How Now My Dearest Moo Moo Cow?

My Dearest Moo Moo Cow,

Mr.Brian Pretti, the managing editor of ContraryInvestor.com has written a fantastic editorial on today's FSO market wrap, Deficit Attention Syndrome

Do give it a good read as Mr.Pretti has raised several very interesting issues.

For example.

• The next chart is really the important one in terms of defining and characterizing the US trade deficit, as we know it today. What we are looking at is the percentage of the total US trade deficit being driven by both imports of crude oil and imports from China. I’ve delineated each separately as well as presented their ongoing combined value in the blue columns. The message is clear. In 2006, 66% of the US trade deficit is accounted for by crude imports and the trade deficit with China. It's no wonder China/US trade circumstances are such a perceptual political flash point. Unless something acts to change the trajectory of these trends, it will probably only be a year or two until crude and China account for three-quarters of the total US trade deficit. Outside of crude and China, it almost seems trade with the rest of the planet is an afterthought in terms of the overall US deficit specifically.

  
  

  

  Although this may sound both a bit philosophical and gloomy, here's the question. Just what is the US going to do to change this? Limiting trade with China means heightened domestic inflationary pressures. And crude oil is simply another story. As you know, the political answer to the crude import issue of the moment is to promote corn based ethanol, which is completely economically inefficient. Corn based ethanol is simply politics as usual (farm lobby) and guaranteed to raise the total price of energy to US consumers (that ought to do wonders for the economy). But that's for another discussion. For now, I see crude as intractable. China is open to debate.

  Simple question. How do we stop what you see below? Talk about a two-decade up trend of significance. This has to be the biggie for the US economy. For now, this is not about to change any time soon. Talk of eliminating the US trade deficit in its entirety is whistling in the wind.

  
  

  

  
  

  When Worlds Collide

  So there you have it, the big message in the trade deficit report of the moment is that a contracting rate of change in goods imports has been a very important pre-recessionary indicator of the past. A message worthy of monitoring. Before concluding this discussion, a few comments on other pre-recessionary dominoes that are stacking up one by one as of late. First, the leading economic indicators are clearly pointing toward recession, if indeed historical experience is still to be any guide at all. I’ve been through housing stats so many times that I won’t recant them here. Housing indicators of the moment are already in recessionary mode. Retail sales? Just have a look below. The following is the year over year rate of change in the quarterly moving average of retail sales. A method of smoothing out the trend a bit. The last time we saw this type of trajectory and level of change was right in front of the 2001 recessionette.

  
  

  

An Mr. Pretti closes with the following commentary.

• We’re going to leave you with a quote that I first posted last year on our subscriber site and in our January open access monthly discussion. In the clarity of hindsight, it now takes on much more meaning and gravity. It’s a quote from a Fortune Magazine interview with Treasury Secy. Hank Paulson from last November. As suggested when it was first posted, LISTEN CAREFULLY to what Paulson is saying. The editorial inserts (ed.) are mine.
  
  

  Fortune: Aren't you concerned that GDP growth dropped to 1.6% in the latest quarter? That's kind of anemic, and we've seen a downturn in the housing market. Convince us we're not going to have a recession next year.
  
  Paulson: "I can't convince you. But as I looked at the third quarter, I felt good because I saw a major correction in the housing market, and I knew that was going to take more than one percentage point off GDP. And then I'm looking at the rest of the economy - strong corporate profits (ed. this is now slowing) and investment (ed.
  slowing also), good growth outside the U.S. (ed. still true), strength in the construction sector away from housing (ed. this is now slowing), and then an equity market that has gone up and added $1 trillion in value.
  
  I know how much people care about housing. But I would be quite hopeful that through 401(k) plans, pension plans, and elsewhere that the average American is feeling an uplift from the appreciation of the equity market that would be very offsetting to any potential decline in housing."
  
  

  As I’ve suggested probably too many times, we’re an asset inflation dependent nation. From stock bubble to housing bubble, and now back to potential stock bubble? What else could Paulson be referring to in his quote? Although you don’t need me to tell you, directly from the horse's mouth, no? Do yourself a favor and savor the moment. After all, how often do you get a rare glimpse of truth on the Street? Ignore Paulson's comments at your own investment peril.
  

