Monday, April 12, 2004

The World Turned Upside Down - Maybe?

The World Turned Upside Down

Chris Temple is editor of The National Investor newsletter and founder of The Foundation for American Renewal.

Much better news on the jobs front as well as another anticipated strong earnings season for Corporate America have helped Wall Street right itself somewhat following the nasty March swoon. This past week the market had to struggle with the escalation of violence in Iraq; thus, it did not manage to push ahead even further than it has recently. Nevertheless, most traders seem to view the Iraqi quagmire as more of a nuisance than anything substantive that will affect our economy over the longer term.

I won’t argue that point here. Rather, I do want to remind readers that—quite apart from Iraq—there have been other developments recently which the overwhelming majority of investors have not paid nearly enough attention to. Twice in just the last few weeks, in fact, developments occurred which have much deeper implications for the U.S. economy and markets. In fact, the eventual effect of these for Americans particularly will translate into a drastically different standing in the world economically than what we’ve all been long accustomed to. It can truly be said that, for us, the world will be turned upside down over the next several years.

None of us alive today has ever dealt with an economic and market environment that did not have at its core somehow one important anchor. And that, my friends, was that—though there were transient occasions since World War 2 when there were some interruptions—the world, in the end, has revolved around the United States of America.

In a military sense, it has been American might and muscle that, for the most part, have kept most of the world a safer place. Sure, there have been small flare-ups, wars and their attendant “police actions.” Yes, there are uncomfortably many of these kinds of things going on right now. Yet nobody can deny that America’s formidable military strength and resolve won the Cold War, have kept historically volatile Europe free of conflict, and have otherwise created an environment of relative stability.

America’s economy has for several decades been the world’s largest. U.S. consumers, though they have dangerously built their seeming prosperity on mountains of debt, have nevertheless contributed to economic activity elsewhere by consuming so much. It can truly be said that, especially in recent years, Americans have virtually carried the entire world on their backs.

Part and parcel of the world being “tilted” toward the U.S. has been the establishment of U.S. capital markets as the largest and most liquid in the world. People and even governments the world over have shoveled endless amounts of money into U.S. financial assets, giving an even greater aura to the United States as the great engine of wealth creation in the world.

As one sage once put it, though, “Whatever can’t last, won’t.” As the above scenario and America’s being the consumptive center of the universe has endured, major imbalances have been built up. For years, pundits of all stripes have speculated as to when the “tipping point” would come, where America could no longer accumulate such massive internal and external debts; and, further, when others in the world would smell trouble—or greater opportunity elsewhere—and begin to change their behavior towards America.

Early answers to these questions—and warnings to the wise—are starting to come in. A few weeks ago, Japanese officials surprised currency traders by suggesting that their long and heavy intervention in the currency markets designed to keep the yen from appreciating too drastically was coming to an end. Make no mistake, said the Bank of Japan; it will still intervene if and when necessary to arrest any sudden or overly sharp yen rallies versus the greenback. However, the signal was clear; an orderly appreciation of the yen was something the BOJ was now resigned to, if not welcoming. As we all know, the Japanese have been buying boatloads of Treasury securities and otherwise keeping the yen in check in order to best protect their interests.

All things being equal, that nation has been best served until now by keeping its citizens employed in the many export-oriented businesses that have fed the American consumer economy. In the recent past, though, signs have been increasing that Japan’s own consumer economy has been revived. Further, it has been doing increasing amounts of business with other nations in the Asian region; most notably, China. No longer as dependent on America’s consumers, Japan has begun the process of a “readjustment” of sorts away from an economic model that has worked well in recent years. Now, Japan must see to its own domestic growth, a reinvigoration of its own lending industry, and as sustainable an increase in domestic consumption as it can engineer. An important element of this will be to, in effect, do what the United States did for much of the 1990’s: have a stronger currency so as to make imports as inexpensive as possible.

As Japan’s resurgent economy increases its appetite for imported raw materials, it will need a strong currency to keep those commodities—all of which are priced in the U.S. dollar—from getting overly expensive in their yen. I predict that China won’t be far behind in following the same course as Japan. As that nation of well over a billion people has developed an even more incredible appetite now for imports, inflationary pressures have grown; so much so that some are suggesting China has become a “bubble,” whose rapid growth is unsustainable, at least in the near term. That may well be. However, what better way to take some of the inflationary pressure away than by “giving in” to the U.S. and finally allowing its currency to strengthen versus the U.S. dollar? The irony here—even more so than with Japan having already moved in this direction—is absolutely incredible.

