Bubble Bubble Toil and Trouble
Posted: October 26, 2010
A nephew of a prominent Unicorn recently reminded us that a favorite toy
when we were kids was those little bottles of soap with a handle and ring
which allowed us to blow bubbles in the air. We’d watch those bubbles dance
and glisten until they popped then blow some more, having great fun in the
process.
Most times the bubbles were small, innocuous and would pop without notice.
Others would be monstrously huge and we’d gape as they drifted off, trying
to see them hit a leaf with enormous (to us) pops. Once in a while, we’d get
combination bubbles with three or four attached together and then stare at
them, waiting for the whole set to pop at one time. They always popped
together, spewing little soap residue all about. Very much great fun, those
bubbles were.
At Unicorn, we’re pretty much convinced that kids on Wall Street, their
younger sisters in London and Zurich and the toddling infants in Shanghai,
Hong Kong and varied hot spots globally are as infatuated with bubbles today
as we were then. Fortunately, when we liked bubbles, their explosions were
unimportant. When the global financial community detonates bubbles today,
the impact is somewhat more stressful.
Like our combination bubbles of yesteryear, bubbles fully formed again
threaten to burst across global financial structures with totally
unpredictable consequences. As retail investors, we need to think through
our positioning on this.
Our first bubble starts, predictably enough, with traders chasing yield.
Making that extra point, a few more bucks in return, is what justifies their
existence (and fattens their paychecks) with consequences disregarded.
Traders, money managers (or, as we see it, mismanagers) are flooding
emerging markets with cash – Brazil, Thailand, Israel, India, Taiwan, and,
of course, China.
Cash isn’t customarily a problem. Too much cash, for most of us, is never a
problem. For countries too much cash is a deadly problem – fatal to
political control, economic stability and currency management. Today, the
chase for yield is producing currency bubbles in most emerging markets and
asset bubbles in virtually every China, Singapore, and Hong Kong market. The
inevitable result of too much cash is imbalance in currency values and an
equally inevitable attempt by governments to intervene to rebalance
currencies in their national favor.
Starting with our favorite 800 pound gorilla, China, we see how a pegged
yuan creates distortions for all their trading partners. Radically
undervalued, the yuan induces greater exports from China to the disadvantage
of their competitors in southeast Asia and simultaneously induces greater
imports into the Western economies, unhinging recovery efforts which require
increased exports. Oddly enough, we suggest efforts by Chinese authorities
to deflate their bubbles in property are precisely the right answer but
simply not aggressive enough to be effective faced with monstrous volumes of
international cash chasing yield.
From the yuan imbalance draws a perceived need for Koreans to intervene on
the won, the Japanese to intervene on the yen and most of Southeast Asia to
react in typically unpredictable ways. Brazil, meanwhile, is finding their
mattresses stuffed with cash from the West AND from Asia. Excess cash
flowing into Asia, with nowhere to land, is being reexported to Brazil where
it also has nowhere to land, driving up prices of commodities, real estate
and bonds in all forms to levels all out of proportion to underlying values.
The US and UK, foremost in the West, are responding with equally irrational
ideas bordering on trade wars, threats of tariffs and other unseemly noise.
Western nations, we suspect, are enjoying unduly low valuations on dollars,
pounds and euros as it makes their exports more affordable even while
politicians engage in mindless blame games over “outsourced jobs” and
similar demagoguery.
Currency interventions do not work particularly well, are not sustainable
and most central banks know better but are so pressed by elected political
types to do something they do. It always amazes us that democracies (and
quasi-democracies) would prefer taking action that is patently the wrong
action than do nothing and let the situation naturally sort itself out, but
in that we digress.
Unicorn believed China would prick the combination bubbles first with a
healthy increase in their interest rates, resulting in a very much needed
cooling of their property and asset markets with downstream rebalancing of
currency (and asset) values globally. Disappointingly, the wise powers of
Beijing tossed out a quarter point – enough to rattle Western investors for
a couple of days but not enough to cool their markets or enough to pop the
bubbles.
Two days after they acted, everything financial was much back to “normal”.
This tells us when the bubbles do burst (by government action or by George
S. going short on the baht again), consequences will be severe. All the
ingredients are being stirred as they were in 1997 except, this time, the
total cash (dollars, pounds, Swiss francs, shekels and euros) invested is
exponentially greater with assuredly greater detria to be scattered.
What does a retail investor do while waiting for the next prick that pricks
the bubbles? Let us understand first what money mismanagers do in crisis –
they flee. They run. They look for caves to hide in. They are cowards so we
should expect them to act like cowards.
That is, they move holdings to US dollars. Always have; always will. Given
they fled to dollars during the Great Meltdown, when the dollar was
returning negative real returns, we are confident they’ll do the same when
all their gamesmanship in Brazil, China, across Asia or in greater Arabia
finally blows up.
Where, then, does that money end up? Much of it will be in US Treasury
bills, depressing prices and letting the Fed finance American wastefulness
at near zero cost. A large portion of it will end up where it started – in
the US stock market. Blue chip stocks, good dividend stocks, will see the
greater share of buying activity. Counter-recessionary stocks, like
drugstores and manufacturers of basic foods or consumer goods, will do well.
Utilities, health care stocks and solid, long term performers will be
coveted.
Companies highly dependent on Asian manufacturing, like textiles and
electronics, will be roiled by pricing issues and the biggest of those
(which we lump together as Nazi-Mart) will have major headaches with
currency conversions and twisted or failing supply chains. Manufacturers of
heavy equipment, relying on Asian sales to bolster income statements, are
likely to suffer as well.
Timing a bursting bubble is problematic. As kids, we watched bubbles drift
toward the ground and could often predict the moment of explosion. As adult
kids, we cannot so easily see when but know it will happen, we know the
immediate aftermath will be bloody all around the globe and we know, when
all is said and done, that bubble money comes home. The best we can do today
is become prepared.
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