Global Musical Chairs

David R. Kotok
Chairman and Chief Investment Officer
Global Musical Chairs
October 5, 2010


The game of musical chairs is played with more than one entrant. The players have to focus on the whole group. Contestants gauge their positions as they go around and around. Only when the music stops is the outcome known.

In the US, many investors tend to focus on our domestic monetary policy and our US markets. They are US-centric. Americans often think that we are the only player and that all the musicians are in our own orchestra. Thus, the various pronouncements of many Fed presidents last week triggered analysis and response; yet it was mostly viewed as an internal US domestic affair. In order to try to clarify things for readers, my colleague Bob Eisenbeis has summarized the current state of Fed policymaking. His commentary is found at In addition, there is a guest essay in the Special archives by good friend Bob Brusca. We recommend this to readers as well.

In the other, non-USA, members of the G4, locally focused responses are also observed. Each G4 member sees its policy as first and foremost domestic. Each has an orchestra of central bankers and politicians. Japan is the most obvious one to be facing the music globally.

We find this lack of global thinking surprising in 2010. By now, one would think that analysis would always view the action of any G4 member in a worldwide setting. World markets are highly correlated. World problems in the post-Lehman era are a reflection of this integration. World real estate bubbles are becoming ubiquitous. So why the local-centric view remains dominant is a puzzle. At Cumberland, we see that narrow view as a trap.

Consider that G4 currencies constitute about 90% of the denomination of the world’s debt. The number may actually be a little higher if one adds the debt in the currencies that are pegged to one of the G4 or engage in a dirty float with one of theG4. Furthermore, there is a bifurcation within the G4. The euro and the dollar are the two big guys. The yen and the pound are the other players. Emerging markets and other mature economies like Australia and Sweden are important. However, when it comes to debt, it is the G4 that really counts. These four are the leaders in the game of musical monetary chairs.

In the US, the Fed Funds policy rate is between 0.0% and 0.25%, the United Kingdom is 0.50%, Japan is 0.10%, and the euro zone is 1.00%. All four central banks have expanded balance sheets and all are engaged in some form of quantitative easing, whether they call it that or something else. QE is the music that continues to blare in the G4.

Knowing the four players’ identity, we can derive the weighted average short-term interest rate for most of the capital markets of the world as being somewhere between zero and a half of one percent. Furthermore, we can project that this weighted average will remain at this very low level for at least another year or two. Thus we conclude that this music has not reached a crescendo, yet. That said, we also conclude that we are well beyond the first or second movement of the symphony.

All four central banks involved are confronting large and exceptional problems. All face internal debates over the construction of their monetary policy. In addition, all are experiencing the large impact of expanded fiscal policy in their respective sovereign state constituencies. One might say that the Bank of England, the Federal Reserve, the Bank of Japan, and the European Central Bank are now engaged in a global dance with each other. Moreover, all fear what may happen if the music stops too soon. That fear drives the encore of QE in the US and Japan.

The audience is participating by watching and waiting and deciding or deferring decisions. That audience is all the rest of us. We too fear any abrupt outcome. Evidence of that fear is found in our investing behavior. At the same time, we have to confront a specific item called the near-zero interest rate, which is all we can earn on our cash. We too are playing with the music, hoping to achieve profits and be comfortably seated when the music stops.

We know that the central banks seem to be talking with each other. We know they have become aware that cooperation and dialogue among and between them is paramount for survival. The post-Lehman era insures this is so. We see evidence of if when so many international central bankers attend the Jackson Hole Fed meeting and displace US veterans.

We also know that the US Fed has a daily call that circumnavigates the monetary globe. Moreover, we know that the actions of any large foreign government or central bank are quickly reflected in the foreign exchange markets. The entire world is working on a fiat currency standard. The value of one’s currency is only relative to other currencies. The global buying power of that currency is determined by the comparative actions of each of the players. The result is high volatility in currency exchange rates. An example is found in the euro-USD rate. Greece and the other peripheral European countries’ problems caused a large selloff in the euro vs. the US dollar. Several commentators declared that the euro zone would collapse and that the euro would become “toast.” The euro traded down to about 1.20 USD. This compares with a pre-crisis level above 1.50. Prognosticators projected a fall to parity.

Then the US experienced a suspected weakening in economic terms and the suggestion emerged that the Fed would engage in another round of QE. We are seeing that affirmed by Fed speakers like NY President Bill Dudley. Markets are reacting with a reversal. The euro seems likely to survive. The “toast” is not burnt. The cost of a euro is now 1.37 dollars. All that happened fast.

In a relative-value world, anything that looks like an anchor catches attention. Thus, gold sets new highs in USD terms. Some say gold will ascend more in the fourth quarter of 2010 because of the Hindu festival of Diwali. Ned Davis reports the correlation after Diwali and other festivals implies that a traditional gold price firming of 6-to-9 percent could occur in Q4, 2010.

Back to fiat currency. When will this currency volatility settle down? We think not for a long time. Will it increase? We think the answer is yes. How does one protect oneself in this environment? Ah, that is the hard question when markets seem to be more highly correlated now than in earlier times.

One way to dampen overall volatility is to find those uncorrelated sectors in the global financial arena and add pieces of them to your portfolio. Think worldwide. Then position pieces where you believe the best growth outcomes exist. Then follow events closely. That is why our Global Multi-Asset Class is overweight the rest of the world vs. the US, and overweight the emerging markets in that international sector. That is why our GMAC also contains non-stock-market elements, including some gold.

To be US-centric or euro-centric or China-centric or anything else centric is to concentrate risk. In 2010, that concentration is a dangerous construction if portfolio gearing is not global.

There is one exception to that mix. It comes into play if the liabilities of the investor are concentrated in one currency. For Cumberland that is mostly true, since we have such a large proportion of US-dollar-oriented clients. Many of their portfolios anchor dollar-denominated liabilities. Matching the liabilities with the assets is a necessary risk-management approach. Thus, the global allocation has to come after the domestic liabilities are covered.

Investing is now a 24/7 global business, with constant, instant information. We do not intend to lose sight of that. We recommend that our readers not lose sight of it either. For now the music continues, but stay close to your chair and think globally.

David R. Kotok, Chairman & Chief Investment Officer, Cumberland Advisors,

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