The following is a re-print of the latest monthly newsletter from Niels Jensen of Absolute Return Partners, published with the express permission of the author. Visit www.arpllp.com to learn more about Absolute Return Partners.  You can reach the firm  by email at info@arpllp.com.

The Absolute Return Letter

October 2009

A Country for Old Men and a Bit of Samba

The Man Card “Excuse me Sir, can I see your Man Card?” The stone-faced look of the security guard at Dallas Fort Worth Airport gave nothing away and, after two days of celebrating John Mauldin’s 60^th, my brain was probably operating somewhat below full capacity. “I need to see your Man Card Sir”. Couldn’t he just go away, I thought to myself, not really sure how to deal with the situation. Suddenly his face cracked wide open and in the broadest possible Texas drawl he said: “With those pink socks on Sir, I need to make sure you are a man”. Welcome to Dallas!

The highlight of the weekend was a two hour roundtable discussion on Saturday afternoon where John had asked 15 of his friends and business associates to share with the group what their fears and hopes were for the next 15-20 years. I duly noted that the issues on the minds of our American friends are not at all dissimilar to what we worry about in Europe – our children’s welfare, unemployment, immigration, racism, the impact of technology and the aging of our society to mention but a few.

This month’s letter is about demographics and is the second in our series about major trends defining the future of the world we live in. Last month I wrote about the energy outlook, and I had an unusually high number of emails commenting on the letter. Many of them made the point that the world is in better shape than I seem to think, even if oil supplies are dwindling, as natural gas reserves are ample. We just need to switch source. Whilst I don’t disagree that natural gas seems the way forward, one should not underestimate the task ahead of us. About 2/3 of all oil is used for transportation purposes and it is an enormous task to reduce our oil dependency. It will take many, many years and cost gigantic sums of money.

It is the banks, Stupid! Back to this month’s topic – in the financial press, there has been no shortage of attempts to apportion blame for the credit crisis. Disregarding the more obvious finger-pointing (it is the banks, stupid!), there seems to be a growing acknowledgement that large imbalances in the global economy are to blame for the current mess.

Put differently, a large number of countries – mainly Anglo-Saxon in origin but also the majority of our Eastern European friends – became credit junkies and spent beyond their means, year-in year-out. Conversely countries with large current account surpluses (e.g. China, Japan and Germany) were only too happy to deliver the drug to the intoxicated.

It is therefore too simplistic to suggest that only the deficit countries are to blame. The suppliers of credit must accept that they carry no small part of the responsibility, just like the drug dealers do when supplying junkies. In the past, I have been critical of Ms. Merkel of Germany when she stated publicly that Germany should continue to do what Germany does best, and that is to export goods of high quality. The obvious point here is that if Germany pursues such a strategy, the world will be no more balanced ten years from now than it is today, and a crisis similar to the one we have just been through could happen again.

It should therefore be obvious that not only should the deficit nations become more disciplined (i.e. save more and spend less), but the large surplus nations should actually put measures in place to ensure that their citizens save less and spend more. In practice, however, that is easier said than done. Demographic forces have a much bigger say on spending and savings patterns than generally acknowledged.

The Life Cycle Hypothesis My story begins with Franco Modigliani. In 1985 he was awarded the Nobel Memorial Prize in Economic Sciences for his life cycle hypothesis which (somewhat simplified) states that spending and savings patterns are predictable and largely a function of demographics. When you are in your 20s and 30s, savings are low as much of your income is spent on establishing a family, buying and furnishing your home, putting the children through education, etc. Then comes a phase, from your early to mid 40s until just before you reach retirement age, where your savings grow significantly. The outgoings are smaller during this phase of your life as the kids have left home, and you focus on accumulating wealth to pay for your retirement. Eventually, when you retire, your savings rate turns negative as you begin to live on your life savings¹.

Empirical evidence has since shown that this is generally true both for the individual and for society at large. Obviously, you don’t win the Nobel Prize for pointing out something that can hardly be classified as original thinking, but Modigliani’s claim to fame was to demonstrate the effect this pattern has on the general economy as the population ages. Let me introduce you to a chart constructed by fellow Dane Claus Vistesen who is an economist and active blogger. He has made a solid attempt to graphically illustrate the consequences of Modigliani’s work (chart 1).

Chart 1:   Age’s Effect on the Current Account

Source: http://clausvistesen.squarespace.com

The blue line represents the current account – it is in surplus when above the red line and in deficit when below. As you can see, when a country’s population is relatively young, the country should (all other things being equal) run a current account deficit. As the population grows older, and the savings rate rises for the reasons described above, the deficit turns into a surplus until such time that the elderly begin to dominate the young at which point the surplus turns into a deficit yet again.

Our export dependency Why is all this important? Well, take another look at chart 1, but focus on the purple line instead, which represents the country’s export dependency. Translated into plain English, Modigliani’s work implies that a country with an ageing population must grow its exports aggressively in order not to build up an unsustainably large current account deficit. Unfortunately, as you can see from the shape of the curve, it is not a linear function. The problem gets progressively worse as the population ages.

Now, with most OECD countries fast approaching the danger zone where an uncomfortably large part of the population consists of old-age pensioners, how do we get out of this pickle? We can’t all export our way out of the problem. Somebody needs to buy our products. I will get back to answering this question later, but let’s take a quick look at the so-called dependency ratio first. If the ratio is, say, 30, it means that there are 30 people at the age of 65 or older for every 100 people between the age of 15 and 64 (which defines the working population).

Obviously, the higher the dependency ratio, the fewer working people there are to pay for the elderly. At some point the cost of supporting the elderly will reach a level which spells economic disaster, and some of the more exposed countries may quite simply be forced to abandon their welfare standards to cope. More about this later – let’s get some data points on the table. In chart 2 below, I have tried to keep things relatively simple. I have assumed, for example, that the fertility rate will remain unchanged going forward. This may or may not be a reasonable assumption. Only time can tell.

Chart 2:   Old Age Dependency Ratios for Selected Countries

Source: http://data.un.org/

A walk in the park The first thing that struck me when I produced this chart was how relatively benign the US outlook is. I read an awful lot of US centric macro economic research (my wife thinks too much!) and, more often than not, there is a reference to the bleak future for America given the fact that baby boomers in large numbers will be retiring over the next two decades. However, when you compare the US numbers (a dependency ratio of 19 today growing to 34 by 2050) to most other developed nations, the US demographic challenge suddenly looks like a walk in the park.

No other country is aging as quickly as Japan. Saddled with a large number of old age pensioners already (the dependency ratio is currently 35), the ratio will grow to an astonishing 76 over the next four decades. The Japanese economy has struggled to drag itself out of a slow growth environment for the past twenty years (give or take). The problems in Japan are well publicised and are often blamed on failed policy measures. I just wonder how big a role demographics have actually played in all of this and whether the Japanese mire is a sign of things to come for the rest of us?

Europe is toasted The outlook for Europe doesn’t make for pretty reading either. In fact, you can argue that we are worse off than Japan given our lower savings, and it raises some serious questions about the sustainability of our entire welfare model. The IMF has calculated that the cost of age-related spending in the average advanced G20 country will cause public debt-to-GDP to grow to over 400%, with Spain and Greece reaching over 600% unless the existing welfare model is cut back (see the April 2009 Absolute Return Letter here). For comparison, Japan has the highest public debt-to-GDP ratio today at about 225%.

As our business partner, John Mauldin, always reminds us, what cannot happen, will not. We may have to prohibit the use of condoms (not advisable for other reasons), import more labour from countries with higher birth rates (immensely unpopular) or simply reduce old-age benefits. The latter carries its own set of challenges as the political influence of the elderly is on the rise, and it won’t exactly become any easier over the next 20 years to pass draconian legislation to reduce old-age benefits. Frankly, I have no idea how we will find a way out of this pickle. But find a way we will.

BRICs versus PIGS As far as emerging economies are concerned, the outlook is considerably brighter (note the big difference between the BRICs and the PIGS in chart 2) but perhaps not as straightforward as you may think. Most investors seem to buy into the idea that, over the next few decades, emerging markets will offer better investment opportunities than more mature markets, as their economies are likely to grow much faster, and you don’t yet pay for the faster growth through higher P/E ratios. Whilst we wrestle with depressing issues such as how to pay for the credit crisis and how not to bankrupt ourselves as we age, emerging economies should benefit from a growing labour force. In fact, as you can see from chart 3, in the next few years less developed countries, which tend to have very young populations, will actually outgrow more developed countries in terms of the size of the working population relative to the total population (which is good for economic growth).

