Renminbi redux.

The Chinese finally decided to let their currency, the renminbi (or yuan), “float” against the U.S. dollar. (For background, please see my prior post: Renminbi revaluation). I put the word float in quotes because it will be highly controlled and not a float in the free market sense.

Political leaders the world over, but especially in the U.S., have been pushing for this revaluation for some time. I doubt it will generate the outcome such leaders hope for. My expectation is higher interest rates and commodity prices in the long run that will eventually make our problems here and abroad worse instead of better.

An interesting question to ask, then, is: why did the Chinese finally do what everyone wanted them to do?

The most obvious answer, and the one that will satisfy most political leaders, is that China bowed to U.S. or international pressure. I doubt that’s the case. Right now the rest of the world depends on China as much as or more so than the other way around.

Another suggestion, mostly from political thinkers, is that China is assuming its position on the world stage and having an independent currency is part of that. Although more feasible than caving to pressure, I think this argument misses the mark, too. I believe China desires a prominent position in the world, but I don’t think it would sacrifice a piece of its low cost edge in order to get it.

No, I think the real reason behind revaluation is inflation in China.

In fighting financial problems over the last decade, the U.S. Federal Reserve has printed a lot of dollars. That printing has led to higher prices, especially for food and the key inputs to production (copper, iron ore, oil, etc.).

This impacts first world countries much less than third world countries. The first world spends somewhere around 20% of their income on such things as food. The third world, including China, however, spends much closer to 60%.

When the price of an apple doubles and it’s less than 20% of your income, you complain a bit, but it doesn’t cause a significant problem.

When the price of food doubles and it’s 60% of your income, you riot in the streets.

That’s the situation I think China is facing. They’d like to keep their currency on par with the dollar to maintain their low cost competitive advantage (with significant margin to spare), but not at the expense of having inflation cripple its poorest people.

I believe China’s goal is to grow to first world standards of living without causing a revolution. That’s a very delicate goal to achieve, especially with centralized planning and in the short time period they want to achieve it.

They won’t get there if their economy slows too much, or if they have high inflation.

I don’t think China is caving to pressure from the west or seeking the prestige of an independent currency. I believe they are walking a tight rope, and inflationary threats were making them lean way too far in one direction.

Revaluation, for them, is a practical economic matter, not purely a political one.

Nothing in this blog should be considered investment, financial, tax, or legal advice. The opinions, estimates and projections contained herein are subject to change without notice. Information throughout this blog has been obtained from sources believed to be accurate and reliable, but such accuracy cannot be guaranteed.

Look east, young man…

In trying to read the economic Tarot cards, most are focused on the U.S. and Europe.

At first glance, this is quite understandable. The European economy is the largest in the world, followed closely by the U.S. But, that’s not where the action is.

Indeed, the world economy increasingly turns on the axis of #3: China.

If you want to know where things are going, look east.

I say this for two reasons: 1) markets have been increasingly led by action in China, and 2) fundamental economic reality is being driven most by China.

When the economies and stock markets of the world turned positive in 2008 and 2009, it happened first in China.

All other markets are reacting to what happens in China, too. When China hints they may let the renmimbi appreciate, markets shout “how high?” When China hints its trying to subdue real estate speculation, markets shutter the world over.

The simple fact of the matter is markets are reacting increasingly to news from China.

You may think of markets as being speculatively fueled, but a look at underlying economic reality provides a basis for these flighty reactions.

China is the world’s third largest economy, passing Japan within the last two years.

The Chinese economy is–by far–the fastest growing large economy.

China became the world’s largest export economy, passing the former #1, Germany, just last year.

Demand from China is driving the markets for the most basic inputs to production. Watch the price of shipping, iron ore, copper, steel, oil, or almost anything else, and you’ll most likely find news from China caused prices to jump or dive.

China has become the manufacturer to the world. You can’t consume what hasn’t been produced, so China is holding the economic cards, now. If you don’t believe it, watch Chinese workers striking Honda or demanding hiring wages from purchasers like Apple and Hewlett Packard. This wasn’t happening a year ago because China didn’t hold the cards. They do right now.

Finally, China’s economy is the only large economy whose government isn’t in a fiscal straight jacket. The U.S., Europe and Japan are all hand-cuffed by borrowing and spending too much. China’s government is almost certainly making uneconomic investments, but they have the ability to invest whereas the other large economies’ governments are out of ammunition (or soon will be).

If you want to know where things are going economically, look east.

Nothing in this blog should be considered investment, financial, tax, or legal advice. The opinions, estimates and projections contained herein are subject to change without notice. Information throughout this blog has been obtained from sources believed to be accurate and reliable, but such accuracy cannot be guaranteed.

Tipping Point?

The next crisis we face may be much worse than the housing crisis. It’s what I’ve talked about in the space before: sovereign subprime or too much government debt.

This may seem like a problem facing far-off Greece or Hungary, but it’s bigger and more problematic in the developed economies. Here, I’m talking about the big economies we typically associate with stability: Japan, Germany, France, Britain and the United States.

The issue is that such developed economies have borrowed too much money, like subprime borrowers, to live high on the hog today. This borrowing is going and has gone to generous social programs, defense, and, most insidiously, growing interest payments.

When the burden of paying debt, both interest and principal payments, get too high relative to incoming money (taxes) or an economy’s size (GDP), you get to a tipping point where there’s no where to go but down.

This problem is exacerbated by two additional issues: who did you borrow from and when do you owe them principal.

