By The Gold Report, on February 9th, 2012
  Preserving wealth in a volatile political and financial world is a job for gold. Greg Weldon, publisher of Weldon’s Money Monitor newsletter and Grant Williams, a portfolio advisor at Vulpes Investment Management in Singapore, will share their insights at the Cambridge House California Investment Conference Feb. 11–12. In this exclusive interview with The Gold Report, they answer the question: How low and high can gold go?
The Gold Report: Recent headlines continue to focus on the debt crisis in Europe as more countries are having their debt downgraded. Greg, you have diagnosed the problem as credit addiction and said that the European Union won’t be able to recover until leaders take painful measures necessary to kick their addiction. What does this mean for commodities and commodity equities?
Greg Weldon: It’s critical for asset prices across the globe. It is a debt addiction, debt refinancing and deficit financing problem, not only in Europe, but also in the U.S. and Japan. Austerity is the real answer to the fact that there is too much debt, and austerity measures in an economic sense are not positive.
My fear is that it’s going to be very difficult to see how economies in Europe, the U.S. and Japan can stand on their own two feet without the assistance of central banks debasing currency through debt monetization. I liken it to filling the sink halfway up with water and pulling the plug out of the drain. Of course, the water level will recede unless you turn the faucet on and start more water pouring into the sink. The level of water represents asset prices, the water flowing out of the faucet represents liquidity provided by global central banks and the drain represents the real macro economy, which has not been fixed.
At the end of the second round of qualitative easing, when the Fed shut off the faucet, the water level (asset prices) started to go down. But now the water is running again—particularly with some of the measures instituted by the European Central Bank, with its three-year loan program, the federal liquidity swaps and the back-ended way that it’s managed to involve the International Monetary Fund.
The problem with all of this is it does nothing to fix the underlying problem, which is too much debt. This is not sustainable. Central banks turning on the water faucet is good for asset prices. The real solutions of fiscal austerity, which are probably not palatable to most politicians in Europe, are the real struggle as we go forward. This problem is not going to go away.
TGR: Grant, in your Things That Make You Go Hmmm…. newsletter, you painted a picture of the final implosion of the euro and U.S. municipal bond meltdown. What would this mean for resource stocks?
Grant Williams: That was part of a prediction piece that I wrote at the end of 2011. It was semi-tongue-in-cheek. My contention was that as volatile as 2011 played out, we didn’t actually get any resolution. And it feels like 2012 will be the year those resolutions start to take place. One of the primary ones is the European situation. A Greek deal to solve the crisis seems to constantly be on the horizon, but they can’t seem to come up with an absolute solution to the public sector involvement haircut issue. When they do, I think it’s going to be the start of a whole slew of legal action to try and either trigger credit default swaps or negate any haircut from those who don’t want to sign up. Greece has a big refinancing coming up in March. It has to raise a little over €14 billion (B), and between now and then it somehow has to get a $130B loan package approved from the Troika. It is very hard to see how Europe can just keep pumping money into Greece. It’s very likely we’ll see Greece exit the Eurozone then, and that’s going to focus everyone’s attention on Portugal. I think Italy will be OK. Spain worries me more than Italy because the economy there structurally is in far worse shape. But if a bunch of countries pull out, that leaves the question of how people unwind any obligations they have in the current euro construct.
What this means for commodities is that the money-printing presses are going to be turned up to the max again. Despite adamant claims from politicians to the contrary, money printing—even if by another name—will have to be implemented at a magnitude much, much higher than ever before to meet current demands. Cash is being given to banks basically for free through the long-term refinancing operation on the quid pro quo that the money finds its way back into the government bond market. The problem is that a lot of this money is going to leak out somewhere other than where it is intended and I suspect it’s going to leak into commodities and equities. We are going to see stock markets float higher, not necessarily on particularly good numbers from corporates, but from the simple dynamic of a lot of freshly printed money looking for a home. We have already seen it in gold and silver this year. They both had big corrections in December, but they are two of the best performing assets of the year so far and I suspect the more money they print this year, the faster these things are going to go up.
People are starting to understand that deflation is not an option for the central banks. Once people realize that if we get a brief period of deflation, it will be fought aggressively with inflation, they will start to look past any deflationary period and position themselves for inflation. That is going to mean higher prices in commodities.
TGR: How high could gold and silver go in 2012?
GWilliams: I think gold trades at $2,200 an ounce (oz) this year. I think silver trades at possibly $60/oz this year, but they’re really just stepping stones on the way to higher ground. This 11-year ascent in both precious metals is only going to change when central bank policy surrounding it changes. I just don’t see that happening in the foreseeable future until they get this debt problem under control.
We are going to see periods with crazy spikes. We are going to see corrections. Some will view this as a collapse but the difference between a correction and a collapse is your entry price. If you bought gold at $700/oz a few years ago and you watched it go from $1,900/oz to $1,500/oz in December, that’s a correction. If you bought it at $1,900/oz, it’s a collapse. I think it’s important to try and take a longer view. The rationale for owning gold and silver is still in place. In a world of printing presses and fiat currencies, no one can manufacture gold and silver out of thin air. I think they are both going to go a lot higher.
TGR: Greg, what are your predictions for 2012?
GWeldon: There is a disconnect in the markets. Currencies really aren’t moving much either. The dollar hasn’t appreciated much. This is why gold is stuck in this range, capped just above $1,700/oz, with potential downside toward $1,300/oz. People are liquidating commodities. My sense is that there is more weakness to come in H112. Commodity prices in Q411 have already come down significantly, pumping some relief into margins. There is a little window of opportunity here where equities and some of the commodities markets could have some upside.
Debt could become an issue again in H212 depending on how central banks deal with that and whether we have a big downturn again in the stock and commodity markets. My longer term view is that when push comes to shove and central banks are staring into the abyss of a potential debt deflation, they will choose to reflate at whatever cost. That is bullish for gold long term. If banks can find the political will to do it, there will be significantly higher prices for commodities across the board in the long term.
China, in particular, has a bullish dynamic. Certain commodities, such as copper, have their own supply-demand dynamics that are detached from the dollar and monetary policies. The Chinese imported copper at a record high in December. Copper stocks on the London Metal Exchange have fallen by close to 30% since October. Copper is one of these commodities that has upside potential regardless of what the dollar is doing.
TGR: Grant, you are based in Singapore. There was a lot of talk at the last Cambridge House Conference in Vancouver about whether China is growing, shrinking, landing hard or soft. What impact will China have on commodities and equities around the world?
GWilliams: China faces a lot of problems. A lot of people think it is in for a hard landing. It is always difficult to believe official Chinese statistics, but the message that the Chinese government is sending through those numbers can be useful. For example, the Chinese growth numbers last week showed an 8.9% increase in gross domestic product. In a world of basically zero growth, that’s a pretty good number, but it’s not the double-digit number we’ve been conditioned to expect from China. Whether it was true or not, it shows that the government is saying: things are OK. We are on top of this, we’re in control. We are not going to slow to zero; we’re just going to grow a little bit slower. The big problem China has is inflation. Roaring food inflation in a society in which half the population lives in relative poverty in rural areas would be a big issue. A lot of people talk about property bubbles—and there are definitely bubbles in Chinese property—but as long as the government can keep people fed, it is going to find a way to get through this—at least for now.
China also has vast currency reserves. The Chinese absolutely understand that paper currency is being devalued incredibly quickly. So, until someone puts a sell-by date on copper and iron ore, it will keep stockpiling the stuff because it will need these commodities to continue growing. China will continue to swap paper money for commodities. The Chinese are bringing gold into the country as fast as they possibly can. Gold is in the DNA here in Asia. It doesn’t take an awful lot to persuade the public to own gold.
TGR: Greg, in your book, Gold Trading Boot Camp, you said gold is at the top of the macro-monetary pyramid. Why does it hold such an important position?
GWeldon: It is a rare and unique mineral that has provided a store of value for centuries that is not backed by any government. It is not subject to anyone’s IOU. Gold stands alone in the level of security it creates in people’s minds as a way to store wealth and protect it from governments that are continually debasing the value of paper money.
TGR: You put the dollar second on the pyramid, but said that could change soon. What will be the catalyst for change and what will be the result for investors?
GWeldon: I don’t know what the catalyst for change could potentially be. For me, the dollar stays as No. 2. There’s been an interesting little sequence recently where the dollar has rallied and gold has declined. But gold has not declined to the same degree that the dollar has rallied. Gold is appreciating in a lot of currencies outside of the dollar where it’s actually outperforming dollar-based gold.
Investors have a greater degree of confidence that the Fed will do what it has to do to circumvent a bigger issue. Next to gold, the dollar still is the second place that people feel comfortable.
TGR: Mining equities haven’t been able to keep pace with the price of gold. Do you see that changing?
GWilliams: It continues to surprise me, frankly, that these stocks are on such crazy valuations against the metal. I think once we start to get wider acceptance that inflation is going to be the outcome rather than deflation, people will start to look at these companies in a different way. Mining companies will instantly become some of the most attractive companies in the world.
I think there’s going to be a tremendous wave of consolidation in the mining sector. When it comes is a tough one to call, though. We’re going to see a lot of junior miners get taken out because it’s going to become a battle for ounces in the ground. If you have proven reserves, the majors are going to come looking for you—particularly if you are in a safe political jurisdiction—and they can afford to pay very, very good multiples of where the stocks are trading now.
In the last 10 years, we have seen some tremendous finds. We’ve seen some tremendous small companies that are very, very well run with incredibly experienced geologists. It requires a lot of due diligence to go through the sheer number of gold mining companies and find the very valuable ones, but I think having ounces in the ground and a good, proven management team are the two fundamental criteria that you have to look for in these stocks. Once the consolidation starts to take place and once the scramble for ounces of gold in the ground begins, I think the resulting valuations will be quite spectacular.
TGR: You are both speaking at the Cambridge House California Investment Conference Feb. 11–12. Based on all of these trends that you’ve laid out, how can investors preserve wealth or even profit during volatile times like these?
GWeldon: Investors who are focused on preserving wealth are best served by buying gold on the dip that is currently taking place. The gold price has a chance to reach $1,450/oz—that’s a sizable move downward.
There’s a chance that monetary authorities would take gold coming off that hard as a sign that they need to be more aggressive. It will be interesting to see how that plays out. However, being long gold and silver is clearly the best play in my mind to preserve wealth.
For investors who are looking to appreciate wealth, the commodities markets offer tremendous upcoming opportunities. That is because there is one thing that I can be certain about: Volatility will remain high. We are not going back to a low-volatility environment. It’s treacherous for individual investors trying to do it themselves. We run a long-short commodity program that’s non-leveraged. But there is a lot of talent in the commodities space for individual investors looking to profit from this market environment.
GWilliams: Preserving your wealth is absolutely the right way to look at it at the moment. Trying to make a profit in markets when there is so much uncertainty is a very dangerous thing to do because things change midgame. So I think for the next several years, using gold, silver and the platinum-palladium group metals as a store of wealth fundamentally makes a lot of sense. I suspect you are going to see outsized gains as a byproduct of using that strategy because I think the prices will go materially higher despite low headline inflation numbers. Using gold and precious metals to hedge yourself as a safety trade is the smart thing to do. By doing that, you will not only protect your existing wealth but you can also generate increased wealth through price appreciation in excess of inflation.
TGR: When you say gold and precious metals, how would an individual investor protect wealth using gold? Are you talking about holding the bullion, buying gold exchange-traded funds (ETF) or buying equities?
