Central Banker Throwdown By John Mauldin
February 1, 2014
Narrative or Reality?
What’s Driving Emerging Markets?
The Second Machine Age
Rajan Strikes Back
A Central Bank Throwdown
Miami, Argentina, South Africa(?), and San Diego
Those of us who have attained a certain age can remember being bombarded by commercials in which we were asked “Is it live or is it Memorex?” The thrust of the ad was that it didn’t make any difference, that the tape recording was just as good as being there to watch that TV show live. Video recording technology was in its infancy, and the ability to play a movie whenever you wanted was really cool. Imagine being able to set a video recorder to record a TV show while you were away! … As long as you had somebody in the house young enough to be able to program the recorder to do it, it was great technology.
Today investors are asking themselves a similar question: “Is the meltdown in the stock market the result of Fed tapering, or is there something else going on?” We’ll address that question today and take a deep plunge into the emerging markets. We have a good old-fashioned central banker throwdown in progress, and if the results didn’t have such an impact on our investment portfolios, it could actually be quite fun to watch. What happens in the emerging markets will unfortunately not stay in the emerging markets. It’s all connected. There is more happening here than a simple correction. Let’s put our thinking caps on and try to connect some dots.
The current emerging-market meltdown is what Jonathan Tepper and I discussed in our book Endgame and specifically predicted in our latest book, Code Red. Let’s rewind the Memorex tape and see what we said:
This unprecedented global monetary experiment has only just begun, and every central bank is trying to get in on the act. It is a monetary arms race, and no one wants to be left behind. The Bank of England has devalued the pound to improve exports by allowing creeping inflation and keeping interest rates at zero. The Federal Reserve has tried to weaken the dollar in order to boost manufacturing and exports. The Bank of Japan, not to be outdone, is now trying to radically depreciate the yen. By weakening their currencies, these central banks hope to boost their countries’ exports and get a leg up on their competitors. In the race to debase currencies, no one wins. But lots of people lose.
Emerging-market countries like Brazil, Russia, Malaysia, and Indonesia will not sit idly by while the developed central banks of the world weaken their currencies. They too are fighting to keep their currencies from appreciating. They are imposing taxes on investments and savings in their currencies. All countries are inherently protectionist if pushed too far. The battles have only begun in what promises to be an enormous, ugly currency war. If the currency wars of the 1930s and 1970s are any guide, we will see knife fights ahead. Governments will fight dirty, they will impose tariffs and restrictions and capital controls. It is already happening, and we will see a lot more of it….
We are already seeing the unintended consequences of this Great Monetary Experiment. Many emerging-market stock markets have skyrocketed. Only to fall back to earth at the mere hint of any end to Code Red policies.
Emerging-market countries have to fend for themselves. Bernanke, Kuroda, and other developed-country central bankers accept no responsibility. If other countries don’t like a weaker dollar or yen, too bad. Bernanke places the blame, not on the United States for weakening the dollar, but on emerging countries for not revaluing their currencies or imposing capital controls. As U.S. Treasury Secretary John Connally said to foreign finance ministers in 1971, “The dollar is our currency, but it’s your problem.” Indeed.
Let’s stop there for a moment, as this is an extremely important point. There have been numerous speeches by developed-world central bankers explicitly explaining that they are responsible for their own markets and that the central bankers of developing economies have to adjust on their own. Just as there have been many emerging-market central bankers complaining about quantitative easing in the developed world creating problems in their markets. In a few pages, we are going to look at a very important interview on Bloomberg with Raghuram Rajan, the brilliant head of the Reserve Bank of India, but now, back to Code Red:
Whenever the Fed hikes rates, bad things happen somewhere. It’s that simple. In 1994 the quick rise in rates killed a lot of leveraged investors in the bond market. Orange County had interest-rate derivatives that blew up in its face. It was the largest municipal bankruptcy in history. Emerging-market stocks and bonds were hammered, and Mexico was even forced to devalue its currency in a major financial market crisis. If (when) the Fed hikes rates today, we’ll see lots of bankruptcies like Orange County’s and blow-ups like the Mexican Tequila Crisis. The very low rates globally in a Code Red world mean that now there are probably hundreds or thousands of investors like Orange County. You can bet on that. And that is why the market gets so nervous about suggestions that the Fed might start tapering its quantitative easing. If QE is finally ended, can rising rates be far behind? [Or at least that’s the thinking!]
Recently, much of QE’s effects have been felt in emerging-market countries. This is a response not just from the U.S. Fed but from the BOJ, ECB, and BoE. Unlike the sick, indebted developed world, many emerging-market countries are growing and doing well. [Let me remind you that we wrote this in August 2013!] We have not seen a lot of borrowing in the developed markets. Instead, growth of credit and lending to private borrowers is happening in emerging markets. Emerging markets have been a popular target of excess capital for a number of reasons: their overall ability to take on debt remains strong, and their balance sheets are still relatively healthy; and more importantly, investment yields have been high relative to sovereign competitors. This two-speed world presents enormous problems. Code Red-type policies in the developed world are leading savers and investors to flee very low rates of return at home in favor of putting money into Turkey, Brazil, Indonesia or anywhere that offers higher rates of return.
Code Red-type monetary policies are designed to produce investment and growth, and they are! Just not in the countries that central banks intended to help. This is a major headache for governments in these countries. For them it is like having loads of visitors drop by all of a sudden. It is flattering that they like your house; but after a while, you’d rather they didn’t show up unexpectedly. Hot money flows are like drunken guests. They create a very big party, they leave unexpectedly, and they leave a god-awful mess behind. Large hot money flows have been behind most major emerging-market booms and busts.
Whenever major, developed-world central banks keep rates at very low levels and weaken their currencies, they cause bubbles. Let’s look at two recent bubbles and crashes that Code Red policies helped cause.
After the Japanese bubble burst in 1989, the bank of Japan cut