Agora Financial’s Rude Awakening

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Melbourne, Australia

• BRIC nations meet to discuss what to do with their glut of U.S. dollars,
• Obama’s administration meet to discuss how to squander their paucity of U.S. dollars,
• Plus some words of warning from Nouriel Roubini and plenty more…

Eric Fry, reporting from Laguna Beach, California…

Yesterday, the Dow Jones Industrial Average recouped 58 of the 300 points it had lost during the prior week. The bounce did not seem particularly lively or convincing, but it did put 58 points on the board nonetheless.

While the stock market was busy trying to recover from its recent mini selloff, your California editor was busy enjoying one of the proudest moments of his parental experience. He was attending the fifth-grade graduation of his son, Ethan.

This event, in and of itself, did not induce any tears of joy, or inspire any overarching sense of parental pride. After all, Ethan is your California editor’s third and youngest child. So your editor has already attended a very large number of silly school ceremonies and corny events. Therefore, he was not among the crush of video-camera-wielding parents, jostling like paparazzi around the matriculating fifth-graders.

Instead, your editor sat quietly in his chair, tranquilly enjoying the moment.

About halfway through the ceremony, the principal gave a little speech. “Every year,” he began, “I try to think of just one word that describes the graduating class. I try to find just one word that captures the unique personality of that class. This year, I struggled because the class has so many different great qualities. Then one day, I was talking to one of the teachers about this and she said to me, ‘You know, this class is just really nice.’

“And so I thought to myself, yes, that’s it, ‘nice.’ This is just a really nice class. The kids are all extremely nice to one another, they have a great time together, and they include everyone in their activities. Let me give you some examples…”

The principal then proceeded to share a couple of anecdotes that illustrated the collective “niceness” of this particular fifth-grade class. After sharing these anecdotes, he offered a third and final illustration…

“But the one event that best illustrates the spirit of this class occurred just a couple of days ago at the fifth-grade pool party. The kids formed a massive Conga line that snaked all around the pool deck, up and down the slide, into the shallow end of the pool and back up onto the deck. Every single kid in the fifth grade was in that Conga line. And the whole thing was led by Ethan Fry…Ethan, please stand up for a round of applause.”

Ethan stood up, pumped his fists in the air and immodestly accepted the applause. His father was very proud. Ethan is not valedictorian. He is not president of the fifth grade class. He is not captain of the soccer team. But he knows how to lead a Conga line.

Ethan is also a talented and passionate artist. Every year, his elementary school conducts a competition. Any student who wishes to do so submits a drawing. Then all the students in the fifth-grade class vote for their favorite drawing. The school places the winning work of art on T-shirts it distributes to every child in the school. This year, Ethan’s drawing won.

As his father reflected upon these fifth-grade highlights – the Conga line and the work of art – he wondered if Ethan might not be better prepared for the America of the future than some of Ethan’s academically accomplished classmates. If America’s economic standing in the world continues to slide, its manufacturing base continues to disappear, its currency’s value continues to erode – while America’s taxation and regulatory burdens continue to mount – the America of the future might begin to resemble the Paraguay of the recent past.

In other words, America might become a kind of banana republic. In such a place, a talented leader of Conga lines might well enjoy a better livelihood than a Harvard MBA.

Please don’t misunderstand us; earning an MBA from Harvard is a great accomplishment. (Earning an MBA from anywhere is a great accomplishment). But the economic value of this achievement is largely dependent upon the context in which it is achieved. Earning an MBA in a failing capitalistic economy is like inventing an iPod in an Amish village. In the absolute, the achievement is commendable, but in context, the achievement is idiotic.

An economy that squelches entrepreneurial activity and impedes capital formation in innumerable ways is an economy that has little use for an MBA. Such an economy would also have little use for talented artists and Conga line leaders. But even in banana republics, the rich minority provides some small bit of demand for artwork and/or infectiously entertaining Conga lines.

I am proud of Ethan…and worried about the path of the U.S. economy.

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Sell Bonds, Buy Energy
By Dan Denning, editor of the Australian Daily Reckoning

When a large holder of U.S. dollars declares that the dollar is in “great shape,” should we believe him? My answer is, “Probably not.”

Russia’s Finance Minister Alexei Kudrin told journalists this week that the U.S. dollar is in “good shape.” He added that, “It’s too early to speak of an alternative [to the U.S. dollar].” These remarks came after Chinese and Russian officials have quite publicly suggested that the world’s financial system would benefit from using a currency that wasn’t being run by a bunch of inflationistas in America.

