Geopolitical turmoil

Where to look?

• Silver making new highs. Without the fanfare of gold, silver continues to shine.

Asia is the real story

Just a quick note about China

Who benefits from a declining euro?

Will the euro break 1.29 today? Well, if not today, then soon. Spreads are unsustainable for rolling over maturing debt, and Italy is the next to fall. I anticipate growing anger from Germany that will make each future bailout more expensive both for the offending countries and the holders of existing debt. A couple of beneficiaries in my mind…

Turkey is sitting pretty. The xenophobic Europeans shunned the country, but it’s having the last laugh. Its demographics are good, growth is OK, internal demand is growing, etc. They’ll have to figure out how to compete with a weaker euro, but at least they won’t be saddled with the same cross holdings of bad debt.

Russia and China are chomping at the bit. If Germany backs off bailouts, and the US hands are limited anyway, Russia and China can demand large concessions in return for bailout money. I’m anticipating some port access, military concessions, favorable trade agreements, etc. to be handed out. At the same time, the US will voice anger, but our own mismanagement will limit our dissent.

Why won’t Europe benefit from a declining euro? Because the wealth destruction will be faster than the increase in monetary competitiveness. Given the continuing employment deterioration and increasing local inflation, which in Europe actually leads to quicker social unrest than would be anticipated from well-functioning democracies, the lower euro will more likely lead to less faith in government policies, not more.

Geopolitics for breakfast

Asian markets are open already, but European and later US investors, will get some more geopolitics for breakfast.

South Korea is down just over 1% as I write this, mostly over tensions with North Korea, military exercises, etc. When money gets tight, tensions run high. I think this is only the beginning of world flare-ups. Shanghai, is down 3%, with property and bank shares leading the charge. How many times can I write about property and finance companies being a sham in China before investors realize they will not get paid for the risk of Chinese investments. If you’re not local and tapped into the bureaucracy, stay away at these valuations!

In the meantime, the euro is ticking lower and I am guessing that it breaks the 1.30 handle before everyone goes away for Christmas. Which brings me to another thought of the evening…

Everyone is expecting a slow, boring week, and the volumes will probably reflect that. But what if they’re wrong? For those who fly, you’ll understand the following analogy: the most dangerous times in a flight are the take-off and landing. The next two weeks are the landing for 2010. Thinner volume, ridiculously low-priced VIX, 6-sigma currency vol, rising bond yields, etc. all lead me to want to buy insurance. I’m already so underweight equities, and short so many asset classes, that I’m not adding to anything, but new funds would definitely be searching for insurance at these levels.

Unemployment at 9.8%

The numbers came out and depending on your interpretation…well, actually, it’s tough to interpret these positively:

(From BLS) The unemployment rate edged up to 9.8 percent in November, and nonfarm payroll employment was little changed (+39,000). Temporary help services and health care continued to add jobs over the month, while employment fell in retail trade. Employment in most major industries changed little in November.

CalculatedRisk.com did a great job of putting all the numbers into charts and I encourage you to look there, but I want to highlight one in particular and the summary:

This graph shows the number of workers unemployed for 27 weeks or more.

According to the BLS, there are 6.313 million workers who have been unemployed for more than 26 weeks and still want a job. This was up from 6.206 million in October. It appears the number of long term unemployed has peaked, however the level is extremely high – and the increases over the last two months is very concerning.

Summary

Perhaps the worst news was the jump in the unemployment rate to 9.8% without an increase in the participation rate. If the participation rate had increased, at least that would mean people were becoming more confident and rejoining the labor force. Instead the Labor Force Participation Rate was flat at 64.5% and this is a very low level. Note: This is the percentage of the working age population in the labor force (here is the graph in the galleries of the participation rate).

Most of the underlying details of the employment report were weak. The positives included small upward revisions to the September and October payroll reports, a slight increase in average hourly earnings, and a slight decline in part time workers.

