O Canada

The Canadian and US dollars are trading at parity, bringing full circle a cycle that lasted almost 31 years. Back in 1977, I won a $100 (US) bet with a Canadian on whether the C$ would see $1.1o or parity first (Guess what side I picked; if I had only invested that money in Microsoft, Intel, Google, etc.). Now that we are back to this level, I'd like to propose something quasi-radical, a US-Canadian dollar currency union.

Let's not make any mistake here. The reason the C$ has strengthened is the commodity boom. Canada is one of the largest exporters on raw commodities in the world. While they have always been a major commodity exporter, it is the mix of exports that has propelled it higher. Eighty dollar-a-barrel oil makes hard to produce Canadian oil profitable generating huge royalties for provinces involved and the national government, monies that weren't generated exporting wheat and nickel (Maybe diamonds. Watching Ice Road Truckers has led me to believe that companies must be making large profits, given the costs involved in production). These royalties have allowed Canada to post a record budget surplus, reducing the debt-to-GDP ratio by more than half over the past 11 years (Of course, if the US spent as little on defense as Canada, which spends somewhere around the amount that New York State spends, every citizen here would be getting a dividend check from the federal government).

Canada is a boom and bust economy. Currency union would force them to invest, in the good times , in businesses and technologies that would see them through the resource bust times. Historically, Canada has allowed the C$ to depreciate to be more export competitive. People seem to have forgotten that it was just over five years ago that the C$ traded at $1.60. Oil has been the great equalizer this time around, but I don't think Canadians want to go down the road Middle Eastern sheikdoms. Eventually, the oil party will end, either in lower prices, increasing use of substitutes, or a combination of both. It would help the US as well, as new legislation here would help reinforce monetary discipline, either through a merged or overriding central bank and create some fiscal discipline as well, as budget deficits would have to be restrained. I would even go farther as to invite other countries that have adopted the dollar around the world to at least have some observer status in the new central bank.

Parity just makes the mechanics easier, as well as making the explanation easier to all involved parties. It is a long-term positive for both countries.

PS: One line in the previous post shows the US$ fall vs. the C$ this year. Can you guess the other line?

A Little Friday Fun

Just a little Friday fun to close out a long week. Can anyone guess what the graph above represents? A hint: it is currency related. While there will be no prizes awarded for correct answers, you will have the satisfaction of doing a job well-done.

The Next Bubble

A wise man (whose name escapes me) said that burst bubbles do not re-inflate. For proof, please look at the NASDAQ and the Tokyo Stock Exchange now as compared to their all-time highs. But that doesn't mean that new bubbles aren't looking form all the time. For the record, the current housing price declines has less to do with the few subprime borrowers that defaulted and more to do with a world reawakening/reacquainting itself with credit risk coupled with funding/liability mismatches (using CP to finance long-term obligations, the carry trade). Many pundits are serving up Emerging Markets as the new bubble candidate. They certainly qualify. Investments pushing to succession of new highs driven by investors trying to eke out any sort of incremental return. Over the past two months, there were many people calling emerging markets the "safe haven" from the credit market turmoil, Russia, now nine years out of bankruptcy, in particular.

Are the emerging markets the safe haven? It boils down to two very fundamental arguments. The first is no, that credit risk has not been repriced and reevaluated in those markets. The second in the new paradigm argument, that emerging markets are experiencing sustained higher growth rates brought on by global acceptance of capitalism creating free markets that didn't exist. This growth and openness has allowed the massive pools of liquidity invested in developed economies, at ever lower returns given the 25+year secular decline in interest rates, to flow to emerging markets. The answer is somewhere in between, with the no argument being more relevant over the intermediate term and the yes side more important tomorrow and five years from now.

The problem with trying to come up with an answer is the emerging market are viewed generally through developed market glasses. It must be kept in mind that business practices, legal protections, investment diversity, and state involvement are usually quite different. The way investments are made in different regions of the world can vary, although with the opening of capital markets, they are becoming more similar. For example, direct investment used to be more common in Asia than Latin America, but that is changing. It is very difficult to make investments in many countries, China for example. Because the investment scope is limited, investors tend to put money to work in items that will give them market exposure, but allow for necessary liquidity. This provides a constant bid for investments that can easily be trading, propping up the market. However, it can be a small door if everyone exits at once.

Short of a global recession or commodity price correction, emerging markets in general are probably OK. Investors have become much at looking at individual circumstance rather than viewing them as a whole. There are exceptions, China for one. Chinese securities firms and banks hold many places in the top ten in market capitalization worldwide. This has a lot to do with domestic Chinese investors having few other options for there money, especially with inflation there above 6.5%. Twenty years ago, the largest securities firm by market cap was Nomura, now not in the top 15. But, remember where the Tokyo exchange was then.

Isn't It Ironic?

A quick note to point out a some ironies of today's world; please indulge. It is strange (not really) that whenever there is a problem in the US, everyone in the world comes out of the woodwork to jump on the bandwagon. In the pre-Ronald Reagan era, this was common. Maybe with a strike at GM, people think that Jimmy Carter is still President (On that note, the anti-union guy on a midday CNBC debate told the GM workers to "suck it up and face facts). But entities living in glass houses, the IMF and Carlos Slim come to mind as recent bandwagon jumpers, should probably not throw stones. The IMF, struggling for relevance in credit risk-free emerging market world, is trying to justify its existence by coming after the US. Carlos Slim, world's richest man created by having monopoly power in Mexico, is warning the US on this and that. Enough already! Mr. Slim, please donate your billions to a foundation dedicated to reforming the Mexican economy. They could start by breaking up monopolies and selling off Pemex, taking advantage of the worldwide oil boom (Take a look a Petrobras for an example). As for the IMF, I'm sure you could put all your knowledge and resources to helping countries that could actually use it. There's a few countries in Africa that may appreciate your advice.

