Double Jeopardy Revisited
We continue to hold the view that the two biggest risks going forward for global markets are rising global interest rates and an ongoing deterioration in global geopolitics. There is also another issue that appears to be coming to forefront as well. Protectionist sentiment, always an issue in the USA, is once again on the rise both in the US and as well in Europe. And in both instances the target is primarily China.
Working its way through congress is legislation that would impose a range of tariffs on Chinese exports. The legislation is designed to cut the massive trade deficit with China that reached $200 billion in the past year. Considering that the US trade deficit is now approaching $800 billion annually the Chinese portion is significant. In order to try and encourage the Chinese to move towards a meaningful revaluation of the Remminbi they are also proposing on offering to grant China market economy status prior to the 2016 deadline.
But the Chinese are not likely to be bullied particularly when they hold several hundred billion of US Treasuries. The Chinese have benefited from the relationship and have little incentive to increase the value of Remminbi except on their own terms. But tensions are certainly rising not only with the Chinese but elsewhere. China has bumped into barriers in attempting to buy their way into US companies as they found out when their bid to purchase Unocal was blocked. Further the recent collapse of the ports deal with Dubai is sending the message that certain kinds of foreign investment in the US are simply not welcome. It will make others thinking of investing in America think twice as to whether it is worth it.
That the US needs huge sums of foreign capital to cover not only the trade deficit that in due course could become a trillion dollars annually but it needs it to cover the huge budget deficits that now exceed $400 billion annually. The trade deficit is currently 6.5% of GDP. We recall that a much lower number in 1987 triggered a stock market crash. Today it seems to barely cause a ripple. The budget deficit is a mere 3.8% of GDP. So combined they are about 10% of GDP. In some respects some might consider it not bad considering that the US grows roughly 5% (before deducting inflation) per year and the world's savings are estimated to be around $6 trillion annually. So the US receives not even 10% of those savings. In some corners that is considered good and an argument as to why the US deficits are not really a problem.
Ben Bernanke got into the act of the US trade deficits this past week when he acknowledged in a letter to Rep. Brad Sherman (Dem. California) that "Although U.S. trade deficits cannot continue to widen forever, these deficits need not engender a precipitous decline in the dollar, nor should such a decline, were it to occur, necessarily disrupt financial markets, production or employment". The US Dollar loved the comments and immediately rose but US Treasuries sold off (yields rose) so we have the spectre of rising interest rates and a save of the US Dollar.
Bernanke went on to explain that "the possibility of future disruptive correction of the U.S. trade deficit cannot be ruled out. The best way to protect the U.S. economy from such an event is to continue policies designed to maintain the stability of the financial system and the flexibility and resilience of the economy". Reading between the lines of course one discerns the reputation of "helicopter" Bernanke that if it did cause a problem the Fed would come to the rescue and flood the system with funds in order to prevent a meltdown. That was the policy under Greenspan and it appears that it will continue under Bernanke, which is no surprise.
In the interim, however, all signs are pointing to a continued rise in interest rates possibly even beyond what the market is expecting. And interest rates are rising in Europe and Asia as well and therein lies the problem for the carry trades that have helped fuel stock and bond markets for the past few years. Falling interest rates are a boon to the carry trades but rising interest rates are a major problem. It raises the risks that the carry trade speculators will be forced to dump assets. With numerous markets in India, the Philippines, Indonesia, Thailand and Latin America at all time highs the risks are rising as interest rates creep higher.
While record current account surpluses and foreign exchange reserves will probably allow the Asian countries to avoid any meltdown as we saw in when the Thailand Bhatt collapsed in 1997 others may not be so lucky. There are two collapses that bear close watching going forward and their possible impacts on the rest of the world. The first is in the Mid East where high flying markets in Kuwait, UAE, Qatar and Saudi Arabia have suffered sharp corrections thus far this year on heavy volume. This has occurred despite the massive amounts of oil money and strong economies in these countries. The UAE recently lost the US ports deal and a strike has stopped construction on what is to be the world's tallest structure.
The other problem is in Iceland. This is the carry trade nightmare. Icelandic banks borrowed heavily on European markets and invested in high yielding Iceland bonds that were over 10%. In February the Iceland Krone collapsed and interest rates are rising in Europe. The result the carry trades are blowing up. The Iceland banks have debt the equivalent of 150% of Iceland GDP maturing in the next two years. A banking crisis and collapse appears to looming sharply on the horizon. And with it could go the Iceland economy where a country debt default is highly probable given their debt is 300% of GDP. The Icelandic Krone is expected to lose even more in the coming months and in turn that could trigger a bigger global problem. At this stage Iceland is in deeper trouble than Thailand was at the same stage in 1997.
