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At 8:30 AM Eastern time, the advance GDP report for the fourth quarter of 2011 will be announced. The consensus is an increase of 3.1% in real GDP and an increase of 1.5% in the GDP price index. At 9:55 AM Eastern time, Consumer Sentiment for the second half of January will be announced. The consensus is that the index will be at 74.0, which is the same as the value reported in the first half of the month.  Join the forum discussion on this post - (1) PostsRecent 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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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.
Frank Holmes, chief executive and chief investment officer at U.S. Global Investors, will focus on the upside of massive Chinese modernization and growth. He is the recipient of both Mining Fund Manager of the Year Award from Mining Journal and International Citizen of the Year Award from the World Affairs Council of America and has a long-term investor’s view of international geopolitics. Author and Commentator Gordon Chang literally wrote the book on why investors should be wary of China’s growth. His book The Coming Collapse of China has attracted attention from the likes of the LA Times and Asia Times and many other publications in between. He has made appearances on Fox News and regularly contributes to Business Insider, Barron’s, National Review and Forbes magazines. When he lived and worked in China and Hong Kong for almost two decades, most recently in Shanghai as counsel to the American law firm Paul Weiss, he saw the ghost cities and environmental challenges up close. “The debate is a direct response to attendees who need to know if China is on a course to grow, slow or blow,” said Nicole Evans, president of the Cambridge House International Conference Division. The Gold Report called these two experts to find out the numbers behind why they have such different predictions about how this enigmatic country will fare in the coming years. Frank Holmes: This veteran investment advisor based his positive prognosis for China and its Eastern neighbors on a combination of tacit knowledge learned firsthand through travel and observation of geopolitical conditions along with explicit knowledge of history and the markets. He studies S-curve patterns, modeled on economist Simon Kuznets’ 20-year long cycles. For example, the world’s population has grown from 1 billion in the 1800s to 7 billion today, which has drastically affected commodity consumption and infrastructure buildout. “Nowhere is this more evident than in the emerging markets, such as China,” Holmes said. “When governments have invested in infrastructure, there has been a powerful impact on gross domestic product (GDP) numbers.” For example, he pointed to the 1950s, when Eisenhower signed the Federal Aid Highway Act, allowing commerce to expand across the nation, with restaurants including Dairy Queen and McDonald’s experiencing tremendous growth over the next several decades. “Paved roads from coast to coast helped sustain a more than tenfold increase in U.S. GDP,” Holmes said. “Whereas the U.S. connected 160 million people with nearly 47,000 miles of freeways, by 2020 China will connect 700 million people across 250 cities, spanning more than 47,000 miles of interstate and 18,000 miles of rail,” Holmes explained. Holmes estimated that over the next 25 years, about $41 trillion will be spent on global infrastructure—$6 trillion has been approved for the 2011 through 2013 timeframe with China projected to spend half of that $6 trillion. He believes these investments will result in rising GDP per capita and trigger a consumption economy. “Once China connects its super cities, it will enable more Chinese to travel around the country, resulting in a completely different consumption pattern. You will see train stations with 50-story condominiums along with U.S. restaurants that have already been expanding in China, including McDonald’s, Dairy Queen and Starbucks. Major hotel chains, such as Wyndham, Starwood and Hilton, along with luxury goods businesses including Cartier, Hermes and Gucci will compete for market share. Infrastructure will change the face of the economy in China just the way it did in the U.S.,” said Holmes. “We are big believers that government policies are precursors to change, so our investment team continuously tracks the fiscal and monetary policies of the world’s largest countries in terms of economic stature and population. The G-7 (industrialized) countries are 15% of the world’s population but 50% of the world’s GDP and growing only about 1%. Western countries seem to be focused on cutting back infrastructure spending and raising taxes to pay for entitlements. At the same time, E-7 (emerging) countries comprise 50% of the world’s population with 20% of the world’s GDP. However, these countries are growing at 7% to 8% and include a rising middle class of some 60 million people out of a total 2.2 billion people. But, 60 million people making $30,000 a year is very significant. Think about the movie “Slumdog Millionaire”—this is what is happening throughout Asia. That is why companies such as Gap and GM and KFC are focusing on expanding in China where its residents love American products and pack the stores in Beijing.” Holmes also saw important policy changes in the works that could improve China’s economic outlook. “Over the past 10 years, we have seen a slow migration of more property rights being given to people in China. The largest transfer of real estate in the history of mankind took place in China seven years ago when more than $500 billion of real estate value was basically transferred to farmers. That was followed by condo building. Additionally, to attract public companies, Shanghai adopted the Hong Kong Stock Exchange listing and bankruptcy systems, which are based on common law. This is significant because if you look at all the countries that have had financial problems over time, no common law system has ever gone bankrupt. Civil law has. China is slowly adopting a rule of law system.” Not all of the changes have been smooth. “One of the biggest things that China has been wrestling with is the fear of inflation,” Holmes said. “The government raised the minimum wage and that resulted in a big spike in food inflation. Then it had to deal with real estate inflation in Shanghai and the cities along the ocean. It required banks to keep more reserves, up to 20% in some cases, to avoid the problems now occurring in European banks. A tax on speculative real estate slowed the economy and it showed up in the psychology of the stock market. “The spike is slowly reversing and rates are falling. Because there is so much less borrowing generally in China than in the rest of the world, prices rebound much faster,” Holmes said. “Only 25% of homes have mortgages so the impact of bankruptcies is much smaller. Also, I don’t think they’re going to print money the way they did in 2008. The Chinese government will move slowly to make sure the country doesn’t get hurt by Europe’s slowdown.” Based on money supply, debt levels and the weakness of the dollar, Holmes predicted economic activity in the emerging countries should double over the next five years. “It is going to be between 8% and 9% this year and it has another 10 years of growth