What Kim Jong Il's Death Means for the Global Economy
All eyes are on North Korea and its repressed economic system this week after the country announced early Monday that Kim Jong Il, the ruling dictator for 17 years, died Saturday. The political instability to follow Kim Jong Il's death could ripple through the global economy, weighing on confidence and growth.
Kim Jong Un, the third son of the deceased leader, will take his place. Kim Jong Un is only in his late-twenties, and has only been groomed for the role since 2008, compared to his father's 14 years of training.
While North Korea has remained economically isolated from much of the world, its military aggression, volatile relationship with South Korea and the United States, and the uncertainty surrounding Kim Jong Un's readiness to lead has put the world on alert.
"This is a tinderbox situation," said Money Morning Chief Investment Strategist Keith Fitz-Gerald. "Almost nothing is known about Kim Jong Un, this "Great Successor.' The deeper questions are the longer-term issues related to a potential power struggle within the ruling elite, given that Kim Jong Un may not have the training nor the power base from which to assume control. Now is the time to watch carefully."
That said, here's what to monitor in the global economy as North Korea rebuilds after Kim Jon Il's death.
North Korea's economic future: North Korea is a notoriously closed society and has shunned foreign investment. Kim Jong Il had started to show signs of possibly being open to economic reform. He even toured Chinese factories to learn about their rapid economic growth, and visited Russia to discuss building a gas pipeline across North Korea.
Of course, that's unlikely to change at least until the country's new leader gets established.
Still, there's hope the long-term outlook for North Korea will change since Kim Jong Un has more Western world exposure than his father, having attended school in Switzerland. That could encourage him to reach out more to other countries to help improve his impoverished nation.
"With China as its example, I am hopeful that North Korea comes out of its shell and slowly crawls to its borders to see who is willing to start a dialogue and trading with the rogue robot nation," said Money Morning Capital Waves Strategist Shah Gilani. "If it's going to be a scary and not a salutary coming out party, all bets are off; but I'm a betting man, and I'm betting North Korea will emerge from its cocoon."
South Korea's economy: South Korea faces the biggest economic disruption. The country already forecast a drastic export slowdown for 2012, with shipments growing only 7.4% next year, compared to 19.2% in 2011. The threat of North Korean instability could also slam consumer confidence, and cause the economy to grow even slower than the 3.7% gain predicted for next year.
Those "New" E.U. Fiscal Rules Aren't
Very soon we will see if the old market adage "Buy the rumor, sell the news" is true.
While rumors of Europe's impending demise were momentarily shot down by an array of silver bullets, the actual news out of Brussels of a grand bargain wasn't… exactly… honest.
Let's call the half-measures agreed to by European leaders "Brussels sprouts," because they're more like "green shoots" than a cabbage patch panacea.
The leaders agreed to agree that they needed an agreement on how to more closely integrate their fiscal and monetary interests.
Yeah, that's what they said. I say good luck with that.
Actually, they made some other moves, too.
They moved up the date for the European Stability Mechanism to get funded (yeah, right), and promised to revisit the European Financial Stability Facility's financing so they could have twin facility spigots.
And – this one's my personal favorite – they winked at having European central banks make bilateral loans up to $264 billion (€200 billion) to the International Monetary Fund so the IMF could back Europe's central banks and the European Central Bank.
You just can't make this stuff up.
Seriously, there's nothing like a crisis to consolidate your power – which is what the Northern Europeans are angling for.
But for the life of me, I can't imagine a bunch of sovereign nations subjecting themselves to forced austerity, being taxed by technocrats (who, of course, will be non-partisan, non-xenophobic, nonplussed objectivists), and dictated to as occupied territories by the machinery that ground them down in the first place… and wants to keep them there.
What… You don't get that?
Here's a newsflash for you: The "new" rules about maintaining strict debt to GDP ratios and other my-way-or-the-highway fiscal demands are not new at all.
