Can The Euro Last?

"This crash is not going to have much effect on business." - Arthur Reynolds Chairman of the Bank of Chicago 24 Oct 1929

As you can tell from the above quotation, I do not believe that the Euro will last.  To me it is almost impossible to keep it together.  The facts seem to point to the obvious that either Europe needs to go back to individual currencies or at best split into a couple of currency baskets.  The reasons are simple:

1. The only way (barring some miraculous discovery of massive oil reserve or some technology) in the short term to make an uncompetitive economy competitive is to depreciate the value of its currency.  Once a currency is depreciated fully, the country's products are automatically priced to compete.  Furthermore imports become so expensive that locals are forced to buy goods produced locally.  This insulation protects local companies from imports, allowing them to gain local market share and slowly but surely things start to turn around.
2. Piling more debt onto already over leveraged nations is a sure fire way to disaster.  Without repairing the internal structural problem of a balance of trade it is only a matter of time until the borrowing nation once again runs out of cash that was lent to it. 
3. The more that is borrowed the higher the cost of the debt.  As we have seen, interest rates are spiralling higher in weaker nations in Europe and this eats quickly into the budget increasing the deficit and weakening the country further.
4. Political differences will not in our lifetime be put to bed.  These are countries that have disputed borders, fought wars against each other and had a history of centuries of conflicts and disagreements.  Until all of these political ideologies are put to bed and a common political platform is set, there will be no possible way for the currency to survive in its current state as politicians will try to push their separate rather than unified agenda on a diverse group of nations.

So what will be the outcome?  I believe that once again there will be an attempt to push the problem further down the road, however the $130 billion given to Spain is just a drop in the bucket.  If you want to completely clear the slate trillions will have to be lent and re-packaged.  The only country that has even the remotest chance of pulling this off is Germany and believe me, they will not step up to that large a plate.  However, it does nto appear that the politicians are ready for the catastrophe that a Euro meltdown would have on Europe as a whole.  As such they will continue to meddle along for as long as possible.

Eventually (and I think that eventually will be relatively soon and probably before the end of next year) economics will win out over politics and no matter what political posturing is presented, the Euro will have to change.  This will be dumped on the politicians through market forces.  Personally I believe that this will push parts of Europe into a depression and this will have repercussions around the globe.  Germany, Britain, China  and the United States will be pushed into a severe recession due to the fallout of this mess and the ensuing financial crisis.  To think that the United State will escape unscathed is a mistake as our banks and economy are heavily reliant on a fully operational Europe. 

Depending on how deep the crisis in Europe goes will determine if there is a shift (at least temporarily) to closer ties between Asia, South America and the United States from the current Europe/US union.  Interesting times are ahead and this certainly warrants an air of caution particularly with the Greek election occurring this weekend and a time to take exposure out of the markets.

The Waiting Game

"There is more to life than increasing its speed." - Mahatma Gandhi

A trader is inherently impatient.  Sitting on your thumbs (in order to prevent trading just for the sake of trading) is a skill that is hard to learn.  Once learnt I ahve found that there are very few able to implement the rule but it is these moments where overtrading can break your portfolio.  As Tiger Woods once said, "You can't win on Friday but you can lose."  This is a good summary of where the market is now.  There are a lot of major events about to happen and to trade now is to take unnecessary risk (unless you are an avid day trader and close out all positions before the end of each day).  Taking a gamble on the outcome of a Greek election and Europe's reaction to it are, in my view, pure folly.  You may as well take your money and head to Vegas.  For what it's worth I think you would win on red!

Seriously though the Federal Reserve Chairman yesterday essentially said he was waiting and watching, Europe is not giving much indication of what they would do if the Greek elections result in a vote against Euro participation (in fact as the Greeks have disallowed any polling it is complete speculation as to the outcome) and Spain is sure to need a bailout package but the terms and conditions of that are unknown and certainly will be influenced by what happens in Greece.

So all eyes are on the Greek election for June 17th and the resulting fallout and there is little that can be done in the interim other than close out and wait or spend loads of time and energy speculating on the future and then trying to protect your portfolio against any potential shocks.  As I have mentioned before, this is a costly exercise and not just in financial terms but also emotionally.

