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Go to pancake mix

October 12, 2011

A few days ago, a friend’s broker called him with this piece of advice: Go to cash! For many years, this has been good advice. When in doubt, get out. US dollars have long been the safe haven for anxious times. On the face, this past week appears to reflect more of the same. In Canadian dollars, the greenback moved up to 1.05 from its July low of just over 0.94. Florida real estate doesn’t look so attractive to Canadian investors anymore.

Here’s the thing. The USD as a safe haven is not what it was even ten years ago. With similar growth rates for M2, I would contend that Canadian gains in money supply have been a function of organic growth, through the productive sale of resources. American gains in money supply, in contrast, have largely been explained by the printing of money (from 2:18 – 2:45).

Ben Bernanke can print non-stop, however, and have virtually no positive impact if the next step in the sequence doesn’t follow along. To wit, money supply is very much a function of the multiplier effect. This means that, for every new dollar injected into the system (Bernanke), depending on borrowing, spending, and the confidence these reflect in the marketplace, the final count in dollars can be much higher. Put a dollar into the banking system and, through this borrow and spend cycling, the reserve ratio (see the link, above) turns it into multiple dollars. Nice concept when it works. When it doesn’t work, the money math spirals in an entirely different direction.

When all this newly printed money pours into the banks and the banks just throw it into a vault, however, there’s no net gain to the economy. Shoring up their financial statements, the banks are now waiting for the other shoe to drop before they lend again. Couple this with the long-overdue awakening of the consumer to the notion that s/he should be borrowing less, and Bernanke’s potential impact on the economy is much diminished. All the encouragement of government intervention through low interest rates and growing money supply will take you no where if the sequence does not carry forward. Let’s leave government spending for another day and another conversation.

What’s worse, the only appreciable impact is an increase in government debt. As the government debt continues to rise at a rate faster than the GDP (think non-existent future cash flow here), the end game is not a pretty sight. The U.S. is on schedule within the next year for its Federal debt to exceed 100% of GDP, matching the PIIGS of Europe. Default or print. We’re at an inflection point, past which this ‘default or print’ quandary will increasingly dominate the investment climate. Until or unless the U.S. government addresses the issue, the outcome will not make for happy faces in the Kettle home. Of course, aside from issues with China, the United States will also need to resolve the conversation at home between Washington and Wall Street. I’ll leave you to decide who plays Washington and who plays Wall Street.

Government manipulation and intervention has masked a significant decline in the risk-adjusted valuation of the USD. How can such a discrepancy exist in the face of the recent S&P downgrade? The answer is fairly simple. When your creditors cannot afford your failure, you don’t fail… for now. Where can you go if you are a large holder of dollars and need to move them? Anyone watching the news understands the challenges facing the Euro. For now, then, among the larger currencies, the USD is the best of a bad lot. This will change soon enough as American debt continues to balloon out of control. Other currency markets such as Canada, Australia, even gold, are not large enough to accommodate the demand. So, demand for the USD is by default owing to its size, not because of any arguably sustainable market case.

As the American economy continues to hollow itself out from the inside, the last thing the Canadian government wants to see is a strong loonie (don’t miss the 2 minute mark!). With a strong resource base, we are an exporting nation. At last check, 78% of our exports were to the United States. We sure don’t want to see our largest trading partner (as we are theirs) unable to buy from us. Who will buy our suds? To prevent this from happening, our own central bank steps in and twists arms to sell Canadian assets heavily into the market, driving the loonie down against the greenback. No country so overly dependent on its position as a resource exporter wants a strong currency. From this one small example, we can see how and why the true reflection-of-value-model can so easily become corrupted by government intervention. What happens if we Canadians don’t play along in the conspiracy?

Now let’s have a look at the real elephant in the corner. China is both a huge net exporter, particularly to the United States, and also a big time holder of American debt. Which way does that lead? Something’s gotta give. Crowding out, default or print, competitive debasement… any way you look at it, it’s a mess.

As a dominant exporter, the Chinese do not want to see the yuan rise against the USD. As long as it suits their purpose, the Chinese will prop up the USD. Because there’s no place else to go besides the USD, it’s a Jenga game, and as we have seen in the EU/US posturing over Greece, nobody wants to take a turn. We all know how a Jenga game ends, and there’s no skipping turns here. In the meantime, the Chinese are buying gold and encouraging their citizens to buy gold.

Is Go to Gold, the better guidance? I suspect so, and have placed my marker on that square, but I do not know for sure, and I certainly don’t know the timeline for resolution of the current mess. Nobody knows. There’s a prognosticator with a different story on every corner, each one certain of the suggested outcome. Hmmm… Those who say they know are liars or fools, or both. As always, time will be the judge.

Increasingly insolvent, the American economy’s role as a big importer of foreign goods will inevitably falter, leaving only one remaining support to this house of cards. Until now… or maybe for a short stretch a little further down the road, the size of its debt has made the United States too big to fail. When the Chinese are ready to move into whatever new reserve currency configuration bubbles up, they will bite the proverbial bullet, write off the American debt, and move on. Unable to continue selling exports to an insolvent USA, this final step will be a lot easier to take.