GWilliams: It depends. I think protecting wealth using highly geared gold mining companies is a dangerous thing to do. Yes, if gold goes crazy, you are going to make some outsize returns, assuming the asset in the ground is good, assuming the management is good and assuming you don’t get any collapsed mines or any other geological anomalies that sometimes are part and parcel of owning gold mining stocks. Holding the bullion itself is absolutely the safest way to do it. You have an asset free and clear with no claims on it. It’s yours. But that’s not necessarily an easy thing to do from a logistical perspective. A lot of people look at the ETFs as a good vehicle, and they are a perfectly good gold proxy. You have a claim on some physical metal there. But for pure safety’s sake, owning the bullion itself or as close to pure bullion as you possibly can is the smartest way to go.
If you’re looking for any kind of leverage or any kind of gearing, then you need to start looking into the mining companies. But outside the major miners, it’s a very dangerous place to be unless you have someone very smart holding your hand, and you need to do an awful lot of work on researching the particular stocks you buy. While the returns can be extremely good, particularly at these low valuations, gold is a very, very tricky thing to dig for and mines are very tricky things to operate and to run. So you have to be aware of that.
Most important, try to steer clear of government bonds. In a world of increasing inflation, and a world where central banks have promised to try and generate MORE inflation, to lend money to irresponsible governments at 0.23% for two years in the case of the U.S is just crazy to me. Over the long term, you are absolutely guaranteed to lose money in real terms by doing that.
TGR: Thank you for your advice.
Greg Weldon started his Wall Street career working in the Comex Gold and Silver Pits after graduating Colgate University. He progressed as an institutional sales broker at Lehman and Prudential before joining Moore Capital as a proprietary trader. At Moore, Weldon honed his systematic trading methodology and risk management discipline before joining Commodity Corporation where he became one of its top risk-adjusted money managers. Today, he publishes Weldon’s Money Monitor, The Metal Monitor and The ETF Playbook in addition to operating his Managed Futures Account Program as a CTA. He has a unique ability to define and forecast the market’s direction through his proprietary dissection of fundamental and technical market data. Weldon Financial is now a highly regarded and profitable publishing company, having garnered some of the world’s most respected fund managers as loyal and daily readers.
Weldon published Gold Trading Boot Camp: How to Master the Basics and Become a Successful Commodities Investor, in late 2006 in which he predicted the current global credit crisis and discussed the impact on golf from intensified central bank debt monetization. You are invited to participate in a “one-time” free trial of Weldon’s research @ www.weldononline.com.
Grant Williams is a portfolio and strategy advisor to Vulpes Investment Management in Singapore—a hedge fund running $200 million of largely partners’ capital across multiple strategies. Williams has 26 years of experience in finance on the Asian, Australian, European and U.S. markets and has held senior positions at several international investment houses. Williams also writes the popular investment letter Things That Make You Go Hmmm….., which is available to subscribers.
By Claus Vistesen, on January 23rd, 2012
Global stock markets are up about 10% since the beginning of the year, volatility has collapsed, US economic data continue to defy even the mild slowdown proponents and the ECB seems to have backstopped the European banking system.
Yes, my dear reader. This is how quickly you move from away from the apocalyptic abyss and back to normal. My base case is that we are close to excess complacency in equity markets and a sell off is overdue, but it is exactly also under these circumstances (where smart money start to hedge) that the market may deliver one final run up to get everyone and the postman in before hosing everyone.
In the short term, one of the only remaining stumbling block in the form of the ongoing default proceedings in Greece seem to be no match for the ongoing positive animal spirit of the equity market. Only a week ago, we got news that talks in Greece had stalled, but most recently we have been reassured that talks are back on track.
The main niggle on the first occasion appeared to be what kind of interest rate that investors would get on their new bonds and thus, ultimately, the loss of face value currently said to be 50% but also, by some, claimed to be as high 62.5%. Another issue would be whether Greece would pass legislation that forces investors to participate in the debt swap if a majority of investors agree to the PSI terms. This was specifically being discussed in the context of a particular group of investors holding both CDS contracts and the underlying bond and who would maximize their payout on the former by forcing through a hard default.
None of the terms seems have changed massively in the past week, but time is running out with March the 20th set as the final deadline as this is when Greece would otherwise have to make a payment of 4.5 billion-euro ($18.7 billion) on maturing debt. The general consensus is that if no agreement is reached, this date would mark the hard default. The reason for the optimism is then that we are very close to full surrender in the form of a 90% participation rate of creditors and, we are told, it is only a matter of time before the final 10% agrees.
The details reported so far are as follows;
Quote Bloomberg (21 Jan 2012)
The parties are near an initial agreement under which old bonds would be swapped for new 30-year securities carrying a coupon that would begin at 3.1 percent, reach 3.9 percent and go as high as 4.75 percent, Athens-based newspaper Proto Thema reported on its website yesterday, without saying where it got the information.
The desired macroeconomic outcome of all this is obviously well advertised. In 2020, Greece is supposed to have a government debt to GDP ratio of 120% and presumingly some form of growth that would allow this level of debt to stay stationary or perhaps even decline over time.
Let me be clear absolutely clear here. Within any conceivably realistic macroeconomic model, there is no way that Greece can reach a stable debt level with moderate growth under these conditions. Under the interest rate scenario noted above (let us with a average interest rate of 3.8% on the new debt) the nominal interest rate would still be substantially higher than the growth rate of the economy. The only way, the nominal debt level could then be kept stationary is by forcing the fiscal balance into surplus. However, the problem is that this affects the denominator in the debt/GDP calculation by sucking out demand (growth) from an economy already structurally impaired (within a currency union and all that).
The implications are clear. The promises of stability that the PSI currently holds (even if it comes with considerable pledges of IMF money) are bound to disappoint.
First act of several to come
First of all, let us be clear. Despite, politicians’ mortal fright to use the D-word and the media’s acceptance of this fact on the basis that CDS contracts are not activated under the PSI, this is a stone wall default. Anyone, who bothered to take merely a scant look at the history of sovereign defaults will see that the current Greek situation fits well within all the models. Indeed, the proposition that this is not a default because CDS contracts are not activated is ludicrous since in the vast majority of sovereign defaults, the debtor country begins negotiations with creditors well before the actual default is forced upon it. The fact that insurance contracts bought to protect a creditor involved in such negotiations have now been rendered useless says more about the nature of the our modern financial system than it does about the definition of a sovereign default.
Hence, we come to the real nature of this game.
The deal which now seems to be close to completed by no means closes proceedings. It is very likely in my opinion that private creditors who are currently the only ones being forced to take a haircut to seniority of the IMF and the ECB will face a near 100% loss on their holdings. The argument here is simple. Given the amount of debt held by the ECB and the IMF and the fact that these two institutions are senior debt holders the debt held by private creditors become something else than actual bonds. It becomes equity, i.e. the tranche which takes the first (and often complete) loss in the event of a default.
Of course, once we reach this point the issue of CDS contracts will rear its head yet again since if a 50-60% haircut can be considered voluntary anything beyond this becomes very difficult to characterize as such. Any rating agency would find it difficult not to classify further losses as a default and thus begins the fun in earnest. And then comes the ECB and IMF’s share. It will be politically dynamite if the ECB had to print on the liability side to cover losses on the asset side on Greek sovereign debt [1].
Finally, Greece only represents the starter here. Any deal agreed on in Greece will be ardently watched in Ireland and Portugal who will feel they are entitled to the same deal with their private creditors.
Most tragedies have several acts, twists and turns. Investors should expect no less from the one currently being played out in the European sovereign debt markets.
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[1] – In practice the ECB could do nothing and see its balance sheet shrink with the amount lost on the asset side (i.e. reduce lending to the banking system (delevering) with the amount lost on the bonds). However, it is likely that it would “need” to credit reserves with the amount lost on Greek bonds (hence printing money). Mind you, only a central bank could do this as it is free to increase the assets of the banking system by creating its own liabilities.
By Claus Vistesen, on January 18th, 2012
Edward Hugh has a brilliant analysis of recent events in the eurozone and especially how banks are leveraging the liquidity provided by the ECB to “cleanse” their balance sheet of bad assets and essentially exchanging these for freshly minted euro deposits at the ECB. I think we should be very clear what is going on here; this is essentially a covert recapitalisation of the European banking system and the ECB is in every sense of the word acting as a lender of last resort.
Here is the relevant part;
Another area where the transfer of liquidity doesn’t show up as a change in aggregate excess liquidity is when banks offload their wholesale liabilities to other EuroArea banks and refund via the ECB. Here again, if they do it smartly, they can even earn a bit of “quasi carry” in the process, by buying back their debt at well below face value from those who are anxious to exit the periphery, and then refinancing at the ECB without writing down the underlying asset. This could be termed a liability “write down”, and again the procedure earns the bank a nice bit of income which can subsequently be used to help the recapitalisation process.
Take the Portuguese Bank BPI (the country’s fourth largest), which is making public tender offers to buy back its debt. If all concerned tender their bonds to BPI, BPI will pay something short of €1.5bn cash to investors. Mortgages which were previously sitting in one of their SPVs will return to their balance sheet, and ECB money will now be on the other side financing them allowing significant profits (and capital) to be reported. In this particular tender the smallest discount is 35% and the largest is 65%. Investors may initially balk at the offer, since they will nurse a heavy loss (equal, naturally, to BPI´s profit) but ultimately they will probably be only too happy to be able to walk away from Portugal, and with some cash in their pocket to boot.
Iberian banks were already aware of the benefits of this kind of restructuring during the 2009-2010 liquidity wave, and went about quietly repurchasing their bonds (bank capital, securitizations, senior bonds) on a selective and private basis at a discount. Much of their reported profits in those years in fact came from either the ECB carry trade or this kind of transaction. So when we read that another Portuguese bank – Banco Espirito Santo – has just had €1 billion of debt guaranteed by the Portuguese state (a sovereign which can’t itself go to the markets) it isn’t hard to imagine that the process going on in the background is something similar to that seen in the BPI case, and that the debt is being guaranteed so it can go over to the ECB to be posted as collateral.
The National Bank of Greece has been doing something similar. They recently offered to buy back some €1.5 billion in covered bonds and preferred securities,offering 70% of face value for the covered bonds and 45% for the preferred hybrids. As the bank itself says, “The purpose of the offers is to generate core Tier 1 capital for the group and to strengthen the quality of its capital base….The offers would generate a gain for the group.”
And Italian banks would seem to be doing something similar, since they issued around €40 billion in government backed bonds specifically to take to the ECB. The bonds are held by the banks themselves and stay on their books to maturity, their only purpose being to provide collateral for use at the ECB. In fact Italian banks took something like €116 billion from the LTRO, or almost 25% of the total. Perhaps this is why Unicredit CEO Federico Ghizzoni and other European top bankers met ECB officials in Frankfurt back in November, to discuss new rules for collateral.
In Spain securitised mortgages sitting on the balance sheets of the bank-ownedFondos de Titulizacion de Activos could also be recycled in this way (here’s a complete list, although note that these Funds are regulated by Spain’s CNMV and not the Bank of Spain, which is why their presence is relatively unknown and people are able to accurately say that the central bank has been very strict on SIVs, since they weren’t their responsibility).