Chart 3:   Working-Age Population as % of Total Population

Source: http://data.un.org/

The growing number of workers should, according to Modigliani, be followed by stronger economic growth and rising savings. If these savings can be invested into new productivity enhancing investments, emerging economies should enjoy much higher living standards in the years to come. You may raise a hand here and say “STOP – didn’t you just argue that countries with young populations should run current account deficits and hence low savings rates?”  It is indeed correct that ‘young’ countries should, according to Modigliani’s hypothesis, not be able to generate savings rates at the magnitude we have seen coming out of South East Asia in recent years.

Cheating is omnipresent But Modigliani didn’t take cheating into account. Virtually every country in Asia has artificially depressed its currency in recent years in order to export itself to prosperity. This cannot, and will not, go on forever. As living standards rise in these countries, and domestic demand fuels economic growth, expect their currencies to appreciate against the old world currencies.

At the same time, one should not ignore the fact that not all emerging economies have young populations. I have included the four BRIC countries in chart 2 in order to make this point clear. As you can see, by the middle of the century, China and Russia will actually both have a higher dependency ratio than the United Kingdom, whereas Brazil and in particular India should continue to benefit from relatively young populations.

In a recent research paper², BCA Research analysed a number of emerging economies and found that, broadly speaking, they can be divided into 3 categories – those where the working population is peaking just about now, those that will peak in the next 7-10 years and finally those where the peak is still 15-20 years away (chart 4).

Chart 4:   Demographic Profile of Emerging Economies

Source: BCA Research

It is clear from BCA Research’s work that some countries are in much better shape demographically than others. Most interestingly, China, which everybody (well, almost everybody) raves and rants about, does not look particularly attractive. Obviously you cannot judge the investment appeal based only on demographics, but if you add to that China’s fragile banking system and a construction boom which has left most new buildings half empty and led the Chinese authorities to block local access to hedge fund manager Hugh Hendry’s website, because he had the audacity to point out the insanity of many of the construction projects in China, then the Chinese investment story loses some of its glamour.

Too much of a good thing A great growth story like China will always attract plenty of capital but, in the case of China, you can actually argue that too much capital has been attracted. As I was taught at university, economic growth loses its momentum if capital spending outgrows labour because of the diminishing return on capital. BCA has illustrated this graphically (chart 5), and it is obvious that China is attracting too much capital for its own good. You want to invest where capital is scarce, not plentiful.

Chart 5:   Capital-to-Labour

Source: BCA Research

You are therefore likely to earn a higher return on investment by investing elsewhere in the universe of emerging economies. One such country is Brazil which does not attract nearly the amount of capital that China does. I have been keeping an eye on Brazil for some time now as I am intrigued about their fledgling oil industry, and the more I learn about this country, the more excited I get. The story has not gotten any worse in recent days after the International Olympic Committee’s decision to award the 2016 summer games to Rio de Janeiro. But that is an entirely different story which I may write more about another day.

Going back to the question I raised earlier, how do we get out of this pickle? As already stated, we cannot all become exporters as we grow older and domestic demand begins to fade. The only way out, if we want to maintain economic growth, is for the younger and more dynamic emerging economies to become net importers. This will require a sea change in policy, and attitude, in those countries. Most importantly, it will require the exchange rate cheating to stop once and for all. There is no alternative, unless you are prepared to accept negative GDP growth year-in year-out. And that is no fun.

Niels C. Jensen

© 2002-2009 Absolute Return Partners LLP. All rights reserved.

See other posts I have published referencing or presenting Niels’ analysis.

• The emerging markets crisis – Nov 2008
• Do BRICs (and Germans) Eat PIGS? – Feb 2009
• Europe on the ropes – Mar 2009
• The Fake Recovery - Apr 2009
• Green Shoots or Smoking Weed? – May 2009
• Make Sure You Get This One Right – Jul 2009
• The Hamster on the Wheel – Sep 2009

Related posts:

• Chart of the day: household debt vs. savings
• Chart of the day: Savings Rate
• Low savings, high debt and interest rate policy
• Savings in America hit 5%, up from nil last year
• Jim O’Neill on the Global Economy

Mark Mobius is one of the most famous Emerging Markets investors and right now he is bullish on Emerging Markets despite a huge rally in shares from late last year. Mobius turned bullish right as shares troughed and has remained so ever since.

Mobius likes the so-called ‘Frontier’ Markets more than the well established BRICs.  He mentions Kazakhstan, Romania, Kenya and Vietnam as examples. Below is a video of Mobius from the Telegraph, explaining that investors need to take a five-year view and be prepared for lower liquidity and extreme volatility (20 or 30% corrections) to profit.

Note that his reasons to be bullish are:

1. Money printing globally will underpin shares (a view Marc Faber also holds)
2. “Derivatives are not dead. There are $600 trillion worth of derivatives out there,” according to Mobius. As a result, leverage will goose returns supplied by the money printing.

Both of these are technical factors that do not speak to the underlying fundamentals.  It does suggest that government action may be the dominant force in markets for some time to come, a view espoused by Pimco’s Bill Gross.

The video runs just over five minutes.

Related posts:

• Mobius: Emerging market stocks are breaking out
• Marc Faber makes bullish comments on Bloomberg
• Marc Faber on passing the baton to emerging economies
• Whitney Tilson of T2 Partners, a new media darling, strikes a bullish tone
• Fred Hickey: Gold starts secular bull, tech ends secular bear

This comes via der Standard, an Austrian daily.  My translation below:

The international financial crisis has hit eastern Europe harder than previously expected, according to a press report. At least ten states are negotiating with the International Monetary Fund (IMF) for billion-dollar aid programs, Handelsblatt learned from within the IMF community. The applications’ status will be decided soon as possible. Given the continuing economic crisis a majority of the IMF’s management is in favor approval of further aid requests.

According to the report, among the countries which have requested assistance at the IMF for the fist time are Bulgaria, Croatia and Macedonia. Ukraine, Serbia, Romania, Belarus and Latvia speculate on receiving a faster payout or increased speculated IMF assistance. Hungary had not yet decided whether it needs more money from the fund. The IMF has recently approved the application of Bosnia, as the Bosnian Minister of Finance announced on Thursday. Bosnia-Herzegovina will receive a credit line of 1.57 billion U.S. dollars (1.13 billion euros) from the IMF.

In regards to emerging markets, this story makes clear how much worse the situation in Eastern Europe is than in Emerging Asia or Latin America.

Source

Zehn Staaten Osteuropas verhandeln mit IWF – Der Standard

Related posts:

• EU planning 200 billion euro package for Eastern Europe
• Quote of the day: Austrian banks
• Eastern European economic growth to crater in 2009
• European banks have hands out for more capital
• Bloomberg talks about the meltdown in Eastern Europe

During Alan Greenspan’s tenure at the helm of the Federal Reserve, he was often accused of using monetary policy to target asset markets so as to keep the party going.  In short, Alan Greenspan was seen by many, including myself, as the bubble blower-in-chief. All of this came to an end with the very hard landing we have experienced after the global housing bubble.

However, despite the economy being in tatters and debt deflation looming as a threat, many asset markets have zoomed ahead. The cause: easy money in the U.S. and elsewhere.  In the U.S., we have zero percent rates with Ben Bernanke at the helm. So, naturally, you should ask yourself: Does Ben Bernanke blow bubbles too?

To get at an answer to that question, I want to highlight a recent post on MoneyWeek called “The next big investment bubble – green energy.”  In this article, research from James Montier of SocGen about investor attitudes in bubbles is quite enlightening.

James Montier at Societe Generale is a specialist in ‘behavioural finance’. This basically takes psychology and applies it to the field of investment and economics.

As someone who’s studied psychology in the past, I’d be the first to admit that it’s a pretty ’soft’ science compared to something like physics, for example. But compared to the pseudo-science that is economics, it’s positively respectable.

And given that markets are anything but rational (even the Chartered Financial Analyst Society of the UK admits that a majority of its members have lost faith in the ‘efficient markets hypothesis’), it makes a lot of sense to take investors’ all-too-human characteristics into account when trying to figure out what markets might do next.

In a recent research note, Montier took a look at the psychology of bubbles. As suggested earlier, you’d think that investors would learn. If they’d seen one bubble, they’d be more careful in future.

And in fact, they do learn. An experiment conducted by joint Nobel prize winner Vernon Smith used an investment game where investors could trade a dividend-paying equity under four different random economic conditions, each of which would result in a different dividend payout.

In the first game, investors at first undervalue the equity, then massively overvalue it, creating a bubble which then deflates. Smith then got the same people back to play the game again. What happened? Well, says Montier, “far from learning from their experience in the first round, participants generally go on to create yet another bubble!” And when they were asked why, “the most common response was they thought they could get out before the top this time!”

