"Get out of the market" - RBS strategist

A caller to the excitable Max Keiser's show (htp: Nathan Martin) quotes from a statement by Bob Janjuah at Royal Bank of Scotland, warning clients to cash in and hunker down while the market tests "new lows". (And Jesse says "wealthy insiders are increasingly trying to liquidate investment positions to raise cash and diversify their holdings into cash and hard assets.")

Keiser got wide attention in July when he referred to Goldman Sachs as "scum" and (I think, not incorrectly) said that the practical results of some of their activities were worse than terrorist atrocities. Protests like this make no difference, except that they may relieve hearts clogged with helpless anger: what we've learned recently is that the shameless tenacity of politicians and bankers will outwear public indignation.

But society may change when everyone gives up looking to the the über-scum to help, and concentrates instead on personal benefit and survival. I think I may not even bother to vote in the next General Election.

Oh, and Nathan Martin also directs us to an article by Robert Kiyosaki, who compares the market to a dead frog galvanized by ever-higher charges of financial electricity until "Pretty soon the dead frog will be fried frog." Kiyosaki cites demographic change as a major threat in the long term.

Emerging markets inflation could break the current system

... says Nouriel Roubini, and there's already a fund to speculate on consequential revaluation of developing world currencies, according to this.

Faber: why the dollar may bounce back

The International Herald Tribune ( October 24) reports a mechanism by which the dollar may recover some lost ground:

Faber said if bubbles in emerging markets deflated, the dollar may rebound from all-time lows against the euro as fund managers who have invested in emerging markets shift investments to the United States.

Stay here and go East

In today's Daily Reckoning Australia, Bill Bonner is at a conference and hears that while the US may languish, some US companies may thrive:

Whole new industries are waking up to a New China, with a middle class...and millions of rich people too... We spoke to a young man here who believes that the key to making money in large US companies actually lies in Asia.

"US companies aren't going to make much money by selling more product to Americans. Americans don't have any money... A company with a good product - especially a good brand - can make a lot of money now by doing two things. One is lowering its costs by outsourcing labour to Asia...not just manufacturing, but even high-level things like design, research, marketing, legal work. The other thing it has to do is to sell its products to this huge rising market of the Asian middle class.

"If it does these two things, it will have lower costs and higher revenues. If it doesn't do these two things, it will be stuck with high costs...and a stagnant market - at best. Actually, as the housing problem deepens in the United States, you'd expect domestic sales to fall."

He's probably right. While the average American will probably grow poorer - in both relative and absolute terms - many US companies will probably do quite well. Many already are.

I've suggested before now, that the white-collar people here are next in the firing line. Those mushrooming Third World (first-class) universities aren't just turning out engineering graduates. James Kynge pointed out that maybe 85% of the end-price of our Chinese imports is added on by sales and marketing. There's a strong incentive for developing Madison Avenue East. Not to mention Great Wall Street.

The good news for investors is that you may be able to make some money stock-picking the right Western companies, where access to shares is easier, accounts are not quite so dodgy, the government doesn't generally have its hand up the corporate puppet, and even governments have (to some degree) to obey the law and respect private property.

Returning to the gold-bubble question, Bill repeats the argument that gold is a haven in a storm, and mooring is getting cheaper:

There are times when the investing world becomes so dangerous that the most likely rate of return for the average investor will be negative. That is a good time to hold gold; your rate of return will almost certainly be better than actually investing! Gold is a hedge against the unknown... But like any insurance, it costs money. When you hold gold, you give up the yield you would otherwise get from stock dividends or bond coupons. Now that Bernanke has cut short-term rates, the cost of holding gold has gone down.

Is now the time to buy gold? The money supply in the United States is rising at a rate nearly five times the growth of the economy itself. The Fed, claiming that inflation is now under control, has just cut the price of credit to member banks by half a percentage point. The economic explorer has to rub his eyes and look twice; he can't quite believe it. How can inflation be under control when prices for key commodities - notably the keyest commodity, oil - are at record levels? He doesn't have an answer, but he can put two and two together. Whatever kind of 'flation' the Fed has been cooking up, we're going to get more of it. So put on your best bib and tucker, dear reader.