That something like this may be happening, with the ECB “buying into” public and private Euro Periphery debt while investors are discretely getting out is suggested by this report in Bloomberg:
The euro is losing the relationship with riskier assets that underpinned the currency in 2011 as the deepening sovereign debt crisis reduces the creditworthiness of even the biggest economies in the region. The 17-nation currency has fallen 8.7 percent against the dollar since October, while the Standard & Poor’s 500 Index has gained 3.4 percent, and the correlation between the two dropped to 58 percent from a record 91 percent in November, according to data compiled by Bloomberg. The euro had moved almost in lockstep with investments linked to growth, including stocks and the Australian dollar, since January 2011.
This decoupling is taking place as European Central Bank President Mario Draghi cuts interest rates and promises banks unlimited cash for three years to rein in soaring borrowing costs for governments… Strategists also anticipate more losses as the US economy improves while the euro zone shrinks, driving international investors away from the region’s assets.
So if the first two objectives were to help the struggling sovereigns, and enable the commercial banks to refinance their debt, then to some extent these objectives have been met. But what about the third objective, moving credit on the periphery to get the real economy moving again? Well, here the ECB’s measures are likely to have far less effect, and indeed what effect they do have may be in some way a mixed blessing, since the banks seem far more worried about demonstrating they have an adequate level of core capital than they are about participating in solutions to real economy problems.
While I would, in general, be hesitant in taking anything from Zero Hedge at full face value I think the following story on Unicredit adds flavor to this by providing further evidence on the points Edward mentions above.
The story is clearly speculative but gets backing from Edward’s accout above. The following seems to be a part of the general process which in itself is, in my view, absolutely mad.
Banks in weak countries have been issuing debt, getting a government guarantee, and then posting them as collateral at the ECB. There are examples of this for Greek banks for sure, but my understanding is it has also been occurring in Portugal and Ireland. It is the only way banks in Greece (and the other countries) can raise money.
The article then goes on to make this more alarming point (but really does not have evidence to back it up) that it appears that about €40 billion of the first LTRO was done by Italian banks (Unicredit?) that issued bonds to themselves and got a government guarantee, and then posted this asset as collateral for liquidity through the LTRO.
So, here is how I understand it.
Unicredit issues a 3m bill and gets a government guarantee so that whoever chooses to buy this bill knows that it will be backed by the sovereign (after all, this is still better than the bank even if the two are joined by the hip). The only problem is that it is being issued to itself with a permanent guarantee from the government.
From an accounting perspective this must be close to illegal in any meaningfully lawful jurisdiction, but I defer to experts here of course. The issue here is not then that the sovereign is guaranteeing a liability of a bank, we have seen this plenty of times and it is indeed the only way that some financials can issue debt, but rather that the bond never gets marketed to third party buyers.
It is absolutely astonishing that this 3m bill is then being posted as collateral at the ECB. But you must understand that it has to be posted as such as far as I can see since you can’t hold your own liabilities. So, the banks posts a bond issued to itself and posts it at the ECB and get freshly minted fresh euros credited to its bank account at the ECB. After the process, Unicredit still has the bond as a liability but instead of the same bond on the asset side (which is impossible) it has a deposit asset with the ECB.
If this is true, and the ECB is agreeing to this I must admit that it amounts to a serious bout of banking follies in the European banking industry.
By Rok Spruk, on January 16th, 2012
Recent debacle at the summit of Brussels in the midst of the political intervention of the EU leaders to facilitate the institutional agreement between the European countries towards the formation of the European fiscal union has caused not only a long-standing dissolution of the “core countries” of the Eurozone and the UK but, more importantly, a non-solvable puzzle on the end scenario of the European debt crisis that pervaded both the eurozone and the countries outside it ever since the beginning of the 2008/2009 financial crisis. The anatomy of the European debt crisis is a multifaceted process that is heavily interrelated with the economic principles of the process of European integration and the unintended consequences that erupted in the recent debt crisis.
The introduction of Maastricht criteria that stipulated fiscal prudence by obliging EU member states to adhere to the level of public debt below 60 percent of the GDP and low fiscal deficit boosted the expectations of stable macroeconomic environment, partly sustained by the European Central Bank which, since its inception in 1999, successfully maintained price stability. Despite an enviable achievement in the stabilization of inflation expectations, the EU Treaty did not stipulate stringent fiscal rules in case of the breach of treaty obligations on behalf of EU member states, neither has European Growth and Stability Pact (EGSP) provided selective mechanisms that would hinge on the EU member state in case Maastricht criteria were not fulfilled. On the other hand, the gradual enlargement of the European union did not finalize in the economic union characterized by the realization of four basic freedoms.
In 1977, Portugal and Spain were acceded into the European Union. Four years late, Greece was admitted as the 12th member of the European community. Over time, the EU grew from an integrated area of 15 Western European countries into a conglomerate of nations that did not impinge of the full-fledged liberalization of the internal market in 1988 but, moreover, has evolved into the spiral that accelerated the community toward the political union. In the mean time, member states of the Eurozone have continuously breached the rules laid out by Maastricht treaty. In bearing the fiscal consequences of the reunification, Germany repeatedly breached the Maastricht criteria both in public debt and fiscal deficit which postponed the introduction of the Euro, following a large shock from gigantic fiscal transfers from high-income West Germany into low-income East German regions. In a similar manner, until 2005, France did not manage to reduce the debt-to-GDP ratio under the 60 percent threshold stipulated by the Maastricht criteria.
Nevertheless, peripheral countries such as Spain and Portugal entered the Eurozone at an overvalued exchange rate relative to German mark before the introduction of the common currency. In the following years, these countries, notably Spain, accumulated significant current account surpluses resulted from the inflows of direct investment from the core countries such as Germany and France. These surpluses were, of course, artificial in the sense that the downward convergence of interest rates in the peripheral countries stimulated the over-leveraging of the financial sector which triggered a balloon in the housing sector.
For years, Italy and Greece have repeatedly breached the Maastricht treaty in the fiscal sense. Prior to adjoining the European Monetary Union, Greece repeatedly experienced volatile inflation rates and default on its external obligations and subsequent Drachma depreciation. Italy’s macroeconomic stabilization hinged on the discretion of government spending which, after excessive rises under various transition governments, cumulated in one of the highest debt ratios within the EMU. How could EMU countries, despite a stringent set of rules delineated by the Treaty of Maastricht, pursued discretionary fiscal policies and jeopardized the macroeconomic stability of the national economies and the Eurozone? Prior to the onset of the financial crisis by the end of 2007, little was known on the perils of excessively leveraged balance sheets which investment banks used to seek high rates of return on high-yield and relatively risky peripheral regions. Until 2007, the exposure of major German investment to over-leveraged financial sector in countries such as Spain and Greece generated sizeable spillover effect. Before the onset of the financial crisis, Spain enjoyed sizeable current account deficit resulted from excessively high and robust overall investment. In 2007, Spain’s investment-to-GDP ratio (31 percent) was roughly comparable to developing Asia. In such highly volatile environment where economic growth departed from its long-run fundamentals, even small-scale macroeconomic shocks can result in a substantial loss of economic activity, notwithstanding the spillovers in the banking system and labor market.
The asymmetry in political structures and underlying macroeconomic fundamentals across member countries casts significant doubt in the long-term stability of the Eurozone as an area with common monetary policy. The necessary condition for the inception of common monetary policy does not hinge on the political initiatives that pervaded the process of European integration but on the careful consideration whether adjoining countries adhere to the macroeconomic criteria as denoted by the Maastricht Treaty. The failure to adhere to the contours of fiscal prudence and budgetary discipline by the major EU member states, with few notable exceptions such as the Netherlands, Austria and Finland, lies at heart of the underlying reasons why significant asymmetry and non-coordination in fiscal policy resulted in the adoption of dispersed economic policies whereas the adverse outcomes were not foreseen neither by the politicians neither by policy advisers and academics. To a large extent, as the recent debt crisis has succinctly demonstrated, the ultimate goal of the European monetary integration was the build-up of political union. But whereas European politicians were preoccupied with all-embracing design of the EU as unitary political union, they forgot to acknowledge that political union would require the full convergence of economic policies including the integration of the labor market which hardly any political initiative within the EU deemed feasible.
The non-coordination of fiscal policymakers was highly evident in the division of member states on the core countries and EU periphery. Considering the peripherical countries, Italy, Spain, Portugal and Greece repeatedly proved ill-disciplined in managing the levels of public debt and the magnitude of the budgetary imbalance. Portugal is often the case in point. Prior to the introduction of the Euro, Portugal experienced unprecedented economic boom. Between 1995 and 2001, economic growth averaged 4 percent per annum and the unemployment rate reduced from 7 percent to 4 percent by the end of 2001. At the same time, nominal wages grew rapidly without the necessary productivity growth compensating for the increase unit labor cost. Alongside the overheating of economic activity, driven by construction boom, current account deficits increased significantly, lowering domestic savings rate. After the country experienced a mild recession in 2003 when domestic output decreased by 1 percent on the annual basis, the slowing of artificial economic growth driven by the Euro boom, turned from temporary into permanent. In the period 2002-2010, growth of domestic output averaged at the level of no more than 1 percent per annum with stagnating productivity and significant pressure on nominal wages. Since the size of the labor cost is the major deterrent on growth, the cure for Portuguese ailing economy is the structural adjustment in the public sector such as the reduction of public debt by generating substantial primary fiscal surpluses and the lowering of government spending. Similarly, the experience of Greece, Spain and Italy suggests the evolution of the same pattern evolving over time although Italy has been known as low-growing economy during the boom time.
However, fiscal policymakers in peripheral countries repeatedly produced ill-conceived fiscal mismanagement of public finances. In 2008, the level of budgetary deficit in Greece exceeded 13 percent of the GDP whereas the country has not adhered to Maastricht criteria ever since the introduction of the Euro. After the depreciation, the net debt as percent of GDP in Greece reached 85 percent of GDP and increased to 110 percent of GDP by the end of 2008. As IMF’s recent forecasts suggest, by 2012, Greece’s public net debt could reach 175 percent of GDP. The failure to adhere to the common set of principles as delegated by the Maastricht treaty and EU Stability and Growth Pact in the peripheral countries stemmed largely from the mismanagement of public finances and structural rigidity of the public sector with resulting increases in the burden of the labor cost. In addition, the adoption of extraordinary measures embedded in the public sector such as very low effective retirement age and substantial bonuses for civil servants exacerbated the burden of the public debt with unforeseen net financial liabilities of governments which have not mitigated the persistent burden of public debt that grew substantially over time in the EU periphery.
A natural question is whether the exclusion of peripheral countries from the Eurozone might be feasible and whether Greece’s default on external obligations might help overcome country’s mountainous strain on public debt. First, the re-adoption of domestic currencies is hardly a solution to overcome the intricacies of debt crisis. If Greece re-introduced drachma, external obligations would be strained by a painful and enduring bank run since investors would withdraw the deposits from the portfolio and invest it into safer holding with less volatility and uncertainty ahead. Another argument in favor of Greece exiting the Eurozone is that a devaluation of drachma would boost inflationary expectations and consequently reduce the burden of the public debt but given junk score on government bonds, a rather immediate bank run would follow the devaluation of drachma rather than macroeconomic stabilization. In addition, when Greece’s domestic output is growing far below the long-term potential, inflationary expectations is not a feasible tool to revive the economy from deflationary trap with 16 percent unemployment Moreover, the only feasible and meaningful short-term strategy to boost growth is the reduction of the size of the public sector including the privatization of inefficient state-owned enterprises to generate substantial fiscal surpluses since this is the only plausible measure to tackle the increasing burden of the public debt. As the history of financial crises suggests, the eruptions of banking crises occurred mostly when governments rested on currency devaluations as the ultimate tool to reduce the burden of external debt. In addition, if Greece defaulted on its external obligations, CDS spreads could indicate a snowball effect where Spain, Portugal and possibly Italy could follow the same track.