The same metrics for fiscal discipline that were lauded last week were already in place – it's just that no one followed them.
Everybody cheated… starting with the Germans themselves.
Latest Eurozone Debt Crisis Plan "Another Grand Illusion"
As European leaders celebrated a tentative agreement to accept tougher budgetary rules among its members, critics expressed doubts the plan would cure the two-year-old Eurozone debt crisis.
Last week's highly anticipated two-day summit resulted in 26 of the 27 European Union (EU) nations – the United Kingdom objected – agreeing to create a new treaty that would require members to keep budget deficits to within 0.5% of gross domestic product (GDP) in good economic times and within 3% of GDP in bad times.
EU governments would need to submit their budgets to a central fiscal authority, and violations would carry automatic penalties. The nations agreed to hammer out the details by March of next year.
World stock markets reacted positively, but many experts remain unconvinced that the EU has finally delivered the silver bullet needed to slay its monstrous debt crisis.
"They needed to create grand plan that's really workable and not another grand illusion," said Money Morning Chief Investment Strategist Keith Fitz-Gerald. "I'm afraid what we're getting is just another grand illusion."
In fact, last week's meeting was the fifth summit called to deal with the European debt crisis since 2009. Each has produced its share of optimistic rhetoric, but no concrete solutions.
European leaders from France, Germany, the European Central Bank (ECB) and the International Monetary Fund all hailed the summit agreement as a major step toward getting the debt crisis under control.
"This is the breakthrough to the stability union," said German Chancellor Angela Merkel at the end of the summit. "We are using the crisis as an opportunity for a renewal."
"It's a very good outcome for the euro area, very good," added ECB President Mario Draghi "It is going to be the basis for much more disciplined economic policy for euro-area members."
Fitz-Gerald said Europe's leaders mean what they say, but ultimately the latest summit will do little more than spark a brief rally in the markets.
"These government officials still don't get it," Fitz-Gerald said. "They're still not addressing the underlying problems. We'll be having this conversation again next year."
A Tough Sell
Although enforcing budgetary austerity would help prevent current debt problems from getting worse, it's unlikely the citizenry of most EU member nations will allow it to happen.
"Their proposal is preposterous," writes Brett Arends of MarketWatch, likening the EU plan to the United States allowing its largest creditors, Japan and China, control over the federal budget.
"How would you feel if you opened the paper to be told that the new Sino-Japanese "Fiscal Stability Commission' in Washington had just slashed your grandma's Social Security checks by one-third, scaled back federal highway repairs, and that it would impose a 10% national sales tax?," Arends said. "That is, after all, effectively what is being offered to the people of Greece, Italy, Spain, Portugal and Ireland."
China Returns to Growth Mode with Major Policy Shift
The damaging global economic effects that Europe's unfolding debt crisis pose have caused a sharp reversal in China's monetary policy – one that will lead to a greater expansion of the Red Dragon's economy.
The People's Bank of China announced yesterday (Wednesday) that it would lower the percentage of deposits commercial banks must hold in reserve by 50 basis points, effective Dec. 5.
This is China's first reserve requirement cut since 2008. It drops the level to 21% for large banks and 19% for smaller institutions.
The move was unexpected from the world's second-largest economy, which has been tightening its monetary policy for more than a year.
The change underscores the country's concern that exports, its main driver of economic growth, would weaken due to lower demand from the troubled Eurozone, China's biggest consumer. However, it's also a signal that after a year of tapping the brakes on growth to curb inflation, Beijing is ready to put its foot back on the accelerator.
"This is a clear signal that Beijing has decided that the balance of risks now lies with growth, rather than inflation," Stephen Green, greater China head of research at Standard Chartered, told The Financial Times. "This is a big move, it signals China is now in loosening mode."
China's gross domestic product (GDP) in the third quarter grew by 9.1% — the slowest pace in two years and down from 9.5% in the previous three months. That's the fourth consecutive quarter of declining GDP growth.