In graduate school, my macro economics final was one of those nasty experiences with only one question: Tell me what you’ve learned this term. Ouch! Three hours later, having laid out all the theoretic principles of econometrics and government policy, my concluding line went something like this: Having studied all the variables, the Canadian government may devise the perfect model (y=mx+b, etc.) for advancing our economy. Model in hand and ready to implement, next day the American president makes a policy speech and you’re back at square one again, without a viable model. When you’re a mouse sleeping next to an elephant, you’ve got to sleep with one eye open. Well, that exam was taken 27 years ago, but as I see it, an American student today could say the same thing about the U.S. government’s dilemma, with Beijing as the extraneous source of frustration.

In fact, my use of the word ‘extraneous’ here is well out of place. No economy today is a closed system, so there really is nothing extraneous. That fact, alone, is what makes today’s world so volatile, so fragile, so precarious.

For now, this precarious balance is guarded like a hot potato. Nobody wants it, but nobody wants the other guy to drop it either, ‘cause it’s loaded with C4. Won’t last for long, though. The first cracks are already showing. When the first major debt holder bolts for the door, the rest will join the race and very quickly we’ll see a reset of the entire global playing field.

What started in the East thousands of years ago will have come full circle. Will the Chinese (and Indians) dominate the World economy with the same pre-eminence as the Americans did in the latter half of the 20th century? It’s doubtful. As I see it, our children and their children will witness a continually evolving landscape as a process of equilibration of power takes effect. Who will usher in the 22nd century? I honestly haven’t a clue. So much can happen between now and then. Maybe Canada will need to step up patrols on our southern border. Maybe we won’t even have countries delineated by borders and currencies as we do now. Wait a minute! That model is already heading to the exit, isn’t it… and how’s that working out, Europe?

I compare this continual morphing process to the board game, Risk. When one player becomes too powerful, everybody else gangs together to bring that player down… and the beat goes on, over and over, and so on and so forth, etcetera, etcetera. Holding back the tide with military force only works for a time. Eventually (refer both to the former Soviet Union and to the current living/dying example), paying for that military ticket brings the whole system to a grinding halt. Tom Friedman was right. The World is Flat. Education and technology have brought new players to the table. Global trade has empowered low-labour-cost countries to stand up and declare themselves as serious contenders. Not long ago, capitalism declared what it thought to be a resounding victory over communism. How does that saying go? He who laughs last laughs best. In such a fluid World market, perhaps it’s better not to laugh.

The pendulum swings back… and then forth again.

Already, the pace of growth in China is slowing under the weight of its own success. Wages rise. Steadily, comparative advantages diminish… and the beat goes on. Equilibration is my word for the century ahead. Overshooting shifts in power, followed by ever-elastic returns past the even point will mark significant macro trading opportunities for many decades to come. Navigating the macro market today is like stepping from oil slick to oil slick with banana peels for sneakers.

The key question to be asked and answered is: How will you position yourself on a micro level in this time of uncertainty? This question is not so easily answered as in times past. Without security in virtually any currency (or is that better expressed as ‘any virtual currency’?), it’s not a simple matter of saying, “I’m out of the market while this crisis works its way through the system.” With real inflation in the range of 10%, how does that line up against your expectations for the general market? Where can you hide? In the event of a total market meltdown, and in the absence of safe fiat money, where will recovery show itself first? What’s the least worst option?

We face a stock picker’s market. This is as true now as it was at any time. You need to become very comfortable with sector prospects and company fundamentals. Within this period of volatility, you can win by becoming informed and confident in your position. I say, ‘confident’ because there are so many forces out there at work trying to convince you that you’ve chosen poorly. Well, have you? Times like these offer true wealth-creating opportunities for those with the courage, conviction, and tenacity required to conduct appropriate due diligence on potential investments… and then to stick with their choices. Choose right, then sit tight.

I have a friend well south of here who keeps a three-month supply of pancake mix as protection in the event of a hurricane. Not so sure that would be my choice of sustenance but he’s a pretty smart guy and I’m sure he’s studied his options carefully. Maybe he’s thinking further ahead in the game. When social security gets axed, Greece may come to the gated streets of Florida. Bagged pancake mix may offer a barricade of sorts against marauding intruders.

Where does this leave you? Better equipped to choose your path of protection? Not likely. Go to cash? Go to gold? Go to pancake mix? Different strokes for different folks is my answer. Go to what you know, is the best answer. If you know floor mops and can make a living at it, go to floor mops. If you know dry cleaning or photo supplies or trading junior resource stocks, go for it and swing for the bleachers. Choose your answer carefully, then dedicate yourself to learning your path better than anyone else in the world. My message here is that we’re all walking on uncharted territory these days. Old paradigms no longer apply, so don’t look to anyone else for the answers. Turn off the TV and think for yourself. Do not… I repeat… do NOT give control of your life over to anyone else. Study, practice, study some more, practice some more. Then, be prepared to start all over again. The rules will change, and then change again. The only thing that won’t change is your requirement to keep learning. Others will not do it for you. If you have chosen well, and backed it up with study and practice, any successes you celebrate will be your own.

In other words, same old, same old. DYODD… and that, my friends… is no laughing matter.


Kevin Graham

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