Weathering the storm

The bankers have shown their hand - they fear deflation more than inflation. Pumping-in cash and cutting rates will keep us going through the economic squalls that they created by the same lax monetary policy. If you believe the monetarists, there will be a price to pay, but as long as this crisis management succeeds, the damage will be insidious rather than cataclysmic: money will slowly rot.

Now that we know the opposition's strategy, what do we do? My guess is, hold cash, wait for further crises of confidence, and buy tangible assets, or assets backed by tangibles, at bargain prices.

That's why I think Buffett and Soros have been so clever in acquiring more rail stock in recent months. Railways are a natural Benjamin Graham choice: mature, income-producing investments. There are big barriers to entry - think of nineteenth-century land speculation and skulduggery, and add-in eco protests, modern politics and the unavailability of coolie labour. Rail has advantages over road, especially as so much freight now is containerised and port-to-city; but from an investor's perspective it is also solidly thing-based.

Other experts are into tangibles also. For example, Marc Faber likes real estate in emerging economies - and possibly in depressed areas of developed countries, and Bill Bonner has farmland in Argentina (the Chinese love beef). And then there's various types of commodity.

I think we'll be back to putting money into things we can understand.

Marc Faber update

.............................................. Real growth: farmland

A most interesting and informative interview with Marc Faber on Bloomberg TV, last Friday. He thinks we've seen, not a correction, but the start of a bear market. In his opinion, the central banks intervention is inappropriate and will cause inflation. He thinks they "should let the crisis burn through the system, and eliminate some players". The Dow should correct by 20 - 30%; and as hedge funds "de-leverage", i.e. reduce their borrowings, the prices of most assets will drop.

In answer to the defence that p/e ratios are still good (i.e. the share price divided by the dividends, one way to test whether shares are over-valued), he says that at the peak of a market, there is a bubble. In 1999 it was a share price bubble, but now there is a bubble in earnings, and we will see "earnings disappointments" in the near future. So the p/e ratio is misleading and shares are not reasonably valued.

He points out that around the time of Dow peaks in July and August, we were also seeing several hundred shares hitting yearly lows, so underneath the surface a recession has already begun. The Dow has held up because of certain areas, such as oil stocks; but in present conditions, he thinks it will be "very difficult for the market to make new highs". Faber says that realism will return when we see a fall in popular stocks such as Research In Motion, Apple and Google.

The fundamentals of emerging markets are sound, and he foresees their economies de-coupling from the fortunes of the USA; but currently their stockmarkets are also over-valued and may correct when deleveraging causes money to flow back out of them.

As to the dollar, he thinks that if the Fed resists the temptation to cut interest rates, the dollar could strengthen against emerging market currencies. Against the Euro and the yen, he's not so sure. "I think against gold, all currencies will depreciate over time".

In relation to property, he says depressed areas like Detroit probably can't fall much further, unlike Miami and Southern California. Asian property looks promising - he mentions cities like Manila, Jakarta, Kuala Lumpur, Bangkok, Hanoi and Ho Chi Minh City. And relative to financial assets, farmland is depressed.

Accused of bearishness, Faber counters that to be bearish about assets is to be bullish about cash, which he has made plain for several months now. He even thinks that US Treasury notes and good-quality commercial bonds are a good investment.

I'm amazed how much valuable information this generous man gives away for nothing.

..................................................... Modern Manila

More on Brad Setser

Further to the last, it's worth struggling through Brad Setser's presentation to the Congressional committee even if (like me) you're not an economics buff.

In essence, he says that America has gotten away with its continuing trade deficit over the last few years, for several reasons:

• the effective interest rate on foreign debt held by the US, is higher than on loans made by foreigners to America


• foreign equities have had higher yields and better capital appreciation, so US overseas investment has done better than foreigners' share holdings in America


• the weakening dollar has amplified the effects in both points above


• foreign central banks' willingness to buy US debt has kept US interest rates low, making Americans' debts easy to service and fuelling share and property booms

But it can't go on for ever. Either America's debts will continue to increase, or foreign sovereign wealth funds will buy more and more equities, or both. If foreigners slacken in their support for US debt, interest rates will rise; and losing equities to foreign owners takes away from America's future wealth and income.

Setser concludes:

The US will likely both have to sell more equity to the rest of the world and pay a somewhat higher interest rate on its external debt than it has recently...