Loosening China's Monetary Policy
China fears its best customers, Europe and the United States, will keep reducing their imports as they're burdened with weak economies. Chinese exports in October rose by 15.9%, the smallest amount in two years.
"The weakness in exports was very much in line with the global environment, especially the slowdown in Europe, and that's going to continue through to the first quarter of next year," Li Cui, an economist with the Royal Bank of Scotland, told Reuters. "I think the underlying weakness is perhaps even weaker. [M]y estimation is that the real growth could only be around 7% to 8%, adjusting for export prices."
Europe Headed for a 'Lehman Moment'
With credit drying up across Europe we may finally see the Eurozone experience its "Lehman moment" – a replay investment banking collapse that triggered the 2008 financial crisis.
Indeed, European banks are having a harder time getting money – part of the fallout from the Eurozone debt crisis – and the resulting credit crunch could freeze business activity, cause bank runs and plunge Europe into a deep recession that would badly damage the global economy.
"The Continent is headed towards deflation if there's not enough money circulating throughout their financing and banking systems," said Money Morning Capital Waves Strategist Shah Gilani. "This all becomes self-fulfilling at some point. It's a very dangerous situation, not just for Europe, but for the whole world."
A global financial crisis would derail the struggling U.S. recovery and pinch the profits of many multinational corporations.
Fresh data this week from the European Central Bank (ECB) showed the M3 Eurozone money supply actually shrank in October by 0.6%, its steepest drop since January 2009 – the height of the Lehman Brothers crisis.
A shrinking money supply is one of the early warning signals that credit availability is drying up, making it difficult or impossible for banks, businesses, and consumers to obtain loans.
"This is very worrying," Tim Congdon from International Monetary Research told The Telegraph. "What it shows is that the implosion of the banking system on the periphery is now outweighing any growth left in the core. We are seeing the destruction of money and it is a clear warning of serious trouble over the next six months."
Signs of capital draining from European banks abound.
The bank bond market is already frozen. European banks in the third quarter were only able to sell bonds worth 15% of what they sold in the same period in the previous two years, according to Citigroup Inc. (NYSE: C).
In the past six months, U.S. money market funds have withdrawn 42% of their money from European banks. And loans to French banks have fallen 69% since the end of May, according to Fitch Ratings.
Even retail customers have started to pull their money out.
"We are starting to witness signs that corporates are withdrawing deposits from banks in Spain, Italy, France and Belgium," an analyst at Citigroup wrote in a recent report. "This is a worrying development."
Three Doomsday Scenarios: What Happens If the Eurozone Breaks Up?
The time has come to confront an ugly truth: The possibility that the Eurozone will break up, or rather fall apart, is growing increasingly likely.
In fact, I'd say given recent developments in Italy the probability of a breakup is as high as 40%.
Indeed, if a country as small as Greece or Portugal were to default or abandon the euro, the effect on the Eurozone would be manageable. The debts of those countries are too small to make more than minor dents in the international financial system, and they represent too small a share of the Eurozone economy for their departure to have much impact.
The psychological effect of their departure would be considerable – if only because Eurozone leaders have expended so much money and effort to bail them out. However, devastated credibility among the major Eurozone leaders is more of a political problem than an economic one.
But now that the markets' focus has moved to Italy and Spain, the Eurozone is really in trouble.
Asking for Trouble
Part of the problem is that in arranging the partial write-down of Greek debt, authorities made it "voluntary," thereby avoiding triggering the $3.8 billion of Greek credit default swaps (CDS) outstanding. Of course, this caused a run on Italian, Spanish, and French debt, as banks that thought they were hedged through CDS have begun selling frantically, since their CDS may not protect them.
Honestly, how stupid can you get! I don't like CDS, but fiddling the system to invalidate them is just asking for trouble. And so far, the only effect has been a considerable increase in the likelihood of a Eurozone breakup.