So what do I believe is the outcome?  To be sure I feel that regardless of what their decision is that a mess will result.  Stay in the Euro and their future looks bleak as the austerity needed will result in a severe contraction and leaving the Euro will result in a severe contraction.  Leaving the Euro could have catastrophic consequences for the rest of the Euro countries as the bandits will smell the prize and will surely hammer the other weakened economies by dumping the bonds into an already fragile market pushing the sovereign yields of Spain, Portugal, Italy and even France through the roof.  The result of this would certainly push Europe into a deep recession and could even move it to a depression.  If Greece stays in the Euro it may buy the Euro countries time but without some kind of a plan in place for the future of the Euro short work will be made of whatever stimulus plan comes out of Brussels.  The result will be just another kick of the battered can a little further down the road and this is becoming less and less of an option as (any 10 year old will tell you) a battered can does not go as far as a new one.

So if I were to place a trade I would be looking to short the bonds of Greece, Spain, Portugal and Italy and use those proceeds to buy into the US treasuries.  Now that may seem to be the craziest trade in the world (which is why I do not plan on taking it), but it makes sense.  There is no reason to believe that US interest rates will suddenly fall from here, in fact I believe that the 10-year note will move to below 1% in the near future.  The reason for the trade is not that I want to earn 1.5% on my money for 10 years but that if the Euro collapses or Europe enters a very severe recession the increased price in these bonds will give me a windfall plus I should make a ton more money of the increased strength in the dollar.

As more and more people around the world seek safety this will continue to drive the yield on the US 10-year note down and strengthen the dollar.  While this is certainly not consensus if it does play out it will enable the US to continue to strengthen its economy in an effort to weather the storm coming from across the Atlantic.

Currency Wars

"If you can keep your head when all about you are losing theirs, it's just possible that you haven't grasped the situation." - Jean Kerr

Just in case you haven't grasped the situation, currency wars are in full force.  They have been raging for years but now things are starting to come to a head.  So while there is no blood being shed those who are supposedly allied during war are happy to fight one another on the currency front.  So what is a currency war and how does this affect anything?

Let's start with an example.  Country A has a strong economy with a budget surplus (the government spends less than it takes in through taxes), a healthy banking system, low interest rates and a stable currency.  This safety attracts investment from abroad and with this investment asset prices start to rise.  At first the rise is manageable but then speculators show up and prices start to accelerate.  The central bank now has a choice to make - let the rising prices (inflation) continue or fight them by raising interest rates.  Most central bankers try to contain inflation so they increase interest rates.  The direct impact of this is to strengthen the currency making their exports less attractive to outsiders while imports decrease in local prices.  This weakens the economy and the government slumps to a budget deficit and starts to print money to pay their bills.

Once debt reaches a high level the government has another dilemma - how does it pay down the debt while not capsizing the ship it is trying to salvage?  The normal solution is to let the value of the country's currency drop which expands exports, curbs imports and stimulates GDP growth through the resulting inflation pressures making the debt burden (whose value remains fixed) drop of as a percentage of the country's GDP.  Voila, debt as a percent of GDP falls to a manageable level restoring the country's credit rating and the cycle starts again. 

As an aside, this is why Greece cannot get themselves out of hot water as they are tied to the Euro and cannot depreciate their currency to help with growth.  Furthermore the problems at Spain, Protugal, Italy and Ireland will continue down the same path unless the Euro drops significantly in value.  The beneficiary to their problems is Germany which has seen its position strengthen due in large part to the Mark (their original currency) weakening (in relative terms) when it was converted to Euros as it was now tied to these weaker economies.

As can be seen in the European example above the problem to this is that while one country is the beneficiary of currency depreciation others fall victim to its weakness.  Their economies feel the negative effect of a strengthening currency and try to put a stop to their country's currency appreciation.  Now what if everyone around the globe has massive debt burdens and they all try to weaken their currency at the same time?  This is the situation that we are in today and the result is all out currency war.  Everyone is trying to depreciate their currency and someone has to lose.  At present the loser is the United States whose currency has been the direct beneficiary of global weakness and this is starting to show up in the United States' anemic GDP growth rate.

Today payrolls were once again weak and once again JP Morgan and the other investment bankers lowered their expected growth rate for the US to 2.0% from 3.0%.  I stated earlier this year that I believed that we would grow by 1.5% but even that is looking optimistic at present.  The problem is that while a stronger currency is not in and of itself a problem but it needs to be based on strong economic fundamentals.  If it is not (as is the current situation in the United States) it will result in slower growth, an increase in the country's debt burden and eventually to an inability to pay (this is the Greek situation).  While the UNited States is a long way from this state of affairs, to think that the market will expand from here is to not have grasped the situation.

