The low inflation and low interest rate environment that we experienced in the last 20 years was only possible as inflation was exported away to low cost producer countries. This is equivalent to offshoring production capacity. It must therefore lead to a trade deficit, if it is successful. We know on hindsight that it has been successful.

A weak CNY allowed the cheap repatriation of offshored finished goods and services. Therefore a weak CNY was tolerated. And indeed was associated with the trade deficit.

The acceptance of vendor financing was also a contributor to the accumulation of the trade deficit.

Low inflation coupled with low interest rates allowed the US to fund negative savings rates through cheap credit.

A rising housing market provided the assets available as collateral to enable the credit creation used to finance consumption.

The low interest rates and the low savings rates precipitated a bubble in the housing market and over leverage in the structured credit market leading ultimately to their collectively implosion.

The policies enacted to address this implosion have not all been ill advised. It was necessary at the point of implosion to apply credit and liquidity support measures, increasing the central bank’s balance sheet by multiples. It was necessary to replace the deficiency in demand from the private sector households and firms with fiscal stimulus. It was convenient and elegant to fund the latter with the former in what has come to be known as quantitative easing.
It is now some 2 years since the financial crisis of 2008. Are the policies pursued today relevant and efficient?

Absent a liquidity of financial crisis it is not rational to solve a problem created by over leverage with the application of more leverage or credit.

Fiscal policy is effective to a degree but the multiplier effect has become attenuated from weak labour markets and the aftershocks of the crisis.

The price of fiscal policy in terms of sovereign borrowing requirements is therefore exorbitant.

The objective is to revive output growth, employment with price stability.

There are many potential solutions but most of them are problematic.

The US seeks a repricing of CNY and other emerging market currencies, effectively repricing the stock of debt held by its foreign creditors. It also seeks to improve its trade competitiveness through this repricing. This strategy is trivially unpopular with the US’s creditors.
All net debtor nations will be motivated to create inflation. This is already underway in most developed nations except possibly in the US where arguably inflation is being under-measured by the CPI for technical reasons.

The effect of inflationary policies in net debtor nations can have inflationary impact on creditor nations as can be seen in the current dynamics between the developed world and emerging markets.

In order to be more effective, inflation leakage needs to be reduced and targeted at domestic markets.

The big picture is that the paradigm of controlling inflation through exporting productive capacity to lower cost producers needs to be reversed or rebalanced.

One perspective, and possibility, is that the reversal of this process will create elevated inflation and low output growth, a most unpalatable combination, for as long as necessary for the imbalances to be reversed. This would be the case if for example the USD was weak and thus commanded weak external purchasing power while US savings rates remained elevated. A protracted fiscal deficit is politically and financially unsustainable. The US economy would have to rely on exports. Is it conceivable that the US could be the world’s sweat shop? It is highly unlikely that the US would prefer a strong USD with domestic prices adjustmenting since this would imply deflation.

The problem of high domestic savings rates in emerging markets is a narrow specification of a wider issue. The problem is one of low per capita output and income. Income levels need to be raised. The problem of low savings in developed markets is currently being corrected. This is as it should be. However, it presents problems for growth in developed markets. With government balance sheets under considerable stress the burden will fall on investment and trade. An efficient solution will address these issues.

The realized solution unfortunately will not necessarily be the rational solution but the politically expedient as well as strategically available solution. Also individually rational strategies may not be collectively efficient.

Ideally emerging market economies will grow not only from their comparative advantage in demographics but from significant advancements in technology as well. Evidence from patent filings in emerging markets indicates that this is underway at least in some form.

Emerging markets need to democratize their capital and currency markets. There are grounds for caution and a measured execution of opening markets but markets need to be more open. Here we refer to markets for all inputs, outputs, and capital.

Markets for information and intellectual property are included in the above definition.

Developed markets need to operate open markets in each of the above input and output markets as much as emerging markets.

Whether this can be achieved lies in the hands of the politicians.

The path of least resistance will see all nations beginning with debtor nations but extending by strategic response to creditor nations, debasing the internal and external purchasing power of their respective currencies. This is a race to the bottom.

By implication, the value of real assets, from real estate to natural resources, and very possibly future claims to the same assets must increase in nominal terms.

The discount rate for future claims on fiat currency must rise. However, short term interest rates are likely to remain low.

The risk for trade protectionism is significant. With the US becoming more reliant on exports and emerging markets unused to non-export driven growth, the path of least resistance is mercantilism and trade protectionism. This can easily escalate to the more serious issue of nationalism. At this point rationality in policy making becomes subordinated to more political objectives.

