It is a sad state of affairs when the markets (populated by rational investors (we hope)) look to politicians for direction. In Europe this is a futile affair. The French seek a Socialist and egalitarian solution while the German’s baulk at paying for it. Perhaps it is the French experience from the Treaty of Versailles and its consequences for the debtors that advise them. Perhaps it is that same experience that drives the Germans. Either way, there is no consensus, and there is much confusion among the politicians and regulators. From these, the markets hope to find direction. Good luck. Europe seems in a bind. Inflation has been persistently high while economic growth slumps. There is a word for that sort of thing. The ECB is caught between Scylla and Charybdis. Even as the Eurozone economies falter, banks teeter on the brink, and people take to the streets to protest home made austerity, the DNA of the ECB cast in the fires of the Weimer Republic, remain hawkish on inflation.

In the US, between a foundering Fed and an increasingly partisan Congress, (no comment on the President), the Senate still managed to gird itself for a potential trade war with China, precisely when the US is most reliant on exports and indeed export data seems to be improving. In the meantime, the US economy which has been in recession for the past year may be bottoming, yet the efforts of politicians continue to confound a real recovery.

Apart from the US, the rest of the world seems to be stewing in the heat of inflation, due in no small part to the US Fed printing money furiously to try to cushion a sagging economy. Such inflation confounds monetary policy which needs to be looser to spur economic growth out of its current slump. Fortunately the inflation pressures in the emerging markets have shown some signs of moderating which have given central banks some room to ease.

Banks. On the one hand governments require banks to be the open conduits of credit, to aid and abet the economic recoveries they try to engineer, and on the other, their regulators require them to hold more capital and to be more conservative of their capital deployment. Utter confusion and chaos. The financial condition of banks remains unknown, in some cases to their own CFOs. The fractional reserve banking system is more efficient than it is robust and established risk mitigation metrics and methods can seem naïve in crises. A bank levered 10X only requires a 10% variation in asset values to wipe out its capital. Marking assets to market or fair value can be more than inconvenient to a bank. The market now frets about European banks’ exposure to poor credits such as Greek, Italian and Spanish sovereign bonds, whose variation in value could pose a threat to banking solvency.

Sometimes the best investment advice one can give is to do nothing, or to do very little. As described above, markets are seeking direction from politicians and regulators who are themselves as clueless as the rest of the market. Market realized volatility has surged. Returns dispersion has also risen significantly. It doesn’t take a big position to move the needle on the P&L. It is not the time to make big bets.

At the same time, the indiscriminate selling, the schizophrenic swings in the markets, the manic depressive sentiment rippling from every meeting of the Eurozone, the Fed, the BoE, the ECB, has led to clear mispricings in asset markets. Arbitrage is available; if only investors didn’t demand liquidity on an hourly basis. But then if investors were patient and rational, arbitrage opportunities probably wouldn’t exist. Arbitrage is the result of fearful, greedy, panicky, ‘trembling hand’ investors, sadly the investors that many an asset gathering hedge fund or arbitrageur is trying to raise capital from… And around and around it goes.

Today, I would do relatively little. I would use sharp drawdowns to pick up assets on the cheap, but be aware that more downside is always possible and even probable. I would be seeking out the arbitrage opportunities, but fully aware that mark to market volatility is always a risk, albeit not one that I have to crystallize if I understand what I am doing. I would be trading small risk capital tactically until clearer trends emerge. I would not be taking long term directional investment bets. Not until the P&L from my short term trading tells me that a trend has taken hold. The arbitrage book is more systematically built; it is accumulated whenever dislocations occur and left to ripen in the back pocket. In the meantime, the politicians may fiddle while Europe burns…

China’s economy posted a rather frenetic 9.1% GDP growth for the third quarter of 2011, short of analysts’ expectations for an annual growth rate of 9.3% and slower than the 9.5% registered in the second quarter. It is widely regarded that a growth rate of over 8% is a base line and is required to sustain social order. While 9.1% growth would be the envy of many a developed country it is considered a slowdown by Chinese standards. It appears that China has other problems, most notably inflation.