ahead of it,” Holmes said. “Investors need to understand volatility and not be fearful of it. If you are trading futures where your leverage is 10 to 1 and you have a big correction, you can get wiped out. But, if you are a cash business, you understand when these markets go through these corrections. Solid companies paying dividends can be an attractive investment over the long term.” Gordon Chang: This China-watcher recently wrote an article for Forbes that said what others considered positive November trade numbers—exports up 13.8%, imports up 22.1% year-over-year—was actually an indication of flat consumer demand once the commodities were factored out. His conclusion was that the government was taking advantage of low prices to stockpile things like soybeans, copper and iron ore while domestic demand remained stagnant. “Since September, we have seen essentially flatlining growth,” he said. “The growth over the last three decades has been absolutely stunning, but that was then, and this is now,” Chang cautioned. “After 35 years of virtually uninterrupted growth, the Chinese economy hit an inflection point, probably in September of this year. I think we are going to see a long-term cycle down. There are a number of reasons for it, some of them short term, some of them long term. The reasons that created this growth either no longer exist or are disappearing fast. Deng Xiaoping’s policy of reform paired with the end of the Cold War and expansion of globalization triggered growth in the 1980s. However, under current leader Hu Jintao, China has seen the reversal of reform, with the government partially renationalizing the economy. Today, we are in the second part of a global downturn, which will be much worse than what started in 2008. A trade-dependent economy like China’s is going to have real problems. Additionally, China was aided by the demographic dividend, an extraordinary bulge in the Chinese workforce, which by most estimates will level off between 2013 and 2016, leaving a demographic tax where one worker supports two parents and four grandparents.” Chang pointed to stagnant electricity consumption, flat car sales, plunging industrial orders and collapsing property prices. “For example, in October, we saw property prices collapse 30% in places like Shanghai and Beijing, and actually across the country. That has to eventually trigger a negative wealth effect. “Domestic growth is vital for a sustainable economy,” Chang said. “Last year, domestic consumption comprised less than 34% of Chinese GDP and it has been dropping in recent years. That means China is not restructuring its economy because the problems go to the core of the political model. The government would have to let the Renminbi float, allow banks to offer market rates of interest to depositors and state enterprises, allow workers to bargain collectively to get higher wages and provide a better social safety net, especially in the health care area. These are things that Beijing didn’t do a half-decade ago when it was growing at 9.9% and they’re certainly not going to do so now in a very difficult environment.” On the manufacturing side, Chang referred to the December HSBC/Purchasing Managers’ Index (PMI). “It showed an absolute, outright falloff in industrial orders domestically. I think that is a really important indication of the problems,” Chang explained. Technically, the Chinese economy went from expansion in October to contraction in November when it crossed the critical 50 line. Any number above 50 shows expansion; any number below 50 shows contraction. The fact that China is reporting negative numbers is telling in itself, according to Chang, who said often government-issued statistics conflict with reports from other sources. Beijing reported 13.8% export growth in November. However, during that same period factories went bankrupt, factory owners fled because they couldn’t pay their debts and some of them took their own lives. Even more damning are container and freight statistics, including reports from mega-container shipper Cathay Pacific that showed November cargo shipments down 13.8%. “Exports to Europe have fallen off the cliff and the EU was China’s largest trading partner so something doesn’t add up,” he said. For the final blow, Chang pointed to the actions of the Chinese government. “If China really does have robust, 8–9% growth as everybody says, why is the central government starting to stimulate the economy again? That just doesn’t make any sense. If we look at things like imports and exports, I think the economy is really in trouble.” Chang warned of political consequences if the country is not growing at least close to a double-digit rate. “I don’t know if China can stand 3% growth—or the other very real possibility, contraction. The American government bases its legitimacy on the nature of its political system. The legitimacy of the Communist Party is primarily based on the continual delivery of prosperity. Already, the number of protests in China has increased dramatically from maybe 70,000 mass incidents a year in 2005, to as many as 280,000 last year. In addition to strikes, riots, insurrections and bombings, the standoff between villagers and the authorities in Guangdong province are threatening the future of the Communist Party.” One solution is for the Chinese government to continue to spend millions on infrastructure to create growth as it did when it spent $1.1 trillion after the 2008 downturn. “This tactic is of limited usefulness the second time around,” Chang warned. “It may be able to play out the game for 18 months, maybe two years at the outside, but it’s pretty much done. Plus, the artificial stimulus also created a stock market bubble, inflation, ghost cities, banking weakness and property bubbles. Massive spending didn’t avoid problems, it just postponed them and made them bigger and more difficult to solve.” Chang said that people in China are starting to see the reality of the problem. “There is a sense of pessimism. Starting in October, we saw large, unexplained transfers of money out of the country.” The bright spot, according to Chang, is that while China will not be able to fuel a global recovery with a consumer-driven middle class, a Chinese meltdown won’t be a major blow to the U.S. either. “We have the world’s largest internal market; 70% of our GDP relates to consumption. Exports don’t really play that much of a role in the U.S. as it does in other major economies. So China can fall off the cliff in a sense, and it would have some negative effect but not very much. In fact, we might benefit from it.” Chang’s conclusion? “People say the Chinese economy is the global engine of growth, but that’s not true. The engine has been the American consumer because we are taking every other country’s exports, and the Chinese, through predatory and mercantilist policies, have been grabbing growth from other countries. For the last 200 years, China has been a potential source of customers for other countries. Still, domestic demand isn’t that significant. China’s imports lately have been commodities and that is going to fall off because China’s exports of manufactured goods, to Europe and the U.S., are going to be stagnant or lower than they have been in the past. So China really reacts to the rest of the world. If the changes over the next couple of months are as dramatic as they’ve been for the past two, then we’re going to be looking at a very different China. The Chinese economy could fall into a big black hole with 1–2% growth or even contraction. Can the government turn it around as it has in the past? That’s the money question.” 