Russia was once described by Sir Winston Churchill, as “a riddle wrapped in a mystery inside an enigma.” Those words, spoken in 1939, eloquently described the Western sense of Moscow as inscrutable and a menacing country that plays by its own rules; perhaps they are no different now with the extraordinary exception that today’s Russia is dressed in diplomat’s pinstripes folded around a pugilist’s muscle with a checkbook of an oil baron.
What’s more, today Russia, along with China, Brazil, India and South Africa (collectively the BRICS), hold the keys to the Western countries economic engines through export driven growth by the West to those countries. Further, most of the fuel that propels the Western economic engines comes in the form of petroleum, natural gas, strategic metals and minerals primarily produced in the BRIC nations and primarily imported by the West. Strategically, the economic levers are asymmetric and it would be a profound mistake to presume the balance of power lies in Western sanctions against the Bear without retaliatory measures that could have extremely disruptive consequences; both intrinsically and extrinsically. We shall explain, but first a little history …
The Smoot-Hawley Tariff Act, signed into law in May of 1930 by President Herbert Hoover, may have arguably been the linchpin that exacerbated the U.S. recession into a worldwide depression. What succeeded the Great Depression was a Greater World War; if delicate balances slip out of control due to statutory arrogance, similar results may ensue with non-quantifiable endings. Rest assured those endings won’t be ethereal.
Ironically, the Smoot-Hawley Tariff Act was designed to protect American jobs and farmers from foreign competition. The current Russian sanctions may cost American jobs– and may also be the impetus to threaten the reserve status of the almighty American dollar through the formation of a G5 currency and trading union (BRICS the new G5).
Some of the negative consequences that the Smoot-Hawley tariffs had on the United States and global economies are worth summarizing here as the parallels with the Russian sanctions may be more ominous than the markets are currently discounting, which effectively are very little. The parallel impacts of then and now might be:
1) Disproportionately negative impact on GDP from concentrated industries and geographic regions. Losses to GDP will not be evenly distributed but will most likely render severe impacts to export industries and agriculture. Ensuing job losses in those states supporting these industries could be punishing.
2) Worldwide retaliation against U.S. minerals exported along with strategic metals and minerals imported could severely affect mining states, the aircraft industry, electronics manufacturers and the auto industry. Banks with concentrated exposure to these dominant industry groups could collapse due to the combined perils of increased loan loss ratios and precipitous declines in commercial loans.
3) The destruction of worldwide trade would have a direct blow to the money center banks as intra-bank lending both domestically and internationally could freeze up. Moratoriums on international debtor repayments, in a world chock full of bail-out nations, could cascade to the point of imparting severe stress on highly leveraged central bankers. Accelerated currency wars, national defaults and exchange controls all become phenomena of global chaos from illiquid markets. The link between sound, robust and controlled international trade conditions and monetary structure is nearly perfectly correlated. The destruction of trade would (or could) swiftly lead to monetary collapse especially with the inter-connectivity of global markets today and the exceedingly high leverage furnished by years of central banker’s manipulative experiments affecting global interest rates.
4) The U.S. Federal Reserve’s manipulation of interest rates, coupled with the USD front as the world’s reserve currency, has caused a deluge of capital chasing growth in emerging markets by leveraging the US Dollar carry trade. Borrowing in cheap USD’s, depositing those dollars in higher yielding foreign banks using the local currency, leveraging the deposits from 10:1 to 30:1 (especially in global hedge funds and proprietary trading facilities of large money center banks) and then employing the leveraged capital into emerging market countries to capitalize on growth opportunities has been a wonderful story for those emerging market countries. Access to cheap capital to fuel the growth in population areas that are several times that of the West, often with plentiful natural resources that could be expropriated and most always under conditions where domestic lending is either at significantly higher or non-existent costs, has been the untold pyramid of success for these regions. A reversal of fortune caused by the fear of international tensions escalating and/or the inversion of the carry trade caused by either higher USD carrying costs (increased US interest rates) or elevated currency risk between the USD and the local currency, could cause a sudden suction of capital from these emerging market countries. When considering alone that the excess alpha of increased earnings and margins for the S&P 500 comes almost entirely from those companies with global extensions, especially in emergingmarket countries, it becomes apparent that a sudden earnings deceleration could result if global trade is dramatically interrupted.
