Con-tango

A 2007 recession?

Paul Krugman

To start, I
urge you to visit Mark Thoma’s blog to take note of the comments sparked by
Paul Krugman’s… 2007 recession prediction in his New York Times
article of 1 December 2006. As a matter of fact, I
strongly recommend reading
all his early December posts, they all touch quite unsettling themes:
the USD
demise ,
the folly
of the war in Iraq and
the wall
to Latin American relations.

But, let’s first home
into Krugman’s statements:

How serious a slump is the bond market
predicting? Pretty serious. Right now, statistical models … give
roughly even odds that we’re about to experience a formal
recession. And since even a slowdown that doesn’t formally qualify
as a recession can
lead to a sharp rise in unemployment, the odds are
very good — maybe 2 to 1 — that 2007 will be a very tough year.

Luckily, we’ve got good leadership for
the coming economic storm: the White House is occupied by a man who’s
ideologically flexible, listens to a wide variety of views, and
understands that policy has to be based on careful analysis, not gut
instincts. Oh, wait.

I
was surprised to find comments arguing that the US economy is moving
at a healthy clip. I fail to see any significant change in the
ongoing deterioration of the US economy, caused by the encroachment
of the globalization and the wasted resources in the war.

A
picture is worth a thousand words, and this is the deflationary chart
which underscores the Chinese et al low wage (3-4% of US
manufacturing wages) effect on world prices:

As
a matter of fact, I find the PBS
series on Wal-mart very
enlightening. It’s
interesting to see how Sam Walton’s unrelenting policy of searching
for the lowest possible prices and transferring the benefits to their
customers, allowed Wal-mart to grow from 30 stores in the ’70s to
3,500 nowadays… or to achieve a market growth from $1 billion to
$250 billion in sales. So, at the heart of the globalization we find
Wal-mart and a few discount retailers (Sears, Target and others …)
taking the control away from manufacturers and dictating that
they should outsource to lower cost regions in order to
survive; which I feel was unavoidable… once the risk to invest in
China was minimized by the guarantees underlying the World Trade
Organization agreements.

In
Who
calls the shots? by
Hedrick Smith, Gary Hamilton summarizes the situation best by
stating:

Instead, the experts tell us, these are self-inflicted
wounds. American companies played a central role in the rise of China
and the Asian Tigers. The seismic shifts in the global economy, they
say, have been largely driven by American companies — not just by
multi-national manufacturers like GE or Hewlett Packard moving
production overseas, but by giant American retailers like Wal-Mart,
Target, Kmart, Toys "R" Us and Home Depot, and brands like
Nike or Liz Claiborne galvanizing Asians to export to the U.S.

The Americans, they say, have gone well beyond merely
hunting for bargains already being produced in Asia. In fact, both
academics and business executives report, American retailers have
actively driven outsourcing — teaching East Asians how to design and
manufacture products for American consumers, creating their own house
brands in league with Chinese and Asian producers, and then bluntly
warning beleaguered U.S. manufacturers that they’d better move their
American plants to China and Asia if they want to survive.

Years of extensive interviews with Asian and American
manufacturers, as well as study of trade flows, have persuaded
Professor Gary Hamilton of the University of Washington, that the big
box retailers, epitomized by Wal-Mart, have been "driving a
massive restructuring of production worldwide; moving jobs from the
U.S. and Europe to Asia. They do it by setting price points and
forcing suppliers to meet their targets. Only lowest-cost labor can
meet their targets, and that means producing in Asia."

In
other words, at a 3 to 4% of the US manufacturing wages, Chinese
manufacturing should… continue to bite away market share from the
US et al; and as much as Wal-mart surely hates the erosion of their
western suppliers… as well as their customers, what can they do?
…it’s a truly unavoidable train wreck.

In regards to the
war, I hadn’t read a more poignant remark criticizing Bush than the
following in Paul Krugman’s Two
More Years :

At a reception following the midterm
election, President Bush approached Senator-elect James Webb. “How’s
your boy?” asked Mr. Bush.

“I’d like to get them out of
Iraq, Mr. President,” replied Mr. Webb, whose son, a Marine lance
corporal, is risking his life in Mr. Bush’s war of choice.

“That’s
not what I asked you,” the president snapped. “How’s your
boy?”

“That’s between me and my boy, Mr. President,”
said Mr. Webb.

…and
I’ll leave it at that.

And
although Robert Reich makes a pass at the case for a weakening USD
here –which eventually is the only possible
outcome for the USD, the question is: when? I’m still a firm believer
that a demise is too harmful for all parties involved, hence, I
would… stick to assets and distance myself from paper.

But,
trading is about following the trend –wrong or right, and I like
Anatole Kalesky’s take in The London Times; which in summary
states:

This is unanimously bearish about the dollar
and wildly enthusiastic about the euro and, to a lesser extent, the
pound. This contrast suggests that the dollar is about to turn,
perhaps in a very big way.

The irrational bias in market
sentiment does not, however, tell us when the trend will turn — or
at what price. And until the trend does turn, investors who try to
fight it risk losing their shirts. And how do we know when the trend
has turned? Some years ago Brian Marber, one of the City’s
best-known and most-respected currency analysts, devised a rule for
assessing trend changes that has, on the whole, withstood the test of
time. Marber’s law states that when a currency reaches within 1 per
cent of a previous important high, it enters a “twilight zone”
from which it could easily emerge in either direction — and as soon
as it does emerge, with a move of 2 per cent or more, that
establishes the new trend.

Last week the dollar entered the
twilight zone against sterling. If the pound now rises above $2.06,
it will keep moving upwards. If it falls below $1.95, it has nowhere
to go but down.

So what should the investor do? Hedge your
bets until it is clear whether the pound decisively breaks through
the $2 barrier. If it does, it could well go a lot higher in the
short term. But if the pound tests the $2 barrier and then falters,
it will be time to take a flutter, if not mortgage your house.