Inflation in September slowed to 6.1% from a peak of 6.5% in July. It would appear that measures to restrict overheating credit growth have been successful. It is expected that inflation will fall further in the coming months due to base effects and monetary tightening policies. Headline numbers could fall below 5% at year end. Be that as it may, the headline number hides a more detailed picture of inflation.

Non food inflation is a paltry 2.9%. Food inflation runs at an eye-watering 13.4% with no signs of abating. Meat products are rising at some 28.4% but is showing some signs of moderation albeit a sharp drop below 20 would probably require, or signal, a concomitant recession. Vegetables and fruits are highly volatile but currently run in the low to mid single digits. Shelter inflation was running around 7% before 2008, it fell to -6% in 2009 and has since recovered to a more moderate 2.5%. Clearly the worry is food inflation which accounts for a larger share of rural household’s consumption.

From a social standpoint, China’s policymakers are likely to focus more on inflation than on growth. It is a fine balance they need to find between maintaining employment and keeping prices stable, however, employment numbers have exhibited low volatility while consumer prices have been less stable.

In a highly globalized economy China’s economy needs to be considered in an international perspective. A significant proportion of Chinese employment is dedicated to the production of US and other developed world goods (by trademark, copyright or patent). As the USD weakens relative to the RMB some of the cost advantages of producing in China have been eroded and are likely to continue to be eroded. The case for repatriation or relocation of production becomes stronger. This has consequences for unemployment and growth. This is over and above the impact on exports.

As the world economy expanded in the last 10 years it became very much more globalized and interconnected. As the pie shrinks on the back of a natural deleveraging in the developed world, some of that globalization will be reversed.

Naturally there will be resistance to change. The risk of trade war, mercantilism and indeed nationalism is heightened. The world needs to be careful that the decades of prosperity are not reversed.

The signing of a clutch of free trade agreements (with Korea, Colombia and Panama) is not a sign for a quick reversal in America’s balance of trade into the black. It is, however, a step in the right direction

and a recognition that if the US is to engineer a sustained recovery, it has to become a more export oriented country. The low hanging fruit are its largest trading partners which, it may surprise some to learn, are its neighbours to the north and south; Canada, Central, South and Latin America.

Two forces are likely to drive a recovery in the US trade balance. One is that the consumer is flat on his back, the government is not much better off, and investment always needs a lead, but that the vendor financing provided by its trading partners’ central banks is no longer as abundant, to the extent that the US government has resorted to using the Fed’s balance sheet to effect what a Chapter 11 court might construe to be a fraudulent conveyance, as well as cornering the commercial banks and depository institutions, as well as Social Security, to financing the federal debt. Second is the currency which is expected to remain weak if not weaken further, and so improve US trade competitiveness.

It will not be a smooth recovery though, since Europe has similar ideas and the emerging markets have yet to be weaned off export dependence. It is not possible to have all countries net exporting.

The US has an advantage. It has the intellectual property to build things people want. So far it simply hasn’t been making these at home. Where are Apple iPads, Callaway golf clubs, Gap T shirts, Ralph Lauren suits, Nike shoes, Caterpillar excavators, Johnson and Johnson’s Tylenol made? Not in the USA. But people want them. Maybe its time to start actually making stuff at home. For many things, it will still be cheaper to make them abroad and nearby to their markets, but if the USD keeps depreciating, there may come a day when its cheaper for Nike to just make’em in the US of A. And as the Greenback weakens, more stuff will be made in the USA. One slightly cheeky gambit is for the USA to require all US companies to state the country of manufacture of all their goods regardless of where they are sold. There is a reason why the Chinese household who can afford it would rather buy Mead Johnson’s Enfamil than a Mengniu equivalent, actual source of production notwithstanding. Might it encourage Coach to make bags at home? And it would be hard to argue that full disclosure is anti-competitive. Such policy will encourage the repatriation of manufacturing to the US boosting employment. In the interim prices may rise which may discourage domestic consumption but this is an acceptable side effect for more jobs and an improving trade balance.

