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Tuesday, September 02, 2008

Pound Is Too Low, Oil Is Too High

I'd be really surprised if the pound isn't substantially oversold at this point.

Look, I know I'm not that swift in these matters. My motto is "I BE STUPID", which actually doesn't sound half bad in pig Latin. The only problem is that it appears that others are often effectively even stupider, so I am left largely to my own economic devices. In the country of those who think they are brilliant, the person who knows she's stupid can do pretty well for herself.

And I know that the UK economy is weak to say the least. But the UK economy is not as weak as the Eurozone, and when I look at the relative values of these currencies my eyebrows just want to fly right over the top of my head, which is uncomfortable. The UK is a largely service-oriented economy with a heavy concentration in finance, so it is true that the current conditions are difficult for the UK. But the UK is also a refuge economy for foreigners who have money and want to take it somewhere safe, and that will play in its favor over the year to come.

Darling's comments and the OECD recession prediction have provided a lot of fodder for traders, but the reality is that the Eurozone contracted in the second quarter, while the UK remained flat. Relatively speaking, the UK economy has depended less on construction and homes (although not so for Ireland) than the high growth economies of the Eurozone in the past years. Therefore, the UK is actually somewhat better placed to weather current conditions if it were not for the overload of consumer debt. However, that same overload is present in some of the Euro economies, and it will not overcome the foreign refugee effect.

As for oil, we have considerably further down to go. At one point this morning dated Brent spot was down to $104 and change. I note that oil seems to trade lower overnight and always rise when the US markets get going, so I am assuming there is an Al Gore factor still in play.

But oil will drop until energy consumption can be sustained without eroding world economic growth, and that point is still well below $95. I don't know where it is, but it is clearly significantly lower than $95. I have been watching the Asian energy moves very closely, and several economies have walked back from their previous reforms. However this is not going to sustain demand, because the damage to budgets is real, which weakens their currencies. We are getting closer and closer to a reprise of the Asian currency crisis, and people are worried enough that less external investment is going in as these currencies get riskier, which is reinforcing a negative cycle.

Malaysia is just one example. India does not know how to handle the situation either. I have been following their struggles and negotiations with the energy companies, and frankly, they appear all out of remedies. Needless to say, both the ringgit and the rupee are dropping against the dollar. UBS is now recommending buying an Asian basket of currencies against the Euro, which is perhaps rational except for the reality that Euro weakness plus limited US imports = additional Asian economic weakness.

As for the Indonesian economy, much of the analysis has been faulty to the point of insanity. In mid August, this was one diagnosis:
Indonesia’s economy grew a higher-than-expected 6.39 per cent year-on-year in the second quarter of this year, thanks to high commodity prices, strong consumer spending and robust exports.

The figures will give a boost to President Susilo Bambang Yudhoyono as he unveils the government’s 2009 budget on Friday. Ministers say this will include a 55 per cent increase in funds for poverty alleviation programmes and a significant expansion of the education budget.
Uh-huh. Strong consumer spending along with inflation running considerably higher than GDP growth, eh? That's usually not very stable. A few weeks later:
The Roy Morgan Consumer Confidence Index dipped another seven points in the April-June quarter to 102, the lowest since the national survey began in Oct. 2004.
But a national index of 102 masks the real picture.
In negative territory since April 2006, the rating for Main Income Earners bringing in less than Rp 600,000 per month to the household is now at an all-time low of 87. The urban poor are in worse shape than their rural cousins.
I still stare in awed fascination at much of the energy analysis of the past six months; a range of people who should have known better seem not to have grasped the reality that the dollar's weakness was limited by the need to buy more dollars as oil prices rose and that inflation trends in Asia were going to cut short the growth in internal consumption as the inequality in Asian incomes abruptly took over the cycle. The same is true in India and China. These countries now have to cut inflation or raise incomes, but they don't have ability to do both, and some don't have the ability to do either.

Somewhere around 1.30 the Eurozone gets a relative competitive boost, but until they get there there may not be much of a floor. However, the situation in the Gulf, the collapse of some of the RE bubblier stuff there, and the need to search for stability plus safety is likely to support the pound above current levels over the longer term.

The world bright spots are the US economy, which is not all that bright, some of the South American countries, and some of the European escapees from the Soviet bloc. There's not much oomph here. We appear to be in the first stages of a world recession, no matter what the OECD thinks, and that is good for the British pound.

Tzar Putin will make the EU a risky proposition for the foreseeable future.

The weird thing is that "cutting off" the US would be a nasty shock here but ultimately fatal to the suppliers. No foreign energy (assuming Mexico and Canada are not "foreign") pumps(love the imagery) tens of billions back into the North American economy since it would have nowhere else to go.
The fall in the pound could be a response to the collapse in the London housing market (just starting its long slide) and to the impact that will have on the British financial sector and the Bank of England's rates. Mish Shedlock has been saying for weeks that the pound and Euro were poised to slide and that there would be a dollar rally.
Dollar/Yen carry has me permanently mystified.

The implication of your post is that emerging markets will start losing their current account surpluses.

Tight money made China slow, but it also ramped their capital flows. So now they appear ready to reverse course. What's the impact of lower rates on their current account? Negative, since hot money flows would slow. This hot money came in not just because of the carry trade, but also in expectation of a remimbi reval which looks less and less likely.

We're at a juncture here. The U.S. economy has been driven by dollar recycling for most of the decade. As emerging market current account surpluses fall, so will dollar recycling end.

I know I harping on this, but what what's the relative impact of current account adjustment on global economies? The answer is it would hit the U.S. -- by far -- the hardest.

Picture our economy with a 5% savings rate. It really is as simple as that. Only, of course, the Fed would drive up inflation before allowing the savings rate to reach that level.
David - the impact of declining exports and increasing budget deficits is particularly hard on manufacturing-dependent economies with poor domestic income distributions.

There is no question that the US MUST redress its own current account deficit, which is why the energy question is so huge. But the US has a lot of wealth distributed in the population in comparison to many of these economies. Also, there was an investment bubble in some of these economies and we are seeing an adjustment down from that bubble.
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