Dollar smashes through resistance as mega-rally gathers pace

HSBC says we are at the early stages of a dollar bull run that will change the world

By Ambrose Evans-Pritchard, International Buisiness Editor

8:19PM GMT 03 Nov 2014

Many $100 US Dollar Bills
Speculative dollar bets on the derivatives markets have reached a record high Photo: Alamy


The US dollar has surged to a four-year high against a basket of currencies and has punched through key technical resistance, marking a crucial turning point for the global financial system.
 

The so-called dollar index, watched closely by traders, has finally broken above its 30-year downtrend line as the US economy powers ahead and the Federal Reserve prepares to tighten monetary policy.
 
The index - a mix of six major currencies – hit 87.4 on Monday, rising above the key level of 87.

This reflects the plunge in the Japanese yen since the Bank of Japan launched a fresh round of quantitative easing last week.
 
Data from the Chicago Mercantile Exchange show that speculative dollar bets on the derivatives markets have reached a record high, with the biggest positions against sterling, the New Zealand dollar, the Canadian dollar, the yen and the Swiss franc, in that order.
 
David Bloom, currency chief at HSBC, said a “seismic change” is under way and may lead to a 20pc surge in the dollar over a 12-month span. The mega-rally of 1980 to 1985 as the Volcker Fed tightened the screws saw a 90pc rise before the leading powers intervened at the Plaza Accord to cap the rise.

“We are only at the early stages of a dollar bull run. The current rally is unlike any we have seen before. The greatest danger for markets and forecasters is that they fail to adjust their behaviour to fully reflect a very different world,” he said.




Mr Bloom said the stronger dollar buys time for other countries engaged in currency warfare to “steal inflation”, now a precious rarity that economies are fighting over. The great unknown is how long the US economy itself can withstand the deflationary impact of a stronger dollar.

The rule of thumb is that each 10pc rise in the dollar cuts the inflation rate of 0.5pc a year later.
 
Hans Redeker, from Morgan Stanley, said the dollar rally is almost unstoppable at this stage given the roaring US recovery, and the stark contrast between a hawkish Fed and the prospect of monetary stimulus for years to come in Europe.
 
“We think this will be a four to five-year bull-market in the dollar. The whole exchange system is seeking a new equilibrium,” he said. “We think the euro will reach $1.12 to the dollar by next year and will be even weaker than the yen in the race to the bottom.”

Mr Redeker said US pension funds and asset managers have invested huge sums in emerging markets without considering the currency risks. “They may be forced to start hedging their exposure, and that could catapult the dollar even higher in a self-fulfilling effect.”

The dollar revival could prove painful for companies in Asia that have borrowed heavily in the US currency during the Fed’s QE phase, betting it would continue to fall.
 
Data from the Bank for International Settlements show that the dollar “carry-trade” from Hong Kong into China may have reached $1.2 trillion. Corporate debt in dollars across Asia has jumped from $300bn to $2.5 trillion since 2005.
 
More than two-thirds of the total $11 trillion of cross-border bank loans worldwide are denominated in dollars. A chunk is unhedged in currency terms and is therefore vulnerable to a dollar “short squeeze”.
 
The International Monetary Fund said $650bn of capital has flowed into emerging markets as a result of QE that would not otherwise have gone there. This is often fickle “low-quality” money that came late to the party.
 
Many of these countries have picked the low-hanging fruit of catch-up growth and are suffering from credit exhaustion. They have deep structural problems and a falling rate of return on investment. The worry is that a tsunami of money could rotate back out again as investors seek higher yields in the US, possibly through crowded exits.

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Kuroda, Bubbles and King Dollar



October 31, 2014


Kuroda stokes stock prices and king dollar.

When it seems almost impossible, things somehow get even crazier. By Thursday afternoon (thinking ahead to my Friday writing project), I was discerning a backdrop increasingly reminiscent of the summer of 2012. Jumping a quick 50 bps, Greek bond yields traded above 8% on Thursday. Italian bonds and CDS were under pressure, as part of general concerns weighing on Europe’s vulnerable periphery (not to mention that nine Italian banks failed ECB stress tests). German bunds were in melt-up (record low yields with widening periphery spreads).  It was also apparent that the direction of the yen and stability of yen “carry trades” were crucial to acutely unstable global markets – keys to the “risk on, risk off” speculative market dynamic. A strong yen would be problematic, perhaps even inciting deleveraging of trades in Greek, Portuguese, Italian and Spanish debt.

I guess I shouldn’t have been surprised to awaken early Friday morning and see that the Bank of Japan (BOJ) had stunned global markets with an up to 30% boost in its QE “money” printing operation (to $725bn annually!). A couple strategists offered apt quotes: “It was great timing for Kuroda.” “The timing of all this was very clever.” Clever indeed.

October 31 – Bloomberg (Kelly Bit): “Julian Robertson, the billionaire founder of Tiger Management LLC, called global monetary policy, such as Japan’s surprise expanded stimulus today, dangerous as central banks push bond yields down and create a bubble. ‘The monetary authorities all over the world are trying to cheapen their own currencies -- it’s a race everywhere and I’m not sure it’s the best thing to do,’ Robertson said… ‘We have a bubble developing because we have forced bonds to almost no yield and it’s really the thing that’s the most dangerous going on economically in the world.”


In the twelve trading sessions sin
ce the October 16th 1,813 (“Bullard”) low, the S&P500 rallied almost 11%. The semiconductors have surged about 18% from October 15th lows and the Biotechs 22%. The Nasdaq100 has jumped 12% and the Transports almost 14%. The small caps have rallied almost 13%.

With the Fed about to conclude QE, a couple weeks back global markets were facing their first serious bout of de-risking/deleveraging without certainty that the Fed was there as the market’s reliable liquidity backstop. Federal Reserve Bank presidents Bullard and Williams were quick to come to the markets’ defense, affirming market expectations that additional QE would be provided as needed. There have been as well leaks that the ECB was considering corporate bonds purchases, buying that would significantly increase the odds of Draghi making good on his talk of a Trillion euro ECB balance sheet expansion. And then Friday, the world sees more “shock and awe” from the BOJ’s Haruhiko Kuroda.

For yet another week that will draw the attention of future historians, there were scores of notable headlines: WSJ: “Kuroda Bazooka Round Two.” “Reuters: “Fed Set to End One Crisis Chapter Even as Global Risks Rise.” Financial Times: “Fed’s Grand Experiment Draws to a Close.” Wall Street Journal: “Fed Set to End QE3, but not the QE Concept.”

The week also saw commentators absolutely lavish praise upon the Fed and its QE measures.