The Dollar Breaks Out

"Money can't buy you happiness but it does bring you a more pleasant form of misery." - Spike Milligan

This week the dollar (as measured against a basket of currencies, predominantly the Euro) broke out.  As you can clearly see from the chart below the strength in the dollar has been building for some time.  This is predominantly due to the considerable weakness in Europe rather than a show of strength in the United States however what are the implications of a stronger dollar on the world's largest economy?

Typically strength in a country's underlying economy results in a strengthening of their currency.  The attraction of foreign capital to that economy results in a stronger currency but the implications are far deeper.  A stronger currency means lower rates of inflation.  Think about it, as the dollar strengthens the price of imported goods, in dollar terms, falls.  On the commodity front, as most commodities are priced in dollars, the price to the rest of the world increases.  As this price increases the demand for these items falls, once again resulting in reduced inflation to the United States.

So does this dollar strength mean that the united States economy is strong?  Well in relation to the rest of the world we are doing quite well.  Our housing market seems to be bottoming, job growth while still anemic is growing, interest rates are low and should remain low for a long time to come particularly if the dollar remains strong, this low interest rate will start to feed into positive growth and if inflation remains tame things look kind of good!

So why is the market falling if things are looking up?  The market is forward looking and while things appear to be getting better I believe that it has run too far too fast.  In addition the problems of the rest of the world can easily come and bite us right where it hurts and this uncertainty will weigh on the market.  As it looks forward, uncertainty is not a good ingredient for positive market returns.

So as long as the dollar strengthens will the market go down?  In trading these types of correlations occur all the time and are reliable until they are not -  meaning that for the present time if the dollar strengthens the market will fall but at some point this correlation will be broken.  In other words, dollar strength does not necessarily mean that the market will fall, but it does right now.  In the past a strong dollar would normally point to a strong economy which would point to a strong market, but the problem is that the dollar is not strengthening due to a strong economy but due to weakness everywhere else.

The good news is that this strength is buying us a lot of time to repair our damage and insulate ourselves as much as possible from the impending crisis in Europe.  However, as the world economy is so tightly knit it will be impossible to protect ourselves completely from any fallout in Europe (just look at the JP Morgan mess) meaning that the risks in Europe will weigh on the market regardless.  So while it certainly appears that some of the underpinnings of a good economy are being put in place, if there is a hurricane from Europe our tent pegs will not hold down a half erected tent and it seems that it is only a matter of time before that storm hits our shores.

The Market Takes Strain

"I had not, it seems, the originality to chalk out a new road to shame and destruction, but trode the old track with stupid exactness not to deviate an inch from the beaten center." - An except from Charlotte Bronte's Jane Eyre

The above quote is one that a lot of us can use but right now it mostly applies to the global leaders and the central bankers of the world.  Whether they admit it or not we are heading towards a problem the like's of which have not been witnessed for almost a hundred years.  Trying to fix a debt problem by printing more money and increasing the debt level just will not work.  I have repeatedly mentioned this through my blogs but it appears that the central bankers of the world disagree with me and others who think like I do.

Even though we are running a fiscal budget deficit of more than a trillion dollars (and it appears that this deficit will continue to run for years to come) there has been no real expansion to the eeconomy.  I would agree that housing seems to be bottoming and that the stock market has been on a tear however the problem behind all of this is that printing money has not created an economic base that can sustain any growth.  Remove the juice from the Federal Reserve and we crater.  The problem is that when you print money you have no control of where it goes and so bubbles are created in areas that are not condusive to long term growth. We should know, our central bankers have been printing money for more than a decade now and the result is an ever larger problem.

An example of this is the fever associated with the Facebook IPO.  The launch was heralded across the globe and the company ahs raised over $16 billion giving it a valuation of over $100 billion.  The fact that it is trading at a price to earnings ratio of over 100 at its launch brings me back to the heady days of the Nasdaq bubble.  I have heard people rage about how it will be the first trillion dollar company, but how many other social netowrking sites are there out there?  If they have nto realized revenues off their subscriber base by now how will giving them $16 billion today help that endeavour.  It once again seems that the money printing has resulted in money being wildy speculated on a company in the hopes that it is the salavation of every investor.

The first quarter of this year is a case in point.  While the governemnt reported that the economy grew at a rate of 2.2% most if not all of that growth came from the automobile "sales".  I say "sales" as digging into the numbers reveals that most of these "sales' were just pushing product onto the dealerships floors rather than to the consumer.  Stripping this out takes growth down to around 1.0%.  This is the number that I believe is an accurate reflection of our growth prospects as long as the large government debt looms above our heads.  Not that the number in and of itself is a problem but as a percent og GDP it is.  Add to this massive budget deficits of more than a trillion dollars a year and you can see why we will rapidly blow well past debt of 100% of GDP in the years to come.

