The market took great comfort in the 4Q GDP number (+8.9%) published an efficient 17 days after the end of the quarter (perhaps the BEA could pick up a few pointers). With a small improvement over the consensus of 8.7%, concerns of a weak Chinese economy have been banished from the 24 hour news cycle for the time being.

Source: Bloomberg

However, investors should probably look elsewhere for comfort.

Although China’s multi-decade economic rise is beyond dispute, China’s GDP pronouncements are more about Beijing’s economic policy thinking than a hard accounting of the sum total of goods and services produced in the PRC over a particular quarter. In my association with the Chinese markets, they have been playing this game since at least 1992 when the B share markets opened to foreign investors in Shanghai and Shenzhen.

For the next few announcements, a number too close to 8% would be signal leadership concern for a stalling economy and that a massive state intervention (a credit loosening) is imminent. A number which leans closer to double digits would signal concerns of domestic economic overheating and would foreshadow a credit tightening cycle to tame inflationary pressures. The thresholds change slightly from year to year but the game does not. China is signalling a “wait and see” stance for the time being. For Chinese provinces and municipalities which rely heavily on a bubbly property market to keep their finances in order, that message is not the one they are waiting for. Domestic demand in China is still driven primarily by investment rather than private consumption. And especially since the Global Financial Crisis, much of that investment has been skewed towards the property sector.

In the meantime, one of the “canaries in the mine” has definitely slipped off its perch. The Baltic Dry Index has halved since mid-December. Despite the name, the BDI covers shipping routes across the globe and the primary cargoes are coal, iron ore and grain. The index is subject to impressive swings because the supply of ships is fairly inelastic while demand for cargo is highly elastic That said, a 50% drop attributed to weaker Chinese demand for iron ore shipments, is not something one should ignore.

Source: Bloomberg

Australia’s “Two Speed” Economy

If China is in fact cooling its demand for iron ore in response to a general domestic slowdown, one should look at the short side of the Australian ETF, EWA. The Australian market is heavily weighted towards resources and financials and any trouble with Australia’s largest export market should show up in the market soon.

This week, there will be no newsletter as we are on the road in Australia.

What does Australia and year three of the US Presidential cycle have to do with each other? Usually, there would not be much of a connection.

But this year, there is a connection.

To over simplify, we are in year three of the cycle, the time when an incumbent President has to make sure the economy is as stimulated as possible so that the voters will give him another four years in the White House. As a result, it is often a good year to invest in risk assets like equities.

In this cycle, growth is coming from government spending and monetary expansion. And, while the Republicans may still get to repeat their temporary government shutdown routine (maybe they can avoid the political backlash this time), the expansionary policies at the FED are harder to stop.

That means we will continue to see inflationary money creation in the world’s reserve currency. And, since the money cannot all be put to work in the US economy, it will continue to fuel asset and commodity price growth around the globe.

How does that money get around the globe and into local economies? Primarily through Central Banks’ efforts to keep currencies from moving up against the US dollar, the FED’s accommodative policy is being exported to countries (like China) where inflationary expectations have already taken hold.

Australia is one of the places where these pressures will become most evident. As a major producer of agricultural and industrial commodities, it is a secondary beneficiary of the FED’s inflation creating policies. Not only has China’s boom created strong demand for iron ore, coal and other resources, it has also sent a wave of investment capital towards the continent sized country. This has ignited a surge in M&A activity as well as frothy real estate markets. The Reserve Bank of Australia has moved short rates about as high as politically possible (mortgages are mostly floating rate) so the next thing to go is the currency which has just crossed the 1.05 mark (FXA). If the Aussie dollar continues towards 1.10 and 1.20 as local investors expect, that’s a strong signal that one’s investments need to be well placed for an inflationary environment.

This week, for example, the base metal ETF (DBB) nudged the S&P 500 ETF (SPY) out of the top 3 in the Seeking Alpha ETF Portfolio. The main aim of the Fund King System is to track major investment flows to keep one’s money deployed in the most promising corners of one’s investment universe. Right now, it looks like major investors are positioning even more towards the inflation trade,

My buy order for EWJ was ignored on Tuesday morning. It wasn’t a large order. I was just putting it in to see if I could pick up the ETF on the cheap.

Unfortunately, I got a bit too clever on the limit (previous close less 10%) so I did not get filled. By 10am, I was pretty sure that I had missed the boat.

Why is that important?

Because the market meltdown in Japan and subsequent bounce are not being driven by rational calculations of the damage to the economy…it is just guesswork at this point. Nor is it a rational response to the nuclear power plant disaster. Our only comparable nuclear power accident scenarios happened decades ago.