While rapid central bank reserve growth and large official financing of the US deficit can help the US postpone the necessary adjustment, the longer the adjustment is deferred, the greater the long-term risks...

Bringing the US deficit and emerging economy surpluses down without tremendous costs will also take time. If the US and the world are to adjust gradually, they need to get started.

Yet again, I wonder whether the UK's enormous purchases of US dollar-denominated securities since June 2006 make sense for Britain.

Another thought: seeing two late market interventions last week, Dan Denning in The Daily Reckoning Australia (3 August) speculated that there may be "...in the financial market a buyer of last resort who comes in to goose the indexes at critical times, when investor confidence is especially fragile."

Rather than the Plunge Protection Team, could it be foreign sovereign wealth funds buying-in on the dips? Maybe that's why the Dow has bounced back 286 points today, as I write.

New Growth Theory: should we pay handsomely to make ideas free?

When Tony Blair became Prime Minister, his slogan was "education, education, education". We thought he was merely reflecting our discontent with schools, but now I'm not so sure.

In 1994, Gordon Brown was quoting a new economic theory by - google him up - PAUL ROMER. Here is a 2001 interview in Reason Online with Romer. It turns out this may be to New Labour what Sir Keith Joseph’s espousal of monetarism was to Margaret Thatcher’s premiership. “New growth theory” is by Paul Romer, and bears on:

• education (a key slogan in Tony Blair's election campaign)
• skills training for workforces (a UK government initiative currently advertised on TV)
• intellectual property rights (relevant to design and patent theft by foreign manufacturers)
• free trade/globalisation

It has some intriguing aspects, but could also be a gift to the anti-big-business Left.

A core debate in this theory is the ownership of knowledge. Romer says that price is both an incentive to the producer, and a means of deciding who gets the product (or what product they choose). An example he gives in his interview is the life-saving treatment for children with diarrhea in poor countries:

...the efficient thing for society is to offer really big rewards for some scientist who discovers an oral rehydration therapy. But then as soon as we discover it, we give the idea away for free to everybody throughout the world and explain "Just use this little mixture of basically sugar and salt, put it in water, and feed that to a kid who's got diarrhea because if you give them pure water you'll kill them."

So with ideas, you have this tension: You want high prices to motivate discovery, but you want low prices to achieve efficient widespread use. You can't with a single price achieve both, so if you push things into the market, you try to compromise between those two, and it's often an unhappy compromise.

Ideas can be duplicated easily and cheaply, but they often cost a lot of money to come up with. For example, pharmaceutical firms do hugely expensive R&D - could they recoup the cost of successful solutions, and all the unsuccessful ones, via a prize competition? What happens if they go bust a yard before the finishing line?

What about areas where the humanitarian argument may be weaker? What if some Far Eastern car factory comes up with a tweak on, say, the Wankel engine design and goes into very successful (and low-labour-cost) production, paying nothing to the people who came up with 99% of the ideas? Sir Tim Berners-Lee (may we never forget his name) gave away the Internet, but should all hard-won knowledge be free?

And what exactly are the implications of a "knowledge economy"? Does State-organised education, with its top-down management, encourage the development of the creativity we need? Do we need 50% of our young people to go to college? Should they choose their subjects, or be told what to learn? Should they be given incentives to study in areas that are thought to be important? How far should we be prepared to fund research that has no immediately foreseeable practical application?

Romer is certainly right in saying that a smart workforce is an asset (and a smart management - we could do with some de-Dilbertising), and that there's lots of potential in continuous, incremental improvement. "Lean thinking" may buy us time in the destabilizing conditions of a globalized market - if we use our brains to improve what's in front of us at work every day, we may not go bust quite as fast as the doomsters fear.

But as the economist himself admits, it's a can of worms.

Futurology

Continuing the argument about sovereign wealth funds, what might this portend for US Treasury securities?

If foreign governments pull the rug out, there could be a run on the dollar on a scale that the US government wouldn't dare correct with proportionately high interest rates, seeing how indebted everyone is. The doomsters are probably right that it could happen, which is why everybody will make sure it doesn't.