However, when Smith asked the same players to play a third time, this time they’d learned. “You end up with a much tighter correlation between the market price and fundamental value,” says Montier.

So twice bitten, thrice shy, it seems. And you might therefore expect the current generation of investors to have learned from the two big bubbles of the past decade.

…but they can get sucked into creating them

But that’s not the end of the story. Smith found that there was a way to get experienced investors back into bubble mentality. How? He cut the amount of stock available in half, and doubled the amount of cash in the game, “effectively creating what might be termed a massive liquidity surge.” This time around, even the experienced investors were sucked back into creating another bubble, although it peaked earlier than the previous ones.

“A massive liquidity surge” is exactly what the world’s central banks are trying to create just now. Montier says he has no idea if it will be large enough to “reignite a bubble (and of course another crash afterwards).” But as US fund manager Jeremy Grantham of GMO has pointed out previously, we’re currently seeing “the greatest monetary and fiscal stimulus by far in US history”. So if that doesn’t do it, arguably nothing will.

What does that tell you?  It tells me that while many are chastened, the recent surge of liquidity is likely to result in bubbles nevertheless.  The article looks to ‘green energy’ as a likely bubble market.  But in “The next bubble” FT Alphaville look to a more conspicuous place, emerging markets.  This article is definitely worth reading.

I would also point to the recent 40% surge in U.S. equity prices as evidence that liquidity factors are at play and that a bubble mentality is returning.  Moreover, $70 oil in a period of depressed demand for oil doesn’t speak to a market running only on fundamentals. If oil prices are $70 today, they most certainly can and will rise to $100, $150 and beyond if recovery takes hold and demand returns.

Therefore, in my view, Ben Bernanke does blow bubbles too.

Below is the research note from Montier which inspired this post.

Forever Blowing Bubbles

Related posts:

• Bank leverage: forever blowing bubbles part two
• Popping bubbles
• All bubbles are equal, but some bubbles are more equal than others
• Liquidity trap of a different sort
• James Montier sees “deep value” in markets – he is bullish

Marc Faber participated in a roundtable discussion on CNBC this morning about the dreadful figures coming out of Europe (see articles here and here).
At one point, the German CNBC correspondent made a very good comment about Eastern Europe getting killed by a falloff in internal demand due to a severe banking crisis and this being compounded by a falloff in external demand as Germans and others increase their savings. She asked whether over-indebtedness and excess consumption was what caused the problem. Why should that now be the solution?

Faber used this as an occasion to promote his thesis that much of the geopolitical tension and economic turmoil is associated with a passing of the baton of economic leadership from the west to Emerging economies. Whether you agree with his sentiments, it makes for a lively discussion. The video is below and runs about 7 minutes. Take a look.

There is also an associated blurb from CNBC Europe’s anchor Geoff Cutmore about the discussion that reads:

Prepare for War, the Death of capitalism and Bankruptcy of the US Government (not necessarily in that order)

A vintage performance from the author of “The Gloom, Boom & Doom Report”. This morning – living up to his reputation for bearishness – Marc Faber forecast a litany of unpleasant events ahead.

His key message is: buy real assets. He thinks it will take years for the global economy to recover, but when it does the effect of governments’ printing money will ultimately reignite inflation.

“If you’re in any field, you should own a farm because one day you will be grateful that you are able to grow your own agricultural produce.”

Recovery will be slow because government meddling in the markets will postpone it. He argues that the final low for markets and for growth will only come when the debt and losses have been cleaned out of the system.

Unless the system is cleaned out of losses, “the way communism collapsed, capitalism will collapse.”

“The best way to deal with any economic problem is to let the market work it through.”

The Fed is destabilizing, it’s creating “enormous volatility”.

Marc thinks the yields in government bonds bottomed out in December 2008 – rather than lend money to the US government he suggests buying a portfolio of large, quality blue chip stocks. They will grow and survive – and reposition to take advantage of the rising importance of the emerging economies.

“I think we are living through a major transition in the world… the economic bloc of emerging countries will be more meaningful than before.”

“I think that in Asia we have lots of sectors that are quite attractive. The banks, they don’t have the toxic assets that we have in the rest of the world.”

While not an optimist on the Chinese economy near term – Marc likes Asian currencies, and banks ex-Japan. He also thinks the real estate markets are improving. Both Russia and Turkey get a positive mention.

Cutmore follows this up with a summation of Faber’s market calls related to this view. See the link at the bottom for those calls.

Source
Cutmore: Marc Faber on Armageddon – CNBC

Related posts:

• Marc Faber: Dr. Doom goes bullish
• Marc Faber Raw
• Marc Faber on CNBC: bearish on oil and India
• Marc Faber: “I am 100% sure that the U.S. will go into hyperinflation”
• Marc Faber: I advise every American to hold his gold outside of the United States

For a moment forget that Mark Mobius is talking his own book.  He suggests in the video below that we are in the early stages of a new bull market for emerging markets. He does not suggest that it will be off to the races from the word go, however. Mobius thinks we are base-building right now.

Mobius is primarily buying stocks with P/E ratios of under ten, of which there are many in the emerging markets. He sees Hong Kong-listed Chinese stocks as the number one place to go (remember that Chinese stocks were decimated in 2008). He favors Brazil, Turkey and Russia as well.

Now, Mobius was making the same comments back in December and I was skeptical. Nevertheless, many emerging markets had their lows in November and December (much earlier than most of the larger Western markets, where lows were registered in March). They have not looked back in the last 5 months.

Related posts:

• Mobius: Still bullish on Emerging Markets
• Sprint: an example of stocks beaten down in the bear market
• The market is moving. You should be too.
• Louise Yamada: Sell stocks; Dow could be headed for 6000
• Selling the good news does not a bull market make

This comes from Win Thin, a senior currency strategist at Brown Brothers Harriman:

Mexico President Calderon is now saying that Mexico stands ready to take a $30-40 bln IMF credit line. This was a surprise to us, and we view this as a negative for Mexico since no country until now has gone to the IMF for any sort of precautionary program due the stigma that’s still attached to such a move. There have been no further details, but we assume that Mexico is talking about the Short-Term Liquidity Facility (SLF). This was established back in Oct as a quick disbursement mechanism for countries with strong economic policies that are facing temporary liquidity problems in the global capital markets. While there has been a surge in traditional IMF programs in recent months, there has been zero demand for the SLF so far. We also note that after the Asian crisis, then-Managing Director Michel Camdessus set up the “Contingent Credit Line” that was intended to be precautionary credit for “good” members. The program was introduced in 1999 and expired in March 2003 after no borrowers came forward.

We do note that Mexico really isn’t that vulnerable compared to Eastern Europe. External debt/GDP is around 20%, while short-term debt/reserves ratio is about 42% and the current account gap this year is expected at around 3% of GDP. However, there are concerns that the corporate sector is facing a large-scale currency mismatch, which would help explain the potential IMF deal. Central bank Governor Ortiz said recently that Mexico may activate its USD swap line with the Fed soon. Still, it’s a bit surprising to hear about a possible IMF program even as the peso is having its best month since the Tequila crisis of the 1990s. In our view, though, investor confidence is likely to take a hit from Calderon’s remarks. USD/MXN tested the 14 level but failed to break it today, and so we look for a bounce higher for the buck after this news. USD/MXN earlier this week broke the 38% retracement level of the Mar drop at 14.434, which targets the 50% level at 14.6532 and the 62% at 14.8725.

Related posts:

• Is Mexico imploding?
• Will Mexico suffer contagion?
• Mexico: Central bank to cut today
• Hungary cut to a notch above junk by S&P
• Regional banks: Zions falls

Standard and Poors had their hands full today cutting credit ratings.  They cut Ireland. But, they also cut Hungary, putting the country just above a junk credit rating.  I don’t think these will be the last sovereign debt ratings downgrades, especially in emerging markets — economies worldwide are deteriorating.

The Brown Brothers Harriman currency group has released a view that includes South Africa, Poland, Mexico and Korea as well as Hungary.