5) It remains astounding to these authors that central bankers have the unfettered audacity to maintain a goal of higher inflation! Beyond being patently disingenuous to any holder of fixed-return assets (Treasuries, annuities, corporate debt, etc.), under what track record has the Fed demonstrated its ability to forecast future conditions with anymore accuracy than a five year old forecasting using a Weegie board? Regardless of the underlying elements that may become catalysts for inflation, global trade interruptions would serve as the impetus for a great monetary contraction for several of the reasons stated above. With stock markets at or near all-time highs and interest rates globally near all-time lows, central bankers silently, if not nervously, are aware of this potential deflationary outcome and perhaps will continue to err on the side of monetary stimulus.
You may wonder why there is such disconnect between Wall Street and Main Street; or global stock prices and the plight of the common man. If you had the pleasure of today’s news stories furnished to you from a time machine just a few years ago and were allowed to invest accordingly, you may not be so clever to be long the markets.
Consider the following headline summation from your time pod: a dysfunctional U.S. government with no site lines of a balanced budget; complete disarray in domestic affairs; the geo-political fires engaging 1/8th of the world’s population; the economic slowdown, if not outright recession, of the United States largest trading partner, the European Union; and as we have elaborated, the potential for global trade retaliations with two of the world’s largest and most appropriated military powers. You might even be massively short expecting a lotto type payoff once you arrive on the other end of the time warp. You would either be disappointed, broke or both.
If you were short given this parlay of negative news, you may be tottering swiftly to your local pharmacist seeking refills on Zoloft, Prozac or Praxil. You may be wondering why you are seeking aide from the depression of not correlating the news with the stock tapes. Your stock psychiatrist may offer you a big comfy couch to cuddle up in as he tells you the story of this day’s sudden epidemic of insanity. Dr. Droid, in a calming baritone voice absent of inflection, proceeds as follows:
“The laws of economics have been altered with a policy known as ZIRP, which is an acronym for Zero Interest Rate Policy. Because of ZIRP, there is no yield in fixed-return assets. But contrary to the wisdom of Samuelson, Hayek, Rothbard or Friedman there appears to be no duration risk of owning bonds either, so they are a nice safe haven if
you are a wee faint about owning equities. The more adventurous seekers of yield have all gathered in equities. You can hear their chants, “there is nowhere else to go” and “buy the dips, stay long and strong” … they’re like zombies and they’re circling the planet. These zombie-like investors have no fear either as they know they will live on forever. You can see their complacency in the charts from the old textbooks; implied volatilities of nearly all asset classes are hovering in single digits; there is massive option compression of premiums; short sellers of option puts are going out the expiration curve and nearer to the money than ever before; there is no fear of tail risk as the world is apparently absent of black swans once again.”
Dr. Droid continues, “the world is awash in liquidity at near zero costs of borrows. Merger and Acquisitions are now accomplishing net positive return arbitrage from day one. The incremental increase in earnings for the acquirer is higher than their cost of capital; the acquiree’s are fat and happy with the acquisition premium paid to their shareholders; and the newly merged company now controls a much larger part of their respective markets competitively. Everyone wins!”
Finally Dr. Droid ends with “the Federal Reserve is now controlled by Keynesian’s and they are running this experiment that not even Mr. Keynes could have conjured, but they still give him tribute. The only thing is that none of the board members know how these chemicals might react once their exposed to the sunlight. It’s really fascinating! The Fed members also found a new phrase to confuse Congress with … it’s called “macro prudential” … it’s an Orwellian term to make sure Congress doesn’t ask any questions, implicitly trusts their guidance and quashes any idea that Congress may have snooping around in an audit. Yes grasshopper, nothing could go wrong. You may have read my recent WSJ article that “Selling on Bad News is for Losers?” Now, did you need a prescription refill? Your hour is up … next patient Nurse Hatchet.”
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The Professional Traders Opinion
Ronald M. George
William J. Taylor
