Download The single most interesting thing about the global economy today is

The single most interesting thing about the global economy today is what hasn’t
happened. Oil prices have soared to near historic highs. The historic high of oil
prices that occurred in 1979 was just over $100 a barrel in today’s dollars. In
recent weeks, oil prices have approached that historic high again. Second, the
sub-prime meltdown continues to play itself out. For all the rhetoric and the
assurances that this is simply the tip of the iceberg, the situation has played itself
our in a fairly orderly fashion. Many financial institutions have been hurt, many
individual lives have been shattered and many formerly brilliant Wall Street
operators have been declared dunderheads.
On the surface, two massive forces have converged. Not only oil prices, but
primary commodity prices in general have soared. One of the periodic financial
bubbles has burst. Either one of these should have already created global havoc.
None have. The stock market has not plummeted. The Standard and Poors 500
fell from a high of about 1565 in mid-October and fell to a low of 1500 on October
19. Since then it has risen to about 1550 last Friday. Given the media rhetoric
and the heads rolling in the financial sector, one would expect to see devastating
numbers. They aren’t there.
Nor are they there in the bond markets. The definition of a liquidity crisis is that
there is too little supply of money and too much demand—in other words, a
liquidity crisis would be reflected in high interest rates. That hasn’t happened. Not
only short term, but more importantly long term interest rates have tended
downward over the past weeks. They certainly haven’t spiked. It might be said
that interest rates are low but that lenders won’t lend. If so, that is at most
sectoral and short term. Low interest rates but no liquidity is an oxymoron.
This is not due to the Federal Reserve. The Fed can influence short term rates,
but the longer you go out on the yield curve, the longer the payoff date on a loan
or bond, the less impact they have. Long term rates reflect the current availability
of money and expectations on interest rates in the future. Like the stock market
in the United States—and for that matter in the world—we have seen nothing like
the devastation prophesied.
As we have said in the past, the sub-prime crisis benchmarked against
something like the S&L crisis is by itself, small potatoes. Sure, those financial
houses that stoked up on the paper are going to be hurt, but that doesn’t
translate into a geopolitical event, nor even into a recession. There are a lot of
people arguing that we are only seeing the tip of the iceberg and that defaults in
other categories of the mortgage market, coupled with declining housing
markets, will set of a chain reaction that will be devastating.
That may well be the case but there is something weird here as well. The idea
that the subprime crisis is only the beginning of a general financial crisis has
become the conventional wisdom. Markets discount in anticipation of events.
They don’t wait for the event to happen. Given the broad belief that the subprime
is the tip of the iceberg and the growing belief that the economy will go into
recession, we would have expected major market declines. Historically, market
declines occur about six months before recessions begin—again markets reflect
future expectations. So far, the public rhetoric has not been reflected in market
action. The perceived liquidity crisis is not reflected in higher long term interest
rates, and the perceived recession is not reflected in a significant decline in the
global equity markets.
When we add in surging oil and commodity prices, we would expect all hell
breaking loose in these markets. Certainly, during the 1970s, the consequences
of high commodity prices helped drive interest rates up, as money was
transferred to third world countries that were selling commodities, and the cost of
money for modernizing aging industrial plants in the United States surged into
double digits, while equity markets were unable to serve capital needs and
remained flat.
Part of the explanation for what is going on here may well begin here. For the
past five years or so, there has been one nation throwing off huge amounts of
free cash flow, China. The Chinese made huge amounts of money selling
overseas. They made more money than they could effectively invest in China.
Grow as it might, the Chinese economy simply couldn’t metabolize all the dollars
thrown at it. That led to massive dollar reserves in China, and the need for the
Chinese to invest that money outside its own financial markets. Given the size of
the reserves and given the fact that the United States was its primary consumer
as well as the only economy large enough to absorb their reserves, the Chinese,
both the state and non-state entities, regarded the U.S. markets as safe haven
for their investments. That is one of the things that has kept interest rates
relatively low, as well as moving the equity markets. Asian money has flowed into
American markets not only recently, but in a process that goes back to the early
1980s.
The rise in oil prices ought to be devastating for American markets. But it has a
self-stabilizing feature. As money accumulates in oil exporting countries, the size
of the price surge and the stability of demand have created dollar reserves far in
excess to anything that can be absorbed locally. So, the United Arab Emirate has
made so much money, particularly in 2007, that it is impossible to invest that
money in the UAE. It has to find a home in overseas markets.