The negatives include the unemployment rate increasing to 9.8%, few payroll jobs added (only 39,000 jobs), the decline in the employment-population ratio, the steady participation rate at a very low level, and the increase in workers unemployed for over 26 weeks.

You wanted a weaker currency…

The euro continues to head lower, and so far, Germany is the only one that’s OK with it.

All German surveys are coming in strong, and rightfully so, with its export focused economy. Problems loom for them, however. For starters, bailouts don’t solve the problems, the just change the creditors and buy more time. In the case of Ireland, the bailout bought a few quarters of stability – at best. The market is already discounting further down the road. Spanish and Portuguese yields continue to soar. Certainly, the number of eurozone countries hurting alongside the euro is increasing.

There’s also an interesting and little-discussed North-South in the eurozone, with northern countries, including UK, Scandinavia, Germany, etc. holding up better (albeit with their own sets of problems, but then again, who doesn’t have them?) than their southern counterparts in Spain, Italy, Greece, etc. Ireland sticks out like a sore thumb, but you get the general idea.

A thought for Obama

Did North Korea just hand you a game changer on a silver platter? Here’s a thought: North Korea is sending out a feeler – will Obama OK a retaliation by South Korea? China is in on the talks and while it wants to back North Korea, might let the retaliation happen, just so it can get some concessions from the US. Yup, it’s a Prisoner’s Dilemma on drugs. In the meantime, the person glued to the TV is Ahmadinejad. If the US let’s North Korea’s moves go unanswered, he knows he’s in the clear. Otherwise, he’s finding a hole in the desert to hide for a while. I expect the former, but hope for the latter.

This is an opportunity during a difficult period for the world. Obama has a chance to bring different countries together around a common enemy, and to rally against extremism, global nuclear proliferation, etc. and to use it as an opportunity to calm talks over economic and currency wars. I hope he uses it wisely.

Did you already go on vacation? Part II

Just when you think you’re out…

North and South Korea exchange artillery fire - and money has to choose sides. Obviously the Korean won is the first to feel it (down about 3%), but let’s look at the second degree. If there’s tension in the peninsula, the Chinese will side with North Korea for ideological reasons and national (political?) pride. Fine, except that investors know that the US will choose South Korea. Which means that the big investor money (US invests more than North Korea) might leave China. That will in turn exacerbate Chinese inflation, already a big concern for the Party. Where that leads? Hopefully, to some strong words that leave a lot of room to maneuver around for all sides. The alternative is for Chinese protectionism/nationalism to drive politicians into a corner where rare earths shipments are again halted, food is hoarded, etc.

In the meantime, the euro continues to head lower (down 1.3% as of this writing). They’ve got their own problems to deal with without worrying about the Korean peninsula today.

Small Cheesemaker Defies F.D.A. Over Recall

To her devotees, Ms. Estrella is a homespun diva of local food. With her husband and six adopted children from Liberia, she makes tasty artisan cheeses from the milk of her 36 cows and 40 goats and sells it at farmers’ markets.

Some even winds up on tables at fancy restaurants in Manhattan and Los Angeles.

But to the federal government, Ms. Estrella is a defiant businesswoman unable to keep dangerous bacteria out of her products. Last month, the Food and Drug Administration moved to shut down her business, Estrella Family Creamery, after tests found listeria in some of her cheese and she refused to agree to a broad recall of her products.

Although no illnesses have been linked to Ms. Estrella’s cheese, listeria is a sometimes deadly bacteria that is especially hazardous for the very young and the very old. Pregnant women who become infected can have miscarriages or stillbirths.

Read the full article here.

This blog is not about chronicling the regulatory or policy framework, per se; however, the investing environment happens in that same framework and thus policy needs to be analyzed, and more importantly, trends in policy and regulation need to be noted. The current trend, which can be traced as far back as the 1930′s with the New Deal, is towards increased government intervention, heightened regulatory risk, and ever shifting policy regimes. This trend makes it tougher for small businesses to start and grow, and will give larger companies an advantage in the competitive landscape.