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 Holmes as mining fund manager of the year. Holmes co-authored 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. Gordon G. Chang is the author of Nuclear Showdown: North Korea Takes On the World. His first book is The Coming Collapse of China. He is a columnist at Forbes.com and The Daily and blogs at World Affairs Journal. He lived and worked in China and Hong Kong for almost two decades, most recently in Shanghai, as counsel to the American law firm Paul Weiss and earlier in Hong Kong as partner in the international law firm Baker & McKenzie. His writings on China and North Korea have appeared in The New York Times, The Wall Street Journal, the Far Eastern Economic Review, the International Herald Tribune, Commentary, The Weekly Standard, National Review, and Barron’s. He has given briefings at the National Intelligence Council, the Central Intelligence Agency, the State Department and the Pentagon. Chang has appeared before the House Committee on Foreign Affairs and the U.S.-China Economic and Security Review Commission. He has appeared on CNN, Fox News Channel, Fox Business Network, CNBC, MSNBC, PBS, the BBC, and Bloomberg Television. He has appeared on The Daily Show with Jon Stewart. Join the forum discussion on this post - (1) Posts
Foreign trade sound much less important when discussed as a percentage of GDP instead dollars. 16% sounds like a relatively small amount, but once you put that in dollar terms it becomes $2.24 trillion dollars.* Obviously, this is a significant chunk of change, roughly equal to the mandatory spending of 2010 federal budget (and equivalent to roughly two-thirds of the total federal budget). Given that unemployment wavered between 16.5% and 17.1% that year (and was likely higher, given how the government manipulates those statistics), it seems reasonable to conclude that it having even half of those imports produced at home would have had a pretty positive impact on unemployment.**
But why not have, if possible, one hundred cent of dollars be paid to Americans? Saying that the effects of foreign trade aren’t that bad is little consolation to those who are unemployed.
The problem with the technology argument is that it fails to account for the impact of governmental interference. Of course, it is impossible to tell with any degree of certainty how much the government, by its interference, has encouraged manufacturers to pull forward their demand for machines to replace workers. It also fails to account for foregone manufacturing in light of a) regime uncertainty, b) the regulatory thicket that is the federal code, and c) the monstrosity that is the corporate tax code. Basically, there is no reason to assume that manufacturing would be as automated if there was actually a free market, nor is there any reason to assume that there would be as few manufacturing jobs if there were no federal regulations.
Now, as has been mentioned at this blog many times before, federal policy has been directly responsible for the current economic malaise. The federal government has hamstrung domestic businesses while simultaneously giving foreign businesses a free pass for trade. The direct effect of this schizophrenic policy has been to subsidize foreign businesses at the expense of domestic businesses. This has also contributed to a high unemployment rate. While free trade is the undoubtedly preferable state of being, it makes no sense to allow this while simultaneously hamstringing domestic businesses. The government must level the playing field, most preferably by deregulating domestic businesses. In the event this cannot be accomplished, the government should ensure that foreign businesses adhere to same labor and environmental regulations faced by domestic businesses or at least pay the difference.
As Walter Williams states:
* The GDP of the united states for 2010 was approximately $14 trillion; 16% of this is $2.24 trillion.
** Keep in mind that, during 2010, the welfare/unemployment budget was nearly $600 billion. Half of the imports would have been $1.12 trillion, nearly double the welfare budget. I’ll let you draw your own conclusions from this.
 At 8:30 AM Eastern time, the U.S. government will release its weekly Jobless Claims report. The consensus is that there were 380,000 new jobless claims last week, which would would be 14,000 more than the previous week. Also at 8:30 AM Eastern time, the final GDP report for the third quarter of 2011 will be announced. The consensus is an increase of 2.0% in real GDP and an increase of 2.5% in the GDP price index. The real GDP estimate is the same as the preliminary value for the third quarter of 2011, and the GDP price index is the same. Also at 8:30 AM Eastern time, the Chicago Fed National Activity Index for November will be released, providing an update on economic activity and inflationary pressure in the United States. Also at 8:30 AM Eastern time, the monthly Corporate Profits report from the Bureau of Economic Analysis will be released. At 9:45 AM Eastern time, the weekly Bloomberg Consumer Comfort Index will be released, providing an update on Americans’ views of the U.S. economy, their personal finances and the buying climate. At 9:55 AM Eastern time, Consumer Sentiment for the second half of December will be announced. The consensus is that the index will be at 68.0, which would be an increase of 0.3 points from the level reported in the first half of the month. At 10:00 AM Eastern time, the FHFA House Price Index for October will be released, providing more information about the direction of the housing market. Also at 10:00 AM Eastern time, the Leading Indicators for November will be released, and the consensus is that there was an increase of 0.3% from the previous month. At 10:30 AM Eastern time, the weekly Energy Information Administration Natural Gas Report will be released, giving an update on natural gas inventories in the United States. At 4:30 PM Eastern time, the Federal Reserve will release its Money Supply report, showing the amount of liquidity available in the U.S. economy. Also at 4:30 PM Eastern time, the Federal Reserve will release its Balance Sheet report, showing the amount of liquidity the Fed has injected into the economy by adding or removing reserves. Join the forum discussion on this post - (1) Posts Leave a comment  U.S. Economics  Bloomberg Consumer Comfort Index, Chicago Fed National Activity Index, consumer sentiment, corporate profits, economic calendar, Energy Information Administration Natural Gas Report, Federal Reserve Balance Sheet, Federal Reserve Money Supply, FHFA House Price Index, GDP, jobless claims, Leading Indicators In recent months, we’ve had a few slip-ups by the official statistical system in India:
These examples are part of a larger theme, of problems of the official statistical system. The Indian statistical system is afflicted by three levels of problems:
The mistakes that we’re seeing are merely a reflection of #2 (the lack of rugged enterprise IT systems). But there is much more going on which holds back the usefulness of official statistics.
