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Tuesday, July 07, 2009


take the long view

via zero hedge, david rosenberg on CNBC -- few people make more sense to me at this juncture. expect massive secular changes -- expect the unwind of the credit bubble to proceed not as an event but as a process, one spanning years. expect at some point to see deleveraged equities scrape along at generational-low multiples, something below 8x the oft-discussed detrended S&P earnings promoted by robert shiller. deleveraging these assets can and probably will produce prices as extreme on the downside as they were on the upside.

it's particularly interesting to hear rosenberg question the practical efficacy of short-term fiscal stimulus. there's not exactly an explanation of ricardian equivalence there, but the tone is there. and of course his point of long-term productivity is essential.

one thing i haven't heard rosenberg expound upon, though, is the expectation of the closure of the american current account deficit in time. the accumulated effect of years of trade deficit, as opposed to surplus, is one of the big differences between 1990 japan and 2008 america.

right now, the dollar sees strength in downturns. this is in part because the dollar, with ZIRP in place in the united states, is an excellent carry trade funding currency; rich world risk aversion should manifest as dollar strength much as it has traditionally (since the institution of ZIRP in japan) meant yen strength. as richard duncan has outlined, there is also no lack of destination for dollars obtained by east asian or middle eastern exporters -- massive treasury debt issuance remains more than enough to soak up diminished trade dollar flows even as private credit unwinds, obviating a potential source of pressure on the dollar.

in time, however, the american financial system will have to shrink as the headwaters of a full third of its funding profile -- namely, the current account deficit -- dries up in this great global rebalancing. this process has only just begun with the collapse of world trade flows and the rise of the american savings rate. it has been massively retarded by the federal reserve since once threatening to correct in one fell swoop back in september 2008. but one of the remaining major adjustments figures to be the eventual and gradual revaluation of the chinese renminbi and other dollar-pegged currencies, as they grow less dependent on export volumes to the united states for economic growth.

this eventual devaluation of the dollar sits at odds with most conceptions of deflation, but it is worth noting that many depressed economies of the 1930s experienced large-scale devaluations without experiencing anything like inflation. i would expect to see similar outcomes this go-round -- with the adjunct possibility of policy rate increases to stage a traditional defense against the kind of disorderly currency collapse that paul samuelson, among others, believes likely.

By the way, I don't want you to think that I think that everything for the next 15 years will be cozy. I think it's almost inevitable that, with a billion people in China wide awake for the first time, and a billion people in India, there's going to be some kind of a terrible run against the dollar. And I doubt it can stay orderly, because all of our own hedge funds will be right in the vanguard of the operation. And it will be hard to imagine that that wouldn't create different kind of meltdown.

UPDATE: david goldman on the contributions of deteriorating demographics:

It seems quite plausible that the dollar will fall sharply against some other currencies, notably the Asians, and against gold and other commodities. That may not, however, interrupt the deflationary tendencies which predominate, for to have actual inflation, someone has to take cash and buy goods rather than (for example) securities. If everyone hypothetically wanted to buy securities rather than goods, prices of goods would crash.

Something like this is happening, of course. An aging population increases its purchases of securities and decreases its purchases of goods as it saves for retirement. Americans have saved nothing for the past ten years, and the capital gains that they considered savings-substitutes have vanished. That means that an enormous savings deficit accumulated over more than a decade has been exposed, and that Americans must attempt to correct it quickly and under the worst of circumstances.

That creates a deflationary shock that a few trillion dollars’ worth of stimulus cannot begin to mitigate. America may have the worst of both worlds: currency devaluation AND price deflation, as in the 1930s. That is why TIPS and other nominal inflation hedges do not convince me. Gold, oil, commodities, and Chinese blue-chips are my preferred hedges against a dollar crash. Most of my portfolio remains in high-quality fixed income. I have sold lower-rated credit and taken profits in anticipation of further market weakening.

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