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Friday, March 18, 2011

Ramblings About Japan And QE

The world is a mess that is for sure. If you are inclined to watch the History Channel you have undoubtbly seen shows like the “Nostradamus Effect”, 2012 and others that posit the notion of the world entering in to an Armageddon scenario. Looking at what is transpiring in Japan one could get the feeling that the end of the world has begun almost like you see on the aforementioned shows.

Before I go on I just want to state the obvious that all of our thoughts and prayers go out to our friends in Japan. That said, the media coverage outside the business world regarding Japan has focused on the nuclear meltdown problem, but once again from an ethnocentric point of view.

It fascinates me that whether you watch the reports on TV or listen to talk radio very large percentage of the reporting is not about the situation in Japan but focuses on America and our own nuclear reactors. Of course in the wake of what happened in Japan we should be taking the time now to evaluate our own plants and see what the vulnerabilities are especially in light of the current disaster.

One should be note that it was not the earthquake that took out the plants but instead the after affect Tsunami that damaged the redundant systems diesel generators which power the cooling systems. The plants themselves survived unscathed and had the backup power generators been protected better against tsunamis we probably would not even be discussing this issue.

As a result of the devastation in Japan the markets have reacted as expected to the downside. Many in the media are calling for an end to the commodity bull market as well as the end of QE. Frankly I don't think these arguments hold water.

Let's start with the commodity bull market. The argument is that with the Japanese manufacturing offline due to the disaster that the demand for commodities will be dented and apparently this also affected demand from all corners of the globe. The argument on its face seems like a good one but it is not reality. China and the rest of Asia along with the US and Europe are not going to stop consuming and will still require commodities.

The argument also fails to take in to consideration that Japan is going to require something along the lines of the Marshall Plan to rebuild. The rebuilding of Japan is going to require a great many things namely various commodities. Furthermore, at the moment the country is in crisis mode and sure production has fallen off but this is temporary. I believe people have a very myopic view of Japan and this leads to the narrow-minded thinking like the prior argument.

Japan is an archipelago with land area roughly the size of California, so to think that every company will halt production there is naive at best. Imagine if there was a great earthquake in Los Angeles and large portions of LA County were destroyed, does this mean that manufacturers in more fortunate areas say in San Francisco will stop production for other than the necessary time. An argument could be made that Japan will end up importing as much if not more commodities of all types from copper, iron to food and this will put an elevated floor under prices for the foreseeable future.

At the same time I have heard many calls that the current disaster will be beneficial to Japan's economy because of all the rebuilding activity. I do believe that there will be benefactors from the rebuild but it will not be Japan primarily. Just as in Henry Hazlit's ,”Economics In One Lesson” , he discusses the fallacy of economic growth by repairing a shopkeepers broken window. The thesis in a nutshell is that a young punk breaks a shopkeeper's window and as a result of this economic activity is fostered since the shopkeeper has to replace the window. While it is true that the shopkeeper will end up paying the glass supplier and the workman but this is not creating true economic growth. The bottom line is the money the shopkeeper spent was not productive in the long run and also prevented him from using it towards more productive ends like business expansion or bringing in new products. Japan in this case is the shopkeeper and the billions or even trillions needed to recover will only bring them back to where they were not create a boom, at least not for them.

The flip side of this is that there will be many commodities and companies that will benefit from the disaster. Among the companies that should benefit would be the likes of Caterpillar (NYSE: CAT), Joy Global (NASDAQ: JOYG), Shaw Group (NASDAQ: SHAW), Fluor (NYSE: FLR) and many others associated with design, engineering, construction, equipment and general rebuilding. In regards to commodities the same holds true Japan is going to require lots of cooper, steel, food and other materials for rebuilding and sustenance.

Companies from around the world will benefit from these needs, but it does not mean world GDP growth as some have implied but instead either maintain current pace or a smaller than expected decline. Moreover, depending on the path that Japan chooses will mean either they rebuild their moribund economy to remain the way it was or they utilize the current disaster to restructure. If the current situation is used to restructure their economy and write off the bad debts that are an albatross, Japan could emerge in a few years stronger than ever even with its aging demographics, but that is a big if.

