Executive Summary

• Why global capital flows will determine everything
• What impact euphoria and fear wil have on liquidation and valuation
• The importance of debt denominated in other currencies
• What's likely as capital shifts from Risk-On to Risk-Off assets

If you have not yet read Part 1: Here's Why The Markets Have Suddenly Become So Turbulent available free to all readers, please click here to read it first.

In Part 1, we listed five interlocking trends that will severely limit the scale and effectiveness of official responses to the next recession. In effect, the world will not be able to “borrow and spend” its way out of recession.

In Part 2, we’ll examine the single most important dynamic in any asset value: capital flows.

The Tidal Forces of Capital

Let’s start with the most basic building blocks of supply and demand.

Capital flowing into an assets class (buying) in excess of capital flowing out (selling) increases demand and pushes prices up.

If supply increases even faster than demand, prices may decline despite rising demand.

If capital flows out (selling) in excess of inflows (buying), prices will decline.

Prices are set on the margin.  If 5 homes out of a neighborhood of 100 homes sell for 25% below the previous price level, the valuation of the other 95 homes also drops 25%.

Risk on = seeking asset appreciation and taking on more risk in exchange for higher yields.

Risk off = seeking capital preservation and accepting lower yields in exchange for reduced risk.

Assets have two ways to appreciate/depreciate: the nominal price, and the underlying currency the asset is priced in.

If a Mongolian bond yields 7%, the owner earned a nominal 7% on the capital. But if the currency the bond is denominated in dropped 20%, the owner suffered a 13% loss when the investment is priced in other currencies.

The consequences of capital flows can be counter-intuitive.

For example, if the Federal Reserve creates $1 trillion out of thin air, our initial expectation would be this huge increase in the supply of U.S.