Clearly, it’s ridiculously early to pass judgment on history’s greatest monetary experiment.

After all, QE is a global phenomenon that hasn’t yet come even close to running its course. And it’s a global Bubble, with both the BOJ and ECB both pushing ahead with even more aggressive global monetary inflation. Importantly, the hope that the ECB would grab the QE baton from Yellen has been fulfilled at the forceful hands of Draghi and Kuroda.

I noted above that the backdrop is reminiscent of the summer of 2012. At that time, the global financial system was at much greater risk than generally perceived. Markets were at the brink of a crisis of confidence in Italian debt, which would have triggered a crisis of confidence in Italian banks, European banks more generally and the euro currency. A run on European banks and the euro would have raised serious issues for the emerging markets and global leveraged speculating community, not to mention counter-party and derivative issues.

Importantly, the risks were deeply systemic. Policy responses were systemic. Draghi moved forward with “Do Whatever it Takes,” followed soon by open-ended QE from Bernanke and Kuroda. I never bought into the notion that Fed “money” printing was about U.S. jobs. I don’t believe Kuroda’s move Friday was about Japanese inflation. Policy responses have been akin to Benjamin Strong’s 1927 “coup de Whiskey,” but on a multi-shot global basis (with chaser).


And over the past two years we’ve witnessed a 1927 to 1929-like market response, again on a globalized basis.

Predictably, throwing Trillions of “money” at a global Bubble has only exacerbated instability. Throwing Trillions of “money” at dangerously maladjusted global financial and economic “systems” will surely only worsen the addiction. I see Kuroda’s move as further evidence of global central bank desperation. Global risks have inflated profoundly since 2012.

October 28 – Bloomberg (Candice Zachariahs and Lukanyo Mnyanda): “For European Central Bank President Mario Draghi, the price of a weaker euro to boost the economy and stave off deflation is a record exodus from the continent’s financial assets. Domestic and foreign investors spurred 187.7 billion euros ($239bn) of fixed-income outflows from the euro area in the six months through August, the most in ECB data going back to the currency’s debut in 1999.”
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Europe is again experiencing alarming outflows, even surpassing 2012 levels. Almost $240bn in six months, wow! And for the first time in a couple years I and others are monitoring ECB “Target2” balances (Eurozone central bank inter-bank balances). Target2 balances have surged euro 67bn in two months, the biggest move since the spring of 2012. Notably, Bank of Italy Target2 liabilities jumped $67bn in two months to $197bn, as “money” owed to the German Bundesbank moves higher. A quiet run from Italy?

I have posited that borrowing at zero in a devaluing yen to play higher global yields is likely history’s greatest speculative wager. I have pondered how Draghi’s “Do Whatever it Takes” market backstop for European periphery debt created the world’s most attractive higher-yielding securities for leveraging. I’ve as well presumed that the “yen carry trade” has likely played a significant role in financing a Europe periphery bond Bubble. Especially over recent weeks of global market instability, I’ve pondered the consequences of a “yen carry” unwind. To this point, the weak euro has not hurt those leveraged in European periphery debt – not if these speculations were financed by borrowing in a devaluing yen. But in a world of increasingly vulnerable speculators and a heightened risk of de-leveraging, a yen rally could have very well pushed European debt markets over the cliff. When it comes to global monetary policymaking, I do not believe in coincidences. Kuroda to the rescue.

There remain these two parallel universes. There’s the Truman Show World: Kuroda has essentially nothing to do with the great U.S. bull market. It is instead driven by robust economic fundamentals, including strong GDP and corporate profits. The U.S. is simply the best place in the world to invest – and American equities are a friggin’ slam dunk, all-in buy.


King Dollar is confirmation of all that is good in the U.S.

The alternative universe is a totally different world: Kuroda is one of a very select group of leading central bankers working desperately to sustain a runaway global financial Bubble.


There’s a historic experiment in “money” printing that is at the brink of failure. Around the world there are speculative financial market Bubbles of unprecedented proportions at risk of bursting. History’s Greatest Credit Bubble already has serious cracks. Moreover, the incredible widening gap between (Truman Show) securities prices and deteriorating (bursting Bubble) fundamental prospects boosts the likelihood of a global market accident.

One of these days, global central banks will lose control. For now, they will continue to print “money,” spur destabilizing speculation and exacerbate global imbalances. Importantly, their measures continue to promote wealth redistribution and inequality – within nations and among nations. Bernanke previously referred to Kuroda’s policy as “enrich thy neighbor.” I wonder if Japan’s neighbors these days see it in such rosy light. With Draghi and Kuroda promoting King Dollar, I wonder how commodity-related companies and countries are feeling about the state of the world. Gold sank below $1,200 this week, crude traded below $80 and the GSCI Commodities Index traded to new four-year lows. Central bank policies are inflicting some real (inequitable) damage this time around.

This was another week to ponder some of my favorite Credit Bubble adages: “Bubbles tend to go to unimaginable extremes – then double!” “Things turn crazy in the ‘Terminal Phase’ of Bubble excess.” “Liquidity loves inflation.” “Central banks can create liquidity but they cannot dictate where it flows.” “It is a myth that central banks control a general price level.” “Credit Bubbles are all about wealth redistribution.”

Despite Kurodamania and record stock prices, I contend that the great global Credit Bubble has been pierced. Energy and commodities prices have collapsed, inflicting irreparable harm on scores of highly-indebted companies and economies. Importantly, King Dollar has turned increasingly destabilizing. I ponder how Putin today views “Western” policymaking that further pressures the price of it key national resource. The Bank of Russia Friday boosted interest-rates 150 bps to support its flagging currency. Ominously, the ruble sold off on the news, ending the session down 3.5%.

The bursting global Bubble thesis holds that others at the “periphery” are now at risk of a downward spiral of sinking commodities prices, “hot money” exodus, acute financial instability and economic vulnerability. In this regard, Brazil joins Russia at the top of the watch list.


Despite recessionary conditions, Brazil’s central bank raised rates Thursday to support its faltering currency. The real bounced 2.5% Thursday on the rate news, only to sink 3.0% in Friday’s Kuroda-induced King Dollar drubbing.

It’s worth noting that Brazil’s central bank has issued over $100bn of currency swaps, payable in local currency (reals). Writing these derivatives – insurance against a declining real – has allowed international speculators and investors to easily hedge their Brazilian currency exposure. And these types of arrangements work wonders – until they blow up. A big downward move in the real would require the “printing” of tens of billions of reals to pay on the central bank’s swap contracts – printing that would further depress the real and perhaps even risk a crisis of confidence. King Dollar is a big problem for a sadly vulnerable Brazil.

