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The recent strengthening of the USD is supposed to be the result of both light trading volumes and also of an atmosphere reflecting the idea that the US economy is in a poor shape, but so is everyone else’s. There may also be an element of reversal of the phenomenon of commodity prices rising as the USD fell. These explanations seem, however, rather inadequate reasons to suppose a fundamental change in the outlook for the US economy and currency. What the surprise USD rebound does bring home is that rebalancing of the world’s economy cannot be described simply as a steady shift of economic strength from the US to Asia and other emerging markets, with Europe remaining more or less unscathed. During this process, almost everyone is getting hurt by the reduction of the USA’s spending power, and there will be many ups and downs. |
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Nevertheless, the above simplistic view of the shift in economic power remains reasonably correct over the long run (measured in years) and is worth reviewing again even as currencies and stock markets pass thorough a period of turbulence: |
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- The USA is overextended in almost every regard: in government debt, household debt, national debt, and militarily. The “solution” brought by Bush Administration is to extend further. We have always been astonished that the world’s biggest debtor is able to continue down the same path, tolerated and even encouraged by its Chinese and OPEC creditors. No one should lose sight of the fact that the route of increased indebtedness and cheap money is inherently unsustainable. We see the current credit crisis as a manifestation of the “end game”. The USD remains fundamentally weak, by which we mean its long term-exchange rate must fall and periods of relative strength are short-lived. The rate of fall is heavily influenced by China’s willingness to hold USD reserves
- Europe has a more solid macroeconomic policy, with the overall balance of its current account and a central bank more committed to fighting inflation than the Fed. The ECB’s policies look like resulting in economic slowdown, particularly in countries where housing bubbles are deflating. The advancing integration of the new EU members, and their supply of low-cost labour obviously create problems in western Europe, but lend strength to the whole
- China’s growth as a manufacturing base should eventually lead to an expansion of domestic household consumption, and to a better balance of international trade. This may be happening, but very slowly. The optimism of the Olympic games and the media coverage of the over fashion-conscious consumers in Beijing contrast with huge, but empty shopping malls and struggling supermarkets
- India may be doing a little better than China in creating a significant consuming class, but fuel and other subsidies are unsustainable in their current form and may lead to a short term correction in growth.
- Russia has much in its favour due to its raw materials and educated population, but its integration with the rest of the world has taken a step backwards with the Georgian war and disrespect of property rights in business
- Brazil looks like the only unqualified success story
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The deflation of the commodities bubble continues as demand moderates with the economic slowdown. In a period when inflation is high, often above the target rates (as in the UK at 4.4% vs. 2% target), inflation will surely moderate as commodity prices fall back, although it is as difficult to digest that in the heat of the moment as it is to accept that bubbles always deflate. Yet we lean toward the view that inflation will moderate by itself, and that interest rates are now less likely to rise (not that reductions are in view either). This explains our recommendation towards fairly long maturities, although we “confess” that our clients are reluctant to follow us in this regard. |
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Fixed-income markets are currently functioning smoothly and will continue to do so until, as one of our wags puts it, the next financial institution goes under. A survey of institutional opinion about that possibility suggests that professionals see such an institutional failure as nearly inevitable over the next six months. The endless additional losses announced by banks give strength to this view, plus, of course, the latent insolvency of Fannie Mae and Freddie Mac. |
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Focus |
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(!) China: PPI was 10 % in July (June 8.8%), the highest in 10 years |
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(–) Russia: the RUB under pressure at 24.to the USD; greatest daily loss in 8 years, –4.5% |
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(+) USA: Paulson sees the housing crisis continuing well beyond the end of 2008 |
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(–) Seychelles: the spread on its main bond (9.125% 2011) continues to widen: 2420 vs. 2150 last week |
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(–) UK: inflation reached 4.4% in July (the highest since April 1992) |
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(+) Gold: with its price falling due to the rise in the USD and the fall in oil prices, gold dropped to almost USD 800 per ounce, a loss of a quarter of its value in five months and back to its price last December |
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(+) positive for bonds (–) negative for bonds (!) watch out (?) begs the question |
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