On 7th May I had the pleasure of attending a seminar in Hong Kong given by Martin Armstrong, founder and chairman of Princeton Economics International (PEI), which was entitled "The Crash Continues". (For an outline of some of Armstrong's ideas and forecasts on the capital markets it is worth re-visiting Orpailleur's article, written 12 months ago, at http://www.gold-eagle.com/gold_digest/orpailleur523.html.) Armstrong spoke for around 1 hour on the factors which are affecting global capital flows, focusing primarily on Europe and Japan. He envisages increasing volatility in the financial markets over the next few years as the currency crisis which began in Asia in 1997 spreads to Europe in 1998. In fact, he believes that the Euro will not survive in its current form and that the next 4 years will be characterised by the accelerating flight of capital from Europe, primarily to the US. A final washout in Japan will also occur, with the Nikkei eventually falling below 10,000. The greatest beneficiaries of this financial turmoil are likely to be the US dollar, which Armstrong sees testing its 1985 highs against the Yen and the Deutschemark, and commodities (particularly gold, which should move significantly above its 1980 high).
Armstrong's premise is that capital flows determine the relative valuations of all markets and that capital is driven in a particular direction in response to many factors including tax rates, wages, government regulations, interest rates, exchange rates, and political instability. An understanding of capital flows is particularly important in any analysis of currency exchange rates. For example, based on Japan's current account surplus it could be argued that the US dollar is over-valued against the Yen. However, such an argument does not take into account the effect of an insolvent Japanese banking system which is labouring under the burden of over 1 trillion dollars in bad debt. Until the bad debt problem is resolved, allowing the banks to once again support the economy and interest rates to be increased to an internationally competitive level, then capital will continue to flee Japan and the Yen will fall against the dollar. As another example, some commentators have pointed to the fact that the Euro will be supported by an economic body of equivalent size to the US and have therefore argued that the US dollar will be partly displaced by the Euro as a reserve currency. This assertion, however, fails to recognise that capital requires certainty above all else. EMU will result in an historically strong currency, the Deutschemark, being eliminated and replaced with a currency of unknown stability. Rather than create a problem for the US through the introduction of a world class competitor, monetary union in Europe should actually enhance the appeal of the dollar over the next few years.
The following overview of the European and Japanese situations is based on the thoughts expressed by Armstrong during the seminar.
Europe
…particularly gold, which
should move significantly
above its 1980 high…
The fundamental problem with EMU is that it is a monetary union, not a fiscal union. Throughout Europe there are huge disparities in wages, tax rates and government regulations which will be difficult to bridge and which will make consistent monetary policies unworkable. Even the Maastricht Treaty stipulations on budget deficits will be impossible to control due to the inability of any government to accurately forecast its income and expenses (witness the US situation in 1997 when the forecast budget deficit changed substantially during the year due to surprisingly high tax revenues).
One supposed advantage of the Euro is that the interest rates of participant nations will converge to a rate which is at the low end of the current range of European rates. However, the vastly differing credit risks presented by the countries involved will ensure that a common interest rate will not be maintained. The fact that interest rates have been converging over the past year is simply a function of hedge funds taking positions ahead of a guaranteed exchange to the Euro. For example, if the yield on Italian bonds is twice that of German bonds, but they are both going to be converted into Euros, then the obvious trade has been to buy the Italian bonds and sell the German bonds until the rates converge. This trade is now complete, with the next opportunity being to exploit any necessary divergence of rates resulting from the differing economic, political and social circumstances of the EMU countries.
A further indication that the Euro will, at least initially, be a weak currency is the fact that the weaker economies such as Italy will be issuing their debt in Euros as of 1/1/99, whereas Germany will not issue Euro denominated debt until 2002. The Euro cannot be a strong currency until it is fully supported by the strong European economies.
European equity markets have risen dramatically over the past 2 years as a result of EMU. This has occurred because equities are a natural hedge against the Euro, that is, when the currencies are exchanged for Euros the prices of company shares will adjust based on the underlying values of the associated companies. Government debt, on the other hand, will be converted to Euros at some arbitrary rate, exposing investors to potential exchange losses. It is this uncertainty which has driven capital either overseas or into European equities. As such, a bubble has been created in many European share markets. Once again, governments have forced capital into investments which could not be justified based on sound economic logic.
Following the presentation I asked Martin Armstrong if the percentage of the European Central Bank's reserves which are held in gold would have any impact on the strength of the Euro. His answer, in summary, was that the percentage of gold would not have a significant effect because all the other problems would still exist. He stated that gold would, however, begin a bull market during the second half of 1998 as private investment capital seeks a haven from the chaos created by EMU.
Japan
A final washout in Japan
will also occur, with the
Nikkei eventually falling
below 10,000.
The banking system remains Japan's biggest problem, with non-performing loans conservatively estimated by PEI at around 1 trillion dollars. Japan is experiencing a credit crunch because the banks are losing money and are not there to support the economy. In addition to the problems presented by the bad loans, Japanese banks have a substantial part of their capital tied up in stock portfolios which are not valued on their books at current market prices. This highlights two regulatory problems in Japan. Firstly, a system which permits banks to invest their capital in the share market is inherently flawed since it will lead to a reduction in liquidity at exactly the time when liquidity is most desperately needed, that is, after a large fall in the stock market. Secondly, accounting standards which do not require investments to be marked to market will act to prolong a decline and will lead to increased uncertainty since the true financial position of the banks will be unknown.
Japanese companies are buying US debt in order to minimise losses at home. Many companies have outstanding loans from the boom times at rates of 4 - 5%. They have cash holdings which could be used to repay the loans, but early repayment is not permitted by the banks. The choice faced by these companies is to leave this cash in Japan to earn interest at 0.5% or less, or purchase US Government debt yielding 5.5 - 6.0%. Forced to look outside Japan to obtain a competitive interest rate the Japanese have accumulated over 2 trillion dollars of US Government debt.
The Japanese stock market has been artificially supported by the government, both through direct manipulation and jaw-boning, to prevent a complete collapse. The result of this support has been to prolong the bear market (now in its 9th year) and to create a one way market of sellers. PEI's clients include many large corporations and financial institutions, none of which have expressed any interest in buying Japanese shares during the past 12 months. Rather than buy, most are looking for an opportunity to get out of this market. A sustainable recovery in the Nikkei cannot occur until the market is allowed to find an equilibrium point at which buying interest is awakened. The longer the final sell-off is postponed, the more dramatic the fall will be.
In addition to the financial problems facing corporate Japan, Japanese business is suffocating under excessive government regulation. The Japanese Government controls, or endeavours to control, every aspect of the economy. One of the more absurd requirements imposed on business is the obligation to report all overseas investments as at 31st March each year to the Ministry of Finance (MOF). The information is then published by MOF. This nonsensical regulation results in the annual migration of capital into Japan during March as companies liquidate overseas investments in order to avoid disclosure, followed by an exodus of capital thereafter.
Conclusion
No long term economic recovery in Japan is possible until the non-performing loans are removed from the banking system and the Nikkei is permitted to make a legitimate bottom. In Europe, after some initial euphoria surrounding the introduction of the Euro, the reality of the economic, social and regulatory disparities between the EMU countries will begin to override the potential benefits of monetary union.
Due to the expected continuation of capital outflows from both Japan and Europe, PEI has targets of 278 Yen and 4 DM to the Dollar within 4 years. The next few years should also see a bull market in commodities and a marked shift away from equities, with the stock markets of Europe and Japan being the hardest hit.
Milhouse
20 May 1998
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