The question is whether non-coordination between European fiscal policies helped facilitate over-leveraged financial sectors which asked for the bailout by central governments in the wake of the 2008/2009 financial crisis. Over-leveraged financial sectors were attributed to the determinants of various extent. Some argued that over-leveraging is the outcome of innovative financial engineering where fancy mathematicians and physicists applied VaR models to calculate the probability of losses in the portfolio distribution of returns whereas the financial derivative schemes developed by advanced and complex mathematical models were so complicated that nobody, sometimes even mathematicians themselves, could understand sensibly. On the other hand, the monetary policy perspective of over-leveraged financial sectors has been rather overlooked in policy discussions since periodically low interest rates encourage excessive risk-taking which further facilitated the construction of portfolios with excessively volatile returns that increasingly relied on VaR assumptions whilst fundamentally ignoring the instability of returns from over-leveraged investments. But a more intriguing question pertaining to the banking perspective of financial crises is whether more prudent financial regulation as envisaged from recent stress tests by European Banking Authority can be achieved by raising capital adequacy standards. Unfortunately, the history of Basel accords demonstrates that the banking sector has been prone to search alternative channels to avoid raising capital adequacy ratios through innovative accounting tricks whereas neither Basel I and II envisaged the adverse outcomes from excessive risk-taking. As stress tests indicated, capital adequacy ratios should be increased substantially but, moreover, the regulatory framework should not only build on increasing criteria on Tier I capital and common equity but also on the safeguard despositary insurance of contingent liabilities to mitigate liquidity risk that led to the systemic crisis.
The solution to revive the Eurozone economy and revive it from a decade of flawed political imperatives should not exclude multiple options. The focal point of the Eurozone’s recovery from debt crisis should be to help peripheral countries establishment fiscal prudence, discipline and soundness of the public finances. In fact, the recovery from the debt crisis will endure for more than a decade. The structural adjustment does not rest on the ability of the EU to provide financial assistance to peripheral countries but on the principled and coordinated action to reform inefficient public sectors which are at the heart of the debt spiral since years of generous entitlements to civil servants have tremendously raised the net present value of public debt to the point that peripheral countries are on the brink of default on its external obligations. Without generating substantial fiscal surpluses, there is no feasibility and no realistic scenario under which public debt level would be brought under the control in the near-term perspective. Hence, recent discussions of the consequences of debt crisis in Europe have simply overlooked the importance of growth-enhancing measures as the real cure for growing debt-to-GDP ratio where the measures do not apply to peripheral countries only.
First, in the wake of fiscal insolvency of public pension systems, effective retirement age should be raised substantially for men and women alike. The studies have shown that under the increase in effective retirement age to 65 years, long-term fiscal obligations would reduce and consequently an important step towards long-term macroeconomic stability would be achieved. Nearly every European country is facing low-fertility trap followed from increased affluence and generous early-retirement policies from 1970s onward. Consequently, European government have amounted a mountain of net financial liabilities that exceeded the size of GDP by several times, respectively. Decreasing the size of net liabilities to contemporary and future generations of retirees, requires a robust increase in effective retirement age. Higher retirement age threshold would substantially increase working-age population by encouraging labor market participation among the elderly. Current levels of effective retirement age are unsustainable in the long-run since a growing burden of pension obligations can seriously threaten the stability of the public finance and increase the probability of fiscal insolvency.
Second, European countries suffer from low productivity growth. In some countries, such as Italy productivity growth has remained stagnant over the course of recent two decades while elsewhere productivity growth is to slow to compensate for the increase in nominal wage rates. The evidence, in fact, overwhelmingly suggested that high tax rates are the prime obstacle to greater labor market participation, particularly among the elderly who face high implicit tax rates on work. In particular, to facilitate the channels of productivity growth, marginal tax rates should be decreased substantially. At current levels, marginal tax rates restrain labor supply significantly. In the Netherlands, the top marginal income tax rates reached 52 percent in 2011 which is a serious hinder on the working activity. In this respect, bold tax reforms should be complemented with more flexible labor markets which remain saddled with employment regulations and distort labor supply incentives. Less regulated labor market to supplement greater labor force participation, especially among women, elderly and the youth is vital to enhance productivity growth since living standards by the end of the day are determined by productivity improvements.
Ultimately and most importantly, peripheral countries should be given a free choice whether to withdraw from the EMU since recent financial crisis has shown that Eurozone is a suboptimal currency area which emerged from non-cooperative fiscal policies among its member states that caused adverse outcomes and asymmetric adjustment where macroeconomic stabilization outcomes are mutually exclusive among member states. Asymmetry adjustment that currently threatens the existence and stability of Eurozone lies at the heart of Eurozone’s debt crisis. As a general matter, economic policies have failed to recognize that structural measures in the labor market and fiscal policy regime could facilitate growth enhancement and provide the necessary impetus to stabilization of crisis-impeded monetary union. Recent suggestions by France and Germany for EU member states to form a fiscal union have led to sustained resistance from the UK which dissolved from the fiscal pact. The ultimate grain of truth in the fiscal union is that a monetary union necessarily requires the coordination of fiscal policies to prevent adverse and asymmetric policy outcomes within the union. The fateful conclusion from recent EU debt crisis is that without the integration of the labor market on the EU level, the monetary integration cannot exist in coherence with asymmetric fiscal policies. In the future, stricter adherence to budgetary discipline will be necessary through budgetary authority. In this respect, countries that fail to adhere to Maastricht criteria and deviate from the fiscal discipline either marginally or substantially should be condemned and pay for their actions of fiscal imprudence by withdrawing from the monetary union.
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By The Gold Report, on January 11th, 2012
  What do investors need to be watching out for in 2012? More Eurozone drama? Record gold highs? A hard landing in China? The U.S. Global Investors team addressed these questions with Endgame: The End of the Debt Supercycle author John Mauldin in a Jan. 5 Outlook 2012 webinar. The Streetwise Reports editors highlight some of the expert insights.
John Mauldin: Instead of doing an annual forecast, I’m going to look out about five years, which may be five times more foolish. What I want to do rather than try and figure out where the stock market is going to be at the end of 2012 or what gold is going to do, is look at the choices we have around the world.
In most cases, political events don’t change the economic world all that much. It’ll probably annoy partisans on both sides, but if Clinton had lost to George Bush senior the first time, we would have still had a bull market. We were already in recovery. Yes, we would have had different Supreme Court Justices, but that’s not the economic world. We were set on a path. If Gore had beaten Bush 2, economically I don’t think much would have changed. We still would have had the end of a bull market and a recession in 2001. We would have had a housing bubble. Greenspan would have probably been reappointed either way. We would have had a credit crisis because we were in the process of building up debt that started in the ’50s. Europe was building its debt up. Japan was building its debt up. That is the reality.
Now the private sector is deleveraging, but sovereign debt is in a bubble. The air is coming out. My view is that the wheels are going to fall off Europe this year. I have been researching the Mayan codes and I have determined that the ancient Mayans were not astrologers; they were economists. They weren’t predicting the end of the world; they were simply predicting the end of Europe. That is a humorous way of saying this is the year Europe is going to have to make some very difficult choices. Greece gets to choose what kind of depression it wants, hard and fast or slow and long. It can’t avoid depression completely. It has borrowed too much money. The government is too big. It has come to the end of the ability to raise money at low rates. Italy and Spain are well on that path along with the rest of Europe. So, they have to make a decision, a political decision that is going to have major economic consequences.
Does Europe want to be a political union that looks more like the United States, where the individual entities have to run balanced budgets and can’t print their own money and have some kind of fiscal controls or they go back to a two-tiered Europe with multiple currencies. One way or another, this is the year that Europe is running out of road to kick the can.
Fortunately, in the U.S. we are not there yet. We have some room to make a decision. That decision is going to be made in 2012 because by 2013 we are going to have to decide how we deal with the deficits and debt. After 2014, the bond markets will start to raise rates. Total U.S. debt is continuing to grow because governments are growing debt faster than private citizens are decreasing debt. The bond markets are starting to rebel long before you would think they would for a country that’s the world reserve currency. The key is whether debt is excessive relative to income. If you can make your debt service, people will still lend you money. When they don’t think you can, they will stop. That’s when you have a crisis. It’s a debt super cycle. And, when you reach the end, you have to deal with the debt. You can pay it down. You can default on it. You can print the money, extend it out with lower rates or financial repression, which are all other ways to look at default. But, nonetheless, that debt is there.
The problem we are facing in the U.S. is that gross domestic product (GDP) is consumption plus investment plus government spending plus net exports. If we decrease government spending over time, we decrease GDP. That’s the problem that Greece is going through right now. It has to decrease government spending by 4.5%, thus shrinking the economy. But it can’t increase government spending without increasing debt or taking taxes away, which decreases consumption. Nothing the government does will make things better. The U.S. is on the same path. We can become Greece by continuing to borrow or be proactive and say we are going to get our deficits under control over a period of five or six years. The economy is still going to be slower than we would like and unemployment higher than we would like. That’s just the rules. We’re at the end game. We are at the end of the debt super cycle and that’s what happens.
Printing money doesn’t increase the GDP in actual real terms, but it makes everyone holding gold happy because the value of natural resources goes up. That is why I buy gold every month. I take those coins, I put them in a vault and I hope I never need them. I quite frankly hope gold goes back to $300/ounce (oz) because that means the economy is in wonderful shape. I’m actually afraid that gold is going to go up in value, which means we are not getting our act together.
That leads to questions about fault. Did the banks do things they shouldn’t have? Yes. Were they the cause of it? No. Was Greenspan the cause of the bubble? No. He was part of the cause. I mean, we did a lot of things as a country that weren’t good choices. Should we have allowed our banks to go to 30 and 40 to 1 leverage? No. Should we have repealed Glass-Steagall? No. The problem is that real median household income hasn’t moved for 15 years because real private GDP hasn’t changed. The only thing that has grown is government spending.
John Derrick: In 2011, the European financial crisis moved from the periphery to the core. Central bank policies were big drivers of the decline. The European Central Bank and China raised rates early in the year and again in July as fears of a China slowdown grew. That early tightening to fend off inflation had a big impact on the course of events throughout the year. The other big events were the U.S. credit downgrade in August and currency intervention, particularly in the Japanese yen.
Frank Holmes: There is a huge amount of borrowing around the world in Japanese yen because it is so inexpensive. That includes investing in commodities, resources and emerging markets. And, every time we see this huge signal move by the yen, you get this rippling effect that takes about six weeks to resolve itself with commodities being sold down. Therefore, a lot of fund managers borrowing in Japanese yen are long energy stocks, resource stocks and emerging markets, which leads to a lot of selling.
JD: The second half of last year was very volatile, but the market ended essentially flat. In fact, much of the volatility was concentrated in the last month, which made for a very difficult psychological environment, as the market has been somewhat schizophrenic with weekly rallies and selloffs.
