Archive for April, 2013

Middle of the End

April 23, 2013

Smith’s Research & Gradings (SRG) announced on March 20th, 2013, the worldwide economic cycle has entered “The Middle of the End”.   In September of 2012, SRG told attendees of SMITH’s High-Yield Conference the economy had entered the “Beginning of the End”, which was projected to last 18 months. Terence M. Smith, CEO of SRG, said, “The Middle of the End will be characterized by a currency war, trade wars, commodity market manipulation, deflationary pressures and regional armed conflicts.  Events are moving more swiftly than during the beginning and middle phases, which may overwhelm the attempts by central banks to control outcomes.”

Indeed.  “The Beginning of the End” was characterized by Mr. Smith as period of persistent eonomic problems.  He described, in detail, how the uncertainty associated with the durability of the revenues from the federal programs would lead to low/no growth.  The federal spending could not offset the lack of job creation in the private sectors of the economy. SRG predicted “The Beginning of the End’s” most persistent economic problem would be “high unemployment”.  SRG has documented how the unemployment rate is much higher than indicated by the Bureau of Labor Statistics (BLS).  SRG noted the Beginning of the Middle was coincident with unemployment benefits expiring.  In an attempt to ameliorate the suffering, many state governments have issued long-term municipal bonds to finance the costs to continue funding unemployment benefits.  So the Beginning of the End was characterized by large deficit spending programs, both at the federal and state/local levels.

To understand the final phase of the global economic cycle, one needs to understand how the lax underwriting/credit standards artificially inflated the balance sheets of lending institutions.  The Beginning was a period of recognition of the damage to these financial institutions and the shoring-up of the capital adequacy.  The Middle period was an extension of the debt crisis, whereby the risks incurred by the financial institutions were moved onto the balance sheets of the sovereign entities. Thus, a credit crisis became a sovereign debt crisis. Now, the sovereign debt crisis is approaching an end-game.

The United States passed The Budget Control Act in August 2011, which solved the U.S. debt ceiling crisis in January by implementing austerity measures.  How the U.S. will paydown the existing debt, while funding ongoing sovereign responsibilities, remains an unanswered question.

Perhaps the European Union can provide a roadmap to rescuing the U.S. Treasury bonds? The Euro has reached the point when the next round of bailouts threaten to pull the middle-tier economies of the European Union into the dark abyss of political turmoil. The European Union got tough with Cyprus and demanded austerity measures be increased.  Cyprus surprised the world when it announced a tax on accounts with more than 100,000 Euros — a tax that may hit 60% of the deposits (for those offshore oligopolists who try to transfer the money out of the country).  A blatant grab for foreign money, to be sure.

How will it workout for Cyprus?  One might do well to consider, say, Argentina. The President of Argentina, Christina Fernandez, is flying coach class on international flights because she fears the Presidential Jet will be confiscated by creditors of its sovereign debt.  And, she has cause to worry.  During the debt crisis of 1999-2002, Argentina defaulted on $100 bln. of bonds.  Subsequently, roughly 90% of the country’s bonds have been restructured with easier terms featuring lower rates and longer maturities. However, a group of hedge funds bought $1.3 billion of Argentina’s defaulted bonds at 20-30 cents on the dollar and subsequently demanded full and timely payment of interest/principal. At the end of March 2013, the 2nd U.S. Circuit Court of Appeals in New York declined to grant a full-court rehearing of a decision by a three-judge panel that went against Argentina in October, which ruled the country had to deal with all its debt holders equally. So, since the hedge funds are led by billionaire Paul Singer’s Elliott Management, President Fernandez must treat the all of the debt holders with the proper respect or face an international embargo backed by the courts.

Currency Crisis
SRG predicted the Middle of the End will climax with a Currency Crisis.  Even prior to the onset of the  economic crisis, SRG monitored attempts by central governments to manipulate currency values in order to attract crossborder capital flows and stimulate growth in employment.  As SMITH’s Cadre of Regulars knows, the Chinese Yuan was pegged to trade at 80 cents on the U.S. Dollar and China was mentioned in the Presidential debates as being a state-sponsor of currency manipulation.

However, SRG has watched the U.S. Treasury and Federal Reserve implement a state-sponsored strategy that is no less manipulative.  The Federal Reserve Bank Chairman Benjamin Bernanke has pledged to continue QE3 (buying U.S. guaranteed mortgage-backed securities and U.S. Treasury obligations) until U.S. unemployment rates have improved.

SRG has noted the Fed has expanded its definition of unemployment rates over the past six months to include the large number of Americans no longer considered part of the workforce.  What’s more, SRG has noted the nearly double-digit percentage increase in the number of Americans qualifying for permanent disability.  The U.S. economy has a nearly 60% participation rate (40% do not work), and SRG predicts the U.S. economy is reaching the tipping point when most people feel they lack any real incentive to look for work.  To staunch the expansion of the leisure class (as Plato referred to it), the ruling class must create jobs (even public sector jobs). So, the U.S. debt crisis has morphed (albeit temporarily) into a domestic economic issue based on inequality.

Political stability was maintained and domestic agendas could dominate the decisions around the globe. Except the Bank of Japan’s Governor, Haruhiko Kuroda, stunned the world’s foreign currency exchange (fx) marts by launching a massive easing policy that he expects will defeat deflation by doubling the money supply. Whoa.

Japanese manufacturers were quick to embrace the new policy.  Suddenly, The Bank of Japan was providing “reinforcements” to the Japanese troops in the world’s markets.

Yet, Governor Kuroda is committed to boosting the value of the yen by 2 percent in two years, signing onto Prime Minister Shinzo Abe’s target timetable. Currently, 1 yen is barely worth a U.S. copper penny at $0.0106.  Governor Kuroda is betting his new liquidity policy will promote a vigorous expansion of domestic employment and rising prices in domestic real estate, which will attract foreign capital and boost the yen’s value.

Germany must fight back to protect its high-end, top quality, products and services.  It will drive the Euro down, particularly against the Japanese yen, by promoting a second round of European debt in the coming six months. Eventually, SRG expects Japan and Germany will be forced to come to the bargaining table by the European Union and the United States.  An agreement will be signed that stabilizes the currency values relative to one another (and some basket of goods/services).  However, China and Russia will be the big winners (by not being at the table).  (Stay Tune for Part 2)