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These nations cannot afford a weaker currency because it tends to fuel
inflation in their economies by making their imports stronger. The only
cure for inflation and the discouraging of the capital exodus is to
raise interest rates. But here is where it gets challenging for them:
if they raise interest rates, their economic growth rates will weaken
and capital outflows will only increase once again. So begins a vicious
circle as selling begets more selling. Some emerging markets countries
have tried to shock their currencies higher by raising interest rates
by 3-5% in one fell swoop. So far, markets have calmed down but the
consensus is that this is not enough as investors believe that
ultimately these countries will have to walk away from higher interest
rate policies. They believe that they will buckle under the pressure of
trying to maintain economic growth rather than price or currency
stability.

A textbook illustration of this scenario is playing out in India. A
falling currency and rising inflation have left India’s central bank
between a rock and a hard place as it must choose between stopping
inflation with even more vigor (raising interest rates again) and
holding economic growth back still more. India’s central bank has gone
so far as to call for central bank decision making to be more
coordinated globally. While this is easier said than done and perhaps
not even feasible given that the economic constraints of nations vary
so widely, it is a recognition that the US footprint is cast far and
wide and ultimately the decisions of the US central bank have
implications for the international community. The Fed has been
unusually blunt in responding to critics who blame US monetary
tightening for the problems of the emerging economies. Jeffrey Lacker,
a Federal Reserve governor was recently quoted as saying that its
policies are conducted strictly towards its mandate of “price stability
and maximum employment here in the United States.”

China is also suffering from the after effects of its ultra-easy
monetary policies that was implemented to combat the effects of the
financial crisis in 2008. China’s monetary stimulus far exceeded the
one undertaken by the US even though its economy was less than half the
size of the US economy. Chinese policy makers have come to grips with
the fact that they have lost control of their economic levers and have
begun to crack down with vigor on lending activity within the Chinese
economy. Several times in the last three months, Chinese banks have
found a severe lack of liquidity and overnight interest rates ended up
spiking to nearly 9 percent as the Chinese central bank sought to send
a message to the banking industry that it was serious in its attempts
to cool lending activity.

One of the great debates in the financial markets is whether or not
China will suffer a hard landing or a gentle slowdown. As we have
highlighted in past commentaries, China’s problems are rooted in too
much lending that is fueling an excess in the construction of housing
and factory capacity. According to data from the International Monetary
Fund, China is only using about 60% of its industrial capacity even
though the economy is growing at over 7 percent annually according to
the latest government data. The challenge of Chinese policy makers is
to ensure that they are able to engineer a slowdown that does not turn
into something more severe.

The weak Canadian economy has left the Bank of Canada with no choice
but to become a little more vocal in its stance that interest rates in
Canada could remain lower for longer. This policy change and a weak
commodity backdrop has pressured the Canadian dollar lower. From its
highs of Q3 2011, the Canadian dollar is down almost 16%.

Once again, we find ourselves looking at equity markets as being at
best fairly valued as a whole but continue to find good companies
trading at cheap valuations from a bottom up, standalone basis. We
believe that at this point, investors should remain selective towards
opportunities in the equity markets. As our title to this newsletter
suggests, investors had likely become too enamored with equities and
were beginning to throw money at the equity markets for fear of being
left behind.