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A Global Macro Paradigm Shift


The one-way relationship between US consuming and China accumulating reserves has come to a grinding halt. This could be the next phase of the financial crisis unfolding as a new paradigm develops between the two countries.

Two of the most cyclically sensitive market indicators are the price of copper (HG) and the Semiconductor Index (INDEXNASDAQ:SOX) both of which are highly correlated with each other and can be seen as a proxy for Chinese economic activity. Copper and the SOX both peaked in Q1 2011 and have made lower highs while US stocks (S&P 500 (INDEXSP:.INX)) have made higher highs. This is notable divergence and should not be ignored.

This past Thursday I had the opportunity to hear the esteemed bond fund manager Dr. Lacy Hunt of Hoisington Investment Management speak at an investment conference. The discussion was a brilliant walk through history of debt cycles and deleveragings. He reiterated many themes he has cited in the past, but what really stood out to me was his discussion of the velocity of money.

Dr. Hunt distinguished between productive debt, which is used for investment to generate an income stream, and unproductive debt, which is used for consumption. I knew what unproductive debt was, but I had never associated it with the impact on velocity. Velocity is the most critical variable, he said. Velocity will only increase if money goes into productive debt. Hmmm.... Of course.

When he showed the chart of velocity peaking in 1997 and subsequently collapsing I thought to myself that he was exactly right. This was the essence of the predicament we find oursevles in today. We spent over a decade accumulating unproductive debt encouraged by easy money from the Fed and financed by subsequent reserve accumulation from China that was recycled back into dollar denominated assets creating an unsustainable imbalance between consumption and investment.

Now that one-way relationship between US consuming and China accumulating reserves and thus USTs has come to a grinding halt. This could be the next phase of the financial crisis unfolding as a new paradigm develops between China and the US. The credit bubble collapse, to a large degree, was the first phase of adjusting this imbalance. The second phase could be a reversal of the trend of the prior decade whereby both economies work off their respective excess capacity generated by the symbiotic relationship that led to the imbalance. The US has to work off excess consumption by saving more and increasing investment. China has to work off excess investment by spending more and increasing consumption.

China economic expert Michael Pettis certainly thinks a rebalancing is underway and he calls for a collapse in commodity prices over the next few years as a result. In a recent post from his blog China Financial Markets:

But even this underestimates the change in demand for commodities. For 30 years, and especially for the past 10 years, China's extraordinary GDP growth was driven by even higher rates of investment growth – generating for China the highest investment rates and investment growth rates in history. Consumption growth failed to keep pace during this time.

But rebalancing means, by definition, that for the next few years consumption growth must outpace GDP growth, and so also by definition investment growth must be less than GDP growth. Even if China is able to achieve 5-7% growth rates over the next decade, which I think is almost impossible, this implies that consumption growth will rise to 7-10% annually, and so from 25% growth in the last few years Beijing will be able to allow investment to grow no more than 2-4% annually, and much less if GDP growth rates are as low as I expect.

If this paradigm shift is underway it presents a very tricky and potentially volatile environment for investors because the old rules will not apply. The consensus trade coming out of QE III is to get long the same reflation trade that defined QE II, short the US dollar and long risk assets which had also defined the old US/China paradigm.

This Sunday morning PIMCO's Bill Gross tweeted: "Don't fight central banks but be afraid of inflationary consequences. Buy what they want you to buy – for now: risk assets."

I'm not sure it will be that easy. Since the QE III announcement markets have not followed the old playbook as the correlation trade has somewhat broken down. Yes, stocks are up, but beta has lagged. Sure, gold has rallied, but oil has collapsed. Mortgage rates are lower, but at the expense of the yield curve.

These cross currents could be indicative that some turbulence is brewing under the surface and if a paradigm shift is indeed underway you would expect volatility at the turn. With implied volatility relatively cheap into an environment that could be increasingly volatile, investors may be well served to play some defense into the year end performance grab.

Twitter: @exantefactor
No positions in stocks mentioned.
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