On February 28th Karlmagnus, in response to a question about major business managers on PF’s Calcium Imaging thread, ventured the opinion that:-

... since the system is about to collapse, the intellectual outlook of management may be very different at Dow 5000 to what it was at Dow 12000.  No point trying to change their thinking at the top of the bubble; large numbers of the current mob (particularly the investment bankers) will be behind bars by 2012, only peripherally because of their ideas on globalisastion.  Just as 1935’s CEO was a very different animal from 1928’s, so too will 2014’s be very different from today’s.

Requests for elaboration went unanswered.  But evidently, KM had already been at work on this because today the following piece appeared at Prudent Bear.

GW

This is what it will look like

It’s impossible to tell when the world’s stock markets will finally wake up from their easy-money induced stupor, but one thing is clear: when they do so the initial break will look like last Tuesday. A modest event of no apparent global significance will cause a stock market drop that cascades around the world, producing severe declines in other markets. Last Tuesday’s break may or may not have started the climacteric sell-off, but that sell-off cannot be long delayed.

More interesting than the unanswerable question of when precisely a crash will occur is that of which sectors will be worst affected, which relatively unscathed. Current market thinking appears to be that since the crash originated in China, that market is due for a significant downturn, and that emerging markets in general are overpriced and due for a fall. That view fails to reflect an intelligent appraisal of where the true economic vulnerabilities are.

Japan, first, is said to be economically feeble and in dire danger of falling back into devastating “deflation” if interest rates are increased one iota from their current 0.5%. Actually, that’s more or less the opposite of the truth. Japan’s market is so liquid that it has for the past 2-3 years been used as the borrowing currency for the international “carry trade” engaged in by hedge funds, whereby a low interest rate currency is borrowed and the proceeds invested in a high interest rate currency. 20% of the proceeds of this simple-minded profit scheme can be skimmed off by the hedge fund managers while its profitability lasts. So attractive has this trade been that it is popularly supposed to have been responsible for the yen trading at levels far below its purchasing power parity, and for dollar bond yields being apparently permanently below the already skimpy returns on short term paper and close to zero in inflation-adjusted terms.

The Achilles’ heel of the carry trade is the yen exchange rate. If the yen strengthens too far against the dollar, the carry traders, who mark their positions to market, are forced to reveal a huge loss as their yen liabilities are worth more than their dollar assets. Hence the whole thing is a vast game of “chicken.” While the yen continues weak and interest rates low, the carry trade continues attractive, but a sharp strengthening in the yen or – apparently less likely – a rise in yen interest rates would make carry traders’ profits collapse, and almost certainly cause a panic of position closing that itself would cause the yen to strengthen much further.

That suggests Japan’s economic position is considerably sounder than it looks (since Japanese owned funds have been only modest participants in the carry trade, though one does worry about the Japanese banks’ hedge fund loans.) The seeming contradiction between very low yen interest rates and apparently tightish Japanese liquidity is explained by the hedge funds’ nefarious activity in sucking all the liquidity out of the yen market and dumping it in the dollar one.

Looking at Japanese economic activity and price trends overall, it is clear that short term yen interest rates should be in the 2½%-3% range and long term rates somewhat higher. At current levels, Japanese savers are getting ripped off; they’re not getting an adequate real return. Once the carry trade is ended, the Bank of Japan will need to raise short term rates rapidly, to prevent a burst of inflationary speculation in Japan itself. It will probably be happy to do so once the surge of liquidity manifests itself in a run-up in Japanese stock and asset prices.

Of course, the BoJ could have ended the carry trade any time it wanted, simply by raising short term rates, thus restoring the Japanese economy to its accustomed stability and abolishing the subsidy currently flowing from Japanese savers to international hedge funds, but one must not expect such wisdom from central bankers. In any case, once the carry trade has ended, Japan will be an island of stability, with moderate asset prices, continuing solid real growth, and expansion concentrated in the domestic rather than export economy as the yen strengthens to its proper value above $1=Yen 100.

Just as Japan will benefit from the unwinding of the carry trade and emerge unexpectedly strong, so the United States and big borrowers of dollars will become unexpectedly weak, with their economies and stock markets faring worse than people predict. Long term interest rates will rise, which Federal Reserve Chairman Ben Bernanke will attempt to counteract by lowering short term rates. However he will find himself unable to do much because of an entirely unanticipated upsurge in inflation. His reassurances to the market that all is for the best in the best of all possible worlds, already utterly fatuous, will finally be seen as such by the wounded and angry denizens of Wall Street, who will ensure, as they face bankruptcy or more likely 20-year jail sentences, that Bernanke will not survive their departure. Needless to say the U.S. housing market, already suffering from its orgy of overbuying in 2001-05, will go into terminal collapse, probably taking Fannie Mae and Freddie Mac with it (oh, one hopes so!) and houses will thereafter be nice and affordable until about 2025.