As for QE (Quantitative Easing) I do not believe the FED in their statements that they will end QE in June because of their “as conditions dictate” language. There have been many times stretching all the way back to the Greenspan FED where we were told one thing and the FED did or believed another, just think back to this past August. Prior to August all we heard was “we don't need further QE” then poof everything changed with Bernanke's August Jackson Hole speech. This time will be no different for a couple reasons and Japan's situation plays a key factor in this thinking and will dictate conditions or at least give the excuse. I believe that the FED will dip in to their bag of euphemisms and come up with some new term to describe what they are doing with monetary policy or they will just use the tried and true cloak and dagger method but with both “invisible hands”.

QE will morph in to something else. Why will QE morph? It will morph because the FED wants to manage inflation expectations since everybody and their brother knows by now that QE is inflationary. Yes I know if you remove the “volatile food and energy” factors inflation remains low, but who really believes any of these figures any more, only the guy living under the rock in the GEICO advertisement.

You have to ask yourself, who do these figures benefit? If inflation were truly low it would be good for all of us, but deceptively covering up the true rate can only benefit government and those who get their hands on money especially freshly printed money first(IE Wall Street). The Government “needs” to maintain the illusion of low inflation to keep rates low, because if they did not then things that are indexed to inflation would shoot up costing the government even more to finance. For example, COLA adjustments to social security would rise, as would rates on TIPS(treasury inflation protected securities). More importantly the rate the government would have to pay for money would increase as bonds would have to carry higher rates there by accelerating the deficit. An additional problem is government debt that is short in duration rolling over and needing to be refinanced. This year alone the government needs to roll over some $2 Trillion in 2 – 10 year debt and this is on top of the projected budget shortfall of $1.6 Trillion. What is the old saying “a trillion here, a trillion there and soon you are talking about real money”. The point is that rolling over $2 plus trillion in to new bonds at higher rates exacerbates the deficit and also leads to further rate rises, a vicious cycle. You can see why Bill Gross doesn't want anything to do with Treasuries. The government is spending $1.6 Trillion it does not have and rolloing over another $2 Trillion for a total of $3.6 Trillion, while its revenues are $2.2Trillion. You could not run your household or a corporation like the government or you would be bankrupt.

Of course if we could get our debt under control and start reducing it or at the very least take serious steps to do so it would help a great deal in diffusing this problem. The reality is that we are not doing the things needed to achieve deficit control or reduction. Originally the deficit this year was supposed to be $1.1 Trillion, but the GAO has now come out and stated it will be more like $1.6 Trillion so assumptions of the deficit and any reduction are out the window. Even with the great Tea Party election sweep the republicans are battling to reduce the budget by $60 Billion which is a pittance and will not achieve anything in either confidence of or actual deficit reduction. Just yesterday it was reported that the debt jumped $72 Billion as the House voted to extend the budget and cut spending by $6billion. I am sure dear reader, even the most economically illiterate among us can see that the ratio of cuts to debt\spending is grossly out of whack. As this was being reported, Tim “Turbo Tax” Geithner, took to the media and admonished congress that they must raise the debt limit or “suffer catastrophic consequences”. Of course what Timmy should have been saying you must raise the debt limit to only further postpone catastrophic consequences? There is no will to fix the problem and few places to cut unless we alter what government's role is and what we expect. As it stands between Social security, Medicare, defense and some other areas that are untouchable accounts for 80% of the budget.

Of course the nonexistent inflation that QE drove has appeared mainly outside the US at least until recently. QE is the reason that counties like China and Brazil are raising rates to combat all the “hot” money that has been pouring in to their countries. The FED by QE and purchases of Treasuries has been keeping rates suppressed far below equilibrium and this has caused the old adage to play out in spades. “Money flows to where it is treated best” and in this case the economies of the emerging markets have been on the receiving end as our rates are too low. The low rate environment has also had the consequence of weakening our currency. The icing on the cake is our national, state and municipal debt burden which may be better than Greece's at least for the moment, but our economy is proportionally like comparing the empire state building to and ant hill (no offense to Greece).

