Thomas Hobson ran a thriving carrier and horse rental business in Cambridge, England around the turn of the 17th century. He rented horses mainly to Cambridge University students and was known for not giving his customers a choice as to their mount – it was simply “this or none”, i.e. Hobson’s choice.
Fast-forward to November 2007 and one cannot help wondering if the US economy has taken on the guise of a modern-day Hobson, really offering no choice at all. And on the receiving end is Fed chairman Ben Bernanke facing an increasingly recessionary economy. A worsening housing situation and the likelihood that significantly more credit losses lay ahead leave him with what Richard Russell (Dow Theory Letters) describes as a “brutal problem”.
Before digging a bit deeper into the alternatives available to Bernanke and the monetary authorities, let’s focus on the graphs of the Philadelphia Housing Index and Bank Index for a snapshot of the market’s assessment of these two intransigent sectors.
These are downright awful pictures and especially disconcerting because the stock market as a matter of course discounts the real economy by anything between six and 18 months. This in itself spells bad news for the outlook for US economic activity.
Should Bernanke and his cohorts drag their feet with interest rate cuts, there is more than a sporting chance of the US economy slipping into recession and dragging the rest of the world down. This will, in my opinion, unleash the forces of deflation with rather dire consequences, especially given the highly-leveraged state of the US economy.
On the other hand, should Bernanke throw increasing amounts of money at the problem and cut interest rates aggressively, the dollar can fall down a precipice. Inflating the economy out of its quandary, however, may be the only policy option with a chance of success.
This raises the question of how foreign investors are going to react to the trillions they have invested in the US dwindling in non-US currency terms. Anybody under the impression that US equities and bonds have been performing reasonably well this year must think again. The graph below shows the Dow Jones Industrial Index in both US dollar terms (red line) and euro terms (blue line). Whereas US investors are showing a return of 9.08% for the year to date, euro investors are in the red to the tune of -0.81%. (Although I am using the euro in this example, the same logic applies to most other non-US dollar currencies.)
The next graph illustrates the same principle for bonds by comparing the US Treasury Note Price Index in US dollar terms (red line) with the same Index from the viewpoint of a European investor (blue line). The results are as bad as for equities.
And for good measure, the hard numbers are summarized in the following table:
|RETURNS FOR US STOCKS AND BONDS (US DOLLAR AND EURO)|
|Year to date||Aug 17 – Nov 2|
|- US dollar||9.08%||5.70%|
|10-year US Treasury Note Price Index|
|- US dollar||3.23%||2.70%|
How much longer will foreign investors put up with a plunging dollar eating away at their returns? On the last count, the formation of 17 Sovereign Wealth Funds (or varieties thereof) have already been announced. It is an open question how much of these countries’ existing US investments will be redeployed to non-US dollar pastures through these entities. Somewhere down the line, a point will be reached where America will start offering bargains galore to the non-US dollar investor, but we may not have arrived at that juncture yet.
It is perhaps too early to conclude that Bernanke is facing a death spiral, but it would appear that he is confronted with the proverbial Hobson’s choice – inflate or die. With stocks still in overvalued territory and bonds looking equally toppish, this really leaves few investment avenues other than cash or gold (in whichever shape or form). Although gold may be overextended in the short term, it should remain the ultimate reflation / safe-haven play for the foreseeable future. That, at least, is the way I will play the markets until such time as Hobson reappears to offer Ben a few additional choices.
Source: Jim Sinclair’s Mineset