London is a very civilized place, and quite fun to visit. I enjoyed meeting with clients and business associates, but it was hard to get used to the prices. And the sad thing is that it is likely to get worse over time before it gets better.
While I was there, I watched the polls from France. Last fall, it looks like 70% of the French voters would approve the new to European constitution. If the vote were held today it would fail, and the polls continue to get worse. This has the elite of Europe in quite an uproar. It also looks like the Netherlands could vote no even before the British get a chance to object.
European voters are being asked to accept an 800 page constitution that almost no one has read and which would create a powerful new bureaucracy in Brussels, as if Europe doesn't have enough bureaucracy as it is. The left in France is worried that the welfare state could be changed and the right is worried that even more regulations and nonsense could come down from Brussels. There are both right to worry.
Will a "no" vote be the end of the European Monetary Union? No. Will the euro go away? No. Will it to force the Euro-politicians to become more realistic about the pressures facing Europe, especially demographic and economic issues? Yes.
But it will also create a great deal of uncertainty. And the one thing we know about uncertainty is that the markets don't like it. I have been bullish on the euro for over three years, almost from its bottom. In the medium-term (five years) I am still bullish. But right now, I am simply nervous. I think I want to find other ways to bet against a falling US dollar. Looking around the world my eyes rest on Asia as the next region to see its currency's rise against the dollar. I would expect the euro to rise as well, but now there is a cloud of uncertainty, so I suggest we sit on the sidelines until we can be more confident about the euro.
For several years, I have been recommending that investors who want to play the currency can do so by investing in FDIC insured accounts and CDs at Everbank. You can purchase a CD in almost any currency you can think of it. I know that many of you have bought euro-denominated CDs. What I would suggest you do, is that when the maturity on your CDs come up, that you roll it over into their new Asian Tiger Index CD. This is what my good friend Chuck Butler recently wrote:
"I am very happy to announce that Everbank World Markets is now offering a new 'Asian Tiger Index CD'... We're going to originate a CD that will be made up of the currencies from Japan, Thailand, Singapore, and New Zealand. Ok, we don't need a geography lesson... We have added New Zealand, because it is 'Pan-Asian,' it exports mainly go to Asian countries, and it pays the interest! If you're interested, call the desk (1-800-926-4922) for the details... The interest rate will be 2% for both a 3 and 6 month CD... I've done this because I continue to believe the next big leg down in the dollar will have to come from the Asian currencies that, to date, have not participated, in a big way, in the dollar's weakness... And where are the majority of our IOU's held? Asia... So... If the global imbalances created by the dollar and these weak Asian currencies are going to receive any correcting, the Asian currencies must rally VS the dollar." Ask for Chuck and tell him I sent you. (I should note that Everbank is a sponsor of my publisher.)
Niall Ferguson is Professor of History at Harvard University. He recently authored an essay which appeared in Foreign Affairs (Volume 84, No. 2) entitled "Sinking Globalization." (There is no free link but you can subscribe if you like at http://www.foreignaffairs.org/.) I would like to recommend this essay to you, and quote a few paragraphs as a way to introduce today's main topic:
"From around 1870 until World War I, the world economy thrived in ways that look familiar today. The mobility of commodities, capital, and labor reached record levels; the sea lanes and telegraphs across the Atlantic had never been busier, as capital and migrants traveled west and raw materials and manufactures traveled east. In relation to output, exports of both merchandise and capital reached volumes not seen again until the 1980s. Total immigration from Europe between 1880 and 1910 was in excess of 25 million. People spoke euphorically of 'the annihilation of distance.'"
Then came World War I, eventually the Great Depression and an even larger WWII. Dr. Ferguson compares the last great period of globalization with today and wonders if we are being complacent.
"The last age of globalization resembled the current one in numerous ways. It was characterized by relatively free trade, limited restrictions on migration, and hardly any regulation of capital flows. Inflation was low. A wave of technological innovation was revolutionizing the communications and energy sectors; the world first discovered the joys of the telephone, the radio, the internal combustion engine, and paved roads. The US economy was the biggest of the world, and the development of its massive internal market had become the principal source of business innovation. China was opening up, raising all kinds of expectations in the West, and Russia was growing rapidly.
