Saturday, February 27, 2010

One Possible Future - Ari Paul

I’ve discussed the challenges facing the US, EU, and China many times. Today I’ll discuss some possible outcomes to their problems and how we can position for (or at least hedge against) these possible futures. When discussing anything beyond the immediate future, we always need to maintain a great deal of humility. So, view these less as predictions than as possibilities.

As I read experts debating the future of the European Union, they seem to talk past one another. The EU bulls basically argue that the EU is politically committed to maintaining unity and will do whatever it takes to avoid dissolution. There are some extreme bears who argue that a break up is inevitable, but most simply argue that the EU is unsustainable given its current labor dynamics. An outcome that would thread the needle between many of the smartest bulls and bears is for the Euro is devalue significantly but remain intact. The heart of the problem of the PIIGS (Portugal, Italy, Ireland, Greece, Spain) is that their labor is uncompetitive both compared to other EU members and the world. If the Euro fell by 25% vs all other currencies, this would cure half the problem. The PIIGS would then be competitive relative to the rest of the world, although intra-EU disparities would remain. The result would be that Germany would become super-competitive and likely start accumulating large reserves. That would eventually cause problems, but they would be less pressing and less severe.

What about China? China’s artificially cheap currency has caused a trade imbalance with the US, but it has kept inflation in check despite massive credit growth. If China revalues its currency upward, that could eliminate the trade gap by increasing Chinese consumption, but that same consumption could cause severe inflation. The inflation would probably be most severe for domestic Chinese assets like real estate and equities that are only listed domestically. Alternatively China could have a deflationary collapse, but the threat of severe inflation makes me disinclined to short anything Chinese, even real estate assets that are already at bubble values.

Now for the US. Bernanke’s latest play has been to secretively shift money printing powers to Fannie Mae and Freddie Mac. The Federal Reserve will wind down its mortgage purchases in March, but Fannie and Freddie have been granted an infinite cash line and have stated they may increase their mortgage purchases. These mortgage purchases are very similar to money printing because they raise real estate prices (or prevent further collapse), and keep interest rates artificially low in all sectors of the economy. They are also a giant subsidy to banks because they provide generous risk free profits; the banks are continuing to make home loans to uncreditworthy borrowers, but they then sell the loan to Fannie for a profit. Fannie recognizes a loss on the loan, but gets a capital injection from the treasury or a free loan from the fed. What this means is that even if we experience a double dip recession, the constant money printing may continue to inflate asset values (or at least soften the collapse). Because of the risk of severe inflation mitigating an equity collapse, I like hedging my large short equity position with a small long agricultural commodity position. Why agricultural commodities instead of gold or oil? I believe the secular fundamentals of agriculture are very strong, and unlike gold, these commodities are less obviously pricing in significant inflation. In other words, I’m getting a less direct inflation hedge but at a much better price.

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