Government officials in this field have pinned a lot of hope on the implementation of the report of the statistical commission (headed by C. Rangarajan, 2001). I am personally not optimistic about this. The report seems to emphasise an incremental agenda of building the statistical system, emphasising the interests of the incumbents. What is required is a ground-up rethink about the statistical system, from first principles, so as to address the three difficulties above.
Turning to the users of official statistics, most economists attach enormous prestige to phrases like GDP, IIP, CPI, etc. But in India, we cannot unthinkingly use some numbers just because they come with the label `GDP’ from some government agency. We have to always skeptically ask first principles questions about how the data is generated. All too often, the standard Indian government data is useless.
In the class of government data that I know of, I feel the CPI is reasonably okay. The WPI is a fairly useful database about prices but useless as a price index. The quarterly GDP data, IIP, NSSO, ASI are untrustworthy.
Decision makers in government and in the private sector need to struggle with these issues, carefully thinking about what statistics are allowed to influence their decision processes. Academic users of data need to be much more careful about avoiding garbage-in-garbage-out problems.
For more on this subject, you might like to look at the label `statistical system’ on this blog.
 There is a lot of gloom in India today about the broad-based failure of the UPA strategy of combining left-of-centre populism, fiscal profligacy, theft, and a lack of interest in the foundations of India’s growth. We learn from history that we learn nothing from history; India has clearly learned very little from its escape from the Hindu rate of growth. The moment we got a little bit of growth, the old style socialism and theft reared up again. In one of the many pessimistic articles of this theme, Shekhar Gupta in the Indian Express says:
In thinking about GDP growth, it’s always useful to think about both growth and fluctuations. Growth is about the underlying trend growth rate. In the olden days, this was all you needed to worry about. The economy trundled along at roughly the trend growth rate (the Hindu rate of growth of 3.5 per cent), being kicked up or down by good or bad monsoons. In that period, macroeconomics in India required thinking in completely different ways, when compared with standard Western textbooks. But from the early 1990s onwards, India changed. The market-oriented reforms, which began with the Janata Party in 1977 and gathered momentum in the 1980s, had started creating a market economy. And every market economy in the world experiences business cycle fluctuations. So, in addition to the trend, we got a cycle about the trend. There were good periods and bad periods, and the story running in there was much like that found in mainstream Western textbooks, with a prominent role being played by profitability, inventories and investment by firms. From this viewpoint, it’s useful to decompose two elements of what we are seeing after 2009. On one hand, trend growth has been influenced by decisions of the UPA. Any perceptive observer also tends to rage at the lost opportunities, of policy decisions that should have been taken, which would have accelerated trend growth. But the second big story is that of fluctuations. Corporate investment is a major driver of business cycle fluctuations in India, and there has been a certain deceleration in this. This may have set off a downturn. The bulk of the drama that we’re now seeing, and what will play out in 2012, is business cycle fluctuations. This is about fluctuations, not the trend. When trend growth is 7 per cent, the fluctuations make GDP growth range from 4 per cent to 10 per cent. Even if trend growth does not change by even a bit, business cycle fluctuations can take us from a high of 10 per cent to a low of 4 per cent, which is a huge swing of 6 percentage points. Many elements of economic policy are pro-cyclical: when times are good, they make things better and when times are bad, they make things worse. The financial system tends to suffer from pro-cyclicality: when times are good, bankers lend exuberantly (thus expanding the boom) and when times are bad, bankers tend to be cautious (thus accentuating the bust). It is important to look for a framework for stabilisation, of tools that will counteract business cycle fluctuations. India has crossed one major milestone, in getting to a floating exchange rate. The floating exchange rate is stabilising, in and of itself. In addition, it opens up the possibility of stabilising monetary policy. As of today, by and large, I think of both fiscal policy and monetary policy as being part of the problem and not part of the solution. While floating the exchange rate (decisions from 2007 to 2009) opened up the possibility of sound monetary policy, the logical next step did not materialise. As of yet, we do not have a sound monetary policy regime. We’re going to require far-reaching surgery to laws and institutions, in order to craft frameworks for fiscal policy and monetary policy that do stabilisation. Until these changes are made, Indian GDP growth will have the high volatility that is characteristically found in countries with weak institutions. A lot of our work in the Macro/Finance group at NIPFP is rooted in this conceptual framework. In particular, you might like to see two relatively non-technical articles: New issues in macroeconomic policy and Stabilising the Indian business cycle. 