Nor is Iceland an isolated case. The British rating agency Fitch recently warned about a "general increase in bank systemic risk in the last six months". The problem as Fitch warned is the huge build up because of sustained low interest rates of equity and property bubbles. Fitch noted there is now "a high level of vulnerability to potential systemic distress in some countries" noting in particular Ireland, Norway, Russia, South Africa and the aforementioned Gulf states (Executive Intelligence Review March 21, 2006). The property bubble in particular is starting to show signs of stress with new mortgages down sharply from a year ago in the US and recent reports of housing sales are falling below expectations.
If the interest rate scenario is becoming clearer the geopolitical scene is somewhat murkier. While nothing is particularly in the forefront there is the potential for any number of issues to explode on the scene at any time. The situation in Iraq continues to deteriorate with the country sitting on the verge of civil war if as some already claim it is not already there. The Iranians will back the Shiites as they have probably been all along, while support for the Sunnis will come from Syria and very likely Saudi Arabia. The Kurds who have wanted independence in the north for some time will probably be able to largely stand back. Against this backdrop in listening to a speech from President George W. Bush on the situation one can only assume he is either delusional or knowingly lying although we agree it would be disastrous to admit that the situation is actually out of control which is what it is.
Bush's popularity continues to plummet along with Iraq and Vice President Dick Cheney's poll numbers are in the teens. And for the White House is going to get worse. Last week 8 US House of Representatives joined as co-sponsors of HR 635 calling for a select committee to investigate the grounds for the impeachment of George W. Bush over misleading the public on the need to go to war, supporting torture (Abu Ghraib, Guantanamo Bay) and illegal domestic spying. In the Senate Senator Russ Feingold who introduced a censure motion on March 13 emphasising the alleged lawbreaking over wiretapping is leading the charge. Senator Feingold added "I think we are required to do our job, to live up to our oath of office, and say, wait a minute, there has to be, at least as a first step, some accountability".
Given that the Republicans still control both the Senate and the House it may be difficult to get to actual impeachment, however, there are sufficient very nervous Republicans who may be swayed. Senator Arlen Specter (Rep. Pennsylvania) Chair of the Senate Intelligence Committee said he agreed "with a number of things ... in his resolution..... an issue that the statute requires all members of the Intelligence Committee to be briefed". (Executive Intelligence Review March 21, 2006). So is an impeachment crisis possible? Certainly it is.
Sometime back we noted how over the past half century Presidents have been plagued with scandals, major problems and impeachment. Even the squeaky clean Dwight Eisenhower faced a love affair scandal in his second term. But it was nothing compared to Vietnam that plagued Lyndon Johnson forcing him to not run again; Watergate and impeachment faced Richard Nixon; Iran Gate plagued Ronald Reagan including calls for impeachment that failed to gain traction; and of course Bill Clinton had the Monica Gate sex scandal. Given the problems already facing George W. Bush coupled with his plunging popularity the cycles of scandals including a possible impeachment crisis appears to be striking once again. Bill Clinton's sex scandal failed to fell the markets but a possible impeachment crisis with George W. Bush over alleged crimes that pale the Clinton scandal could rock the markets.
The Iranian situation is not going to go away. The US is well on record for regime change in Iran just as they were over Iraq. The alleged WMD is merely part of the long litany of excuses that were built up prior to the invasion of Iraq and are once again being built for Iran. That under the nuclear proliferation treaty the fact that the Iranians have actually done nothing wrong is irrelevant. Nor unlike India, a non-signatory to the NPT, they have followed the NPT that even the NPT inspectors have acknowledged. While the excuse of the Iranian oil bourse may be valid it will probably be months before any one can determine whether it actually does have a negative impact on the US$.
But the US has not ruled anything with regard to Iran including tactical nuclear strikes on Iranian nuclear facilities which even conservative estimates have said could kill upwards of 10,000. And worse the Russians in particular and the Chinese both of who have significant investments in Iran have made it clear that they do not support any military action against Iran nor will they support sanctions at the UN. Revelations have come to the fore that Russia gave military information support to the regime of Saddam Hussein as the US was preparing to invade. A close look at the external debt of Iraq reveals that Russia was owed upwards of $7 billion. At this point all of it has been lost and it is effectively uncollectible. The Russians do not intend that their even more significant investments in Iran also be lost.