With the S&P500 having now recovered all losses from the recent bout of market instability, the bulls are ready for another leg higher. Certainly, investors and speculators alike have been reassured by the words and deeds from the Fed, ECB and BOJ. Worries that central bankers might not be there to backstop markets have been alleviated. The rabid bulls have been emboldened.

The mortgage finance Bubble was initially pierced in the spring of 2007, as subprime securities suffered losses and “hot money” flows abruptly reversed course. An aggressive Federal Reserve policy response helped push U.S. and global stocks to record highs in 2007’s fourth quarter.


These reflationary measures spurred Bubble excess, including a speculative run in equities and $145 crude. At best, however, these measures only slowed the deflating Bubble as it gravitated from subprime to prime mortgage Credit. I’ve always been convinced that 2007 reflationary measures only exacerbated the 2008 global crisis. International risk markets turned more speculative (and highly correlated), when general stability would have been better served by a more orderly deflating of Bubble excess.

Each bout of market instability (August ’07, November ’07, January ’08, March ’08 and July ‘08) worked to solidify the view that policymakers had everything under control and would not tolerate a crisis. After trading above 30 in five separate bouts of market turbulence (August ’07 through July ’08), the VIX dipped below 20 by late August 2008. About six week later, in the midst of a so-called “black swan” financial panic (central banks actually don't have things under control!), the VIX reached 80.

And this gets right to the heart of the fundamental problem with central bank (“Keynesian”) market manipulation and “money” printing: there’s a fine line between acting to lessen the effects of a bursting Bubble and measures that inflate and prolong precarious Bubble excess. As we’ve witnessed, the deeper policymakers fall into the market intervention and manipulation trap the greater the fragility. And the more acute the fragility the more quickly officials must intervene to ensure that things don’t start to come unglued. In the end, it regresses into desperate measures to hold collapse at bay – 2012 to 2014.

October 30 – Bloomberg (Ben Moshinsky): “The shadow banking industry grew by $5 trillion to about $75 trillion worldwide last year, driven by lenders seeking to skirt regulations and investors searching for yield amid record low interest rates. The size of the shadow banking system, which includes hedge funds, real estate investment trusts and off-balance sheet investment vehicles, is about 120% of global gross domestic product, or a quarter of total financial assets, according to a report published by the Financial Stability Board… Shadow banking ‘tends to take off when strict banking regulations are in place, when real interest rates and yield spreads are low and investors search for higher returns, and when there is a large institutional demand for assets… The current environment in advanced economies seems conducive to further growth of shadow banking.’”


I’m not convinced “the current environment in advanced economies seems conducive to further growth of shadow banking.” Actually, if I am on the right track with my bursting Bubble thesis, the surprise could be that fragility lurks in “shadow banking” – from New York to London to Tokyo to Beijing.


Why the Financial and Political System Failed and Stability Matters

Nomi Prins

Monday, October 27, 2014 at 3:39PM


The power elite may exude belabored moans about slow growth and rising inequality in speeches and press releases, but they continue to find ways to provide liquidity, sustenance and comfort to financial institutions, not to populations.
 
The very fact - that without excessive artificial stimulation or the promise of it - more hell breaks loose - is one that government heads neither admit, nor appear to discuss. But the truth is that the global financial system has already failed. Big banks have been propped up, and their capital bases rejuvenated, by various means of external intervention, not their own business models.
 
Last week, the Federal Reserve released its latest 2015 stress test scenarios. They don’t even exceed the parameters of what actually took place during the 2008-2009-crisis period. This makes them, though statistically viable, completely irrelevant in an inevitable full-scale meltdown of greater magnitude. This Sunday, the ECB announced that 25 banks failed their tests, none of which were the biggest banks (that received the most help). These tests are the equivalent of SAT exams for which students provide the questions and answers, and a few get thrown under the bus for cheating to make it all look legit. 
 
Regardless of the outcome of the next set of tests, it’s the very need for them that should be examined. If we had a more controllable, stable, accountable and transparent system (let alone one not in constant litigation and crime-committing mode) neither the pretense of well-thought-out stress tests making a difference in crisis preparation, nor the administering of them, would be necessary as a soothing tool. But we don’t. We have an unreformed (legally and morally) international banking system still laden with risk and losses, whose major players control more assets than ever before, with our help.  
 
The biggest banks, and the US and European markets, are now floating on more than $7 trillion of Fed and ECB intervention with little to show for it on the ground and more to come. To put that into perspective – consider that the top 100 global hedge funds manage about $1.5 trillion in assets. The Fed’s book has ballooned to $4.5 trillion and the ECB’s book stands at $2.7 trillion – a figure ECB President, Mario Draghi considers too low. Thus, to sustain the illusion of international systemic health, the Fed and the ECB are each, as well as collectively, larger than the top 100 global hedge funds combined.
 
Providing ‘liquidity crack’ to the financial system has required heightened international government and central bank coordination to maintain an illusion of stability, but not true stability. The definition of instability is this epic support network. It is more dangerous than in past financial crises precisely because of its size and level of political backing.
 
During the Panic of 1907, President Teddy Roosevelt’s Treasury Secretary, Cortelyou announced the first US bank bailout in the country’s history. Though not a member of the government, financier J.P. Morgan was chosen by Roosevelt to deploy $25 million from the Treasury. He and a team of associates decided which banks would live or die with this federal money and some private (or customers’) capital thrown in.
 
The Federal Reserve was established in 1913 to back the private banking system in advance from requiring future such government injections of capital. After World War I, a Laissez Faire policy toward finance and speculation, but not alcohol, marked the 1920s. before the financial system crumbled under the weight of its own recklessness again. So on October 24, 1929, the Big Six bankers convened at the Morgan Bank at noon (for 20 minutes) to form a plan to 'save' the ailing markets by injecting their own (well, their customer’s) capital.  It didn’t work. What transpired instead was the Great Depression.
 
After the Crash of 1929, markets rallied, and then lost 90% of their value. Liquidity froze. Credit for the masses was as unavailable, as was real money. The combined will of President FDR and the key bankers of the day worked to bolster people’s confidence in the system that had crushed them - by reforming it, by making the biggest banks smaller, by separating bet-taking arms from those in which people could store, and borrow money from, safely. Political and financial leaderships collaboratively ushered in the reform measures of the Glass-Steagall Act.  As I note in my most recent book, All the Presidents' Bankers, this Act was not merely a piece of legislation passed in spirited bi-partisan fashion, but it was also a means to stabilize a system for participants at the top, middle and bottom of it. Stability itself was the political and financial goal.
 