Outside the U.S., Britain, so proud of its position at the epicenter of the overblown speculations of world finance, will find its economy in collapse and London house prices dropping by more than half over the next 5 years. Only the Russian mafia, accustomed to stealing their money directly rather than through mere financial manipulation, will remain in London, more or less safe from Vladimir Putin, propping up the West End housing and luxury goods markets to a limited extent by their vulgar excess.

Western Europe will suffer less than Britain and the United States, but will nevertheless feel the pinch as the world economy overall goes into a downturn. Needless to say, the EU’s reaction will be one of protectionism; the Smoot-Hawley tariff of 2008, causing a lengthy world depression and untold hardship, will emerge from Brussels not Washington. However the German and French strengths of high quality products sold at premium prices will remain. Their markets will suffer but in the long run they will emerge little weakened, smug in the knowledge that Anglo-Saxon capitalism was always bound to lead to ruin.

Emerging markets will bifurcate, depending on their financial and economic positions – the term “emerging market” is increasingly unhelpful as a description of reality. Those relatively prosperous countries in Asia with rapidly growing productivity and little debt (or, in the case of Taiwan, a net asset position internationally) will do fine, benefiting from rising dollar and yen interest rates on their net asset positions and losing only modestly from increased protectionism – their relatively high value-added products will remain essential to a West that has hollowed out its manufacturing base. Most of these markets do not have excessively high price-earnings ratios (South Korea’s is only 12) so will survive nicely with only a modest market downturn.

If much of the MSCI emerging markets equity index does fine, the major constituents of the EMBI+ emerging markets debt index, primarily Latin America and Russia, will find life very difficult. Finance will become more expensive and harder to come by, and the phone will no longer be ringing with offers from international buyers for their dodgier assets. With a world downturn, commodity prices will be weak. Since most of these countries have not established themselves properly in non-commodity exports (Latin America in general has an atrocious productivity record, though Russia’s is better) their economic and financial positions will deteriorate rapidly. At that point, many of these countries will come to regret bitterly their insouciance about property rights, whether of Western investors or of their own middle class. Except for those few countries which have nurtured their domestic savings base and not overspent (one thinks of Colombia and to a lesser extent Chile) it will be too late.

The Middle East, too, will suffer from declining oil prices, and relapse into its customary status of angry penury, only occasionally interspersed with bouts of spectacularly wasteful consumption.

That leaves India and China, which fall neatly into no category, being neither the Idle Apprentices of Russia and Latin America nor the Industrious Apprentices of Korea, Taiwan and Singapore.  Although as industrious as the Industrious Apprentices, they will be hit harder by world economic downturn and protectionism, because their products are mostly commoditized and substitutable by domestic goods as tariff barriers rise. Moreover, both countries have cash flow problems.

In China, the $1 trillion of bad loans in the banking system is only covered up by the extraordinary willingness of U.S. investment banks and their clients to invest in dodgy Chinese banks they know nothing about. Without the enthusiasm of Wall Street the Chinese banks will quickly run out of money and undergo a very expensive forced recapitalization by the state, probably involving loss of most of the domestic Chinese savings base.

In India, the government has planned for 9% economic growth on average over the next 5 years, and has demonstrated by an 18% increase in spending in this week’s budget together with tax rises that it means to spend as much as possible of that growth itself. Of course, even without a world downturn that policy would be economically suicidal in the long run; with a downturn the suicide will arrive more quickly and more thoroughly. India will suffer a severe liquidity crisis in its domestic economy, resulting in a sharp and unexpected recession. Where it goes from there will depend on politics. If the Indian electorate has the sense in 2009 to avoid its mistake of 2004 – and is offered an equivalent free market choice to Atal Bihari Vajpayee’s BJP – it will do fine. If not, it’s in for another couple of decades of Hindu growth rates and impoverishment.

Was this week’s hiccup the beginning of the big downturn? Who knows! But that downturn cannot now be long delayed, so wise investors will prepare for it, rearranging their portfolios accordingly.

Martin Hutchinson is the author of Great Conservatives (Academica Press, 2005).