Macro Musings

Fate, it seems, is not without a sense of irony.- Laurence Fishburne (The Matrix)

Last week, Macro Musings compared Hugo Chavez to Tony Montana, the cocaine kingpin played by Al Pacino in Scarface. The analogy runs deeper than expected, as the WSJ reported on Wednesday:
Latin American drug cartels are using commercial airports and ports in Venezuela as a "safe base" to ship increasing quantities of cocaine to Europe, according to U.S. antidrug czar John Walters.
The U.S. estimates that the flow of cocaine through Venezuela has risen to more than 200 metric tons a year. Mr. Walters also said U.S. surveillance suggests that a growing number of ships seized carrying cocaine had come from Venezuelan ports. He said the DEA was particularly concerned about container traffic.
Chavez himself has not been directly implicated--el presidente has bigger fish to fry (and a more addictive drug to sell). But, just as Tony Montana's bad habits eventually overwhelmed him, Chavez is threatened by a problem of his own making--inflation. Again the WSJ reports:
...many believe the charismatic Venezuelan leader's [nationalization threats] reflect increasing frustration at his inability to brake the country's galloping inflation -- price increases that are eating away at his political support. Last year, Venezuela suffered Latin America's highest inflation, at 17%. Since then, inflation has continued to accelerate. This year, most economists believe Venezuela will post annual inflation of more than 20%.
...Venezuela's inflation is driven by a massive surge in public spending, mostly to fund a slew of social programs. To this end, Mr. Chávez, in the past two years, has transferred some $15 billion in central bank reserves to a fund for domestic spending projects. Mr. Chávez has tried to curb the resulting inflation by imposing strict price and exchange controls. But the controls are blamed for creating widespread shortages of such things as eggs, meat, and beans, a growing irritant to the population.
Venezuela is suffering from a form of "Dutch Disease," named after a phenomenon that occurred in the Netherlands in the 1960s. When oil and gas revenues flood an economy, prices can quickly become distorted in unexpected ways. Non-energy related industries often get left out in the cold. And of course, the bigger the state's role in allocating funds, the less room the free market has to self-adjust... putting things even more out of whack.
In regard to inflation, China is facing a related "too many dollars" problem. In order to keep the exchange rate from rising (and thus keep exports competitive), China's government must offset the flood of greenbacks coming in. There is only one way to do this: print local currency like mad. The resulting liquidity has fueled a paper asset mania, and Beijing's bankers are worried.
On Tuesday, Zhou Xiaochuan, the governor of the PBOC (People's Bank of China), expressed serious concern over the possibility of an asset bubble in the Chinese stock market. (The Shanghai Composite has now broken above the psychologically key 4,000 level.) Mr. Zhou's comment was the latest and strongest in a series of official statements trying to cool things off. Chinese investors used to take such statements from senior officials as "gospel," the Financial Times reports. But now those same officials are whistling into the wind... or rather, into a whirlwind of speculative buying.
How speculative, you ask? Consider that new trading accounts in China are being opened at a rate as high as one million per week. Fraser Howie, an authority on Chinese stocks, tells the FT that "There are a lot of gamblers with a whole pile of money who are prepared to continue punting." Andy Xie, a former Morgan Stanley economist, adds that "College students are putting their tuition money into the market...stroke-stricken retirees get wheeled into branches of securities firms to trade."
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The threat of accelerating inflation is a serious problem for China on the whole--as it is for all countries trying to drink from the dollar firehose without releasing pressure elsewhere. Some fear that the global liquidity boom could come to a bad end when one of the BRIC banks (Brazil, Russia, India, China) decides to panic and slam on the interest rate brakes too hard... as the Federal Reserve did circa 1929.
Europe is worried about inflation too. Inflation in Britain is running at a ten-year high, prompting the Bank of England to raise rates again this past week. The European Central Bank has also telegraphed its intention of further raising rates in June, with the ECB President (equivalent of Fed Chairman across the pond) speaking of "strong vigilance."
Meanwhile, back in America, the Federal Reserve points to inflation as its top concern. The Fed left interest rates unchanged this week, but hinted hawkishly that hikes may be needed down the road.
The folks at Goldman Sachs and Merrill Lynch think the rate hawks are dead wrong. They believe the Fed will be cutting soon, not hiking, to offset the pain of a burst housing bubble. Bloomberg news reports:
The conflict boils down to opposing views about real estate. Central bank governors found no evidence that the housing market had affected the broader economy, according to notes of their March policy meeting, released April 11. The National Association of Realtors said last week existing home sales fell 8.4 percent in March, the steepest drop since 1989.
Bernanke is missing ``the linkage between residential housing investment and the broader economy,'' Jan Hatzius, chief U.S. economist at New York-based Goldman, the world's most profitable securities firm, said in an interview. ``The housing downturn is of the first order of importance.'' Hatzius says the Fed will cut rates three times this year, to 4.5 percent from 5.25 percent.
Regarding the burst housing bubble's potential effect on the economy, the quote du jour goes to columnist Caroline Baum: "To say that ex-housing the economy is doing just fine is tantamount to claiming that, ex-Iraq, Bush's Middle-East policy is a rousing success."