And such a fall wouldn't be in the interest of creditor nations who still value the trade surpluses they enjoy with Uncle Sam. Many Chinese light manufacturing industries are working on narrow margins and don't want to see their profits disappear through foreign exchange movements (though their State is sufficiently powerful and ruthless to go that way if it wants to). I suspect that China will continue to develop towards heavier industries and gradually allow the trainer-stitching work to go to even poorer countries like Vietnam. Meanwhile, it's in no hurry to kill the US cow while she's still giving milk.

So here's my bet:

1. For domestic political reasons, the US will not do what is needed to get the economy back on the level. It will continue to borrow but, fearful of its vulnerability to potentially unfriendly foreigners, lean on its friends for more finance.
2. The US Treasury securities held by China will remain much the same, or even gradually increase in dollar terms, but "ally nations" will increase their holdings proportionately faster. There's not much an emotionally or politically vulnerable British PM won't do for a pat on the back at G8 summits, Bilderberg tie-looseners etc. Goodness knows how much of our future has been sacrificed to the last one's ego.
3. Creditor nations will increase their sovereign wealth funds, favouring investments that are involved in the supply lines from their manufacturing concerns to our end purchasers. Marxism has moved on: you have to have control of the means of production, but even more so of the means of distribution.
4. They will also invest in the lines leading towards their industries: energy, industrial metals and infrastructure. I also guess China will explore healthcare, energy-efficiency, food-oriented genetic research and environmental protection. And water. And foreign farmland (Bill Bonner and Marc Faber are really smart). City planning in all its aspects could become really important.
5. If these countries were private investors, we'd be seeing their portfolios alter their balance between bonds and equities, in the direction of higher risk, higher returns. And like good long-term investors, they will get richer. Maybe eventually, as James Kynge says, demographics and healthcare will eat into this wealth, but it's not going to benefit the West much either way.
6. In the US and the UK, our collective concern will be how to handle the social disruption in our own societies; our concern as individuals will be how to save and invest while we still can, and how to set up our own children in relative security.

Why commodities are the future

Martin Hutchinson, writing in PrudentBear yesterday, explains why he thinks commodities are in a long-term bull market: the developing world wants the "white goods" and other consumer durables that we already have and take for granted.

Marc Faber on the world bubble and his own investments

I have already referred today to Faber's interview on Minesite.com and would like to pull out one or two strands:

Faber thinks "...all real estate markets around the world are in cuckoo land and that they will all correct at some stage meaningfully even if you print money".

Asked whether he has real estate himself, he says, "I own properties in Asia, in New Zealand and in Vietnam in particular and in Thailand, and Indonesia and some in Switzerland; but ... I never borrow money to buy my properties, I pay cash ... I also own gold, and I also own some shares of course, I’m just diversified; but in general, I am very liquid at the present time... I’m holding a lot of cash at all times."

Re precious metals and inflation: "I tell you, the US has no other option but to print money. And they’ll go down like the Roman Empire in a huge hyperinflation. " He is bullish on silver and gold (especially gold), though he notes the danger that in a crisis, the government may simply expropriate investors' holdings of precious metals, as has happened in the US before.

Faber also notes that the expansion in the money supply in the West is not matched by increases in GDP, which is why we have speculative bubbles and a stalled standard of living: "...in the 50s and 60s and 70s if you increased your debt in the United States by $1 you got essentially also a dollar's worth of GDP growth. Now in the last 5 years, total credit market debt in the US has grown by $13 trillion but GDP by just $2.3 trillion." By contrast, in the East, living standards have risen: "I moved to Hong Kong in 1973. When I came, Taiwan, South Korea were very, very poor countries, as well as Singapore was like a dump at that time. Today, Singapore is the richest country in the world and, you see that the standards of living of people, has over the last 30 years, improved very dramatically in these countries. Whereas in Switzerland I go there, back, a few times a year I don’t see any meaningful improvements in the standard of living."

I think I have to speak personally now. What worries me, since I'm not rich and live in a large ex-industrial city, is not how to profit from the crash, as Peter Schiff advises, but what my life is going to be like when my neighbours and their children are strapped for cash, unemployed (or in Mcjobs) and increasingly resentful. Shouldn't we get our noses out of the financial press and start to become concerned about the social cost of the folly and cynicism of our banks and governments?

