Waiting for the other shoe to drop

August 25, 2010


-Laurence Copeland is professor of finance at Cardiff University Business School. The opinions expressed are his own and do not constitute investment advice. -

The unemployed and the terminal insomniacs who have nothing better to do than read my blogs will know that I have long been gloomy about most of the Western economies. How can you fail to be pessimistic when the world economy is still dominated by the U.S. – a basket case, becoming weaker every day, with a political class too blind or too scared to admit in public the obvious fact that the country cannot carry on living beyond its means?

Now house prices are plunging again and, with the dollar still strong, the prospects for an export-led recovery look bleak. In fact, a return to recession is far more likely, and the markets are starting to show signs of that sickening here-we-go-again feeling.

How will it all end?

Anyone who claims to know how this will all play out is on no account to be trusted, but there’s nothing wrong with trying to guess – in fact, that’s exactly what we have to do before we can decide what assets to invest in, or whether to invest at all rather than simply blowing it all on a long bankruptcy binge.

So here goes. I start from the observation that the bond and currency markets, in their infinite lack of wisdom, seem to have divided the whole membership of the United Nations into two classes, high-risk countries and low- (or no-) risk countries.

The former include ClubMed Eurozone members (the PIGS) plus Ireland, most East European and Latin American countries, and a ragbag of the weaker Asian sovereign borrowers.

The amazing thing (at least to me) is that the latter group includes not only such rock-solid risks as Germany and Switzerland, the Nordic countries and Netherlands, but also France (OK, maybe), Japan (debts more than twice as high as GDP, but with even greater accumulated savings balances), and . . . the UK and U.S. as if the mere fact of speaking English were a guarantee of creditworthiness.

(Note that there are solid reasons related to raw materials prices and sound fiscal policy for rating Canada, Australia and New Zealand as low risk).

Now as far as the UK is concerned, prospects have improved a lot since the general election on May 6, thanks to the fact that the coalition government has shown a readiness to deal with our problems that has surprised everyone (well, me at least).

Having talked tough (25 percent and cuts in spending in almost every department except health), the government now has to deliver – carry through the cuts, stick with them and keep its nerve, while all hell breaks loose in parliament, the media and, probably, in the streets too.

Meanwhile, across the Atlantic, the Americans remain in denial, with monetary and fiscal authorities primed to pick up any slack created by U.S. consumers unable to make their mortgage repayments and maxed out on their credit cards.

The policy is patently not working, because the U.S. economy is caught between a rock and a hard currency. On the one hand, America needs the world to keep believing in Uncle Sam, because the moment it stops trusting the greenback, it will dump U.S. Treasuries, pushing up interest rates dramatically and driving tens or hundreds of thousands more Americans out of their unaffordable homes.

On the other hand, as long as the markets continue to see the dollar as a safe haven, it remains strong and U.S. competitiveness suffers accordingly, making it impossible to generate the export-led recovery the U.S. so desperately needs.

How will it play out?

Japanese-style deflation and stagnation is certainly a possibility. But my guess is that it will be preceded by another major crisis  – maybe next week, next month or next year, but the longer the reckoning is delayed, the more drastic and painful it is likely to be.

It will be triggered by a drastic rerating of U.S. (and possibly British) debt, as it suddenly dawns on those who speak the language of Confucius and the Koran that those who speak the language of Shakespeare cannot necessarily be trusted to repay their debts – at least, not in hard currency.

If, by that time, Britain has taken credible steps towards solvency, it may conceivably be exempt. But more likely it will be swept up in the panic which will engulf the U.S. as investors rush to sell dollar assets.

As I have explained before, I think it highly unlikely that either country will explicitly default. But as the dollar falls, it will generate rising prices in America, and the Fed will go with the flow, since inflation will be seen as the soft option/short term solution/easy-way-out, offering the opportunity to repay the debt with devalued currency while simultaneously restoring the competitiveness of U.S. output on world markets.

So what should the ordinary investor do about it? First, remember that, with the exception of the Canadian and Australian dollars, and Swiss franc, all the world’s major convertible currencies are priced on the Manure Standard: the dollar is viewed as slightly higher grade organic fertilizer than the euro, the yen is somewhat less disgusting than the dollar . . .

All are malodorous to a degree which would have made them near-worthless only a few years ago. No wonder gold – useless, but odourless – is riding high. If I am right, it has far further to go.

As long as China keeps booming, commodity-based economies like Australia and Canada seem likely to benefit, and both have relatively responsible monetary and fiscal policy regimes too. As far as I am concerned, 10-year Australian government debt yielding nearly five percent shines like a good deed in a wicked world.

U.S. Treasuries are, on this view, grossly overpriced – the biggest bubble in the world. But if you accept the judgment that neither the UK nor the U.S. is going to default, then index-linked are attractive.

Otherwise, safe and stodgy equities . . . utilities, supermarkets, healthcare and energy. Boring is beautiful.

Picture Credit: Four thousand U.S. dollars are counted out by a banker counting currency at a bank in Westminster, Colorado, in this file  picture.  REUTERS/Rick Wilking


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