Outlined below are the key highlights from our recent conference call with Jim Rickards. While we don’t necessarily share all of his views, we definitely found him to be very thoughtful and his perspectives insightful. A key non-consensus perspective he has is a bullish view on the Euro.
The replay is below:
Summary of Jim Rickards’ Hedgeye Call, 8/29/2012
A) Philosophical View of Chaos Theory
Rickards introduces his topic of “Currency Wars, Capital Markets & Geopolitics” by saying that capital markets are a complex system, grounded in complexity theory. To solve for this complexity one needs to know the dynamics of the system and determine a methodology for the system. While it may not be possible to have 100% accuracy in making predictions, what’s key is to get the method right and isolate larger significant factors to draw inferences and reach probable outcomes which lead to the most accurate forecast.
Unfortunately, a lot of economic and policy advisors, people on the Board of Governors, Federal Reserve staff economists, and people in the Treasury (to name a few) are using the wrong methods. They’re stuck with the thinking of Keynesianism and monetarism, which are simply the wrong tools for evaluation. Our job is to identify and utilize the right tools so that we can understand capital markets.
Capital markets are complex systems and there are four characteristics that govern them:
- Diversity – you need a lot of agents or participants and they need to be diverse from each other.
- Connectedness – how are the agents arranged, so that they can observe and perceive one another to figure out what the others are doing, or not?
- Interaction – if I do something does that affect what other people do, or vise versa?
- Adaptation – based on the experience do I adapt, do I learn?
Clearly capital markets fit all of these characteristics closely: Diversity (bulls and bears; fear and greed; long term vs short term; people operating using different currencies); Connectedness (Bloomberg screens, CNBC, Twitter, etc.); Interaction (buyers and sellers trading for instance over $1 Trillion in FX daily and Billions of shares on NYSE); Adaptation (funds close or adapt to the macroeconomic environment).
Complex systems however are not limited to the capital markets and can be seen in catastrophic events such as forest fires, earthquakes, and power grid failures, to name a few.
And what you get out of these systems are a couple of power tools:
- The Critical State – when the players in the system are arranged in such a way that they’re vulnerable to some kind of a collapse, what physicists call a phase transition (ex. Boiling water turns into steam).
- Emergent Properties – the whole is greater than the sum of its parts. That is to say, things come out of the system that one would not infer based on knowing all the pieces in the system -- what Nassim Taleb would call Black Swans.
The point is that we can put together highly predictable models and although we may not be able to name a Black Sway or exactly pin-point a collapse, we can come close in understanding the magnitude and narrow the timing of events based on our understanding of the scale of the system. Again, we will never have all the information to solve a problem, but a powerful way to solve a problem is to get one big thing right and draw inferences and hypotheses from it to narrow down a set of possible outcomes.
B) Obama’s US Dollar Policy
The starting point is that the US wants a cheaper dollar. In fact, it is a stated policy of the Obama administration to double exports in five years, which can only truly happen with a weaker dollar.
Bernanke and Geithner, with support from the White House, are out to cheapen the USD. However, this doesn’t mean that they’ll get a cheaper dollar because they want one -- the dollar has shown periods of strength over the last two years partly due to the fear trade coming out of Europe and changes in the Chinese policy stance.
Taking account of the recent political climate to reduce government spending and reflecting back to explicit comments from President Obama in his State of the Union address on January 2010 in which he outlined an Export Initiative policy to double US exports in 5 years, it’s clear that this administration (and its advisors) believe net exports are the only way to drive the economy.
While exports may be a much smaller part of the economy than say Germany, if you double exports that leads to a 1% - 1.5% increase in GDP, which could put growth towards 3%.
However, the only way to double exports is to trash the USD, so that is implicit in the President’s policy. Drawing inferences from two rounds of QE that have not resulted in the USD going down a lot, then you can expect that some level of QE3 is coming on September 13th to cheapen the USD.