Now that is bad enough (and is the only reported number), but when you add in the problem of the aging population you then have to factor in the drains of the baby boomer population on Medicare and Social Security.  These holes take our total debt to $200 trillion.  This number is supported by a GDP of $14 trillion so in balance sheet terms we have leveraged ourselves 1,400 percent.  Try doing that as an individual and see what happens to your credit rating!  Also try doing that and then try getting another loan!

This is the problem that desperately needs to be fixed and it needs fixing now.  European problems are allowing us the time to get our economy in order as no matter how much money is printed the dollar remains strong.  Looking across to Europe it appears that we have a number of years before anyone looks our way, but believe me when they do they will not be happy with what they see.  If interest rates suddenly spiked, the bleed on the Treasury would consume most of the revenues to the government and would result in a continued deficit.  This is why it is imperative that the Federal Reserve keep interest rates low for the foreseeable future.  Keeping these down allow them to leverage the balance sheet to buy time to repair the damage to allow continued confidence in the US economy.

It is a conundrum and not one that is new however, with all the world's problems it is rapidly being exposed as the problem that it always has been and it will require a leader with vision to turn it around.  Looking therefore at the political landscape, our coming options are not good which means at least four more years of the same.  Cutting taxes will not work.  How can you cut your revenue to pay down your bills?  To take this to an extreme if you pay no tax how does the government pay its bills?  This idea that lowering taxes creates jobs and stimulates an economy looses merit at these levels of deficit.  Increasing taxes also does not stimulate growth.  So raising taxes is not the best policy either.  Cutting spending will become harder and harder to do as a smaller and smaller piece of the budget is going to actually running the government while almost 90% is being used up through Medicare, Social Security, interest payments and defence.  What is needed is to take a long hard look at our obligations, bring them to the forefront of debate and take them head on.

To do this requires a visioanry that can get the public to understand that pain must be felt all around in order to protect what we have created.  Pushing the can down the road has not worked.  In fact it has resulted in the current mess.  Socialism has seen its flaws revealed, communism with an open market will not work and while democracy is under attack the clear point is that free markets have not been the order of the day but rather a manipulated market has been tried and has not worked.  We are treading the tried and true path to massive problems and the rolling over of the stock market is beginning to show the cracks.

What are Commodity Prices Telling Us About the Future?

"Advice is the only commodity on the market where the supply always exceeds the demand." - Unknown

Having traded commodities for years I love to refer to them to get a few clues about where inflation and global growth are headed.   As commodities are the raw materials required by all economies of the world, their prices reflect as pure a demand and supply curve as can be found anywhere.  Obviously there is also a lot of speculation and at times manipulation of commodity prices but by and large the globally traded commodities of gold, copper and oil provide a very good insight as to inflation and global growth prospects.

I will start with a look at the price of gold.  Gold is thought to offer a hedge against inflation and is used in as a wealth protector in times of fear of global armegedon.  At present it appears that with fear of a global meltdown subsiding that most of the price is reflecting expectations of inflation.

The chart above shows clearly that gold has broken down giving a clear picture that the prospects of global inflation are muted.  I know, I know, the price at the pump and the price at the grocery store and on your insurance premiums are going up quickly, but that is not what comprises the entire basket of products that you consume.   So if inflation is muted that must mean that the input prices are coming down in price.  Well one of the main contributors of inflation is oil and the following chart will show you one of the major reasons why gold is falling in value.

The crude oil chart, while not completely broken is on the verge of breaking down.  This should translate into reduced prices at the pump and this will also, in time, feed through into other prices.  The caveat with oil is that prices can spike at any moment due to unrest in the middle east or any one of the oil producing states.  As there always seems to be a high probability of this happening prices can spiral higher at any time however what this does point to is the potential that demand does actually exceed supply and this could only be the result of weakening demand as the supply of oil is relatively stable.  So let's look at global growth prospects and there is no better guage of this than my old friend doctor copper!

High grade copper is used in everything and its price directly reflects global demand and this demand is based on global growth.  No economic growth and the price drops quickly, resume global economic growth and the price rises.  As you can see it appears that the price of copper is coming under strain and this points to a global economic slowdown.  This also confirms the above presumptions that point to lower inflation and hence lower prices in gold and oil.