Through World War II, the Cold War, and Vietnam, and until the dissolution of the gold standard, the financial system remained fairly stable, with banks handling their own risks, which were separate from the funds of citizens. No capital injections or bailouts were required until the mid-1970s Penn Central debacle. But with the bailout floodgates reopened, big banks launched a frenzied drive for Middle East petro-dollar profits to use as capital for a hot new area of speculation, Third World loans.
 
By the 1980s, the Latin American Debt crisis resulted, and with it, the magnitude of federally backed bank bailouts based on Washington alliances, ballooned. When the 1994 Mexican Peso Crisis hit, bank losses were ‘handled’ by President Clinton’s Treasury Secretary (and former Goldman Sachs co-CEO) Robert Rubin and his Asst. Treasury Secretary, Larry Summers via congressionally approved aid.
 
Afterwards, the repeal of the Glass Steagall Act, the mega-merging of financial players, the explosion of the derivatives market, and the rise of global ‘competition’ amongst government supported gambling firms, lead to increase speculative complexity and instability, and the recent and ongoing 2008 financial crisis.  
 
By its actions, the US government (under both political parties) has chosen to embrace volatility rather than stability from a policy perspective, and has convinced governments in Europe to follow suit. Too big to fail has been replaced by bigger than ever.
 
Today, the Big Six US banks are mostly incarnations of the Big Six banks in 1929 with a few add-ons due to political relationships (notably that of Goldman Sachs, whose past partner, Sidney Weinberg struck up lasting relationships with FDR and other presidents.) 
 
We no longer have a private financial system responsible for its own risk, regardless of how it’s computed or supervised. We have a system whose risk is shouldered by the federal government and its central bank entities, and therefore, the people whose deposits seed that risk and whose taxes and futures sustain it.
 
We have a private financial system that routinely commits financial crimes against humanity with miniscule punishments, as approved by the government. We don’t even have a free market system based on the impossible notion of full transparency and opportunity, we have a publicly funded betting arena, where the largest players are the most politically connected and the most powerful politicians are enablers, contributors and supporters. We talk about wealth inequality but not this substantial power inequality that generates it. 
 
Today, neither the leadership in Washington, nor throughout Europe, has the foresight to consider what kind of real stress would happen when zero and negative interest rate and bond-buying policies truly run their course and wreak further havoc on their respective economies, because the very banks supported by them, will crush people, now in a weaker economic condition, more horrifically than before.
 
The political system that stumbles to sustain the illusion that economies can be built on rampant financial instability, has also failed us. Past presidents talked of a square deal, a new deal and a fair deal. It’s high time for a stability deal that prioritizes the real financial health of individuals over the false one of financial institutions.


The Single-Engine Global Economy

Nouriel Roubini.

OCT 31, 2014 .


TOKYO – The global economy is like a jetliner that needs all of its engines operational to take off and steer clear of clouds and storms. Unfortunately, only one of its four engines is functioning properly: the Anglosphere (the United States and its close cousin, the United Kingdom).
 
The second engine – the eurozone – has now stalled after an anemic post-2008 restart. Indeed, Europe is one shock away from outright deflation and another bout of recession. Likewise, the third engine, Japan, is running out of fuel after a year of fiscal and monetary stimulus. And emerging markets (the fourth engine) are slowing sharply as decade-long global tailwinds – rapid Chinese growth, zero policy rates and quantitative easing by the US Federal Reserve, and a commodity super-cycle – become headwinds.
 
So the question is whether and for how long the global economy can remain aloft on a single engine. Weakness in the rest of the world implies a stronger dollar, which will invariably weaken US growth. The deeper the slowdown in other countries and the higher the dollar rises, the less the US will be able to decouple from the funk everywhere else, even if domestic demand seems robust.
 
Falling oil prices may provide cheaper energy for manufacturers and households, but they hurt energy exporters and their spending. And, while increased supply – particularly from North American shale resources – has put downward pressure on prices, so has weaker demand in the eurozone, Japan, China, and many emerging markets. Moreover, persistently low oil prices induce a fall in investment in new capacity, further undermining global demand.
 
Meanwhile, market volatility has grown, and a correction is still underway. Bad macro news can be good for markets, because a prompt policy response alone can boost asset prices. But recent bad macro news has been bad for markets, owing to the perception of policy inertia.

Indeed, the European Central Bank is dithering about how much to expand its balance sheet with purchases of sovereign bonds, while the Bank of Japan only now decided to increase its rate of quantitative easing, given evidence that this year’s consumption-tax increase is impeding growth and that next year’s planned tax increase will weaken it further.
 
As for fiscal policy, Germany continues to resist a much-needed stimulus to boost eurozone demand. And Japan seems to be intent on inflicting on itself a second, growth-retarding consumption-tax increase.
 
Furthermore, the Fed has now exited quantitative easing and is showing a willingness to start raising policy rates sooner than markets expected. If the Fed does not postpone rate increases until the global economic weather clears, it risks an aborted takeoff – the fate of many economies in the last few years.
 
If the Republican Party takes full control of the US Congress in November’s mid-term election, policy gridlock is likely to worsen, risking a re-run of the damaging fiscal battles that led last year to a government shutdown and almost to a technical debt default. More broadly, the gridlock will prevent the passage of important structural reforms that the US needs to boost growth.
 
Major emerging countries are also in trouble. Of the five BRICS economies (Brazil, Russia, India, China, and South Africa), three (Brazil, Russia, and South Africa) are close to recession.

The biggest, China, is in the midst of a structural slowdown that will push its growth rate closer to 5% in the next two years, from above 7% now. At the same time, much-touted reforms to rebalance growth from fixed investment to consumption are being postponed until President Xi Jinping consolidates his power. China may avoid a hard landing, but a bumpy and rough one appears likely.
 
The risk of a global crash has been low, because deleveraging has proceeded apace in most advanced economies; the effects of fiscal drag are smaller; monetary policies remain accommodative; and asset reflation has had positive wealth effects. Moreover, many emerging-market countries are still growing robustly, maintain sound macroeconomic policies, and are starting to implement growth-enhancing structural reforms. And US growth, currently exceeding potential output, can provide sufficient global lift – at least for now.

But serious challenges lie ahead. Private and public debts in advanced economies are still high and rising – and are potentially unsustainable, especially in the eurozone and Japan. Rising inequality is redistributing income to those with a high propensity to save (the rich and corporations), and is exacerbated by capital-intensive, labor-saving technological innovation.

This combination of high debt and rising inequality may be the source of the secular stagnation that is making structural reforms more politically difficult to implement. If anything, the rise of nationalistic, populist, and nativist parties in Europe, North America, and Asia is leading to a backlash against free trade and labor migration, which could further weaken global growth.
Rather than boosting credit to the real economy, unconventional monetary policies have mostly lifted the wealth of the very rich – the main beneficiaries of asset reflation. But now reflation may be creating asset-price bubbles, and the hope that macro-prudential policies will prevent them from bursting is so far just that – a leap of faith.

