Putin calls out Europe

Outlook

The calendar is relatively light today, including PPI and the University of Michigan consumer sentiment index. But before looking at next week’s relatively full calendar, we’d like to get grip on yesterday’s equity market panic. For one thing, a sell-off is always to be expected after new all-time highs. Both the Dow and S&P posted new life-time highs last Friday. For another, chartists can claim some credit here, with the charts indicating an overbought condition.

As for the tech and biotech sectors having benefited the most from Fed largesse and thus be the most affected on the downside when the Fed takes away the punchbowl—we don’t buy it. The most interest rate-sensitive sectors are banking and real estate, not tech and biotech. Besides, the interpretation of the Fed minutes was that the members were worried their truly dovish attitude would not be taken seriously enough, so for the tech and bio-tech traders to see relentless rate hikes coming is just wrong. You can’t have it both ways—the Fed clearly saying hikes long delayed (lower for longer) and the very next day, screaming fear of hikes.

We have other evidence of overvalued equities, as the JP Morgan earnings report shows. Revenue and earnings fell more than forecast, led by trading fixed income, currencies and commodities (down 21%). Golly, did new regs stifle trading capability? Hogwash. A good trader adapts to conditions. Besides, a bigger drop was posted in the consumer bank, with net income down 25%. The FT says “The weakness was concentrated in mortgages, where the muted revival in new purchases has been insufficient to counter the plummet in fees from homeowners refinancing their loans.” Well, a good manager re-allocates resources, too. You can’t blame the Fed for everything.

We wonder if the biggest event today is not Putin calling out Europe—imagine writing a letter to 18 European leaders!—to act as a sovereign on an equal footing with Russia. The wording of Putin’s letter suggests Russia is demanding equal sovereign standing with each of the European countries, but the hidden message—18 letters!—is that Europe is not a sovereign. To qualify as a sovereign, you have to have more than a common currency—you also need an army to defend your borders (and a treasury to tax the people and pay for the army). We go into the “qualifications for sovereignty” in detail in our book The FX Matrix. If Putin were less insecure, he would be making full use of the lack of cohesion instead of pleading for a deal on equal footing. Europe doesn’t actually have a foreign policy. It’s clinging to the feet of NATO, which has been asleep for a decade or more. We deduce that Putin wants Gazprom’s past-due revenue more than he wants to twist Europe’s nose, but don’t let the incident go unremarked. It’s a big deal. And the implication is that Europe will not respond cohesively because it’s not designed to do so, and unless Chancellor Merkel steps to the plate, Gazprom will go unpaid and supplies will get cut. We are putting our money on Merkel.

The other Event is India’s newish Reserve Bank Gov Rajan, the world’s darling, complaining but elegantly on the sidelines of G20 and the IMF meetings that start in full today that too-low rates in the developed world will push emerging markets to squander money on building reserves instead of promoting growth. According to the FT, Rajan says “Any remaining rules of the game are breaking down.” It is “inconsistent for advanced economies to tell poorer countries to keep their exchange rates stable at the same time as pursuing policies that led to huge destabilizing flows of hot money across the world.” This argument is no different than the currency war comments from the Brazilian FinMin at G20 in Seoul two years ago, and Mr. Bernanke called him on it, saying “the difference between QE and exchange rate manipulation was that the former added to world demand while exchange rates diverted it.” We can come to no other conclusion than that emerging markets need to institute exchange controls. They are bad and distort prices and promote corruption, but the only remedy. QE is bad an distorts prices, too, and the Fed is trying to back-peddle its way out of it as fast as it can without trashing the economy. Rajan is the new darling (and the only handsome central bank gov we can recall) but he needs a re-boot on this one. Still, the currency war story has not ended. Love of yield can still turn smelly.

We don’t see safe-haven flows into the dollar given these conditions, except maybe yields faltering and lower on Chinese growth. But that is certainly not helping the dollar. After whatever pullback we get today, we see a resumption of euro strength next week. The AUD is probably the most threatened, but even then has only a small loss of momentum.