We already see this in medicine (http://www.crainsnewyork.com/article/20101114/SMALLBIZ/311149979):

Over the past few months, hundreds of New York area doctors have dealt with the choice Dr. Steinberg is mulling. In exchange for a steady paycheck, these doctors have signed contracts that mandate they hit productivity and patient-satisfaction benchmarks. An added benefit for giving up their autonomy: relief from the pressures of federal health care reform and Medicare cuts.

…The situation is most acute for cardiologists, whose revenue has been hit by federal cuts for diagnostic procedures. A full 60% of the specialty’s businesses are in merger talks with hospitals or other practices, according to a recent survey by the American College of Cardiology.“There have been fundamental changes in reimbursement” for all physicians, says Dr. Andrew Brotman, NYU Langone’s senior vice president and vice dean for clinical affairs and strategy. “They’ve made it more difficult for independent practitioners to operate, and many have sought other opportunities.”

…and we’ll see it service companies from law firms to accounting firms. The implications are vast: from higher structural unemployment to lower levels of productivity gains. For investors, it also means that large firms might have an advantage; it also means that going public will be even more expensive. We’ll continue to explore the specific implications, but for now, I hope Ms. Estrella is able to hold out and stanch the tide of increased costs and regulations for business-owners.

The Sacrificial Bank

I don’t know which bank it will be, but one of the big ones. Obama and Bernanke are facing mounting political pressure: Deflationary pressures continue, commodities are correcting, risk assets are coming down, etc. while on the other hand political pressure against QEII is mounting and already it looks too big to the hyperinflation crowd and too small to the Keynesians. So what’s a bureaucrat to do?

Set an example by sacrificing one of the big banks and that should get the people off your back for a while. I think the political strength to bail out one of the banks will be gone in the next go-around. Already, Europe is going to need to bail out their own banking system as the euro falters, and the federal government will need to bail out California alongside countless municipalities such as Philadelphia. If they bail out the next bank failure, Obama will have no retort during the debates against the claim that he’s socializing everything. If he lets one of the banks go under, he’ll be able to point to his supposed strength and market-oriented mentality.

Given that I think the banks are still undercapitalized and have not marked down the majority of bad debt on their books, I believe we’ll hit a new financial snag in the next few months, but this time, the government won’t step in. Roger Altman who is rumored to be the next financial appointment might end up being an interim installment for Geithner who will end up being the fall guy for the tough decisions that need to be made in the next few months.

If I had $600 Billion, I’d be rich

The Fed cam out with QEII and the essence is that there will be $600B pumped into the market for the next 8 months in the hopes of stimulating economic growth. I won’t go into the differing opinions of whether QEII will actually work, but simply state mine: if QEI didn’t work, why would QEII? We don’t have a liquidity problem that can be solved with more POMO activities. We have credit/faith problem, which isn’t solved with free money; quite the contrary, something that is free isn’t worth anything.

When the dust settles, I don’t think this round of QE will make much of any difference. The focus now is the turning point in the yen, the turning of Chinese growth numbers which I believe will come in over the next few months, and the breakdown of the euro (Ireland and Greece are only the beginning). The dollar will look like a superstar compared to the alternative, and will squeeze nay-sayers.

GDP is out and disappointing, but that’s not what is important today…

Let’s start with the GDP report:

The Bureau of Economic Analysis reported today that U.S. real GDP grew at an annual rate of 2.0% during the third quarter.

Read the breakdown at Econbrowser.com.

But quite honestly, the market doesn’t care and neither should you. Why? Because this market is being kept in tact until after the election: POMO, China talks, whatever can keep the market from going where it will eventually go.

And then, there’s the geopolitical. As I write this, I see the headline flash on CNN that a bomb was found on a UPS flight from Yemen. Additionally, the TSA is investigating other cargo planes. No news on it yet, just a headline, but certainly more important than the unexciting GDP numbers.