Exciting times ahead? Well, the Dow closed a third straight closing record while the US Dollar tumbles to record low versus euro!and Bill Bonner of the Daily Recknoning nicely puts as Dollar Fights Dow for Importance Supremacy.

And finally Bernard Ber of CIBC, Toronto, raises an interesting issue, is this too Much Like 1929?

And Mr Ber raises some interesting issue about China.

• The Chinese stock market began to rise in value dramatically starting in November 2006. It has literally doubled in value since then (over a period of 6 months), with the Shanghai composite index rising from 1800 to a present level of 3600. The over-inflated state of the Chinese stock market recently resulted in a one-day decline of 9% on February 27, 2007, which in turn caused global stock markets to sell off sharply. As well, the economic growth rate in China has accelerated to an annualized rate of 11.1% in the first quarter of 2007. The run-up in the Chinese stock market and the acceleration in economic growth at the same time that China’s foreign exchange reserves rose sharply is also no coincidence.
  
  The point is rapidly approaching when China’s central bank will be forced to abandon their fixed exchange rate regime. On March 20, 2007, the governor of China’s central bank stated for the first time that they “will not stockpile foreign exchange reserves any more” (an extraordinarily important comment that few people took note of). Given the present state of affairs, how could that possibly be accomplished without the abandonment of the fixed exchange rate system? They will realize that the alternative to this (keeping the policy in place) can only result in the destruction of the Chinese economy. When the peg on China’s foreign exchange rate is dropped, the US economy (as well as the global economy) will implode.
  
  The global economy is critically dependent right now on what happens in the Chinese economy. To that extent, it is very important to focus on three elements going forward: the growth of China’s foreign exchange reserves, Chinese economic growth and the Chinese stock market. In turn, what happens in China will depend on the rate of deterioration in the US economy (which will determine the amount of private investment capital that returns back to China and causes their economy to overheat further). At this point, we are witnessing an extremely unusual relationship, whereby deterioration in US economic growth actually causes an acceleration in Chinese economic growth.
  
  Further deterioration in US economic growth from this point onward will cause the US Federal Reserve to consider cutting the US short term interest rate. While many participants in the US financial markets are conditioned to look at this outcome favourably, at this point such a decision would result in a repatriation of foreign capital (and rising longer term interest rates), because the interest rate differential versus other countries will become less favourable. An interest rate cut for a highly indebted country that is highly dependent on foreign capital will result in a completely opposite effect from that intended. The flight of private foreign capital back to China would result in the termination of China’s fixed exchange rate system, as the tremendous increase in their domestic money supply would necessitate it. Once that occurs, the foreign capital outflow would turn into a flood, given that there would be no foreign central bank intervention to offset it. Any benefit to debtors from a lower short term interest rate will be negated by the tremendous offsetting cost of sharply higher longer term interest rates (as US government debt is sold off in the US dollar liquidation). The US Federal Reserve is in a box. The Fed is now powerless to rescue the US economy, because of the threat of foreign capital flight. The emperor has no clothes.
  
  The tension in the world financial system will continue to build as the system is stretched from two opposite ends (the US and China). Further acceleration in Chinese economic growth or further deterioration in US economic growth will increase this tension to the point that the system literally breaks (remembering again that these two trends are linked together). Any further increases in the Chinese short term interest rate or decreases in the US short term interest rate will amplify these stresses and cause the cracks in the dam to widen (until the dam bursts).

And Mr.Ber poses this very important issue.

• Now fast forward to today, and what you see is China as the emerging industrial power and the United States as the mature and stagnating industrial power. China is printing money in an effort to prop up the economy of the mature industrial power (the US). The inflation of the money supply is resulting in the overheating of the Chinese economy and stock market. Very interestingly, on February 27, 2007, it was the sharp 9% one-day drop in the Chinese stock market that led to the sharp drop in stock markets worldwide, including the US. People may be conditioned to think that economic events in developing countries pale in significance to economic events in the US, and may fail to see how what happens “way over there” in China would have any significant impact on their economic well-being. But how different the truth really is. I think most people even now after the February 27th turn of events, fail to grasp why the US stock market sold off so sharply after the Chinese stock market sell off occurred first. The idea that a foreign stock market could dictate what happens in the US stock market almost offends the American sense of national pride (so the event is casually dismissed as “market irrationality”). A word of advice: you better get used to it, as there is much more of that to come. The crash is coming.