Here is what Win Thin, a senior currency strategist in the group, had to say about the downgrades:

S&P has been busy today. Besides downgrading Ireland, it also cut Hungary by one notch to BBB- with the negative outlook kept. Just like they missed the mark with regards to subprime, so too did these agencies overrate many of the weaker EM credits (was Iceland really AAA?). Our internal sovereign ratings model (which we just updated for the latest FX quarterly) puts Hungary at a BB- rating vs. BB last quarter and actual ratings of BBB-/A3/BBB actual. Yes, Moody’s still puts Hungary at A3 (equivalent to A-). We think junk status is in the cards shortly for Hungary, and to reiterate our rather frank view, most of these EMEA credits really never deserved to be investment grade in the first place. Our model points to severe downgrade risks in the Baltics and the Balkans. We think Poland and South Africa face modest downgrade risk in 2009, as does Korea and Mexico. Otherwise, we believe the lion’s share of downgrades this year will be in the EMEA region. EUR/HUF likely to retest the 317 high.

Obviously emerging market risk still remains quite elevated and will not diminish for some time to come.

Related posts:

• Baltics: Fitch downgrade and more downgrades to come
• A bearish view on Eastern Europe
• More trouble in the Baltics as S&P downgrades
• Moody’s: Iceland, Latvia and Hungary in “fragile stabilization”
• Greece sees credit rating cut by S&P

Goldman Sachs London conducted a poll of FX/Macro fund managers today that had interesting results.  The poll demonstrated that fund managers are expecting deflation more than inflation and that they expect the U.S. or Asia to escape the downturn first (and certainly not Europe or the UK).  I imagine that funds are positioned accordingly in currencies, stocks, and bonds.

Here are the poll results:

• 83% of participants believe that the biggest global threat at present is ‘deflation’ vs 17% believing this will be ‘inflation.’
• 82% believe we will se a US style 1930s Depression vs a German style 1920s period of hyperinflation.
• 47% believe the US will recover first from the current crisis, 42% believe it will be China/Brazil… Only 7% believe this will be the UK and only 4% believe it will be Europe!
• 73% believe the US will recover before the Eurozone (only 6% believe that Europe will recover before the US while the rest believe they will both recover at the same time).
• 55% believe a country will leave the Eurozone 10 years from now or later – only 10% believe that this will happen within the next year.
• 44% indicate that they are avoiding all EM investments for now – 20% would invest in Latam, 27% in non-Japan Asia and the rest in EMEA.

Related posts:

• Stephen Roach: Downturn in Asia less severe, but recovery later
• Switzerland gets deflation too
• The inflation-deflation debate
• Britain gets deflation
• Inflation or deflation?

The Chief Economist of Goldman Sachs, Jim O’Neill, sat down with the FT’s David Oakley and had a go on a number of topics from the financial crisis, investments in Emerging Markets, the future of the Bric (Brazil, Russia, India and China) economies, to the global economy.

Below are links to the three-part video series on the FT website. While he is more optimistic than I, I do think the videos are well worth watching.

Enjoy.

This first video is on the global economy. (Click on image below)

Click here for the second video on the Bric economies.

And click here for his view on investment in emerging markets.

Related posts:

• The bullish argument for the global economy
• Three views of the global economy
• Marc Faber: Investment strategies for June 2008
• Where is the global economy headed?
• Jamie Dimon on the economy

The question on everyone’s mind in the emerging markets is who will blow up next. Arnab Das of Dresdner Kleinwort Benson takes a stab at answering that question. He targets the Baltics as the problem children and sees current account surplus nations in Asia as lest vulnerable. He also discusses his views on Russia.

Below is the video with him on CNBC giving forth his view.

Related posts:

• How Iceland collapsed
• Is Ireland the next Iceland?
• Violence erupts in Iceland
• Iceland fast tracked for EU membership
• Iceland: a cautionary tale for small nations

You probably know that I am gearing up for some serious writedowns in Eastern Europe because I see these countries as having external imbalances which will have to be corrected as the economy softens. In previous posts, I had mentioned that there was considerable exposure to Eastern Europe in Austria, Sweden, Denmark and Germany in particular. Austria is the worst of the lot. Today, I happened upon an article and a quote which puts the Austrian exposure into context.

Internationally, Smick said export-dependent developing countries, and the western banks that financed their growth, are particularly vulnerable.

“If too many of these emerging markets go down, the IMF (International Monetary Fund) lacks the necessary resources to mount rescue operations,” writes Smick, author of the 2008 book The World Is Curved: Hidden Dangers to the Global Economy.

“To put things in perspective, Austrian banks have emerging-market financial exposure exceeding $290 billion. Austria’s GDP is only $370 billion.”

Yves Smith tells me the word on the street is that Germany may be holding back on fiscal stimulus in anticipation of a need to bail the Austrians out when their banking system comes under fire. I have not heard these rumours, but, it does stand to reckon that some larger government entity is going to be left holding the bag here. The Austrians will not be able to get out of this alone.

Source
Economic ‘bubbles have only begun to burst’ – Vancouver Sun

Related posts:

• European banks have hands out for more capital
• Is this Austrian real estate company a canary in the coalmine?
• The EU promises to bail out eurozone members
• Peer Steinbrueck says Germany might bail out the Austrians
• EU planning 200 billion euro package for Eastern Europe

The punderati has been especially kind to China. As the global recession takes hold, the conventional wisdom has moved from the largely debunked de-coupling of China to a story where China slows, but much less so than the west. But is that really how things will play out?

Marshall Auerback certainly thinks China faces some stiff headwinds, but he believes these are issues that can be overcome. Debt levels are extremely low and savings levels very high amongst the consuming masses there. Mark Mobius believes that the emerging markets generally are shortly due for an upswing. However, I would like to take a more pessimistic tack here.

You may recall that just yesterday I quoted from an Indian article which underlined the cratering of export demand for China. Let me add to those thoughts with the following analysis:

1. The Chinese are highly dependent on manufacturing exports to maintain growth. Most of their growth in the last two decades has come from export demand subsidized by a cheap currency and massive numbers of relatively low wage workers.
2. However, demand from the west is cratering because of the worst recession since the 1930s.  Because China’s export economy is geared to the west, this has had a devastating impact on export demand.
3. As a result, the Chinese will need to switch to a focus on domestic demand. Where is this demand going to come from? Granted they have no debt. However, people don’t just start buying stuff in the middle of the greatest downturn in 75 years. Chinese people see these and must know that caution is warranted.
4. Moreover, their residential property market has imploded as has the stock market. This too must work against the psychology of increased domestic spending as the wealth effects here are significant.
5. And the banking system was already fragile. My general thinking would be there are huge hidden losses at Chinese banks as a result. Therefore, lending capacity has to be restricted going forward. I would not be surprised if we saw a reduction in the money multiplier in China as well.
6. Ultimately, I would argue that the Chinese domestic consumer is not going to consume more.   In fact, they would need to consume a lot more given the GDP per capita of the average Chinese person in order to replace the lost demand from the West.  But, I believe they will consume less given the factors enumerated above.

I await more data from China. In the meantime, I remain skeptical but open to persuasion.

Sources
China’s industrial output growth stalls – Sydney Morning Herald
China ‘repeating US mistakes of 1930s’ – Sify.com, India
The Great Crash of China – Far Eastern Economic Review
China’s Output Growth to Drop Further, Minister Says – Bloomberg
China: Industrial Output – Bloomberg
China Industrial-Output Growth Is Weakest Since 1999 – Bloomberg

Related posts:

• China cutting overcapacity
• China can handle collapse of speculative inflows
• Marc Faber: China’s numbers are fake
• China wants all of Repsol’s Latin American oil assets
• The world’s biggest bank is Chinese

Last night an article by Niels Jensen of Absolute Return Partners caught my eye. In it, he made a very strong case for worrying about European bank exposure to emerging markets and its potential for creating systemic risk. I would like to share some highlights from this well-written piece and add a few thoughts of my own.

I have talked quite a bit about this problem in my blog in the past. Below are a few related articles. I am generally of the view that the crisis in the U.S. and Western Europe has been addressed sufficiently to provide a slow recovery. However, I am quite concerned of collateral damage from elsewhere bringing things to a head and precipitating a systemic problem. European bank lending to over-indebted emerging markets is tops on my list of worries.

Niels Jensen puts it quite well.

In the US, bank lending is already responding to Fed’s tactics. Total commercial and consumer bank lending has grown by an annualised rate of almost 50% in the last month and a half. Quite impressive in an economy which is supposedly in recession.

So far so good. The problem is, however, that the near meltdown has unleashed an asteroid storm of problems. Take Iceland. As most investors know by now, Iceland is in very serious trouble. According to at least one estimate, European banks stand to lose about $75 billion on Iceland – not exactly pocket change. And that is on a population the size of Coventry! Earlier this week, the Central Bank of Iceland raised the policy rate from 12% to 18%. Inflation is now running at about 16% and will undoubtedly peak at much higher levels. According to Danske Bank, expect it to hit 75% before things get better. That is ugly.

