The economic dog is wagged again by the QE tail
“If you are not confused about the economy, you don’t understand it very well.” This delightful quote I picked from a report sent to me earlier this week after the annual Berkshire Hathaway investment meeting in the USA. It was said by one of the presenters Charlie Munger who cautioned in the same breath that he is not predicting the demise of the global economy, only pointing out that markets in general pose some of the biggest challenges in history to investors hunting yields on behalf of disappointed clients.
Excessive volatility in international markets is back since Thursday a week ago when the Nikkei 225 index lost 7.3% in a single day, the biggest one-day fall since Fukushima. Thursday this week, the Nikkei followed it up with a repeat performance, dropping again 5.2% in a single day. This happened while the Dow Industrial Index was groping for 15400 with some extravagant analysts predicting it will go to 16000 before the end of the semester.
As an analyst, I am not privy to the inside dealings (and expectations) of Wall Street. But as an outsider, I may notice certain trends of which all but the most alternative investment managers, appear to be ignorant. From a technical point of view, I can fully concur that there is a definite possibility of the Dow touching 16000 index points. It is typical for these large, sentiment driven, markets to end the first semester on an exuberant note, but what happens after that?
A short term pattern has lately emerged. The day after the Nikkei goes skydiving, European and US bourses follow suit. The excessive gains in all major European and US indices on Thursday, prompt me to expect a rather serious slump this Friday, cued by the Nikkei’s performance.
My views about monetary policy in Japan are on record. I regard it a futile experiment to copy the US Federal Reserve’s QE strategy, especially when a central bank embarks on this path, on top of a national debt that exceeds 230% of GDP. In the past, Japan was saved by its own citizens through their propensity for saving, but that fountain is now dry, and Japanese bonds will be exposed to the vagaries of international investors going forward. As I have pointed out in earlier commentaries, only a few percentage points shift in the interest rates on Japanese bonds will have a major impact on their overall liquidity. If investors demand a 2% return on these bonds, instead of the current almost zero percent, then Japanese sovereign financing costs will go through the roof. One recent report estimates that a 2% interest rate on Japanese bonds will swallow 85% of their national budget, just to service interest. The more dependent Japanese bond issuances become on investors other than their own nationals, the higher the risk of their bond rates exploding. And the more unpredictable and unstable the entire global economy’s financial side becomes.
I am not in a position to forecast movement in the Japanese bond market, I can only state what common sense dictates. No other economy, either in partnership, or in competition with the Japanese economy, will allow an unchecked depreciation of the Yen – which is what the Bank of Japan reluctantly agreed to when ordered by the government to start buying up its own sovereign’s bonds. The Japan economy is inextricably linked to the economies of China, Korea, Malaysia, and several other smaller economies of Asia. When it blows, the damage will be severe with widespread fall-out.
One may think that these events are far removed from our horizon, and that our interest is academic at most. On the contrary, what affects China affects all economies that rely on extraction. If I had a blasé attitude, I may as well say, forget about the East, worry about what is happening in South Africa. This is true, keeping in mind that South Africa is in many instances only a conduit for metals mined in Namibia, but reduced demand from the Chinese industrial complex, has a far more direct impact on our local economy than it has on South Africa’s. Extractive resources, as a percentage of overall economic activity, contribute a much bigger slice to our well-being, compared to our powerful southern neighbour. They can ride out the effects of their own mining strikes while we find it much harder to absorb depressed commodity prices, and that because of their doings.
And where we deal in international markets, our own currency is only a proxy for the Rand. In the end, exchange rate volatility in the Rand, has a much bigger impact on our local extractive industries.
My crystal ball tells me we are headed for severe volatility again. The trend may seem up, at least until the end of the semester, but I am skeptical. Nowhere in economic history has any single nation managed to defy the fundamentals indefinitely.