So the Iranian situation remains potentially the most explosive issue going forward and unlike Iraq an invasion of Iran most likely by air only would be met by the markets with dismay and alarm. So too is the potentially explosive situation in Israel/Palestine since the election of Hamas. Cutting off aid as the West appears to be leaning towards will not resolve the problem, as aid will come from Iran or Saudi Arabia both of who have pledged support. The Israel/Palestine situation is a boil that merely festers but could flair up at any time and turn into something, which drags in far more parties.
We are embroiled once again in the Great Game that has gone on for the better part of the last century and certainly since WW1 in the entire region of the Mid-East and Central Asia. As we noted in a recent issue of International Speculator (Casey Research - March 2006 Volume XXVII, Issue 3) "that nobody in the West listens to what the region wants. They don't want foreign troops in their countries; they don't want foreign interference in their politics, especially the installation and maintenance of puppet regimes (see US support of the Shah (Iran), Saddam (Iraq in the 1980's), Mubarak (Egypt), the Saudi Royals (Saudi Arabia), the Kuwaiti Royals (Kuwait), Musharraf (Pakistan), Suharto (Indonesia) and a host of penny ante thugs in Central Asia) ; and they don't like the one-sided support of the state of Israel, which is viewed as a violent and illegal occupation of Palestine."
The prize of course is the oil and rich minerals of the region that the West needs to run their economies. But you won't find that listed as any of the reasons for why we are there. Instead we appear destined to continue towards what could not only be the clash of civilizations in the region between the West, China, India and the Islamic world, but as well the clash of the competing interests in the region ( Russia, China, United States and Europe). And that is not something that markets will be able to withstand no matter how far down the road we are towards more serious clashes.
The current market is running out of time and the down cycles we have talked about in the past are starting to come to the fore. The four-year, eighteen year and seventy-two year down cycles all continue to coalesce in this period and over the next number of years. Our chart of the NASDAQ 1000 Index Tracking Shares (QQQQ-NASDAQ) shows a possible head and shoulders topping pattern. The S&P 500 shows a possible ascending wedge triangle (bearish).
The US Dollar can be construed a number of ways as our weekly chart shows. Is that a huge head and shoulders bottom forming over the past two years, or is it a smaller head and shoulders topping pattern forming over the past few months? Well we have to watch the key points. Fundamentally there is no reason for the US Dollar to go higher but we are not analyzing here what we think we can only react to break outs in one direction or the other. Below 88 it could be the bear scenario that takes us back to the at least the 2004 lows. Above 92.70/93.00 we could be embarking on a multi year rise of the US Dollar targeting up to at least 105/107.
Bonds on the other hand are looking increasingly bearish and that is not good for the US Dollar. WE note a large head and shoulders top forming over the past year and half targeting at least down to 100/101. As well we note a potential huge symmetrical triangle forming that has very bearish implications. Symmetrical triangles can either be a consolidation pattern or a topping pattern and here after years of falling interest rates we could be nearing the end of that major long cycle that has been in place since 1981. The line is around 107 so that should be watched carefully as it has potential measuring implications down to around 80/81. A long term bear market in bonds would not be friendly to markets going forward. Of course a drop of that magnitude would be played out over years with numerous up and down cycles.
If bonds fall and the US$ falls then that is positive for gold and gold stocks. Even so we could still be going through a shorter-term corrective period for the precious metals and their stocks. The long up trend from the lows of 2001 is clearly intact. And we see no signs at this time of any major topping patterns. Still the recent rise over the past year or so has been steep and a fall to the bull trend lines on gold just above $500 and for the HUI to near 260-270 could still occur. The more bearish scenario is a drop to $450 gold and near 200 for the HUI. This of course cannot be ruled out.
We have noted that gold and gold stocks have played out roughly 12-16 month cycles of lows since 2001 so the current cycle (and weak seasonals as well) could have a few more months to go. Even within that context we could see divergences form with new highs in gold but not in the stocks and vice versa when this down cycle is coming to an end. But the HUI in particular is demonstrating that once that prolonged correction from 2003-2005 finished we were embarking on a new up leg in this long term bull market (note the huge corrective pattern on the HUI and also what appears as ascending triangle on gold itself during that period). If that is the case no matter what short term correction we go through we are in the throes of a bull market that still has years to run.