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Economic and Strategy Update
Q4, 2004
The US: imperial dilemma
Executive summary and conclusions
This
update focuses even more than usual on the US than on other countries or
regions of the world because events are moving rapidly and it is the situation
in the US more than elsewhere that is driving those events. American decision
makers successfully siezed the initiative after 911 but are losing it. Our
opinion that the US War on Terror is in fact part of a global offensive to
ensure American hegemony ought not to be controversial. The US is, after all,
just another country, and the problems it faces are not unique. Others have
faced them at different times and different places. What makes them unique is
that these are our times, and we have to live with them.
It
is our belief that 2005 is an importatn turning point for makrets and that we
have embarked in January on the first leg of a resumed major bear market in
equites. In brief, the following presentation seeks to show the following:
* World demand continues to be strong.
* However, the rate of industrial output growth peaked in the
third quarter last year.
* Signs of tighter liquidity are emerging.
* The chances of a sharp slowdown later this year are rising.
* Inflation is likely to break higher.
* The US has entered a debt trap.
* The solution it has evidently chosen is to force the
adjustment on to the rest of the world.
* Our central scenario calls for a wider war in the Middle
East and increasing tension with Russia and China.
* The world's uncertainty premium is rising fast.
* Stocks are overvalued. Bonds are undervalued, but cash even
more so. The dollar remains very vulnerable.
* Credit spreads and emerging markets are vulnerable to an
accelerating fall in major equity indices with resultant margin calls forcing
other markets down.
* The Fed is caught in a dilemma of its own. It needs to
facilitate the financing of US credit demand, but is running out of room to
manoeuvre as inflation rises. The former has to take precedence, hence the path
of least resistance for inflation remains up.
* It is likely that we have made an important peak in stock
prices this month (January '05). We see no reason to expect a recovery before
mid year, possibly longer.
* When you think Bush, remember Richard Nixon.
Market performance, 2004
In local currency terms, the US and Europe paced one another
for most of 2004. As it happens, our view from Q2 last year that it was time to
step aside from the stock market proved to have been premature.
Having said that, our view that in dollar terms the US market
would underperform and that emerging markets would outperform was correct, with
the gap between the two rising to more than 15% by year end. The fall in the
trade weighted dollar had a very big impact, while rising commodity prices
favoured the resource exporters of the developing world.
Global bond returns in dollar terms were similarly affected
by the dollar fall. Our views on relative performance proved out, although our
caution from mid-year on emerging markets and credit spreads has proved
premature, to say the least. Nevertheless, risk-reward does not favour those
sectors for the same reasons that it does not favour stock markets, as the
shakeout in the first trading days of this year has proven.
Gold put in a relatively poor showing in 2004, falling well
short of the $500+ level we thought attainable by year end. This was not
because of the economic forecast, which was validated by the sustained increase
in oil and industrial metals prices. We think, rather, that the gold price is
still being managed along with currencies, making the timing of its rise more a
political question than one of supply and demand. Agricultural commodities gave
a poor return last year after double digit rises in 2003. This should reverse in
2005 as higher fertiliser and pesticide feedstock cost feeds through to final
food prices.
The dollar spent most of the year in a corrective mode,
before extending its declines in the second half. As the short term chart above
indicates, it is now in interesting technical territory; testing its downtrend
very near the all time low levels reached in the middle 90s. In the very short
run, it is hard to say which way it goes. Longer term we think that the
probability of new all time lows being reached in 2005 is very high. In the
late 80s the dollar staged a corrective rally of some two year's duration
before resuming its downtrend into the middle of the next decade. We think that
the risks of such a rally occurring today are lower than they might otherwise
be ffor reasons that we will develop below.
Economy
Output and demand
There is little sign of a world economic slowdown to judge
from real factors.
Take oil, for example. Demand is remorselessly growing. In
the above charts, we have had to adjust Eurozone and Japanese import figures
for exchange rates and per barrel oil prices to arrive at the quantitative
approximations shown above so that the data is comparable with those countries
that report oil trade in quantitative as well as monetary terms. Japan is the
exception that proves the rule. The Japanese have proven quite successful in
limiting their demand for oil, but to the extent that corporate Japan has
relocated production in China or elsewhere in Asia, this simply represents a
displacement of demand, not a global saving.
Steel production is skyrocketing. What appeared to be a
developing peak in output in the spring of 2004 resolved itself in a surge to
new all time highs in October. Output is simply following price; scrap steel
prices have more than doubled on a year ago, and the amazing thing is that
these sorts of increases appear to be sticking. There is simply not enough
scrap to come close to filling demand, hence the increases in new steel output.
World shipping rates have remained quite firm, and as proxies
for activity reflect the strong increases in energy demand and real output. In
our view this also reflects changes in patterns of global production.
