Market View - September 2011

"There is no means of avoiding the final collapse of a boom brought about by credit (debt) expansion. The alternative is only whether the crisis should come sooner as the result of a voluntary abandonment of further credit (debt) expansion, or later as a final and total catastrophe of the currency system involved."

This profound statement was made by Ludwig von Mises the famous Austrian Economist and philosopher who believed that the only viable economic policy for the human race was a policy of unrestricted laissez-faire, of free markets and the unhampered exercise of the right of private property, with government strictly limited to the defence of person and property within its territorial area. His philosophy and economic strategies which have been largely rejected by the Western World for most of the last century, appear to be making something of a comeback as more and more market commentators and investors come to the conclusion that the more popular (and intrinsically totally opposite) Keynesian policies that the West has been practicing have failed miserably.

One of the big problems with the Keynesian approach of increasing government expenditure to take up the slack (from the drop off in private enterprise) whenever the business cycle goes into a recession is that historical evidence suggests that at best it is a much less efficient use of capital in terms of the overall return, and at worst it creates (or exacerbates existing) inflationary problems which destabilise the currency and economy. These are indeed trying times for global economies and markets as the strain of having most of the excess debt problems emanating from the folly of the banks in the lead up to the credit crunch fall out in 2008 transferred to Western tax payers, combined with what now increasingly looks like a still born recovery despite all the Keynesian stimulus pumped in was reflected in August both by the sharp correction in most global equity markets as well as rioting in the streets of some of the cities and towns across England.

While it is too soon to tell to what the extent the latter was influenced by the former, there can be no denying the existence of some correlation. For Keynesian policymakers, August was also rather painful as it marked the fortieth anniversary of the decision by President Richard Nixon to end the fixed exchange rate system, and economists still argue about the wisdom or otherwise of severing the last tie between the greenback and the yellow metal which at the former’s birth under the Coinage Act of 1792 was fixed as being worth 0.0565 of a troy ounce of gold!

Were the link still to exist, $1 would effectively be worth more than $103 based upon gold’s current market value of around $1,824.60 an ounce (1st September) although the US Treasury still bizarrely insists upon valuing its Fort Knox held gold holdings at $42.22 an ounce (source "Good As Gold" by Christopher Webber).  A recent Buttonwood article in The Economist newspaper, An anniversary of the currency markets, analysed the impact on both the dollar and the global economy following Nixon’s decision on August the 15th 1971 to close the gold window, devalue the dollar against bullion and impose a 10% surcharge on imports, thereby heralding "the era of paper money and floating exchange rates".

After arguing the pros and cons of the floating rate regime in contrast to the fixed regime linked to gold under the Bretton Woods agreement that preceded it, Buttonwood concluded "perhaps the lesson of the past 40 years is that neither a fixed nor a floating-rate system is a panacea. Many governments have used currency pegs as a shortcut towards economic credibility without structural reforms needed to ensure their economies remained competitive. Floating rates create the temptation for governments to drive down their currencies and grab a bigger share of world trade. That temptation is very strong at the moment and could lead to further political tensions if America opts for another round of quantitative easing. In a world of competing devaluations, gold keeps driving higher; it surged above $1,800 an ounce on August the 11th and in terms of the old gold measure the dollar has devalued by 98% since the end of the Bretton Woods era"

August saw extraordinary volatility as global equity markets after breathing a sigh of relief at the US Congress finally agreeing to raise the federal budget debt ceiling, then crashed mainly on the realisation that another recession may be coming in the US, albeit aided by the ongoing euro sovereign debt crisis, and continuing concern that the Chinese economy may be headed for a hard landing after all! Despite something of a recovery in global equity markets at the end of the month, when the dust finally settled on August, FTSE 100 had fallen 7.23%, the S&P 500 had fallen 6.14%, and the EuroTop 100 was down 13.10%!

Sadly, emerging markets fared no better with the MSCI EM index down 10.90%, while the place to be (gold also experienced something or a crash in August) was once again fixed income as the JP Morgan Global Bond index rose 2.39%. Effectively several leading equity markets technically entered a cyclical bear phase during August as a result of having fallen more than 20% since their post Lehman highs, although both the S&P 500 and FTSE 100 have thus far narrowly avoided doing so.

Many respected market commentators believe that since the Federal Reserve is out of "magic bullets" and can no longer hold back the tide of debt cleansing that the market is forecasting, the trend is likely to continue on down much further, but even the gloomiest bears such as Marc Faber accept that compared to sovereign fixed income and cash, blue chip higher yielding Western stocks and attractive growth companies in emerging markets offer better risk reward potential going forward, while additionally investment grade corporate bonds and precious metal focused commodities are also attractive.