Global Position, Part II

Further to my note of the 30th June, here is a little more detail in relation to some of my broader comments on global imbalances. No pondering of the market today is going to make sense unless you have a handle on these imbalances and the political arguments that are made around them.

Major Imbalance No. 1

Germany throwing stones from a glass house. I have been making comments that Germany should be a little less patronising of EU countries that are having troubles with their deficits, as the German export economy benefits massively from any devaluation of the Euro. Chancellor Merkel apparently gets upset at such comparisons, and uses circular arguments to simply again berate countries living beyond their means and point to the benefits of Germany’s fiscal discipline helping the Euro. Truly, if ever there was an example of platitudes, this would have to be one. There are excellent articles sitting on Speigel Online that highlight actual figures to confirm the issues surrounding this.

If you consider where Germany exports its goods, you’ll see that the other EU members have a pretty solid argument for running a common currency that does not include Germany. To a much lesser extent, you could argue to exclude France as well. The newly structured Euro would fall even further, enabling these countries to try to rebuild on the basis of more competitive prices.

The impact of this imbalance is that a large chunk of the global currency/debt/investment world (the European Union) is destabilised and is perceived as a threat to global recovery. Individual movements of smaller EU members (such as the potential derating of Spain’s debt) will have a disproportionate impact on global markets. Result : more volatility added to global pricing in all markets.

Major Imbalance No. 2

Chinese currency peg to the United States dollar. This is far more intricate than any superficial comment can possibly convey, so i will stick with my brand of Pidgin Economics to set out my thoughts on the issue (remembering that i am not claiming to be an expert in all this… this is simply me sharing my views as an Australian Financial Planner who needs to implement strategy into client portfolios on a daily basis while being bombarded by all this data).

In the aftermath of the Global Financial Crisis, China’s position of surpluses and reserves should have seen its currency increase substantially to account for its better financials than (say) the United States. This would have made the US’s currency relatively lower, increasing the competitiveness of US exports, leading to a reduction in the Chinese surplus. Instead, the Chinese government stopped its currency moving against that of the US. They in effect locked the relative value at early GFC levels. This meant that China’s currency retained its competitiveness, allowing its huge export sector to make it through the GFC and maintain or recover employment.

The impacts of this imbalance are many. US exports are less competitive against Chinese products than they otherwise would be. You could argue that Chinese employment has been maintained at the expense of US employment (although again this is a tricky one, as a higher Chinese currency would flow into higher import costs for the US, leading to the potential for inflationary impacts).

One of the biggest impacts is that a lot of that Chinese surplus is invested into US fixed income debt, which then keeps the US cost of its debt low (by keeping demand for US debt comparatively high and therefore the interest rate that needs to be offered/paid by the US at a lower rate than it would otherwise be).

The Chinese government has recently announced a loosening of this currency peg but only in stages and always subject to any adjustments required to keep the Chinese economy more stable.

Result : more volatility added to global pricing in all markets. Especially Australia for who China is a major trading partner.

Major imbalance No. 3

Ultra-low interest rates in the United States. The cost of funds for the key banks and traders in the United States is set by the Reserve at around 0.25%. This is against a 10 and 30 year bond rate that, while low, remains substantially higher. The ‘loose money policy’ helps banks to “rebuild their balance sheets” (read : make money on a massive scale with minimal risk), which will hopefully lead to greater stability and therefore more readily available credit for business to expand and for the residential property market to be supported.

This leads to very short term risk/return tradeoff requirements, shortening the time horizons of major global investors and turning them into speculators. This increases risk in all markets that these funds end up in – currency, credit and equity markets.

It also means that productive investment (and therefore jobs) will only happen with a proportion of the funds and only once the banks/speculators are comfortable that they will make more money than they can make speculating. Therefore, the US unemployed are highly unlikely to be employed in the near term.

This is patently obvious to anyone who looks at the US history of employment (in the ‘boom time’ period leading up to the 2007 /08 GFC) and subsequent unemployment. Simply put – it’ll be a miracle if loose money leads to enough new jobs to employ the ranks of unemployed and the new entrants to the labour market caused by a growing population. The actual figures are contained in my Musings from March. The United States employment problem is covered in detail in that note.

It astounds me when i read heavy-weight economists and commentators suggest this as if it might be a new ‘concern’ or a ‘possibility’. On the face of raw evidence, an extended period of high unemployment is a very sound bet for the gambling oriented amongst us. It’s not a possibility, it’s a near on certainty.

Result : more volatility added to global pricing in all markets. Especially Australia in our role as a major provider of commodities/energy/agricultural products, all of which should benefit from global trends, making our currency and companies key targets for speculative activity.

These are just the imbalances pertinent to my 30th June comments. Of course, we could add to that a few other imbalances/bubbles that are awaiting sorting out: