Watch the Invisible Hand!November 6, 2014
As my first mentor, Gary Shilling, would often say–“A recession is a correction of excesses.” In this cycle, the key global excess is savings, which so overwhelm investible ideas that interest rates are zero–and in some countries negative! Many believe rates are zero because central banks want them so, but it is the low long term rates and short term futures trading well below central bank targets that belie this notion. We have noted before that when faced with zero rates, the invisible hand will follow four strategies to destroy the efficacy of capital and so reduce available supply relative to demand. First, and most desirable, is Schumpeterian creative destruction, which reduces the value of existing capital by replacing it with new technology. This is happening, but more slowly than normal as bank lending and credit access for new firms is still quite restrictive. Second, large firms with access to capital (and especially at artificially low rates) will use it to consolidate market power by mergers & acquisitions. Monopoly and oligopoly are less efficient capital structures than perfect competition, and require more capital to generate the same result because they are revenue maximizing–not profit maximizing–strategies in the short run. Third, greater market concentration and income inequality will spur increased government regulation and interference in markets, obviously reducing the effectiveness of capital. Finally, in absence of all other solutions, war–whether shooting or economic–will disrupt supply chains and destroy capital, or trap it in inefficient uses.
In addition to sanctions on Russia, global devaluations and tumbling oil prices are now the most notable source of capital destruction. The invisible hand has effectively targeted the largest remaining pools of savings on the planet–China, Germany and oil producers–and is eroding their capital bases. Many have argued that 20 percent lower oil prices will not alter supply. Maybe not, as variable cost is well below current prices for most producers. However, somebody lost $20 a barrel in revenue–and if it was not the beneficiaries of production (such as laborers and suppliers) then it had to be out of profits, which is to say savings. The same argument can be made for a wide array of commodities, like corn and iron ore, where prices have tumbled as supply overwhelms ebbing demand. A key question is how low will commodity prices have to go before supply stabilizes with demand? Falling prices keeps inflation and interest rates low–and apparently QE high–all spurring demand. The commodity supercycle is now in its downwave, with the major beneficiaries the new economies of Asia. However, real economic growth globally will likely still remain soft in early 2015, as it takes a year for the real world to reflect movements in financial markets.
Devaluation is where the distinction between stimulus and reform will play out strongest. Many countries want a cheaper currency so that their export industries that have been hardest hit by the recession will rebound. Unfortunately, that is not how the real world works. Before currencies adjust, every nation has comparative advantages which determine which industries will profit–though some have far more advantages than others. Industries in decline are generally falling because they are losing their comparative advantage. The right strategy is to lower that industry’s costs or improve its productivity via investment–or abandon it as it inevitably shrinks. Hopefully, capital freed up can be used more effectively elsewhere–but sometimes whole cities or nations die.
When a country devalues, it lowers the price of all of its goods–both for the weak industries and the strong. Foreign buyers will buy more of all goods, because of the lower prices–but the greatest advantage will go to already strong industries where prices didn’t need to go down. In some cases, these industries will raise their domestic prices as demand rises, increasing profits and shifting domestic capital their way. Weak industries may see better sales–or just a slowdown in erosion since they needed to lower prices anyway. Similarly, foreign and domestic investors, seeing the better profitability of the strong industries will commit more capital, reducing interest costs relative to weaker firms. The invisible hand makes the strong industries stronger and eliminates the weak. Countries that use devaluation as a stimulus strategy–hoping to rekindle the old–are likely to fail. Those that use it to help buy time for reform and a shift to new comparative advantages may succeed. When everyone is following the same strategy, those with the ability to make the boldest commitments to new strategies generally prevail. We see that commitment in China and much of Asia–but not in Europe, Japan or much of Latin America.
The preceding is an abridged version of a commentary for McVean Trading and Investments, LLC and has been reposted here with permission of the author.
The ideas and opinions expressed in this blog are those of the author, and they should not be perceived as investment advice or as any other kind of advice.