Sand

Yesterday I got chatting to an emerging market fund manager. And she told me that she’d tried to be bearish emerging markets, but it just wasn’t happening. So she was bullish. And anyway, she said, whatever the doubters believed, there was plenty of liquidity.

Now that caught my attention. Charlie Munger would have been horrified. His view – if you want to maximise your investing IQ – the first thing you need is patience. A bear market rally, after the extreme moves into mid-January, shouldn’t be enough to shake your view of the world. Munger said he’d often spent years in treasuries before he found enough value to buy stocks. A couple of months doesn’t really count.

And then there’s the issue about hanging your hat on liquidity. You’ve got to be dead sure you know what it is and how it works.

What is it? It is dollars passed abroad and multiplied through the global commercial banking system.

How does it work? It is very slow, but utterly relentless.

So, to trade on the basis of liquidity, you need to be very patient, and you need to think in terms of probabilities – the liquidity regime changes the odds of the investment game. A liquidity downturn is a time to be more cautious equities. It can last for years.

This is how I build it up. First off, I look at the US current account deficit. This is like global base money. It’s the number of extra dollars flowing out to the world.

Now the obvious thing about the US deficit is that it shrinks in a US recession. It’s not completely obvious before hand. After all export could slow as fast as imports. But imports are much larger. They also have a much higher macro beta – as they comprise an outsize proportion of basic cyclical inputs at one end, and luxury items at the other. But few basic services. The bottom line is that if you are the US in recession, the world – to use Bill Clinton’s phrase – feels your pain.

Now the most intelligent question in global macro is one I’ve heard asked only once of late; where is the US current account deficit going?

Back in the 1990 recession, and again in the 2001 recession, the US current account deficit shrank by 1.5 percentage points of GDP. In both cases, the result was global financial carnage.

Since Q107, the deficit has again shrunk by 1.5 percentage points. But this time the deficit has not shrunk from 1.5% or 2.5% to near zero. It has shrunk from 6% to 4.5%. Already we’ve seen a good dose of financial destruction. But, the question is – is this it? Or are we headed for 3%, or 1.5%, or zero again?

I see no conceptual reason, in the face of the mother of all self reinforcing housing and credit downturns in the US, that the deficit can’t get back towards zero over the next two or three years. The chart shows that every time the deficit swings down, we get a financial crisis. If we do go to zero, then, on past form, we are due three more financial crises from here.

Now, there’s no way that a reduction in imports from the rest of the world would be sufficient to cause a major financial problem on its own. The issue is not so much the direct slowdown in growth – it is the contraction in ‘free’ dollars travelling round the world. And each of those dollars finds itself in a commercial bank – where it is loaned, returned and loaned again. So much so that the effect is to turn the initial flow of dollars into a five to tenfold greater increase in the supply of global credit.

Now, there are no perfect series for global financial flows. But the best series is FRODOR – developed by Ed Yardeni. It is base money in the US added to global central banks reserves held with the Fed. This works as a kind of global broad money – how much cash is sloshing around once it’s been through the commercial banking system. If it runs faster than 6% (average nominal global growth) then it’s expansionary, below and it starves the world of credit.

In a world short of credit, the weakest credit usually goes bust.

Now FRODOR hasn’t collapsed yet, but with a shrinking US deficit, and the clear signal from banks across the developed world that they are pulling back from lending – my bet is FRODOR heads towards zero – genuine danger territory – over the coming year or so.

But this being global capital flows, it’s not that simple. Because the Gulf States don’t report their reserves. So what I’ve done is to try to approximate them – using oil prices, Gulf production and an assumption on costs. And once you do that you get a chart that shows a bit of extra juice coming through over the past year.

That was one of several data series that kept me bullish resources through the first five months of this year.

This week, I went back to look at the assumptions behind the chart. That Middle East oil cost $35/bbl to get out of the ground. And that the surplus flows directly into reserves.

First off, the likelihood is that costs are escalating fast. The start-up operations in Saudi are substantially more expensive than Ghawar, and Ghawar itself is getting more expensive as the water cut rises, and the pressure falls. Burgan in Kuwait is looking increasingly expensive as production fades from peak. And that’s before we get into the runaway inflation across the region, the specific rise in material costs, the shortage of engineers, and the increased security costs. Perhaps a more realistic view of production costs is that they are rising through the forties.

The second issue is where the cash is going. A lot has been written about sovereign wealth funds. But the bigger story is the Gulf infrastructure boom. And this is no flash in the pan – it is a deliberate policy, based on a far reaching vision that the Gulf will be the hub of the new ‘spice route’ of global trade. The vision is massive, and it will consume the surplus. My suspicion is that, with the major rise in infrastructure costs over the last two years, combined with the fantastic increase in the Gulf States’ ambitions over the same period, those surpluses are likely fading – even in the face of the vertical move in oil. If oil stops going up, heaven forbid.

That reminds me of a passage in Adam Smith’s ‘Paper Money’. In the 70’s the financial markets had got used to petrodollar reflows. They were a major source of liquidity. But then, in the late 70s, they stopped. Noone knew why.

Until some bright spark found that Saudi Arabia was importing sand. Now of course, as there is more sand per capita in Saudi Arabia than in any other country in the world, this made no sense. It turned out that someone had persuaded the Saudis that they had the wrong kind of sand for construction cement. They imported it, and it was the lasting symbol of their disappearing financial surplus.

The Gulf States may not be importing sand today, but they are importing just about everything else, as they build out one of the greatest infrastructure programmes in all history. My bet, some month soon, those petrodollars will stop flowing round the world, and instead they will slip back into the desert sands.