The Private Sector Needs Uncle Sam
10/31/08
Be careful what you wish for, you just might get it. Remember the GaveKal theory I had quoted in our June 2008 newsletter? In there we had started out with the assertion that one benefit of fractional reserve banking is that it leads to the multiplication of money available for lending. Over the last 15 years new methods of securitization helped in this regard as they partially substituted the banks lending activities. We asked the question why double digit growth in MZM did not lead to double digit inflation in this country. My explanation was that Money supply MZM represented giant institutional pools of money hunting for yield in the US (sub-prime mortgages) but especially abroad. The theory proposed by GaveKal (which made eminent sense to me) explained that Euro-Dollars (institutional dollars deposited with banks outside the US) allowed those banks to create loans in their own currency and that Eurodollar deposits thus created loans, economic growth and (yes) inflation all over the world but not necessarily in the US. The current account deficit has always been the mechanism through which the United States could reflate or deflate the global economy. Now, that everybody has had enough of "return on capital" and is focusing more on "return of capital", yield becomes a secondary consideration. 'De-leveraging', 'retrenchment', 'liquidation' are the new action-words. This also means that Euro-Dollars are no longer driving international growth but are in fact inhibiting it. All those people who reflexively blamed the US account deficit for the ills of the dollar (and of this world) have finally gotten their wish. The US current account deficit is finally improving and dramatically so. No more inflation, no more business expansion in emerging markets, no more growth. Are you happy now? Would you not rather have your old deficit back?
For investors around the globe, October was bad. S&P 500 lost 16.9% and the MSCI World Index lost -19.1%. These losses are masking the true extent of the carnage because the last week of the month witnessed a strong rebound in global stock markets as investors brushed aside discouraging economic reports and took heart from central banks cutting key lending rates and positive developments in the credit markets. The FOMC lowered the Fed funds target rate from 1.5% to 1.0% on Wednesday. This action followed an emergency 50 basis point cut in the benchmark rate on October 8. The target rate was last at 1.0% in 2004 and has not been below this level since 1958. The Fed followed up its rate-cutting action with an announcement that it was setting up dollar swap lines with Brazil, Mexico, South Korea and Singapore, contributing to the sharp turnaround in emerging-market assets. These initiatives also led to a pause in the dollar rally. All year long, countries and companies around the world who had loaded up with a great deal of debt denominated in dollars (some of which was used to build productive stuff, and some of which was used to buy financial products from the U.S.) had been chasing dollars around the globe. Just in case they would need to make payments, or even pay back that debt. Trouble is, when lots of companies and countries and hedge funds all start hoarding U.S. dollars at the same time it increases the demand for said dollars. This scrambling for dollars finally came to an end. It took the implementation of major SWAP lines to European and emerging market countries to easy the worldwide hunger for dollars, for now. One week does not make a market trend, but we have encouraging signs that stresses in the worldwide financial system are easing. The two charts below illustrate why.
The first chart shows the Adjusted Monetary Base (AMB) as computed by the St. Louis Fed. The AMB consists of vault cash at banks plus "reserve balances and required clearing balance contracts with the Federal Reserve". As you can see, half a trillion dollars of liquidity has been created. Bill Gross estimates that it will eventually rise to over $1 trillion. All the credit facilities created by the Fed from the Term Auction Facility to the Term Securities Lending Facility to the Primary Dealer Credit Facility to the Bear Stearns Maiden Lane facility and to the AIG credit facility, however, have had no actual effect on MZM and are only slowly increasing M2 money supply. The credit facilities represent essentially just swaps of assets, not the creation of money. The banks simply obtained liquid assets (Treasury securities) in exchange for illiquid assets (loans, MBS, CDO, etc.). The second chart represents MZM, the liquid money supply within the economy. The annual growth rate has slowed and the quarterly growth rate has almost turned negative. This reflects the de-leveraging that has been going on. Balance sheets of municipalities, corporations, hedge funds and citizens are contracting. In other words, AMB represents the government's expanding balance sheet whereas MZM represents the contracting balance sheet of the private sector. This way, the governments of this world were able to prevent a full blown worldwide panic. Paul McCulley had been recommending this course of action for quite some time. It is now coming to pass and he should be glad. I don't know about all the people who demanded "hands off" policy from Washington. They seem to be OK with the privatization of profits and the socialization of losses. I guess events of the past 12 months turned us all into socialists. Throughout the last twenty years "de-regulation" was not only the mantra; it became religion, to the point where Greenspan thought that a Clearing House for Credit Default Swaps would have been too much government intruding on the private sector. Don't get me wrong. Free markets are our salvation, not our demise. Free markets are like children, however. If you give them rules and boundaries, you will be surprised how proud they can make you. If you let them run wild, they will run roughshod over you.
Hermann Vohs
"Temptations, unlike opportunities, will always give you second chances."
Orlando A. Battista
Hermann Vohs is president of Cales Investments, Inc., a registered Broker-Dealer. All material presented herein is believed to be reliable but we cannot attest to its accuracy. Investment recommendations may change and readers are urged to check with their investment counselors before making any investment decisions. Opinions expressed in these reports may change without prior notice. Hermann Vohs and/or the staff at Cales Investments, inc. may or may not have investments in any of the markets cited above. Hermann Vohs can be reached at 303-765-5600.
This information is not to be construed as an offer to sell or the solicitation of an offer to buy any securities.
