy, and our friends Fannie and Freddie. And in response, politicians have wasted no time in jumping in front of anything with a lens to demonstrate their commitment to "fixing" things.
Unsurprisingly, most of our esteemed congressmen and senators have left no doubt that they collectively lack any understanding of financial markets or basic economics. And quite frankly, we find it insulting (despite the fact that Wal-Mart reported a surge in plasma screen television sales post-stimulus check and further data indicate that online pornography sales were up sharply); people aren't as dumb as Washington hopes. Even without an academic understanding of economics, the lowest common denominator in society is noticing fewer Miller Lites for his dollar at the checkout line, and that reality cannot be hidden with political rhetoric. At this point, it's safe to assume that, with a few notable exceptions like Cheerleader-in-Chief Larry Kudlow, most people know the largest economy and most widely-held currency in the world are in trouble.
The following points are likely subject to question and interpretation: 1) What's causing this, 2) How bad can it get, and 3) What can be done to limit its effects? It seems clear to us that the political and media establishment have jumped immediately to question 3 without really stopping to consider the first two. This reminds us of Army doctors who robotically prescribe a strong dose of Motrin to treat pretty much every symptom under the sun without ever devoting a token amount of time to determining the root cause.
The proposed remedies have been far-reaching: from banning speculation and short-selling altogether; to providing yet another round of fiscal stimulus (hey, the digital TV switch is only a few months away); to creating the new New Deal whereby Mother Government will employ large swaths of workers to rebuild our deteriorating infrastructure. So what are you waiting for, comrades? Pick up a shovel, there are dams to build!
From a social perspective, we know we're at a turning point when friends who once decried our misadventures in seeking faraway contrarian fortunes are sending us emails saying, "Hey, uh, can you tell me again about Panama?" They are realizing that, as we explored last month in our Dispatch from Dubai, personal liberty is not always best protected in a democracy. How much freedom does one truly have in a government controlled by herd mentality? People are smart enough to realize that they have absolutely zero power to affect change in a country with hundreds of millions of different perspectives. At this point, the idealists usually say something about starting a grassroots campaign to "raise awareness" and -- as utopian as this sounds -- who has time for such things when everyone is struggling to pay for the skyrocketing costs of daycare, healthcare, education, food, and transportation?
At the end of the day, whether we live in totalitarian Zimbabwe or the United States of the North American Union, we are left with the freedom to choose between "take it" or "leave it." The former is a resignation to accept the things we cannot change, complain prodigiously, and make the best of it. The latter implies a rewarding adventure in seeking a new breeding ground for personal liberty. Chances are, if you are a subscriber to this humble publication, you are at least sitting on the fence and probably leaning towards the "leave it." Don't feel guilty; you are not alone. A recent study from US News & World Report indicates that a growing number of North Americans are joining the ranks of the new "lost generation," except that the group seems to be truly pan-generational; young and old, we come across a surprising number of expats scattered across the globe, ranging in age from 18 to 80. Some are seeking entrepreneurial fortunes; others are seeking to stretch their retirement savings; others are escaping the rat race; yet the commonality seems to be a clear distaste for the direction that things are headed -- and absolutely no one thinks that it's getting any better. This new generation finds the concept of swearing blood-oaths of allegiance to gerrymandered figments of Winston Churchill's alcohol-induced imagination to be a bit antiquated... god save the queen and all that.
For everyone else, the Social Contract experiment has worked well, and people around the world see governments not only as an inextricable part of their lives, but also, in many cases, as a means of support and comfort.
Take Pakistan, for example. Last month a small army of individual investors looted the stock exchange in Karachi because the market had lost about 40% of its value over a few month's time. Rather than take their lumps, they rioted, demanding that the government 'do something!' And something they did. Markets were calmed, albeit temporarily, based on Finance Minister Naveed Qamar's assurance that a 20 Billion Ruppee 'fund' would be activated to bail out small investors and save them from their losses. Seem like complete insanity? Yet one doesn't have to look hard to see similar instances around the world, whether it's larger pensions in Italy; a shorter workweek in France; cheaper maize in Mexico; or soon-to-be-reproposed universal health coverage in the United States. Mother Government's responses to declining and turbulent economic conditions also fit in this category.
The question is: Where does all this bailout/social welfare money come from?
Apparently thin air. With declining tax revenues in a down economy, governments around the world have been stepping up to recklessly spend more, usually borrowing from the haves and giving it right back to them in interest payments or proceeds from importing their wares. There's one problem though, at least for the U.S.: The Financial Times recently reported that Arab and Asian funds are cutting their exposure to the U.S. dollar. Can't really blame them. For years they had been buying U.S. debt and recently switched to ownership: real estate, public equities, etc. But their cash infusions from private capital injections over the last twelve months have withered as the market value of major financial stocks continues to deteriorate. At this point, there is little course of action remaining other than to continue deflating the value of the currency by printing more money.
So, many developing markets are experiencing significant inflation because of a surge in foreign investment (which normally has the effect of driving up wages and asset prices), as well as rising commodity prices. Even though commodities are generally priced in USD, many developing markets historically peg their currencies to some multiple of the dollar, so they feel the inflationary effects of rising corn, wheat, and oil as well. De-pegging would usually cause their currencies to strengthen against the dollar, mitigating the inflationary effects of rising commodities prices. Sounds great in theory, but many developing markets have been focusing on pro-growth policies, allowing inflation as a necessary evil. In our view, this trend is changing rapidly.
As we have discussed earlier, it doesn't take too many riots for governments to give in and 'do something.' Unfortunately, this has historically been a far cry from actually 'accomplishing something' because, after all, you can always blame the other political parties. Our assessment, however, is that the great constituency is growing impatient, and as family budgets around the world are stretched thin in the face of a myriad of other challenges (real and perceived) like climate change, energy scarcity, and population growth -- governments will eventually adopt freer market policies with long-term benefits. Argentina's recent decision to eliminate export taxes for agricultural products is an indication of this trend, even in a highly leftist regime. China's reduction of fuel subsidies is another.
The great shift in defending against inflation will likely culminate in many developing markets abandoning their dollar pegs and floating freely. Last year, Kuwait and China broke away from their strictly USD pegs in favor of a basket of currencies which includes the euro, yen, pound, ruble, South Korean won, Thai baht, Aussie dollar, Canadian dollar, and Singapore dollar. Kuwait has been the most hawkish of the GCC about the dollar, at least publicly. The country, which has the world's most highly valued currency (its currency unit buys the most of any other currency unit), made the change in preparation to switch to the proposed GCC single currency, the Khaleeji, when it debuts in 2010 across Saudi Arabia, the UAE, Qatar, and Kuwait.
As long as the world's energy trade balance favors the Gulf, our expectation is that the new currency will perform well against the dollar and euro, and it is likely that other members of the currency bloc will flirt with de-pegging prior to 2010.
The same analysis applies to China's renminbi (which literally means "the people's currency"). Prices may rise and growth may fall, but China will likely maintain its status as a worldwide manufacturing source and export-intensive economy; and turning a cold shoulder to U.S. dollar-denominated investments will put significant upward pressure on its currency.
ABOUT THE AUTHOR
Disclaimer: The opinions expressed above are not intended to be taken as investment advice. It is to be taken as opinion only and I encourage you to complete your own due diligence when making an investment decision.
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