Response to my China stance

A couple of days ago, I mentioned my stance that China’s legal infrastructure, valuations, government-mandated policies, etc. are all reasons why I’m staying away. A few readers responded, but one summarized all the responses pretty well, and with permission, I’m posting it below. Over a few emails, we had a back and forth, so I’ll post some more thoughts down below even further.

Hi Yaron,

I read your recent postings on China and the Dollar.

I do regret writing a short emotional posting on your blog in 2008 about “Helicopter Ben” and the threat of hyperinflation. In hindsight, I think it might also be easily misinterpreted. However – this time more soberly – I do want to challenge your bearish stance on China as I am one of the guys gone ga-ga for China.

Here are a few articles/speeches from people who are more eloquent than me in presenting the case:

 Marc Faber – Speech, Austrian Economics and the Financial Markets

http://www.youtube.com/watch?v=H0sS6a9RW2E

A very thought-provoking presentation regarding America’s loss of power and its currency.

 Charlie Munger – Basically, It’s Over

http://www.slate.com/id/2245328/

Charlie seems to be quite bearish – and much more bearish on America than Warren.

 China’s Rising Role in Africa

http://www.cfr.org/publication/8436/chinas_rising_role_in_africa.html

One of many articles showing how China is building a power base and securing access to raw materials in Africa. From my travels through Africa and Central Asia I can confirm that China’s presence can be felt far and wide. They are very strategic about this – and they do have capital to build, buy and bribe.

I haven’t met anybody who has been repeatedly going to China over the last 10 years and is not in awe of the speed and scale of its development. And because the country is so huge and has so much to catch up on, there is a lot of untapped potential. I have been thinking about civilization lifecycles a lot recently. No, I do not think the West is going down. However, I do believe that the momentum is on China.

Oh, well. I guess only time will tell

Here is my response:

Here’s some more of my ranting…I hope I can convince you before it’s too late. I’ve never been to China, but I don’t think that should cloud anyone’s judgment. I haven’t visited the firms I’m buying or not buying, but I think the numbers tell a story. Additionally, the biggest long-term determinant of performance is underlying market structure. Property rights being top of the list, rule of law, bankruptcy procedures, employment foundations (ease of hiring/firing), etc. all play into that. The US used to be better, and I still think it’s one of the best, in all these categories. Europe has traditionally been great on some (property rights), horrible on others (hiring/firing) and has lagged as a result. I once helped develop a relative value strategy by looking at country policy towards immigration – open immigration policies lead to better long term performance.

 China has gotten a little lucky. 1.3 billion people who are hard working is an immense resource. But by itself, it’s not enough. Without the underlying foundations, China will go the way of Russia (planned government) or Nigeria (resource-based economies without property rights and rule of law). That is, it will have a small level of the uber-wealthy, but overall, a poor society. Visitors are often enamored from the bright shiny new roads. But they have 60 million (yes, million) empty apartments that no one can afford. They have overcapacity in every industry they touch. Rising wages would be great, except the vast majority of the population barely has running water and the income disparity is so great that social unrest could be explosive. No wonder Chinese gabillionaires are buying apartments in NYC, diamonds, and gold (and a fast plane) – they need to be able to run.

Lastly, everyone is thinking the US should be afraid of China because China holds so many treasuries. If I was a Chinese yeoman, I’d be pissed that my government is using my money to buy up return-free risk, and funding US purchases of TV’s. When yields rise, and they will, China will be sitting on IOU’s with no bidder. They won’t be able to sell fast enough. Will it hurt the US? Of course, but the US has a stable system that will handle it. China doesn’t. They’re the ones facing the greater risk.

Now, I have to admit, that I’m biased. The rest of the world seems to be fine with shorting USD and buying everything from 100 year Mexico bonds to secondary stock offering. I’m taking the other side of their trades. AUD? Why would I buy it when I think China is going to slow, if not implode? Yen? Why would I be long it when I know the government has to issue new currency just to fund interest payments? I prefer Japanese equity which is trading at low valuations after years of deflationary pressures.

And yes, time will tell.