Mereja

Author: Greg Canavan

  • The Triffin Dilemma

    There is a fundamental incompatibility between the attainment of global economic stability and having a single national currency perform the role of the world’s reserve currency. This is hardly a new revelation. But events of the past few months have brought this topic back into the spotlight.

    Belgian born American economist Robert Triffin first highlighted this incompatibility in the 1960s. He observed that having the US dollar perform the role of the world’s reserve currency created fundamental conflicts of interest between domestic and international economic objectives.

    On the one hand, the international economy needed dollars for liquidity purposes and to satisfy demand for reserve assets. But this forced, or at least made it easy, for the US to run consistently large current account deficits.

    Triffin argued that such persistent deficits would eventually put pressure on the US dollar and lead to the demise of the Bretton Woods system of international exchange.

    The Triffin Dilemma, therefore, argued that the demands on an international currency meant that excess supply would undermine its value.

    Bretton Woods

    After WWII the Bretton Woods international monetary system came into being. This was a fixed rate currency regime with the US dollar as the global reserve currency. But to ensure stability and financial discipline, the major currencies were fixed to the US dollar and the US dollar was fixed to gold at the rate of US$35 an ounce.

    This is where the Triffin Dilemma kicked in.

    The US soon understood that reserve currency status allowed them to run large deficits. The deficits were ‘paid’ for by issuing US dollars. When the excess US dollars began showing up in global central banks, they began converting their dollars into gold. This lowered the value of the US dollar in relation to gold.

    At first the authorities tried to manage the Dilemma. In 1961 they established the ‘London Gold Pool’ in an attempt to keep the US dollar price of gold to $35 an ounce. This system worked for a while but fell apart by 1968 when France withdrew from the Pool.

    The various nations then attempted to preserve the Bretton Woods system by maintaining a two-tiered gold market; one operating at the official US$35 an ounce price while another traded gold at the market price, which was well above $US35. Of course such a policy was completely unsustainable and it too failed.

    Bretton Woods was on its last legs. President Nixon ended the system once and for all when in August 1971 he suspended the convertibility of US dollars into gold. From that point on, the US dollar was without an anchor and the global monetary system went from a fixed to floating regime.

    What followed was a decade of monetary instability and record high inflation.

    US Dollar maintains reserve currency status

    Perhaps surprisingly, the US dollar maintained its role as the world’s reserve currency throughout the decade. Due to its economic and military might, the reserve currency status of the US dollar actually grew in acceptance throughout the next few decades.

    But Triffin’s Dilemma never went away. It did remain out of sight though as parties on both sides of the equation enjoyed the mutual benefits of the US dollar’s reserve status.

    The US benefitted by paying for imports with essentially costless US dollars. In turn, the US’ main trading partners enjoyed robust demand for their products, creating employment and income growth.

    The huge deficits brought about by excess US consumption produced a massive amount of liquidity throughout the global economy. While Triffin’s Dilemma would have predicted a collapse of the dollar because of the glut of dollars in the system, such an outcome didn’t eventuate.

    This was primarily because the beneficiaries of US consumption didn’t want it to end. So they reinvested their excess dollars back into US asset markets, notably US Government debt. Such actions supported the dollar, kept interest rates low, and perpetuated the imbalances.

    Some commentators called this apparent happy state of affairs ‘Bretton Woods II.’ As the saying goes, markets make opinions and this was a flawed opinion born out of an ignorance of what brought the first Bretton Woods system undone.

    Triffin Dilemma persists

    The underlying conflicts identified by the Triffin Dilemma always remained. The ease with which the US could borrow and create debt was tolerated for decades. No doubt such tolerance was due to gold no longer being a monetary anchor.

    But in 2007/08 it reached a point where it could no longer be tolerated. Not because investors decided to be prudent, but because the market structure could no longer cope with more debt.

    At this point, the end of the decades long US driven credit expansion turned abruptly into a contraction and asset markets collapsed. Amongst the carnage, the US dollar was about the only asset to increase in value relative to everything else. This was because previously abundant global liquidity rapidly evaporated and returned to the source, pushing up the value of the US dollar.

    The point here is that in times of crisis, the US dollar trades as the world’s reserve currency, not based on its domestic fundamentals, which are just as bad as other countries. That’s what you saw in late 2008 early 2009. And because of the European sovereign debt crisis, you’re again seeing the US dollar rise against most other paper currencies.