Italy, Spain, and France are too big to bail out without the European Central Bank (ECB) simply printing euros and buying up those countries' debt. However, if the ECB adopted the latter approach, hyperinflation would almost certainly ensue. Furthermore, the ECB itself would quickly default, since its capital is only $14.6 billion (10.8 billion euros) – a pathetically small amount if it's to start arranging bailouts.
Of course, Europe's taxpayers could then bail out the ECB by lending the money needed to recapitalize the bank, but a moment's thought shows that the natural result of such a policy is ruin.
So what would a breakup of the Eurozone look like? Basically, there are three possibilities.
Rising Government Bond Rates Push Eurozone Debt Crisis to the Precipice of Collapse
Rising government bond rates are making it increasingly costly for several key Eurozone nations to borrow money, stoking fears that the sovereign debt crisis has reached a critical stage.
Yields on 10-year Spanish Treasury bonds rose to 6.8% during yesterday's (Thursday's) auction – uncomfortably close to the 7% level at which many experts feel is unsustainable. When the 10-year bond yields of Portugal, Ireland, and Greece passed 7%, each was forced to seek a bailout.
Just last week the 10-year bond yields of Italy crossed the 7% threshold. Though yields dropped back below 7% after Italian Prime Minister Silvio Berlusconi stepped down, the respite proved short-lived. The Italian 10-year bond yield fell back to 6.84% yesterday but is expected to stay in the danger zone for the foreseeable future.
Perhaps more worrisome is the rise in French bond yields. While France is not one of the troubled PIIGS (Portugal, Ireland, Italy Greece and Spain), it has deep financial ties to those nations. French 10-year bonds now yield 3.64%, twice that of equivalent German bunds despite both nations having a top-tier AAA credit rating.
The cost of borrowing is rising even for nations that until now had been outside of the fray, like the Netherlands, Finland, and Austria.
"Momentum is building," Louise Cooper, market strategist at BGC Partners, told MarketWatch. "Ten-year French borrowing costs are now around [two percentage points] greater than Germany, Spanish borrowing costs are rocketing and 10-year Italian debt is yielding over 7%. The hurricane is approaching. Time to batten down the hatches."
As the Eurozone debt crisis deepens, many analysts worry that the rising government bond rates could put the brakes on lending and lead to a credit crunch such as the one experienced during the 2008 financial crisis.
In the short term, however, the steady stream of scary news is taking a toll on the stock markets. The British FTSE 100 was down 1.58% and the French CAC 40 was down 1.78% yesterday, while the Dow Jones Industrial Average fell 134.79 points, or 1.13%.
"Investors keep thinking that the powers that be in Europe are getting in front of this – only to be disappointed when additional bad news emerges," observed Money Morning Capital Waves Strategist Shah Gilani. "That's why we're seeing these whipsaw trading patterns that are so frustrating to retail investors who've been schooled to buy and hold. The reality is that this will get much worse before it gets better."
Three Psychological Stumbling Blocks That Kill Profits
Face it, the past 12 years have been horrible for most investors.
This is not necessarily because the markets have been rocky, but rather because the vast majority of investors are hardwired to do three things that kill returns.
You can blame Washington, the European Union, debt, high unemployment, or half a dozen other factors if you want to, but ultimately, the person responsible is the same one staring back at you from your bathroom mirror in the morning.
That's why understanding the bad habits you didn't know you had can be one of the quickest ways to improve your financial wealth.
Here's what I mean.
Dalbar, a Boston-based market research firm, produces annual research that compares the returns of stock and bond markets with those of individual investors. The latest, covering the 20-year period ended last year, shows that the Standard & Poor's 500 Index returned an annualized gain of 9.1%. That stands in sharp contrast with the measly 3.8% gain individual investors averaged over the same timeframe.
Fixed income investors didn't do any better. According to the Dalbar data, t hey gained a mere 1% a year versus an annualized return of 6.9% for the Barclay's Aggregate Bond Index.