Production is becoming more regionally specialised, with components being
manufactured in disparate locations and shipped to assembly centres from which
the final product is shipped to distributors. The increase in demand for
containers and shipping therefore displaces historical inventories because
parts are being "stored" in transit. It is a highly complex system
that appears quite flexible; in fact that apparent flexibility masks a very
real rigidity. Anything that might disrupt a point in the supply chain will
have outsized effects on the system as a whole.
Liquidity
All this has been very much at odds with our expectation of a
peak in world output growth by the fourth quarter of 2004. A reason for the gap
between expectation and reality is a gap between rhetoric and policy. American
monetary policy at least has not been as tight as the talk. Having said that,
our model of Big 3 real broad money growth and industrial production suggests
that we were right on target.
On a year on year basis, US, Eurozone and Japanese industrial
output growth combined peaked in September before falling precipitously. Real
broad money growth slumped in the first two months of the last quarter of 2004.
A look at the Big 3 breakdown shows that output growth in
Japan and the Eurozone has slumped. Of the three areas, Japan has been the
"tightest" and Europe the "easiest." The US has barely
begun to snug. Taken together, the picture that emerges is of a world
industrial economy that is more fragile than the raw output numbers suggest. A
real move to restrict liquidity on the part of the central banks could well
cause a collapse.
This is why the year end drop in the US monetary base is of
interest. A fall in the monetary base is not always associated with recession,
but recessions are always associated with a fall in the monetary base.
Coupled with a fall in consumer credit in November, it
appears that liquidity is gradually tightening. Although bank consumer lending
picked up in the last few weeks of the year, associated with the holiday
season, consumer credit outstanding has been contracting year on year for over
two years.
Global dollar liquidity growth continues to be strong, with
the rate of growth cooking along at more than 17% year on year. the reason that
this did not fall in December was continued intervention by Asian central banks
which reinvested the proceeds in Treasury and Agency securities.
Note, however, the fall in foreign custody holdings at the
fed in the first two weeks of this year. Any fall in foreign official holdings
is of great interest because of the voracious American demand for credit. The
nation's current account deficit is, in effect, its finance gap. That is to
say, it is the difference between the cash needed to meet current liabilities
and the cash available from savings. Although they are not identical, this
tracks the country's trade deficit closely.
The trade deficit is exploding, hitting just over $60 billion
in December or more than $720 at an annual rate. To get a feel for just how
fast it is growing, consider the following chart showing its year on year rate of
increase:
It is often suggested that the "problem" posed by
the trade deficit is not a problem at all, since the US can "just"
devalue and anyhow, as a percentage of GDP, it is not critical. Both of these
ideas are silly for a variety of reasons, but two stand out. For a country so
dependent on foreign manufactures and resources, to devalue significantly
implies an equally significant loss or purchasing power; in other words, a loss
of real wealth with all the domestic and international political implications
that entails. The second reason is related: the loss of manufacturing jobs and
plant closures - in other words, America's deindustrialisation - means that the
US has not the capacity in the short to even medium term to redress the problem
because it simply does not have anything to sell. This is a significant
downside of allowing the economy to become so tilted toward finance. It loses
economic flexibility and the range of policy options that flexibility implies,
a point we shall return to later.
One of the striking features of this issue is the breadth and
depth of the problem across all sectors of the economy. There are only two
trade sectors in which the US is currently running a surplus, and the
larger of these, services, is due to move into deficit itself by the end of
this quarter on the present trend. The other, agriculture, fell into deficit in
mid year last year for the first time in American history. Although it has
since recovered somewhat, the implication is clear, and ominous. Nor is the
outlook brighter on a regional basis: the US runs deficits with all significant
regions of the world.
Another way of looking at this issue is to look at the US
finance gap by sector:
The numbers are troubling. Neither the public, corporate or
personal sectors are generating net savings and have not done so for two years.
This is no flash in the pan, it is a conflagration. The personal numbers are
troubling not just because they are in deficit, but because share and bond
ownership is concentrated at the upper end of the income spectrum.
Therefore the gap between earnings and the cost of living is especially large
for the majority of the population. It also means that the population cannot
come close to making ends meet by working, no matter how hard they try. This is
impossible; something has to give.
Inflation
It is useful to bear in mind that what market economists and
the media call inflation or deflation is are not what is meant by inflation in
a strict sense. The popular usage of the terms refers only to the price of
goods and services. Strictly speaking, this is incomplete. The price of
everything that is exchangeable for money should be considered. It is easier to
state this than it is to calculate a meaningful measure, but in the modern
liberal capitalist market economy, it is true to say that a bond or a share is
a substitute for a bunch of bananas or an automobile. They are excluded from
the calculation of inflation for entirely arbitrary reasons. Money creation by
the world's central banks led by the US Federal Reserve has, just as theory
suggests it should, driven the price of both financial, physical and
manufactured assets upward. What has fallen over the last twenty five years,
has been the rate of appreciation of internationally traded goods, which in
turn has caused the broader indices of consumer rice and producer price
inflation higher. That, we think, is about to end.
