October 15, 2010

Here’s the news of the week – and how we see it here at McAlvany Wealth Management:

1. Capital Controls
2. What? No Inflation?

1. Capital Controls. This last week, Tim Geithner further explained the need to rebalance the global economy and pointed to the many misallocations of capital and systemic weaknesses that remain. His focused assault centered on China. Due to the “suppression” of the Chinese currency (it has been argued), China is stealing American jobs and creating havoc in the financial markets, with a resulting global misallocation of capital. Conveniently, the blame for all things malignant can be laid on the foreigner. Doesn’t that play well during an election season? Nobody can be blamed (not Greenspan, not Bernanke, and certainly not Congress) but the “other guy”.

If there was a problem with the exchange rate, and for the sake of argument, one currency was overpriced and the other underpriced, what you need is a shift in the relationship between the two currencies. Either one moves up (“Revalue the Renminbi higher!!” says Geithner and many in Congress) or the other comes down (dollar depreciation – already occurring).

With a currency peg, there is no way for such realignment to occur, but the idea that that the Renminbi is undervalued in this fixed relationship overlooks the other possible assessment – that the U.S. Dollar is significantly overvalued. Perhaps the dollar isn’t worth the scrip it’s written on.

The more dangerous policy choice leading to misallocation of capital is not currency suppression in China, but interest rate suppression in the U.S. Keeping rates too low for too long has always led to significantly higher rates (Knut Wicksell, 1851-1926). More importantly, when rates are artificially suppressed, savings and investment are driven to higher-risk venues (and carry-trade dynamics abound), eventually creating structural imbalance.

When you revisit the Asian contagion, the Tequila crisis, the Russian bond default, and the Argentinean bond collapse – all occurring within the last twenty-five years – you find hot money flowing into a region and then changing course and running for the exits. With hot money (mass amounts of Foreign Direct Investment) flowing into a region, you temporarily inflate currencies and assets and create inflationary or bubble dynamics. Then comes the collapse as the currency reverts to the mean along with the assets in question. The U.S. Treasury and Federal Reserve are together setting the stage for the next round of losses, and a true trade war.

To avoid this rush of cash, many countries are implementing forms of capital controls that either restrict or penalize investment inflows. In a near-ZIRP (zero interest rate policy) environment, money is clamoring for high-yield junk bonds, emerging market debt (yes, even Greek debt), and emerging market equities. These trends are capturing the imagination of needy and greedy investors alike, and will see nearly $1-1.5 trillion in investment flows.

In the Greek tradition (ancient) you were encouraged to Gnothi Seaton, or “know thyself.” It is this bit of information that Geithner, Bernanke, and Congress all seem to be avoiding as they look to blame and scapegoat. As a result, we march closer to capital controls and currency wars. We will someday expect higher integrity and a more honest self appraisal from our leadership and elected representatives.

2. What? No Inflation? According to Ben Bernanke and the speculative investor community, inflation remains “too low.” As a result, the Fed sees a case for “further action.” Bernanke also believes that inflation, if any, can be magically eaten up by corporations in the nebulous world of productivity gains and cost intermediation. So it’s apparently full steam ahead on money printing.

We continue to be astounded at those who would encourage QE II, or something of that sort, because they have no conception of the damage it would do to the cost of living and subsequently to the economy. Already this year, commodities have outperformed almost everything to the upside. Corn is at a two-year high, soybeans hit a 16-month high, and copper is at a 27-month high. The CRB RIND Index (spot price for 22 basic commodities) is at an all-time high – with cotton soaring to the highest price since the commodity began trading in New York 140 years ago!

The PPI (producer price index) also jumped 0.4% over an expected increase of only 0.1%. If you think food and energy are not important and exclude them from the index, then it jumped only 0.1%. The trade deficit also rose a bit more than expected due to the recent Fed bludgeoning of the dollar. Imports rose 2.1% vs. a rise in exports of 0.2%.

While recent inflationary pressures seem to be rapidly increasing, inflation still has not hit the pocketbooks of consumers. Corporations have done well to absorb the higher cost of raw materials thus far – using several means. One way has been through refinancing of debt. As the Fed manipulated rates lower in recent months, corporate issuers, both investment grade and junk alike, have taken advantage of the opportunity and issued a record amount of debt at lower rates – averaging over $25 billion a week in the last few months. The last time we saw issuance at such levels was in early 2008, when corporations were dealing with $100+ oil prices. What followed shortly thereafter was a collapse of the stock market, with the Dow losing 6,000 points.

Corporate refinancing, debt accumulation, layoffs, mergers, government stimulus, and bailouts seem to be standard fare for delaying the inevitable consequences of such manias. The inflationary pressures that ensue will eventually force adjustments in the currency, trade, and our standard of living – this is obvious. We are surprised only at the alarming pace the Fed wishes to realize this conclusion. Perhaps, following the election, they may temper the charge.

Have a wonderful weekend.

David Burgess
VP Investment Management

David McAlvany
President and CEO