Mass competitive devaluations will lead to market mispricings and bubbles. Unfortunately the dynamics of such policies and their implications will not be recognized by markets until a point of extremity is reached and there is a discontinuous repricing. This can come from a loss of confidence in one of the major currencies. Inflation may be a monetary phenomenon, but hyperinflation is always born of a crisis of confidence. Conversely, less intuitively, and therefore more dangerously, a superinflated real asset (such as iron ore, copper or silver) may lose its independence on risk and become primarily a risk asset. This happens when an inflation hedge, for example, becomes too widely utilized as a hedge so that the correlation is introduced by the actions of the holders and hedgers, and dependence on the other assets in the hedgers’ portfolios is suddenly introduced.

What are investors worried about? There is a lot to worry about but there are usually two to three factors that really drive sentiment.

The G20 summit has brought the relationship between China and the US into the spotlight. The concerns extended beyond currency wars and trade protectionism to strategic and geopolitical issues.

The inflation deflation debate remains unresolved.

The suitability and effectiveness of a second round of currency printing dubbed QE2 remains undecided.

Sovereign risk in Europe has resurfaced since it first emerged in May with Irish, Spanish and Greek sovereign CDS spreads widening again.

So, lots to worry about.

However, markets don’t rise in a straight line. Neither do they fall in straight lines.

I certainly don’t have all the answers. Or even many of them. But I do have some.

European sovereign I know little about. In an earlier post I considered the position of an investor looking at sovereign debt purely as an investment where I thought that the investor is only interested in two things, the purchasing power of the asset in its domestic currency and the purchasing power of the same asset in the investors’ currency and the value of these two measures in a debt restructuring. We know that debtor nations will almost certainly engineer inflation and attempt to debase their own currencies so as to minimize the value of the assets to the investor in all their relevant measures. Investors recognize this and thus adjust the premium they require in compensation.

Why are US treasuries different? During and immediately following the crisis US treasuries were demanded as a risk free asset. This was the right strategy if the objective was risk aversion. Why are US treasury yields so low? QE and QE2 are the other reasons. Even if no one else will buy US government debt, the US Federal Reserve will. Distinguishing between planned and unplanned quantitative easing will be an interesting exercise.

Inflation and deflation I have also dealt with in an earlier post. Inflation is everywhere, even in the US. It just hasn’t been detected because of how the CPI is constructed. Owner equivalent rents (27% of CPI), lower rents, lower mortgage rates and a weak housing sector are artificially depressing the official inflation numbers.

Which brings us to China US relations. The risk here is more strategic than commercial, although economics plays an important part.

The US points to an artificially low CNY threatening US competitiveness and sustaining an acute current account imbalance.

China points to QE as being dangerously inflationary as capital floods inwards from the Fed’s printing press.

Both sides have their points and therefore a compromise is the efficient solution. Whether we get compromise is another matter, and it is a matter not for economists but for politicians. This is the greatest worry.

Both the US and China have pockets of insularity and nationalism which could destabilize the symbiosis that defines their relationship. And the rhetoric from both sides is not encouraging.

China needs to understand that the US being a democracy is hostage to populism and special interests, which could confound the more rational policy makers.

The Americans need to understand that the Communist Party is a labyrinth of politics and that their counterparts in government may be as constrained as they are domestically, hobbled by conservatives and nationalists advancing their own agenda.

The issues are not just currency. One suspects that a free floating CNY might not necessarily strengthen. One can imagine that the PBOC’s diversification program of reserve management is reducing demand for US treasuries that might be inducing unplanned quantitative easing. This theory supports China’s rampant demand for natural resources.

Militarily China will take years to match the US but the build up has begun. Interestingly this build up has little to do with challenging the US as a world power. Like all empire building throughout history it stems not from ambition but from necessity, the need to protect its own interests, which for the moment thankfully lies in Africa and is at little risk of bumping shoulders with the developed world. Asia has more to fear from China than the US and cleverly the Americans have responded to that fear with friendly gestures to India, Japan and ASEAN.

These are some of the fears that plague the markets. Will they ultimately induce a bear market? Stocks are priced nominally and money printing lifts all boats. Volatility will probably rise but I do not see a bear market unless the political and strategic concerns precipitate some sort of commercial or trade conflict which hits the bottom line of companies. In the meantime, happy trading. This is not the time to be passive.

Inflation and the internal purchasing power of money:
 
On the surface there appears to be no inflation in the US. 1.1% YOY inflation is neither too high nor too low. However, given the state of growth in the economy, central bank policy, fiscal strength or lack thereof, the risk of deflation has become a topic of concern. In macroeconomics the debate between inflation and deflation is one of the most important for the future health of the economy.
 
In the inflation camp are those who point out that the rate of monetary expansion will inexorably lead to inflation both from the fact that inflation has historically been a monetary phenomenon, and from the fact that debasement of currency must lead to a repricing of goods and services. Already natural resource prices have recovered as developed country currencies have weakened which will lead to at best margin squeezes for corporates or outright retail price inflation facing consumers.
 