C) Acceleration of the Money Velocity May be the Key Catalyst that Leads to a Tipping Point in Inflation
The Fed controls money supply, and although we saw huge spikes in money supply growth from the QE1 and QE2 programs, over these same periods the velocity of money collapsed. (This of course bucks the assumption held by economists that the velocity of money holds constant). In fact, velocity is something the Fed cannot control and if velocity is crashing so is GDP unless you can get some inflation in the mix. So the Fed is now very determined to attempt to change velocity but this is something that is a behavioral phenomenon. For example, if people are worried about their job they’re going to reduce spending and let their money sit in the bank. Conversely, if people are optimistic they’ll spend more freely and maybe take their friends out to dinner.
There are two ways the Fed is going about trying to manipulate velocity. First, it will try to create negative real rates (that is to say to get inflation rates higher than nominal rates), which is a huge incentive to a borrower. Second, it will attempt to deliver an inflationary shock to scare people into spending money. While Bernanke may say he is targeting 2% inflation, what he really wants is closer to 4%. Essentially, Bernanke is setting a target (an expectation) which he’ll then beat to change expectations and create the shock to change behavior, and spark, for example, a consumer buying a new refrigerator now before rates move higher.
Keep in mind the Fed wants to get to 5% nominal growth. While under ideal conditions this could be achieved with 1% inflation and 4% real growth, under current conditions Bernanke is willing to take 4% inflation and 1% real growth.
And of course the easiest way to get more inflation (to get 5% nominal growth that is imperative to pay off nominal debt) is to cheapen your currency. The only problem we [all] should have with this policy to import inflation via currency debasement is that the Fed thinks it is playing in a linear world (like the impact of turning the dial on a thermostat to the room’s temperature); the Fed is actually playing with a nuclear reactor, in which dialing up or down the reactor can result in a catastrophic meltdown.
D) Contrarian View of the EUR/USD
Rickards has been bullish on the EUR/USD for a long time, and ruled against those that think the EUR is going to parity or even $1.15. Over the longer term, he remains firmly of the opinion that no country is leaving the Euro, no country will be kicked out of the Euro, and that new countries will join the Euro over time (for example Hungary, Iceland, Scotland, and others).
Specific reasons for this bullish view are represented by a triangle of the three major currencies: USD, EUR, and YUAN. Rickards already stipulated that the US wants a cheaper dollar. China has been under enormous pressure to appreciate the Yuan versus the dollar, but the Chinese don’t want to have the Yuan appreciate versus the USD and the EUR and be the biggest loser in the Currency Wars. Because it is a zero sum game and the USD is going to be depreciated and the Yuan is going to be capped or pushed lower, there’s no other way than for the EUR to appreciate. And you can’t have a cheaper EUR than the USD because the US has a bigger printing press!
Further bull cases for the EUR:
- Germany realizes that it must have slightly higher inflation rates to compensate for low to negative rates in the peripheral countries. To do this, Germany will increase its unit labor costs (which historically have been much lower than the periphery’s) which should help to balance out inflation/deflation across the region and spur the common currency.
- China desperately wants to diversify away from dollars and is looking to invest heavily in Europe (after the storm clouds clear from the sovereign debt and banking crisis).
- Huge cohort of youths, especially in the periphery, are hungry for work (especially for a first job) and will take entry level jobs at advantageous costs for companies.
- Europe has taken its austerity and will emerge stronger and ahead of the US, which has yet to take its austerity medicine.
- The IMF can print via STRs to bailout Europe/restore confidence, if needed.
E) The Four Horsemen of the USD Apocalypse vs the Upside in Gold
Since 1980 the US has not been on a gold standard, but a dollar standard. In the last 10 years the USD has declined from 70% of reserve currencies to 60%, which still provides a tremendous anchor for global currencies to be pegged to. It would be a very unanchored world if reserve currencies were split say 40% USD, 40% EUR, and a remaining 20% mix of Swiss Francs (CHF) and other currencies.
But, under a scenario in which you get a collapse of economies, countries may be forced to a gold standard. And this would have drastic price appreciation consequences. Looking at gold prices based on global monetary aggregates, an ounce of gold (based on M2 money supply metrics) could be worth as much as $44K!