Spikes in the yen caused market selloffs. This hit commodities especially hard. So the secret for 2012 is to use the volatility. Buy on the volatility spikes. Unfortunately, what most people do is just the opposite. Another thing to look for in 2012 is a positive fourth year of the presidential election cycle as the government tries to implement policies that will get them reelected.
Brian Hicks: There has been a lot of concern about money supply growth in the emerging markets, particularly in China, which reduced bank reserve requirements last year. A reacceleration of global money supply can be particularly constructive for commodities going forward as there has been a high correlation between money supply growth and commodities.
If you were to take all the global money and back that by gold, the price of gold could go to $10,000/oz. If you just use half of the global money supply, gold would trade at about $5,000/oz, up from approximately $1,600/oz right now. The more U.S. dollars in circulation, the higher the price of gold. This has been the main factor increasing the price of gold since 1998 and will continue to be the case in the years to come. Gold has a lot of running room to go.
Another driver for the price of gold has been federal deficits. Government spending is way above revenues. We hit a point in 2000 where spending as a percentage of GDP greatly exceeded taxes as a percentage of GDP. This could be a point of no return and could potentially drive the price of gold even higher. There has been a large bifurcation between the price of gold and gold equities, particularly in the last couple of years as risk aversion has prompted many investors to buy the bullion as opposed to gold equities. This is creating opportunity. We feel like there’s going to be a catch up in gold equities, many of which are trading at very low multiples to cash flows and earnings. Stocks such as Newmont Mining Corp. (NEM:NYSE) look like value stocks now paying high dividend yields and trading at sub 10-times price to earnings ratios. This could really present an attractive opportunity in 2012.
JD: Just a comment on all the takeovers. We were seeing 6% premiums on takeovers in ‘06. Now we are talking 60+ premiums. That’s another reflection of how undervalued the stocks are relative to commodities.
BH: That’s a great point. We have seen tremendous value creation based on mergers and acquisitions.
Shifting gears a little bit, crude oil and refined product inventories ended the year at the lowest level on record (about 685 million barrels). That’s 6% below the prior year. It’s particularly interesting when you consider some of the geopolitical factors that have arisen with Iran talking about blocking off the Strait of Hormuz. This is a primary factor behind oil price supports despite the tenuous economic environment. Many investors don’t realize that Russia is very important for non-OPEC (Organization of Petroleum Exporting Countries) supply, a key factor in containing oil price spikes. Russia is increasing production while other non-OPEC production in Mexico or in the North Sea have been declining significantly, which has helped to bolster OPEC’s market share. It has also limited the ability of oil markets to increase production out of the Middle East due to the inability to invest in those troubled areas. In fact, Russian production has been quite steady since 2006, increasing anywhere from 100 to 400,000 barrels per day (bpd), mid-single digit growth. But, forecasters predict in 2012 we will see flat production growth, which is troubling given the fact that we continue to see demand increase in other areas of the world, mainly out of China. This will be a driving factor going forward for crude oil prices.
Evan Smith: Oil supply threats include geopolitical problems at a time when oil supply and spare capacity at OPEC is rather low—a little over 2 million bpd. Nearly 40% of global supply is under autocratic rule. Iran has threatened to disrupt the supply of crude oil and products through the Strait of Hormuz where about a third of global oil supply passes. So, any disruption, even temporarily, would cause a severe spike in oil prices. We think oil prices could support $100/barrel. One of the things we like in 2012 is higher exposure to master limited partnerships partly because of their steady cash flows. They are becoming a growth business now. The capital expenditures here in the United States have grown from $3.5 billion (B) in 2005 to nearly $16B this year. This is partly because of the growth in many of the shale plays, which require increased infrastructure. We think this is an excellent investment opportunity. We also see a big opportunity for the global oil services. We can see that capital expenditures have been rising. We expect them to rise from about $500B to nearly $.5 trillion this year, an increase of 15%. So, we see tremendous opportunity for some of the oil services contractors and equipment providers. Another key driver is the impressive amount of money that has been invested in North America. Just over the last three years nearly $129B in mergers, acquisitions and joint ventures has occurred. Global companies are coming to North America to invest in these shale plays because the economics are so attractive due to improved technology. They want to learn that technology and take it home. So, we think there is continued opportunity for investors in the resource play here in North America.
Shifting gears, one of the base metals we will target is copper. It is our favorite base metal. The demand side is holding up relatively well compared to some of the other base metals. Even in China, which is the largest market for copper growth, the build out of the grid is really a key driver. That is holding up quite well. On the other side of the supply/demand equation, supply has been a problem. Through most of the boom in copper prices, mine output has lagged forecasts. Causes included weather, labor strikes and just poor grade. The bottom line is that supply has not kept up with demand. We have not solved that problem so we think 2012 should be a relatively good year for copper prices.
Another theme we like is the agricultural space. Global population continues to grow. The emerging middle class continues to consume more grains, principally through the production of more meat as people consume more protein in their diets. There has been a huge surge in the need for the production of grains, yet no more land is being created. One of the key ways we’re seeing increased yields out of croplands is through higher applications of fertilizers. That has created a fairly tight situation for potash, specifically. But, other fertilizers such as nitrogen and phosphate are also benefiting from this trend.
FH: I would just add that the world’s population has doubled from the ’70s when we had rising commodities. There’s a very different factor and China and India have a global footprint that they didn’t have.
Xian Liang: China remains the biggest driver of world demand for energy due to a rising middle class, but it is in a very early stage when it comes to discretionary spending. Take for example passenger cars. Despite a tremendous growth in auto consumption in the last decade, only 18% of Chinese households own a car. Car ownership in China is just one-tenth of U.S. levels or the same level it was in the U.S. in 1914. Air travel remains at the U.S. equivalent of the 1950s. This illustrates a great growth potential going forward. Urbanization is one of the most significant trends driving consumption. In 2011, the number of urban residents in China exceeded rural residents for the first time in Chinese history. But, China won’t stop at this 50% urbanization rate if the historical trajectory of its richer neighbor, South Korea, is any guide. We could have another 30% of growth by the year 2013. South Korea outgrew its urbanization rates in a 40-year time span. And, if China continues to urbanize, there will be about 200 million new urban households in China, which creates enormous demand for consumer staples, durable goods and housing.
China’s government policies signal the trend will continue. China raised reserve requirement ratios 12 times since January 2010. We view that as an early signal for the next easing cycle. The last time China eased reserve ratios in October 2008, that triggered a big market rally in Chinese stocks. This should bode well for stocks. We don’t think the Chinese auto boom is over. Actually, in the last couple of days, officials in China hinted that new measures may be introduced to support auto and home appliance sales.
Outside of China, we see government policies remaining very positive in southeast Asia, especially in Indonesia and Thailand. The money supply in the past two years has not deteriorated in these two countries, in fact, it is growing at a healthy 16% year over year. This is part of the reason why we remain positive on southeast Asia. Indonesia is rich in natural resources, but it doesn’t depend as much on exports. In fact two-thirds of its GDP is driven by domestic consumption, which is how it managed to escape a recession in 2008 and 2009. Favorable demographics is a factor. It is a very young country. More than 45% of the population is under 24 years old and 2 million people a year are joining the work force. Second, urbanization is creating new consumer demand. Just like China, Indonesia’s household debt is low. Total mortgage loans outstanding account for only 3% of GDP. Consumer credit is still at a very early state. I see tremendous growth potential going forward.
FH: The money supply is growing very rapidly in the entire region. I think it’s not just a China story. It’s a whole emerging market. And, I like to characterize it as the American dream trade as all these countries want the American dream. They all want a house. They want a car. They want all the lifestyle that we have.
John Derrick joined U.S. Global Investors Inc. in January 1999 as an investment analyst for the U.S. Global Investors money market and tax free funds. In March 2004, he was promoted from portfolio manager to director of research and now manages the day-to-day operations of the investment team. Prior to joining U.S. Global Investors, Derrick worked at Fidelity Investments. He has appeared on CNBC and Bloomberg TV and has also been a guest on Marketwatch Radio and NPR. Derrick has been featured in stories for BusinessWeek, The New York Times, the Associated Press and USA Today. A graduate of The University of Texas at Arlington, Derrick earned a Bachelor of Arts in finance. He sits on the board of directors for the CFA Society of San Antonio.
Brian Hicks joined U.S. Global Investors Inc. in 2004 as a co-manager of the company’s Global Resources Fund (PSPFX). He is responsible for portfolio allocation, stock selection and research coverage for the energy and basic materials sectors. Prior to joining U.S. Global Investors, Hicks was an associate oil and gas analyst for A.G. Edwards Inc. He also worked previously as an institutional equity/options trader and liaison to the foreign equity desk at Charles Schwab & Co., and at Invesco Funds Group, Inc. as an industry research and product development analyst. Hicks holds a Master of Science degree in finance, and a bachelor’s in business administration from the University of Colorado.
Frank Holmes is CEO and chief investment officer at U.S. Global Investors Inc., which manages a diversified family of mutual funds and hedge funds specializing in natural resources, emerging markets and infrastructure. In 2006 Mining Journal, a leading publication for the global resources industry, chose him as mining fund manager of the year. Holmes coauthored The Goldwatcher: Demystifying Gold Investing (2008). A regular contributor to investor-education websites and speaker at investment conferences, he writes articles for investment-focused publications and appears on television as a business commentator.
Xian Liang is an Asia research analyst at U.S. Global Investors Inc. and a Shanghai native.
John Mauldin is the author of New York Times Best Sellers list four times. They include Bull’s Eye Investing: Targeting Real Returns in a Smoke and Mirrors Market, Just One Thing: Twelve of the World’s Best Investors Reveal the One Strategy You Can’t Overlook and Endgame: The End of the Debt Supercycle and How it Changes Everything. He also edits the free weekly e-letter Outside the Box. Mauldin also offers The Mauldin Circle, a free service that connects accredited investors to an exclusive network of money managers and alternative investment opportunities. He is a frequent contributor to publications including The Financial Times and The Daily Reckoning, as well as a regular guest on CNBC, Yahoo Tech Ticker and Bloomberg TV. Mauldin is the President of Millennium Wave Advisors, an investment advisory firm registered with multiple states. He is also a registered representative of Millennium Wave Securities, a FINRA-registered broker-dealer.
Evan Smith joined U.S. Global Investors Inc. in 2004 as co-portfolio manager of the Global Resources Fund (PSPFX). Previously, he was a trader with Koch Capital Markets in Houston where he executed quantitative long-short equities strategies. He was also an equities research analyst with Sanders Morris Harris in Houston where he followed energy companies in the oil and gas, coal mining and pipeline sectors. In addition, he was with the Valuation Services Group of Arthur Andersen LLP. Smith holds a Bachelor of Science degree in mechanical engineering from the University of Texas in Austin.
By Claus Vistesen, on November 28th, 2011
The rumour mill is grinding particularly fast at the moment. Germany and France seem to be working on the famous nuclear solution, Spain plays tough on outsiders, the IMF is rumoured to be preparing an aid package for Italy not to mention Hungary and Austria (just like Belgium) has entered the rating agencies’ cross hair.
So, what to believe?
I don’t know, but it is interesting that Reuters are now reporting France and Germany to be in an agreement on a fast track move towards fiscal union as well as allowing the ECB to aid sovereigns more forcefully (i.e. unsterilised intervention).
I want to see this before I believe it. Germany is certainly sending conflicting signals. Yet, this may be because they are truly unsure how long they can play this game of chicken with the rest of Europe. Clearly, Merkel has a point in refusing to issue euro bonds and/or letting the ECB step in since the periphery needs to put their house in order or at least show a credible plan to balance the budget. This is essentially quid pro quo as Merkel knows that Germany needs to pay in the end.
