THE SKEPTICAL INVESTORTM

Issue No. 6. November 1997

Posted in parts


Finding myself behind in my self-imposed writing schedule, and with the November Issue rapidly threatening to become the December Issue, I have decided once again to post The Skeptical InvestorTM in parts, as and when they are completed. Please bear with me.

CONTENTS:-

Asia Watch (Posted 28.XI.97)

In the great Greek and Shakespearean Tragedies, the hero progresses, inevitably, towards destruction. To the audience, the eventual outcome is obvious, indeed, this sense of our helplessness in the face of impending doom is what draws us into the plot. But the hero himself remains unaware of what must happen. His sufferings and eventual fate are not merely "slings and arrows of outrageous fortune" but a direct outcome of a fatal flaw in his otherwise noble character. In most tragedies, this flaw is an overweening pride. The Tragedy is an exploration of hubris.

All these elements are present in the economic Tragedy now unfolding in Asia. There is the noble hero: the hard-working, productive, disciplined Asian worker and manager. And economic hubris has been present in scads: nothing could go wrong. But, to me, the greatest resonance of true tragedy has been the inevitability that, as audience not participant, I have felt throughout as the drama has unfolded.

And the plot has not yet progressed to a conclusion. There is more to come in this play.

Back in June of this year, when I wrote the first Skeptical InvestorTM,anyone reading the (western) established press may well have been totally unaware of the problems then starting to become apparent at the periphery in South East Asia. Now, only five months later, the region is at the forefront of the news, and anyone can read about what is happening there in their daily newspaper. In view of this there is little point here in presenting a chronicle of recent events: so instead I will try to stand back and offer a broader, different, and hopefully more predictive perspective than that you will find in the regular media.

The International Bail Outs. (posted 28.XI.97)

The International Monetary Fund (IMF) was established at a conference held in Bretton Woods, New Hampshire, USA, from July 1-22, 1944. It came into official existence on December 27, 1945, when 29 countries signed its Articles of Agreement (its Charter), and commenced financial operations on March 1, 1947. It now has a membership of 181 countries.

The IMF provides various services to its members. Technical assistance is offered in monetary and fiscal matters, and it also carries out what it calls surveillance, which is "the process by which the IMF appraises its members' exchange rate policies within the framework of a comprehensive analysis of the general economic situation and the policy strategy of each member" (Ref: IMF Web site). But the service of which most people are aware is the financial assistance (credits and loans) extended to member countries with balance of payments problems. Financial assistance, which is usually in the form of short- to medium-term repayable loans, is provided "to support policies of adjustment and reform" i.e. the money is there to meet immediate needs while the recipient's economy is restructured.

This approach can be very effective. The IMF is always extremely tough minded--which of course is the reason that the South Korean government resisted so long, unsuccessfully attempting instead to get direct aid from America and Japan, and why the Malaysians refuse to even consider it. In consequence an IMF aid package, though it may be very hard on many of the residents of the country concerned, carries with it enormous credibility. It is very effective medicine, and thus ought to boost the confidence of creditors and investors: an absolute essential to prevent a further slide and pave the way for eventual recovery. There is though an important assumption in all this. It is that the root causes of the problems that are besetting the nation concerned are mostly or entirely domestic.

What if, speaking hypothetically, the causes are primarily external? An IMF package may then provide temporary relief, but obviously in itself it is not addressing and correcting the international forces that are the real causes. In a worst case where the problems are symptoms of deep-rooted systemic global economic forces, country-by-country action by itself will have no more overall effect than the manipulations and gyrations of our national governments have had in the past in artificially intervening in and manipulating our economies in the face of implacable market forces.

We are touching here on the nub of the problem of divining the course and global implications of the events in Asia. Are major underlying causes global or are they essentially domestic? If domestic, then the analysts who project the effects on the rest of the world in terms of current trade balances and business sectors will likely not be far off the mark: the earnings of some corporations will decrease, a tenth of a percent or whatever will be shaved off the GDP of this or that country, "irrational exuberance" in the USA will decline a bit --a good thing too--and all will turn out well. But if they are global, then the picture is much bleaker.