    So the Triffin Dilemma is beginning to rear its head again. The US domestic political preference is for a weaker dollar to stimulate exports and create employment. But the international situation, being market driven, is more powerful.

    The US dollar is therefore strengthening just as the US economic recovery loses momentum. Or perhaps the economic recovery is losing momentum because the dollar is strengthening?

    Check out the accompanying chart. It shows the performance of the US dollar against a basket of currencies. You can see how the dollar has traded as an international currency in the past few years. As described above, the large rises in 2008/09 occurred as liquidity evaporated.

    Performance of the US Dollar

    The weaker dollar throughout 2009 signified the recovery or ‘reflation’ of global markets. But that has given way to renewed concerns. The dollar has rallied in the past few months (especially against the euro) and now looks overbought.

    In the past the US response to this currency strength would have been to lower interest rates and turn on the liquidity taps. This would have increased credit growth domestically and liquidity internationally (think of all those US treasuries piling up in foreign central banks when US economic growth is strong). But the interest rate ammunition has been spent.

    Like every other country, the US needs a weaker currency. However a global reserve currency operates under different rules to ordinary currencies. In times of global uncertainly, like now, the US dollar will be strong regardless of its fundamentals.

    With the Euro-zone under pressure, the reserve asset of choice remains the US dollar. Perversely, this will allow the US authorities to pursue even more reckless policies in their attempts to provide global liquidity.

    We wouldn’t be surprised to see the Federal Reserve restart its quantitative easing program by the end of the year. And Federal Government deficits will likely remain elevated for years.

    Investment Implications

    As you can see, the inherent conflicts in the global monetary system that led to the GFC have not been addressed. The US dollar has served as the world’s reserve currency, without being linked to gold, since 1971.

    While on the surface the experiment has been a success, the legacy is a huge build up of debt. The need for global liquidity creates an incentive for the US to live beyond its means and run up debt levels. Perversely, the debts sit in the vaults of foreign central banks and masquerade as assets. (It is from this asset base that domestic banking systems generate their own credit growth).

    But debt levels have reached a point where this system no longer works properly. The crisis of 2008 has quickly given way to the European sovereign debt crisis of 2010. It is a sign of things to come.

    The implications for you as an investor are many. Expect continued uncertainly and volatility as the world increasingly recognises the current financial system has reached its use by date. This is a gradual and subtle process. You won’t see this recognition splashed across the front pages anytime soon. But it is happening now.

    Uncertainty leads to lower stock prices. Our disciplined valuation methodology is designed to ensure that won’t overpay when buying companies. In times of high volatility, we expect to see share prices trading well below intrinsic value and that’s when our prudent approach will pay off.

    In the shorter term you should expect continuing loose monetary policy out of the US and a lack of fiscal discipline. The demise of the euro is leading to renewed buying of the US dollar, providing more incentive for authorities to run deficits.

    Of course, the big picture investment implication here is that the US dollar will eventually lose its role as the world’s sole reserve currency. This is a multi year event and certainly difficult to assess in terms of the effect on markets.

    But as we told you last week, the IMF is already holding discussions about making changes to the financial architecture. Very few people understand the magnitude of what is going on, but it hasn’t been lost on the gold market.

    Gold will be one of the major beneficiaries of change. Back in the 1960s Robert Triffin warned about the dollar glut and the fact that it would bring the Bretton Woods system undone. He was right.

    The rising gold price was the first warning sign of the system’s weakness. Now, the gold price is again warning of monetary instability. It has been rising along with the US dollar. Gold is again being viewed as a reserve currency.

    So the best way to profit from this instability is to own physical bullion (not ETF’s or gold certificates). For a longer term bet on forthcoming changes to the financial system, you should be looking to buy gold on weakness.

    Greg Canavan
    for The Daily Reckoning Australia

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  • Gold and the Coming Short Squeeze

    Greg Canavan is the editor of Sound Money. Sound Investments, a weekly report on the best value investment ideas in the Australia share market, with a commentary on the global economy and economics. For a free four-week trial to Sound Money. Sound Investments, go here.

    A few weeks ago a momentous event occurred in the precious metals market. As we detailed in a report to paying subscribers, a London metals trader by the name of Andrew Maguire recently blew the whistle on gold and silver price manipulation orchestrated by JP Morgan.

