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All Skewed Up

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A bit more than 5 weeks ago we wrote about our dumbbelled recovery. We are now in the midst of a nasty stress test of a skewed up global economy. Sovereign credit issues have erupted casting doubt on the sustainability of Euro Zone recovery and the Euro as a rock solid currency. Meanwhile, China's economic miracle has come in for some overdue scrutiny. Fears about lending, property bubbles and vacant space have pushed Chinese shares down by 20%. As folks have cast a newly critical eye across the global financial landscape, fear has returned. The VIX, often referred to as Wall Street's fear gauge, has spiked. US markets have slid over 10%, into official correction territory. European markets are off 10%-20%. Oil, copper and faith are ebbing. The present stress test is revealing that correlations are higher than many had thought. No matter what path we take forward, as an optimistic tide retreated we discovered a lot of assets swimming without bathing suits.

We, among others, have pushed the notion that our present problems are more structural and less cyclical than the conventional wisdom and policy response suggest. Investment, monetary and fiscal policy are taking aim and firing at giant cyclical crises. The problem is that we are in a structural crisis as well as a cyclical downturn. Thus, the high road forward requires a different path be taken. The turbulences in the Euro Zone, The US and China make this very clear. It is not recent asset price retreats that reveal this fact. It is the way asset prices busted, boomed and gyrate that offers the clue. Nearly $5 trillion in global asset market wealth has been destroyed since late April. The latest rounds of sell-off are born of the same forces that produced the great rally between March 2009 and April 2010.

We are in the midst of a dumbbelled world recovery. America is "recovering" with 9.9% unemployment, rising foreclosures, bi-polarity of politics and massive injections of monetary and fiscal policy steroids. Europe is clawing back with spiking public spending and limited tax revenue. China and oil led the way with soaring asset prices since February 2009. China is an export powerhouse that has been substituting vast lending and building for structural weakness in key exports markets. Faced with a crisis of over capacity, China has invested in real estate, equities and more capacity. Oil demand has been weak and oil prices more than doubled as US Dollar shorts and v-shaped recovery stories filled people's dreams almost as quickly as oil filled every available storage vessel. China and oil have been moving up as huge speculative flows into both asset types have tricked investors into thinking growth must be here, near and solid. This is the skewed up recovery in The US, EU and China.

Northeast Asia, North America and Europe have recovered by doing what they were doing before, with more government money and lower interest rates. This kind of response can work very quickly but requires suspension of lessons learned 2008-2009. America needs to wean itself off debt and speculation. Moving from private credit creation to state assisted credit creation is not enough change. Europe needs more structural integration. Monetary union without fiscal policy and macroeconomic convergence is structurally unsound. China needs to invest in a social safety net and much higher domestic final goods consumption. In short, we need more robust structural change in the global economy. Absent structural reform, recovery will be skewed up and fragile in rising markets and falling markets.

The time and money we lavish on short cuts and quick fixes is not well spent.

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