Fortunately, rising geopolitical risks – a Middle East on fire, the Russia-Ukraine conflict, Hong Kong’s turmoil, and China’s territorial disputes with its neighbors – together with geo-economic threats from, say, Ebola and global climate change, have not yet led to financial contagion. Nonetheless, they are slowing down capital spending and consumption, given the option value of waiting during uncertain times.

So the global economy is flying on a single engine, the pilots must navigate menacing storm clouds, and fights are breaking out among the passengers. If only there were emergency crews on the ground.


Nouriel Roubini
Chairman of Roubini Global Economics
Professor of Economics at the NYU’s Stern School of Business.


Japan risks Asian currency war with fresh QE blitz

The Bank of Japan is mopping up the country's vast debt and driving down the yen in a radical experiment in modern global finance

By Ambrose Evans-Pritchard, International Business Editor

9:01PM GMT 31 Oct 2014


The Bank of Japan has stunned the world with fresh blitz of stimulus, pushing quantitative easing to unprecedented levels in a bid to drive down the yen and avert a relapse into deflation.
 

The move set off a euphoric rally on global equity markets but the economic consequences may be less benign. Critics say it threatens a trade shock across Asia in what amounts to currency warfare, risking serious tensions with China and Korea, and tightening the deflationary noose on Europe.
 
The Bank of Japan (BoJ) voted by 5:4 in a hotly-contested decision to boost its asset purchases by a quarter to roughly $700bn a year, covering the fiscal deficit and the lion’s share of Japan’s annual budget. “They are monetizing the national debt even if they don’t want to admit it,” said Marc Ostwald, from Monument Securities.
 
In a telling move, the bank will concentrate fresh firepower on Japanese government bonds (JGBs), pushing the average maturity out to seven to 10 years. It also pledged to triple the amount that will be injected directly into the Tokyo stock market through exchange-traded funds, triggering a 4.3pc surge in the Topix index.
 
Governor Haruhiko Kuroda said the fresh stimulus was intended to “pre-empt” mounting deflation risks in the world, and vowed to do what ever it takes to lift inflation to 2pc and see through Japan’s "Abenomics" revolution. “We are at a critical moment in our efforts to break free from the deflationary mindset,” he said.             
 

The unstated purpose of Mr Kuroda’s reflation drive is to lift nominal GDP growth to 5pc a year. The finance ministry deems this the minimum level needed to stop a public debt of 245pc of GDP from spinning out of control. The intention is to erode the debt burden through a mix of higher growth and negative real interest rates, a de facto tax on savings.
 
Mr Kuroda’s own credibility is at stake since he said in July that there was “no chance” of core inflation falling below 1pc. It now threatens to do exactly that as the economy struggles to overcome a sharp rise in the sales tax from 5pc to 8pc in April.
 
Marcel Thieliant, from Capital Economics, said the BoJ already owns a quarter of all Japanese state bonds, and a third of short-term notes. Its balance sheet will henceforth rise by 1.4pc of GDP each month, three times the previous pace of QE by the US Federal Reserve.
 
There is little chance that the BoJ will meet its 2pc inflation target by early next year, showing just how difficult it is to generate lasting price rises once deflation has become lodged in an economy. Household spending fell 5.6pc in September, though there are tentative signs of an industrial rebound.
 
The latest move - already dubbed QE9 – sent the yen plummeting 2.6pc to ¥112 against the dollar, the weakest in seven years. The currency has fallen 40pc against the dollar, euro and Korean won since mid-2012, and 50pc against the Chinese yuan. This is a dramatic shift for a country that remains a global industrial powerhouse, with machinery and car producers that compete toe-to-toe with German and Korean rivals in global markets. “They are going to be screaming across Asia if the yen gets near ¥120 to the dollar,” said Mr Ostwald.




Panasonic said it plans to “reshore” plant from China back to Japan. There are increasing signs that Japanese companies are rethinking the whole logic of hollowing out operations at home to build factories abroad.
 
Hans Redeker, from Morgan Stanley, said Japan is exporting its deflationary pressures to the rest of Asia. “It is not clear whether other countries can cope with this. There have been a lot of profit warnings in Korea. The entire region is already in difficulties with overcapacity and a serious debt overhang. Dollar-denominated debt has risen exponentially to $2.5 trillion from $300bn in 2005, and credit efficiency is declining,” he said.
 
Albert Edwards, from Societe Generale, said Japan is at the epicentre of a currency maelstrom, a replay of the Asian financial crisis from 1997-1998, though this time the region is a much bigger part of the global economy. “China cannot tolerate this kind of shock when it already faces a credit crunch and has suffered a massive loss in competitiveness. Foreign direct investment into China has already turned negative,” he said.
 
It was a yen slide in 1998 that led to the most dangerous episode of the Asian drama. China threatened to retaliate, a move that would have threatened the disintegration of the regional trading system. It took direct action by Washington and concerted global intervention to stabilise the yen and contain the crisis.
 
This yen-yuan dynamic is looming again. China has for now stopped buying foreign bonds to weaken its currency but this has let deflationary forces gain a footing in the Chinese economy.

“If China’s inflation rate falls below 1pc, it will be forced to devalue as well. Currency war was always how this was going to end, and it risks sending a wave of deflation across the world from Asia,” he said.

 



As each country resorts to a beggar-thy-neighbour policy in moves akin to the 1930s, deflation is dumped in the lap of any region that is slow to respond - currently the eurozone.

Stephen Lewis, from Monument, said the BoJ’s new stimulus is a disguised way to soak up some $250bn of government bonds that will be coming onto the market as Japan’s $1.2 trillion state pension fund (GPIF) slashes its weighting for domestic bonds to 35pc. This avoids a spike in yields, the nightmare scenario for Japanese officials.
 
The GPIF will have buy $90bn of Japanese equities and $110bn of foreign stocks to lift its weighting to 25pc for each category. This will be a shot in the arm for global bourses, but also a clever way for Japan to intervene in the currency markets to hold down the yen.
 
The BoJ has in effect outsourced its devaluation policy, shielding it against accusations of currency manipulation. Any retaliation by China is likely to be conducted by the same arms-length mechanism.
 
Japan has to move carefully. The world turned a blind eye to the currency effects of Mr Kuroda’s first round of QE because the yen was then seriously overvalued. This is no longer the case.
 