The $90 Billion Question

Ninety billion dollars is the amount reported in the Wall Street Journal this morning that the Big 3 US auto manufacturers owe their current retirees in future health benefits. Now, the auto industry is on the eve of arriving at an agreement with the UAW to shift this obligation to some off balance sheet trust; GM is the first one up. On the surface, this looks better than the one way ticket to liquidation that GM, Ford and Chrysler seem to be headed. However, it will take much more than this to turn these companies around.

The US auto industry is a case study on how not to run businesses. Once holding a virtual monopoly on the domestic auto market, now 1 in every 2 new vehicles sold in the US is produced by foreign manufacturer. The positive thing here is that a large percentage of those "foreign" cars are actually built in the US (and Canada, which is considered a domestically produced car due to the 40+ year old auto free trade agreement between the two countries). Big 3 employment has dropped by over 40% since 2003, exacerbating the retiree situation. The truly sad thing is that it didn't have to be that way. Most of the innovations in auto industry over the past 30 years came out of the Big 3. This is evident in the fact that most auto manufacturers worldwide have design operations in the US. The Big 3's costs and fairly rigid structures did not allow, however, the "nimbleness" necessary to capitalize on them over the long term. GM. for example, has and had different divisions selling basically the same vehicle to the same customer.

So, the $90 billion dollar question is: Does this move finally help them turn the corner? Well, yes and no. This agreement does nothing to get buyers into showrooms, which is the real problem now with the not so Big 3. If they can convince buyers that there product is competitive (which isn't the case currently on price, as any recent shopper will attest to) and reinvent themselves as smaller, leaner companies, then this agreement will help to some degree. The more likely scenario on how this will help is that it will make it easier, from a public relations standpoint if no other, to file Chapter 11 to force renegotiation of contracts and a restructuring of operations.

We Won The Battle...And The War

The US dollar is getting a lot of press lately, but when you see Maria Bartiromo on the Today show talking about her bar bill, it has really pushed into the mainstream (By the way, it was a incomplete example. Her EUR 70 bill for two drinks in a hotel bar is high, but without equating it into a US dollar equivalent, it is just a EUR 70 bill). Today's hot topic is the parity level of the US and Canadian dollars. Yes, it has been 30 years since that has occurred. What is forgotten is that prior to that time, the Canadian dollar traded at a premium to the US dollar. I'm a very big believer that market forces should set currency levels based on purchasing power parity. When central banks and governments get involved, market players get involved to capitalize on those actions. George Soros and the Bank of England and the breaking of the ERM come to mind.

That brings me to the title of this post. We won the war. With the exception of Venezuela and North Korea, capitalism rules the roost. No need to look any further than Russia or China to see that. The consequence of winning is this war is a more competitive global environment. The US and its currency at at a crossroads. We can either continue down the current path and live with the consequences or change. There is no one option for change, but they must all start with putting domestic US interests first. This isn't meant to be xenophobic. On the contrary, the US should engage our friends and enemies more energetically. The phrase "Freedom isn't free" doesn't apply in most places in this world. The US taxpayer pays for it and the US military enforces it. Since there is very little chance of cutting entitlement spending (let's hope there can be a lid on future entitlements), the only other viable option is to reduce the defense budget. The billions around the world that have benefited now need to foot the bill, in more ways than one. The US could then balance the budget and couple that with a realistic domestic energy policy, one that isn't dependent on the whims of unstable regimes, and the dollar will take care of itself. The US is still the most dynamic country in the world, but it is time to put aside our differences on the critical issues and focus on the task at hand.

Quantitative versus Qualitative

For regular readers of this blog, you know it to be one that has a qualitative bent. That is, a dialogue dedicated to provide some amount of insight garnered from years of experience in the fixed income markets. This is not to say that I ignore quantitative methods. In fact they are quite useful to me, but that information, ex proprietary models, is readily available elsewhere and is used by the author to help draw a conclusion. I have no interest in producing that kind of information, as it would put me into a coma. The basis for what is written here is common sense. In general, if something doesn't meet the "smell" test, there is usually a problem.



Having prefaced this post with the above, it is my contention that the current troubles in the financial markets were caused by an over-reliance on quantitative models, the abandonment of common sense, as it were. Common sense and experience acts as a check on models that can't possibly account for variables like liquidity and fear of loss accurately. Certainly Long-Term Capital could have used more common sense back in 1998. Certainly, the guy that made the highly questionable statement about his model, as mentioned in a previous post, having several 25-standard deviation moves (once-in-100,000-year event). I guess that model will be pretty boring over the next million years!

Unfortunately, it remains to be seen if anything has or will change given what has happened over the past two months. I don't want this to sound like sour grapes (those of you that know me know that I have felt this way for years) but if the job boards are any indication, it looks like the financial world is ready to pile back into the models. If you have a PhD in physics, there plenty of positions open, some with seven figure compensation (guess what I'm telling my son to major in). Physics, however, won't help you when there is no bid. I've had more than one intelligent colleague tell me that the theoretical value of this or that is higher or lower than where it is trading. Sometime anomalies do exist, and there is a definitive reason for them. Market efficiencies usually take care of them quickly. The theoretical value usually doesn't take into account intangibles. That is where common sense comes in. We can hope that fear has instilled some common sense, but I wouldn't bet on it.