If you borrow from your own citizens, you’re in a better situation than when you borrow from foreigners, especially when those foreigners aren’t your best friend (hello, China).

If you borrow the money short instead of long term, you face the same problem as paying off a credit card versus a home loan–no credit card will give you wiggle room while you get your financial house in order.

Japan and Britain borrowed mostly from their own citizens. The U.S. borrowed mostly from Japan and China. Japan and Britain predominantly borrowed long term, the U.S. borrowed short term and must roll over most of its debt over the next several years.

The U.S. has an advantage over Japan, Britain, France and Germany, though: our economy grows faster and so does our population (both organically and from immigration). This gives us some wiggle room they don’t have.

Back to the tipping point issue. When interest payments get too high relative to economic production or tax revenues, those who lent you money want a higher interest rate. Guess what a higher interest rate does to those interest payments? Yep, higher and higher.

You can see why there’s a tipping point–once you reach a certain threshold, people start to doubt you can pay and want higher interest payments (or won’t lend you money), which creates a vicious cycle.

The developed economies of the world are entering that vicious cycle over the coming years. We stand on a knife’s edge and can chose, now, to stay on the good side or go to the dark side. And, we don’t have much time to chose.

If you tip to the dark side, what do you have to do? Theoretically, you can grow your way out of trouble, lower your interest payments, get bailed out by someone else, cut spending and jack up taxes, print money (inflation) to pay back loans, or default (also known as restructuring, repudiation, rescheduling, etc.).

The U.S. has been growing its way out of trouble for over 200 years. Unfortunately, when government spending grows to a certain percentage of the economy, your growth rate slows dramatically. We’re reaching that point, so we need to allow a lot of immigration, cut government spending, and reduce taxes to increase growth. I’m guessing the chance of any of those three happening is as great as finding a snowball near the sun’s core.

Is there any way we could lower the interest rate on our debt? You’ll have to ask Japan and China on that one, but don’t count on it.

Is it possible that any country in the world is capable of bailing out the U.S.? Please see snowball reference above.

Can we cut our spending and raise additional taxes? We could, but in a populist environment like we’re in, that will probably work as well as it has in Greece (please see riot footage as reference).

Can we inflate? This is the most likely outcome, and it won’t be a lot of fun for those who lent us money or for those on a fixed income here in the U.S.–and, by the way, that’s a lot of people!

Can we default? Like inflation, we can do it, but it won’t be pretty and will likely be a disaster for many.

Standing on the knife’s edge and looking at those six options, I would chose to knuckle down now, so we don’t have to go down the path of the six. I’m not optimistic that will happen in a democracy, so I’m planning on inflation.

So should you.

(I think we’ll still experience slight inflation/deflation over the next couple of years, but the turning point is hard to predict because our lenders will get to chose the timing).

Nothing in this blog should be considered investment, financial, tax, or legal advice. The opinions, estimates and projections contained herein are subject to change without notice. Information throughout this blog has been obtained from sources believed to be accurate and reliable, but such accuracy cannot be guaranteed.

Judging expertise–the right way!

I was simply dumbfounded.

I was having breakfast with a good friend, recently, when she explained the good qualities of her financial advisor. Specifically, she referred to her advisor’s a) ever-present volunteer activities in the community and b) diligent hobby fly-fishing on every possible occasion.

First, let me highlight that my friend is no dummy. She’s one of those people that is fiercely dedicated to her job, an expert in all the important areas of her work, and possesses a mind-numbing amount of information about her interests. This is one smart cookie.

Second, I have nothing against volunteer activities or fly-fishing, or long walks on the beach for that matter.

Third, I’m not an unbiased observer. I am, after all, an investment advisor myself.

With all that, why on earth would you judge your financial advisor based on their presence in the community or their various hobbies!

When I look for a doctor, I don’t care if she sings in a barbershop quartet, or if she likes to play bridge. All I care is if she is an expert in her medical specialty. I want to know she reads the latest journals and works diligently to improve her results over time.

When a fireman comes to pull my unconscious body from my burning house, I don’t care if he enjoys flower-arranging or Internet chat rooms, I just care if he can carry me down a flight of stairs and then put out the fire with minimum property damage. I want to know that he can squat 300 pounds and studies fire damage to figure out how best to put them out in the future.

And, when I look for an expert in investments, I don’t give a hoot if they volunteer and fly-fish, all I care is that they are expert at what they do.

Personally, I want that doctor, fireman and financial advisor to be a neurotic, obsessive/compulsive individual so dedicated to their field that they seldom have time for much else.

So why was my friend so excited that her financial advisor was always volunteering and trying to fly-fish? I don’t get it.

Doesn’t she realized that when her advisor is doing something other than being an expert in their field, she’s the one losing. Doesn’t she realize that every hour volunteering or fly-fishing is another hour when the advisor’s competition is finding ways to get better returns, better plan for her future, or broaden their knowledge?

There’s a right and a wrong way to judge expertise. You don’t judge it based on ancillary interests or good intentions in the community. You judge it based on best practices, proper education, diligent improvement, and long run results.

And one more thing while I’m on my rant: when your advisor regularly calls you to suggest you make changes to your portfolio, and he’s compensated based on commissions, he’s not calling to help, he’s generating sales so he has more time to fly-fish while your portfolio is floundering.

Nothing in this blog should be considered investment, financial, tax, or legal advice. The opinions, estimates and projections contained herein are subject to change without notice. Information throughout this blog has been obtained from sources believed to be accurate and reliable, but such accuracy cannot be guaranteed.