The Gold Report: In the Nov. 4 edition of Hotline, you note that America’s ratio of debt to gross domestic product (GDP) is north of 350%. Our total debt as a society is somewhere around $57 trillion (T). That’s worse than Greece. Is deflation America’s biggest economic threat? Jay Taylor: I believe it is, however, most of my goldbug friends wouldn’t agree. It is important to realize that the U.S. is not a third-world country. It still has the world’s reserve currency. The central bank, the Federal Reserve, doesn’t put money into the hands of the masses. It puts money in banks. It’s all about credit extension. That is very difficult to do now. With the debt-to-GDP ratio as it is, it’s unsustainable. The markets are telling us that—not only in the U.S., but clearly in Europe as well. We are undergoing one of the largest debt-deleveraging periods in a long time, which may be much larger than what we went through in the 1930s. TGR: You believe there should be no more bailouts, let this debt wrench itself out of the system and let bankruptcies occur. JT: Absolutely. Most people don’t understand the reason we’re in trouble is because the good times that we had were false. They weren’t based on savings and investment. They were based on money creation through credit extension. The nice homes, the big office buildings, fancy cars, everything—it wasn’t earned, it was based on debt. Now that the debt cannot be repaid, the expansion goes into a contraction. That process has a long way to go. TGR: Bob Prechter of the financial forecasting firm Elliott Wave International is predicting that gold and silver “should decline in conjunction with the stock market selloff. Gold should work down toward $1,300 an ounce (oz), while silver should fall into the low $20/oz area.” What’s your position? JT: If you believe that we’re in a deflationary environment, the nominal price of gold could go down and the purchasing power of it could go up a lot. The real price of gold is most important for gold mining companies. Before the Lehman Brothers failure in July 2008, an ounce of gold would have bought only 17% of the Rogers Raw Materials Fund. It rose to 44% by March 2009, but came back a bit to 30%. It was recently up to a new high of 47.5%. Gold’s purchasing power is rising much more dramatically than its nominal price. Gold has fallen off its highs and is around $1,700/oz. As Ian McAvity has said, an ounce of gold is an ounce of gold. A barrel of oil is a barrel of oil. What is a dollar? It’s a meaningless measure because Federal Reserve Chairman Ben Bernanke can create trillions of dollars out of thin air. TGR: Silver’s purchasing power on the Rogers Raw Materials Fund hasn’t experienced quite the same gain. In June 2008 it was just below 1%. Now it’s just below 3%. JT: Silver has done very well, but it’s much more volatile. It has outperformed gold in general since Lehman Brothers’ collapse, however. TGR: The International Monetary Fund (IMF) has agreed to throw the Eurozone countries a lifeline of about $0.5T. Will that be enough? JT: My view on Europe is the same as on the U.S.—the kindest, gentlest thing to do would be to allow the debt to implode immediately. We’re allowing sick entities to survive and eat up resources. It’s contrary to free market capitalism. It’s really fascism. Large corporate interests are being protected because of their cozy relationships with government. A half trillion is not going to be enough. Where does the IMF get its money? Is the U.S. going to be asked to pony up more money for Europe? Probably. Are they going to sell the rest of the gold they have? Perhaps. That’s what the Soviet Union did before it collapsed. TGR: You’re biased toward credit market deflation, but you continue to be partial toward gold and gold mining stocks. What are the reasons for that? JT: Margins are widening. There is an explosion of profits for major mining companies in production before 2008: Agnico-Eagle Mines Ltd. (AEM:TSX; AEM:NYSE), AngloGold Ashanti Ltd. (AU:NYSE; AU:JSE; AGG:ASX; AGD:LSE), Barrick Gold Corp. (ABX:TSX; ABX:NYSE), Goldcorp Inc. (G:TSX; GG:NYSE), Kinross Gold Corp. (K:TSX; KGC:NYSE), Newmont Mining Corp. (NEM:NYSE) and Yamana Gold Inc. (YRI:TSX; AUY:NYSE; YAU:LSE). In 2008, those companies recorded $5.77 billion (B) of earnings collectively. In 2009, that jumped to $7.05B. In 2010, it jumped to $13.62B. The analyst consensus is that it’s going to go to $20.22B in 2011 and $28.28B for 2012. Margins have increased in this deflationary environment because the real price of gold has risen relative to the cost of mining it. Bob Hoy, a technical analyst in Vancouver, figures we are in the sixth large credit contraction in the last 300 years. In every case, the real price of gold has risen over 15 to 20 years. The real price of gold started to rise in 2007. We could be in the early days of a super bull market for gold mining shares. TGR: Those majors probably average $500/oz in cash costs. However, you have a buy rating on small Australian producer Crocodile Gold Corp. (CRK:TSX; CROCF:OTCQX), which just reported a loss of about $6 million for the quarter. Its cash costs are above $1,400/oz and its stock is down about 80% this year. Why on earth would you still have a buy rating on Crocodile Gold? JT: I believe in the long-term prospects of this company. It’s had a lot of problems. Its costs were $250/oz higher than projected this year because of lower-than-expected grades from its open-pit projects. Clearly, that’s a black eye for management because something went wrong. But I still believe that this company has extraordinary exploration potential and will get costs under control. TGR: For example, silver producer Great Panther Silver Ltd. (GPR:TSX; GPL:NYSE.A). As of Nov. 18, it was up 355% since you took your initial position. Great Panther is down almost 20% this year despite a strong Q311, however. What’s your outlook for Great Panther? JT: Its decline is in line with the general market decline. It keeps improving on a fundamental basis and expanding its resource. It’s a fine operation that’s earning money. TGR: What other smaller gold and silver miners are you interested in? JT: My favorite might be Sandstorm Gold Ltd. (SSL:TSX.V), which is a royalty play. It has one of the best looking charts in a horrible market. Sandstorm provides the capital to get companies into production and then it gets a royalty. It usually gets the chance to buy maybe 15% or 20% of a project’s production for the life of that project at cost. It has several properties that are producing now. Its projects are getting bigger and production is growing. This is a company that’s going to continue to earn more and more very rapidly. There are fewer risks involved in this model than if it was an operator, too. TGR: Its production forecast for this year is from 16–18 thousand ounces (Koz). However, that will increase to more than 50 Koz by 2014. That’s certainly strong growth. JT: The gold price, where it is relative to the cost of mining and the expansion of production, means that earnings are going to grow very rapidly, if not exponentially. TGR: Do you think that too many royalty plays kill the goose? JT: That could be the case. With increased