    He provided exact details of the fraudulent trading to officials at the Commodity Futures and Trading Commission (CFTC) before and during the manipulation episodes. Unbelievably, the CFTC ignored these claims. Even further, they did not allow him to give evidence at the recently held CFTC hearings into position limits in the commodities markets.

    (The hearing was in part designed to investigate whether allowing market players to hold large positions would lead to price distortions or manipulations).

    So Mr Maguire went public and told his story to Gold Anti-Trust Action Committee (GATA) member Adrian Douglas. GATA have been claiming for years that the precious metals prices are manipulated in order to boost confidence in fiat currencies. Without the manipulation, gold prices would be much, much higher.

    There are many who dispute this claim. But to be honest their reasons are flimsy. It’s far easier to reject something out of hand than to be labelled a ‘conspiracy theorist’, as GATA and their supporters are. But if you take the time to actually think about the claims and study a bit of history, you’ll see that government manipulation of the gold price is nothing new.

    Let’s take just a few examples.

    Roosevelt’s Attempts to Manage Gold

    Soon after Franklin Roosevelt’s inauguration in 1933, he set about the highly controversial policy of ‘inflationism’. Funnily enough, the same policy is accepted wisdom today.

    His first step was to ‘temporarily’ – which actually meant permanently – end the export and hoarding of gold. The next step was to announce that the US was off the gold standard.

    The impetus for this was, as always, political. Roosevelt’s primary motivation was to appease the farmers, who were groaning under the size of their mortgage debt and were demanding higher prices for their product. His aim was therefore to raise the price level for commodities, agricultural commodities in particular.

    He became wedded to the theories of a Professor Warren from Cornell University. Warren believed that if the price of gold was increased, commodity prices would follow. Even the inflationist Keynes thought the theory was ‘rubbish’.

    But it didn’t stop Roosevelt. He arranged for the Reconstruction Finance Corporation (RFC) to purchase gold on the US Treasury’s behalf. Each day for weeks on end, the RFC would announce the price it was willing to pay for gold, a price that was always higher than the prevailing free-market price.

    Needless to say the plan did not work, commodity prices did not benefit but the policy was causing grief in other parts of the economy. And faith in the value of the US dollar was at rock bottom.

    Roosevelt convened a meeting to halt the experiment. With some of his advisers fearful of the effect of a weak dollar, Roosevelt said: ‘…if at any time the dollar should get too weak, the RFC could always reverse itself and sell some gold to the world markets’.*

    And a few days later, that’s just what they did. But it wasn’t long before the period known as the ‘gold standard on the booze’ came to an end. In January 1934, Roosevelt announced the return of the US to gold at the prevailing market rate of $35 an ounce. In nine months the US dollar had lost 40% of it value against gold.

    The London Gold Pool

    Fast forwarding a few decades and we come to the second example of blatant government manipulation of the gold price. It concerns the London Gold Pool, established in 1961 to maintain the price of gold at $US35 an ounce. The paragraphs below are taken straight from Wikipedia.

    ‘The London Gold Pool was the pooling of gold reserves by a group of eight central banks in the United States and seven European countries that agreed on 1 November 1961 to cooperate in maintaining the Bretton Woods system of fixed-rate convertible currencies and defending a gold price of US$35 per troy ounce by interventions in the London gold market.

    The central banks coordinated concerted methods of gold sales to balance spikes in the market price of gold as determined by the London morning gold fixing while buying gold on price weaknesses. The United States provided 50% of the required gold supply for sale. The price controls were successful for six years when the system became no longer workable because the world’s supply of gold was insufficient, runs on gold, the British pound, and the US dollar occurred, and France decided to withdraw from the pool. The pool collapsed in March 1968.’

    Once again, this method of controlling the price of gold to maintain faith in the value of paper currencies (or in Roosevelt’s case, to placate special interest groups) proved to be useless. A few years after the London Gold Pool collapsed, the US refused to exchange dollars for gold and the dollar price of gold went from US$35 and ounce of over US$800. It took a decade to get there but the gains, even if you participated in some of the move, were sensational.

    Today’s Gold Market

    A similar situation is unfolding today. Andrew Maguire’s revelations and subsequent testimony at the CFTC hearing, which basically conceded that 100 times more gold is traded than actually exists, will eventually produce a massive short squeeze in physical gold.