The canary in the coalmine

I have an increasingly uneasy feeling that Iceland is the canary in the coalmine. Hungary is struggling. So are Pakistan, Ukraine, Belarus, Romania and Argentina. Cristina Fernández de Kirchner, the President of Argentina, took everyone by surprise last week when she announced that the country’s private pension funds (about $26 billion) would be transferred into the state pension system. The official line is that she is aiming to protect the country’s pension funds from the global turmoil. Who is she kidding?

Now, the Federal Reserve Bank has decided to provide emergency loans to Mexico, Brazil, Singapore and South Korea. Not that long ago, it was Singapore (amongst others) which provided emergency funding to the ailing U.S. banking sector. If countries such as South Korea and Singapore require help from the outside, the state of affairs in other and less developed nations could be much worse than generally perceived.

This is the problem. There are any number of countries that are in jeopardy of imploding from a slowing economy, high debt and macro imbalances. The list extends from Asia to Eastern Europe to Latin America and beyond.

“So what?” you say. Well, not so fast. In a globalized economy, the interdependence of nations is a lot more than you might think. In fact, European banks have a lot of exposure to Emerging markets, having lent ridiculous sums over the past decade. Think of this as a 1980s Latin American debt problem writ-large.

European banks at risk
Worldwide cross-border lending now stands at $37 trillion with about $4.7 trillion going towards Eastern Europe, Latin America and emerging Asia. Cross-border lending by European and UK banks to emerging market countries accounts for 21% and 24% of respective GDPs compared to 4% for U.S. banks and 5% for Japanese banks (see chart 4). Europe has about $3.5 trillion of debt outstanding to emerging market countries whereas the U.S. has only about $500 billion on the line.

The country most exposed to emerging markets is Austria with total emerging market loans accounting for no less than 85% of the country’s GDP – most of it to Eastern Europe. Austrian banks have been aggressively pursuing opportunities in Eastern Europe for years. They have in fact been so aggressive that their total lending to the region (approximately $300 billion) exceeds the amount lent by Germany to Eastern Europe. Even more worryingly, Austrian banks are the largest holders of debt on Hungary and Ukraine – two of the most fragile economies on the old Soviet bloc. As an aside, when the global banking system collapsed in May 1931 in the midst of the Great Depression, it was a run on the Austrian banks which acted as a catalyst.

Italy is possibly in an even more dire condition. According to a recent article in The Daily Telegraph3, Italy’s public debt is now the third largest in the world, behind the U.S. and Japan. And, at 107% of GDP, it is almost twice the limit set by the Maastricht Treaty (so much for treaties!). Italy is also a big lender to Eastern Europe. Unicredit alone has about $130 billion of debt outstanding to Eastern European countries. Italy’s predicament is well recognised by fixed income investors. 10-year Italian government bonds now yield 1.08% more than their German sister bonds. The market is telling us that something rather unpleasant could happen to Italy. It is even possible that Italy could be forced to pull out of the euro, unless they can turn the ship around fairly quickly.

Meanwhile, UK banks are primarily exposed to emerging Asia and Latin America. Only Poland stands out in Eastern Europe as a major recipient of loans from UK banks and Poland is perhaps not up to its neck in problems the way Hungary and Ukraine are right now, but the situation is deteriorating there as well. Sweden is mostly exposed to the Baltic countries. The three Baltic countries owe a total of $123 billion, $83 billion of which originate from Sweden. Knowing that Latvian banks in particular have been rather innovative with the structure of their mortgage products (such as Yen based loans), would you sleep well if you were the credit officer of one of the major Swedish banks?

Spain is the Latin juggernaut

Spain is another worry. Contrary to popular belief, the U.S. is not the largest lender to Latin America – Spain is. Just under $1 trillion of cross-border debt is outstanding across Latin America. Only 17% of that comes from U.S. banks. Spanish banks, on the other hand, have more than 30% of the debt on their books. Let’s hope for Spain’s sake that Ms. Kirchner is telling the truth when she claims that the nationalisation of the private pension funds was done to protect them from the evils of this world. Somehow I doubt it.

The sharp rise in the value of the U.S. dollar and the Yen is not helping emerging market economies either. We do not know exactly what proportion of the $4.7 trillion of loans to emerging market countries are denominated in U.S. dollars and Yen respectively, but we suspect that it is a significant share. As long as the world is deleveraging, you should expect both currencies to continue to appreciate in value, as most carry trades have been based on either U.S. dollars or Yen. Meanwhile, some countries are putting up a brave fight (e.g. Hungary and Romania). However, as we learned in 1992, a wounded currency is like a bleeding torso in shark infested waters. You can rest assured that speculators will finish off the job. No central bank can win that battle.

One might argue that a devaluation of the Hungarian currency or a collapse of the Pakistani economy won’t really affect your portfolio, but that misses the point. It is the risk to an already wounded banking industry you have to worry about. And, as I have pointed out above, European banks are much more exposed to emerging market countries than their U.S. competitors.

And this is a big problem because European banks are undercapitalized. You might remember an article I wrote in June referencing a Citigroup study that said that European banks had a $400 billion capital shortfall. This shortfall has not disappeared. Arguably, it is much worse despite the many government bailouts in the intervening months because the losses have been much greater than anticipated.

If European banks were to suffer large losses in the emerging markets, we could have another panic on our hands, and this time no amount of government intervention would be able to forestall the inevitable bank runs and deleveraging. I recommend you read Niels’ piece. We need to sound the alarm on European banks because these institutions are in desperate need of more capital. If we wait until crisis hits to tackle this looming threat, it may be too late.

Source
When the Chickens Come Home to Roost – Niels Jensen

Related posts:

• A shift to Eastern Europe and emerging markets too
• Currency crisis is gathering storm
• Ten eastern European countries now looking to IMF for bailouts
• Quote of the day: Austrian banks
• Switzerland threatened with bankruptcy

In the last few weeks, the currency market is where the action has been. We have witnessed massive moves in every major currency and in some not so major ones. To my mind, all of this is a prelude to some sort of currency crisis.

This crisis has been sneaking up on us as most of us have been transfixed by the U.S. subprime crisis and the subsequent credit crisis. For some currencies, it has been a sickening ride. The U.S. Dollar plunged to 1.60 to the Euro only to snap back viciously to 1.25. The U.S. Dollar plummeted to below 2.10 to the British Pound but is now above 1.60. All of this in the space of a few months.

But, it is in commodity and emerging market currencies where the trouble is brewing. First, we saw a nightmarish plunge of the Australian and Kiwi Dollar as commodities plummeted. This all out assault on commodity and emerging market currencies then widened to include the Icelandic Krona, the South African Rand, the Polish Zloty, the South Korean Won, the Hungarian Forint, and the Mexican Peso amongst others.

This speaks to hot money fleeing emerging markets wholesale as the carry trade started to unwind. And I have slowly started a drumbeat of concern regarding these events. However, today, I caught two interesting perspectives on this debacle that made me blanch. One was the cover story in the Economist.

A few months ago, many emerging economies hoped they could take mass casual leave from the credit crisis. Their banks operated far from where the blood was being shed. The economic slowdown evident in America and Europe was regrettable, but central bankers in many emerging economies, such as India and Brazil, were busy engineering slowdowns of their own to reverse high inflation. They were more interested in the price of oil than the price of interbank borrowing.

This detachment has proved illusory. The nonchalance of the RBI’s staff, for example, is not shared by the central bank’s top brass, who, a day before the strike, cut the bank’s key interest rate from 9% to 8%, having already slashed reserve requirements earlier this month. Their staff’s complaint about pensions looked quaint on the day that Argentina’s government said it would nationalise the country’s private-pension accounts in what looked to some like a raid to help it meet upcoming debt payments. The IMF, which has shed staff this year because of the lack of custom, is now working overtime (see article). The governments of South Korea and Russia have shored up their banking systems. Their foreign-exchange reserves, $240 billion and $542 billion respectively, no longer look excessive. Even China’s economy is slowing more sharply than expected, growing by 9% in the year to the third quarter, its slowest rate in five years.

The emerging markets, which as the table shows enter the crisis from very different positions, are vulnerable to the financial crisis in at least three ways. Their exports of goods and services will suffer as the world economy slows. Their net imports of capital will also falter, forcing countries that live beyond their means to cut spending. And even some countries that live roughly within their means have gross liabilities to the rest of the world that are difficult to roll over. In this third group, the banks are short of dollars even if the country as a whole is not.
-A taxonomy of trouble, Economist

This article makes a compelling argument for expecting emerging markets to be the next leg down in this metastasizing credit crisis. And the Economist devotes much more space to this emerging problem (pun intended).