The risk for premier Shinzo Abe is that further bursts of stimulus may be taken by critics as an admission of failure, though it is in reality far too early to judge whether the country has closed the chapter on its two Lost Decades. What seems certain is that Japan was sliding headlong into a debt compound trap before Mr Abe launched his “Hail Mary” pass into the unknown.

Feature

Investors in Brazil Have Reason to Celebrate Dilma Rousseff

Its stock market has been in turmoil over the election. But the outlook is much better than investors expect.

By Lewis Braham 

November 1, 2014

 
Want proof that investors behave irrationally? Look no further than Brazil. In recent weeks, Brazilian stocks have gyrated wildly, based merely on polls as to which presidential candidate—left-wing incumbent Dilma Rousseff or right-wing challenger Aécio Neves—would win. Meanwhile, the financial outlook for Brazil’s businesses largely hasn’t changed.
 
The so-called Dilma dump seems ridiculous in retrospect. During this year’s second quarter, the iShares MSCI Brazil  exchange-traded fund (ticker: EWZ) gained 8.2%, largely on hopes that Rousseff would be ousted. Then, in the third, it fell 9% as she gained in the polls. Then it bounced around like a yo-yo during the elections, gaining 4% on Friday, Oct. 24, with a Neves poll bump, and falling 5% on Monday after Rousseff was victorious.
 
The question is: How much damage can Rousseff do that investors aren’t already aware of? Her Workers’ Party has been in power for 12 years. Rousseff merely perpetuated many of its pre-existing social-welfare policies during her first term, and these have largely been successful. They are credited with lifting 40 million people—about a fifth of Brazil’s population—out of poverty in the last decade. Meanwhile, this September’s 4.9% unemployment level was a record low for the country.
                                  
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The market seems to hate that Dilma Rousseff, re-elected as Brazil’s president last week, puts people ahead of businesses. Photo: Paulo Fridman/Bloomberg News
 
           
What the market seems to hate is that Rousseff puts the Brazilian people before business. She has waged an ongoing battle with oil giant Petrobras PBR (PBR) to keep prices below market rates, so citizens can have affordable heat and gasoline. Petrobras is now so cheap that rational investors argue that her interventionist policies are priced into its shares. “Petrobras is trading at 50 cents on the dollar of what we see as its value,” says Marc Tommasi, who oversees the Manning & Napier Emerging Markets fund (MNEMX). The stock has a price-to-book value of only 0.4, while the average stock in the Energy Select Sector SPDR  ETF (XLE) has a 1.89 P/B, according to Morningstar.
 
Tommasi’s fund has a 17% weighting in Brazil, well over his MSCI benchmark’s 10%, even though he dislikes Rousseff’s policies. He thinks that, in Petrobras’ case, there’s evidence that Rousseff will ease the oil-price restrictions to allow the company to be more profitable. “Ultimately, there will have to be some give in terms of these interventionist policies,” he says. “Rousseff has already backed off on some price constraints.”
 
Moreover, some companies will be unaffected or will even benefit from Rousseff’s policies. Co-manager Richard Hoss has made the EP Latin America fund (EPLAX) the best performer in the Latin category in the past year largely by avoiding Brazil. Yet, even he favors companies like Kroton Educacional (KROT3.Brazil) in Brazil’s education sector. “Education spending has been a cornerstone of Rousseff’s campaign,” he says. “We knew that under either candidate, the sector would do well.”
 
Though he favored Neves, Hoss had said prior to the election that its results were largely irrelevant to what he sees as Brazil’s generally gloomy outlook. If Rousseff won, the country’s low unemployment, but high inflation—now 6.75%—would persist. But if Neves won and succeeded in cutting government spending, unemployment would spike, and growth would slow even further than it recently has. Both scenarios were unappealing. “It’s six of one, half a dozen of the other,” Hoss says. Whether he’s right or not, his long-term view makes more sense than the crazy zigzag the market expressed for either candidate.
 
TRUTH BE TOLD, there are more similarities between Rousseff and Neves than many investors are willing to admit. Neves stated during his campaign that he had no plans to scale back Rousseff’s popular antipoverty programs. “In India, the excitement this year over having a new prime minister was more black-and-white,” says Amrita Nandakumar, who covers emerging markets for Van Eck Global. “But I don’t know if there was such a distinguishing factor between the candidates in Brazil’s case. No one has been able to find a good explanation for why people seem so nervous.”
 
Ironically, some of Brazil’s hardest-hit stocks might benefit the most from the Rousseff government. The Market Vectors Brazil Small-Cap  ETF (BRF) consists largely of consumer-discretionary companies that cater to Brazil’s growing middle class—home builders, education, retail, autos—not the highly regulated energy sector, which accounts for only about 1% of its portfolio. Yet, it’s down 15.7% this year, compared with the 6.2% decline in the energy-laden, large-stock iShares ETF.
 
“We’ve seen a huge divergence between small-cap and large-cap performance,” says Sophie Bosch de Hood, co-manager of the JPMorgan Latin America fund (JLTAX). “Some of the small-cap names have overreacted, and you can find value opportunities there.” She points to companies such as bus maker Marcopolo (POMO3.Brazil) as an example. As an exporter, it will benefit from the weaker Brazilian currency, which has fallen on investors’ negative sentiment.
 
Though it has proved somewhat more resilient, the Global X Brazil Consumer  ETF (BRAQ) is also down 3.1% this year and has plummeted 13.3% in the past three months. “Rousseff has a history of building the middle class and lifting people out of poverty,” says Jay Jacobs, a research analyst at Global X Funds. “If that trend continues, it will certainly help consumer stocks.”
 
So what the election really means is a buying opportunity for believers in Brazil’s long-term prospects. Disbelievers probably should have gotten out 12 years ago. 


Wall Street's Best Minds

Byron Wien: Slow Growth Good for Stock Market

The Wall Street vet writes that stocks can rise along with earnings gains in a modest economy.

By Byron Wien           

Oct. 31, 2014 2:57 p.m. ET

All through the summer, the U.S. equity market made new highs in spite of increasing turbulence around the world. The economy was continuing to grow modestly, earnings were coming through and the geopolitical problems were a long way away.
 
The Ned Davis Crowd Sentiment Poll, which includes transactional data like the put-call ratio, showed that investor mood was very optimistic. Historically, the market is vulnerable to a correction when optimism is extreme. You don’t know what will cause the sell-off, but you have the uneasy feeling it’s coming. The market had gone through two years without so much as much as a 10% correction and we were due for one.

