The Inescapable Law of Equilibrium
By Frank Suess - November 19, 2009

We know, in other words, the general conditions in which what we call, somewhat misleadingly, an equilibrium will establish itself: but we never know what the particular prices or wages are which would exist if the market were to bring about such an equilibrium. – Friedrich August von Hayek

In nature just as in our personal lives, the principle of equilibrium is paramount. It permeates pretty much everything we know and do. All matters are drawn to equilibrium: the farther things move away from the state of equilibrium, the greater the forces are that pull them back to the center. Global economics and financial markets are no exception.

For several years now, we have been alerted to a situation of growing global imbalances. For us, it was never a question of IF a re-balancing would occur, but WHEN and HOW the macroeconomic imbalances would be corrected? We´ve been introduced forcefully to some of that last year. Was that it? I personally doubt it. I think that the worst is still to come.

The global economy is in a precarious situation: A large number of national economies are sensitive to interest rate movements as they accumulate an ever-increasing amount of debt. Can these imbalances persist? Are they sustainable?

The clear and simple answer is NO. The imbalances must and will correct at some point in the future and the pendulum will swing back. But we do not know when, nor do we know how. In the section below, we will take a look at what we consider to be the three most possible scenarios.

If I could only get my hands on the crystal ball!!!

Possible Scenarios Ahead

1. The Boom Scenario – From Bubble to Bubble…

It is absolutely perceivable that the imbalances will continue to grow for some time before another correction occurs, or even simply walks away into the sunset. Hollywood lovers would certainly easily expect and fully enjoy the expectation of this scenario.

They could possibly be right. A widely spread and accepted position seems to be that the good times are back for 2010 and beyond. Today´s global monetary system has proven to be far more enduring than anything we expected. This appears to be the expectation (and hope) of a large portion of the mainstream constituency, particularly in Asia, where this year´s phenomenal returns in equity may have triggered the "greed-factor".

And why not?!?! The means of economic and financial procrastination are well-developed and manifold: Central banks are actively co-operating, and with low interest rates and continued concerted US dollar support, the party could go on for some time.

It is possible that excess capital exports from low-consumption industrialized countries, developing countries in Asia, and oil-exporting nations could possibly continue and counter-act the widely feared cyclical rise in interest rates.

This could potentially produce a self-perpetuating cycle in which low interest rates fuel the financial markets, and at some point even revive struggling economies. Capital exports from surplus countries would, in turn, ensure that interest rates remain low. In this case, imbalances would become even more pronounced, thereby further delaying the necessary adjustments.

2. The Moderate Scenario – Re-Balancing Slowly…

This scenario is widely accepted as the most probable scenario by institutional investors. While this scenario accepts the fact that re-balancing must take place at some point, the expectation is that it will happen gradually over the next two years, bringing the US dollar down to a more sustainable level, with the US economic slack being picked up gradually by other nations.

In this scenario, the economic recovery is expected to sustain its momentum. Inflation is generally not seen as an issue in this scenario.

In 2010 and 2011, however, a wide consensus expects that gradually rising bond yields may put corrective pressure on those economies that are sensitive to interest rate movements, potentially piercing the NEW "bubbles" and reducing consumption. Ideally, with this scenario, time would heal away the imbalances and bring the world back into a more balanced, sustainable situation.

The US consumer, in particular, is heavily exposed to debt. Lower US consumption will continue to have a cooling effect on the entire global economy. On average, however, the real rate of economic growth could still be expected to remain higher in 2010 and beyond. So, this could result in another good year for investors.

3. The Doom Scenario – Quick and Really Ugly…

If the world comes to see that the American debt load will force the US dollar to its knees, investors may no longer feel inclined to hold US bonds. The central banks of the emerging countries – which to a large extent finance the US current account deficit through currency interventions – could be pressured by their populations to look for better ways of investing national reserves.

Therefore, there is a real risk that the year 2010 could see a faster and more drastic correction of basic imbalances than most expect.

Slowing, or actually ending, the external flow of funds to the US Treasury will have monetary, financial, and economic effects. Monetarily, the absence of foreign funds going to the US Treasury bring the ‘safety´ of the US Treasury debt market into doubt and could lead to a rapid increase in rates, perpetuating possibly then further doubts about the ‘safety´ of the US dollar. Financially, both central banks and commercial lenders could get a gigantic attack of rattled nerves, likely leading some of them to sell out of their US Treasuries, and causing others to follow.

That would bring both the US Treasury market and the US dollar into quite dangerous territory; territory of which it is skirting the line of already. The temptation will grow for US dollar holders to sell. If they do, the global rout is on.

A savage downwards break in the international value of the US dollar could destroy the central bank balance sheets and reserves of many countries. Moreover, it could have a devastating effect on world trade, in particular those exporting countries that have been "feeding" the US consumer for so long. One could expect more protectionism to spread with certainty.

Economically, the effect would be to begin a global economic CRASH. The major signal or indicator for this scenario approaching might be seen in the gold price breaking out to new highs.

4. Conclusions:

The Boom and Doom Scenarios are two extreme versions of only one ultimate reality. The Moderate Scenario could be expected to be the most probable in today´s world. However, what concerns us today is that, more than we´ve seen for a very long time, global economic and financial market affairs appear to be walking a tightrope with no safety net and very little protection left.

Any number of small pops or even larger ‘party poopers' — for example, a crisis in commercial real estate, gyrations in the derivatives sector, the failure of a large bank, a pandemic, or a war — could easily occur and throw us into the Doom Scenario.

As an investor, what is most important is to look for common denominators, for opportunities and risks that overlap in the various scenarios.

You must ask the following:

– Which scenario do I consider the most probable?

– What is my investment time horizon? Based on that time horizon, which scenario is most relevant for my investment decisions?

– Which asset classes / investments will do well in the more probable scenarios?

– Is there an asset class / investment that will do well in all scenarios?

– Which risks do I consider the most dominant? Which risks need to be prioritized in terms of my risk management?

These questions will ultimately lead you to a choice of investments and asset allocations that should allow you to protect and grow your wealth most effectively.

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