FT Alphaville: The renminbi black swan

FT Alphaville ran a piece yesterday that reinforces a couple of previous posts on the Baltic Dry Posse blog.

Take $1,500bn in Chinese dollar reserves, add generous dollops of concern about currency debasement, mix in a shopping spree by the Chinese state. Then scream.

At least, you should be screaming if your life savings are in dollars.

Given the volatility and continued uncertainty underlying currency, commodity, equity and bond markets, rebasing helps us frame broader changes in capital markets.

It would seem that the Chinese are doing more than just analyzing: they're actually rebasing their currency.

The piece speculates that Chinese hard asset purchases are a dollar hedge that positions for long-term yuan convertibility:

No, the Chinese are buying, they say, because they are quietly tip toeing away from the dollar and hoping that no one else will notice:

"The investment community is waking up to the reality that China is buying hard assets (gold, precious metals, oil, copper/ally etc) for more than simply industrial purposes. They have $1.5tn in $ reserves. They understand the $’s day as a reserve currency is over and hold the biggest key to future debasement: full Yuan convertibility."

It's a speculative analysis, and a lot has to happen before the US$ is no longer the reserve currency. But it is consistent with public statement and investment activity alike.

Legislation of Unintended Consequences

In previous posts, we've raised concerns about Cash for Clunkers. An aritcle on the back page of the Company's and Market's section of Monday's FT points out that those concerns are being realized.

For one thing, we pointed out that Cash for Clunkers doesn't create sustainable demand for automobiles: it simply pulls demand forward. The uptick in demand is a short-term blip, not a resurgance of the auto market. As the FT wrote on Monday:

The incentives, however, have advanced many car purchases, and the industry is bracing for a hangover.

For another, this piles debt onto consumer balance sheets that are already over-extended:

Furthermore, a sizeable number of cash-for-clunkers participants have buyers' remorese as they contemplate hefty payments on their car loans, according to CNW, an Oregon-based market research firm. Those payments "could negatively impact the total family budget more than expected prior to buying the new vehicle", it reported.

Finally, like all forms of legislation, there are unintended consequences. While Asian and European automakers have assembly facilities in the United States and are subsequently important employers, domestic automakers employ far more US taxpayers. On top of it, GM and Chrysler are, for all intents and purposes, taxpayer-owned. Strangely, the policy appears to have become a transfer payment from the US taxpayer to firms and people outside the US.

The scheme had another unexpected outcome. Intended to benefit Detroit's three hard-pressed carmakers ... it helped their Asian rivals, such as Toyota and Hyundai, even more.

Were these outcomes "unexpected"? No, they weren't unexpected. "Embarassingly disappointing" would be a more appropriate choice of words.

FT Op-Ed: Iceland shows the dangers ahead for us all

Last week, we posted an analysis on the Baltic Dry Posse pointing out the similarities in the economic situations and way forward for Iceland and the US. An op-ed piece in yesterday's FT by Robert Wade, a professor of political economy at the London School of Economics, concluded much the same:

This is a postponed crisis. When the government brought in the International Monetary Fund in late 2008 the IMF prescribed deferring the pain for a year. Now the pain is coming.

There has been a freeze on mortgage repayments in Iceland, similar to US banks being voluntold to reduce residential foreclosure in recent months. Iceland is cutting government spending (which the US is not), but it is increasing taxes (which the US is, in many different forms). Iceland is taking on new soverign debt to the tune of 50% of GDP just to cover depositor losses in Icesave, an Icelandic bank operating in the UK and The Netherlands. The US is similarly taking on significant soverign debt.

Mr. Wade continues: "As the summer tourists go home commerce will slow and unemployment will rise." Substitute "government transfer payments" for "tourists" and you have the US "stimulus" spending; tourism is a transfer payment in another form.

He then concludes:

[T]he news from the canary in the coal mine suggests people in other vulnerable economies in America and Europe should enjoy the good economic news while they can. There are good reasons to think it may not last.

Which is very similar in sentiment to what we wrote last week:

[E]ach nation is facing a long economic detox on the heels of credit-fuelled spending benders. And that is going to have significant, long-term impact on what both "stabelization" and "recovery" eventually shape up to be.

Changing the Frame

Back in May, John Authers wrote a column in the FT recommending that we change the frame when looking at market performance. For example, if we denominate the S&P 500 in sterling, euros and gold, the index has performed much more poorly over the last decade than it has in dollar terms.

Given all the market volatility in recent months, it's worth doing a similar analysis of how markets have performed since the March lows. Instead of gold, we'll use oil. Like other commodities, oil is being used as an inflation hedge. It also has significant intrinsic value, whereas gold has very little.

In dollar terms, the S&P 500 has gained significantly since it's bottom on 9 March. But currency fluctuations take a 15% edge off those same returns. In oil terms, equities show no change since bottom. Indeed, while equities and oil have followed different paths, oil and equities yield the same over that period.

While we're at it, there's another market phenomenon worth taking a look at. Most of the gains made in the history of equity investing in the DJIA have been made on just a few trading days. The CXOAG blog points out that the 10 best trading days in the history of the DJIA account for 65% of terminal wealth, while the 20 best trading days account for 83% of terminal wealth. (Just as importantly, avoiding the 10 worst trading days of the year would boost wealth by over 200%, but that's a separate analysis.)