But, the analysis penned by Ambrose Evans-Pritchard is what really caught my eye. He makes the case for us to worry about a full-scale currency crisis worse than the 1931 currency crisis of the Great Depression. The link: Bank credit. You can think of Sweden in the Baltics, Austria in Central Europe, Spain in Latin America — and you begin to picture the interconnectedness that will imperil Europe’s banking system much more than either Japan’s or America’s.

The financial crisis spreading like wildfire across the former Soviet bloc threatens to set off a second and more dangerous banking crisis in Western Europe, tipping the whole Continent into a fully-fledged economic slump.

Currency pegs are being tested to destruction on the fringes of Europe’s monetary union in a traumatic upheaval that recalls the collapse of the Exchange Rate Mechanism in 1992.

“This is the biggest currency crisis the world has ever seen,” said Neil Mellor, a strategist at Bank of New York Mellon.

Experts fear the mayhem may soon trigger a chain reaction within the eurozone itself. The risk is a surge in capital flight from Austria – the country, as it happens, that set off the global banking collapse of May 1931 when Credit-Anstalt went down – and from a string of Club Med countries that rely on foreign funding to cover huge current account deficits.

The latest data from the Bank for International Settlements shows that Western European banks hold almost all the exposure to the emerging market bubble, now busting with spectacular effect.

They account for three-quarters of the total $4.7 trillion £2.96 trillion) in cross-border bank loans to Eastern Europe, Latin America and emerging Asia extended during the global credit boom – a sum that vastly exceeds the scale of both the U.S. sub-prime and Alt-A debacles.

Europe has already had its first foretaste of what this may mean. Iceland’s demise has left them nursing likely losses of $74bn (£47bn). The Germans have lost $22bn.

Stephen Jen, currency chief at Morgan Stanley, says the emerging market crash is a vastly underestimated risk. It threatens to become “the second epicentre of the global financial crisis”, this time unfolding in Europe rather than America.

Austria’s bank exposure to emerging markets is equal to 85pc of GDP – with a heavy concentration in Hungary, Ukraine, and Serbia – all now queuing up (with Belarus) for rescue packages from the International Monetary Fund.

Exposure is 50pc of GDP for Switzerland, 25pc for Sweden, 24pc for the UK, and 23pc for Spain. The U.S. figure is just 4pc. America is the staid old lady in this drama.

Amazingly, Spanish banks alone have lent $316bn to Latin America, almost twice the lending by all U.S. banks combined ($172bn) to what was once the U.S. backyard. Hence the growing doubts about the health of Spain’s financial system – already under stress from its own property crash – as Argentina spirals towards another default, and Brazil’s currency, bonds and stocks all go into freefall.

Broadly speaking, the U.S. and Japan sat out the emerging market credit boom. The lending spree has been a European play – often using dollar balance sheets, adding another ugly twist as global “deleveraging” causes the dollar to rocket. Nowhere has this been more extreme than in the ex-Soviet bloc.

The region has borrowed $1.6 trillion in dollars, euros, and Swiss francs. A few dare-devil homeowners in Hungary and Latvia took out mortgages in Japanese yen. They have just suffered a 40pc rise in their debt since July. Nobody warned them what happens when the Japanese carry trade goes into brutal reverse, as it does when the cycle turns.

-Europe on the brink of currency crisis meltdown – Ambrose Evans-Pritchard, Telegraph

When the markets open on Monday, I expect the crisis in Emerging markets to take top priority. Iceland was the first victim of this crisis. The dreadful events there should be a warning to policy makers to address this now or else we could see some awful writedowns at European institutions in the very near future — not to mention the potential economic destruction this turmoil could cause.

Sources
A taxonomy of trouble – Economist
Europe on the brink of currency crisis meltdown – Telegraph

Related articles
Eastern Europe: Who’s next? – Economist
South Korea: Second time around – Economist

Related posts:

• The emerging markets crisis
• Is China avoiding using US dollars?
• More thoughts on the switch from dollars as reserve currency
• Iceland and the wonders of competitive currency devaluation
• The Big Mac Index

While I am markedly more upbeat of late about economic matters, I still harbor some deep concerns about the direction of both the global economy and resultant political stability.

The Washington Post columnist Anne Applebaum has summed up my gravest fears about a global depression and its destabilizing effect on emerging market economies with this quote:

Political instability will follow economic instability like night follows day. Iceland is not alone. Serbia, the Baltic states, Kazakhstan, Indonesia, South Korea and Argentina are all in financial trouble; so, too, are Russia and Brazil.

And here’s a final, unpleasant thought: Pakistan. This is a country with 25 percent inflation and a currency in free fall; a country with a jihadist insurgency on its border with Afghanistan, permanent hostility on its border with India, nuclear weapons and a tradition of street demonstrations in response to suspect newspaper articles. Dozens of people, with all kinds of agendas, have an interest in using financial markets to destabilize Pakistan, and Afghanistan along with it. Eventually, one of them will.

-The Iceland Syndrome, Anne Applebaum, Washington Post

My sincerest hope is that monetary and economic stewards understand this close connection between economics, politics and geopolitical stability. The last time we had a period of equal or greater economic devastation, it led to the rise of Fascism, the Holocaust and the Second World War. While the developed economies look a might bit more stable, things are going pear-shaped in a hurry outside of the G-7.

We are not out of the woods yet.

Related posts:

• Quote of the day: Nationalized banking predators
• Doubling down at AIG
• TED spread signals better conditions
• Quote of the day: The Paulson Bailout Plan
• Quote of the day: TARP not based on any facts

Yesterday, I made the case for us to be less concerned about the U.S. and even Western Europe, but to be very concerned about a slowdown in Asia. The reasons for this are simple: most analysts now understand the extent of problems in the U.S. and Western Europe.

This, is part of the reason I am more optimistic about financial markets in Europe and the U.S. I am even bullish on some sectors of those economies despite the slowdown. However, less is known outside of the U.S. and Western Europe. Expectations are too high and disappointment is likely.

Today, I want to continue the theme of looking outside Europe and North America, but this time I want to focus on Eastern Europe and Emerging Markets. And to get right to the point, these areas will see a very marked slowdown, leading to very hard landings in some cases.

We have seen what can happen in a small country like Iceland when the macroeconomic data show an economy out of control. Iceland was the first small country to melt down because it had the biggest imbalance with its gaping 14.6% current account deficit. The results are especially dire for these small nations because they do not have the world’s reserve currency like the United States does. And, thus, they are more likely to feel the full force of a loss of confidence.

But, unfortunately Iceland is not an isolated case. In Eastern Europe, it’s all about overvalued currencies and poor macroeconomics. For instance, Estonia has a massive 11.8% current account deficit, Latvia’s is 13.8% and Lithuania’s is 14.0%. In Slovakia, it is 5.6%, Slovenia 6.6%, Hungary 5.9%, Poland 4.9%, and in the Czech Republic 2.8%. All across Eastern Europe there is a massive capital account surplus (hot money from abroad) to match this current account deficit. Western European Banks have been speculating in Eastern Europe and are sure to get burnt when things start to unravel there.

In July, I noted the problem in the Baltics in particular:

The Baltics are looking a lot like Argentina was before it collapsed at the beginning of the decade: fixed exchange rate, large current account deficit, significant foreign bank lending, overheating economy turning to bust.

This combination is a toxic mix that will certainly end in the disaster it did for Argentina. I have a vivid memory of being in Buenos Aires when workers were rioting in the streets, knocking over cars and setting them on fire. Foreign banks were littered with Graffiti, including the word “ratas,” scrawled across them. Many banks were shut down and closed and too many bank I could see had armed guards with submachine guns out front to protect them. I can’t say this same disastrous scenario awaits the Baltics, but things could get pretty dicey there in any event.
-Are the Baltics the new Argentina?

For other countries, it s not as much the current account as it is falling commodity prices. All across Latin America, commodity prices are important — in Chile, Peru, Argentina, Brazil, Venezuela and Mexico to name the biggest economies in the region.

As you can see from the graph above, commodity prices are falling across the board as the global economy heads into a recession. This has had different but equally staggering effects on various parts of the globe.

