An Intellectual and Tactical Challenge

Financial and investment markets at mid 2010 have rarely presented an equivalent challenge.

The growing concensus in early May of a V-shaped recovery abruptly shattered by June against the morphing of the international crisis of housing and banking into a sovereign debt crisis. This materialized with the exposure of the unsustainability of southern European national finance and social policy through their negative impact on the Euro. The outcome briefly made it appear that the US dollar was inherently strong. But it soon became apparent that the effect was only one of relationships, during which the Euro's decline simply accelerated to catch up with a decline that had already occurred in the US dollar.

Muddied over by the ongoing news coverage of the gulf of Mexico ecological disaster, the dawning understanding that the US housing debacle's effect had not yet played out occurred just as the inability of the federal government to continue its monetary stimulus made the dreaded W-recovery (or double-dip) loom as the more likely outcome. US consumers appeared to be spending on current needs by ceasing mortgage payments on houses in which they had no equity and from which they were unlikely to be evicted. State and municipal tax revenues continue to plunge.

New financial regulations (the so-called FINREG bill) may become within the US are expected imminently. However, the investment community feels that as presently constructed, they will serve banking interests far more than consumer interests as originally proposed.

While that works its way along, there is the realization that the post-2008 monetary easing is for the first time occurring within a fully engaged and therefore essentially closed global system, which now needs to be priced into international debt and equity markets. During the leadup to the Toronto G20 meeting, increasing angst and ink was spent on the relationship between the US dollar, the Chinese yuan (RMB) and gold. Gold morphed from an inflation play to a fiat currency issue and reached new current (non inflation-adjusted) highs. Saudi Arabia disclosed a major proportionate increase in gold among its reserve holdings. Already the largest producer, China continued to lock up more non-Chinese gold properties throughout the world by commercial deals, at the same time stating it saw no reason to buy more on the open market, such as from the IMF. Its latest currency adjustment makes gold cheaper within the domestic market.

The slow decline policy of the yuan from its former US peg as newly revealed this past weekend will allow elasticity for consumer demand in the US and elsewhere to remain more intact than it would have been with the major one-off revision the US had pushed for. Since wages are rising in China and domestic demand there will be stimulated, any success of the revised Chinese export policy will mean the rest of the world will pay for the rise in the Chinese standard of living without being able to correct their own trade deficit issues. The sovereign debt issue will persist.

The relative rise in the dollar over the last month helped the US Treasury successfully sell more debt to income-starved investors around the world at ultra-low rates of return. As economic historian and Harvard professor Niall Ferguson stated in a CNBC interview today (June 21), a realization among investors is bound to arise - within 2 to 4 years at best, sooner at worst - that rates must rise. The outcome, when translated into the billowing aggregate global debt, will be that debt maintenance - let alone reduction - will have already moved beyond reach. If and when that day arrives, bond values will plunge as demand for higher yields force them down. The impact on many ordinary and institutional investors - especially the more conservative ones - will be disastrous.

The challenge right now is serious. Many mature investors will be hard pressed to survive with their lifestyle intact and with a recovery doubtful for them in a meaningful time frame, while most younger ones appear to be carelessly texting and tweeting into their financial fate. Collectively, it is not clear if the various national publics affected, from Greece to Britain and the US, will be willing to accept the necessary fiscal medicine as politically palatable, in view of the high economic price that, with hyperinflation the other option, needs to be paid.