"... the end of globalization after 1914 was not unforeseeable. There was no shortage of voices prophesying Armageddon into prewar decades. Many popular writers earned a living by predicting a cataclysmic European war... Yet most investors were completely caught off guard when the crisis came. Not until the last week of July 1914 was there a desperate dash for liquidity; it happened so suddenly and on such a large-scale that the world's major stock markets, New York's included, closed down for the rest of the year."
There were five factors which helped precipitate the global explosion of World War I. The British Empire was over-extended; there was a significant rivalry between the great powers; unstable alliances (think NATO, he says); a rogue regime sponsoring terror; and, "the rise of the revolutionary terrorist organization hostile to capitalism turned an international crisis into a backlash against the global free-market."
Ferguson notes the parallels between the former period and today. I can think of a number of significant differences. For one, there are no nations with the military power to rival the United States, and there will not be for a long time. The rise of free markets and free people is a calming factor. That does not mean the world is without problems. We all know, as Ferguson points out, that a nuclear device planted by Al Qaeda in London or civil war in Saudi Arabia would disrupt the world order significantly. We could spend the next three or four pages listing possible doomsday scenarios, however unlikely.
However, it is not Al Qaeda, Saudi coups, the US trade deficit or a crisis over Taiwan that worries me. I am far more concerned about politicians creating an economic trade war which would destabilize the global economy. For new readers, my long-term view is that we are in what I call the Muddle Through Decade. I expect a series of recessions over the next ten years to provide the impetus to deal with the US trade deficit, consumer debt levels and rebalance global trade into a more sustainable model. It will also be a period of slower than usual growth, thus "Muddle Through."
This is not gloom and doom. It is a simple recognition that the current trends cannot continue and we will have to get back to a more stable economic situation. In the past it always required multiple recessions to be the motivating factor for people to get their house in order. I see no reason why that should change in the future. Most of us with a few gray hairs have lived through numerous recessions and while it may have forced a few uncomfortable changes, our generations are no worse for the wear.
The one thing which could derail my rather benign scenario is a trade war. A real trade war, in my opinion, would lead us to a global depression which would take us decades from which to recover. Sadly there are significant forces in both the United States and Europe which would like to see a rise of protectionism, tariffs and trade wars. These politicians pander to voters who would like to see the status quo maintained. "Protect my job, welfare, benefits and lifestyle," they cry.
However, one of the things that we can confidently predict in a world of accelerating change is that the status quo will not be maintained. The status quo will be increasingly under assault from all directions, not the least of which is the demographic imperatives of an aging developed world. The developed world (the US, but especially Europe and Japan) simply cannot afford to maintain their welfare states over the coming decades. Yet that is precisely what the voters will ask them to do.
Politicians will never admit that the problem is with the systems they have created and which are essentially bankrupt. The voters don't want to hear that their benefits are at risk. They will blame others and pursue policies which will have negative economic consequences. This will of course make the situation worse, but it will be too late.
Smoot-Hawley is Alive in the Senate
Such a scenario does not have to happen. Calmer, wiser heads should prevail, as most sane people realize that a trade war would devastate the world. Yet there are times I get nervous and last week provided just one of those examples.
Senator Charles "Smoot-Hawley" Schumer of New York is sponsoring a bill which would slap across-the-board tariffs on imports of Chinese goods unless China agrees to revalue its currency. The Senate failed to kill the legislation last Wednesday on a vote of 67-33. Never mind that such legislation would be a huge tax on the American consumer, would signal to the world that free trade is no longer the policy of the United States, and would have an almost immediate affect of raising interest rates, causing a drop in housing values and a recession. By the latter, I mean that if the Chinese were not buying our US debt interest rates would rise.
Pardon me a moment of cynicism, but I don't think there are 67 senators who are that economically illiterate (perhaps 40 or so, with Schumer being chief among them!). What I do think is that they see this as a free opportunity to pander to the voters in their states. They know that the President Bush would veto such a bill so they vote for the bill with the comforting knowledge that they will never have to deal with the consequences. They get to have their cake and get to eat it too.
We see the same sentiments echoed in Europe. In next Monday's Outside the Box we will read an essay from those very smart guys at GaveKal Research discussing the dismantling of the European Growth and Stability Pact last week. They note "In Brussels, we saw a French president [Chirac] give echo to the more protectionist thesis of the greens, the reds and other fruitcakes. We saw a French president blame Europe for 'dumping social, dumping fiscal, dumping ecologique'."