Now these commodities are not necessarily linked together, in fact there is often a time when they are not moving in tandem, but looking at these charts shows that on the commodity front that the future points to lower inflation and anemic global growth and this is further confirmed by weakness in Europe, China and the United States.  Until these commodities point to global growth it appears that the slow grind to economic health will continue for a long time to come.

So if global growth is anemic and inflation is coming down there is no reason that interest rates will rise any time soon and furthermore there is no reason that stock prices will continue their march north.  There is a high probability under this scenario that stock prices bumble sideways for a long time or, if Europe cannot contain their problems, that they are met with a large downdraft.

China An Economic Superpower?

"If basic economic, political and legal reforms left undone since the 1980s are not addressed....China's onward march will be hobbled, and the world as a whole will feel the consequences as the snake tails wrap themselves around the tiger's head." - Hindustan Time

There is much debate about China's rise to supremacy particularly when it comes to being an economic superpower.  This has been highlighted by their taking the number two spot from Japan, their massive global reserves and their dauntingly large population.  The theory goes that it is not a matter of if China will become the next economic superpower but when?  Some say that this will happen by 2020 but I have to admit that I find that hard to believe and in all honesty I do not see them as an economic threat for at least the next 20 years.  My reasons are numerous and in this blog I will list what I see as sufficient hurdles to becoming an economic superpower that will hinder any meteoric rise into the world's premier economy.

Certainly they have the population size and drive to get it done.  They also have a vast pool of cheap labor and this too will allow growth however underneath this large population is a very troublesome issue - the one-child policy.  This policy was introduced in 1978 and has remained in effect through today.  According to reports this has reduced China's population growth by more than 400 million.  The main problem with this limitation is that by 2020 China will have a baby boomer style population with more of the population in the 35 and above age category than below.  This starts to become really top heavy by 2030 as you can see in the chart below and we have all seen the problems associated with supporting a large ailing population with a smaller younger population.

 
For an example look no further than the stresses that are being placed on social security and Medicare in the US and you can see that this will result in the first problem to China's financial resources in the relatively near future.  This will also have a large effect on the wage rate as less workers will be required to do the same amount of work and pricing power will start to shift to the labor force creating a problem for their manufacturing machine.  Already wage rates are creeping up and, based on this demographic shift, look to continue to accelerate into the future slowing the mainstay of their growth - their manufacturing competitiveness.

The next issue is the lack of economic transparency.  The press is full of reports of trademark and intellectual property theft.  Until this and the laws of the country are cleaned up and considered protective to the investor there will not be enough trust to become a global superpower.  Sure plenty of money is being poured into the country to take advantage of the country's burgeoning rich population, but that cannot translate into an economic superpower until the laws protect investors and there is a safety net of transparency.

Investing in Europe or the United States comes with risk but there is a level of trust that while certain individuals may try to swindle the investor that overall the market is honest and regulated plus there is a vast amount of transparency particularly when it comes to government debt.  Do not get me wrong, I still believe that a lot of the numbers are manipulated on either side of the Atlantic but at least there is some form of accountability and liquidity to the market whereas there is always a fear in China that the market will be closed at any second should something untoward happen.

The next issue is that to become an economic superpower you need a large and liquid debt or bond market.  This does not exist in China at present.  In order to become an economic superpower you need to have your currency widely distributed around the globe.  Look at the dollar, it is everywhere and is often used as the local currency during times of crisis.  It is stable and readily available and this is due in large part to the massive bond market and government debt market.  Through this medium dollars can easily be exchanged in vast quantities around the globe.  Second to the dollar is the Euro and then the Yen while due to the closed market economy that China prefers at present there is little in the way of Renminbi in global circulation.  There really cannot be any significant circulation until the currency peg is released and the markets open up.  I cannot see this happening any time soon as the Chinese government continues to control all aspects of the market with an iron fist and as far as I can see they will continue this trend for the foreseeable future.

Finally while there is no requirement to be a democracy there has never been a closed political body with an open economic environment that has lasted and become a global economic superpower.  Russia tried it and failed and the cost to their economy was horrendous and I just cannot see it working in China.  Something has to give.  With the handover of power coming soon there is a chance that the new leadership will promote a more open political and economic environment, but the time that it will take to implement all of the requirements to become a global economic superpower I believe will confound even the might and desire of the Chinese for years to come.  So while I agree that they are an economic force to be reckoned with, the step to becoming an economic superpower is a long way off.