Macro Overview: United States
In markets, as in life, the best indicators of future trends are often quite simple. One of the simplest and most effective acid tests entails recalling all the headlines you have seen in the past several days, and asking yourself, judging only from the headlines themselves, where you think the market should be. (To work, this requires that you spend obscene amounts of time trolling the internet so that you have a large, reasonably reliable sample of financial headlines.)
Last week's headlines were pretty uniformly bad, yet the market cheered every piece of bad news as proof that more Bernanke Airlifts would drop manna on starving traders, while every piece of good news was greeted as proof that the market was still “dancing” (as Citigroup CEO Chuck Prince said, in early July). The only piece of “good news” was a very surprising Labor Department report showing 112,000 jobs added. Drilling deeper, 75,000 new hires were teachers and assorted government employees. There is absolutely no corroborating evidence that the government hired to that extent, and I expect significant future downward revisions.
Meanwhile, state sales tax revenues, a collective indicator of consumption patterns, have begun to crash. (These statistics have the added benefit of being highly trustworthy, because nobody pays more taxes than they have to, and sales taxes are very easily and efficiently collected.) Georgia, for instance, has seen its sales tax revenue drop 11 percent. The US deficit has similarly widened. The US economy is on the cusp of a recession.
Last Monday through Thursday afternoon were characterized by lots of technical rallies, in addition to the market blithely misinterpreting every available piece of information that came its way. The dollar's epic slide to $1.42 against the euro weakly pushed back to $1.40. And then, at about 13:00 EST Thursday, Axel Weber, Germany's representative on the European Central Bank, suggested that the ECB might raise interest rates.
Except for two or three occasions in those heady days of August, I have not seen the market react so violently to one single piece of news in a long time. The VIX blistered its way up from 15.5 to 19.0 in a matter of minutes. The Dow went from +120 to -100. The dollar's flaccid technical rally ended immediately. (Remember, this was not an official raising of interest rates. This was a suggestion by one central banker that he personally leaned towards expanding the interest-rate differential between the eurozone and the United States by 25 basis points.)
However, the symbolism was profound. In the past month, Qatar, Vietnam and Saudi Arabia broke their dollar pegs. The United Arab Emirates faces domestic inflation of 11 percent, and its own dollar peg is not sustainable. Now Europe is straining to break the peg as well.
Last week, I asserted that central banks behave analogously to private businesses, not a monetary equivalent of the College of Cardinals (as they are almost always portrayed). I said that the European Central Bank will always err on the side of hawkishness given ambiguous data and a lack of unified political pressure to devalue the euro (as is the case currently), because the world is tired of importing US inflation. Why this was such an evident shock to all US markets was simply mystifying to me.
One SIV to Scam Them All
The epicenter of the next volatility shock – which I believe will be greater than the one experienced in August – will not come from “surprise” ECB mutterings, at least not directly.
Hank Paulson, when not putting on his made-for-media “We have always favored a strong dollar” kabuki show this week, will continue to stitch together a bad-debt banking cartel, called the Single Master Liquidity Enhancement Conduit, a.k.a. SMLEC or M-LEC.
Basically, the large banks still hold huge amounts of bad subprime debt in the form of collateralized debt obligations (CDOs) packed into funds called “structured investment vehicles” (SIVs). These CDOs are the “assets” backing the asset-backed commercial paper (ABCP) market, which “rolls” new commercial paper to help all manner of companies raise capital to continue operations. (Instead of setting aside inordinately large amounts of their own cash, which may or may not be needed to fund future operations, companies could raise the exact amount of money they needed via the ABCP market.)
Because the CDOs have lost most of their value, the ABCP market has hemorrhaged volume and value – and a huge wave of rolls is set to expire in the next three weeks, with no prospect of ABCP recovery, and thus no prospect for ABCP-issuer companies to raise new capital (because the market for the CDO assets is completely discredited, with no prospect for significant recovery). Companies would have to raise capital through other, much more expensive means, in a rapidly deteriorating macro environment. Lots of operations would have to be shut down.
To forestall the looming crisis, Citigroup – which, incidentally, has by far the biggest SIV problem at over $70 billion – has formed a banking cartel, under Hank Paulson's anxious aegis, to pool resources with Bank of America, JP Morgan Chase, and other banks, and effectively bail out the $320 billion sunk into the SIVs.
Vaguely sentient readers might be wondering, “How the hell does $75 billion bail out $320 billion?” That's a very good question. It certainly helps that Paulson, as Treasury Secretary, has been so eager to publicly associate himself with the SIV cartel. Thus, Treasury has staked its credibility on the success of M-LEC, so even though Paulson has sworn that M-LEC has “no official backing,” he will be yanking every lever of government power he can to make sure that it does.
However, even with Paulson's obvious imprimatur, the reaction to M-LEC has been surprisingly skeptical for what is usually a very complaisant financial press. The banks' chutzpah has not helped: Citigroup, JPMC, and BoA will collect enormous fees for “managing” the SIV. There is simply no difference between this and Charles Ponzi securing a huge credit line with government approval, and proposing to take a hefty management fee for bailing himself out of a crisis of his own engineering. It's ridiculous.
More importantly, the banks could assume the vast majority of the $320 billion as bad debt, be big boys, and take the hits they have finally earned. But that would involve the banks actually assuming responsibility, and ultimately liability, for their collective failure – and personal responsibility is for the bankers in the best of times, and the lower-middle and lower classes in the worst of times. Real capitalism with real consequences is for poor people.
Ten-percent markups are now ricocheting through China-based supply chains to US consumers. The dollar is back at $1.42 against the euro, and gold is at $764. China's massively overcapitalized export sector is starting to feel extreme pain from a cheaper dollar. Investing in China has become the new carry trade, as investment managers flee US and European markets in search of the “freebie” of investing in China to profit from a purposely undervalued yuan.
It won't last.
The Bottom Line
I remain very pessimistic on the USD. Furthermore, a recession is already happening in real terms, if not in inflation-adjusted terms. The “money at zero maturity” (MZM) leading indicator of USD money supply is a runaway train. The only way the banks will be able to deal with their SIV crisis will be through 1) selling pieces of themselves to sovereign wealth funds, or 2) creating more money. In the meantime, forward earnings are being readjusted downwards rapidly, and equities P/E ratios are conversely going up.
We haven't had a real recession in a long time. We are overdue for a significant one, and the SIV cartel ultimately changes nothing. (I wouldn't be surprised to see the SIV cartel collapse, however, if market conditions deteriorate at the pace that they have so far today).
Maintain all major recommendations from the past several weeks (short USD, long gold, long cash, short GBP) but sell some of your euro position.
--Alex Forshaw,
Editor in Chief
http://www.bestwaytoinvest.com
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