A Vicious Cycle: Part II

247Bull.com Editor: In his latest Amphora Report, John Butler tackles one of the most important macro trends we see. That of currency debasement. As John points out, “There is, however, one method that trumps all others: Currency devaluation. Yes, this may clearly and directly rob savers (and importers) to bail-out borrowers (and exporters), but if other methods fail, then devaluation will ensure a de-leveraging of the economy. Every investor, and anyone with wealth, should be deeply concerned about this long-term trend. For further reading on how to protect yourself from what we believe will be the greatest wealth transfer in history, see: The single best reason to own gold, and How to profit from QE3 & the coming wave of liquidity, and Why today’s system of fiat money is doomed to fail & what it means for investors.

To read part I of A Vicious Cycle click here.

From QE to currency and trade wars

Regardless of the insidious wealth transfer it engenders, artificial reflation can be difficult to engineer when faced with such a huge accumulated debt, as so-called ‘balance sheet effects’—debt write-downs—can overwhelm ‘income effects’-the rising nominal incomes associated with inflation. There is, however, one method that trumps all others: Currency devaluation.4 Yes, this may clearly and directly rob savers (and importers) to bail-out borrowers (and exporters), but if other methods fail, then devaluation will ensure a de-leveraging of the economy. It will also make it poorer overall, but the borrowers, being bailed-out in the process, avoid bankruptcy and thus are naturally all for it. Who cares if the pie shrinks a bit if your slice increases disproportionately in size? Such is the attitude of an established, self-serving elite.

By announcing QE3 last month, the US Fed is raising the stakes in the reflation game. Asset purchases are now ‘open-ended’; in other words, the Fed will buy up whatever is required to generate what it believes is a sufficiently high rate of inflation. If that sounds radical, it is. This is the greatest economic central-planning experiment of modern times, one that threatens to wreck the US economy via chronic resource misallocation as described above.

Whether or not QE3 results in a material decline in the value of the dollar relative to other currencies is unclear. There are two sides to any exchange rate, and many other economies have issues of their own, including their own versions of QE. Who succeeds in devaluing against whom is one of the great unknowns at present. But be under no illusions: A ‘currency war’ of sorts is already underway. (Brazilian Finance Minister Guido Mantega seems particularly fond of this term, having used it on multiple occasions to criticise US monetary policy. He has also claimed that the current currency war is leading toward a more general global trade war.)

Back in October 2010, in the Amphora Report titled Begun, The Currency Wars Have (The link is here.), I considered the potential implications of a general global currency war:

Currency wars might appear to be zero-sum. But this is true only up to a point. For if all countries intervene to weaken their currencies in equal measure, no country succeeds in devaluing versus the others. As such, they might then resort to raising trade barriers or enacting currency controls which restrict the flow of capital across borders. These sorts of actions cause substantial economic damage however and are thus hugely counterproductive. The 1930s were characterised by, among other things, currency devaluation, capital controls and rising trade barriers such as the infamous “Smoot-Hawley” tariff.

While potentially growth negative for the global economy, currency and trade wars can, however, contribute to rising price inflation. Why? Well, the weapons of currency wars are the printing presses. The more you print, the more you can weaken your currency, or at a minimum prevent it from rising. He who prints most, devalues most and “wins”. But if all print in equal measure, exchange rates don’t move, but the global money supply soars. As such, currency wars don’t stimulate real economic growth–indeed they are much more likely to weaken it–they stimulate only nominal growth, that is, inflation. The net result is most likely to be a global “stagflation”.5

Now imagine that the current global downturn is met with even more aggressive attempts by various countries to weaken their currencies, increasing uncertainty with respect to currency and trade policies. Tariffs and import quotas for sensitive goods begin to rise from historically low levels. Globalisation, as it were, begins to go into reverse.