It was the dramatic movement of money.

Smart Money Investors panicked and stabbed the sell button as soon as they saw their competitors doing the same. No one was waiting to see if mutual funds were going to be redeemed on the back of the shocking pictures and videos that blanketed the airwaves and bandwidth.

But, foreign investors only own about 25% of the Japanese equity market. There was only so much they could do. And once the selling pressure eased off…investors jumped in and bid the market up (both in Tokyo on Wednesday and EWJ not long after the opening bell on Tuesday).

The lesson in all this is that the weight of money can have dramatic effects on the value of assets. Japan’s “big picture” has not changed since last week. This week it is still the world’s #3 economy with an aging population, strong export sector, shocking level of government debt and extremely low interest rates. In the short term, it has sustained a mighty blow from Mother Nature but it has the institutions and experience to deal with the disaster. Fundamentally nothing much has changed. Emotionally, there have been several very big shifts.

What does the Fund King System have to say about it?

The System was not built for “Black Swan” events like this. What it can tell you is that Asia leading up to this event had some pretty crummy numbers behind it. Japan was the strongest of a weak bunch but the whole region is under a dark cloud of uncertainty over China’s short term economic outlook.

The first shocks have hit the market and there will undoubtedly be more aftershocks. One of the longer lasting aftershocks will be in the energy sector. As governments around the world (like Germany) take a close look at their nuclear power programs, the demand for oil is likely to rise. With the popular uprisings in Northern Africa and the Middle East threatening to disrupt the supply side, oil prices are likely to remain firm for the foreseeable future.

An informal study picked up in this Wall Street Journal blog shows that a number of basic items in East China (Hangzhou, Zhejiang Province) are actually more expensive than the same items found in Boston. The study compares basic things like eggs, milk, beef, gasoline and apartments and finds that those aspiring to join the Chinese middle class are going to pay heavily for the privilege.

When I was an expatriate in Shanghai in the 90′s, the cost of living for my family was 50% higher than that of Hong Kong but that was largely due to government imposed restrictions. Private housing was a brand new concept, expats were restricted to certain government controlled areas that charged outrageous rents and private car car ownership was almost unheard of (bicycles and buses were the main form of transportation around town). Beef and milk were frivolous luxuries and priced accordingly. A comparison of this sort 10-12 years ago would have been an apples-to-oranges type of undertaking.

But in the major cities of Eastern China (Zhejiang Province, Jiangsu Province and Shanghai municipality), owning a 100m (3600 sq ft) apartment, driving a nice car and buying more than rice and veggies for dinner have become the signposts of entry into the middle class for the young urban professional couple and their one child. The fact that these prices are both on the rise and that they constitute a much higher proportion of disposable income than in Boston is a serious political issue for China.

But Chinese officialdom is no better off than the hamster on its exercise wheel. Slowing the economy to control inflation imported from the US FED’s extremely accomodative policy (through a nearly fixed exchange rate) runs the risk of stalling the economy and sending tens of millions of urban workers to the unemployment lines. Keeping the hamster wheel going at present speed threatens a return to double digit inflation off a not so low base (as demonstrated in this article) which will eventually price China out of its traditional export based markets.

As we pointed out last week, the yield curve in the US dollar is just too attractive for any profit seeking financial institution to ignore. Until the trade becomes less attractive or something better comes along, expect continued US dollar strength. (DXY is the dollar index; UUP is an ETF which closely tracks the DXY).

Source: Bloomberg

Why is the yield curve so steep?

The short term (or left hand) end of the curve is anchored by government fiat (in the US through the agency of an independent Federal Reserve). Many pundits, experts and others expend tremendous resources to divine the inner thoughts of the men and women in charge of that decision. However, it does not take away from the fact that the Fed Funds rate is set by committee and not the market. The rest of the curve is determined by pure supply and demand. Will this always lead to a steep curve? No. Sometimes the Federal Reserve needs to squeeze inflation out of the system in which case, a higher than otherwise expected Fed Funds rate is decided upon. Under the right circumstances, that can lead to an “inverted curve” of high short rates and lower medium and long term rates.

Supply

On the supply side of the equation, with a US Federal deficit running well over 10% of GDP per annum for the foreseeable future, it is clear that we will not run out of US government debt instruments any time soon. Such a large and growing supply should and does fuel downward price pressure (and upward yield pressure) on the long end of the market. Those investors who fear that ever larger government spending programs will eventually lead to system wide inflation are amongst those who worry about the supply dynamics of the treasury market. When you hear a “Treasury Bear” argument which is framed entirely in terms of future supply, be careful with the recommendation because it is build upon only half the story. Supply is not the only factor.

