Of course I'm still on the dark side. A number of western economies have yet to surpass their nominal GDP highs of 2007 and I am not persuaded that this is a typical economic recovery that requires double-dip considerations; it feels like a mild depression to me. The debt of the private sector remains too high and as the events in Ireland highlight it can even hobble the security of the sovereign. Why is it so contentious therefore to declare oneself cautious if not downright pessimistic? Could the next great trade be a bear trade?
We have a number of such trades that all have asymmetric payoffs and are largely predicated on the notion that there are no policy prescriptions for a debt deflation. Accordingly the astonishing profits of the carry down trade in Japan in the 1990s remain our fascination and focal point for our rate trades. Simply put, we think the market is overstating the risk premium of the term structure. That official policy rates are unlikely to rise for some time in Europe and the US.
But I also cannot completely shake off the analogue of the 1920s/30s. In 1929, global economic growth was to be found almost exclusively in the creditor country, America. From 1927 to 1929 the debtor countries of Europe struggled to reconcile the savagery of austerity cuts without having recourse
to a weaker currency. The fixed gold standard offered no redemption to soften the tremendous social costs of unemployment. And when domestic demand finally faltered stateside, the decline was made more dramatic by this lack of offsetting economic growth elsewhere.
Today of course the analogy runs true with the Asian countries, especially China, representing the only story in town. But the comparison breaks down when it comes to assessing how pro-cyclical the Chinese have been in thwarting the steep recession of late 2008. According to the thirties analogue the Chinese should have displayed monetary hawkishness concerning their domestic speculation and soaring asset prices. But this time around, the dominant creditor has shown great monetary extravagance and as a result global GDP growth is bounding back.
The only hope for my analogue comparison is the recent Chinese hysteria concerning the Fed's QE2 program. I find the very vocal Chinese admonishment of the Americans strange. Sure they own over a trillion dollars of US short dated Treasuries and the value of this asset is vulnerable to inflation. But so what? The Chinese are not running a fixed income hedge fund; there is no consideration of two and twenty. Indeed I would happily wager that they would accept an almighty paper loss on such securities should it underwrite a robust cyclical economic recovery for their largest customer, the US. Remember all economic policies in China are predicated on maintaining the Communist Party's hold on power. The true nightmare for the Chinese has to be a prolonged Japanese style recovery in the west where US nominal GDP fails to grow beyond its debt fuelled peak of 2007/8.
Arguably their QE2 misgivings say more about their anxiety of food price inflation taking root and threatening their precious social cohesiveness. As other interventionists have learnt much to their chagrin, you can game the monetary system but you cannot beat it. China's insistence on undervaluing and managing its currency whilst capital flight to its shores pushes more freshly printed renminbi back into its expanding banking system is evidence of the international economic order seeking equilibrium if not through the
external value of the renminbi then through higher domestic Chinese prices.
The Chinese have been the global economy's magic tooth fairy these last two years, absolving us from our economic sins and making the fallout from the crisis of 2008 more manageable than bears like myself thought possible. But it is just about possible that their benevolence is changing as they seek to rein in their own domestic price inflation. Charity to strangers has come with a cost and their bureaucrats are frantically twiddling their knobs to cool the monetary system down. The danger is that a credit bubble when starved of its marginal credit soon exhibits a sudden and sharp reversal in asset prices. So the time is nearing when we might experience the world's two most successful creditor nations (Germany and China), seeking, if not a purge of the rottenness, then certainly its moderation. This is an environment rich in policy error contingencies and justifies, I believe, your ongoing and much appreciated investment in the Fund.
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