While the neo-luddite, anti-globalisation crowd might rejoice at this development, for investors, there will be little to celebrate. Modern corporations are highly leveraged to relatively free trade. They are already facing higher input costs due to the general global commodity price inflation resulting from previous QE. Industries ranging from airlines to mining are facing industrial action as workers push for wage increases. These factors are beginning to place pressure on profit margins.

But now, already facing margin pressure, corporations might need to contend with unforeseen trade barriers springing up right in the middle of their highly specialised, globalised operations. These may have a huge impact on their cost structure and in some cases will render entire divisions uneconomic. Large restructurings may be required, costly as they are. Some corporations may find that they are simply unprofitable absent free trade and will wind down operations or possibly even end up in bankruptcy. Shareholders may be in for a rude shock.

At a minimum, the equity risk premium is likely to rise in the event that it appears that the currency wars are morphing into trade wars. That will depress valuations. At worst, the global equity market might crash. Indeed, some economic historians believe that the proximate trigger for the great stock market crash of October 1929 was news of a major compromise in the US Senate making it highly likely that the proposed Smoot-Hawley Tariff Act would pass.6 Of course, the world was hardly as globalised back then.

Just imagine what effect something along the lines of Smoot-Hawley would have today.

Investing for the vicious cycle

When economic upturns are disappointing and downturns trigger counterproductive policy responses, equity risk premia naturally adjust higher, implying lower market valuations. When those policy responses escalate into currency and trade wars, the result can be a major correction or even a crash.

Near term, regardless of whether such risks materialise, I would be concerned about the equity markets. QE-euphoria has led to fresh advances but there has been a noticeable lack of participation by transportation stocks. That may be due in part to a handful of profit warnings in prominent firms such as FedEx, but then global industrial bellwether Caterpillar also issued a warning late last month. Meanwhile, the euro-area crisis stubbornly refuses to go away. In Spain, demonstrations have recently turned violent and at least two regions are considering seceding as a way to opt out of further central government attempts to impose ‘austerity’.

While not a prediction, I would not be at all surprised by a 15-25% stock market decline over the next few months. We have now entered a seasonal period which contains a majority of major market declines, including 2008, 1987 and 1929. Just last year, there was a sharp correction in Aug-Sep, immediately prior to the current window.

Cautious investors should consider waiting in cash for a more attractive valuation point at which to re-enter the equity market. But be under no illusions: In a world of QE, cash is not a store of value, rather merely a convenient place to wait out the downside risks associated with the current, ‘vicious’ cycle, artificial reflation and the associated currency and trade wars that may lurk in future. Bonds are an even worse store of value of present, as they represent a leveraged exposure to devaluation risk.

As an alternative to cash, investors may want to consider an allocation to relatively defensive commodities, that is, those with a low correlation to the business cycle. As I pointed out in my September report, Par for the Pathological Course (link here) a handful of these look relatively inexpensive at present, including cotton and sugar. Among industrial commodities, following a recent sharp decline, oil is looking relatively cheap at just over $90/bbl.

Gold may be approaching the previous record high from 2011, but given currency debasement and other, associated risks discussed here, it will probably continue to rise in price, as indeed it did as the US descended into the Great Depression in 1929-1934. Remember, gold is a form of insurance, not a productive asset. As uncertainty rises, so does the demand for insurance. But if the supply of insurance is relatively fixed, then the price must rise.

4 Fed Chairman Bernanke stated as much in a (in)famous 2002 speech in which he discussed how central banks can always prevent deflation and create inflation if desired. The link is here.
5 Begun, The Currency Wars Have, Amphora Report Vol. 1 (October 2010). The link is here.
6 The US House of Representatives passed a version of the Smoot-Hawley bill by nearly a 2/3 majority in May 1929. It was assumed at that time, however, that the bill was unlikely to get through the Senate, and the stock market continued to rise. Indeed, even following much debate and compromise, the Senate’s version of the bill passed by only the narrow margin of 44 to 42.


John Butler | Amphora Capital

Mr Butler is the author of The Golden Revolution: How to Prepare for the Coming Global Gold Standard

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