The world is waking up to the fact that the US has issues and it is showing up in interesting ways. For example while the dollar has rallied somewhat during the current disaster unfolding in Japan it has not really demonstrated its leading role as a safe haven like the past. In fact the dollar was out performed by the Swiss Franc in this crisis. Now granted the Swiss Franc is a smaller currency and less flows would be needed to move it up than the dollar but the point is the dollar did not act as in the past.

Due to the sheer size of our debt is there is less of a group lining up to buy treasuries and keep yields down in the 2 - 10 year range that the FED wants to control. The Chinese are buying less, PIMCO's (World's Largest Bond Fund) Bill Gross has dumped out of all US Treasuries and is not buying more all of which is problematic for the FED. Gross has looked at the situation the US finds itself in and asks a simple question “who will buy the debt?”. His answer was to vote with his money and get out because he believes that there will be less and less buyers going forward. This is a pretty significant development to me as this is no ordinary investor but the “Bond King” and he is not interested in Treasuries because what he doesn't say is that the FED will be the only buyer in the future contributing to the inflationary environment rendering bonds a poor investment.

Now add to the mix the Japan disaster and you have a government that is no longer in a position to buy more treasuries meaning that there will be a decline in the coverage ratio at best and a shortfall at worst. Add to the lack of buying the fact that Japan holds about $885 Billion in treasuries and suddenly finds themselves in a position of needing cash to rebuild, stabilize their markets and defend their currency. Just like an investor on margin they may sell something of value like the treasuries to offset the margin call that is their economy. Moreover, the Japanese are injecting Trillions of Yen in to their economy effectively printing money in an effort to deal with the disaster. I d do not fault the Japanese for monetizing given the situation, but just how bad are things in the US when Japan announces that they will pour Trillions of Yen in to the market and it strengthens against the dollar. Additionally, I would not underestimate the FED using a backdoor QE to help the Japanese. What you don't think the FED would do such a thing? This FED has demonstrated that it is willing to do anything whether it is in their mandate or not and they have been given a pass on everything allowing the “leviathan” to continue to grow and become more complicated and tangled. In the last crisis the FED lent to the likes of Harley Davidson and foreign banks and insurance companies as well as European governments, so why would they not push QE out to the Japanese?

The takeaway for me is that despite the talk that the commodity bull is over and QE is ending in June, it is all just talk. We are in a situation similar to that of the French who had the Assignat as their currency. The French of the late 1700's had huge debt and their solution was to print currency, which lead to conditions improving for a period. Then as today the officials began to remove the punchbowl and conditions would worsen so the printing presses would be flipped on again. As Mark Twain once said “History does not repeat but it sure does rhyme” and so it is today. The FED is keenly aware that the economy would slide without QE and as in the past they will talk tough but take the easy road just as the French did. Unless we begin to get serious about restructuring Government and really controlling our deficits QE will not be over.

In fact Jim Rickards, presented a case that the FED's balance sheet has gotten so large that they will now be collecting some $750 billion a year in maturing debt which can be used to purchase new debt to continue the cycle. The amount of money that the FED will be collecting each year is roughly equivalent to ¾ of the 2 – 10 year debt issued each year assuming the deficts spending stays at $1 Trillion. There will be those that argue this is not inflationary because they are not printing, true but they are suppressing interest rates and thereby cheapening our currency. The cheapening of the Dollar is inflationary as we import so much and our currency will not buy as much as before. Moreover, the FED's ability to purchase the debt will be impacted because the deficit number is not $1trillion as Mr. Rickards suggests but it is running higher ($1.6 Trillion) and the net result is the FED will have to come up with the Dollars for the overage. I believe that QE or whatever they will call it will be with us for a long time and as Mr. Rickards suggests.

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