Stratfor Decade Forecast
Everyday I eagerly read an e-mail from Stratfor.com. Stratfor is described by Barron's as "a private quasi-CIA [which] has enjoyed an increasing vogue in recent years as a result of its heady forecast and many news breaks. It is a private intelligence and security consulting organization based in Austin, Texas with a global network of intelligence sources. They provide corporations, governments, financial institutions and individuals with geopolitical analyses and forecasts that assist them in managing risk and helping them to anticipate political economic and security issues vital to their interest. George Friedman runs the firm, and I consider his essays on the world political situation to be some of the more insightful I read anywhere. He is one smart gentleman.
While their services can be quite expensive, their daily e-mail is somewhat more affordable. I consider it a must-read. Every five years they produce a 10-year geopolitical forecast. In 1995 they predicted the meltdown of Asia, which happened in a 1997. They have been consistently right in their analysis of Russia and Europe. I could go on for pages about all the correct calls they have made, (along with a few misses, of course), but let's go ahead and look at a partial summary of what they predict for the next 10 years. The entire report is 45 pages, but we will cut it down to the main points in the next few pages. Quoting from their introduction:
"A decade forecast is the longest we attempt at this time, because anything greater than a 10-year forecast encounters history's tendency to have wild discontinuities. Even a 10-year forecast has discontinuities built in. A 10-year forecast in 1980 would have had to forecast the collapse of communism in Eastern Europe. A forecast in 1910 would have contained World War I.
"The art and science of forecasting requires that you recognize that the least likely outcome is simple extrapolation. You can draw straight lines for a year, but drawing them out for 10 years is dangerous. A decade forecast, therefore, is about predicting the unexpected. [emphasis mine] But it is precisely the wildly unanticipated that a decade of history throws up at you. Predicting in 1995 that the United States would invade Afghanistan in 2001 would have been enormously difficult. It would have been far easier to draw a straight line showing that the post-Cold War interregnum would be eternal.
"It follows from this that expecting the U.S.-jihadist war to continue to dominate the world in 2015 - 14 years after the war started - is fairly unrealistic. If the Islamic world remains the focus of the international system, it will be on very different terms than today. In fact, it is our view that the jihadist issue will not go away, but will subside over the next decade. Other - currently barely visible - issues are likely to dominate the international scene."
I should note that their forecast, while having some disconcerting elements, is nowhere near as pessimistic as the Ferguson essay mentioned above. Indeed, compared to that essay, it is quite reassuring. And they are at their most (relatively speaking) optimistic when looking at the United States.
They see the focus of the US going from the Middle East to East Asia. They expect the US to disengage from Iraq and the Middle East in general, as we essentially minimize the risk from the jihadist movement by the end of the period. Interestingly, they expect a decline in US foreign involvement in the years around 2010, followed by increased involvement in Asia. They see increasing coalitions uniting in an effort to resist American power, primarily in East Asia, which will require our attention.
In summary on the economy: "It is our expectation, based on our Asian forecast, that pressure on the trade deficit will subside before the end of the decade. At the same time we continue to forecast productivity growths and smoothed demographic curves throughout this period. We expect two or more recessions during the coming decade - at least one of which will be triggered indirectly by Chinese problems. When China's own version of the Asian model falters, China's export sector will cease its current red-hot growth. This will gut Chinese exports to the United States, thereby removing China's need to heavily invest in American government debt.
"For the past two years, China has not only been a leading source of U.S. trade deficit, it also has been a leading purchaser of U.S. government debt to finance that deficit. The Chinese crunch and step-back from U.S. debt purchases will cause the U.S. dollar to plummet on international markets, most likely triggering a recession until the U.S. economy's inherent efficiencies allow it to regain its strength. We do not expect to see a return to 1990s growth rates. At the same time, we regard the American economy very positively indeed."
Maybe I like this because it sounds almost exactly like my Muddle Through scenario, but I think there is much to commend this.
The Global Economy
Moving onto the global economy, they spend several pages noting the demographic problems of both Europe and Japan. Long-time readers know that I repeatedly refer to these problems, so I'll not go into detail here. But their conclusion bears noting:
"At the end of the day, the United States is set for a decade of high investment, and by extension, high productivity growth. Europe and Japan simply cannot replicate these developments - even if they were willing to restructure their economies from the ground up. Building such an environment requires a generational effort, not one that can be implemented in a "mere" decade. The replicability of economically healthy demographics in the United States does not mean it consistently will be the state of affairs.
