The
last several weeks have been an Armageddon for emerging and
small market investors. Many emerging currencies have depreciated
dramatically versus the greenback, euro and yen. Emerging
bonds and equities have been affected. The New Zealand dollar,
Mexican peso, Brazilian real and Turkish lira have dropped.
The wave of panic began with the Icelandic kroner.
Let’s pause for a moment and understand
why.
Iceland is a tiny country of 400,000 people.
The economy is based on three industries, fish, aluminum
and entrepreneurship. Why in the world would investors rush
to invest there? More so, why in the world would investors
everywhere panic about their investments all over the world
because one tiny nation has an economic hiccup? A look at
the numbers begs the question, “What the heck is going
on?”
The real problem comes, as Lemony Snicket
would say, “from a series of unfortunate events”.
The reason behind these unfortunate events
is sound. Globally economies are trying to equalize.
Homogenization is a universal fundamental and spreading
wealth around the globe is good. People should have abundance
everywhere.
The way the globally economy has approached
spreading this wealth is unfortunate.
The first unfortunate event is that America
has been spending, spending, spending more than it has been
earning, earning, earning. All the emerging nations have
been selling to America. America has not been buying back
as much. This creates trade deficits.
The second unfortunate event is that Europe
has been doing likewise (though to a lesser extent).
This spending has been financed by a diluted
dollar.
The third unfortunate event is debt…lots
of it.
Here is why this debt has tuned into such
a dirt pile.
The industrialization of mankind has evolved
in numerous waves of technology fueled first by water power,
then steam, then the internal combustion engine, then the
jet, TV and phone and most recently by the computer and internet.
Each wave made individuals more productive. They could produce
and thus have more.
In the 90s the West became more efficient
and productive by adapting the computer and internet to everyday
life. This allowed America and much of the Western world
(Japan included) to improve its material standards by producing
more and then using their earnings from that production to
buy more things. Much of this buying was done in emerging
countries.
Everyone loved this spending. People in
the West bought more and more stuff….cheap! This made
them feel rich. People in emerging markets raised their standards
of living by having lots of work and selling all the stuff.
This made them feel richer as well.
Wealth expanded because everyone invested
in an exploding US stock market. This made investors appear rich.
Then this wave of increased productivity
reached its zenith and the stock market crashed.
But everyone wanted the boom to go on. Everyone
still wanted to spend and feel rich.
So rather than slowing commerce, the next
unfortunate event is that governments in the US, Japan and
Europe turned on the printing and borrowing machines, lowered
interest rates and made money more easily available.
This especially deceived American investors
where (with a monthly payment mentality) easy, low interest
mortgages allowed home prices to skyrocket. Now home equities
instead of stock market holdings appeared to make
Americans rich.
But, really an increased value in
a home does not increase productivity. It just allows the
owner to borrow more. This is unfortunate because America
already had quite a bit of debt though nothing compared to
what was (and is) coming.
Easy money unfortunately is not real money.
Real money must be backed by productivity and rare. We looked
at why in a recent message at spottingtrends.com/investment_philosophy_28.htm
This caused dilution in the value of the
US dollar. This is a very unfortunate event because the greenback
also happens to be the reserve currency of the world. As
such it should even be rarer than most currencies.
Slowly every person in the US, through personal
and federal borrowing, went deeper and deeper and debt. More
and more people became aware of this. Finally, even the newspaper,
USA Today, which cannot be called an economic bastion started
writing about this huge debt problem.
Its May 25 front page article entitled “Retiree
benefits grow into monster-Taxpayer burden: $510,678 a family” begins
by saying: “Federal, state and local governments have
added nearly $10 trillion to taxpayer liabilities in the
past two years, bringing the total of government's unfunded
obligations to an unprecedented $57.8 trillion. America’s
government obligations are five times what people owe for
mortgages, car loans, credit cards and other personal debt.
The $57.8 trillion liability is the amount that government
needs now, stashed away and earning interest, to generate
enough cash to pay future obligations. The obligations are
valued in today's dollars and come due as early as in a few
days, when Treasury bills mature, to as long as 75 years
for Social Security and Medicare.”
Let’s examine these two numbers, “two
years” and a “10 Trillion dollars” in more
depth. Current Federal debt is somewhere between 8 and 10
trillion. This is the debt that the US has acquired in its
entire existence.
In just the last two years US
government agencies have added 25% more debt than previously
acquired in the nation’s entire history! This is
really unfortunate.
Investors are not stupid so they correctly
assumed that the US dollar would lose value because of this
huge debt. They began to invest elsewhere. A lot of these
investments went into emerging currencies which is also unfortunate.
Most emerging currencies pay high interest
rates. Remember Western governments created low interest
rates because they wanted their citizens (and voters) to
feel rich. These Western loan rates (Japanese, US and European)
were so low that they enticed a lot of the investors to borrow
low and invest high into emerging currencies.
Over the past decade increasingly
huge amounts have been invested into currencies of small
emerging countries. These currencies normally do not have
a large volume of trading. This added activity
pushed the value of these emerging currencies up. This
also meant that that these high values were based on speculation
and were ripe for correcting. If lots of investors wanted
to all sell at once there would be few organic buyers.
There would only be lots of speculators and most of them
would all want to sell the currency…not buy.
All these unfortunate events led to a crunch
created by two more unfortunate events.
First the US government started pushing
up US interest rates. Worries grew that interest rates would
rise in Japan and the Europe as well. Investors started to
worry that the liquidity pushing up the emerging currencies
would fall. As I said, they are not stupid so they began
to jump out of their emerging market investments.
This sad happening coincided with Iceland’s
own little series of unfortunate events.
Iceland has many imbalances in its economy.
They have inflation. Their trade deficit and debt is high
and growing.
Not long ago the credit rating agency Fitch
became worried that two of Iceland’s banks, Kaupthing
and Glitnir may be having liquidity problems. Based on this
and all of Iceland’s weak economic fundamentals, Fitch
lowered Iceland’s credit rating. This was the spark
that started the investor stampede out of emerging markets.
Investors were looking at all these unfortunate events and
the Fitch warning was enough to created a mild panic.
The fear became self-fulfilling and emerging
markets have dropped around the world. Such waves of fear
are wonderful in the market place for investors who are
well positioned and choose not to run with the herd.
Investors with good diversifications are
still doing well. When currencies, bonds or stocks drop they
have to drop against something. When investors pull their
investments out of one asset class they have to put it somewhere.
Diversification protects.
For example an equal balance of the five
emerging market portfolios we track in our “Borrow
Low - Deposit High Service” (See garyascott.com/catalog/bldh.html are
down from 20.5% since October 21, 2007 to 9.9%. in just three
weeks. This is a huge drop but a 9.9% rise over seven months
in a portfolio is more than respectable. And now….fortunately,
as expected…. we are beginning to see some values
emerge from the carnage. The first glimmer of a turn around
may be where this downturn began in Iceland. See why below
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