“Investments” such as metals and emerging-market equities remain more attractive than dollar denominated securities, and it will take a crash of titanic proportions to redirect money back to developed markets in general and the U.S. in particular.
Consider that the return on U.S. equity investment from 1989 to today is 10 percent, while it’s 12 percent in emerging markets — and in some cases, such as China, a gain of nearly 600 percent. Japan has been the major loser in all this, going from a 40-percent share of global market cap in 1989 to 13 percent in 1997 and 9 percent today. Emerging markets had one percent of global market share in 1989, seven percent in 1997, and 11 percent today.
From 1989 to the present, the return on Japanese equities has been -2 percent. But where the outgoing investment flow from Japan used to head directly to the U.S. or Western Europe, today it is increasingly going to emerging markets, especially China.
The market is in the grip of another unbearable contradiction. It wants to flee the dollar — for euros, for Chinese stocks, for speculative positions in metals and oil — but it has to keep returning to the dollar every time a scary piece of news comes out. After every incident, however, the dollar is a little lower than it was before, getting no lasting support from hot-money inflows.
If you have been trading forex since August, you know the drill: Some bad news emerges about credit markets, oil inches another notch toward $100, or the stock market wobbles, and risk aversion gets a grip on panicky traders. They dump high-risk securities and high-risk trades, which in the forex market means carry trades such as Australian dollar/ yen, British pound/yen, and euro/yen.
Strangely, the dollar tends to benefit from risk aversion as investors flee to safe-haven U.S. government paper. But this is a fleeting thing — as investors buy U.S. government bills and notes, they drive the yield down (hence the aforementioned tightening of the bond-Bund yield spread).
Then things calm down for a day or two and risk appetite, which until recently was called “greed,” pokes its head out again. Carry trades are re-established, the yen falls against everything, and traders are free to bash the dollar. On several occasions, sentiment flip-flopped in a single day, or every two or three days. Trading has been horrible for more than three months now. Sometimes it seems as if the only way to make a buck is by sheer luck — by guessing, for example, that the price of oil would take a breather short of $100. The seeming correlation among equity indices, oil, or gold and currencies is confusing and can be explained only by the unifying factor of risk aversion. The question on everyone’s mind is whether the summer credit crisis was the tipping point that shifted securities markets into another gear. The answer is likely yes. The new gear is higher and it’s moving money around faster. Who would have imagined that carry trades would be put on and taken off in a few days, let alone hours? Carry traders used to be far more staid and cautious; you could calculate breakevens over the course of months. Now our heads are spinning from daily and weekly reversals in currencies such as the Canadian dollar and Australian dollar, whose fates are now divorced from central bank management and economic performance.
The threat to the U.S. dollar takes two forms — reserve diversification and hot-money flows. Reserve diversification has been around for a while, although it was a little unsettling for the Gulf Cooperation Council, which includes Saudi Arabia, the United Arab Emirates, and Qatar, to announce it will study the dollar and consider advising a change to their currencies’ fixed rates against the dollar. A summit will take place in Doha, Qatar Dec. 3 and 4.
Let’s assume various countries continue to embrace diversification away from the dollar. This is certainly what the market is expecting and it’s even beginning to be taken in stride. It’s a core assumption now, not a shock. The chief consequence is to make the U.S. current account deficit appear harder to fund. But long-term portfolio inflows don’t fund trade; bank and supplier credits fund trade. The shocking long-term capital outflow in August, which was a function of managers liquidating to get their hands on cash at the height of the credit crunch, was only partly reversed in September. The most recent Treasury International Capital System (TICS) report was only a little positive. The net long-term portfolio inflow rebounded in September to $26.4 billion from an outflow of $70.6 billion (revised) in August. However, the “Total TICS” number, which includes bank deposits and short-term paper, was negative: -$14.7 billion from - $150.7 billion (revised) in August when it is usually a big inflow, as it was in July ($83.5 billion). Foreigners bought $26.3 billion in U.S. Treasury bonds, $11.5 billion in U.S. agency bonds, $15.1 billion in corporate bonds, and a feeble $2.5 billion in U.S. equities. This is better than the giant sale of $40.7 billion in U.S. equities in August. (Meanwhile, U.S. investors bought $9.2 billion in foreign equities and $19.7 billion in foreign fixed income.)
We can rationalize this was an ongoing need for liquidity and doesn’t necessarily reflect a loss of confidence in the U.S. economy. It must be acknowledged, however, that flows into and out of U.S. paper (even plain, old checking accounts) can be red-hot in today’s electronic world.
Hot money is dangerous. We saw what it did in Thailand and other emerging markets in the 1997-98 crisis. The only real antidote to hot money flows is:
1) restored confidence based on hard evidence and
2) capital controls. It’s difficult to see where hard evidence of structural integrity and excellence is going to come from when the U.S. trade deficit is more than 5 percent of GDP and U.S. debt is an unknown number (there are so many conflicting reports). Nobel Laureate Joseph Stiglitz, author of Making Globalization Work, recently estimated the Iraq war alone has cost about $2 trillion so far (in an economy of $13 trillion). Stiglitz also says from an economic perspective, Bush is the worst president since Herbert Hoover, which is not unrelated to the pickle the country is now in.
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