Submitted by Michael Krieger of Kam LP
If we desire respect for the law, we must first make the law respectable.
The greatest dangers to liberty lurk in insidious encroachment by men of zeal, well-meaning but without understanding.
Experience teaches us to be most on our guard to protect liberty when the government's purposes are beneficent.
Fear of serious injury alone cannot justify oppression of free speech and assembly. Men feared witches and burnt women. It is the function of speech to free men from the bondage of irrational fears.
- Quotes by former Supreme Court Justice Louis Brandeis
Is Plaza Accord 2.0 Coming?
On the fringes of the typical daily news blitz in which I fully immerse myself, I have noticed heightened chatter about this concept that we may be on the cusp of some sort of “Plaza Accord 2.0” type agreement between governments and central banks globally. I feel the need to address this because I do indeed think that some sort of informal or unspoken agreement of this nature may already have been agreed upon behind the scenes. First, just a quick recap on the first Plaza Accord.
The Plaza Accord was signed on September 22, 1985 and it consisted of an agreement between the major Western economic powers at the time (including Japan) to devalue the U.S. dollar relative to the Japanese yen and the German Deutsche Mark. The trade backdrop was similar in many ways to today. According to Bloomberg the current account deficit as a percentage of GDP in September 1985 was -2.59% and today it is -2.96%. While many have pointed out the similarities, I want to make it very clear that I believe the structural, social and political environment in the United States right now is multiples worse of what it was back then. One statistic that I think is worth mentioning is the budget deficit as a percentage of GDP. The latest available data here is for June 2010 when it stood at a banana republic -9.1%. In September 1985 it was -5.0%.
So what would a modern version of the Plaza Accord look like. I have been writing for several years now and since before the economic crisis that a major dollar devaluation, while not a good thing for the country, had become inevitable. The debt and spending that has been piled on since the crisis to “avoid another Great Depression” (give me a break we are in it) has only compounded the situation and makes an even larger devaluation a certainty. The reason why I think the chatter of a Plaza 2.0 is so compelling right now is because we have only two choices left. We can devalue in a disorderly and completely chaotic fashion, or we can agree to do it in a more measured and sane manner. A massive QE2 program would be the chaotic choice and would lead to total and complete monetary and economic destruction throughout the world. This is what people have been referring to as the currency wars. I actually think that Bernanke’s threat to QE2 to infinity has scared some of the emerging market leaders and central bankers straight; as it should. At this point it is in everyone’s best interest to come together and say ok, the dollar needs to be devalued but it needs to be devalued versus all major currencies more or less simultaneously. The truth of the matter is this. With commodities surging and the CRB RIND Index (the spot price for 22 sensitive basic commodities) at an all time high, the booming economies in Asia and elsewhere in the emerging world are experiencing horrific inflation that is much worse than the official statistics demonstrate and this creates an environment where currency appreciation is a necessary tool to keep prices under control. The BIG problem here is that they are wary to allow significant strengthening as long as the yuan remains static. No one wants to devalue while China sits there and does nothing. On the other hand, I believe they would all be very willing and content to allow a major appreciation versus the dollar if China comes along for the ride.
This is where a new Plaza-type agreement comes in. If all countries can decide it is in their best interest to collectively allow market appreciation for their currencies versus the dollar then everyone can probably live with that. It is certainly better than an all out currency war where each Central Banker yells my printing press is bigger than your printing press. Listen, no one’s printing press is bigger than Banana Ben Bernanke’s and I think the world is starting to figure that out. This brings me to an even more interesting point. Has the G20 already agreed to such an arrangement informally? While the financial press was abuzz with articles that nothing came of recent meetings, can we believe this at face value? Look at various currencies versus the dollar. In the OECD, look at the yen, the Swiss franc, and even the euro for crying out loud. In Asia, look at the Thai bhat, the Indian rupee, the Korean won. Look a the Singapore dollar last night!!! Even the yuan is moving and appreciated by 0.20% versus the dollar overnight. See the yuan/dollar chart below.
One Year Yuan Chart
So What Does this Mean?
I am about to do something that I never myself expected to do. I am going to give Bernanke the benefit of the doubt on the recent QE2 chatter. What if it was all just a threat to other nations to act on their currencies? What if he was merely bluffing to blast the dollar into oblivion in an attempt to get other central banks around the world to give in to the concept of dollar devaluation? At the end of the day, this was probably not his intent because all the evidence shows that the Federal Reserve have no comprehension of how markets really work and how their participants really think. Nevertheless, whether it was his intention or not is irrelevant. The endless chatter of QE2 did indeed send a shiver down the spines of the rest of the world and their currencies have been appreciating consistently as of late. This brings me to two important points that I think the market has failed to appreciate.
The first is that the Fed may be likely to do LESS not more at its November 3rd meeting. An announcement of $500 billion let’s say in QE2 at this stage in my opinion is the equivalent of no QE2. Furthermore, I have noticed that my general fears on Zimbabwe, fiat money, hyperinflation which I have been harping on for the last two years has gone mainstream. The conclusions do not seem to be particularly thoughtful however. The markets are rallying as if the dollar will be totally destroyed in the near-term and I don’t believe this will happen because the world has too much to lose. Rather there may be a somewhat orderly but significant broad-based dollar devaluation. There is this notion in the markets that this is good for equities in general. I disagree completely. Take a step back and think of the U.S. economy for a second. The economy is still dominated by consumer spending and a financial system that survives on creating ponzi schemes that investors buy in search for “yield.” This then takes me to the two sectors I think have the most to lose in the scenario we are entering. Financial services (especially the bailed out TBTF guys) and retail. As the dollar is devalued and imported goods become prohibitively expensive due to the direct currency effect as well as the costs to ship things (fuel anyone?) we will source more of our consumption locally as well as the input costs. Capital will allocate in a more efficient manner to manufacturing and away from ponzi finance creations. Financial services has had a great run in dominating the U.S. and this was unfortunately extended thanks to cronies like Hank Paulson but the gig is up. Then there is retail. You have got to be kidding me on this sector. Again, retail has benefited from a business model where they outsource cheaply from abroad and sell to a consumer that spent beyond its means. None of this works in a dollar devaluation scenario. People are buying into this sector because of some LBOs and a vocal hedge fund manager taking stakes in companies. Give me a break.
So this brings me to the conclusion of this piece. I believe the equity markets are pricing in near-term QE to infinity and I do not think this will necessarily happen. Even if it did, I am not convinced stocks broadly would go up on this. My major advice to anyone managing money is to dump the loser sectors like financials and retail and move into sectors where the secular growth will be in a dollar devaluation scenario. For me, that is primarily in companies that produce globally traded commodities. I continue to think increased relative exposure to oil, agriculture and precious metals are the most attractive areas. Later on, manufacturing will join this list. I believe the best way to play any potential market sell-off is to bet against the financial and retail sectors specifically. While many will call the world we are entering de-coupling again, it’s really more like de-valuation.
All the best,