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The news last Wednesday
coming on the cusp of Thanksgiving celebrations in the U.S. should serve as a
reminder of the globalization of risk and the importance of fundamentals in
disparate locations around the world. While Dubai World’s credit
crunch was “expected” according to some analysts, the speed and
impact of the news was certainly noteworthy.
Financial bubbles from
excessive leverage, without underlying fundamentals, can occur in parts of
the world assumed to be immune from financial realities. As the near
partial eclipse of the Dubai World brush with darkness passes into
investor’s memory and archive of anecdotal cautionary tales, it becomes
increasingly important to glean lessons as financial history unfolds.
The announcement about
Dubai World’s creditworthiness sent an instant shock through world
financial markets. Global equity markets lost about 2.5% following the
news. This was taken hard by those in Europe with significant money out
to Dubai World. Interestingly, funds moved rapidly to traditional safe
havens such as the U.S. dollar. Gold, which seems to move increasingly
opposite the U.S. dollar, declined and took down metal and mining
stocks.
It was announced
Tuesday that $26 billion of debt was being quickly restructured. By
comparison, this is relatively small compared to the hundreds of billions
extended to AIG or the TARP program in its entirety. Nevertheless,
Dubai is looking more like the Middle Eastern version of “too big to
fail” as its bankers and network of neighbors step in to position
themselves to their advantage. With gold breaking through $1,200 per ounce,
the incident in Dubai is fading, and the U.S. dollar continues its
slide.
Lessons
From Dubai and the Wealth of Nations
Dubai is a long way
from the U.S., but its profile is unexpectedly American. The image of new
construction and sprawl of residential waterfront communities crystallizing
in palms from the shoreline is reminiscent of the desert around Las Vegas or
Phoenix. Its manly impetus to erect buildings to even greater heights
provokes thoughts of ziggurats in ancient times attempting to reach heaven or
mythology flying with wings of wax too close to the sun. It is
inappropriate to fault such ambition, except that it be done without the
requisite stable foundation or upon the backs of others. It is no longer
the domain of bards and story tellers to render judgment, but today the story
is told by the market. While the market may quickly render a judgment
for effect, the foundation of the story may take some time to unfold.
The promise of
technology in advancing the efficiency of financial markets may have, as
well, hit its zenith. The quality, abundance and flow of information
has led to a reduction in transaction costs, has accelerated trading, and
revolutionized portfolio management. Stock selection appears to have
been superseded by diversification, not just in numbers of investments, but
by tranches of securities in derivatives, in a blended whirl of homogenized
risk and return. Over the past decades, while touting returns, the
underlying motivation is to do no worse than one’s competitor, or the
“index.” This could be the best example of
“systemized risk” and in the recent financial downturn, the
fruits of diversification (outside of cash) were not easily found.
An unintended
consequence of globalized systematic risk was its near universal reach and
democratization to the innocent base supporting the financial pyramid.
In response, as would have been suggested by Milton Friedman, central banks
around the world increased credit and liquidity necessary for markets to
function and restore confidence. It is interesting that the impact,
while widespread, has shown diversity in the manner and speed in which
individual nations appear to be recovering.
Nations whose economies
were based on something of fundamental value in a crisis have fared better
than those that were not. Countries such as Australia and Norway, which
are rich in both natural resources and willingness to extract and deliver
those resources to market, were among the first to recover. These
countries were the first to raise interest rates and reverse policies of
monetary easing. Unable to escape global markets, their currencies
became relatively more attractive. They were placed in the unfortunate
position of experiencing bubbles of their own as their investments became
more attractive. Their domestic exporters also were challenged as their
goods became more expensive on world markets. Despite these effects,
they appeared to move to normality and are getting back to business.