competition, they might be paying too much for the deals that they strike. However, I’m not concerned about that with Sandstorm at this point. Royalty plays, like Sandstorm, Silver Wheaton Corp. (SLW:TSX; SLW:NYSE), Royal Gold Inc. (RGL:TSX; RGLD:NASDAQ) and others, generally sell at much higher multiples than mining companies because there’s less risk involved. An operator can have any number of things go wrong and have to put in more capital to get things moving again. TGR: It’s more of a matter of vetting these projects and being sure the geological model works and the metallurgy is good. JT: Yes. I have a high regard for the management of Sandstorm. They’re really sharp. They get involved in projects that have enormous upside potential. It’s not just the ounces that might be in a bankable feasibility study. They look at the exploration potential and the expansion of production, too. TGR: Let’s move down the food chain to the explorers. The portfolio scorecard in each edition of Hotline doesn’t paint a very kind picture of gold and silver exploration plays lately. JT: Nope, not this year. TGR: As of Nov. 18, only 8 of 50 exploration companies on that list, or 16%, were up: American Bonanza Gold Corp. (BZA:TSX), Metanor Resources Inc. (MTO:TSX.V), Prodigy Gold Inc. (PDG:TSX.V), Aurvista Gold Corp. (AVA:TSX.V), Meadow Bay Gold Corp. (MAY:TSX.V; MAYGF:OTCQX), Pretium Resources Inc. (PVG:TSX), Nautilus Minerals Inc. (NUS:TSX) and Rye Patch Gold Corp. (RPM:TSX.V; RPMGF:OTCQX). You still have buy ratings on the other 42 companies, however. Why are you still recommending small-cap companies exploring for precious metals? JT: I believe in the sector. I can’t explain why the markets have treated the sector badly this year. The majors’ profits are up very sharply, yet the share prices haven’t even begun to keep up. It tells me that most of the players in the equity markets don’t recognize this as a gold bull market and they don’t see the potential for turnaround. They don’t realize, as Bob Hoy points out, that there’s probably another 15 years to go. Gold is going to be strong for a long time because the financial sector, deleveraging and the loss of confidence in fiat money is going to keep the real price of gold and real earnings high. I told my subscribers when things started to turn that they should build some profits and keep some cash on the sidelines because the entire sector is likely to decline in price along with the general market. The gold sector is being hurt badly and that’s an extraordinary opportunity. Why would I sell companies that I believe in even if, like Crocodile Gold, they’ve lost 80%? It would be a stupid time to sell. It would be a great time to take some of that cash that I suggested investors put aside and start to buy some of these companies as they decline. I don’t see any reason to jump ship now because I believe so firmly in the fundamentals of this industry. TGR: The biggest gainer on the list of the companies that are up this year is American Bonanza Gold. It’s up about 70% this year, but about 232% since you took your initial position. Why is that junior performing so well? JT: It’s on the verge of production at the Copperstone gold mine in Arizona. There were a lot of skeptics and the stock was extremely cheap. The costs are very low. It’s not a big mine and the production levels are fairly small, but it has really good exploration potential that can be built into a much bigger mining operation over the long term. TGR: When is initial production expected? JT: I believe in Q112. TGR: American Bonanza should be generating some cash flow at that point. JT: It should, with the caveat that more often than not startup operations have some kinks to work out. However, this was a previously producing mine. That reduces some of the metallurgical risk and other risks of a new startup. I’m confident it’s going to get the job done. TGR: You recently interviewed management from Merrex Gold Inc. (MXI:TSX.V; MXGIF:OTCQX), which is not doing too badly this year. What did you learn about Merrex? JT: Merrex is exploring the Siribaya deposit mine in Mali with IAMGOLD Corporation (IMG:TSX; IAG:NYSE) as its 50% joint venture partner and largest shareholder. IAMGOLD is there because it believes this is going to be a multimillion ounce deposit. And IAMGOLD is committed—it spent about $10 million to earn a 50% interest. It has about 460 Koz from a relative high-grade open pit at a quarter grams per ton. However, that’s based on less than 5% of the total strike length of two major zones, plus another zone was discovered, too. Moreover, some of the assays recently from the south end of the zone that was drilled have been much higher grades. The average grade may be even higher than 2.25 grams. The only real downside is that the company has to rely on diesel fuel for now. There’s some vulnerability to spiking oil prices. TGR: IAMGOLD is effectively using Merrex as an exploration arm. JT: IAMGOLD is the operator of the project. It has a joint committee that decides on the strategy and drill programs. In fact, one of the management members of Merrex who I was with in Switzerland was going to Toronto on his return to talk to IAMGOLD about the next drill program. TGR: You also have a buy rating on Calico Resources Corp. (CKB:TSX.V; CVXHF:OTCQX), which is drilling the Grassy Mountain gold project in Oregon. Oregon is generally not considered the most mining-friendly state. Why does Calico make your scorecard with a buy rating? JT: Washington is probably considered one of the most difficult states in the country for mining. California had been very difficult, but it’s getting tougher everywhere. Calico management discovered by doing research that Oregon is no more difficult than any other Western state. Politicians with common sense know the local people want jobs. Where are the jobs going to come from? Mining is a wealth-creating activity. It’s not going to be easy. Getting permits moved through the pipeline can be difficult, but I have confidence in the management team at Calico led by Chairman Buck Morrow, for whom I have a high regard. Grassy Mountain was worked on during the last gold bull market. The potential there is extraordinary. It has gotten some really nice assays back. TGR: What are some other precious metals explorers that you’re following closely and remain excited about? JT: I love Rye Patch Gold in Nevada. It has 3.1 million ounces (Moz) gold, but it has 3.9 Moz gold equivalent including silver. Rye Patch clearly has a shot at building something much bigger than that with its good management and miniscule market cap. I also like Metanor Resources a lot. Since Sandstorm provided capital, the company has been focusing on its underground Bachelor Lake mine in Le Sueur, northeast of Val d’Or, Québec. Bachelor Lake is going to be put into production within the next six months to a year. It should do very well with that. It also has the Barry deposit, which has the potential to be a very large deposit similar to Osisko Mining Corp. (OSK:TSX). Québec is one of the best provinces in which to run, explore and develop projects. Aurvista Gold in Québec has 2 Moz and huge exploration potential. Pretium Resources also