“Remember, the storm is a good opportunity for the pine and the cypress to show their strength and their stability.”
– Ho Chi Minh
There is an old adage in the investment business that all correlations go to one in a down market. Meaning, opposite to a rising market where stocks can move in different directions unrelated to each other, a down market will cause most stocks to fall together, all being very much correlated to each other. Even when buying the shares of a highly rated company, swimming against a greater market tide can be a losing proposition.
One such market tide, developing over the last six to nine months, may not be fully appreciated by the broader investing populace. Around the globe, countries such as China, Russia and Saudi Arabia are liquidating very large sums of their reserves to bridge the gaps in their government budgets and stem the decline of their currencies. UBS, the Swiss banking giant, estimates that the world’s total central bank and sovereign wealth assets ($18 trillion in 2014) will contract by an alarming $1.2 trillion, or almost 7 percent of the total in the span of just this year. And the trend is expected to persist as long as oil prices stay depressed and the global economy continues to slow.
These countries were able to build these huge reserves over the last fifteen years as oil moved from $20 to over $100 a barrel and as U.S. dollar money supply greatly increased following the Federal Reserve’s reaction to the Asian financial crisis in the late 1990s and the 2001 U.S. recession. Many economists agree that the enormous increase in the money supply significantly contributed to the global savings glut, the housing debt crisis of the Great Recession and existing global credit imbalances. And now the trend may be reversing, but the blow back consequences may be less than desirable.
Since most of the assets sold by these countries are denominated in the world’s reserve currency – the U.S. dollar – asset prices here will continue to be pressured and the liquidations cannot be dismissed as insignificant. U.S. dollar assets in the stock market are approximately $20 trillion and the tradable U.S Treasury market is less than $10 trillion.
In addition to the pressure on the U.S. markets already being witnessed, these foreign government actions will be a further drag on the world’s now contracting money supply. In times of economic slowdown the money supply naturally contracts, adding to the downward pressure on a receding economy. To maintain standards of living, central banks, through lessons learned in the past, put forth tremendous effort to keep the money supply inflated against the prevailing and naturally contracting force. Unfortunately, any measure to increase the money supply must, by definition, increase debt.
But in a persistent and world-wide economic crisis, efforts to hold back the natural economic tides can be like building a dike in front of a tsunami. Also over the last fifteen years, policymakers have financed an underlying global shortfall in wealth creation and productivity through fiscal and monetary policy, waiting for the revival of better times ahead. But this has left the industrial countries of the West with the highest debt to GDP ratios since World War II and the policymakers’ economic tool boxes may soon be empty.
There is no doubt that the economic challenges facing the global economy have been unparalleled since the time of the Great Depression. Policymakers back then were blamed for getting it wrong. But are policymakers getting it right any better today? Is there any real solution other than a substantial increase in wealth creation caused by a corresponding increase in worldwide productivity? The economic woes of the Great Depression only started to turn as the world moved toward the massive war production efforts and the horrors of World War II.
As today’s geopolitical volatility continues to rise in the Middle East, Eastern Europe and the South China Sea, one cannot help but think that it may be time to be cautious in more than just portfolio decisions.