"As workers retire, income shrivels and the torrent of money reverses. Instead of being large-scale net suppliers of investment capital, former workers become hoarders and spenders. The bulk of their financial assets are switched from high-growth stocks into low- to no-growth bonds and even cash so they cannot lose their shirts in the stock market crash of the moment. In short, aside from their spending - which usually decreases after retirement - retirees cease to participate in the national economy and capital formation. At that point, investment slows, credit becomes far more expensive and growth falls off.
"A reduced supply of capital means two things. First, the cost of doing any sort of financing - anything from getting a car loan to building a skyscraper - will increase, setting the stage for lessened consumption and, by extension, slower growth across all sectors of all economies. Second, less supply always increases volatility. Crunches are next to impossible in well- or over-supplied markets; lower supply means the swings from economic booms to busts will be far more rapid and far more disruptive overall.
"For the United States, the above description will manifest itself sometime around 2015, as the bulk of the U.S. baby boomers pass into retirement. For Japan, it begins here and now."
The China Meltdown Syndrome
Stratfor's most dramatic prediction is a meltdown in China. Essentially they see the current euphoria over China as a focus on Shanghai and the growth in the coastal areas and ignoring the problems deep within China. The staggering proportion of bad debt, enormous even in relation to official dollar reserves, represents a defining crisis for China. While they expect China to hold together through the 2008 Olympics, for a variety of reasons they see power devolving to the various states and region of China and away from Beijing. They predict massive social upheavals because of the difference between rich and poor, especially the relatively rich coastal areas which last year received a 87% of foreign direct investment as opposed only 3% given to the inner provinces, yet 25% of the people live in those inner provinces.
They do not see China going away, of course, but they do see Japan replacing her as the premier power in East Asia, with Taiwan aligning itself with Japan. Within the next few months, I will do another specially letter on China and will go into their concerns more carefully. Hopefully I will get some face time with George Friedman and ask him a question or two which will give us some insights.
The Russian Orthodox Church Leads the Way
Their view of Russia is just as disconcerting. They say Russia is collapsing and expect that to continue, but this will create an increasingly nationalist and anti-Western movement in Russia. They expect Russia to eventually reassert itself as a major international player with the traditional anti-Western course. They also believe that Russia may try to reintegrate part of its old union, perhaps forcibly.
And they provide this rather startling prediction: "On the whole, we expect a fundamental Russian crisis and prolonged fighting in various forms - including military conflict at times. A number of scenarios could play out, but in the end, Russia will become the nationalist, statist entity it was before the last 20 years of openness and marketization.
The question now is what the reversal will look like. The Communist Party is likely finished in Russia; it will not be the driving force. A new, anti-Western leading force will emerge from street protests and popular anger. Moreover, a completely new elite will probably form from this period of turmoil. The new elite will consist of national capital representatives, mostly from the production economic sector; patriotic intellectuals; officers in the military, security and intelligence; and popular resistance leaders.
"By 2015, the regime will probably be religion-oriented, with the Russian Orthodox Church taking a leading role, joined by moderates from other large religious traditions in Russia, such as Islam and Buddhism. A new regime will have to draw upon one resource or another for its strength; traditionally, Russian morality and human capability have been vital to the country's success. With the communist ideology in crisis and the market ideology inspiring relatively few Russians, moral strength can be drawn from revived religious values that argue for a strong Russia and a just society. Also, it will probably be a very conservative regime, resting on the foundation of a production economy, with low-paid workers, intellectuals and peasants as well as those dependent on social benefits."
Moving on to the Middle East, as noted above, they believe the US-jihadist war will end in the favor of the United States, and that US involvement will shift from military to political with the odd base left over here and there. They also see major leadership transitions in Egypt, Syria and Saudi Arabia.
"As the U.S.-jihadist war winds down, an intra-Islamic struggle in the Muslim world will begin to take shape. This conflict will pit Islamists against non-Islamists and will alter the nature of U.S. involvement in Muslim states from military action to political engagement, where Washington will - on a case-by case basis - negotiate with Islamist forces. This trend already is under way - most visibly in Iraq, where Washington has been working with the country's Islamist-leaning Shia first to oust Saddam Hussein's regime and then to effect a political reconstruction of the country - obviously in keeping with U.S. geostrategic objectives in the region.