In the deflation camp are those who recall the vain efforts of the Japanese for the last 2 decades to revive their economy from a deflationary slumber. They fear that the economy will slip into a second recession, a fear that is quite real when one considers the risk that bank disclosures have been less than crystal clear, that debt refinancings loom in the next 2 to 3 years, that sovereign balance sheets look like junk and unemployment remains persistently high.
 
The truth is somewhere in between. Inflation is subtler than the rate of change of the CPI. A closer inspection of the constituents of CPI is illuminating. 25% of the index is an item called owners’ equivalent rent. This is an item that represents no cash flow and therefore has no income effect on consumers. Housing as represented by actual rental is a normal good. Substitution effects are always negative delta. As price rises demand falls. Income effects are complicated. In the case of rented housing, a fall in rent has a positive income effect so that more is demanded. With owner occupied housing, however, the income effect is negative (via home equity credit, psychological effects etc), since the nominal value of an asset has fallen. Note that the owner’s welfare or utility is invariant to changes in the value of the principal residence. A more relevant measure is the cost of financing the asset, thus mortgage costs ex capital repayment. With CPI growing at 1.10% YOY and if we assume that housing prices relapse into a 5% decline over the next year, then inflation in all other items would have to be running at over 3%. It is entirely possible that inflation is already underway but is being under-detected by the CPI methodology.
 
With higher inflation the term structure of interest rates may need to steepen.
 
 
 
FX and the external purchasing power of money:
 
Trade and current account imbalances have threatened a so called currency war. The US would like to see a stronger RMB. The Chinese would like to see less quantitative easing in the US. The Chinese have amassed a huge inventory of US assets which would be devalued if the RMB was allowed to appreciate. More importantly the Chinese export economy would suffer and more subtly, Chinese SMEs do not have to sophistication to manage FX exposure and are likely to face significant problems managing large fluctuations in the RMB exchange rate. A weaker USD will be inflationary in the very short term as prices are slow to adjust. In the longer term, the nature of imports and exports will change and the story is less clear. Given the volume of oil imported by the US, a weaker USD is likely to be inflationary.
 
Behind the trade imbalances lie a feedback loop that needs watching. If the US indeed manages to reverse its trade deficit with China, the need for China to recycle USD will be greatly diminished to the extent that the PBOC may not support Treasury auctions, which would require the Fed to plug the gap lest there is a failed auction or yields head significantly higher. This would represent unplanned printing of money which would further weaken the USD. Normally, in an open economy, a trade surplus exerts supporting pressure for a currency. Here, it might not. The eroded external purchasing power of the USD could require higher interest rates to compensate holders of USD.

As the US increasingly moves closer to becoming a net exporter, by intent and also since the PBoC and BoJ are reducing vendor financing in the form of purchasing US treasuries, the US current account may move into surplus against China and Japan. This would mean a shortage of USD to recycle which would mean a further withdrawal of demand for US treasuries. If the PBoC and BoJ fail to support a treasury auction long rates could spike.

The current movement of trade flows and capital have us moving in that direction.

Last week end I was walking down Bond Street when I came to the Hermes shop. Nice clothes, nice bags, nice scarves, nice long queues at the till, and with a clientele that isn’t as predominantly Asian as LVMH.

I’m not sure I would buy the clothes, JP Gaultier has just quit womenswear, the menswear is nothing to write home about, Birkin’s have gone from a rare sight to de regueur in the more fashionable parts of London, I don’t really care for alligator luggage. I would, however, consider buying the stock, if only it wasn’t so bloody expensive.

Hermes trades on a PE of 60, an EBITDA multiple of 20, a P/CF of 40, a P/Book of 10, and pays a dividend yield of 60 basis points. That said it has almost no debt, has an operating margin of 25% and an ROE of 17%.

Asian growth is more than making up for the slowdown in growth in Europe. US sales have recovered and are growing fast.  Asia Ex Japan grew at over 30% in 2009. US sales grew at over 10%. European growth was flat. France and Japan sales grew at about 3%.  With the exception of Japan where sales faltered in 2007 and 2008, Europe, US and Asia ex Japan all registered consistent growth in sales across the credit crisis year of 2008.

Hermes goods are not as cyclical as LVMH, they sell at a significantly higher price point. The business is therefore more resilient in downturns. Cyclicality is introduced by the fragrances, home and leisure lines.

This is not a detailed analysis of Hermes as a stock pick but a highlight that here is a great company that is trading at very high multiples on almost all metrics. For all that it has created an unparalleled franchise. Between the company and its goods, I would buy the company. Not the stock mind you, the company, all of it.