Financial Contagions Spread Global Investment Dysfunction

By Daniel R. Amerman, CFA


Australia and New Zealand, as well as many other nations around the world, have caught an economic virus of sorts. This contagion is primarily being spread by Japan, the United States and the European Monetary Union, all of whom have undertaken increasingly irresponsible monetary and financial policies whose effects are proving communicable.

People are used to goods being in global competition, where the prize goes to those nations who produce the best goods at the lowest cost.  However, there is a loophole in this simple relationship, whereby cost depends on the relative value of a nation's currency, and that can be deliberately altered by a nation.

What we are now seeing among many nations is a rather twisted kind of competition. That is, whoever does the best job of cheating their own citizens out of the value of their savings and investments gains a competitive currency advantage, and thus a business and employment advantage.

And in this tightly interlinked world of globalized economies, a necessary byproduct of these competitive currency devaluations is collateral damage to the more or less innocent bystanders around the rest of the world.  Which then forces these nations into defensive measures.

As we'll explore herein, one of the most powerful countermeasures is currently being deployed by Australia, which is essentially to strip wealth from its own savers and investors, as a defensive measure against the United States, Japan, Europe and other nations who are effectively stripping wealth from their own savers and investors.

Once the process has started and a nation has been "infected", it becomes very difficult to opt out.  For a nation which fosters a healthy long-term investment environment for its own citizens by letting market forces rule, can then face a potentially acute competitive disadvantage as a direct result.  With the most vulnerable of all individuals being the citizens of the source economic powers, such as US investors.

What this means for individual savers and investors around the world, whether we're talking about the United States, Europe, Australia, Canada or elsewhere, is that the contagious spread of measures and countermeasures - even if the origins lie within the economic dysfunctions of other nations - can become one of the dominant determinants of your personal long term investment success. And that will apply even if you never leave your own country, never buy a security or investment from any other nation, or never have any idea that any of this is going on.

Japan's Quantitative Easing "Success"

When we look to our international contagion, Japan is in some ways the sickest of the major economic powers. It was the first major power to fall ill, and it has been a leader in adopting some of the dominant economic policies for the world today.

Japan has spent decades in a slow growth situation. Moreover, it has one of the oldest populations in the world, and it has some of the highest debt levels. At 240% of GDP, Japan's national debt exceeds that of the United States by more than two to one. These are among the reasons why Japan was the first (though certainly not last) major nation in modern times to introduce quantitative easing.

Japan faded into the background a bit with the rolling series of acute crises that have enveloped the United States and Europe since 2008, but has now again seized the global center stage and the "lead" by taking monetary and fiscally irresponsible policies to a whole new level. With the introduction of "Abenomics", Japan has openly declared that the political decision makers now have effective control over monetary policy, abandoning the fiction of an entirely independent central bank that's supposed to be insulated from politics.

That is, Japan is overtly creating fantastic sums of money out of the nothingness, with the stated objective of stimulating its economy and flooding the financial markets with cheap cash. There is also the public goal of artificially creating inflation, with the intent to openly warn global investors that the yen will be dropping in purchasing power.

The preliminary results of these radical new policies have been one of overwhelming "success". The yen did indeed plunge in value versus the US dollar, the euro and other currencies. This in turn has created a competitive advantage for Japanese corporations, who are expecting near record profit growth from both increased future exports and rising domestic consumption as a direct result.

Between mid-November of 2012 and mid-May of 2013, the Japan Nikkei index soared upwards by over 80%. This was a fantastic surge for a still dysfunctional economy, even though a good portion of the rally has recently been given back with multiple major downward movements over a two week period.  The yen has recently been climbing, and interest rates have moved up as well.

Nonetheless, over the last six months Japan's stock indexes are much higher overall, while the yen has a substantively lower value, and the yield on ten year government bonds is below 1%.  This is below Japan's inflation target, which translates to an intended negative real interest rate for investors.  So when we look at the bigger picture over the last six months, this explicit use of quantitative easing to slash the value of the yen - and thereby exploit the globalization "loophole" of relative cost being dependent on currency values - is working essentially as desired.

Competitive Financial Irresponsibility: Japan, US And Europe

Japan is of course far from being the only major power with a sick economy.

There is persistent high unemployment in the United States, which in reality remains close to 20%, despite the headline unemployment rate continuing to fall (with falling official unemployment being driven by workforce participation rate reductions rather than actual declines in unemployment levels). So the United States faces a combination of high unemployment, debt levels that now exceed 100% of GDP, and still formidable annual deficits despite the dysfunctional implementation of the sequestration budget cuts.