In the last couple of months, I have been assailed by reports and news items that clearly make the assumption--without supporting it--that the problems of the Asian nations are domestic. A typical example is this editorial from our local daily newspaper :-

Whether it is bad debts, corporate losses, political cronyism, weak bank regulation or a lack of respect for human rights, the countries now in trouble have largely got themselves there by hiding things.

(The Chronicle-Herald, November 27th 1997).

The fact that all these things were there while the Asian countries were booming does not seem to have struck the editorial writer. There is an element of truth in them of course, nothing in economics is simple, but it is difficult to make a case for them as the ultimate cause of the problems. Such arguments are little more than misleading rhetoric. They spring from a left wing Western mind set, not economic analysis.

You will find such "explanations" throughout the media and financial press, especially in Canada and the USA. The European press has been more thoughtful, while the Asian (and Australian) press--being more directly aware of the harsh realities--has often sounded closer to my own position.

Among the pieces of evidence that I can offer in support of the importance of non-domestic factors being driving forces are firstly (1) the obvious"domino effect" as one country after another has succumbed. This is much more than the kind of (initially short-term) reverberations felt by, say, the European stock markets. It indicates an underlying systemic problem, and the suggestion that all of these economies are suffering simply because they all share the same domestic weaknesses, is an argument that, for me, is hard to swallow. What about Hong Kong? And now Japan? Both are very different in many important ways from Thailand, the Philippines, Malaysia and Indonesia, but both have been affected.

Secondly (2) is what the actual economic response has been to the IMF bail-outs so far being negotiated or in place.

Considering that IMF packages are potentially such effective medicine for sick economies, I will argue that any real evidence that such intervention is not working also constitutes evidence--not proof mind you--that important underlying problems are external in nature.

At this point (end November) early evidence is that IMF intervention in several countries has not arrested the slide. ( I know that it can be argued that things would be much worse without them. But that is untestable. And it is not the point anyway.) IMF intervention in the Philippines,Thailand, and Indonesia, and anticipated help for South Korea, has neither prevented the effects of the crisis from spreading, nor even prevented further deterioration in the nations concerned.

Now that the crisis has spread to much bigger countries, the nation where the problems first surfaced--Thailand--is no longer front and foremost in the news. But it was the first, obviously has importance in the mosaic, and is a pointer to what may happen elsewhere. Despite a $17 billion IMF-led assistance package, its currency and stock markets have continued to slide. By last night (28th Nov ), Bangkok's SET Index had fallen to yet another new low of 395, off 77.5 % from its peak ( 1753 ) in 1994. On the same day Moody's Investors Service cut Thailand's sovereign debt ratings to one notch above the level for junk bonds.

And consider South Korea. When this nation's currency collapsed in mid-November and it too had to throw in the towel and go cap in hand to the IMF, the announcement that it was seeking a $20 billion package was followed not by stabilisation but instead by further financial and economic chaos. Amidst panic selling and demands that the markets be closed, by last night the KOSPI had collapsed to a low of 412, the lowest level in more than 10 years. (Note added 29th November: the KOSPI fell further to 408 in the abbreviated Saturday trading session: down 17% in one week.) The stock index (High = 1138 November 9, 1994) has fallen 37 percent so far this year. The recent plunge was led by bank stocks, which began falling sharply after Moody's downgraded South Korea's foreign currency ceilings for bonds, notes, and bank deposits.

I must emphasise again that none of this constitutes proof that the IMF packages are not working. It is suggestive though and for investors attempting to assess the severity of the Asian crises I suggest:-

Point 1: Watch not only whether the crisis continues to spread geographically but also what is happening in those economies that receive IMF help.

My own view remains as follows. Systemic global forces--especially the movements of capital being engendered by the strength of the USD--are the important factors. The Tragedy that we have watched playing itself out upon the global stage probably has several more Acts in store.

Point 2: with the crisis in Asia still fluid, I do not see any evidence that it is yet the time to "bottom-fish" any of the equity markets there.

