Leaders the world over are sowing the seeds of the next big financial crisis. When it comes, the few that were ready are going to have the opportunity of a lifetime to make a fortune. Here’s what you need to know to make sure you’re one step ahead…

Rising living standards in emerging markets is a powerful investment trend. There are many reasons to expect this trend to continue. But central bankers and politicians all around the world, who think of ways to “improve” every possible situation with their enlightened meddling, are acting in a way that promotes future crises.

The most powerful, influential meddling right now is happening in the currency markets. By flooding the system with liquidity, and promises of much more liquidity, central banks have fueled the 2009 rally in “risk” assets.

The Federal Reserve’s zero interest rate policy has been the most important factor in financial markets for months. This policy is acting as an accelerant for money supply growth in many emerging economies. As Jim Grant says, the U.S. is the world’s reserve currency, so the Federal Reserve is the world’s central bank.

The U.S. dollar carry trade is prompting “hot money” to flow into countries like Australia — those with upward-trending currencies and short-term rates above zero. The Fed’s outlook for inflation focuses myopically on outdated, industrial-era statistics like the “output gap,” while its loose monetary policy fuels dangerous, unproductive bubbles.

The promises of limitless free money from central banks also embolden the big spenders in government, who are ramping up the GDP figures (but destroying real capital) at unprecedented rates. Without the belief that “quantitative easing” is available to finance deficits, big spenders in government might think twice about having to pay higher interest rates to borrow from the bond market.

The policies of central banks are also aggravating dangerous imbalances in the global economy. Countries that traditionally rely on exports are upset. With President Obama embarking on his first official visit to China next week, the issue of the dollar/renminbi peg is at the forefront of concern.

As the U.S. dollar index weakens, so does the exchange rate of the Chinese renminbi versus floating currencies like the euro and the Japanese yen. This translates into an effective price cut for American and Chinese exporters, without the typical hit to profit margins. European and Japanese exporters are suffering from what they consider to be an unfair playing field.

Debasing the value of a currency is an old-fashioned way for politicians and central banks to subsidize politically powerful exporters. Cheap currency policies are widely popular among the bureaucrats and central planners that populate the halls of academia and policymaking. But over long periods of time, the quality, efficiency, and productivity of an export sector will determine its success — not whether it’s located in a nation with a weak currency.

Like doping in sports, a weak currency gives exporters a price advantage against its competitors. But once too many countries get involved in this “mercantilist” type of policy, it transforms into an ugly race to the bottom. In the end, the average citizen is impoverished by diluted purchasing power.

Policies that actively weaken currencies are not good for the health of the middle class. Our “bail out bank shareholders and bondholders at any cost” policy is a hidden long-term threat to the health of the U.S. middle class. And the stimulus spending and inflation created by the Chinese Communist Party is a threat to the emerging Chinese middle class. This wasteful spending doesn’t appear to have a cost right now, but those costs will become obvious in time.

An August 2009 report from asset manager Pivot Capital Management has gained notoriety in the press lately. The report, China’s Investment Boom: The Great Leap Into the Unknown, captures the bear case for China.

Some of the themes outlined in his report will relate to Strategic Short Report’s future short ideas. In preview, Chinese central planners are blowing massive bubbles in asset-heavy industries like steel and cement. The ultimate returns on capital invested in these sectors will be nonexistent or negative. You can download the PDF version of Pivot Capital’s report at this link.

It remains to be seen whether positive global trends like advances in technology and education and the post-Soviet era trend toward freer markets and stronger property rights will overcome negative trends like the “white elephant” projects that will inevitably result from stimulus spending.

There certainly will be winners and losers in China’s capital spending bubble, and we’ll be targeting the losers.

Regards,
Dan Amoss

November 24, 2009

Dan Amoss

Dan Amoss, CFA, is a student of the Austrian school of economics, a discipline that he uses to identify imbalances in specific sectors of the market. He tracks aggressive accounting and other red flags that the market typically misses. Amoss is a Maryland native, a graduate of Loyola University Maryland, and earned his CFA charter in 2005. In spring 2008, he recommended Lehman Brothers puts, advising readers to hold the position as the stock fell from $45 to $12. Amoss is managing editor of the Strategic Short Report.

View articles by Dan Amoss