Europe is of course also caught up in an economic crisis with climbing unemployment levels, high debt levels, high annual deficits, and no resolution of the underlying issues.  Instead, the purported diminishment of the crisis is based upon the expanding powers of a European central bank that grow stronger every year. This gives the European Monetary Union expanded flexibility to implement its own quantitative easings, as well as the ability to intervene in member nation bond markets.

Indeed, Europe, the United States and Japan have tightly interrelated monetary policies, as they try to recover from their crises even while jostling for economic advantage. When Europe got very sick last year to the extent it was a candidate for potential breakup, the United States and Japan were not aggressive at all, for the financial world needed stability.

Then, the day after the German High Court cleared the way for expanded central banking powers for the European Monetary Union, the United States announced Quantitative Easing Three with its creation of $85 billion per month out of thin air. This was an immediate - and largely successful - attack on the value of the dollar.

The round robin continued as Japan reentered into this twisted competition of undeclared currency warfare, with the most powerful offensive against its own currency of any of those nations.

Now this has been quite "successful" for Japan so far, which creates the incentive for other nations to respond in kind, which in turn creates the real problem here. Which is that attacks against your own currency only work when you're better at it than the other nations are. Each ratcheting up will then invite a new level of counterattacks, and the European Union, the United States and China may all go after the values of their own currencies in response to Japan's campaign.

Punishing The Innocent Bystanders

As the major economic powers alter the value of their own currencies in a competitive attempt to recover and gain the advantage, other nations whose problems may not have been nearly as bad (indeed their economies may have been thriving) have not been immune to its effects.

Examples include Australia and New Zealand, as well as many Asian nations. While a country such as Australia has its own substantial economic issues, it is in relatively better shape when we lower our standard for comparison to that of the ailing economies of the United States, Japan and Europe.

The world is flush with cash right now, even while investment opportunities are quite poor when compared to the decades prior to the crisis of 2008.  And let me suggest that this situation of plentiful cash combined with scarce opportunities is no coincidence. Rather it is the direct result of massive government monetizations and market interventions.  The investment climate in the United States, Europe and Japan consists of a combination of weak economies and fundamentals, very high debt levels, artificially introduced inflation, and near zero or very low interest rates.

From a long-term, fundamentals-based perspective for investors, this is a toxic 1-2-3 combination.  With 1) artificially low interest rates, and  2) equity markets that have been pushed artificially high relative to profits and the state of the economy, investors risk buying high and selling low, even as 3) the major nations of the world are competitively attacking the value (and purchasing power) of their own currencies.

So, quite naturally, the response of many rational investors has been to try to pull out of this hazardous environment, and find a healthier investment climate.  They will seek nations in which interest rates are higher, the currency isn't under attack, and in which there are healthier fundamentals for the economy in general - and for corporate profits in particular.

Which leads to money pouring in from around the globe into places like Australia, New Zealand, Thailand, South Korea and elsewhere.  And as the money pours in, the Australian dollar (for example) climbs in value.

This situation isn't all bad for these "innocent bystander" nations, particularly in the short term.  After all, imports just got cheaper, including energy, food, and finished goods.  Which allows a somewhat higher standard of living to be enjoyed, at least by those who have jobs.

However, cheaper imports mean that domestic industries lose domestic market share, as firms are undercut by lower cost competitors around the world, who have been aided by the soaring value of the local currency.  Meanwhile, the nation's exporters are now handicapped by that same soaring currency, making them globally less competitive, and they begin to lose market share to foreign competitors.  Employment begins to shrink at companies serving foreign markets as well as those serving domestic markets.

So the very act of money escaping from dysfunctional financial systems and migrating to a nation with a healthier investment climate, serves to decrease the latter's corporate profits while potentially increasing unemployment.  The contagion has jumped from the sick to the relatively healthy, infecting the new host with slower economic growth.

Falling Values & Climbing Prices

This fundamental deterioration is not necessarily reflected in share prices and other asset prices, however.  Quite the reverse in some cases, for the money pouring in needs to go somewhere, and that may be into investment assets.  Thus stock markets may climb.  Companies may be purchased at healthy premiums.  Farmland and rental properties may climb in price. 

The local single family housing market may in some cases start to see rapid growth in prices, creating new homeowner wealth around the nation.  Housing starts may jump and construction jobs grow, partially or even entirely offsetting the fundamentals-based job decrease in other areas (at least for a time).  Again, for perhaps a few years or more, the flood of foreign money can create a surprisingly pleasant situation for many residents, with the appearance of prosperity.