    A short squeeze means that players who are ‘short’, i.e. those that owe gold to someone else but don’t actually have any, will be forced to buy gold on the spot market to honour their contracts. Either that or default.

    We think there will at some point be a scramble for physical metal and the price will surge higher.

    This will happen because gold is like no other asset. The whole reason you own it is to avoid counterparty risk. Gold is a store of wealth and by owning physical gold you are not relying on the solvency of any other party.

    So while some might think that $100 of outstanding claims on gold versus $1 of actual gold availability is ok because that’s how other markets operate miss the point completely. They say the leverage inherent in the gold market is ok because if short sellers cannot deliver, ‘cash’ settlement is always available.

    But gold is the ultimate form of cash, and those owning physical gold do so because they want to diversify away from paper currencies. Why would they settle for a paper cash settlement?

    Up until now, hedge funds have been predominant in the gold futures market and they have been willing to settle for cash. They have simply been playing the theme that increasing monetary disorder will be good for gold. In other words they have participated in the gold bull market without actually owning bullion itself.

    But that might be about to change. Recent revelations have highlighted a weakness in the market structure. In financial markets, weaknesses eventually get exploited.

    We believe more and more large gold investors will begin to take delivery of their bullion to ensure that they actually possess what they own. The benefits of having ‘exposure’ to gold (via the futures markets or in unallocated accounts) without the costs of storage, insurance etc will soon be outweighed by the risk of not actually owning gold when its most needed.

    This move to take possession or have gold securely stored has already begun on a small scale but it will intensify. Physical gold will slowly diminish in circulation, producing the short squeeze discussed above.

    This process is known as Gresham’s Law, named after 16th century English financier Sir Thomas Gresham. Its basic premise is that bad money drives out good money. It’s happening right now and will continue to do so.

    Greg Canavan
    for The Daily Reckoning Australia

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  • Property and the Big Four Australian Banks

    There is an increasing amount of focus on the Australian residential property market. Last week, outgoing BHP Chairman Don Argus said: ‘I think the Australian Banking Sector has gone too far. You can look at some of them now as giant building societies.’ He was referring to the large exposure that the big four Australian banks have to residential property.

    Last Monday morning, RBA Governor Glen Stevens took the unprecedented step of appearing on Sunrise, the popular breakfast program to, among other things, warn people against speculating on house price appreciation. ‘I think it is a mistake to assume that a riskless, easy guaranteed way to prosperity is just to be leveraged up into property. It isn’t going to be that easy.’

    Stevens’ comments, and Argus’ for that matter, both reflect concern over the potential outcome of Australia’s multi-year infatuation with property. These two men join a long line of commentators who, over the past few years, have warned about the sustainability of rising house prices and their effect on the economy.

    Despite this, the market refuses to buckle. The warnings are roundly ignored. Now, just a year ‘after’ the global financial crisis, things are apparently back to normal and house prices are surging around the country again.

    But like the boy who cried wolf, the warning that you should have listened to will be ignored. This warning will more than likely turn out to be Stevens’, delivered on 29 March 2010. We shall see.

    Property bulls cite a number of reasons why the market has solid fundamentals behind it. Strong demand driven by population growth and lack of supply (caused by government meddling at the local and state level) are the main ones.

    What is mentioned less by the property bulls is the seemingly endless availability of credit supplied to the property market by the banks. As we have seen over the past few years, property price declines occurred in the US, UK, Ireland etc, because of a restriction of credit.

    Indeed, as credit was drying up in Australia in 2008, house prices were beginning to register falls across the board. But plummeting interest rates (which fell to 3%) and taxpayer guarantees for bank borrowing ensured that the supply of credit remained plentiful. To absorb that supply, the government handed out up to $21,000 to first homeowners.

    The policy was a resounding success. But success in economic matters depends on timeframes. A politicians’ timeframe is roughly to the next election. That is, the pollies are interested in short-term success. Unfortunately, a focus on short-term success can lead to long-term problems.

    Here is one of our favourite quotes on the matter:

    “Economics…is a science of recognising secondary consequences. It is also a science of seeing general consequences. It is the science of tracing the effects of some proposed or existing policy not only on some special interest in the short run, but on the general interest in the long run.”