But there is a rub. One issue is surely the fact that public finances across the eurozone are unsustainable but another is how these economies are going to achieve anything near the growth needed not to collapse (default) anyway.
We keep on coming back to two main points.
1) It was clear for all that pain was coming in the periphery already in 07/08 and that this would be a substantial period of negative growth/deleveraging consolidation.
2) But the question was always whether such pain could be administered from within the euro zone. We are steadily coming to the conclusion that this is not possible and Germany knows this. But the solution is not clear since jettisoning the euro would have grave implications for the EU too and therefore there is a very strong lock-in mechanism here which it is difficult to get out of.
Finally, there is always the risk that one or many of the Southern European economies will simply “get” enough and make some quick and devastating decisions. It is important to understand my point on this.
I am sure it would be catastrophic for Greece or another country to leave by their own accord and do a messy default, but at some point the rest of Europe and the market will simply corner whatever government that might be in place and they will start taking their own independent decisions.
I note that there are calls for the new government in Spain to play “hardball” with Germany. In this situation, Germany has a distinct interest in just letting the market squeeze the periphery, but of course the rest of the “core” is getting dragged down too and the whole banking system is now at risk of a major liquidity/solvency crisis. In this sense, I only agree conditionally with Felix Salmon:
El-Erian is very good at explaining the problem which needs solving:
“Europe must still stabilize its sovereign debt situation. But this is now far from sufficient. Policymakers must also move quickly to contain banking sector frailties, and do so using a more coherent approach to the trio of capital, asset quality and liquidity.”
It seems to me, though, that sequencing matters here. Liquidity is — always — more important than capital/solvency. Give an insolvent bank enough liquidity, and it can live indefinitely. Remove liquidity from a bank, and it dies immediately, no matter how solvent it might be or how high its capital ratios are. And as for asset quality, we’re pretty much talking a zero-sum game here: when the banks’ dubious assets are the sovereign’s liabilities, the real solution is inflation, not nationalization.
I agree that liquidity is a key issue at the moment in the euro zone banking system, but let us not kid ourselves. Europe has not had a functioning interbank market since 2008 and we are just now seeing the accumulated effect of this.
I just read a big and very detailed BC report on deleveraging among EZ banks and I am extremely concerned. It is clear to me that not only sovereigns are battling with solvency issues but so are many banks and the extent to which they are fighting it means that they will have to cut lending and asset growth substantially. As such, I am afraid that the problems in the euro zone are beginning to resemble a widespread solvency problem both amongst banks and sovereigns, a combination which, to boot, will feed off each other. Especially Eastern Europe are going to have big problems in 2012. They are going to see an almost complete stop of credit flows through the banking system due to parents cutting cross border lending.
I think that we will see a wholesale and government driven process of bank nationalisations and restructuring in the next 6 months in the euro zone. I also think that most southern european economies are ultimately facing both public and private insolvency issues which will need balance sheet write-offs to get solved. It seems to me that, as so many times before, euro zone politicians are once again getting caught out by reality.
By Ajay Shah, on November 18th, 2011
How did it happen?
The worst financial crisis in the western world for nearly 80 years broke in September 2008.
It required banking/financial systems to be supported and recapitalised by governments across the EU and in the US.
In June 2009 it became apparent that the peripheral countries of the Eurozone (Greece, Portugal, Spain and Ireland) were grossly over-indebted.
Yet in some instances (Spain) their public debt to GDP ratios happened to be lower than those of the US, France, the UK and Germany.
The continued viability of their public finances depended entirely on markets being willing to refinance them with cheap money.
But, when markets scrutinised the sustainability of their fiscal positions, they baulked from refinancing except at punitive rates.
CDS spreads (against Germany as a benchmark) of peripheral Eurozone countries (PIGS or Club Med) debt began widening relentlessly.
Global financial markets began to price in an escalating risk of partial/full voluntary/involuntary default on PIGS bonds since December 2009.
Contrary to first impressions, except for Ireland, that was a result not just of the financial crisis and bank recapitalisation demands on the fiscus.
It became apparent instead that bank recapitalisation demands on public finance were only the last straws that broke the camel’s back.
Greece, Portugal, Spain and Italy, as a direct consequence of joining the Eurozone, had been running up unsustainable fiscal deficits since 2000.
Ireland had not. It suffered because the bailout of its disproportionately large banking system caused its public debt to rise astronomically.
PIGS became over-indebted despite the supposed self-imposed discipline adopted by the Eurozone of prohibiting fiscal deficits >3% of GDP.
That discipline was violated by almost all Eurozone members, beginning with France and Germany, but more egregiously by the PIGS.
To make matters worse, however, the PIGS were also running increasingly large current account deficits (with Germany, France, China).
Though countries like France (and to a lesser extent) Germany were fiscal sinners, they were at least running current account surpluses.
PIGS had access to excessively cheap public and private money available on terms totally inappropriate to their economic circumstances.
Given their inherent risks, which markets mispriced completely, their borrowing costs should have been 300-500 bp higher than Germany’s.
Instead, they were virtually the same for nearly a decade. That relieved market-induced pressure on PIGS’ governments to behave responsibly.
Consequently, their public expenditures after 2000 ballooned out of all proportion to their intrinsic capacity to fund them from tax revenues.
Such expenditures became almost wholly dependent on access to increasing amounts of cheap public borrowing from capital markets.
In response to access to excessively cheap money, wages in the PIGS rose across the board as did growth in public sector employment.
With the financial crisis triggering bank recapitalisation needs, on top of this unsustainable structure, the edifice began to crumble.
The first early warning signals became apparent in December 2009 but the dam broke in mid-2010 with the first Greek bailout.
How has the Eurozone crisis been handled?
Extremely ineptly; indeed very foolishly, by sophisticated Eurozone authorities (political, fiscal and monetary) that should have known better.
Eurozone leaders learned nothing from the preceding debt crises in Latin America (1982-87, 1994-95) and Asia (1997-2000).
They went through avoidable phases of serial denial that there was a structural debt (solvency) crisis that could spread via contagion.
They treated it as a liquidity crisis that could be dealt with by temporary patch-ups of additional money combined with fiscal restraint.
They reiterated their commitment to ensuring there would be no default – partial or full, voluntary or involuntary – by any Eurozone member.
They believed that their remedial measures would stop the crisis from ballooning beyond the first bailout package for Greece.
They were totally wrong. That package did nothing to convince markets that Eurozone leaders understood the nature/severity of the problem.
In fact, the inadequacy of that first bailout package — which did not provide enough money for sufficiently long – became quickly apparent.
Eurozone leaders were fixated on debt-affected PIGS being forced to live within their means through indefinite austerity without end.
Debt recovery/sustainability models did not provide sufficient new money, or permit debt restructuring, in ways that would restore stability.
Least of all were bailout packages designed to restore growth in a conscionable period of time that would be socially/politically acceptable.
Without financial system (and borrowing cost) stability, and absent growth, debt problems can never become better. They can only worsen.
Instead, as a result of poor design, all the bailouts did (except for Ireland) was to add new debt to bad debt and reduce growth prospects.
To exemplify: In mid-2009 the debt/GDP ratio for Greece was 115% of GDP and the debt service ratio about 11% of GDP.
But, by October 2011 the debt/GDP ratio for Greece was 161% of GDP and the debt service ratio nearly 20% of GDP.
It is projected with the third bailout to rise to 185% of GDP (although debt service will be lowered to 16%) before it comes down again.
In the meantime, over the last 32 months, the Greek economy has shrunk in size by almost 17% in nominal terms. It will be 1/5 th less in 2012.
Such inane ‘remedies’ do not solve debt problems. They only aggravate and exacerbate them.
While behaving in this absurd fashion Eurozone leaders repeatedly asserted for two years that they would do everything in their power to:
- Maintain the credibility of the Euro while ensuring that every member stayed in the Eurozone
- Not allow any default of publicly issued bonds to occur; and
- Do everything possible to avoid contagion spreading beyond PIGS (even as it became clear that markets were worried about Italy.
Instead they achieved the exact opposite of all three objectives through their inability to understand the implications of what they were doing.
Though now contrite and claiming to have learnt a few lessons from their serial bungling over 30 months Eurozone leaders have no solution.
The EFSF facility they created is woefully underfunded. It can barely deal with financing the third Greek bailout.
The idea of leveraging it or using it as a partial guarantee facility is absurd since it would add to risk and uncertainty not resolve them.
Yet over-indebted governments (including France and Germany) would have to issue more public debt in order to fund the EFSF properly.
That would simply mean requiring their fragile, near-bankrupt, banking systems (or the ECB) or global markets to buy more Eurozone debt.
Except for Germany (and even that will be in doubt soon) the market has no appetite for taking on more Eurozone debt given its risks.
Contagion has spread from the periphery and now lodges at the core of the Eurozone economy in which Italy is the third largest member.
What could have been resolved with about 300 billion euro in additional financing in mid-2010 is now a problem that may require 2 trillion euro.
Where are we now?
Over 35 EU/Eurozone summits in 30 months have resolved nothing. They have made matters worse; despite Herculean exertions!
Right now Greece is in ‘effective’ default; though markets are overlooking that because of the implications of CDS contracts being triggered.
Its borrowing costs for refinancing its debt would exceed 30% if it had any access to private markets; which it does not.
Any refinancing of, or addition to, Greek debt can now only be financed by the ECB; which the Germans will not permit the ECB to do.
Meanwhile the Greek banking system is bankrupt. Indeed the entire Eurozone banking system’s credibility/stability/solvency is in doubt.
Today an outstanding portfolio of about 11-12 trillion euro in Eurozone debt – of which about 80% is held by EU firms – is souring relentlessly.
About 7 trillion euro of that portfolio is sufficiently affected by contagion to require provisioning (France and Belgium may soon be added).
About 5 trillion euro of Eurozone high-risk-debt is currently held by EU banks, insurance companies, pension funds and individuals.
That sovereign debt, which is supposed to constitute the ’safest’ component of any asset portfolio, now constitutes perhaps the riskiest element.
That reality inverts the whole basis of banking/financial system soundness and stability across Europe (including the UK).
It compounds the problem of calculating capital adequacy requirements for these banking systems and puts regulators in a quandary.
Ireland’s bailout programme is working but could be derailed by what is happening in the rest of Europe.
Portugal’s programme is not working as intended. But nobody is talking about it because it pales in comparison with Italy and Greece.
Italy’s outstanding public debt will soon cross 2 trillion euro (120% of GDP) and its debt service payments amount to around 300 billion euro per year.
That is made up of about 120 billion euro in interest payments and 180 billion euro in principal repayments. Average duration is 5 years.
Public debt service in Italy now amounts to around 17% of GDP and will rise to 20% unless Italy’s debt is dramatically restructured.
Italy now needs to borrow about 40 billion a month euro (gross) and about 28 billion euro a month net in private markets to refinance its debt.
The world is holding its breath with every auction of Italian public debt (3-8 billion euro per week) any of which could trigger accidental default.
The cost of refinancing Italy’s public debt has risen from around 4% a year ago to around 7% now. That adds 20 billion euro a year to
its debt.
Meantime the Italian economy is flat-lining and its capacity to service additional debt is diminishing despite its running a primary balance.
