Lessons from the Pros

In fact, the “China Price” is a far more complex phenomenon. It is driven first and foremost by a vast “reserve army of the unemployed” numbering over 100 million workers that chronically and severely depresses wages. Only slightly less significant are China’s lavish subsidies to industry and continued violations of the WTO, huge advantages gained from lax environmental protection and workplace safety, and, most subtly, an unprecedented influx of foreign direct investment that provides China with the latest, most sophisticated, and low-cost manufacturing technologies.

This is not to say that we shouldn’t pressure China to reevalue their currency. Rather, it is to say that if the U.S. truly wants to compete with the China Price, the President, Congress, and business and labor leaders need to come up with a much more comprehensive set of strategies than a mere currency revaluation.

That said, that are two very real benefits of forcing China to fairly value its currency. These are significant reductions in both the U.S. budget and trade deficits. These “rewards”, however, are not without significant risk.

To see why, consider the dynamics of these potential twin deficit reductions. These dynamics begin with this perverse effect of the current fixed dollar-yuan peg: To keep the yuan artificially low, China must buy huge sums of U.S. government securities. That is well understood.

Less well understood is that other Asian countries that now directly compete with China – principally Japan, Korea, and Taiwan — must also artificially hold down the value of their currencies so as to not surrender further advantage to China. Moreover, they do so just like China does — by recycling large sums of U.S. dollars gained through trade back into the U.S. bond market. The result is a far larger Asian trade deficit than would otherwise exist in a floating exchange rate regime.

The U.S. budget deficit is likewise bigger than it would otherwise be for similar reasons. In particular, the current and massive Asian accommodation of the U.S.’s structural budget deficit helps keep long term interest rates artificially low. In doing so, it significantly reduces political and economic pressures on the President and the Congress to balance our burgeoning structural budget deficit.

Forget, then, all that Fed Speak nonsense from Alan Greenspan and Ben Bernanke and others about an “Asian savings glut” causing a “conundrum” of an inverted yield curve. Much of what is really going on in the bond market is a reverse run on the dollar, with China’s dollar-yuan peg the real culprit.

It should be immediately clear from this discussion why forcing the yuan upwards would also pose great dangers to the U.S. economy. As soon as China, Japan, Korea, and Taiwan no longer have to buy so many our treasury bonds to keep their currencies low, interest rates will rise – likely quite significantly.

Higher interest rates, in turn, will help prick the speculative housing bubble at a time when the froth is already considerable. Higher interest rates might also deal a deadly blow to domestic automakers like GM and Ford. Higher interest rates will also severely strain the heavily in-debt U.S. consumer. The result may well be a very nasty and long-lasting recession.

This may not be the worst danger longer term. A stronger yuan would also dramatically strengthen China’s hand when its comes to its acquisition of foreign assets – whether China is targeting a U.S. oil company, an African cobalt mine, or a Chilean copper reserve. That is, instead of China “benignly” buying U.S. treasury securities with its excess dollars, it might decide to go on a global shopping spree with its stronger currency. Any resultant acquisitions would only strengthen China’s manufacturing, distribution, and marketing capabilities at a time when China is already poised to soon become the biggest manufacturing Hegemon on the global block.

This Week’s Market Movers – Data Galore

The week gets off with a big supply side bang with the ISM index report on Monday. It’s been very bullish for months. However, its robustness begs the question as to whether or not firms are simply building inventories to meet real or phantom demand.

Tuesday the big market mover will be auto sales. They were weak last month and will likely be again – with all signs pointing to both housing and autos receding as big players in the next leg of growth. After Tuesday, the market is likely to cruise on lighter volume until Friday’s job report, always a market mover. Both the bond and stock bears will be looking for any further signs of a tightening labor market and attendant wage inflation. Insiders will watch for whether the labor participation rate is increasing, which would take some heat off the inflation gauge. So far, no good.