"...The last four years also has led to the Muslim world's significant radicalization along religious lines. This has boosted several radical (non-militant) Islamist groups, which have been able to leverage societies' religious currents to advance themselves. Though they have remained secure from much of the destruction that has befallen their militant counterparts, the radicals - given their dogmatic predisposition - are unable to provide the masses with more than an outlet for protest.
"Here is where moderate Islamist groups increasingly will come into play, providing an expression for socioeconomic frustrations and a forum for identity politics. Moderate Islamist groups will make significant political gains in many Middle Eastern and Muslim states in the coming decade, as the establishments buckle under pressure from calls for change from within and without. That said, there are other non-Islamist political forces that will compete with the rise of moderate Islamists.
"This will bring about a struggle over the question of moderate Islam. Since the Sept. 11 attacks, there has been an upsurge in the global discourse involving moderate Muslims and moderate Islam. This issue is complicated not only by the U.S.-led West's attempts to seek out the moderates in the Islamic world but also by the diverse set of groups in Muslim states who claim to be the upholders of moderate Islam. What is curious in all of this is not the Western demand for moderation but the ample Muslim supply of moderation.
"There are at least four different types of Muslims who advance themselves as the adherents of moderate Islam. They are moderate Islamists, traditional Muslims, liberal Muslims and certain moderate Islamic regimes. An intense struggle will take place over ownership of moderate and authentic Islam in the course of the next decade."
The Collapse of the European Political Union
As relatively optimistic (if you can call predicting two recessions and a collapsing dollar optimistic) as Stratfor is on the US, they are not as sanguine on the prospects for Europe. They predict the political union will collapse, but the economic union will continue. Much of the economy of Europe will remain stagnant under heavy social costs and a rapidly aging demographic. They predict increased tensions over Muslim immigration with the potential for some states to limit immigration.
On the political front, they believe there is the potential for conflict with Russia as Russia tries to reassert its authority and direct control over some of the former Soviet states in the Baltics, Georgia and Ukraine. This will present a problem to Europe, as they will have essentially no way to counter Russian power.
"The European Monetary Union (EMU), unlike the political union, will not fall apart in the coming decade. At present, there are more countries trying to join the EMU than are trying to leave it. Estonia, Lithuania and Slovenia will likely join in 2007, followed in 2009 by Latvia and Cyprus. Similar to the political union, the demise of the eurozone requires the departure of one major country - Germany. But Berlin, as the EU's largest economy, has more to gain from being in the eurozone than not being in the eurozone, simply because Germany is the undisputed leader and exemplar of the European economy."
"...Exogenous shifts make a European common position - on anything - much harder to achieve. A resurgent Russia forces Europe to choose what it hates more: U.S. troops on the ground, the costs of rearmament or Moscow calling the shots. Some countries would not mind U.S. troops, but for others, that would represent the complete destruction of national sovereignty. Islamist militant attacks force the Europeans to take action against immigration - but some states need Muslim immigrants to make up for declining populations. These difficulties add to the probability that the political union of the EU will break apart in the next decade."
It is best to stop here, as the letter is already getting long. If you are interested in getting the report and subscribing to Stratfor's basic service, you can go to http://www.stratfor.com/offers/050411-bmg/?ref=bmg001. For those who need to be in the know about what is going on in the world, and need a high level resource, I know of none better.
La Jolla and Houston
I am obviously back in Texas. It feels like summer, as they are playing baseball outside my office. The Texas Rangers are beating the Toronto Blue Jays 3-2 in the sixth, but there is still time for our pitching to collapse (sigh). The crowd is sparse, but it will pick up as the season moves along.
I fly to La Jolla to meet with clients and my partners at Altegris Investments next week, and then on to Houston the week after. With the exception of one weekend, I am home for the month of May, which after all the travel this month, I need a month to catch up.
I got to have dinner with good friend Bill Bonner last night in London. I gave him a copy of a book I was reading called "Younger Next Year." I highly recommend the book for every man over 45. There's not much (actually none) investment advice in the book, but there is a lot about how to stay healthy. The book also emphasizes the importance to your health of having good friends. While I'm working on the exercise part, I have the friendship part down. Based on the quality of my friends I should live to be a hundred. I told Bill to read the book and follow it so that we could both be a hundred together.
So here's to staying healthy as we go through the next 10 (and more) years. I plan to still be here writing and I hope you will still be here reading. Have a great weekend.
You're always and ever the optimist analyst,
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