Living off our inheritance: global wealth distribution, GDP and debt

The World Institute for Development Economics Research of the United Nations University (UNU-WIDER) launched a report last December, about household net worth around the world. Here's a nugget or two from their press release:

“The study finds wealth to be more unequally distributed than income across countries. High income countries tend to have a bigger share of world wealth than of world GDP.” (p. 3)

This suggests to me that the wealthy countries are to some extent living on their capital.

‘China … fails to feature strongly among the super-rich because average wealth is modest and wealth is evenly spread by international standards. However, China is already likely to have more wealthy residents than our data reveal for the year 2000, and membership of the super-rich seems set to rise fast in the next decade.’ (p.4)

Surprisingly, household debt is relatively unimportant in poor countries. As the authors of the study point out: ‘While many poor people in poor countries are in debt, their debts are relatively small in total. This is mainly due to the absence of financial institutions that allow households to incur large mortgage and consumer debts, as is increasingly the situation in rich countries….many people in high-income countries have negative net worth and—somewhat paradoxically—are among the poorest people in the world in terms of household wealth.’ (p. 5 - italics are mine.)

Figure 7, “Asset Composition in Selected Countries”, shows the proportion of real property, financial assets and debt in 7 countries, including the US, Canada and Japan. Looking at the ratio of debt to financial assets, China is clearly the least debt-burdened.

When a spendthrift heir meets a poor but hard-working and hard-saving entrepreneur, the result seems predictable. Look at page 16 of Warren Buffett's 28 Feb 2007 letter to shareholders, which I quoted at greater length on July 5:

"The world is ... willing to accept our bonds, real estate, stocks and businesses. And we have a vast store of these to hand over.... [but] foreigners now earn more on their U.S. investments than we do on our investments abroad. In effect, we’ve used up our bank account and turned to our credit card."

The world is flat - or is it? Is Leamer right about Friedman?

Thomas Friedman's book, "The World Is Flat" is a best-seller - Wikipedia summary here. Friedman's related website is here - I think the photograph of the author is interesting, for those who like to read faces.

Last year, Edward Leamer reviewed Friedman somewhat snippily here. Gosh, I wish people could be more succinct. As Byron wrote of Coleridge, "I wish he would explain his explanation". Still, I guess Leamer has to fly the flag for critical scholarship.

The issue is important: does globalization threaten America's standard of living? Free traders say no. But have a look at Figure 6 on page 33 of Leamer, showing global income distribution in 1980, when US per capita GDP was 4 times the world average. That's quite some inequality, and if they were two very different levels of water in the same canal, opening the lock between them would see wealth gush from A to B.

So as barriers to trade are coming down, why hasn't this happened? Leamer says (p.34), "Much of the difference in GDP per capita among countries comes from the greater amounts of physical and human capital in the West, which advantages aren’t going to go away any time soon."

I'm not so sanguine. As regards human capital, I think the East is very keen indeed to increase its investment in education and training, and isn't hampered by notions of equality of outcome for its students. As to industrial capital, we are watching a vast sucking-in of resources, right down to our iron manhole covers, by China and other emerging economies; but also (particularly in China) we see a rapid and determined acquisition of slowly-accrued Western intellectual capital.

I think the catch-up process would be even faster in China if their industries observed patent and copyright more scrupulously, so they weren't almost wiping out each other's profit margins in their domestic market; and financial capital will accumulate far more rapidly when Chinese manufacturers get to keep more of the foreign buyer's price, instead of losing most of the profit to shippers, distributors, marketers and advertisers. If I were Chinese, I'd be looking at those areas for the training of my bright young people; and I bet they are.

Figure 7 on page 35 compares global income distribution in 1980 and 2000. The rich have done fine, the middle earners have made almost no progress, the poor are gradually rising. But when you think about it, maybe the middle is progressing: Western industrial workers are losing their jobs and looking for work in less well-paid service industries, while new industrial jobs are being created abroad. James Kynge ("China Shakes The World") says he sees heavy industry taking over on the Chinese coast, and labour-intensive light industry being forced inland. The move from low-skilled to higher-skilled labour in China is certainly a progression, matched by downward movement in the West. I wonder what the higher end of the graph will look like in another 20 years, when the Chinese have their own armies of industrial tycoons, company VPs, economics professors, investment analysts and marketing experts? I bet they're quite content to watch their coolie-work go to even poorer countries, as long as it doesn't happen too soon in the game.

