Some Fear the End of the World as We Know It

August 5, 2011

Investor psychology is best summed up in hit song titles sung by Barry McGuire, Eve of Destruction, and R.E.M., The End of the World as We Know It.  The current mood is reminiscent of September 15, 2008 – March 9, 2009, the span of time between the failure of Lehman Brothers and the day that share prices finally stopped tumbling.  Back then, risk aversion pummeled commodities and commodity-sensitive currencies like the Australian dollar against which the U.S. dollar advanced 30.6%.  Oil, which has fallen about 25% since end-April, plunged twice as much (53.5) during that earlier period.  To hedge the risks of extreme uncertainty, investors bid gold up 20.4% and sought out the yen and dollar, which proved to be good foul-weather paper currencies.  The greenback rose 13.3% against the euro from $1.4222 to $1.2554 but lost 9.3% against the yen, sliding from 108.0 to 97.9.  The Swissy was also favored and eased merely 3.2% against the U.S. currency.

The current panic has different immediate causes from the outbreak three years ago, but the problems are linked in an inevitable evolution of balance sheet adjustments.  Rampant recession fever in present times emerged from a perfect storm of factors: a sequence of weak economic data, the U.S. debt deal, political and fiscal disarray in Italy, and policy initiatives by Swiss and Japanese officials to cap rises in the franc and yen.

U.S. real GDP advanced only 0.2% per year over the four years between 4Q07 and 4Q11 and, despite loads of monetary, fiscal and unconventional stimulus, 2.5% per annum over the first two years of the present business upturn.  U.S. politicians are low on ammo and lack ideological will to sustain assistance while private sector balance sheets continue to be reduced.  Similar to Japan, no evidence yet confirms that the U.S. economy can be sustained without such help.  As a long-time watcher of Japan, that’s been a huge worry of mine since 2009.  Consumption in the period ahead will remain hostage to stagnating incomes and high unemployment.  Businesses will not invest without better sales prospects even if they perceive friendlier tax and regulatory policies.  The U.S. and much of Europe already seem to be moving at just over stall speed.

The silver lining of Europe’s debt crisis until now is that such was confined to small so-called peripheral countries, and much of the motivation for the series of aid packages came from the the desire to shield the crisis from Spain, the group’s fourth biggest economy.  Spain’s economy is 91% larger than Ireland, Greece and Portugal combined.  Italy’s GDP exceeds Spain’s by 46%, and its debt is 189% larger than Spain’s and about a quarter of the entire euro area debt.  Spain was considered too big in Euroland to fail, while Italy would be too significant to the world economy to fail without catastrophic repercussions.

When currency intervention halts an adjustment that would occur otherwise, other financial markets must bear the strain.  At an emergency meeting at the Louvre in Paris in February 1987, G7 officials agreed to use interest rate adjustments, intervention, and other policy tools to stop the decline of the dollar.  The depreciation had been promoted by the Plaza Accord seventeen months earlier, so those two agreements served as bookends to a concerted plan to make the dollar more competitive and to reduce current account imbalances.  As 1987 later unfolded, however, economic policy tensions mounted steadily between the United States and Germany.  Investors sensed a commonality of interests that was unraveling between the two nations, and long-term interest rates bore the brunt of market pressures that couldn’t vent in the currency markets.  All that potential energy suddenly shifted in October 1987 to equities, and the Dow famously plunged 22.6% on the 19th of the month.  That blowout, in turn, freed the dollar to depreciate considerably in the final 2-1/2 months of the year.  The moral of this tale is that major intervention operations imposed on an unsettled financial landscape can unleash unexpected and undesirable consequences.

Based on the events of late 2008 – early 2009, the dollar’s near-term prospects look improved, and at least one measure corroborates that directional risk.  The Big Mac index, designed and updated annually by The Economist suggests that the euro is slightly more than 20% overvalued against the dollar and that the Swiss and Swedish currencies have become extremely expensive.  In contrast, China’s yuan appears more than 40% undervalued, and dollar/yen relationship is about at its proper level according to purchasing power parity theory upon which the Big Mac Index is based.

Needless to say, investors must work their way through a maelstrom of near-term policy complications.  One concerns the ECB’s program of buying sovereign bonds, a policy over which the bank’s key players disagree.  Whether the ECB or EU leaders isolate Italy from danger before it’s too late is a key variable still in play.  Another concerns the FOMC, which meets this week.  U.S. monetary officials pretty much have given the impression that no dramatic new stimulus will be deployed unless a recession is confirmed to be happening, not merely threatening.  Will the Fed remain on the sidelines and allow more market pain to be endured at risk of a recession?  A third area to watch involves the Swiss and Japanese.  Japan was more successful than the Swiss National Bank this past week in stopping currency appreciation.  The franc hit a new high against the dollar today, while the yen continues to avoid a 75 per dollar or better handle.  These relative successes mirror a similar pattern of effectiveness over the past year but contradict inferences one would draw from what the Big Mac indices are showing.

Meanwhile, the stream of data will continue to flow.  Key releases next week include U.S. retail sales, trade, and productivity, a whole month’s worth of Chinese figures, Japanese machinery orders, German trades, and the Bank of England’s quarterly inflation report with fresh macroeconomic projections.  The final year of U.S. presidential election campaign starts in November will no doubt offer many twists and turns with policy implications.

It’s risky to bet against the dollar and other traditional havens when the sense of crisis is so elevated.  But the long-term prognosis is still punk from where I sit because the positions of America and the dollar at the hub of the international monetary system is transitioning to something different and less powerful from what it has been.   Gold continues to be highly coveted.  That’s another bad omen, suggesting investor qualms about all reserve currency assets.   The dollar has a higher pedestal than the others from which to fall. 

Copyright 2012, Larry Greenberg.  All rights reserved.  No secondary distribution without express permission.

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