On closer inspection, there does not appear to have been much of a credit crisis, rather, there was a crisis in confidence, which impacted a specific part of the overall credit market - namely the mortgage sector.
"We think the real and unfolding crisis is currency related, and the source of the world's problems on this front is the US dollar. "
According to the Credit Bubble Bulletin (www.prudentbear.com), over the past 11 weeks, bank credit in the US has increased US$339 billion (18.5 percent annualised). The provision of credit still appears to be in a roaring bull market!
We think the real and unfolding crisis is currency related, and the source of the world's problems on this front is the US dollar. US authorities have chosen to sacrifice the dollar to maintain the illusion of economic prosperity.
The latest feel good interpretation from Wall Street is that a weak dollar will benefit the US as it will revive the export sector, but won't cause inflation. In other words, exports will get cheaper for the rest of the world but imports won't become more expensive for US consumers. We find this interesting. No other country in history has managed to devalue their currency and achieve prosperity, so we're not sure why the US is any different.
This reasoning fails to recognise that most US multinationals (who account for a large chunk of the export pie) have relocated their manufacturing operations to Asia over the past decade. When these countries finally allow their currencies to float freely and reflect fundamental value, costs will rise in terms of US dollars and competitiveness will decline. But this is likely a 2009 story, and is conveniently being ignored.
Right now, investors are piling into US large cap stocks as they look to take advantage of this export driven windfall. The Dow Jones Industrial average has risen strongly since August as investors anticipate higher offshore earnings from global companies such as General Electric, Microsoft, Proctor and Gamble and IBM.
Moreover, demand for these stocks is potentially flowing from 'Sovereign Wealth Funds', which are investment funds established by countries to invest their surplus reserves. These funds generally invested a large portion of funds in US treasury bonds but the persistent weakness of the dollar is forcing a change in strategy.
While there is no official data to support this claim, one way to mitigate against a weaker dollar is to buy large companies that can benefit from a falling dollar.
The performance of the Dow has certainly been impressive from a US dollar perspective, but foreign investors have not done so well. Below we chart the performance of the Dow in US dollars, as well as in euros and pound sterling. While the headline number looks good, we can see the gains have been largely currency related.
This brings us to the pound, which recently climbed to US$2.04. While there are undoubtedly stronger fundamentals to support sterling, the recent rise appears to have been more a story of US dollar weakness rather than broad-based strength, as shown in the chart below.
The Pound has risen sharply against the greenback and the Japanese yen, but not so much against the euro. In terms of the yen, it appears the 'carry trade' is back in full force. This is the process whereby speculators borrow yen cheaply and sell it in exchange for higher yielding commodity based currencies, such as the Aussie or the Kiwi.
The upshot is that there is arguably a considerable amount of 'hot', or short-term money pushing up the Pound. While we remain bullish on the currency's long-term prospects, a short-term correction could be on the cards.
But back to the US dollar and the slowly unfolding currency crisis. If the greenback were just a regular currency, the persistent weakness wouldn't be such a problem. But it is the world's reserve currency. The smooth functioning of the world's economic system relies on a stable and reliable store of value, and the US dollar no longer provides this stability.
Many Asian (notably China) and Middle Eastern nations have relied on a previously solid US currency to provide stability to their own monetary systems, by pegging their currencies to the dollar. However, the dollar's relentless falls are now creating inflation as these high growth countries import the monetary policy of a slowing mature economy.
To maintain the peg with a depreciating dollar, these countries have to print their own currency. This is simply an official form of currency devaluation.
The result of all this is inflation. Consumer prices are rising at a 6.5 percent annual rate in China, 9 percent in Vietnam and 11 and 12 percent in the United Arab Emirates and Qatar. The latter two countries are symptomatic of many oil exporting nations. Record high oil prices and strong demand is resulting in billions of dollars flowing into these countries' coffers, and as the reserves pile up, they print their own currency to avoid rapid appreciation.
A weak US dollar combined with strong underlying fundamentals has pushed the oil price to record highs this week (see below). The gulf region already has around US$3,500 billion in reserves, and with oil over US$85 per barrel, these will continue to grow, placing greater pressure on the world's currency system.
The record oil price is not just about US dollar weakness though. Recent strength in West Texas Intermediate crude has seen oil hit record highs in euros and Sterling, as well as the greenback.
The depreciating dollar is not only leading to higher commodity prices, record equity markets and inflationary conditions around the world. There is increasing concern over the strength of the euro. The euro, along with freely floating commodity based currencies, is taking the brunt of US dollar weakness. However, not everyone is pleased with this.
The newly elected French President, Nicholas Sarkozy, is challenging the European Central Bank's independence and agitating for lower interest rates. He believes the French export sector is suffering from the high euro and wants a cut in interest rates to stimulate growth. The language of competitive devaluations has started.
Which is where gold comes in. As the currency crisis unfolds over 2008, we believe investors will recognise the inherent fragility of the system and turn to gold for protection. The process has started, with gold recently rising over US$750 an ounce, but we believe gold's run has much further to go, in all currencies.
This includes the Pound. As shown in the chart below, the gold price in terms of sterling looks bullish with a clear break above trendline resistance (green line)
What does all this mean for investors? While equity markets around the world look stretched on fundamentals (PE ratios, dividend yields etc) we believe stock markets are discounting inflationary conditions in the years ahead. This is why markets are soaring in the face of all the bad news emanating from the slowing US economy.
Shorter term, we are due for a decent share market correction, which could involve a rally in the US dollar and weakness in sterling. But longer term, increased worldwide production of paper currencies is likely to push up the nominal prices of real assets, including quality stocks, gold, oil and a host of other commodities.