    Henry Hazlitt – Economics in One Lesson

    So we await the long run secondary consequences of the government bailing out property owners (the special interest) in the short run. It should be interesting.

    With so much space being devoted to the pace of interest rate rises and their effect on property prices, we thought you should know how exposed the big four banks are to the housing market.

    We have gone through the big four’s balance sheets to come up with the data in the accompanying table. The National Australia Bank (ASX:NAB) is the largest bank by assets, followed by the Commonwealth Bank (CBA), Westpac (WBC) and ANZ (ANZ).

    As you can see, loans and advances are a banks’ largest asset. In the table below we focus on Australian domiciled loans. The other main asset components are listed in the table.

    We further break down the Australian Loans and Advances data to show Australian housing loans.

    The ratios produced from this data are interesting indeed.

    As shown in Australian lending as a % of total assets, WBC and CBA are most leveraged to the Australian economy with nearly 70% of their lending assets based in Australia. ANZ is next and NAB, with its large UK exposure, has less than 40% of lending assets in Australia.

    Housing as a % of Australian Lending shows all four banks have around 60% of their local lending books exposed to residential property. From a broader risk perspective, both CBA and WBC appear highly exposed to property, with 45% and 43% of their total assets respectively comprising Australian residential property. ANZ and NAB have a greater strategic focus on offshore markets and so are less exposed to the local property market.

    There are a number of reasons why the banks (especially CBA and WBC) have such large exposures to housing. According to the recently released Financial Stability Review conducted by the RBA, in the early 1990s business lending accounted for about 60% of total credit outstanding.

    The deep recession at the time saw banks suffer heavily as high interest rates pushed businesses to the wall. Ever since the banks have been increasing their exposure to housing at the expense of business.

    You shouldn’t be surprised though. The regulatory system makes it more profitable for banks to lend against housing than against a business.

    Here’s how it works.

    Regulators require banks to hold capital against their assets. This is the Tier 1 and Tier 2 capital ratio’s that banks mention when discussing their ‘capital adequacy’. However they don’t hold capital against their total assets. Rather, they are required to do so against their ‘risk weighted assets’.

    In determining the value of risk-weighted assets, the banks are only required to include 50% of the value of a residential mortgage loan. (This assumes a loan to value ratio of 80-90% and no mortgage insurance). In other cases the requirement is only 35%. For business loans, banks need to include 100% of the loan value in their risk-weighted asset calculation.

    So it’s far more capital efficient (and therefore profitable) for the banks to make housing rather than business loans. And surprise surprise, that’s what the banks have been doing.

    Housing loans only require around 50% of their value to be included in the risk-weighted asset calculation because they are considered a very low credit risk. And that has historically been the case. Funnily enough, this was also the claim to justify the huge amount of speculation in the US housing market a few years ago.

    As the great US economist Hyman Minsky was famous for saying, ‘stability breeds instability’. In effect the stability and ‘safeness’ of residential mortgages has led to this asset class being rewarded with a larger and larger amount of credit. This in turn has pushed up property prices, which has increased demand for property and credit.

    If the past is prologue, then Glen Stevens’ warning will be widely ignored. It is the availability of credit that has the largest bearing on asset price bubbles, not the words of the man who tries to put a price on that credit each month. Even returning interest rates to ‘normal’, which is around 5% may not be enough to halt the renewed speculation around housing. 5% interest rates are hardly likely to deter the banks from continuing to extend housing credit either. As we will see, that is what underwrites their profits.

    Our best guess is that an external credit shock will turn the tide for the property sector. We saw this in 2008 when foreigners were reluctant to continue lending to Australian banks to fund property purchases. We have little doubt that in a deleveraging global economy, another such episode will occur. (See the next essay for a discussion on Australia’s foreign debt and the role of banks).

    The bulls will retort that the government will step in again, guarantee debt and support asset prices. We have no doubt the government will meddle again. But financial markets rarely respond the same way twice and we doubt that property investors will get lucky the next time the flow of global credit dries up.

    But in the meantime, the banks are benefitting handsomely from the relentless rise of the property market. You can see from the expected profitability levels (see consensus ROE in the table) that CBA and WBC are the standouts. This is no doubt a reflection of their exposure to Australia and in particular the Australian mortgage market.