Banks around the world are dumping their holdings of Italian public debt but there is no buyer other than the ECB because of the risk.
The ECB’s capacity to refinance Greek, Italian and Portuguese debt is limited and constrained by Germany’s unwillingness to consider
that.
Contagion from Italy is now beginning to affect Spain and France which is supposed to be a bulwark for the EFSF’s borrowing capacity.
The resulting gridlock is pushing the entire Eurozone system toward a catastrophic denouement with a binary outcome. Either:
- Crisis-induced progress toward fiscal union with national sovereign bonds being replaced by a single Eurozone bond with a joint/several guarantee, or
- Sudden disorderly collapse of the Eurozone with unimaginable fallout and consequences that would trigger a global double-dip
recession.
Such a recession would last for a minimum of 2-3 years and would probably be quickly followed by a similar debt crisis in the US.
The resulting fallout of disorderly Eurozone break-up could trigger a break-up or restructuring of the larger EU as well.
So where do we go from here?
With the foregoing in mind it seems absurd that the world is waiting with bated breath to see what the new technocratic governments
in Greece (Papademos) and Italy (Monti) will actually achieve by way of structural reform and increased debt servicing capability in coming months.
These technocratic governments inject new credibility but lack political and social legitimacy. They have been appointed not elected.
It remains to be seen how long their technocratic legitimacy holds out without the backing of gradually earned political/social legitimacy.
The risk is that if the ministrations of these technocratic governments (which their societies believe have been imposed on them
from the EU above) do not work and bear fruit relatively soon (the probability is that they won’t), public patience with them will melt.
Will they be able to convince electorates to accept the inevitability of austerity without growth for the indefinite future?
The next Greek crisis is perhaps 10-12 weeks away.
The next Italian crisis could be triggered by any one of the upcoming weekly auctions of Italian government debt.
Despite these rather obvious realities, global markets deem to be reacting in dream-like hope and optimism that all will be well.
There is of course a solution at hand; and the only one that will work because all the other options seem to have been exhausted.
That option requires Germany to reconsider its refusal to bear its large share of the fiscal burden that will come with Eurozone fiscal
union.
It requires political/social willingness on the part of rich northern Eurozone members to finance fiscal transfers to poorer
southern members through an exponential expansion of structural funds, currently applied to help develop more rapidly the poorer regions of the EU.
Reciprocally, it requires other Eurozone countries to relinquish fiscal, and a great deal of political, sovereignty immediately; in
order to assure global markets of their commitment to structural reform, restoration of competitiveness, and relentless pursuit of fiscal/monetary discipline.
It requires all unwanted national sovereign bonds of Eurozone members to be replaced by a single Eurobond that is jointly and
severally guaranteed and underpinned by the weight and ability of the ECB behind it to print money if necessary to ensure that such bonds are honoured.
This solution would resolve both the over-indebtness problem of the Eurozone and the problem of banking system collapse at a single stroke.
If it were adopted the need to provide for risky Eurozone debt and recapitalise (yet again) the EU banking system would disappear.
Yet, this is the one solution that keeps being discarded because of legitimate German constitutional, judicial and political constraints.
They inhibit movement in such a direction regardless of the consequences for the Eurozone, the EU, and mostly Germany itself.
It is like witnessing a repeat of 1939; not of conquest but of mindless destruction. But, this time with money rather than tanks being involved.
If that only workable solution continues to be discarded, the other possibility that will manifest itself is the disorderly break-up of
the Eurozone; simply because its orderly break-up defies contemplation and imagination.
Talk of Greece being ejected from the Eurozone, or of Germany departing from it voluntarily, is fanciful simply because neither can
afford to bear the costs of the consequences that will follow, regardless of what their populations and political leaders may believe
or think (though ‘thought’ seems to be conspicuously absent from the process just now). Neither can their neighbours, regardless of what they may think.
Yet it is not unimaginable that a break-up will be forced on Eurozone members by global markets if the only workable solution
continues to be ruled out as it seems to be repeatedly by the German Chancellor. But she has changed her mind so often the hope is she will yet again.
A disorderly break-up may result in a reversion to national currencies; which would be better than members trying to retain some
semblance of the Euro through separate residual monetary unions of more compatible economies.
That would probably require four different Euros (for the super-efficient Northern economies a Baltic Euro, for the relatively efficient middling economies a Franco-Euro; for the newly acceding countries an Eastern-Euro and for the inefficient, uncompetitive Club-Med economies, a PIGS-Euro). Other than the first, none of the others would be credible for holding as reserves, or for trading significantly in global currency markets.
Finally, bear in mind that we have spoken of only the public debt problem in the Eurozone.
Should the unthinkable (but increasingly likely) disorderly break-up happen, the public debt problem will be accompanied by an unresolved private debt problem throughout the Eurozone of equally monumental proportions! That really will break the system and the banks!
By Doug Gentry, on October 12th, 2011
So, who cares about the Greek debt crisis? It’s a small country, a long ways away.
Answers:
Greece as a Country: “We care!”
The Euro currency countries: “We care!”
Europe Generally: “We care!”
U.S. and International Financial Community: “We care!”
Stock Investors: “We care!”
All right, already. Here’s why they care.
The background
Through a series of missteps over the last 10 years the Greece government amassed a large government (or sovereign) debt, and then disguised it from its citizens, lending institutions, its Euro partners, and international financial organizations. The recession exacerbated the problem, threatening to push the Greece government into bankruptcy. Annual deficits as a percent of GDP or total national debt as a percent of GDP are higher but not that different from the United States, but in contrast to the U.S. the global investment community has very little confidence in Greek bonds and the ability of the government to repay them. That means Greece has to pay much higher interest rates on its debt, if it can borrow money at all.
What Can Greece Do?
When faced with larger government deficits, policy makers typically turn to two economic “levers” – fiscal policy and monetary policy. On the fiscal side the government can cut spending and/or raise taxes. Both of these actions have met strong resistance in a country used to heavy subsidies of middle class citizens and notoriously poor tax collection records.
Monetary policy can be an effective tool – often because it does not require the approval of the legislature or the voters. Normally a central bank can inject funds into the economy (electronically “printing” money) and use that to pay debts. This injection of money can also lead to the devaluation of the local currency. While devaluing doesn’t sound appetizing it can be very effective, since it encourages more exports and more tax revenues, and because it makes it easier to pay off debts denominated in the local currency.
BUT, Greece can’t execute its own monetary policy. It is a member of the Eurozone – using the Euro as its currency rather than the drachma. As a result Greece cannot unilaterally change the supply of its currency. It does not have control over monetary policy. To make matters worse for Greece, the Euro has held a fairly high value against other world currencies – just opposite of the direction Greece needs to help with its problems.
 Euro
How Does the Crisis Affect the Euro?
The Euro is a common currency, currently used by 22 European countries. Decisions on the supply of the Euro are made by a representative body at the European Central Bank.
When a member country, like Greece, threatens to default on its loans, global investors pull funds out of Greece and the Eurozone. This reduces the demand for euros, and causes the value of the euro to fall. This is a mixed blessing. Countries often prefer a strong currency, but a weaker one can encourage exports. Europe is an export driven continent.
Joining the Eurozone initially, countries have to prove that their economies and government budgets are healthy. It is like welcoming someone new onto a lifeboat. You prefer the new person to be healthy. It appears that Greece hid or obscured its economic reports when applying for membership and now its fellow lifeboat members are not happy.
Commentators, such as Paul Krugman, have argued that Greece should never have been allowed in the Eurozone. They also argue that the Euro common currency is flawed if monetary policy is directed centrally, but fiscal policy remains with individual countries. Macroeconomic theory suggests that both need to work in concert, and the slow, deliberative and political style of the European Central Bank is not well suited to crisis management. Here’s one of many Krugman posts on the crisis.
Why the Large Bailouts by European Governments?
Other European countries, particularly those who share the use of the euro currency, want to stabilize the currency in their own self-interest. In additional many of the large banks and financial institutions in Europe hold Greek debt. If Greece defaults on that debt, those institutions are in trouble. France and Germany have been two of the largest contributors. French voters have been relatively quiet about the bailout, but German politics are much more sensitive to the issue. Chancellor Merkel of Germany has to balance the need to preserve the Eurozone economy against the indignation of German taxpayers who feel little affection for Greece.
European policymakers also worry about other members of the Eurozone – including Spain and Ireland. These two countries have stressed economies for reasons different than Greece. Neither of them had profligate government spending, but both have been hit particularly hard by the recession. Additional stresses on Europe could tip these countries further into trouble.
Why the International Community and Stock Investors Worry
The source of concern in the stock markets and among international investors is mostly fear of default. Large financial institutions and other holders of Greek debt would be seriously hurt. If a Greek default pushed other European countries like Spain and Ireland over, the impact grows significantly.
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By The Gold Report, on October 3rd, 2011
 If you want to know the future, pay attention to the decisions European policymakers will have to make regarding debt, says Scott Gardner, chief investment officer at Verdmont Capital. In an exclusive interview with The Gold Report, he shares his analysis of debt policy investment implications, plus which gold mines Verdmont likes in Latin America and beyond.
The Gold Report: In one of your June research reports you wrote, “In the Eurozone, there has been limited political will to really make an impact on the debt side of the equation. With gross domestic product (GDP) growth set to slow, things should really get interesting for euro policymakers as they attempt to make their shaky union work.” In the Eurozone, there is more than adequate money to take care of the debt situation, but the question remains, is there enough political will to keep all the member countries inside the Eurozone? What sort of impact will pending Eurozone issues have on the gold price?
Scott Gardner: First off, you say that there’s enough money, but I think that a lack of money is the primary concern. The European Financial Stability Fund has something like €440B in committed capital and the members haven’t agreed upon future funding requirements. Also, the European Central Bank (ECB) itself only has €10B. If you compare that to the three largest banks in France, for example, they own roughly $600B in PIGS (Portugal, Ireland, Greece, and Spain)-related debt. You can see how imbalanced the system is and how undercapitalized some of these organizations are that are meant to be the solution.
TGR: In terms of a percentage of euro GDP, it’s a relatively small amount.
SG: I think the overall liability in the banking system has been estimated at about €2.5 trillion, in terms of PIGS-related financing needs over the next few years. This is significant. People talk a lot about the economics behind the crisis, but the issue in the Eurozone is just as much a social one. It’s questionable whether or not, for example, the German populace will remain in favor of bailing out some of the peripheral regions’ largess. This is where we get into the will of keeping the Eurozone together, and Europe is going to see ongoing pressure there.
TGR: George Soros said we are in a double-dip recession, and he believes that the euro will come apart. Is that your view on both accounts?
SG: People have been focusing largely on the numerator in the debt:GDP ratio and the market has become used to the pressures as they stand now. However, austerity measures and other proposed solutions will put a tremendous amount of pressure on GDP. A double-dip recession cannot be ruled out. Clearly, this will only exacerbate the debt:GDP ratio and further handcuff policymakers in terms of the policy response.
TGR: How will these issues impact gold and silver prices?
SG: During the acute stages of a systemic selloff, all investments typically get punished. We saw that during the correction at the height of the credit crisis in 2008. We’re also seeing that today in the current selloff, with gold and silver both down substantially. Over the long run, the crisis in Europe is clearly very bullish for gold and silver because the only way out of the current situation is additional stimulus from central banks. Additional stimulus will put further downward pressure on all the major currencies.