Japan (posted 30.XI.97)

Events in the last month have lent increasing credence to my stated outlook. Within the five weeks subsequent to the Nikkei 225 falling through the 17000 level (see Issue No. 5 October 1997), four financial firms have collapsed. The yen too has weakened against the dollar and the major European currencies. The timing of these events shows them to be correlated with the ongoing regional chaos. Given that the situation elsewhere in Asia continues to deteriorate, it is reasonable to assume that we will see the same in Japan, and I will be very surprised indeed if no more financial firms go under. I also expect that the country (which has been experiencing low but positive growth for several years) will slide into recession, but it is too early to predict whether this will be as far as things go. If the worst that happens is a mild recession, then it is likely that the western economies will experience nothing more serious than some slowing of growth. But a severe deflationary recession or depression in Japan will, as discussed in previous Issues, be very damaging here too. The Japanese economy certainly now looks to be the key, and it is too big for the IMF to bail out so for some time it may be wise for those of us living and investing in the West to listen as carefully to Tokyo as we do to Alan Greenspan in Washington.

It has been pointed out by some commentators that Japan is different and the problems there are not the same structurally as those being experienced by other Asian nations. This is certainly true: particularly in that they are facing huge external foreign currency denominated debts whilst Japan has huge reserves to draw on. But remember also that it is facing the current crisis before it has recovered from the collapse of its own 1980s bubble.

One of the things to watch for in gauging the underlying severity of their financial problems is evidence that funds are being redirected from international holdings to domestic needs. In the initial stages, this will not be from the strong currencies (USD, GBP, DM, etc.). Weak currencies including the Australian and Canadian dollars are the vulnerable ones: these may prove to be leading indicators.

What is Japan Doing? (posted 1.XII.97)

The Nikkei 225 climbed back above 17000 by the close: this partial recovery has been driven to a considerable extent by finance stocks. Apparently what is behind this is the belief that government is about to abandon its long-standing position that it would not loosen fiscal policy to stimulate demand. This was an election promise, but there has been frantic international pressure in the last couple of months for Japan to resort to Keynesian pump-priming to boost the economy. And the severity of the problems may have caused them to lose their nerve: I also wonder if some secret deal was made at the recent APEC meeting in Vancouver. Whatever has happened, this will be a dangerous course. The only thing that gets an economy going again is real business activity generating wealth through real enterprise. Government spending never has and never will succeed in stimulating productive activity: it is more likely to destroy enterprise. Worse, pumping liquidity into a dispirited economy increases the money supply whilst not increasing total business capital--by which I mean productively employed money--and is thus inflationary. If such a scenario develops in Japan over time, the only choice may be to allow runaway inflation, or do an about face.

The United States (posted 1.XII.97)

There is nothing mysterious in the apparent paradox that America* can experience a growing economy, even potentially inflation, whilst at the same time being inextricably woven into a deflating global environment.[* and the United Kingdom too]

The flow of capital--driven by both the strong dollar and by the risks of Asia and elsewhere--has continued to support Wall Street and has also driven down US government bond yields. Equity investing by domestic investors, as evidenced by net mutual fund inflows, was reduced for a while, but many investors now appear to be convinced that the overseas crisis has been contained. Many are anticipating a resumption of the long Wall Street bull market.

Alan Greenspan's remarks last month--which left no remaining doubt that the Federal Reserve considers US stocks to be overvalued--suggest that investors will worry about a preemptive interest rate hike if the DJIA looks like it is going to reach its August 6th high of 8259 again. I think this will limit gains. However a reader e-mailed me the other day suggesting that the market in 1929 seemed much more "frothy" than today. This can also be said of the Japanese market at the end of 1989, so I have to accept the possibility that we may experience a speculative blow-off. The ultimate economic consequences will be very severe if that is what happens.

Point 3: For now, I see a continuation of the well-established trend of strengthening USD assets. The dollar may strengthen further, US T-bill yields may remain around 6% or even fall, and stock markets are likely to remain range bound, though a final speculative blowoff is certainly a possibility.

Investors have, however, apparently lost sight of the fact that even before the Asian crisis, when everything looked to be going well everywhere, US equities were already grossly overvalued. One of the underpinnings of the New Era thinking that could be trotted out as--in my opinion spurious--justification for these valuations was the benign effects of globalisation. This has now been dealt a severe blow. Japan, Hong Kong, South Korea, Singapore and Taiwan together take almost 25% of American exports. Thailand, the Philippines, Indonesia and Malaysia take 4%. Thus almost 30% of exports go to the region directly affected. And the anticipated surge in exports from the region will further erode America's already bad trade imbalance. Just these facts alone ought to make the bulls take pause.