    Even ANZ and NAB’s latest results show their Australian operations as the standout performer. However their different strategies (ANZ: Asian expansion, NAB: wealth management focus, large UK exposure) sees the market expect lower profitability from them compared to CBA and WBC.

    So what does all this mean?

    Well, this analysis clearly shows why CBA and WBC have been the standout profiteers in the banking sector. With a large focus on the booming Australian housing market, it’s no wonder their profits and valuations (see price to book measures in the table) are at a premium to their peers.

    But it also suggests why you need to be cautious on the sector as a whole. At some point the abundant credit now enjoyed by the housing market will diminish. This will put pressure on prices and for the banks, loan volumes will decline, which will in turn lower profitability.

    Greg Canavan
    for The Daily Reckoning Australia

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  • Inflation or Deflation?

    The question of whether we are headed into an inflationary or deflationary environment is probably one of the most important, complex and difficult questions to answer right now. For investors, getting this call right or at least thinking about the potential possibilities is absolutely crucial.

    As Dan discussed last week, we too think inflation is a likely long term outcome but you should also be wary about the very real possibility of a nasty deflationary episode beforehand.

    In a deflation, cash is king and your investment strategy should be one of focussing on valuation and margin of safety. In an inflationary environment, valuation is still important but opportunities for the disciplined value investor will be much harder to come by, as speculation becomes the dominant theme.

    So where are we? Ahhh…if only it were that easy.

    Before we try to answer the question, we need to establish the framework for our thinking. To keep things simple, we’ll keep our focus on the US, which as manager of the world’s reserve currency is THE economy to focus on.

    Now, a definition – inflation or deflation refers to an expansion or contraction of money and credit. Some analysts have focused exclusively on the money supply or the monetary reserves injected into the banking system by the Fed and made the claim that this is inflationary.

    This is because in a fractional reserve banking system, the monetary reserves created by the central bank are lent out many times over by the banking system. This is how banks ‘create credit’.

    But an increase in money does not always lead to an increase in credit, which is what is happening now. So when attempting to answer the question of inflation or deflation you need to take into account money supply AND credit.

    The other point to note in this debate is that we’ll focus on the two areas that concern us as investors – inflation or deflation in asset prices and in consumer prices. Movements in money supply and credit impact on both, but to varying degrees.

    Firstly, let’s talk about asset prices.

    An historic credit expansion from 2001-2007, which was predominantly an expansion of private sector credit driven by the banks, resulted in sharply rising asset prices. Greenspan’s ultra low interest rate policy was the driving force here. Capital-intensive assets, namely property and also commodities, benefitted most from the credit expansion.

    But it was more than just that. As the credit expansion made its way through the economy it resulted in higher household incomes, company profits (and therefore share prices) and government tax receipts, giving the illusion of widespread prosperity.

    Then the credit expansion stopped, causing a collapse in the asset prices that most benefitted from the boom and a general fall in nearly all other asset prices.

    Because the underlying banking system that provided the credit was capitalised largely by residential and commercial property, the collapse morphed into a credit crisis. Banks were widely viewed as insolvent and under these conditions no one was willing to extend credit to anyone.

    Because the credit expansion was allowed to run unchecked for so long (and keep in mind the 2001-07 run-up was part of a much larger secular expansion of credit which had been running for decades) the bust was particularly nasty.

    Money supply and credit were contracting simultaneously as banks wrote off their assets and the household sector decided it did not need to take on any more debt. So from roughly late 2007 until early 2009 we experienced an acute deflationary asset price shock.

    But then the government and Fed stepped in to halt the deflation and credit contraction. The Fed expanded its balance sheet massively and the government ran an equally massive fiscal deficit. This stabilised the credit contraction.

    It is important to realise that the unprecedented intervention has not caused credit to begin expanding again. The monetary base has soared but an excess of debt and a dysfunctional banking system is not turning this into credit growth – and nor will it. Government and central bank actions have merely stabilised the massive deflationary force of a burst credit bubble.

    The recently released Fed Flow of Funds Report shows Total Credit Market Debt Outstanding at $52.4 trillion. It has declined marginally for the past three quarters and is pretty much flat year-on-year. Federal Government credit expansion has offset the small decline in Household Sector credit and large decline in Financial Sector credit.

    Yet this total credit market stabilisation has resulted in widespread asset price inflation.

    How can this be?