Identifying the precipitating event is hard and probably unimportant. A few of the geopolitical problems had actually cooled somewhat, albeit temporarily. Russian troops had pulled back from the Ukraine border; there was a cease-fire in the Israel/Gaza conflict; the Iran nuclear talks weren’t making much progress, but they were continuing; and in the South China Sea issues had quieted down for a while. However, the situation in Syria and Iraq, which had been invaded by the Islamic State of Iraq and Syria (ISIS), remained serious. The two threats that may have unsettled investors were the possibilities that the Ebola virus might spread to Europe and the United States and that the economic slowdown in Germany might abort Europe’s weak recovery and bring the continent back into recession.
 
The decline in stocks gained intensity as it moved along, with many days down 1% or more on the Standard & Poor’s 500. Rallies gave way to further declines and eventually the market fell almost 10% before prices stabilized. The correction did pound some of the optimism out of investors’ minds. The Crowd Sentiment Poll dropped from optimistic into pessimistic territory, setting the stage for a rise in the market through year-end. There may be further declines, but in my opinion the worst is over. I believe that this was a necessary correction and not the beginning of a bear market.
 
Sometimes, the market is smarter than all of us participating investors and a sharp downturn precedes a recession by about seven months. I do not think that was the outcome signaled by the September/October correction. The U.S. economy is actually doing quite well. Real growth is expected to be approaching 3% in the second half of 2014 and growth of 2.5% to 3% is expected to continue into 2015. The economy usually provides some warning signals before a recession occurs. According to an Omega Advisors study, danger is signaled when the yield curve is inverted, unemployment claims are rising, personal income is down, consumer confidence is falling, industrial production is declining, and/or inventories are increasing.
 
Virtually none of these indicators are giving a warning signal now. There have been some notable earnings disappointments (including IBM, Amazon, AT&T, McDonald’s and Coca-Cola), but Apple, Caterpillar, Microsoft and others did well. More worrisome is the shortfall in revenue growth, and because margins are no longer increasing, net profits have only improved modestly. Companies have continued their share buyback programs, however, and this has played an important role in earnings per share growth. That is expected to continue.
 
I believe we are in a prolonged period of slow growth in the United States, Europe and Japan. As a result I think a favorable environment for stock prices could continue for several more years. In my mind, valuations are not excessive and equities can appreciate in price in accordance with earnings increases. I do not expect much in the way of multiple expansion, except perhaps at the end of the cycle when everyone becomes comfortable that the good times are going to last forever and nothing is ever going to go wrong. That’s when the “animal spirits” take over.
 
During the decline, there was wide suspicion that the end of Federal Reserve monetary accommodation in October had something to do with it. The balance sheet of the Fed was $1 trillion in 2008. It is over $4 trillion now. There is general agreement that easy money was a factor in the rise in the stock market over the past five years as well as the low level of interest rates. Accordingly, the end of the tapering process was pointed to as one of the causes of the decline. In addition, there was continued speculation about when the Fed was likely to start raising interest rates. The consensus had been that the first rate rise would occur in the middle of 2015, but the recent decline in the stock market, along with low inflation, some soft economic data and continuing high unemployment, has caused many analysts to think the Fed may act later rather than sooner. My view is that there is little reason for the Fed to raise rates anytime soon, and when they do finally act, they will do so very gradually.
 
A Fed increase in rates has been so well advertised that it may not have the deleterious impact everyone seems to fear. In the period 1950–1980, an eccentric market analyst, Edson Gould, developed the “three steps and stumble” rule. This was based on the observation that it took three increases in Fed rates before the market impact became severe. A study by Omega Advisors showed that on average the market does not decline significantly until 29 months after the first rate hike.
 
In October, I spent a week in the Middle East to visit clients and get some feeling for the mood there. It was not cool in terms of temperature – in the high 90s minimum every day – but there was no sound of artillery in Qatar, Saudi Arabia, Dubai or Abu Dhabi. I would like to say there is a consensus on Israel/Gaza or Syria/ISIS/Iraq, but there is not. I did observe that the conflicts in the region are not a part of everyone’s daily conversation in the places I visited.

Most of those living there are focused on economic opportunity, and the price of oil is more important to them than the fighting in the western part of the region. A range of opinion exists on what price is necessary for Saudi Arabia and others to finance their domestic activities.
 
Some believe $80 will do it and there are estimates as high as $110. Oil is priced in dollars and the strength of the American currency has obviously increased its purchasing power. The prevailing view is that the price of oil is generally influenced by cyclical factors. Since the economies of the United States, Europe and China are slowing, you would expect weaker demand to be reflected in the oil price. North America is also becoming more energy self-sufficient as a result of hydraulic fracking and conservation. The emerging markets, where the incremental demand is expected to come from, are not growing as fast as they were previously.

On the other hand, the expanding middle-class throughout the developing world will want motorized vehicles, and this will drive future prices higher. In the meantime the present price is sufficient to finance current operations in the producing countries. If some capital projects need to be deferred because of insufficient funds, it is not a great tragedy.
 
Turning to the major geopolitical issues in the region, most expect Iran to have a nuclear weapon eventually. In the current negotiations they will keep deferring deadlines by a few months until they are finally within weeks of producing a nuclear device. Their hope is that if they stop short of processing an actual weapon they can defuse the issue and justify some sanctions being lifted. Iran is using its willingness to financially support American efforts to combat ISIS as a way to move the nuclear negotiations forward on terms closer to their objectives. People in the region view Iran as a potentially great commercial opportunity with a modern, well-educated population yearning for a higher standard of living. The clerics are holding the country back, but that restraint is not expected to continue indefinitely. If Iran does have a bomb, it does not seem a threat to their Middle East neighbors. There are countless Iranians everywhere in the Middle East and their countrymen don’t expect to be harmed by them. There is some concern about the arms race that might be precipitated by Iran having a nuclear weapons capability. That would destabilize the region somewhat but nobody in these countries expects the weapons to be used and if they are, certainly not on them.
 
The Israel/Gaza hostilities are viewed as a civil war that is likely to go on forever. It is totally separate from the Sunni/Shiite conflict. Hamas will never accept Israel’s right to exist, and wants a right of return for former residents and a restitutions of all the pre-1967 territory. Israel will never withdraw from all of its West Bank settlements. There will be periodic cease-fires, but peace will prove to be unattainable. There is the feeling that as long as Israel is preoccupied with Gaza, the likelihood of a strike on Iran’s nuclear facilities is reduced.
 