Rapidly rising asset prices may create their own weather system, drawing in hot money from around the world and feeding the firestorm, as rising currency values and rising asset markets work together to create double-barreled profits for foreign investors.  Asset bubbles are created, potentially in multiple markets, as fundamental economic health is replaced by the easy money of a speculative boom. 

The discrepancy grows ever greater between the fundamental economic health of the nation, and the prices paid for the assets of the nation.  This sets up a potentially catastrophic bubble collapse at some point, with the particulars of the collapse potentially being driven by foreign investors, and outside of the control of the citizens of the formerly healthy nation.

In an attempt to slow down the inflow of foreign money, avert asset bubbles and/or protect domestic jobs, the nation is likely to take defensive measures.  New Zealand is choosing direct central bank currency interventions, a traditional method that can be expensive and not nearly as powerful as some of the currency warfare tools being deployed by other nations today.  According to Frederic Neumann of HSBC in Hong Kong (per the New York Times), "South Korea, Hong Kong, Taiwan, Singapore, Malaysia - all have tried to restrict lending because of the rapid inflow of cash."

Australia and Thailand have chosen the more fundamental method of artificially lowering interest rates in order to make their nations less attractive for foreign investors, and thereby reduce both currency values and the rate of capital inflow. 

When a nation like Australia repeatedly lowers interest rates as a currency defense, we have a full spread of the contagion from the sick source nations to the new host nations.  Lower fundamentals for economic growth, combined with artificially high asset price levels (meaning lower future price appreciation potential), along with artificially low interest rate levels, along with deliberate attempts to lower the purchasing power of the currency - all work in combination to staunch the inflow of foreign funds, by creating a mirror of the toxic environment that the foreign investors are fleeing from.

Which means that ultimately there may be a transmission of the toxic investment environment, so that local investors in Australia and other nations face the same wealth-crippling challenges faced by their counterparts in the major economic powers which are the source of the contagion. 

This then predictably leads to a transmission of political dysfunction into financial results all around the world, whereby the primary determinants of long-term investment results for local investors in Sydney, Perth and Bangkok may have more to do with economic situations and political considerations in Washington and Tokyo than with the local economy or political decisions, as politics trumps Modern Portfolio Theory.

Investor Implications

Globalization was sold to voters around the world with some key simplifying assumptions.  (Whether these were entirely innocent oversights, or whether there was at least a component of some quite deliberate plans on the part of influential players to profit from the redistribution of wealth, is a question I will leave to the reader.)

The core issue is that like so much of modern economics and financial theory, globalization isn't so much based on human history as it is on simplifying assumptions about human behavior. Specifically, it is assumed that nations will behave in a highly rational manner that is driven by the free markets and that they won't "cheat".

Of course real human history demonstrates that many nations cheat for competitive advantage pretty much every time they think they can get away with it, and you could say that is the subtext to most financial headlines about the globe today.

The way you cheat with globalization is to use politics to twist your financial system for economic advantage, and take advantage of the cost /currency value loophole. Over most of the last 15 years, the Chinese have been the masters of this, manipulating the value of their currency to keep it artificially low, and enjoying the highest sustained growth rate that any major nation has ever seen as the direct result. Until the defensive measures started being taken.

Now all the major powers are going after the value of their currencies while cheating long-term domestic investors in the process, which then spreads the contagion throughout the world.

The simplifying assumption, the naïve theory that was used to sell globalization, is that market forces would rule, and the benefits would go to whatever nation produced the best goods and services at the cheapest prices. Thereby forcing other nations to make their own economies better and more efficient in response, as wealth increased around the entire world.

However, financial competition in terms of politics setting up financial systems for competitive advantage is the exact opposite.

What has emerged around the world is that direct monetization on a massive scale is used by a nation to attack its own currency and try to induce inflation. This is done in combination with artificial controls on interest rates to take money both from savers and investors, in order to be able to afford the massive debt levels, as well as to compete with other nations. So for a saver or investor, the way that your nation is likely competing with others right now is to try to cheat you out of market returns, which of course then results in a redistribution of wealth within your own society.

This creates a highly ironic position for investors around the world. Modern Portfolio Theory and its derivatives in areas like conventional financial planning and retirement planning are theoretically based on a market economy.

The reality is that in a competitive contagion that is continuing to grow around the world, politics is superceding market systems, and as a direct result thereof, retirees and investors around the world find themselves unable to enjoy the benefits upon which their financial plans are built. That is, decades of financial planning have been rendered obsolete because of political changes, but political changes are not allowed for in the financial models, and people are not prepared to respond to them.

This creates a thoroughly dysfunctional system, in which the only chance an investor has is to understand what is actually happening.