Personally, I so see a high rate of job creation as a reliable sign of a strong economy or bullish future market. Job creation and the unemployment rate are both lagging indicators. My own view is that the very smartest companies would not be hiring now given the downshifting economy, but companies that countercyclically manage the business cycle well are in the minority.

Portfolio Shorts and Longs – STAA and IMAX
My two significant portfolio additions last week were Staar Surgical (STAA) and IMAX Corporation (IMAX) Imax needs no introduction to the movie crowd. Staar makes medical devices for cataract and glaucoma surgery. The technicals for both companies are very strong and Staar may have a better mousetrap than competitors. Volume in Staar is a bit light for my tastes but for now, both stocks show buy signals.

I’m remain short QQQQ despite the Nasdaq’s strong performance last week. I’m not particularly worried. I’m in at $41.22 and current price ending last Friday is $41.93. Risk-reward continues to favor the downside. And by the way, even though the market is up for the year, once you get below the surface into individual stocks, it’s still an ugly market.

I added to my DVSA long, the ethanol biotech play. I’m holding AKSY, HEPH, and SVA with little enthusiasm. I remain short XLF, but my position is small so there is little pain and I still believe this one turns over. Finally, XING is behaving nicely.

Hedging Your Bets With Matt
Davio:  Charts Don’t Lie 

Here’s a great chart. So construction spending continues like a drunken sailor at port. While New Home Sales have clearly become the laggard. I would say, there is no denying the inevitable with higher interest rates, laggging wage growth, and escalated housing costs. Not a time to be buying a new house, I say if you are new to the market, wait a few more years and when real estate isn’t the most talked about item, build a nice relationship with your local banker and let him know when he can’t take the pain of his inventory on his books you will be ready to buy. Same game happened in stocks. Reflation game is nearly over for Real Estate.

Former Fed Chairs Don’t Lie

The new weekly commentary by Jeffrey Saut is out. He has a first-hand account of the PIMCO investment conference where Alan Greenspan attended:

“Then there was Alan Greenspan, who said that the ‘new conundrum’ was the collapse of ‘risk premiums’ around the world. Now our definition of risk premium is the excess return required for holding a more ‘risky’ investment than a risk-free investment. For example, the excess yield spread between Treasury and non-Treasury Bonds of comparable maturity. Or, the extra return the overall stock market, or a particular stock, must provide over the interest rate on Treasury Bills to compensate for the market risk. While the esteemed ex-Chairman attributed some of this ‘new conundrum’ to excess worldwide savings, he suggested the untold story is the extraordinary low-inflation expectations that currently exist. He proposed those low expectations have been driven by the collapse of Russia, which showed the world that ‘central planning’ doesn’t work. Many countries, therefore, eschewed communism/socialism in favor of capitalism/democracy. And that, ladies and gentlemen, caused a few hundred million educated people to be thrown into the workforce, which in turn has kept wages ‘flat.’ Mr. Greenspan observes that ‘flat’ wage growth is not just a U.S. phenomenon it is ubiquitous.

“On the dollar, Greenspan is bearish, noting that ‘concentration risk’ will, over time, curb capital flows into the greenback. To wit, eventually China will have too many dollar reserves and will have to diversify its currency exposure. He was also quite concerned about the looming Medicare/Medicaid deficits as more of the baby boomers come of age. While the social security deficits are quantifiable, he noted, Medicare/Medicaid deficits are not! He further opined that short-term deficits tend not to matter, yet long-term deficits (like Medicare/Medicaid) matter a great deal. Whenever the 30-year Treasury Bond begins discounting these deficits is unknowable, but eventually it will with an attendant rise in interest rates. Greenspan concluded his comments with a bullish stance on energy. He said that while reserves were growing somewhat in-line with demand, refining capacity, to process that crude oil, was woefully short due to 25 years of underinvestment (we are bullish on the drillers).”

This raises a good question: is it more contractionary for the economy (or less expanionary, depending on how you want to look at it) to have a flat yield curve with interest rates of 4.5%, as we did 6 weeks ago… or for the yield curve to not be inverted but to have top long-term rates of 4.9%, as we have today?