has a huge deposit up there next to Seabridge Gold Inc.’s (SEA:TSX; SA:NYSE.A) gold-silver deposit. Pretium is headed by Bob Quartermain and a very strong management team. It’s actually been one of the winners this year. TGR: Do you have any parting thoughts? JT: It’s painful sitting with stocks in this kind of a market, but that’s the nature of the beast. You hold a junior mining company and all of a sudden it takes off. You just don’t know when. You have to believe in the fundamentals of the story and the chance to come up with something big. A couple of times I’ve walked out of a stock and a day or two later the company made a great discovery—that is really painful. TGR: How would you respond to someone like Rick Rule who says it’s not about the 80% you lost, it’s about what you do with the 20% that you have left? JT: I suppose that’s right. Rick is a very conservative investor. He really likes to buy stocks when they’re cheap. He’s a very disciplined trader. You want to protect that 20%. When you get a market that’s on the upside, you can make that 80% back very quickly if you’re in the right stocks. Of course, I’d never recommend that investors back up the truck and bet the farm on any one company. I have a lot of companies on my list because I believe in diversification. These little penny mining companies, the miniscule market-cap companies, can be tenbaggers in a hurry if they’re successful. Whenever you invest in a deal, you can lose 100%, but you can’t lose 1,000%. The upside is limitless. With 20/20 hindsight I should have sold everything and waited until now to buy, but I didn’t know for sure how the markets were going to treat gold stocks this year. But I’ve been telling investors to build some cash for this kind of environment. Now is the time to be buying. TGR: Thank you. As he followed the demolition of the U.S. gold standard and the rapid rise in the national debt, Jay Taylor’s interest in U.S. monetary and fiscal policy grew, particularly as it related to gold. He began publishing North American Gold Mining Stocks in 1981. In 1997, he decided to pursue his avocation as a new full-time career—including publication of his weekly Gold, Energy & Tech Stocks newsletter. He also has a radio program, “Turning Hard Times Into Good Times.”
The Energy Report: You’ve been tracking macroeconomic trends and their impact on energy commodities for decades and since 2004 through your Shadow Government Statistics newsletter. In a Nov. 10 piece on the trade deficit, you wrote:
What would be the first sign that hyperinflation is taking hold? John Williams: I’d look at the dollar. You’ll see massive selling of the U.S. dollar and dumping of U.S. dollar-denominated assets as an early indication. That will be very inflationary, and an indication of global loss of confidence in the U.S. currency. We’ve already crossed that bridge. Based on generally accepted accounting principles, the annual U.S. budget deficit is running in excess of $5 trillion. Such a deficit is beyond control and containment and dooms the U.S. government to ultimate insolvency and a likely hyperinflation. Money is printed to meet obligations; the government cannot cover its debt otherwise. The efforts by the Fed and federal government to contain the current systemic solvency crisis have moved the onset of a hyperinflation from the end of this decade to the relatively near term. If you look at the debt-ceiling negotiations and the deficit-reduction deals that were in progress back in early August, it became clear to the rest of the world that the people running the U.S. government had absolutely no political will to address its long-term insolvency. You saw a very heavy selling of the U.S. dollar right after that. This was even before the Standard & Poor’s downgrade. TER: The downgrade was an indicator of the loss of confidence, though—not the cause. JW: The downgrade only exacerbated the problem. Once it was clear that there was no political will to address the fiscal issues, dollar selling became intense. Official actions followed that provided temporary support for the U.S. currency. You saw the Swiss franc soar relative to the dollar. The Swiss then intervened, with a quasi-tying of the franc to the euro, which effectively also meant intervention to support the dollar. Gold prices soared, and gold future margins were narrowed. The lack of global confidence in the dollar underpins the extremely volatile markets since that time. We’ve seen all sorts of interventions and all sorts of rumors floated, but I believe the fundamental global confidence in the dollar has been mortally shaken. As you see mounting selling pressure on the dollar, you’ll generally see spikes in commodities that are denominated in U.S. dollars, particularly oil. That’s very important to the U.S. in terms of inflation. That’s where heavy dollar selling will be seen as a trigger for rising consumer prices and as an early trigger for hyperinflation to move into full speed. TER: What happens to oil prices in hyperinflation? JW: It depends on how they’re denominated. I suspect if the dollar becomes weaker, we’ll see a very rapid and strong movement to base oil pricing in something other than U.S dollars. The value of the OPEC (Organization of the Petroleum Exporting Countries) members’ income will drop very quickly as the dollar value drops in terms of international exchange. If oil were denominated in Swiss francs, you might not see too much of a spike, but looking from the perspective of someone living in a U.S. dollar-denominated world, the pace of increase in oil prices will be directly and proportionately tied to the weakness in the dollar against whatever the valuation base is for oil. TER: The Department of Energy (DOE) reported that gas prices declined 0.8% in September. Are you seeing that gas prices are declining or increasing according to your statistics? JW: I think the DOE aggregate prices are reasonably accurate on gasoline. You’re going to have ups and downs in the market with very volatile oil prices, as we’ve seen over the past couple of years. Various factors will affect it. For instance, a crisis in the Middle East can spike oil prices very rapidly. But as the dollar comes under massive selling pressure, oil prices will spike, and a rapid decline in the U.S. dollar will result in a very rapid rise in oil prices in dollar-denominated terms. TER: September gross domestic product (GDP) numbers showed a slightly narrower trade deficit compared to August, partly due to declining oil prices and import volume. Your newsletter suggests possible inaccuracies in federal data. Can these numbers be trusted? JW: I pay no attention to GDP as an indicator of what’s happening in the broad economy. There’s a major problem with the way the government adjusts its data for inflation. The way it comes up with the headline number, growth is deflated by its estimate of inflation. To the extent that the inflation is understated, you end up with overstated GDP growth. Perhaps not too surprisingly, government-reported inflation is understated, which causes significant overstatement of official economic growth. That’s one reason the GDP is out of whack. The GDP inflation estimate includes what the