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Thursday February 12, 2009 - 14:03:42 GMT
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Looking for silver bullets…

Key News
World stock markets fell Thursday, with Japan's Nikkei index losing over 3 percent. (AP)

“A bird does not sing because it has an answer. It sings because it has a song.”
Chinese Proverb

FX Trading – Looking for silver bullets…
It’s not that we have any interest to defend our newly appointed Treasury Secretary, as it’s too late for that anyway.  He was summarily savaged by the financial press after his presentation of a “solution” to the financial crisis.  And maybe that was justified given the vagueness of what was delivered after building expectations so high.  But the driving of the bus back and forth over Mr. Giethner seemed a bit excessive. And I think it goes to the point that many are looking for some “single bullet” or savior to pull everyone out of this mess.  There has to be “something we can do” seems the lament.

Well what if there is nothing we can do, but muddle through at best. We think that will be the case. And we think it will get worse before better. 

But we also think the potential for this mess to get much worse is building if we deny this is a market problem and primarily a market solution is required—excess debt must be cleared, not re-created.  This is not a call for government to do nothing, we know that will not happen, but for government to do less so overall US debt levels can subside. 

What’s wrong if US savers save again?  Nothing!  In fact it is exactly needed for that repair of $10-12 trillion of wealth destruction from housing and stocks. 

As I talk with various investors, one thing they keep coming back to as evidence the US dollar will be killed is this concern: What if China sells off its US Treasury bonds?  That is going to crush the dollar.  We have two points on this:

1) US Treasuries have been the best single major asset class investment since this crisis began;  so it might be a stupid investment decision to sell them, and more importantly,
2) So what?  Let them sell.  If US savers increase their savings rates to 10% of GDP, from a low of -2% GDP in this cycle, that pool of money almost entirely displaces any loss associated with China (an most of the rest of Asia) should they decide they need or want to sell US Treasuries and stop buying in the future.

We realize this process is scary and painful to many.  But what we think is playing out is the great re-balancing of excess consumption (US) in one part of the global economy versus excess production on the other side (China).  More balance growth will ultimately be better for all if we reach that stage.

The symbiotic relationship between the US and China during the past cycle is history!

Given the huge demand destruction and the ongoing change in the demand patterns as US savers save and rebuild wealth, the exchange of goods from China for dollars from the US, to recycle back into US Treasury paper won’t be happening.  This means two things: global liquidity based on US financial system recycling of Asian reserve access is dead, and China’s export model is dead in the water. 

The key question: Who takes on more pain from this major re-balancing?  Our guess is that without a doubt China does.  They have no place to run to and no place to hide.  They cannot make-up quickly for the complete evaporation of demand for their goods because former massive global demand cannot nearly be absorbed by China’s relatively smaller domestic market. 

China will bear the brunt of this global readjustment in the form of falling production and sharply rising unemployment—this is already very apparent when you look at the numbers.  Their race is to build domestic demand.  But, this race will be effectively neutered if Chinese officials continue to crackdown on the very people they expect to buy the excess production—Chinese citizens. 

This slide from a rent presentation I gave over the weekend sums up the problem now facing China—social unrest.

 (Chart unavailable in text format.)

Chinese President Hu Jintao is cracking down hard.  Many are labeling his latest proposals as the “great leap backwards.”  The official urban unemployment is around 5%; unofficially it is pushing 10%.  Official GDP growth is around 8%; unofficially maybe it’ below 5% and falling fast. 

So, this is why we believe things can get much worse for global markets before they get better and there is no “silver bullet” that will solve the problems of global rebalancing.  And logically we shouldn’t want to stop this process because it is the market’s way of cleansing. 

Ludwig von Mises says that capital investment is the driver of real wealth for an economy, not consumption.  We agree.  With US savers on the path to creating a big pool of domestic capital for US industry we can’t see how it can be a bad thing in the end.  Let’s just hope our “solutions” don’t get in the way. 

Jack Crooks
Black Swan Capital


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