TGR: In one of your June research reports you wrote, “Gold continues to break out in all major currencies despite prevailing concerns in the market that gold is due for a major pullback. Of course, since then, gold has had a dramatic rise, but more recently, it’s beginning to look like there is a major correction under way in the gold price.” Is the correction for real? If so, what range do you believe it will bottom in?
SG: Nothing goes up in a straight line, and a gold correction from current levels is actually quite healthy as the short-term rise was technically overextended. We remain in a gold bull market and the market usually uses the 200-day moving average as a floor within a long-term uptrend. Therefore, we would be aggressive buyers in and around the $1,600 range, which would bring gold close to its 200-day moving average.
TGR: Do you believe that pullback will inhibit the performance of junior precious metals plays, given that the dramatic uptick in the gold price in August didn’t seem to carry many precious metals juniors much higher?
SG: We learned during the selloff in 2008 that junior gold stocks behave like stocks first and gold investments second. If there is substantial risk in traditional investments, gold stocks selloff in sympathy. This time around, we believe investors will look through short-term weakness and see the inherent profitability that gold stocks offer. Arguably, in the current environment, gold stocks are the only game in town, given that they’re the only sector that is growing earnings and profitability to the extent that it is.
TGR: In a May research report you wrote, “Despite the recent correction in the base metals complex, it is too early to initiate positions or increase underweight allocations within resource-focused portfolios. Our preferred segments of the commodity market remain energy and precious metals at the expense of agriculture and base metals.” Has your position changed?
SG: No. We were lucky enough to advise clients to short copper a few months ago, and we still see continued pressure in base metals–related equities. Many argue that current base-metal stock valuations are reasonable, but we believe overly optimistic commodity forecasts are baked into earnings estimates. Analysts are still forecasting 2012 copper at around $4.30/lb. We’d like to see more conservative copper estimates before we get more enthusiastic on the base metals complex. Meanwhile, gold analysts are forecasting, on average, something like $1,600/oz., which may prove overly cautious.
TGR: You’re based in Panama, and you get to regularly visit gold projects in Latin America. What are some projects you visited recently?
SG: We recently visited Sunward Resources Ltd. (SWD:TSX.V) property, which was very exciting. We advised clients to buy Sunward in May of this year, and we’ve done quite well. We were impressed with how advanced the project was and how quickly management was moving along. The company just came out with an updated resource of 8.2 Moz. of gold, which more than doubled the existing resource of 3.7 Moz. That is very encouraging.
TGR: That’s a gold-copper porphyry project in Colombia. Five rigs continue to drill the property; is that right?
SG: It has seven drills currently turning, and it’s moving toward nine at the end of the month. There is still tremendous exploration upside at the property, given that the current resource estimate only incorporated two of seven identified anomalies.
TGR: Is the project’s metallurgy relatively simple? Is there potential for a bulk-tonnage target?
SG: Given that Titiribi is a low-grade project, it’s key for Sunward to really get the tonnage up and it has proven the ability to do that with the recent resource update. One of the main concerns with the project is metallurgy. The company is coming out with some metallurgical testing in October, which we believe is a key catalyst for the stock and will answer a lot of questions concerning profitability.
TGR: Colombia is certainly seeing all kinds of exploration since the government has become more mining-friendly. What other projects in Colombia are you following?
SG: We’ve been supporting a company by the name of Red Eagle Mining Corp. (RD:TSX.V) for over a year. We were involved in the pre-initial public offering (pre-IPO) financing. The company IPO’d in June of this year. Generally, we’re guiding our clients toward developed projects with recognizable assets and advanced-stage projects, but Red Eagle Mining is an example of an early-stage exploration company that people should look to take a small position in. It has two highly prospective projects in Colombia and they have a great management team. Even though the company only recently IPO’d, it already has a team of 15 geologists in place and a 25,000-meter (m) drill program under contract. In this market, we want to focus on companies that have near-term news flow and REM will be coming out with results in mid-October.
TGR: Red Eagle is trading at about $1.05. Is that a good entry point?
SG: Yes. Whenever there’s heightened systemic risk in the system, these early-stage plays get hurt. Moving forward, due to the fact that Red Eagle has a sizeable and prospective land package, is drilling and is well capitalized, we think the market will start looking beyond current weakness.
TGR: What other projects in Latin America are you hot on?
SG: We’ve recently bought Belo Sun Mining Corp. (BSX:TSX.V). It is an interesting story in the Pará state of Brazil. The company has a 3.4 Moz. resource at its Volta Grande project. It has 11 rigs on site, and the main resource envelope remains open in many directions. The company is due to have an updated resource estimate at the end of October. Analysts are expecting it to boost ounces into the 4 Moz range.
TGR: Peter Tagliamonte is on Belo Sun’s board. He was also part of Desert Sun Mining & Gems, which got the Jacobina gold mine up and running, and that spurred a takeover bid from Yamana Gold Inc. (YRI:TSX; AUY:NYSE; YAU:LSE). Does the presence of someone like that, who’s been involved with takeovers and successes in the past, hearten your investment choice?
SG: Without question, Belo Sun is a company that a larger-size company would find attractive given the known resource, the exploration upside and its location in a mining-friendly region. The recent takeover of Grayd Resource Corp. (GYD:TSX.V) is a perfect example of what the larger-size companies are looking for. They’re looking for an existing resource with decent exploration upside in a mining-friendly region, and Belo Sun fits that bill rather nicely.
TGR: How about one more in Latin America?
SG: We’ve been actively supporting Pershimco Resources Inc. (PRO:TSX.V), which is advancing its Cerro Quema project right in our backyard here in Panama. Pershimco has a 500 Koz. deposit, and we see the potential for this to grow considerably. It has two drills on site, and recent results in the easternmost segment of the property expanded the footprint of the mineralization to more than 4 km.
TGR: Pershimco also has a couple of projects in Mexico and one in Canada. Do you like that diversification, or is it spreading resources too thin?
SG: PRO has assembled quite a team, and the focus has been primarily on Panama. I think it’s done a tremendous amount with the property here, and we’ve been very pleased. Things might begin to look up at the Quebec property. The market has been assigning little value to the project, but management has been slowly building up a sizeable land package in the area. As seasonal factors make drilling possible, that might wake people up to the property’s merits. Management could always do a joint venture on their other assets if they were concerned about being spread too thin due to their focus on Panama.
TGR: Verdmont invests all over the world. What are some other juniors Verdmont has taken an interest in?
SG: We tend to favor advanced-stage exploration plays in the current market. Lydian International (LYD:TSX) is an attractive prefeasibility, heap-leach gold development story in Armenia. The project has great infrastructure and a strong management team that’s led by Timothy Coughlin. He’s the former chief geologist with AngloGold Ashanti Ltd. (AU:NYSE; ANG:JSE; AGG:ASX; AGD:LSE).
TGR: That’s the Amulsar gold project. It has outlined about 2.5 Moz. and is working toward a feasibility study and production in 2014. Is that realistic?
SG: We don’t have any issues with that. The company has been focused on expanding the known resource. It’s currently due to finish 40,000m of drilling over the course of 2011. Even though it’s a little bit off the beaten path, Armenia has favorable, Western-style mining policies in place. We don’t see anything that makes the project’s timeline unrealistic, and we don’t see any real permitting issues.
TGR: Name one more strong junior.
SG: With the majors and the advanced-stage gold stories being so cheap, we’re focusing a lot of our efforts and investors’ capital in those areas. But one pure exploration name that shows up on our radar screen is Smash Minerals Corp. (SSH:TSX.V). Smash is a relatively advanced exploration company with a sizeable land package in the white-gold district of the Yukon. Smash was put together by Adrian Fleming, the founder of Underworld Resources (UW:TSX), which was sold to Kinross Gold Corp. (K:TSX; KGC:NYSE) in early 2010.
Smash is interesting due to its very prospective and sizeable land package. It has more than 4,000 claims representing something like 800 sq. km. One thing that concerned us before we started investing was that the white-gold district was quite hot, as well as the Yukon in general. We were concerned that with Adrian Fleming and Shawn Ryan (owner of Ryanwood Exploration Inc.) involved, the story might be overly promoted, but in the current selloff, the stock is trading at an enterprise value in the single millions. For a highly prospective exploration company like Smash Minerals, it’s a no-brainer at current levels.
TGR: One issue with a number of the Yukon plays right now is that assay labs are backed up at an unprecedented level. These companies can’t get the news flow out as quickly as they would like, and that’s hurting share prices in some instances. What would you tell investors about that phenomenon?
SG: I think the weakness in Yukon plays is largely due to the fact that they ran so far so quickly, and a lot of them have outstanding paper. The assay lab issue is not a primary concern. That simply creates an opportunity to invest in Smash Minerals, which has been dragged down with the group. It’s one of the few early-stage companies that are drilling this summer. Results are due out in October, so there is lots of news in the pipeline.
TGR: Tell us one economic situation that you’re going to watch the most closely as Q311 comes to an end and Q411 begins.
SG: All eyes will be on Europe and the pressures there. Generally, the market is trading in sympathy with both European financial stocks and, to a lesser extent, American financial stocks. Policymakers need to find a solution before we get a base and see strength in a lot of these junior mining stocks.
TGR: Thanks, Scott; it’s been a pleasure.
Scott Gardner, CFA is the Chief Investment Officer at Verdmont Capital S.A. based in Panama. He is responsible for guiding firm investment strategy and is the head of the company’s discretionary investment management program, research and corporate finance operations. Prior to joining Verdmont, Scott was a portfolio manager with an offshore bank in Bermuda, where he managed discretionary investment portfolios, mutual funds and was the bank’s lead strategist for commodity-related investment programs. Scott is a CFA charter holder and a member of the CFA Institute.
By Claus Vistesen, on August 5th, 2011
In case you did not notice it, the much discussed “range” on the SP500 broke in spectacular fashion yesterday as the short rollers bypassed the 1250 mark in the same style as the Germany pantzer passed the Maginot line back in the early stages of WWII.
Basically, two many people tried to catch the knife of the falling market (everywhere) in anticipation of just one good data point or perhaps CB intervention but nothing came. As such the pain trade is still down I think. Of course, we DID walk into the office to some JPY selling by the BOJ and the ECB finally looked outside the ivory tower to see the badlands that its stfu policy has so far engineered even if the continuing mention of inflation risks somehow strikes me as beyond crazy.
With most market participants probably now sitting shivering in a corner wishing that yesterday was Friday, there is indeed a day today and one has to assume that a bad jobs report will bring the whole world down on the back of stock investors. Blood is currently flowing but it can get worse, much worse than this.
Given the feedback loop between our recession indicators and the SP500 with the former taking the latter as an input there is clearly now a real risk of a recession in the US and on my casual calculation it is well above 50%.
Now, if the pain trade is still down the decision by BNY Mellon today to charge customers for holding large piles of cash indicates to me that the pendulum has swung extremely fast into uber fear mode. My feeling is that the market has much further downside from here in the short term, but nothing goes down in a straight line forever. In this sense a US recession market level is likely to be very close to this level, it may still squeeze the longs yet awhile.
More generally, I am constructive on how this might impact emerging markets in the sense that inflation is now likely to be even more a non issue. This is especially the case in economies who have mainly been combatting headline inflation (e.g. Chile with India as a rather more sinister case of demand pull inflation too). There will be no recession in EM and therfore a re-rotation into EM from here on as DM slumps into a recession is one way to stay constructive even in the midst of the bloodbath taking place.
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