government calls hedonic adjustments, where nebulous quality adjustments are factored in and subtracted from inflation. I estimate this takes about two percentage points off the annual inflation number. If you deflate the GDP corrected for that, you’ll see that we never recovered from this recession. TER: Is that the case with oil price estimates? JW: Oil price impact on the GDP is not obvious to the casual observer. If oil prices rise, that usually means a higher inflation number and, therefore, it could be expected to weaken the inflation-adjusted economic numbers. So in terms of domestic oil production reflected in the GDP, in nominal terms—before inflation adjustment—part of the production number increases because oil prices are higher, but that gets reduced out when inflation it is factored in. That’s what most people think of as the inflation effect. But remember, we import more oil than we export, and the imports are subtracted from the GDP. So high oil inflation, which would traditionally lower the rate of growth, actually increases the pace of total GDP growth because the negative effect actually is subtracted out as part of the aggregate negative net exports. In other words, higher oil prices actually spike GDP reporting because of the way the net exports are handled. That’s the nature of the GDP. Again, I put no value in the GDP as an indicator of economic activity. TER: That’s for prices of oil. What about volume? In September, oil volume was down according to government statistics. JW: I believe the government has fairly good measures of the physical flow of oil. The reporting of the flows, though, does not always hit when it should. The paperwork flow on imports is better than it is on exports. Duties are sometimes assessed on the imports so they keep much better track of that than they do for goods where they don’t collect money. TER: So if oil imports were down from September to October, is it simply because, as you said, we never came out of the recession? Or does it mean we’re going into a double-dip recession? JW: I wouldn’t read much into that because you can argue it either way. You can make all sorts of stories from it, and the people who hype the GDP numbers for the market are pretty good at spinning their yarns. TER: So if we’re looking at hyperinflation sooner rather than later—which would affect oil prices very directly—how can individual investors protect themselves? JW: They need to preserve their wealth, assets and purchasing power by getting into hard assets. If you look at oil as a hard asset, it will tend to preserve purchasing power, but it’s a consumable and not easily portable. You can’t stick it in your briefcase and carry it with you if you move from one place to another. It’s difficult to spend physically. So in terms of hedging, I would look primarily at the precious metals and getting assets outside the U.S. dollar into the stronger currencies, particularly the Australian dollar, the Canadian dollar or Swiss franc—despite the Swiss interventions. I’m looking long term. We can expect a lot of volatility short term, but when massive movement against the U.S. dollar begins, those areas will do very well. TER: Any other energy-related issues that our readers should be aware of to prepare for hyperinflation? JW: I’m looking at the hyperinflation primarily in the U.S. dollar, not in other currencies, so it’s largely a dollar problem, and the basic protection for those living in a dollar-denominated world is to be out of the U.S. dollar. If you live in a world denominated in Swiss francs or one of the other stronger currencies, you need to think seriously about where you have your dollar investments. That’s the basic consideration from the standpoint of hyperinflation, whether you’re in the energy industry or you’re a farmer or Wall Street trader. TER: Is there any way to create store-of-wealth value in agriculture? JW: Farm land is a good hedge, but there’s a difference between holding hard assets with short-term liquidity, such as physical gold, to get through the tough times until after things stabilize, versus assets that may have short-term liquidity issues. Real estate may present liquidity problems at various times, although long term, it’s a fine hedge in terms of maintaining purchasing power. Up front, though, your core assets hedging a hyperinflation have to have enough liquidity so that you can respond to circumstances as they evolve. In this environment, those invested in the energy sector also have to realize that demand for energy goods will tend to be lower than it might be otherwise, because the U.S. economy will continue to be weak, and not much is being done to fundamentally address that. On the other hand, if domestic oil production could replace foreign production, you could still have a positive domestic demand environment. I’d push for that as much as possible. TER: Could drilling for natural gas in the U.S. really have an impact on the import/export statistics going forward? JW: If we can increase exports, that would be a plus. To the extent we produce it domestically and import less as a result, that also would be good for the economy. To the extent anything is produced domestically, that’s a big plus for the economy. TER: Can we pump and use enough natural gas domestically from the shales to actually make a difference or are we talking too small of a number compared to the amount of oil we import? JW: I am not an expert on natural gas production. Of course volume is an important factor, and a major increased production would have a significant, positive impact on the GDP. Anything that increases U.S. production and reduces the trade deficit is a plus. Usually increasing domestic production would have the effect of decreasing the deficit. The deficit is a negative for the economy and for jobs. So anything that reduces the trade deficit will be a positive factor for U.S. employment. TER: That makes sense and is very helpful. Thank you for taking the time to talk with us. Walter J. “John” Williams has been a private consulting economist and a specialist in government economic reporting for 30 years, working with individuals and Fortune 500 companies alike. He received his AB in economics, cum laude, from Dartmouth College in 1971 and earned his MBA from Dartmouth’s Amos Tuck School of Business Administration in 1972, where he was named an Edward Tuck Scholar. Williams, whose early work prompted him to study economic reporting and interview key government officials involved in the process, also surveyed business economists for their thinking about the quality of government statistics. What he learned led to front-page stories in the New York Times and Investor’s Business Daily, considerable coverage in the broadcast media and a joint meeting with representatives of all of the government’s statistical agencies. Despite a number of changes to the system since those days, Williams says that government reporting has deteriorated sharply in the last decade or so. His analyses and commentaries, which are available on his ShadowStats.com website have been featured widely in the popular domestic and international media. |
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