A number of countries
in Asia whose economies have at their base a resource of low-cost of
manufacturing or operation seem to be on their way to grow out of
difficulty. Clearly China comes to mind, but this may not be the best
example, as they have the U.S. as a primary export partner, and for the time
being appear to have an insatiable appetite for U.S. Treasuries and the
ability to tolerate a fixed currency exchange rate with the U.S. despite a
trade imbalance. The recent action by Vietnam to simultaneously increase
interest rates to sop up liquidity while devaluing their currency to track
with Chinese exports is worth noting. India also appears to have
maintained its rapid pace of growth. These nations and others in Asia
are conditioned to survive and thrive in a competitive environment, where the
importance of survival requires no moralizing.
Israel is among those
nations that have increased interest rates to reverse monetary easing, and
provides yet another example of resources in a human form. Clearly, any
review of modern history or a map would lead one to dismiss the friendless
postage stamp size nation of Israel. Many analysts hail Israel as
having the “strongest recovery story.” Characteristic of
the Israeli military culture of teamwork, undergirded by the instinct for
survival, their government was quick to act and focus on its strengths.
Much of the credit may be tracked to the leadership of Israeli Prime Minister
Benjamin Netanyahu, who enjoyed his first term in the 1990s. Israel is
now rivaling Silicon Valley in research and development and absorbing venture
capital. While impressive in the aggregate, when metrics are converted
to a per capita basis, Israel’s accomplishments should be both
applauded and replicated.
Lessons
from Dubai and Other Bubbles
Logically, nations with
relatively favorable natural or human resources would be the first to
recover. It would be too easy and unfair to single out Dubai as a
scapegoat of excess liquidity built upon a foundation of sand. It is
important that investors consider the impact of other bubbles that may form
as funds flee to safer havens or bubbles yet to pop. It is interesting
that many bubbles are tolerated until some “tipping point” is
achieved, usually brought about by some “unsuspected” exogenous
event. This will surely lead to numerous “what if”
scenarios and conversation in future reflections. Existence in the
present requires attention to bubbles forming and yet to burst to assure
survival.
The growth of the U.S.
debt in the past year is worth examining. It is interesting that its
growth has not sounded more alarm bells (see www.USDebtClock.org for an alarming demonstration of
the financial impact of past government policies in the U.S.). The debt
situation in the U.S. can only be considered a starting point. The U.S.
Congress and Administration appear to accept that the debt will increase at a
rate of one trillion dollars per year, with the assumption that heath care
reform and carbon tax legislation may be revenue-neutral to the taxpayer
without increasing the deficit.
It is difficult to find
a government program that in actuality costs less than forecast at
inception. It has been deduced in matters of military weapons systems
that they eventually increase to a factor of Pi from their original estimate.
(The development of the A-10 stands alone as an example of a functional
weapon system to have come in on time and under budget.) The new
proposed social entitlements present an uncanny resemblance to weapons
programs birthed from a Military-Industrial-Congressional Complex.
These programs are front-end loaded, intentionally underestimating costs, and
politically engineered through Congressional districts to gain support, which
are institutionalized and beyond reform even before inception.
Legislative success for
new initiatives may appear assured in a one-party form of government where
“crises”, real and perceived, are produced almost in production
line form for the occasion. Rahm Emanuel, the U.S. President’s
Chief of Staff, appears confident and proud that the current President will
achieve all his legislative priorities and that they will be
“deficit-neutral.” Assuring as this may be to holders of
U.S. debt, this feat could only be accomplished with higher tax revenues from
either a growing economy or increased tax burden.
To entrepreneurs and
free-market academics, the concept of economic growth and higher taxes are at
odds with each other. If markets are indeed forward looking, then 2010 may
be tough sledding. Currently, a surtax on the wealthy is being
considered for both financing health care reform and the war in
Afghanistan. In the relative near-term, estate taxes will increase and
the Bush tax cuts are set to expire. Should inflation resume, a
progressive income tax will push an increasing portion of those sheltered in
the middle-income segment into higher brackets for them to pay their
“fair share.”
Even now a trillion
dollar deficit and new debt, without new legislative initiatives, appears
inevitable as debt is piled on debt. As long as other nations see no
alternatives to the relative safety of the U.S. dollar, they will continue to
accommodate and enable our self-destructive financial policies. While
alarming in direction, the “tipping point” may be years away or
may be accelerated, depending on self-correcting social-economic-political
forces.
