The Gathering Storm!

By: David Chapman | Tue, Apr 22, 2003
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The war with Iraq was in the end completed fairly quickly. Of course that was the easy part. The hard part will be trying to put Iraq back together again. Early indications are that it won't be easy as while the Iraqi people are happy that Saddam is gone it is also clear that widespread support for the US staying there longer then necessary is not. And while the fear of a wider war is not yet there the level of rhetoric directed against other regimes such as Syria remains at a high level from numerous US officials and may again be preceding an actual confrontation. The market still seems to believe that the war dividend that started with the rally on March 12 is the start of a new bull market that will carry it to new heights over the next several months. While we can not rule out some movement to higher stock prices over the next few weeks there are other potentially more serious storm clouds gathering in behind that tells us this is once again merely another bear market correction.

One storm cloud is a fairly obvious. SARS. Despite a death toll that is so far quite low, SARS is acting more like a terrorist attack as it grounds airlines, shuts down conventions, disrupts hospitals and places of work, places large numbers of people in quarantine and restricts travel including border crossings. It has not as yet reached real crisis proportions as the actual number of cases remains reasonably low but the inability to completely control it means that it may mean that the worst is yet to come. As well it is thus far contained largely in China, Hong Kong and Canada largely in the Toronto area where the economic impact is being felt more directly.

While obviously unfair to compare it at this time, the Spanish influenza of 1918 also started slowly but before it had run its course some 18 months later upwards of 25 million died and a global recession followed. Economic slowdowns were also seen after considerably milder influenza outbreaks in 1957, 1968 and 1977. But for the most part SARS remains a problem elsewhere and the impact thus far is local rather than global. But it does heighten awareness of the risks and it can have a similar impact to a terrorist attack including heightened security to prevent its spread.

If SARS in the end does not prove to have the impact that its potential dictates then another gathering storm could prove to be more problematic. We have often noted the high levels of debt carried by both corporations and individuals in North America in general and the USA in particular. As well the US has twin deficits growing in both external trade and budget deficits. The trade deficit is running at $450 billion per year and still rising and the budget deficit hit $300 billion last year and is expected to be higher this year with the war in Iraq and reconstruction. These huge debt loads would not be a problem as long as people stay employed, corporation profits keep growing, foreigners keep financing the trade deficit by recycling the dollars and the Fed maintains a sufficient enough liquidity stance with low interest rates and a steady growing money supply to fuel the economy.

Of course that is the ideal but there is a wide gap between the desirable and the actual results. The US economy is estimated to have shed some 2.5 million jobs over the past few years. While this has generated an unemployment rate of 5.8% that number is believed by many to be low, as it doesn't count those that have just given up and dropped out of the economy. We have seen some estimates that the real unemployment in the economy could be closer to 11.5%. And this is against a backdrop of almost negligible savings in the economy. Growing budget deficits, particularly in US states, are beginning to have a considerable impact, as cuts are becoming the order of the day and this could further impact employment.

What that translates into is sliding consumer confidence as job losses mount, lower retail sales, rising bankruptcies and an inevitable ending to the housing boom that has held the economy together over the past several months. This has not fully manifested in the corporations, as thus far some profit reports are actually slightly better than expected. But corporations remain over indebted as well and many are still struggling from not only the collapse of the bubble stock market but also the bubble that was created over the lack of ethics in the boardroom that led to Enron, Arthur Anderson and numerous others.

The over indebted corporations and individuals are one thing but the twin evils of trade and budget deficits are another particularly against a backdrop of war and disputes with other major nations. While the disputes at the United Nations over Iraq are one thing the growing desire to punish those that did not assist in the war have a potential to be even more destabilizing. The US Dollar is the world's reserve currency. All central banks keep US Dollars to pay for the myriad of transactions priced in US Dollars and as reserves to protect the value of their own currency.

But while one dispute was left in the balance when the US decided to ignore the United Nations and with a few others became the first democracy to preemptively invade another nation, another dispute is looming with United Nations over sanctions against Iraq. The US has asked that the sanctions end. But this could prove problematic for the UN at a couple of levels. First the UN did not authorize the war. Second the sanctions were to end upon completion and elimination of alleged weapons of mass destruction (WMD). Only the UN has the authority to end the sanctions and declare that there are no WMD or see to it that are there are destroyed. Further the US has made it clear that the UN is to have no role in post war Iraq save for humanitarian aid.

This almost ensures that there will be further disputes at the UN particularly between the main protagonists of France, Germany and Russia and to a lesser extent China. Iraq is not that simple. The Geneva Convention also imposes on the military occupier full responsibility for the well being of the civilian population. And it severely restricts the occupiers right to make use of the occupied country's resources. All of this could lead to more disputes not only at the UN but also within NATO and the G-7 and G-8 as France and Germany are members along with Canada and Russia all of whom did not participate in the war against Iraq.

There have been calls particularly within the United States to punish those that did not participate. This would be shortsighted. A world power that has the military might has in the past been able to call the shots because they were creditors and they exported their capital around the world. This was certainly the case with the US after WW2 and Britain at the height of its empire in the late 19th century. But the US today has become the world's most indebted nation and depends on importing capital in order to finance the trade and budget deficits as well as considerable corporate debt. They can ill afford to get into what could potentially turn into nasty trade disputes. This would have serious ramifications for the entire world.

But it may happen anyway. With the birth of the European Union the US for the first time has a serious competitor to its position as the world's reserve currency. The Euro has risen some 32% from its all time lows and is up 15% from last year. Those that deal with the European Union are becoming more aware that they would be better off if they priced and billed their dealings with them in Euros rather than US$. This includes commodity exporters especially oil producers some of who have indicated that they may be willing drop the US$ for the Euro. Iraq had been doing that since 1999. If others now follow it could cause considerable trouble for the US$ just when the US needs stability to deal with the twin deficits.

A weaker US$ has numerous winners and losers. While US exporters and companies that have considerable foreign holdings and sales in currencies other than US$ will benefit from a falling US$, others such as importers, those exporting to the US, holders of US$ assets and debt and the US consumer will be clear losers. US interest rates would also have to rise to compensate for the falling US Dollar. The Euro also has a positive relation with gold while the US$ is negatively correlated with gold. Euro countries mark their gold reserves "to market" unlike the US which still carries theirs on the books at an official price of $41.22 per ounce. The European countries also have put restrictions on gold sales and leasing. The US is forbidden without the approval of congress to sell its gold reserves.

So there is a problem here that in the rush into Iraq there are some administrative things they may have been overlooked. An America buying fewer world goods and foreigners buying fewer US assets (stocks, bonds etc.) will not be a way to finance military adventures in foreign countries. Others have tried this type of deficit financing in the past and they eventually collapsed (Czarist Russia comes to mind). While it might seem logical that the European economies will benefit from this it is important to note that economically they have been under performing the US (latest 4Q GDP +1.3% vs. 2.9%) and there stock markets remain weak as well.

For investors wishing to protect themselves against a falling US$ they can look at Euro currency issues of the Government of Canada as well as others including some provinces. As well it might be wise to be careful with Canadian companies that are dependent upon exports to the USA such as Bombardier Inc. (BBD.B-TSX).

SARS is a very visible gathering storm but it may turn out be a lot of fury signifying little if they are able to control its spread. If they cannot then the economic fallout will spread. The collapse of the US$ and the rise of the Euro on the other hand will be a storm that could prove quite devastating if investors are not paying attention. Another reason to hold gold as protection against the coming storm.


David Chapman

Author: David Chapman
Technical Scoop

Charts and technical commentary by:
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