Housing troubles are hitting the American consumer hard. It doesn't take a real-estate market meltdown to cause problems in the heartland; all that is needed is a squeeze on discretionary income. (And in that regard, the price of gasoline isn't helping either.)
We saw evidence of what's to come for consumers with the truly awful retail sales data out this past week. Wal-Mart, that bellwether for middle America, posted its worst sales decline in 28 years. Michael Niemira, chief economist at the International Council of Shopping Centers, declared same-store sales figures to be the weakest he's seen since 1970.
So the world is worried, and itching to raise rates. But the American consumer is weak, like a hospital patient too sick to handle medicine, and thus the Fed may have to stay its hand.
One would think the European situation is at least more robust, given the firm hikes and strong language over there... but one would be wrong.
Bloomberg columnist Matthew Lynn notes that "Cracks are starting to appear in the real-estate markets of Ireland, Spain and France -- the three euro-area countries where property prices have soared in recent years." Lynn goes on to add that "That isn't about to blow over. The housing markets in these countries may be on the verge of a sustained period of stagnation -- and maybe even a full-blown collapse."
Spain indulged in a little bit of panic two weeks or so ago. All kinds of Spanish stocks with property market ties--banks, construction firms etcetera--abruptly plunged. And as if the real estate troubles of Ireland, Spain and France weren't enough for Europe, British consumers could also be headed for the wall. The WSJ reports:
...concerns about Britain's borrowing binge are gathering momentum. Personal insolvencies in England and Wales last year hit a record 107,288, up almost 60% from 2005. In the first quarter, insolvencies totaled a seasonally adjusted 30,075, up 24% from a year ago. Treasury officials announced in January that they're considering a nationwide financial-education program. The consumer squeeze is particularly worrying for the British economy, reliant as it is on consumption for nearly two-thirds of its output.
How to sum up this crazy state of affairs? Let's see...
Try imagining the global economy as a gigantic wave pool. (The kind you see at water parks, with thousands of people bobbing in the summer heat.) Now imagine that, circa 2002 / 2003, the Federal Reserve (under Alan Greenspan) cranked the wave-generator up as high as it could go.
First that giant wave machine lifted real estate (causing the global housing boom). Then it lifted emerging markets. Then it lifted private equity buyouts. And finally it lifted merger and acquisition activity. Although there is quite a bit of overlap, we can see how the giant liquidity wave has moved "through" these various stages, causing squeals of delight as it did so.
But now there is a problem. The wave-generator ran at full strength for too long, until it finally conked out in the summer heat. So now the scenario runs in reverse. First the global real estate market comes tumbling down... then emerging markets... then private equity, and so on. Everyone who leveraged up without protecting themselves--from consumers to banks to hedge fund titans--winds up getting hurt. (Some much more than others.)
The analogy is far from perfect. For one thing, it doesn't make room for the incredible leverage involved. For another, things tend to end much more quickly than they begin. The space of time between "bye-bye housing boom" and "bye-bye buyout boom" could be much more compressed.
But what's important to understand is this: the crazy situation we have here is not all that surprising and not truly unprecedented. (History doesn't repeat, as Mark Twain once noted, but it rhymes.) Markets tend to over-react; investors tend to get over-excited; governments tend to over-extend and over-spend. This has been true for hundreds (if not thousands) of years. Expectations get inflated. People forget that trees don't grow to the sky. A savvy minority cashes in near the top (or on various points along the way), while the majority give back everything, or nearly everything, they had temporarily won. It has been this way for a very long time.
Ludwig Von Mises once observed that booms and busts are essentially born of government attempts to avoid downturns by massaging the credit cycle. I believe that is what is happening here, on a global scale. Von Mises also observed that the ultimate resolution to such a mess is the Hobson's choice between "destroying the economy or destroying the currency." We are seeing the world's reserve currency get destroyed now, before our very eyes.
Your Macro Musings editor is no permabear. I am simply a fan of Warren Buffett's advice: "Be greedy when others are fearful, and fearful when others are greedy."
As a trader, I am also a fan of Jesse Livermore's advice: "There is only one side to be on in the stock market. Not the bull side or the bear side, but the right side."
Many exciting developments of the past few years are real. The "emerging market century" is real. The promise of three billion new capitalists is real. The promise of 21st century technology is real. The fact that expectations are drastically inflated right now does nothing to change that. An ugly market decline--or even a flat-out market crash--would do nothing to change that. (And, in the event of either case, there will still be stocks worth buying with both hands.)
Markets get ahead of themselves from time to time... but the pendulum also swings the other way, creating rich opportunity for those prepared to pounce. Fittingly, the Macro Musings message is not "head for the hills," but rather, "man the battle stations."
As we head into the inevitable Austrian endgame--in which crushing debt loads face off against accelerating inflationary pressures--things are only going to get wilder and woollier. Great opportunities will present themselves in result. Conviction pays the greatest dividends when others are uncertain... and conviction via understanding is what Macro Musings aims to provide.