The US needs trade and cannot afford bad relations with her trading partners. China’s currency needs to be allowed to appreciate, but there are other considerations besides trade competitiveness. A drastic devaluation of the USD to the RMB would likely be construed by Beijing as a de facto default or at least a poor bargain for over two decades of funding US trade deficits. Similar currency issues have cropped up in Switzerland and Japan. It is remarkable that more noises have not been heard in Washington given the size of Japan’s trade with the US. Perhaps the US is simply focusing on new markets.

China is still a nascent market for US exports and China is still an export economy. Its latest surge in economic growth has not been due to consumption, or for that matter exports, which have slumped since 2007. Investment and most notably government investment in infrastructure, has kept the Chinese miracle alive. In order for China to develop a more balanced economy it needs to distribute wealth and income more equitably. For all the queues outside the Louis Vuitton shops in Shanghai and Beijing (or indeed the Chinese shoppers outside the Bond Street and 101 avenue Champs Elysees stores), most Chinese households are still only just subsisting, at least by international standards. A Gini coefficient of 0.47 is evidence of the acute economic inequality that has built up in this Communist country. If for nothing else, there are limits to how far wealth distribution can diverge before they translate into non-commercial problems.

And China needs a more balanced economy if only for its own self interest. Relying on a single large customer has resulted in its being paid with a whole lot of vouchers whose exchangeability for real goods and services is now truly in question. China has effectively lent the US 10 boatloads of gold or Calvin Klein underwear for which it will only be able to recover 5 boatloads of the same, while being accused of being a currency manipulator at the same time.

Unfortunately, the analysis of China is more usefully approached from a political angle, which means understanding the Party. Will there be an attempt at more redistributive policies? Has the capitalist rot infected the Party? Does the Party understand the people, their needs and aspirations, their fears and frustrations? Does the Party have the depth and range of influence in social and economic policy? Did it ever? With a change of management around the corner these questions are doubly hard to answer. We have to make some sweeping assumptions of will and ability.

Assuming good faith, China will play by international and generally accepted rules. But even the Chinese are human, only more so. Expect them to be aggressive with their advantages and gradual with their concessions. Therefore while a stronger RMB is a long term eventuality, expect the appreciation to take longer than the markets expect. China will not endanger a whole slew of businesses who may not be able to manage currency volatility. And while China will become more consumption driven, expect them to fight tooth and nail in their export markets.

These are long term trends. More topically, the recent ISM data is encouraging. It seems to provide, granted incipient and not quite unequivocal evidence of a revival in exports. The latest US trade deficit was also less negative than expected with strong orders from Asia and the Americas. This bears watching closely. The seeds for recovery are already sown and will take hold. They lie in the normalization of trade which will boost the US economy more than markets expect. Apart from direct effects, investment is serially correlated to growth in whichever corner of the econo
my it hails.

The Rich get Richer.

Even if initial conditions included an even distribution of wealth, different individuals have different capabilities and a meritocracy implies at least some deviation from equality. Once the divergence has occurred is it likely to further diverge or converge?

The rich have access to capital which can be invested for an additional return over and above the returns to labour. This argues for divergence from equality. This divergence is not predicated on any assumptions about the overall growth of the economy. It is entirely possible that the poor get poorer.

Richer households tend to have fewer children.

Many rich households are rich because they have deferred having children and spent more time accumulating wealth. These households are more likely to plan their financial management more thoughtfully. They are likelier to impart this financial acumen to their offspring. Households with fewer children are also likely to devote more resources to better equip their offspring with the necessary skills to prosper. Inheritance faces less dilution in smaller households. Richer households having fewer children exacerbates the concentration of wealth.

Richer households tend to have children later in life. As experience varies positively with age, richer households are likely to have more experienced parents who can transfer such experience to their offspring. However, having more time, resources and stock of wealth may deter risk taking, discourage competitiveness and result in more conservative behavior and a smaller variance of future wealth generating potential among offspring.