Demand

Demand is driven by rational economic calculation and emotion.

The rational economic calculation is a long term estimate of growth and inflation rates by which investors weigh the purchase of a medium or long term Treasury against alternative investment options. Those considerations are well discussed in the market and tend to change slowly on a quarter by quarter basis. Has something fundamental changed in the last three or four weeks? Possibly. The Euro’s foundation has been show to be a lot weaker than previously expected. That doesn’t impact US treasuries directly but it does reduce the attractiveness of Euro Government Debt instruments that compete for investor attention. Right now, the biggest source of demand comes from the banks who are able to borrow at the short end rate and “lend” it back to the US Government in the form of 2,3 and 4 year Treasuries.

The emotional side is responsible for the short term moves. Emotional factors are almost always couched in fundamental terms. Sometimes those short term emotional excuses will become longer term rational economic calculations. However two things are for sure. They start out as emotions and investors often don’t realize they are reacting to emotions because they rationalize the decisions as fundamental changes in the economic landscape. Very rarely will a fund manager get on TV to announce that he or she is petrified by the market and plans to hide in two year treasuries for the time being. It is much more likely to hear the fund manager point out two or three recent datapoints as justification for making a mid-course asset allocation adjustment.

What are the emotional buttons today? Europe has certainly provided the bulk of them lately but one shouldn’t forget the employment figures in the US, the retail figures (both can be bundled into general “double dip” recession fears), China’s property bubble and a myriad of other worries lurk in today’s financial markets.

The Giant Sucking Sound

In the 1992 Presidential Campaign, Ross Perot warned that the NAFTA trade agreement would move so many jobs from the US to Mexico that the result would be akin to a Giant Sucking Sound. If Ross Perot were in charge of the European Central Bank, he might be hearing that sound today as European financial institutions fall all over themselves and other global players to participate in the US dollar yield curve trade. The reason we do not hear Mr. Trichet moaning too loudly is because a weaker Euro is precisely what political leaders in Germany, France and Northern Italy want to see. From luxury goods to machine parts to wine, cheese, ham and sports cars, Europe’s exports will receive a nice short term boost. With capacity utilization at 75% and rising however, the fun cannot be allowed to continue indefinitely as Europe’s banks will need to refocus on bread and butter loans. So, while it is fun to attribute some sort of deeper meaning to the Euro heading back to parity with the US Dollar, larger fundamental forces in Europe will likely remove some of the demand for US dollars when European manufacturers try to expand on the back of strong export sales.

So, what does this mean for investors?

A rising dollar means that commodities (mostly priced in dollars) are unlikely to rise soon. Part of that is the dollar price tag but another part is falling demand from the Eurozone. Oil in particular can be quite sensitive on the downside to a strong US dollar.

With petroleum products like gasoline not rising (contrary to what normally happens during the US summer driving season) and European imports on sale, expect the mushy US retail numbers to improve through Labor Day at least. Consumers won’t necessarily spend just because gasoline prices are low but if there is a sale on as well, wallets should open. Therefore, we are not surprised to see VCR and XLY in the top rankings of the system.

Will GLD perform well? Not likely. Short term Treasuries and Gold are competing for the attention of the panic stricken investor. If we toss in near term US dollar strength, the balance tips from non-yielding gold to low yielding treasuries. Of course, all of these conditions are reversible so if one sees gold correct nicely in the coming months ($800-900), a sensible investment opportunity may present itself on the next upcycle.

How about equities by region? Small caps are showing continued resilience in the US but there is not much conviction behind the trade. Large caps, as represented by SPY, are not going anywhere with a very slim preference for Value (slightly ahead) over Growth (slightly behind). Large Cap European stocks (FEZ, for example) are at the bottom of the rankings as the sovereign debt issues play out at large European banks, swamping the positive benefits accruing to the large export manufacturers. Emerging Europe is still promising as it will benefit from export driven outsourcing from Germany as well as M&A opportunities as mature European corporates are compelled to switch focus from expensive US dollar based assets to cheaper Euro linked asset markets.

Asia is a mixed bag. Japan’s equity market looks to be cooling off a bit as the Yen is the only other currency as strong as the US dollar. China is at the bottom of the list for largely internal reasons related to the unwinding of a property bubble while India is close to the top of the rankings. Other Asian markets, which are tied to the US dollar, are in the middle of the pack and can be safely underweighted at this point.