Dangers Are Increasing

As our readers know, our baseline scenario for this year is fairly flat market, with increasing volatility and narrowing breadth. Although the economic improvement in U.S. is very weak, and equity prices have increased substantially driven on the wave of liquidity, which is unsustainable over the long term, we feel that downside is limited due to still fairly easy monetary conditions, raising profits, and the fact that Obama/Bernanke duo would easy monetary conditions further and/or enact another stimulus package if S&P 500 falls below 950. However, in the recent weeks, several factors are threatening our baseline scenario:

• Chinese economy is booming at unsustainably rapid pace and policy makers started withdrawing stimulus. New policy tightening measures are announced on almost weekly basis. While we see these pre-emptive measures as good for long-term growth, they pose threat for both equity and commodity prices.
• The Fed is scheduled to stop purchasing mortgage-backed securities at the end of March, while the U.S. housing is still extremely weak and inventory is at very high levels. Relapse in U.S. real estate prices is not out of the question.
• Euro area policy is overly restrictive for most European periphery countries. Greece is on verge of debt default, and both bailout and non-bailout scenarios could sow the seed of euro meltdown or at least significant weakening. A weaker euro essentially tightens monetary conditions in the U.S. and Japan.
• The Fed moved to hike the discount rate from 0.5% to 0.75%. The effects of the discount rate hike are basically non-existent as discount window borrowing is at a mere $14.9 billion (compared with the pre-crisis levels of $110 billion) and commercial banks are sitting on a $1 trillion cash hoard, however this might signal a change of policy and more tightening measures might follow sooner than we anticipated.
• Sentiment against big government spending has increased significantly, with Tea Party movement gaining more ground (although from very low levels), support for Obama’s policies waning, and Democrats loosing super-majority in the Senate. This could pose significant headwinds for any further stimulus packages.

Nonetheless, these sources of uncertainty will likely be resolved in the coming months, but until such time, investors should be alert and more nimble than usually.

Capitalism In North Korea
It recently came to our attention that Premier Kim Jong-il sacked his top monetary official, Pak Nam-gi for hyperinflation in food prices, caused by failed currency reform at end of last year. Marcus Noland, of Peterson Institute for International Economics, explains what happened:

In principle, currency reforms are not a bad thing. […] The North Korean case is significantly different from the conventional case in that the move was sprung on the populace without warning, and most critically, enormous limits were placed on the ability to convert cash holdings, in effect wiping out considerable household savings and the working capital of many private entrepreneurs. Citizens were instructed that they had one week to convert a limited amount of their old currency to the new currency at a rate of 100:1 (i.e., one new won would be worth 100 old won). The limit would not finance much more than a 50 kilo sack of rice at prevailing retail prices. 

The announcement set off panic buying as people rushed to dump soon-to-be-worthless currency, buying foreign exchange or any physical good that could preserve value. As the value of the North Korean won collapsed on the black market, the government issued further edicts banning the use of foreign currency, establishing official prices for goods, and limiting the hours of markets and products that could be legally traded. 

As social opposition to these moves began to manifest itself, the government was forced to backtrack, offering compensatory wage increases, sometimes paying workers at the old wage rates in the new currency, amounting to a 100-fold increase in money income. The result has been a literal disintegration of the market, as traders, intimidated by the changing rules of the game, withheld supply, reportedly forcing some citizens to resort to barter.

Food shortages, civil disobedience, protests and fighting in the streets intensified. As governments saw situation getting out of its hands, scapegoats were chosen, market regulations were lifted, use of foreign currency was once again allowed, Premier Kim Jong-il issued an unprecedented public apology, arrested money changers and illegal traders were freed, and jangmadangs (open-air markets) are once again returning to normal.

I’m in no way suggesting that North Korea is becoming next haven of free-market capitalism, as that might be years or decades away (readers should remember that attempts of freeing economy were already made in mid-1990s only to be reversed in 2004). I merely wish to highlight that no matter how many times governments around the world and through the history attempt to over-regulate and over-control the economy, starvation and bad living standards will always force the population to turn to black markets, both in currency and in goods. In fact, the existence of black markets in some sector of economy is the best indicator of unsustainable government regulations (gold during the Great Depression, alcohol during the Prohibition, various currencies through the history, and drugs at the present time).

While waiting for North Korea to open up, we encourage our readers to get some exposure to Vietnam, which recently started opening up and is now where China was a couple decades ago, and to stay alert for ways to invest in Sri Lanka, which recently won the civil war against Tamil Tigers. It is often most profitable to start investing in country immediately after a major civil war or after it starts opening up its economy – economies of Peru after winning against Shining Path and of China after opening up are great examples of this. Although the journey might be bumpy and there are bound to be problems, in the long run, the economies of such countries often offer great investment opportunities.

Investment Considerations
As we mentioned above, next few months will be critical. Current correction could still have some room to run, and it is too early to bottom-fish. While we would not recommend shorting the market or getting out of strategic positions yet, readers should still “sell the strength” rather than “buy the weakness”. We continue to like some countries and specific sectors that we mentioned in the past (i.e. U.S. refiners, Japan and Japanese banks, Thailand and its tourism-related shares, Canadian energy companies) and select commodities (primarily in precious metal and agriculture sectors), we would not add to these positions at this time or would at least scale in very slowly.