In some sense it doesn’t matter where the money goes. Money like oil is fungible,
which means that if all the Petrodollars went into Europe, then other money
would flow into the United States, as European interest rates fell and European
stocks rose. But there are always short term factors to consider. The Chinese
and the Persian Gulf oil producers share one thing in common—both are linked
into the dollar. As the dollar declines, the price of assets in other countries
becomes more expensive, particularly if you regard the dollars fall as ultimately
reversible. Dollars invested in dollar denominate vehicles make sense. And
therefore we are seeing two massive flows of dollars into the United States. One
is China’s dollar reserves—derived from sales to the United States, so they are
stuck with being in the dollar zone, plus they have pegged their yuan to the
dollar. Second is the money from the energy industry, also part of the dollar
zone. That money also needs to find a home and the largest, most liquid dollar
denominated market in the world is the United States.
The United States has created an odd dollar zone that links China and the
Persian Gulf (other energy producers like Russia, Nigeria or Venezuela have no
problem using the dollars internally). Unhinging China from the dollar is
impossible. They sell in dollars to the United States, and the linkage gives them a
stable platform, even if they pay more for oil. The Arabian Peninsula sells oil in
dollars and trying to convert their contracts to Euros would not only be mindbogglingly difficult, but by the time they did it, the Euro would be falling and the
dollar rising. The dollar zone has a structural basis.
It also provides and explanation for the resiliency of its markets. Every time the
news on the sub-prime situation sounds horrendous and the American markets
look like they are going to finally crash, you see what happened this week, with
the markets rallying globally and particularly in the U.S. Where is the money
coming from? Certainly not from commentators in the media who are focused on
the subprime crisis nor from the people who believe them. But the markets have
risen through the early days, then sold off and now rallied again.
Where is the money coming from, we would argue from the dollar bloc and its
huge free cash flow—the Chinese and particularly at the moment, the Arabian
Peninsula. Most of it is the anonymous movement of money through ordinary
market actions. But on occasion, you can see it in large, single transactions that
are quite open. This week, Dubai invested $7 billion in Citigroup, helping to clean
up its balance sheet and not incidentally, let it be known that dollars being
accumulated in the Persian Gulf will be used to stabilize American markets.
This is not an act of charity. Dubai and the rest of the Arabian Peninsula as well
as China, are holding huge dollar reserves and the last thing they want to do is
sell those dollars and drive the price even lower. Nor do they want to see a
financial crisis in the U.S. markets. Both China and the Arabians have far to
much to lose for that. So in an infinite number of open market transactions, as
well as occasionally public investments, they are moving in to support the U.S.
markets.
It is the only explanation for what we are seeing. The markets should be selling
off like crazy given the financial problems. They are not. They keep bouncing no
matter how hard they are driven down. That money is coming from somewhere
and it is not coming from the financial institutions and hedge funds that got ripped
on mortgages. But it is coming form somewhere and we would thing that that
somewhere is the land of $90 dollar a barrel crude and really cheap toys.
Many people will look at this as a tilt in global power. Perhaps, but to us it looks
far more like the Chinese and Arabians are trapped in a financial system that
leaves them few options but to recycle their dollars into the United States. They
wind up holding dollars—or currencies where the transaction is linked to
dollars—and then can speculate by leaving or play it safe by staying. In our view,
these two sources of cash are the reason global markets are stable. But they are
particularly linked to dollars and that particularly means resilience of U.S.dollars.
Energy prices might fall, and the amount of free cash flow in the Arabian
peninsula might drop, but there will still be free cash flow and there will still be
surplus dollars in China. Put another way, the international system is producing
aggregate return on capital distributed in peculiar ways. Given the size of the
American economy and the dynamics of the dollar, much of that money will flow
back into the United States. The U.S. can have its financial crisis. Global forces
appear to be stabilizing it.
How much power they have in the United States is, of course, the question. The
problem they have is what else are they going to do with their money? They are
not coming into the American markets because they like the United States. They
don’t. They are locked in and for all the rumors of major shifts, it is hard to see
how they can happen. When someone must invest in you, they’re not the ones
with the power. You are.
It is the irony of the moment that China and the Arabian Peninsula, neither of
them particularly fond of the United States, are trapped into stabilizing the United
States. And they are doing a fine job.
Surging energy prices have sucked money out of the United States. Given that
energy prices are dollar denominated and that the dollar has been historically
week during this period, it means that the United States and economies whose
currencies are linked to dollars have seen a greater increase in the price of
energy than others, like the Euro and Yen that are not dollar denominated. They
have also had a jarring rise in prices, but it has been softened by the dollar.