For some time now, politicians of both parties have sought to cover their systematic dismantling of America’s domestic economy on behalf of corporations by blaming China (just as they used Japan as a scapegoat in the 1980’s.) “If only China would get rid of its unfair currency peg to the dollar and allow the yuan to rise,” they tell us, “we wouldn’t have such a trade imbalance. Exports would soar. We’d have an even playing field.” And so on. There’s an old saying that one should be careful of what one wishes for—because one just might get it! Soon, China will join Japan in allowing its currency to rise against the U.S. dollar. Particularly if this occurs before November, President Bush will claim a major victory in having finally succeeded in cajoling the Chinese into being more “fair” and in opening the door to greater U.S. competitiveness. Almost nobody will understand the true meaning of such a move, however. First, it will demonstrate China’s belief that the previously insatiable American consumer is finally about “full,” and that the best days of exporting gobs of cheap goods to America are over. Second, it will ratify China’s own growth story; one that is likely to play out over many years to come, but perhaps with some future geopolitical tension thrown into the mix as China flexes its bigger muscles. Finally, the Japan/China moves will translate into soaring costs for everything priced in U.S. dollars which will, of course, most acutely affect Americans.

That brings us to the second watershed event of recent days: OPEC’s refusal to cancel planned production cuts, thereby keeping upward pressure on oil prices. Here again, this signals a major change from a regimen that has pretty much been the norm for many years; that being America’s past ability to compel the oil cartel to follow our will. Following the 1970’s embargo, an implicit deal was struck between the U.S. and OPEC, with Saudi Arabia being the main representative of the latter. With the U.S. by far being the world’s largest importer and consumer of oil, OPEC has had to consider at times what its major customer could “bear” as far as prices were concerned. Simply put, the U.S. has on many occasions been able to browbeat the cartel into pushing prices down to make already (relatively) cheap oil in America even cheaper. The threat was that if Americans were asked to spend a rising percentage of their incomes for energy, the U.S. economy would stagnate or go into reverse; and future sales at any price would thus suffer. That was a point that President Bush argued forcefully in recent weeks; but a point which the OPEC cartel, led by Saudi Arabia, rejected. This has led to some of the most lame partisan wrangling of anything we’ve yet seen in the early days of this election season (yes, I know, it’s still early—and that things will get even more insulting by November.) Bush and presumed Democrat nominee John Kerry are jousting over what Bush might still do, or what Kerry would have done, in a juvenile discourse that completely ignores reality.

That reality, dear friends, is that the world has begun to turn upside down for America. We no longer dictate every element of the global economy and prices as we once did in order to maintain our own advantage (in this case, much cheaper costs for oil than in the rest of the world.) The real issue here is that, due in great part to exponential growth in China and elsewhere, demand for oil is so great that prices have to rise. That’s the free market, folks, that Bush and others—and even John Kerry--claims to support. With other buyers increasingly demanding their product and willing to pay its price, why in the world would OPEC continue to kowtow to America, when it’s no longer necessary? What OPEC essentially said to America a couple weeks ago was that, “We’re sorry you think our price is too high; but if you don’t want our oil at US$36 per barrel, we have plenty of customers in Japan and China (and, increasingly, India) who will buy it.”

The implications for America are clear: Continuing records for gasoline and other energy products, with their attendant drags on corporate profits and spending, not to mention their own inflationary pressures.

As evidenced by both the Japanese and OPEC developments in recent weeks, America will no longer be the author of its own destiny. The implications are enormous; yet the handwriting now on the wall is being ignored by almost everyone else. Only those who understand that, for America, the world we’ve known for more than half a century is irreversibly changing will be able to both protect themselves and profit in the years ahead. In addition, only those who apply these new facts of life in a positive, constructive way will be able to lead their friends, neighbors and nation in, hopefully, one day repairing the damage to America that has been done while our caretakers and leaders have fiddled (or, in some cases, willingly sold out their countrymen.)

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