Note, to begin with, equity and commodity returns. Commodity
returns are inflated buy the use of the Goldman Sachs commodity index which
calculates a financial return inclusive of carry, but the comparison is
nonetheless astonishing.
The crucial variable will be oil, which much of the market
seems to believe will average significantly lower in 2005 than 2004. The only
way we see that happening is if we see a significant global slowdown, soon. Oil
has moved a long way, but could well move a lot further.
It takes around 30 barrels of oil to purchase one unit of the
S&P 500. that merely winds the price clock back to where it was in 1995-96
when the dollar collapse prompted the US to stage a policy u-turn and encourage
the so-called strong dollar policy, which is just another way of saying the US
got the Japanese to support the dollar by creating huge amounts of yen.
World inflation rates are picking up. If oil stays firm and
goes higher, these will very likely break out to the topside.
Politics
Doubling the bets
The US faces a basic structural dilemma. On the one hand, the
political economy is based on the twin pillars of cheap oil and cheap credit.
Both are based on the use of the dollar as the world's store of value and
transactions unit for international trade. This has allowed a vast inflation of
the country's liabilities without reference to a need to re-establish
equilibrium prices with the rest of the world. It is the rest of the world that
has had to accommodate the US.
The debt inflation has financed a fundamentally uneconomic
industrial structure dominated by the national security complex with a
cost-plus acquisition methodology, creating a positive correlation of profits
to costs. Three opportunities to reform and restructure the country's
industrial base have been foregone. The first after the Korean War, the second
after Vietnam, and the third after the collapse of the Soviet Union. This
enumeration is useful because it makes the point that were there any
intention of reform, the chance has been there to do so under relatively benign
conditions when American prestige and relative economic power were both at
highs. Neither condition applies today.
At the beginning of this period the US was a net exporter of
oil. No longer. Nor is the US the world's leading manufacturing nation. It
leads in the perception of military power, but that power can be circumscribed
as the Iraqi resistance is demonstrating daily. Like the British Empire before
it, the US is dependent on creditor nations of uncertain allegiance to validate
its balance of payments deficit. This turned out badly for the Empire, and
there is no reason to believe that it will not turn out badly for its American
successor. The US managed an imperial role relatively cheaply as long as it had
the good will of the key industrial nations of the West. Not even that seems
assured today.
As long as the prevailing view in Washington is, as Dick
Cheney puts it, that "we proved that deficits don't matter," then it
is unlikely that the US will change course. That course is being steered on the
heading set by Rumsfeld's dictum, "If you have an insoluble problem,
change the terms of reference." In other words, if you have problem,
create a bigger problem. The problem of industrial competitiveness was not
addressed by addressing the cause of the problem but by forcing the workforce
to accept a role as a cost variable in one direction only: down. As in other
periods of American history this is being accomplished by allowing massive
immigration. The inevitable international tensions that this raises as the
country becomes more and more dependent on foreign lenders is to insist that
this is a US sacrifice for the good of the rest of the world. This plays well
in some quarters in the US but less well to the audie nces in the lending
countries and elsewhere abroad, who correctly perceive that the logical
consequence of such policy unchecked is war.
This is the context in which the so-called War on Terror is
being waged, and it is manifestly and indeed self-evidently the case that it is
being pressed in order to change the international terms of reference by
placing America and her dwindling band of allies in a position to control the
distribution of energy worldwide. It is a brash repudiation of free markets;
access to oil is not the issue. Saddam sold to the US right up to the end. Hugo
Chavez does likewise. The issue is control, because without it, the US will be
forced to come to terms with its own need to reform.
The issue for investors is not the rights or wrongs of this
but the consequences. The least that can be said is that the world uncertainty
premium has gone up by a lot. Indeed, it is much higher in our opinion than
during the Cold War, when at least the terms of engagement were understood and
to a great degree formalised. What is at stake is the very international system
that has underpinned market valuations since Bretton Woods: acceptance of the
dollar. Not since Sterling abdicated its role has a change of such fundamental
importance occurred. It was no more self-evident to the British then that the
Empire was lost than it is to the Americans today, and in some respects one
could say the stakes are higher for the US. Will it be willing to negotiate a
solution, or will it seek to enforce one? The former strikes us as inevitable
at some point, while the latter process is at best a preliminary step, the
meaning of which is that the US will negotiate only on its terms. That is, of
course, if it gains control of the world energy net. To do that it is not to
the Persian Gulf that our attention should be drawn, but to Siberia. The stakes
are high indeed.
PS: Remember Richard Nixon
The similarities between today's incumbent and Nixon in 1972
are interesting. Bush has his war, Nixon had his. Both prevailed in very dirty
elections. Bush like Nixon has many skeletons in his closet that could be used
to embarrass or destroy him. Bush like Nixon has polarised the country. And
like Nixon, Bush faces a very similar economic conundrum but with less going
for him. Bush may well be more vulnerable than he looks today.