In other words, investors' self-defeating decisions contributed to an underperformance that was 58% below what it could have been for stocks and 85.5% below what it could have been for bonds.
Three reasons: recency bias, herd behavior, and fear.
It's All About Perspective
Recency bias is what happens when short-term focus trumps long-term planning and execution.
It's what happens when somebody yells "fire" and everybody runs for the same exit at once despite having entered through any of half a dozen doors in the auditorium. Simply put, recency is recent knowledge that overrides longer-term thinking and memory.
This is why momentum trading works, for example, or the news channels seem to cover the same stocks at nearly the same time – because a huge number of people are focused on exactly the same companies simultaneously. Logically, they then become the subject of increased attention and tend to move more strongly or consistently.
The question of why is the subject of much debate among human behaviorists, but I chalk it up to the fact that human memories tend to focus on recent events more emotionally than they do longer-term plans that are put together with almost clinical detachment.
And the more extreme the events or the news, the sharper our short-term focus becomes.
That's why, according to "Mood Matters," a book by Dr. John Casti, one of the world's leading thinkers on the science of complexity, "bombshell events are assimilated almost immediately into the prevailing [social] mood" where as longer-term cycles bear almost no witness to gradual change.
If that doesn't make sense, think about what happened on 9/11. Most of the world's major markets bottomed within minutes of each other on short-term panic and emotion. Then, when trading resumed days later, they began to climb almost in sync as highly localized events once again faded into the longer-term fabric of our world.
And that brings me to herding.
The Herd Mentality
We'd rather be wrong in a group than right individually so the vast majority of investors tend to make decisions, and mistakes, together en masse.
Five Companies to Avoid Until the Eurozone Debt Crisis is Over
U.S. companies with significant exposure to Europe will take a profit hit regardless of how the Eurozone debt crisis shakes out.
The financial strain of Europe's efforts to avert default among its troubled members – Portugal, Italy, Ireland, Greece and Spain (PIIGS) – has set the Eurozone on course for a recession even if its efforts succeed.
Yesterday (Thursday) the European Commission dropped its forecast for growth in the Eurozone to just 0.5% from its previous estimate of 1.8% in May. The commission blamed austerity measures, which were aimed at lowering budget deficits, but ended up eroding investment and consumer confidence.
"The probability of a more protracted period of stagnation is high," said Marco Buti, head of the commission's economics division. "And, given the unusually high uncertainty around key policy decisions, a deep and prolonged recession complemented by continued market turmoil cannot be excluded."
Falling consumer demand has already begun to affect the bottom lines of many U.S. companies that derive large portions of their revenue from the Eurozone bloc.
"In light of cutbacks in government spending, tax increases and waning business confidence, there already has been some [company] commentary on slipping appliances, bearings and heavy-duty trucks demand," Citigroup equities analyst Tobias Levkovich told MarketWatch. "In many respects, these early remarks are a worrisome sign."
For example, General Motors Co. (NYSE: GM) on Wednesday said the debt crisis would prevent it from breaking even in Europe this year. And Rockwell Automation Inc. (NYSE: ROK) on Tuesday warned of declining capital spending in Europe next year.
Although sales to Europe account for only 10% of revenue for the Standard & Poor's 500 as a group, several sectors have far more exposure to the Eurozone.
The auto sector derives 27.6% of its sales from Europe, followed by the food, beverage and tobacco sector at 22%, the materials sector at 19.8%, the consumer durables and apparel sector at 16.2% and capital goods at 16.4%.
"Europe is a major component to the U.S. economic engine and it is a concern," Howard Silverblatt, an analyst with S&P Indices, told MarketWatch. Silverblatt noted that while a European recession may not necessarily take down the U.S. economy, "it has an impact that will move stocks."
Here are five U.S. stocks that have significant exposure to Europe and leveraged balance sheets high – making them risky investments until Europe gets back on its feet: