Enzio's Clock

Background

WHY THE CONVULSIONS?

We have been saying that Fed Funds would rise to around 6% since June, 2004, when the latest up cycle started. Few believed us. The big banks then started (mis-)leading investors by proclaiming that Fed Funds were "about to be cut". Well, that unisono view vanished when higher growth and tighter labour market data came through in America. Add to that the rate hikes in New Zealand in by Europe's ECB, and you see that people finally have cottoned-on to the fact that The Economic Time™ has been changing for about two years already: the global excess demand for goods keeps goading Central Banks want to create an excess demand for money - precisely in order to thwart inflationary pressures.

But none of these points are new: it is not exactly as if just yesterday European, British or New Zealand or indeed US rates started moving up, is it?

I think that the market just got so spoiled that the success got to its head - it was in denial (like America's top neo cons on Iraq, key ones now out of office), so it simply could not fathom that there actually is bad news out there. In short: yesterday and today are about market players finally moving out of denial. Finally they pared back expectations of an imminent cut in the Fed Funds rate.

COSTLY CONTRADICTIONS

Markets finally are accepting that Fed Funds have further to climb - but that acceptance is nascent. So you get these kinds of riddles presented by one economist - strangely in the highly respected Financial Times of today (I have italicized the key curiosity):

"The jump in US ten year yields is largely due to increased optimism that the US economy will rebound...In contrast, inflation expectations have remained subdued..."

Curious, markets yesterday finally came around to the view that America's excess demand for goods is fanning the inflation fire, thus prompting the Fed to raise the Fed Funds more! So how one can speak of subued inflationary expectations is baffling.

And in today's otherwise respected Bloomberg we read that "Asian stocks retreated for a second day on concern that rising global rates will curb consumer spending and corporate profits". Reverse the logic: it is because of an excess demand for goods that global rates must rise, not the other way round!

We are not seeking to display our cleverness, but just wish to point out that such statements indicate just how confused markets are. So let's put some intellectual direction into where we are headed. Put differently: so where are we in the cycle? Once you know that you can avoid such costly contradictions, profiting instead.

THE ECONOMIC CLOCK™ and THE ANATOMY OF CRISES: where are we in the cycle?

So markets got spooked because they finally accepted that the global economic time is characterised by an excess demand for goods (EDG)- and that this has inflationary threats. Hence the bond and thus stock market rout.

Our Economic Clock clearly points to an excess supply of money (ESM) - especially outside of the USA and Japan. That ESM is fueled by two forces outside of the usual ones of easy bank credit:

• a "resources tax", whereby the commodity-rich countries have been getting money, so the commodity-poor countries have been paying this "tax" to commodity producers, and
  
• a "broken dam", whereby people in places like Russia, China and India finally get to put their funds elsewhere than just in low-yielding bank deposits.

Current market convulsions have not changed this ESM at all. Thus, buy into market weakness - all the more if US growth is expected to rebound, implying stronger Asian exports to America and thus stronger Asian as well as corporate profits.

Prof. Charles Kindleberger, ex-MIT genius, provides a very useful anatomy of crises.

Prof. Kindleberger wrote a marvelous anatomy of a crisis:

o Displacement happens when the economic outlook is altered by changing profit opportunities. (currently: China and India’s emergence is propelling commodities markets as well as corporate profits thanks to improvement in lifestyles)

o A boom ensues. Bank credit and personal credit expands significantly. This results in Adam Smith’s “overtrading”: pure speculation, overestimation of profits and excessive gearing step forward. (currently: sub prime lending, ETFs based on air). Bubbles occur. Economists define bubbles as “deviations from fundamentals”. Back to my Economic Clock: the only big markets that have such deviations from fundamentals are the USA and Japan. However, the current mania (Mr. Greenspan’s "irrational exuberance") will keep feeding on itself. We are in the latter stage this boom phase now and, excluding America and Japan, there is no bubble – markets are in line with fundamentals, with their respective Economic Time.

o Distress sets in. The smart money starts selling. One event is the tripwire; Prof. Kindleberger calls it a "causa proxima". More recently, for instance, I thought that the sub prime mortgage matter might be such a tripwire to crisis, but I was wrong, alas! He also says that "causa remota" is due to an excess supply of money (ESM). “Revulsion” rears its ugly head: revulsion against commodities or securities leads banks to stop lending on the collateral of such assets.

o Panic sets in. Everyone bolts for the exits. Then, one of three things happens. Either prices fall so lowly that people load back up (currently: that is what February was about), market “circuit breakers” are established, i.e. trading is stopped if certain price limits are reached, or a lender of last resort stabilises confidence,

So here is where we are in the cycle:

• The Economic Clock™ suggests that the Excess Supply of Money (ESM) has fuelled an Excess Demand for Goods (EDG). The EDG has inflationary implications, so Central Banks keep wanting to curtail the ESM, and thus slowly convert this to an Excess Demand for Money (EDM). Thus, The Economic Time™ is set to worsen.
• But when? Prof Kindlebergers marvelous work suggests that we are in the latter stages of the boom phase - its "causa remota" has been the ESM (really ever since the tragedy of 9/11, when Central Banks flooded money into the system).
  
• We believe that America's Economic Time has been worsening for months. And subscribers know that we have not liked Japan's either. So we think that America will crack first, and that Japan will go nowhere. Asia will falter once the Olympics in China are over with next summer. Then the pigeons will start coming home to roost; until then, China understandably will want to present itself to the world in the very best possible light.

How to Save/Make Money Off This Idea

1. Buy into weakness: overweight Asia (ex Japan) and Europe - but not America . We are in Kindleberger’s boom phase, but we are nearing its end – say the end is once the Beijing Olympics are over with in 2008? Then, distress sets in …
2. Within this, our preferred countries are: China, Hong Kong, Korea, India, Australia and the Philippines.
3. Our preferred sectors are Asian exporters, such as Hong Kong's Li & Fung (LFUGF:US): they will thrive off a rebound in America's excess demand for goods.
4. Our preferred arbitrage play is to buy H-shares, which are traded at a considerable discount to A-shares.