Leamer admits (p.46): "The real bottom line: we do not know the breadth and intensity of global contestability of US jobs, and until we do, we will not have a real handle on the impact of global competition on the US workforce."

Why is he relaxed? See page 48:

"Finally, I want to comment on what I think is the big issue. It isn’t globalization or a flat world; it’s technology and the post- industrial labor markets.

The US is in the midst of a radical transformation from industrial to post-industrial society. Some of this transition is associated with the movement of mundane manufacturing jobs to low-wage foreign locations, but much of it comes from the dramatic changes in technology in the intellectual services sectors. The policy response to the globalization force is pretty straightforward: we need to make the educational and infrastructure investments that are needed to keep the high-paying non-contestable creative jobs here at home and let the rest of the world knock themselves silly competing for the footloose mundane contestable jobs."

Well, I don't think the rest of the world is quite as silly as that. I don't think Western education systems are geared to excellence, as once they were; so for that reason, as well as IPR enforcement issues, I don't think we can bank on using our intellectual property to sustain our global income differential. I don't think multinational businesses have, or feel they can afford, nationalistic sentiment. And whenever I read statements that start "we need to do x", I get the feeling that x isn't going to happen. Individuals will still make their stellar way, but I can't envision the West as a whole reclining in comfort in a "post-industrial" society.

But maybe I'm wrong.

Is modernisation good for India?

I am grateful to a respondent to my earlier post, "Have we overlooked India?" and I think the exchange is relevant to India's future generally. The visitor says:

I am wondering where we are heading in so called modern era. Example in textile machinery, one airjet can replace 100 handlooms, this means 100 peolple are displaced by a single machine. I am from Handloom city of Panipat (India). Earlier a person with 20 handlooms was happy and feeded his family well. Now even 50 looms are not enough because of the increased cost of living in so called modern era and people are getting trapped in vicious cycle of high cost, loans and increasing capacity.

My reply:

Yes, I am sure that this is extremely difficult and in fact English weavers suffered the same way nearly 200 years ago, which is why some of them turned to wrecking the machines that were harming their trade. But it didn't succeed in halting the changes. On the other hand, people in Britain are now materially much better off, so in the long run industrialisation is to everyone's advantage.

I suppose that the best thing that can be done is for government to support people who have been affected by modernisation, and help them to re-train in new areas of work. If you look at the post after the one you commented on, I give a link to Cafe Hayek. That writer points out that if saris can be made more cheaply, then sari-buyers will have more money left over to buy other things, so there will be demand for items that they could not have afforded before.

I think you cannot stop change happening, but governments can help manage the transition and far-sighted individuals can take advantage of new business opportunities.

Have we overlooked India?

Indian respondents to Mr Venkatesh's article worry about the movement of the dollar relative to the rupee. But just as America's problem is not the dollar but its national economic fundamentals, so perhaps India should raise her eyes to a more distant prospect. The country has a well-established democracy and an independent judiciary; respect for law, family and property rights; many millions of fluent English speakers (don't worry, the call centres will eventually overcome problems of Western vernacular); and a famously entrepreneurial culture.

India may not be sitting on a vast coalmine, like China, but natural resources aren't everything. It's not natural resources (other than mountain ranges) that preserved Swiss independence, but the history and character of the Swiss. As to commerce, I forget which mega-businessman said he could lose all he had, but so long as he kept his staff he'd get it all back again.

If India avoids over-reliance on its low wage advantage and continues towards more intensively capitalised production, then it too can be a powerhouse in the new world economy. Remember that recently, the British Swan Hunter shipyard has itself been shipped to India.

Dollar's rise only temporary

Chris Gaffney in Friday's Daily Pfennig comments on the recent rise in the dollar and puts it down to a sell-off in emerging market equities and some selling of gold to settle cash calls. He says the money is only "parked" in the dollar and will be off again soon:

The dollar will continue to trend down versus the currencies of economies that are better off.
As investors move away from riskier assets, the countries with strong balance sheets will begin to trade at a premium.

This refocusing on fundamentals suggests a return to sanity is on its way - initially not pleasant.