If there were any geopolitical issue that troubles those living in the Middle East, it is the rise of ISIS. This is a more formidable military force than has ever been seen in the region with the exception of Israel. What’s more, ISIS has been effective in using social media as a primary tool to recruit combatants from all over the world who are willing to fight to create an Islamic caliphate in the region. For disaffected young people with limited economic prospects, the opportunity to do what they perceive as God’s will and get paid for it, while fighting beside others who believe fervently in the good of their efforts, is very appealing. Airstrikes have blunted ISIS encroachment in Syria and Iraq, but there has been no successful effort to retake territory that ISIS has already gained. That can only be done by troops on the ground. So far Kurdish forces have prevented ISIS from taking over the city of Kobani on the Syrian border and some moderate Syrian rebels have neutralized ISIS advances in Syria, but the idea that troops from moderate Middle Eastern nations like Jordan, Turkey and Saudi Arabia might be sent to Syria and Iraq to fight ISIS has gone nowhere. I got the feeling that no country (especially Saudi Arabia and the United Arab Emirates) in the Middle East, other than those already committed, wants to get involved militarily in the conflict with ISIS. There is no appetite for losing lives to defend another country in anticipation of preventing the problem from spreading to your own territory.
 
Even though descended from Al Qaeda and therefore Sunni-based, ISIS is viewed in the Middle East as a terrorist organization. There is general agreement that it must be stopped and both Saudi Arabia and Iran (not often on the same side of an issue) are funding the opposition.

Financial support for ISIS is reported to come from independent sources in Qatar, Saudi Arabia and Russia, as well as the oil wells in Syria that their troops have captured. The Syrian rebels are effective but have limited weaponry. Iraqi military forces are inexperienced and need more training. American advisers in the region believe it may take as long as two years to mount a fighting force strong enough to retake territory already gained by ISIS. The United States could accelerate this process by sending a fighting force, but President Obama has already ruled that out.
 
At this point, nobody expects ISIS to move beyond Syria, Iraq and possibly Afghanistan. In the places I visited there is concern but not fear. Observers in the region are disappointed that the United States has not played a broader role. They believe that the U.S. is not willing to back up our “red lines” after witnessing our failure to act when Syria used chemical weapons against its own people and when Iran moved forward with its nuclear weapons development program.

The foreign nationals and the local citizens in the Middle East have a fatalistic attitude. They are used to living in warlike conditions and general adversity is part of the way of life there.

They know that ISIS is a threat, but believe it is not likely to affect them over the near term.

Right now they are more concerned about the price of oil and the direction of the financial markets.

Wien is a senior adviser to Blackstone Group, a global private equity and asset-management firm.
 



Opinion

How Plunging Oil Scrambles Geopolitics

The price drop deprives Putin of revenue for military moves, but Moscow will find other ways to make trouble.

By Brenda Shaffer

Oct. 30, 2014 7:53 p.m. ET


The global oil price has dropped by 25% since June, with oil traded in the U.S. hitting $79.80 a barrel this week, the lowest it has been in four years. Many Western policy makers are pleased, hoping that the price crash will rein in the ambitions of dangerous oil-dependent actors like Vladimir Putin and Iran. Yet the price drop may have negative consequences, too.

Global oil prices and geopolitics interact like a delicate kaleidoscope. When the oil price changes significantly, it sets off a chain of economic and geopolitical consequences. The price collapse is also a sign of deeper, disquieting economic trends.

Oil supply has risen thanks to astonishing U.S. crude production, which has increased by more than a million barrels a day in the past year. While that could be expected to push down prices, the price drop has been accelerated by slowing demand, the result of economic declines in major markets, including Germany and China. In the second quarter of 2014, world economic growth slowed to 2.6%. Germany estimates its growth at 1.2% this year, and the World Bank says China’s growth will slow to 7.6%.

   Corbis 


The greatest impact of lower oil prices will be on states that derive most of their government income from oil exports—especially those that assume a certain oil price in trying to balance their budgets. When the actual price is well below the expected price, it can be alarming for oil producers with large populations that make it harder to maintain extensive social-welfare benefits and subsidies. The OPEC members rallying for a price-boosting cut in oil production are more-populous countries like Iran and Venezuela.

Although some states may be vulnerable to social instability if they are forced to trim subsidies due to the drop in oil prices, Russia is not among the most vulnerable. Its energy and other subsidies are relatively modest compared with other oil exporters and Russia also has ample reserves, estimated at $177 billion, in its revenue funds to sustain social and public services.

Iran’s regime, which faces great public dissatisfaction and has significantly smaller financial reserves, might encounter more substantial challenges. If oil prices continue to hover around $80 a barrel through this year, Iran’s revenue will drop by about 12%-15%. Tehran’s currency reserves stand at an estimated $80 billion, however, which will help the regime buy time.

Another consequence of the oil-price fall is that most oil exporters will dip into their sovereign wealth and revenue funds to fund their budgets. Since most of these investments are held outside their countries, this wealth retransfer will influence global markets as significant amounts of capital will fly back to the producers.

All of this will have mixed foreign-policy outcomes. It certainly will not prompt Russia to withdraw from Crimea. What it may do is increase Moscow’s motivation to de-escalate the crisis with Ukraine and renew the gas flows for the winter—supplies that have been suspended since June. Earlier this month, President Putin signaled his readiness to renew gas supplies to Ukraine, although an agreement still has not been reached.

While the oil-price drop will deprive Moscow of resources to expand its military interventions, Russia is likely to continue its low-profile interference in neighboring states, as seen when it threatened Moldova with economic retaliation after Moldova signed the EU Association Agreement in June.

The impact of lower oil prices on economic sanctions against Russia and Iran will also be mixed. There probably won’t be much global pressure to reduce sanctions to get more oil flowing from these two states. But the Continent’s economic slump means Europe is less likely to support additional and sustained sanctions on Russia.

There will also be consequences from worsening economic trends and the oil-price drop. In periods of austerity, there often is a switch in power generation from natural gas to coal in markets where coal is cheaper, such as Europe and Asia. This could be bad news in the short term for those hoping to conclude new contracts for U.S. natural-gas exports. It is also bad news for climate-change-prevention policy, which loses support when the economy slumps.

As oil and gas profits plummet, companies will abandon some mega projects and investment in new technologies. Many oil companies, such as Total, are already engaging in major divestment activity and many, such as Italy’s ENI and BP, reported losses in the last quarter. The drop in the oil price could also end the trend of delinking gas-supply contracts from the price of oil.

In evaluating the potential impact of the drop in the oil price on Russia, Iran and other oil-dependent states, the key thing to remember is that an economic downturn doesn’t necessarily temper foreign-policy behavior. In some cases it has the opposite effect. As with economic sanctions, austerity doesn’t always stir people’s resentment against their own governments either. It can galvanize them against foreign enemies alleged, and perceived, to be the cause of their economic misery.


Ms. Shaffer is a visiting researcher and professor at Georgetown University’s Center for Eurasian, Russian and East European Studies.