Poorer households tend to have more offspring, less time and resources to spend on the offspring and a smaller stock of wealth to distribute among a larger pool in inheritance. However, they may encourage greater competition, greater risk taking and a greater variance of future wealth generating potential among offspring.

Richer households save more and consume less. They have more investment capital. While the current expectations for real return on capital may be substantially negative, this is due to low interest rates and high inflation. The high inflation is likely to be more damaging to lower income households as the source of inflation is coming from higher agricultural prices as well as energy, a larger proportion of what a lower income household consumes.

Another factor of income inequality is globalization and world trade which favors highly skilled workers at the expense of lower skilled workers. Trade liberalization transmits economic inequality across borders depressing lower skilled workers’ wages in developed markets while increasing their wages in emerging markets.

There are many factors which contribute to inequality of income and wealth and these are well known. Above are but a few. While traditional studies of income or wealth inequality focus on directly measurable quantities to estimate the marginal factors of contribution future trends may be less measurable and more oblique instrument variables may be required. Alternatively, a raw statistical study ignoring factors may be more illuminating. It is hard to quantify human ingenuity and motivation. What is clear is that absent a unilateral and oppressive redistributive policy, the variation in human ability and the self reinforcing nature of that variation in ability implies divergent distributions of wealth.

Unconstrained divergence in wealth distribution may be economically viable (although I am not totally convinced about this) but it is certainly neither socially nor politically sustainable.

In a closed system, development sometimes requires the subjugation of an underclass. Income and wealth inequality empowers this. There will be jobs which are not preferred which either command a low compensation or are unsatisfying. It is assumed that the unsatisfying nature of such jobs is priced into the marginal cost of supplying that form of labour. Often in reality it is not.

Countries are not closed systems and in some examples there is an active policy of filling the lower tiers of the labour market with imports. An optimal immigration policy (ignoring social and political aspects) seeks to attract individuals who are accretive to per capital or aggregate GDP growth. Such immigration policy of course includes courting talent for the higher tiers of the labour market seeking individuals who are accretive to per capital GDP growth either directly through their efforts or through osmosis or other transfer of intellectual property. It also includes attracting individuals to fill less attractive functions which indigenous or incumbent residents may be unwilling to supply their labour to. Optimal immigration policy must discourage individuals who are dilutive to the economy whether resident or potential immigrant alike to exit or not seek entry to the country.

This is a wholly unworkable policy. At some stage, the supply of talent for the less attractive functions must be constrained in scarcity. It is not possible to protect resident incumbents from either supplying such labour to the market themselves or from depressing the marginal cost of employing such talents through imports. Ultimately, however, if we expand the boundaries in the example, it seems to imply that at some stage, either some forms of labour will not be supplied at ‘acceptable wages’ whatever that means, or wages in those sectors must rise. In a totally free and unmanaged market, some such sectors must command wages higher than traditionally preferred sectors. In some developed metropolises a plumber may be paid more than a teacher or a skilled healthcare professional. While these are positive examples of the free market in action, many examples exist to the contrary.

I usually have something to say at the end of a busy week in the markets. This week I am speechless.

This week the US considered punitive action against China for its currency policy.

If you sell something to a shop and the shop owner tells you he will pay you in vouchers, you might accept this if you thought that they had the goods to make good the promise on the redemption of the vouchers. If the shop repeatedly paid for stuff with vouchers, while not having much stuff to back up those vouchers, you would call that either incompetence (if unintentional) or fraud (if intentional.) If the shop then told you that the vouchers they gave you were redeemable for only half of the goods they initially agreed to redeem the vouchers for, then considered branding you, the creditor, guilty of manipulating the value of said vouchers, you might be forgiven for thinking that you had been defrauded.

Lots of shops pay for stuff with vouchers, which these days aren’t worth the paper they’re printed on. Hold the vouchers, hand over the goods.

The US and China see the current account, capital account and foreign exchange issues between their two countries differently. The US sees a flow issue and argues for efficiency and an unwinding of the imbalances. The Chinese are just asking for their money back.