Let's apply that thinking to the beginning of the equities rally. Suppose you didn't call a bottom on Friday the 6th, but instead jumped into the market on Wednesday the 12th.




We see that top-10-day phenomenon at work. Returns across the board are significantly lower, primarily due to changes in the index.

Currency fluctuations have a bigger impact on yield. Between 9 and 12 March, the S&P 500 jumped nearly 75 points. But market uncertainty kept demand high for US Treasurys. This kept the USD strong, and the exchange rate changed only from $1.2586 to $1.2719 during those few days. However, since then, the USD has slid considerably: from 12 March through today, the EUR-denominated investor is up on US equities, but not nearly as high.

More interesting is that the S&P has underperformed oil by 10%. If we think of oil as an inflation hedge, this is not a positive indicator.

As Mr. Authers pointed out in May, "Financial markets are not as efficient as many believed, but they can adjust swiftly when anomalies are exposed." Given the weakness of the dollar and the strength of commodities, US equity indexes framed in USD may not be telling a complete story. Restated, there may be significant market adjustments brewing in one dimension or another.

Urgency rather than naivety

Back in June, we blogged that China was buying commodities as a hedge against US inflation. According to last Friday's Short View column in the FT, there is evidence to suggest that China is reducing its dollar exposure via commodities:

China reportedly made the largest cut to its Treasury holdings in nine years in June, providing more circumstantial evidence that ti is heading for the dollar exits slowly enough to avoid starting a stampede in which it, too, would be trampled.

China's comodity-buying binge could also partly reflect these fears.

Its lack of concern about almost single-handedly driving up prices could reflect urgency rather than naivety. Imports of copper, oil and other commodities have set records as demand slumps elsewhere.

More significant have been tens of billions of dollars of debt and equity investments in oil, iron ore and nickel producers, giving China companies a claim on vast quantities underground.

The implied urgency of their move into commodities on this scale suggests they have reason to believe that inflation risks are significant.

FT Alphaville: The shape of things to come is probably not 'V'

Earlier this week, FT Lex ran an analysis of the national debt spiral that appeared. FT Alphaville subsequently posted a piece analyzing the US household debt burden. The Lex and Alphaville analyses provide a complete set of supporting data for the points we made yesterday on the impact the debt burden will have on the US economy.

The Alphaville piece cites a report from Bank of America-Merrill Lynch economists who assert US households need to retire considerable debt - between 4.5% and 15% in consecutive years - to get debt-to-income ratios back in line with historical measures.

They conclude:

Either way you look at it, US households will remain mired in a period of balance sheet repair. And the continued debt elimination necessary to reach a more sustainable household balance sheet means that the ability of the US consumer to lead the recovery on a sustained basis will be limited.

Indeed.

Debtor's Prison

Back in June, Breakingviews.com ran a story by Rob Cox analyzing Iceland's situation. Among other things, its citizens took personal loans denominated in foreign currencies that have become extraordinarily difficult to service due to the collapse of the krona. The household debt burden is high: 8 out of 10 households have inflation-pegged or foreign currency denominated mortgages, while 4 out of 10 have car loans similarly denominated in foreign currencies. The story doesn't get much better from there. Wealth has been wiped out: their stock market collapsed from 250% of GDP to 16%. They're carrying a significant national debt, of some 120% of GDP. And they're facing a budget deficit of 13%.

The piece goes on to point out that the only way out of "debtors prison" for Iceland is through growth, and Mr. Cox details their growth prospects in fishing, energy, tourism and technology. (I'm pleased to note that his analysis is structured similarly to an article we posted to the Baltic Dry Posse on how the US must service its debt that appeared a few weeks prior to the Breakingviews.com article.) Mr. Cox's conclusion: however the Icelanders go about doing it - exporting more fish or legalizing cannibis and growing it in geothermally heated hothouses - they have a lot of good old fashioned hard work in front of them to get out from under their debt.

Contrast the analysis of Iceland with some data in Monday's Lex column, Deficit attention disorder:

In 20 years, [US] debt to output reaches either 65 per cent if tax cuts expire or 136 per cent if they continue. By 2050, it reaches 127 per cent or 321 per cent, respectively, and becomes self-perpetuating.

Like any debt, the sooner the insidious effect of compound interest is checked, the less painful it will be. But even reversing earlier tax cuts and avoiding expensive new programmes will not be enough. The CBO calculates that a permanent spending cut of 8 per cent of output today would be necessary to simply stabilise borrowing in the long run - equivalent to eliminating all military spending plus healthcare for the indigent overnight.

US citizens didn't take out loans denominated in foreign currencies. However, the substantial foreign ownership of US soverign debt and high commodity prices (caused in no small part by a weak US currency) create transfer payments that bleed wealth out of the US economy. Although less burdensome than the foreign-currency-denominated loans the Vikings have to make good on, the situation is quite similar: US citizens are pretty deep in the red. Of course, the Fed could fire up the printing presses and monetize the debt, but that introduces an entirely different set of catastrophic dynamics.

The US is not likely to become Iceland. It's domestic market is stronger and it's economy is far more diverse. But add the fact that household debt stands at 130% of disposable income to the debt projections published by Lex and the fundamentals are the same for Viking and Yankee alike: each nation is facing a long economic detox on the heels of credit-fuelled spending benders. And that is going to have significant, long-term impact on what both "stabelization" and "recovery" eventually shape up to be.