The
Rise of Asymmetric Forms of Journalism
New technologies in the
hands of enthusiastic individuals have changed the world. The Internet
and other communication/recording devices have assaulted the monopoly of
major media, including the evening news and newspapers. Individuals
with recording equipment have upstaged orthodox journalists with
investigative journalistic efforts to great effect (ACORN). Individuals
can play orthodox media, ever hungry for content (even for low brow reality
TV), by floating balloons or crashing White House galas. Possibly the
most devastating act of exposure was the recent hacking of servers in the
U.K., revealing activities to suppress discussion and alternate points of
view on climate change.
Recovered
correspondence makes plain with Newtonian precision acts of squelching
dissent to have the equal and opposite reaction of pushing out
opposition. Like Galileo having championed a Copernican view that
heretically questioned the earth as the center of the universe, there is the
likelihood that some may wonder the same about Al Gore. Unlike
Galileo’s time when truth was then the object, special interests are now
more sophisticated. In the current era, payback now in the form of
favorable media exposure, research grants, government careers and corporate
favoritism dominate purchase acquiescence. It will be interesting to
see what, if any, effect this new information will have on upcoming climate
discussions in Copenhagen.
It is clear that the
writing is on the wall. China and India, as well as other developing
nations, are reluctant to carry the burden of this commercially motivated
academic self-interest group. While international cooperation is
becoming increasingly unlikely, man-made global warming may be another bubble
that has burst. The aftereffect may include the demise of the slavish
devotion to hold to an unsupported and almost religious devotion paid for by
the tithes of unsuspecting non-believers. In any event, technology has
initiated and accelerated the self-correcting mechanisms that are now in play
to minimize self-destructive global policies.
Gold
Remains a Store of Value during Periods of Financial Anxiety
Extreme caution is
warranted when a stock or commodity reaches a 52-week high. Accordingly
gold, having pierced the $1,200 level and reaching a new all-time high,
should merit even more attention. Depending on points of reference in
completing technical analysis, with or without inflation-adjusted prices,
charts can be made to support most any opinion (the same may be said for
modeling in fundamental analysis). One could look at recent purchases
of gold by central banks, whose reputation is to sell low and buy high, to
suggest that gold has crested. Others may look at historical periods to
draw comparisons with the present day to gain direction to act one way or the
other.
It is becoming
increasingly clear that the current financial period is both unique and
historic. The world is interconnected, and with rare exception, most
nations are devaluing their currencies to support domestic exporters.
Many nations are reluctant to stall or reverse monetary easing, and one, the
U.S., appears comfortable in its role to expand deficits while it prints the
world’s dominant currency. From this perspective, the upward
trend in gold prices does not appear surprising.
It would appear that
investment in gold in its many forms (physical, ETFs, and mining equities)
may continue to do well in 2010. As seen with the anxiety about Dubai,
the strengthening of the U.S. dollar will increase the volatility of gold
prices. This may be accentuated by any perceived interest rate hike by
the Fed. In addition, gold equities may enjoy some correlation to
increases in the underlying metal, but as seen in 2008, events that increase
uncertainty in the stock market will affect potentially risky mining equities
as well. It is quite possible that regardless of metal prices and
investor’s desire to avoid risk, sector rotation back into mining
stocks may be very strong in 2010.
Mike Niehuser
Beacon Rock Research.com
Also
by Mike Niehuser
Mike Niehuser is the founder of Beacon
Rock Research, LLC which produces research for an institutional audience and
focuses on precious, base and industrial metals, and substitutes, oil and
gas, alternative energy, as well as communications and human resources. Mr.
Niehuser was nominated to BrainstormNW magazine's list of the region's top
financial professionals in 2007.
Mr. Niehuser was
previously a senior equity analyst with the Robins Group where he was a
generalist and focused on special situations. Previously he was an equity
analyst with The RedChip Review where he initially followed bank stocks but
expanded to a diverse industry range from heavy industry to Internet and
technology companies.
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