• In Western Europe and the U.S., deleveraging is going to slow credit growth and reign in consumer spending, leading to recession across the board.
• In South Africa, Australia, New Zealand and Canada, a combination of lower commodity prices and tighter credit will cause housing bubbles to burst and lead to deep recessions.
• In Africa, Latin America, Russia and the Middle East, commodity deflation is going to kill the commodity-dependent economies.
• In Eastern Europe, excessive current-account deficits due to hot money is going to lead to capital flight and depression as we have seen in Iceland. The most overexposed here are the Baltics. As Sweden is a major lender there, it is no wonder they are putting a massive $200 billion prop under their financial services sector.
• In Asia, slowing demand worldwide will not be offset by increased domestic demand. We have already seen Singapore enter recession, South Korea bail out its banking sector China begin to experience a stock market and housing bubble unwind, and Japan suffer recession. Growth there will be much slower than expected.

Make no bones about it, we are headed for a major global recession and no economy will be spared. This is one major reason governments are cushioning the blow with stimulus packages. As for the emerging markets and Eastern Europe in particular, the headlines below in related posts from today and yesterday should make clear that there is a crisis of confidence in those regions. Anyone investing there should beware, lest they find another Iceland on their hands.

Related articles
Emerging-Market Banks Suffer in `Iceland Look-Alike Contest’ – Bloomberg
Baltic Governments May Run Wider Budget Deficits in 2009 – Bloomberg
Sweden Pledges SK1.5 Trillion to Guarantee Lending – Bloomberg
Swedbank Credit Rating Cut at Moody’s on Debt Reliance, Baltics – Bloomberg
Hungary Cuts 2008 Growth Forecast on Credit Crisis – Bloomberg
Ukraine, IMF May Sign $15 Billion Loan By Next Week – Bloomberg
Argentine Bonds, Stocks Plunge on Pension Takeover Speculation – Bloomberg
Russia May Need to Cut 2009 Spending Amid Falling Oil Prices – Bloomberg
Brazil’s Real Weakens as Global Investors Unwind Carry Trades – Bloomberg
Credit Crisis Fools Latin America’s Leaders: Alexandre Marinis – Bloomberg
Mexico’s Peso Falls for Third Day on U.S. Recession Concern – Bloomberg

Source
Trade, exchange rates, budget balances and interest rates – The Economist
Commodity Futures – Bloomberg

Related posts:

• A bearish view on Eastern Europe
• UBS does not see the need for panic over Eastern Europe
• The emerging markets crisis
• Bloomberg talks Eastern Europe as Latvia downgraded
• Emerging Markets will be tested by inflation

So, I am back in the saddle after a great weekend in Palm Beach. And three days almost entirely away from Newspapers, Televisions, Telephones, and Computers is a very good thing to clear the head. (Although I did happen to catch Sarah Palin on “Saturday Night Live” and I thought it was well done.)

Let me start off this week with some thoughts that come out of conversations with friends in the financial industry that I spoke to at the weekend. I sincerely believe the panic that we experienced over the past few weeks is over. In time, risk premia like the TED Spread and LIBOR-OIS spread will damp down somewhat and they have already begun to do so.

However, much of the underlying problem: leverage, excessive debt and inflated asset prices remains. Moreover, we are now about to experience the pain of recession, which is an entirely different beast than what we have experienced to date. And all of this will take time to work through.

However, my focus will be on Asia because Asia is next. Let me explain why?

This crisis and downturn is a manifestation of how markets respond to a realization that an unsustainable mania has weakened the entire banking system. In Manias, Pancs and Crashes, Charles Kindleberger outlines the stages of a financial mania and crisis.

The events begin as a result of legitimate speculation in a promising asset class: metallic coins in the Holy Roman Empire in 1618-23, British Government Debt in Amsterdam in 1763, Railroads in the U.S. in the 1870s, Technology and Telecom stocks in 1995. However, easy money steps in and monetary expansion fans the flames of the speculation turning legitimate speculation into a bubble.

As the bubble takes form and money is to be made, swindlers enter the scene. Time and again, this has bee the case and in the present case things were no different. However, at some point the unsustainability of things becomes evident. Warning signs appear, leading to changing expectations, and, eventually, financial distress. Then comes the crash and panic. This is what we have seen to date in the present crisis.

However, Kindleberger also mentions the infection of asset classes due to the speculative mania in Chapters Seven and Eight. The speculation and bubble events do not happen in a vacuum. Easy money and large profits spill out into other asset classes domestically and are also propagated internationally.

Now, I would argue we have seen the spill over events in terms of residential real estate infecting leveraged loans, high yield debt, Collateralized Debt Obligations and so on. Moreover, we have seen that a number of countries have experienced housing manias that are in unwinding right now. However, I would argue that, in a globalized economy, no one is going to “de-couple” — no nation can insulate itself from the global effects of this largest speculative mania in history, That is why Asia is next.

In August, I penned a blog post “Europe is next,” in which I said:

As you could probably tell — from all the stories I have been writing about the Baltics, Denmark, Sweden, you name it — I believe that Europe is the next leg down in the global housing bubble. As such, it will pay to focus as much attention on events outside the US, where the housing bubble began as it will to focus on the continuing U.S. problem.

Make no bones about it, with distress in Alt-A, Prime, Option Arm, and Negative Amortization mortgage products still rising, the U.S. has many more writedowns to come and some bankruptcies. Yet, it is Europe where the next leg down will be interesting.
-Europe is Next

I went on to elaborate on how I saw distress in Europe and that Europe was going to suffer along with the U.S. in this downturn. And the script has largely unfolded as expected. Now, it is Asia which should move center stage. The signs of weakness are readily apparent. Three major economies are in recession: Japan, New Zealand and Singapore. Others will follow.

Moreover, the financial distress that we saw first in the U.S. and then in Europe is also apparent as well. Look at the Bloomberg headlines from Asia today:

India Lowers Key Rate for the First Time Since 2004
Citic Pacific May Lose $2 Billion From Currency Bets
Kazakhstan to Use Oil Reserves to Avert Bank Failure
Asian Stocks Rise as Government Policies Provide Market Support
Dollar Hoarding Fuels Won, Rupee, Real Drop on Losses
Pakistan May Seek IMF Bailout to Avoid Debt Default
China’s Economy Grows 9%, Slowest Pace in Five Years

All of this suggests that the ill effects of the global economic crisis have finally made their way to Asia and emerging market countries in Latin America and elsewhere. For me the South Korean banking mess is the canary in the coalmine here:

South Korea sought to rescue its financial system by guaranteeing $100 billion of lenders’ foreign-currency debts and providing $30 billion in U.S. dollars to banks.

The won rose and the Kospi was little changed after the government said it will also give tax benefits for long-term investors, and the central bank will provide “adequate” currency liquidity to the markets. The plan, unveiled yesterday, aims to help lenders overcome overseas funding difficulties.

South Korea, struggling with Asia’s worst-performing currency and a stock market that has lost 38 percent this year, joins Europe, Australia and Hong Kong in providing banks with state backing amid a global lending drought. The measures should boost confidence in the banking system and return attention to “Korea’s solid macroeconomic fundamentals,” the International Monetary Fund said.

The guarantee is “essential,” said Kim Hag Ju, head of research at Samsung Securities Co. in Seoul. “Rather than give banks the money they need, it’s much cheaper and effective to back their debts so they can borrow it. With the credit freeze, it’s extremely difficult for a bank or company to be able to borrow money without a sovereign guarantee.”

The Kospi slipped 0.3 percent to 1,177.11 at 9:29 a.m. in Seoul after initially rising as much as 1.3 percent. The index fell 9.4 percent on Oct. 16, the biggest drop since September 2001, and is heading for its first annual decline since 2002.

Currency Rises

The won gained 4.1 percent to 1,280.80 against the U.S. dollar today. The currency fell last week by the most since an IMF bailout of South Korea in 1997 after Standard & Poor’s said it may cut the credit ratings of the nation’s largest lenders.

South Korea’s government said it has no immediate plan to recapitalize lenders or increase deposit guarantees.

-Bloomberg News

If you recall, these were measures initially undertaken in the U.S. and across Europe. Eventually, greater support in the form of bank recapitalization and explicit deposit guarantees were necessary. Why would it be any different in South Korea or elsewhere in Asia?

My last though on this issue is about China. China has had a massive property and stock bubble. The stock bubble has burst and the monetary authorities are doing all that they can to keep the property bubble from collapsing in a disorderly, panic-filled way. However, it seems to me that China will suffer a hard landing as the magnitude of these bubbles become evident.

What’s my point? Asia is in a much better situation than either North America or Europe. Yet, it will not completely de-couple. The speculative mania certainly spilled out into Asia in terms of excess capacity across Asia, stock market and property bubbles in China in particular, and inflation and easy money across the entirety of Asian economies. Therefore, while Asian macro data is better than it is elsewhere, I believe we are about to witness the next leg down in the global credit crisis and it will be in Asia where the action takes us.

Asia is next.

