The Independent Market Observer

8/23/13 - Summer Is Almost Over

Posted by Brad McMillan, CFA, CAIA, MAI

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This entry was posted on Aug 23, 2013 9:27:32 AM

and tagged Debt Crisis, On My Bookshelf

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I will be taking some time off next week. I will still be blogging every morning, but I plan to spend the rest of each day doing some resting and recreating. There are a number of issues I want to think more deeply about before reengaging, and this will give me a chance to do some long-deferred reading and thinking.

This fall, I can see several things brewing on the horizon that will warrant your attention. Some we have known about for some time—the pending federal budget and debt ceiling negotiations, for example—while others are only now coming into focus.

One of the most interesting, and worrisome, issues is the change in the international economic environment, as expressed by currency valuations and flows. This has been a major driver in the recent underperformance of emerging markets, and it potentially could emerge as a crisis factor of its own.

I have been reading a book called Currency Wars, which explains very well some of the second-and third-order economic effects of currency movements across history, as well as how financial warfare could actually be waged today. I wrote some time ago about how we were actually at war with Iran—citing, for example, our imposition of currency and trade sanctions—and this book is a much more developed treatment. I will post a review when I complete it, as I think it will be worth your time.

What moves the currency discussion from interesting to urgent are the current trends in relative valuations. Part of what I want to do next week is really think through some of the consequences.

Other emerging risks are technical, as expressed by the Nasdaq shutdown yesterday. I was interviewed on this by several major publications, expressing the view that this particular case was not necessarily a big deal. But the trend is worrisome.

Not to minimize the effects, but my argument that a three-hour shutdown was not material was based on the fact that other markets did not react, that trading markets have shut down in the past for reasons ranging from squirrels to storms, and that things happen. This particular shutdown was not a cause to worry.

What is a cause to worry is the fact that this has been happening more and more frequently, and for increasingly undefined reasons, which suggests a creeping systemic weakness. I suspect a lot of this is technological—anything driven by software will crash, in the technical rather than the market sense, as we have all experienced with our personal computers for decades. As markets become increasingly networked and computer operated, the chance of technical malfunction simply increases.

The increasing unreliability, though, will definitely hit the confidence of investors at both the institutional and retail levels. Confidence is the foundation of liquidity, which, after all, is the reason markets exist. As confidence is eroded, markets become less effective, and we all suffer.

Ironically, what is driving this increasing complexity is the competitive need for exchanges to provide more liquidity. Perhaps we have reached the point of diminishing returns here—and more focus should be placed on optimizing for reliability, rather than speed. I suspect the regulators will be weighing in on just this point pretty soon. And the ultimate importance of the Nasdaq shutdown will depend on whether the cause is identified and whether it can be fixed easily or it provokes regulatory restrictions on innovation.

Although these are pending risks, I continue to believe that the most immediate risk is the debt ceiling debate. I brought up earlier this summer the fact that the Treasury is now operating under “the usual emergency measures” to stay under the debt ceiling and that this could morph into another potential crisis in the fall.

Well, here we are, and this story has moved back to the front page in both the New York Times and the Wall Street Journal. The problem, as it has been in the past iterations, is the Republican caucus in the House; members are apparently determined to use their leverage to extract concessions on other matters from the White House. The administration, on the other hand, says it refuses to negotiate at all over the debt ceiling.

August has been hot. As we move past vacation season and into September, the fall may be even hotter.

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