At some point it will all fall apart. I now believe that a fall of 40%-50% in average stock prices (rather than something similar to 1987) is the most likely consequence. By a very rough comparison with America (1929- ),Japan (1989- ) and SE Asia (1994- ) it should be a couple of years to bottom: implying late 1999. The Last Act.

Canuck's Corner (posted 1.XII.97)

Every year around this time I go along to the investment seminars offered by the major Canadian banks and brokerages, and listen to the (now predictable) opinion that the Canadian dollar is "fundamentally undervalued". I understand why this is believed, but have consistently disagreed: in the last thirty years Canada has been turned into a thoroughly socialist nation crippled by confiscatory taxes and every species of Politically Correct claptrap known to man. No state run on such lines can do well, and this one will continue to decline until there is real change. Canada survives now only because it is a huge country, rich in natural resources and with a small population. The much vaunted Federal deficit reduction has been achieved mainly through massive tax grabs: spending reductions have been restricted to a large extent to "soft targets" such as the Armed Forces.

The bank rate stood at 3.25% in mid-June. There have subsequently been three increases of 25 basis points each (June 26, October 1 and November 25), but, despite this and several bouts of direct intervention in the market, the currency lately slid to its lowest level against the USD in several years (now just above US$0.70).

Considering that I can remember when the Canadian dollar was worth more than the USD,it has suffered a secular decline over the last two decades of about 30%. The eighty cent dollar is a pipe dream.

I expect further interest rate hikes (the business press here seem to think another 50 basis points) just to maintain it in the US$0.70-0.71 range, or instead a further depreciation. Further speculative attacks are also likely.

The Canadian stock market is weaker than that in the US, and, in the event of a bear market or crash there will almost certainly suffer at least as much here. The Asian turmoil is bearish for Canadian resource stocks, which are overweighted in our main market indices (reflecting the economy).

Point 4: If you are a Canadian resident, consider the possibility of currency diversification to hedge against further currency weakness. Others, in my opinion, ought to avoid CAD denominated assets altogether.

Currency Diversification

A reader recently raised the question of which currency to park cash in for maximum safety:-

Question: One question that crosses my mind is that of the U.S. dollar. It would appear that investors outside the U.S. have chosen to park their funds in the USD as a ( temporary?) safe haven. This appears to have driven the U.S dollar to unrealistic high values in relation to other currencies world wide. I am tempted to take advantage of this artificial high and convert funds to a different currency. The problem, which one?

Response: "There is no totally safe haven. Have you considered holding a diversified portfolio of several currencies? Because their "values" are mostly just relative to each other, that may offer some degree of safety. And, if I am correct that we are entering a period of global deflation, the purchasing power of such a portfolio ought to increase. Those currencies that spring to mind include the Irish punt, which is very strong now; the Pound Sterling, which is also doing very well (the UK has a very strong economy and the pound is also seen as a "safe haven"from EMU and the Asian crisis); the German mark; the Austrian schilling; and the Swiss Franc (weak these days, but being near its recent lows versus the dollar some pundits think is a good buy. Maybe.). I would include the USD in my mix. I would not myself include any Canadian dollars. You can get quite good interest rates even on instant access deposits in most of these currencies (e.g. 7%+ on Sterling) from Offshore Building Societies in the Channel Islands or the Isle of Man*. Another strategy is to use an offshore Managed Currency Fund. Though that is for medium or longer term investments (they typically charge a 5% front end load). All this is just in my opinion of course, but I hope it gives you some food for thought." [Offshore British and Irish Building Societies offer currency accounts in Sterling, Irish punt, US dollars and D-marks. They are very safe institutions, well regulated, and set up so that you can conveniently operate your account by mail, or --subject to some common sense restrictions--by fax or telephone. These are interest bearing deposit accounts, not cheque accounts. Often used by international investors who are looking for reasonable interest rates combined with great safety. If you would like to find out more, pick up a copy of the monthly London (UK) magazine INVESTMENT INTERNATIONAL: it always has lots of ads and information about these institutions. As for managed currency funds there are many to choose from: the above mentioned magazine usually also has some information and adverts.]


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