But the dilemma for the large dollar-holders of the world – Japan, Russia, and China to name a few – is how candidly they should verbalize in public about what everyone knows in private. By blowing the whistle on the Fed’s inflationary monetary policy, dollar-holders penalize themselves. The lesson? There’s a price to pay for rightly pointing out that a huge supply of Treasury bonds threatens the credit rating of the U.S. That price is paid by owners of dollar-denominated assets.

The dollar-supportive remarks by Kudrin, then, should be seen for what they are: a white lie, designed to halt the dollar’s slide…at least temporarily. In the meantime, however, you can bet that these same dollar-holders are working behind the scenes to find alternatives to the greenback and, of course, to diversify their currency reserves into other currencies or tangible assets. It’s just that you don’t want to precipitate a crisis until you’re good and ready to profit from it with a well-planned trade. Goldman Sachs would never make that kind of mistake!

There may be a few escape avenues from the dollar. It comes down to figuring out what-if anything-will go up when the U.S. dollar resumes going down. In fact, the question on everyone’s minds is what U.S. creditors will do with their money if they aren’t lending it to Barack Obama to spend.

“Over time,” says Nouriel Roubini, professor of economics at the Stern School of Business at NYU, “the willingness of the U.S. creditors to finance U.S. spending and buy dollar reserves is going to be reduced. People are getting nervous rightly about us devaluing or inflating our way out of the debt problem and causing real losses on the holdings of those assets.”

If you’re losing money on an asset, naturally you’re going to either sell of it, or at the very least, accumulate less of it. But then what? Where does your money go after that? We’d suggest the investment needs of the emerging market nations are the natural replacement for throwing away money in the U.S. Treasury market. Granted, there’s risk in emerging markets. But it’s now clear there’s risk in the sovereign bond market too. Take your pick.

Speaking of those emerging markets, four of them spoke with one voice in Russia this week. The leaders of Brazil, Russia, India, and China gathered to figure out how to solve their dollar dilemma. Criticize it too much, you lose value on your current dollar-denominated holdings. Do nothing, you lose value on your dollar-denominated holdings as Obama and his Congress spend America into poverty and servitude…and then inflate like mad men.

“There is a strong need for a stable, predictable and more diversified international monetary system,” the final statement from the BRIC nations read. Russia’s Dmitry Medvedev added his own “two roubles,” saying that existing reserve currencies, “have not managed to perform their functions.”

And what is the function of a reserve currency? Well, it’s probably the same as the tripartite function of any money: as a store of value, a unit of account, and a medium of exchange. Countries hold baskets of currencies (yen, Euros, Swiss Francs, U.S. dollars) in order to conduct international trade and commerce.

Of course all this is relatively new. That is, when money used to be a commodity (gold and/or silver) then a country’s monetary reserves were the same as its precious metal reserves. Debtor nations that consumed more than they produced and borrowed to do so paid the price in a net outflow of commodity money. But things don’t work that way in a world where everyone uses fiat money. So what we’re seeing now is a worldwide monetary system that is, well, systemically flawed.

Make of it what you will. What we make of it is that the very foundation of the world’s commerce and the currency in which it’s conducted is shifting. The stock markets of the world have no idea what to make of all this because it is not clear yet who the winners and losers will be.

All that we know is that paper currencies and government debts are proliferating very rapidly. We also know that natural resources are not. In fact, they are depleting very steadily. So we conclude that the prices of most natural resources will go up…a lot. That’s why lots of bears on the U.S. dollar suggest buying gold. We are sympathetic to this idea, but we’d suggest a slightly different strategy: Sell bonds. Buy energy.

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[Rude Endnote: Well, global markets took the ball from Wall Street and ran with it overnight. How far they’ll run before they run out of puff, we can’t be sure, but for now, there seems to be a case of temporary optimism among traders and investors.

Here in Asia, Hong Kong’s Hang Seng and Japan’s Nikkei 225 both added over 0.8% during the week’s final session. The Aussies eeked out a 0.2% gain, but the big story Down Under was the Aussie dollar’s 1.5% rally against the yen. Not-so-curiously, the South African rand also perked up against the wobbly Japanese currency as investors sought higher yields of “commodity backed” currencies.

In Europe, most measures were on the up and up last we checked. London’s FTSE was 1.6% in the green a few minutes ago while Germany’s DAX and France’s CAC were better by 0.2 and 0.9% respectively.

Crude inched over the $72 per barrel mark over in the commodity pits while gold, good ol’ gold, is still hanging in there around $935 an ounce.

That’s it from us for the workaday week. We’ll be back tomorrow with our usual wrap.

Until then…

Cheers,

Joel Bowman

The Rude Awakening
aussiejoel@the-rude-awakening.com