Sources
Manias, Panics and Crashes – Charles Kindelberger

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Morgan Stanley economist Stephen Jen has said that it is the emerging market central banks, not the G-7 central banks who will be most tested by this bout of inflation that we are experiencing. His view of the implications of global inflation square well with Stephen Roach, Morgan Stanley’s head of Asia who recently said that Asia was the epicenter of the fight against inflation.

Note, many Asian central banks, like the U.S. Fed, have held interest rates below the rate of inflation. These negative real rates have led to overheating and cannot be sustained long-term. Eventually, interest rates in Asia must move higher. In the meantime, Asian producers are under pressure to pass through increased energy and wage costs or suffer margin erosion. The first signs of cost pass through are already evident in consumer goods from Asia.

See Stephen Jen’s research below or on Morgan Stanley’s website.

Some EM Central Banks to Be Stress-Tested by Inflation

Energy and food inflation has remained high. As the global economy has continued to exhibit signs of remarkable resilience, investors’ attention has, not surprisingly, shifted from ‘stag’ to ‘flation’. We are of the view that inflationary conditions will likely be negative for the currencies of many EM economies that are experiencing a negative terms-of-trade (ToT) shock. Stagflation would be even worse for these currencies. In contrast to developed markets, whose central banks could stay ahead of the inflation curve, we believe that developing market central banks will likely struggle to stay ahead of both the inflation and growth curves. The macroeconomic challenges to be faced by EM economies will be quite acute, and many EM currencies are likely to be penalised against the dollar.

Monetary Policy and Oil Price Shocks

Global energy and food price inflation poses a major challenge for monetary authorities around the world, with implications for currencies. Up to a certain threshold, say 6%, inflation should be positive for developed market currencies, in our view. Most central banks enjoy a meaningful enough amount of credibility that upside surprises to inflation should make investors look for eventual monetary tightening. The rule-of-thumb, thus, should be to buy the G10 currencies of countries that have upside surprises to inflation.

Having said this, it is important to appreciate the acute dilemma monetary policymakers are facing, and that, at some stage, if these types of global inflation persist and accelerate, central banks in developed economies may have rather diverse reactions and approaches, and the aforementioned simple rule-of-thumb would no longer be appropriate.

While much of the rise in oil and energy prices could be attributed to global demand for these products, from the perspectives of individual countries, oil and food price increases are supply shocks. Early work on the relationship on oil prices and developed market GDP suggests oil shocks were the dominant determinants of US recessions. For example, Professor James Hamilton (see Hamilton (1983) “Oil and the Macroeconomy since World War II”, Journal of Political Economy, vol. 91, (April), pp. 228-48) claimed that, since 1973, every upward spike in real oil prices has been followed by a surge in the US output gap. More specifically, Professor Hamilton demonstrated that an oil price shock had preceded (Granger-caused) all but one recession (in 1960) in the US since WWII.

Since shocks of this type are stagflationary, the Fed and other central banks are obliged to counter these inflationary pressures and not fully accommodate this shock. A reasonable approach for central banks would be to follow the Taylor Rule, i.e., adjust the FFR (fed funds rate) in response to changes in the deviations in core inflation and unemployment from their targeted levels (see Ed Gramlich (2004), Oil Shocks and Monetary Policy, Fed Speech, September 16). It is also important to keep in mind how high oil prices could reduce the potential world growth rate.). In an influential piece of research, Messrs Bernanke, Gertler and Watson (1997) (“Systematic Monetary Policy and the Effects of Oil Price Shocks”, Brookings Papers on Economic Activity 1: pp. 91-142) argued that, at most, only half of the observed GDP declines after oil price shocks could be attributed to the oil shocks themselves, with the other half of the recessionary pressures coming from the monetary reactions to the oil shocks. This exaggerated compression in output growth can be interpreted as a price to pay to secure stability in inflation expectations.

If, however, there is an underlying stagflationary trend coming from demographic pressures (aging and the shrinkage in the relative size of the work force in the U.S. and other developed nations) and globalisation, the stagflationary proposition confronting central bankers could be more acute than during the last great oil shock in the 1970s.

The bottom line here for developed economies is that oil shocks themselves are stagflationary and monetary reactions to these shocks have, during past episodes, exacerbated the declines in GDP growth, in exchange for more restrained inflation. Up to a certain point, inflation should lead to strong currencies as central banks tighten. But how developed market currencies perform as inflation rises will be a function of how stagflationary conditions get and how successful various central banks are seen at handling the stagflationary conditions.

Policy Dilemma Will Be More Challenging for EM

There are several reasons why central banks in EM will likely have much greater difficulties in the months ahead:

• Reason 1. Imported inflation cannot be offset. EM economies’ CPI baskets contain much higher weights for food and energy products than developed economies’ CPI baskets. This is important, because to offset inflationary pressures in these products – which are increasingly determined by international forces – EM central banks will need to somehow generate enough deflationary forces elsewhere in the economy. In other words, for EM central banks to achieve their targets on inflation, in the presence of high internationally determined energy and food inflation, they would need to be willing to drive the domestic economies into deep recession – a proposition that we believe is unlikely to be politically acceptable. The combined weights of energy and food products range between 30% and 70% for many EM economies, compared to around 25% for most developed economies. Further, actual food accounts for a bigger fraction of the retail costs of food items in EM economies, whereas in the developed world, the bulk of the retail cost of food items reflects retail, advertising and other service costs. In fact, it has been estimated that actual food accounts for some quarter to a third of the total cost of food products in the US. In any case, the point here is that fluctuations in international food commodities tend to feed into EM economies’ CPI far more easily than in the developed world, and such an impact tends to be so powerful that offsetting it would imply extreme measures by central banks. This cannot be positive for EM currencies.

• Reason 2. Rollin
g back of energy and food subsidies to keep stagflationary pressure sustained. We have pointed out previously (Enjoy the Energy Subsidies While You Can, May 22, 2008) that half of the world’s population now enjoys energy subsidies and about a quarter of the world’s gasoline is subsidised. Our analysis in that note was limited to the gasoline market, but the same logic applies to other energy products and food items. Subsidies mute the impact of high prices on the quantity of demand (i.e., prevent the demand curve from being downward-sloping). With subsidies, global demand for food and energy is not ‘destroyed’. But as food and energy prices stay high and rise further, EM economies will be under pressure to roll back these subsidies. The end result is that stagflationary conditions will persist longer in EM with subsidies than elsewhere. Often governments are forced to roll back on the subsidies and, by construction, the timing of the withdrawal of these subsidies is likely to be bad, both from a macroeconomic and social perspective. This cannot be positive for EM currencies.

• Reason 3. Inflation-targeting (IT) in general will be seriously stress-tested. The world’s headline inflation has trended lower over the past decades. Between 1997 and 2007, OECD headline inflation declined from 4.8% to 1.9%; BRIC headline inflation fell from 9.2% to 4.1%. (During this period, core inflation also fell, from 4.4% to 2.1% for the OECD countries, and from 4.4% to 1.3% for the BRIC economies.)

While better, more disciplined monetary policies have likely played an important role behind this trend, other factors (such as globalisation, deregulation and luck (this includes the lack of major global military conflicts and absence of other major shocks)) have arguably been at least as important. In this ‘Goldilocksy’ environment of the past, it was relatively easy for IT regimes to look good. But if the structural trend in global inflation is indeed turning, then IT regimes could be stress-tested. In fact, rigid forms of monetary policy will be stress-tested if the natural rates of unemployment and corresponding inflation rates are shifting. Further, if indeed this worry about more rigid forms of monetary policy is justified, then it is reasonable to expect these stress-tests to be more extreme for EM economies than for developed economies, due to Reason 1 mentioned above. We believe that the likes of Korea, Thailand, South Africa, Russia and Turkey will need to consider the following options: raise the numerical targets on inflation, have a moratorium on applying their inflation targets, change the targeted inflation indices (from headline to core), or abandon IT altogether. None of the above will be supportive of their currencies, in our opinion.

Bottom Line

Inflationary pressures of the type we are dealing with (triggered by energy and food price shocks) will pose a considerable challenge to monetary authorities, particularly those in EM economies. We believe that this is a powerful theme, which will hurt many EM currencies.

Related posts:

• Morgan Stanley warns of a new inflationary period
• Asian inflation in the pipeline
• Quote of the day: William White and inflation
• Chart of the day: Inflation
• Debtflation

Transcript of the interview with CNBC India here. He’s bearish on oil short-term. He’s bearish on financials and sees bankruptcies in the offng soon. This is a view I share. Bearish on India as well. I’ll be looking to update via the original video, if possible.

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