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Financial Contagions Spread Global Investment Dysfunction

June 5, 2013

Australia and New Zealand, as well as many other nations around the world, have caught an economic virus of sorts. This contagion is primarily being spread by Japan, the United States and the European Monetary Union, all of whom have undertaken increasingly irresponsible monetary and financial policies whose effects are proving communicable.

People are used to goods being in global competition, where the prize goes to those nations who produce the best goods at the lowest cost.  However, there is a loophole in this simple relationship, whereby cost depends on the relative value of a nation's currency, and that can be deliberately altered by a nation.

What we are now seeing among many nations is a rather twisted kind of competition. That is, whoever does the best job of cheating their own citizens out of the value of their savings and investments gains a competitive currency advantage, and thus a business and employment advantage.

And in this tightly interlinked world of globalized economies, a necessary byproduct of these competitive currency devaluations is collateral damage to the more or less innocent bystanders around the rest of the world.  Which then forces these nations into defensive measures.

As we'll explore herein, one of the most powerful countermeasures is currently being deployed by Australia, which is essentially to strip wealth from its own savers and investors, as a defensive measure against the United States, Japan, Europe and other nations who are effectively stripping wealth from their own savers and investors.

Once the process has started and a nation has been "infected", it becomes very difficult to opt out.  For a nation which fosters a healthy long-term investment environment for its own citizens by letting market forces rule, can then face a potentially acute competitive disadvantage as a direct result.  With the most vulnerable of all individuals being the citizens of the source economic powers, such as US investors.

What this means for individual savers and investors around the world, whether we're talking about the United States, Europe, Australia, Canada or elsewhere, is that the contagious spread of measures and countermeasures - even if the origins lie within the economic dysfunctions of other nations - can become one of the dominant determinants of your personal long term investment success. And that will apply even if you never leave your own country, never buy a security or investment from any other nation, or never have any idea that any of this is going on.

Japan's Quantitative Easing "Success"

When we look to our international contagion, Japan is in some ways the sickest of the major economic powers. It was the first major power to fall ill, and it has been a leader in adopting some of the dominant economic policies for the world today.

Japan has spent decades in a slow growth situation. Moreover, it has one of the oldest populations in the world, and it has some of the highest debt levels. At 240% of GDP, Japan's national debt exceeds that of the United States by more than two to one. These are among the reasons why Japan was the first (though certainly not last) major nation in modern times to introduce quantitative easing.

Japan faded into the background a bit with the rolling series of acute crises that have enveloped the United States and Europe since 2008, but has now again seized the global center stage and the "lead" by taking monetary and fiscally irresponsible policies to a whole new level. With the introduction of "Abenomics", Japan has openly declared that the political decision makers now have effective control over monetary policy, abandoning the fiction of an entirely independent central bank that's supposed to be insulated from politics.

That is, Japan is overtly creating fantastic sums of money out of the nothingness, with the stated objective of stimulating its economy and flooding the financial markets with cheap cash. There is also the public goal of artificially creating inflation, with the intent to openly warn global investors that the yen will be dropping in purchasing power.

The preliminary results of these radical new policies have been one of overwhelming "success". The yen did indeed plunge in value versus the US dollar, the euro and other currencies. This in turn has created a competitive advantage for Japanese corporations, who are expecting near record profit growth from both increased future exports and rising domestic consumption as a direct result.

Between mid-November of 2012 and mid-May of 2013, the Japan Nikkei index soared upwards by over 80%. This was a fantastic surge for a still dysfunctional economy, even though a good portion of the rally has recently been given back with multiple major downward movements over a two week period.  The yen has recently been climbing, and interest rates have moved up as well.

Nonetheless, over the last six months Japan's stock indexes are much higher overall, while the yen has a substantively lower value, and the yield on ten year government bonds is below 1%.  This is below Japan's inflation target, which translates to an intended negative real interest rate for investors.  So when we look at the bigger picture over the last six months, this explicit use of quantitative easing to slash the value of the yen - and thereby exploit the globalization "loophole" of relative cost being dependent on currency values - is working essentially as desired.

Competitive Financial Irresponsibility: Japan, US And Europe

Japan is of course far from being the only major power with a sick economy.

close to 20%, despite the headline unemployment rate continuing to fall (with falling official unemployment being driven by workforce participation rate reductions rather than actual declines in unemployment levels). So the United States faces a combination of high unemployment, debt levels that now exceed 100% of GDP, and still formidable annual deficits despite the dysfunctional implementation of the sequestration budget cuts.

Europe is of course also caught up in an economic crisis with climbing unemployment levels, high debt levels, high annual deficits, and no resolution of the underlying issues.  Instead, the purported diminishment of the crisis is based upon the expanding powers of a European central bank that grow stronger every year. This gives the European Monetary Union expanded flexibility to implement its own quantitative easings, as well as the ability to intervene in member nation bond markets.

Indeed, Europe, the United States and Japan have tightly interrelated monetary policies, as they try to recover from their crises even while jostling for economic advantage. When Europe got very sick last year to the extent it was a candidate for potential breakup, the United States and Japan were not aggressive at all, for the financial world needed stability.

Then, the day after the German High Court cleared the way for expanded central banking powers for the European Monetary Union, the United States announced Quantitative Easing Three with its creation of $85 billion per month out of thin air. This was an immediate - and largely successful - attack on the value of the dollar.

The round robin continued as Japan reentered into this twisted competition of undeclared currency warfare, with the most powerful offensive against its own currency of any of those nations.

Now this has been quite "successful" for Japan so far, which creates the incentive for other nations to respond in kind, which in turn creates the real problem here. Which is that attacks against your own currency only work when you're better at it than the other nations are. Each ratcheting up will then invite a new level of counterattacks, and the European Union, the United States and China may all go after the values of their own currencies in response to Japan's campaign.

Punishing The Innocent Bystanders

As the major economic powers alter the value of their own currencies in a competitive attempt to recover and gain the advantage, other nations whose problems may not have been nearly as bad (indeed their economies may have been thriving) have not been immune to its effects.

Examples include Australia and New Zealand, as well as many Asian nations. While a country such as Australia has its own substantial economic issues, it is in relatively better shape when we lower our standard for comparison to that of the ailing economies of the United States, Japan and Europe.

The world is flush with cash right now, even while investment opportunities are quite poor when compared to the decades prior to the crisis of 2008.  And let me suggest that this situation of plentiful cash combined with scarce opportunities is no coincidence. Rather it is the direct result of massive government monetizations and market interventions.  The investment climate in the United States, Europe and Japan consists of a combination of weak economies and fundamentals, very high debt levels, artificially introduced inflation, and near zero or very low interest rates.

From a long-term, fundamentals-based perspective for investors, this is a toxic 1-2-3 combination.  With 1) artificially low interest rates, and  2) equity markets that have been pushed artificially high relative to profits and the state of the economy, investors risk buying high and selling low, even as 3) the major nations of the world are competitively attacking the value (and purchasing power) of their own currencies.

So, quite naturally, the response of many rational investors has been to try to pull out of this hazardous environment, and find a healthier investment climate.  They will seek nations in which interest rates are higher, the currency isn't under attack, and in which there are healthier fundamentals for the economy in general - and for corporate profits in particular.

Which leads to money pouring in from around the globe into places like Australia, New Zealand, Thailand, South Korea and elsewhere.  And as the money pours in, the Australian dollar (for example) climbs in value.

This situation isn't all bad for these "innocent bystander" nations, particularly in the short term.  After all, imports just got cheaper, including energy, food, and finished goods.  Which allows a somewhat higher standard of living to be enjoyed, at least by those who have jobs.

However, cheaper imports mean that domestic industries lose domestic market share, as firms are undercut by lower cost competitors around the world, who have been aided by the soaring value of the local currency.  Meanwhile, the nation's exporters are now handicapped by that same soaring currency, making them globally less competitive, and they begin to lose market share to foreign competitors.  Employment begins to shrink at companies serving foreign markets as well as those serving domestic markets.

So the very act of money escaping from dysfunctional financial systems and migrating to a nation with a healthier investment climate, serves to decrease the latter's corporate profits while potentially increasing unemployment.  The contagion has jumped from the sick to the relatively healthy, infecting the new host with slower economic growth.

Falling Values & Climbing Prices

The second half of the article is linked below:


Daniel R. Amerman, CFA


E-mail: [email protected]

This article contains the ideas and opinions of the author. It is a conceptual exploration of financial and general economic principles. As with any financial discussion of the future, there cannot be any absolute certainty. What this article does not contain is specific investment, legal, tax or any other form of professional advice. If specific advice is needed, it should be sought from an appropriate professional. Any liability, responsibility or warranty for the results of the application of principles contained in the article, website, readings, videos, DVDs, books and related materials, either directly or indirectly, are expressly disclaimed by the author.

In the Aztec language the name for gold is teocuitlatl which means "excrement of the gods."
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