    Our best guess is that much of it has to do with sentiment, or ‘animal spirits’, as well suspension of the rules regarding marking bank assets to market. The second point is related to the first. (Co-ordinated global stimulus and unprecedented credit expansion in China are also no doubt playing a major role).

    As we mentioned banks’ asset bases are underpinned by property. Marking these assets to market would render the whole banking system insolvent, which is hugely deflationary. Obviously the authorities do not want this to happen so mark-to-market accounting has been suspended and the Fed has purchased $1 trillion worth of dud mortgage debt.

    The plan is for banks to trade their way back to solvency. But because the private sector doesn’t want to borrow, banks instead try to make their money from speculating in asset markets (proprietary trading) and lending to the government, thus earning easy money on the interest rate ‘spread’.

    This has given money managers and private investors the green light to head back into the market. As a result equity and corporate debt markets in particular have rebounded spectacularly over the past 12 months.

    But in order for asset inflation to persist from here, total credit outstanding must grow again. Federal stimulus is set to fall later this year and the Fed is due to end its quantitative easing program this month. The expectation is that the private sector will pick up the slack again but we doubt that will happen. As Japan proved following the bursting of its credit bubble in the late 1980s, deleveraging is a long term trend.

    So if the artificial support of the government and the Fed begins to diminish, we expect deflationary forces to re-assert themselves. The risk to this outlook is that the authorities actually have no intention of removing stimulus. We will soon find out.

    Should some form of exit strategy unfold, does this mean markets fall to new lows? While any decline could be significant, we do not think this is a likely scenario. Governments have proved they are always ready to ‘do something’ and any significant equity market fall would be met with more government credit creation.

    So by our reckoning, the next phase for asset markets will be deflationary. Your current investment strategy should therefore be focussed on fundamental value and in the absence of these opportunities – cash.

    But the automatic government response to such an environment will be to print and spend. As Ludwig Von Mises wrote in Human Action many years ago:

    All governments are firmly committed to the policy of low interest rates, credit expansion, and inflation. When the unavoidable aftermath of these short-term policies appears, they know only of one remedy – to go on inflationary ventures.

    You can guarantee the people who did not see it coming will blame the renewed deflationary forces on that fact that the prior stimulus was not big enough. They will advocate even larger spending programs. The next round of stimulus will be larger fiscal deficits and more money printing. Such a policy is inflationary, first in asset prices (as we have seen in the past 12 months) but ultimately it will manifest in consumer price inflation.

    How quickly this inflation comes about depends on a few things. If the wider public maintains faith in the purchasing power of the dollar, the increase in dollars will probably be matched by an increase in demand for dollars and dollar denominated assets. In this case inflation will take quite a few years to manifest because of the considerable unemployment and spare capacity in the economy.

    We reckon the global economy is in this position now. It explains why bond markets are rallying or at least holding up in the face of massive government bond issuance.

    But, if the public begin to question to value of the dollar then demand will decline (as the same time as its supply rises) and the demand for real assets or goods or whatever will take off. This is the ‘crack-up boom’ that Mises talked about, the exchange of paper money for goods at any price. The end result is the destruction of the monetary system.

    We think we are some years away from Mises’ end game. And if governments make some hard decisions in the years ahead, it can be avoided. But is there another Volcker out there to replace Bernanke? Let’s hope so.

    Bringing all this together, our best guess is we get deflation then inflation of asset prices, followed by a general rise in consumer price inflation, the severity of which depends on how quickly the populace loses faith in government fiat currency. We’ll be watching the bond market closely for clues here.

    So what should you do about it? The first thing to recognise is that macro events play out over a number of years. But you still need to be prepared. Because we are cautious about a renewed deflationary downturn we think you should focus strictly on quality companies with cheap fundamental valuations. In the absence of such opportunities (and there are not many) we like cash…and gold.

    If we are right in our thinking, the silver lining for investors holding decent cash balances is that there will be some very, very good opportunities down the track. We just have no idea when those opportunities will arise.

    And how do you take advantage of these opportunities? We advocate and practice good old-fashioned valuing investing. Forget trading, forget charting and forget other short-term schemes…these are simply methods designed to separate you – slowly – from your money.

    Over the decades, all great investors have proven that simply buying good quality companies well below intrinsic value (no matter what the macro environment) leads to healthy outperformance and increasing wealth. But it takes discipline, and that’s were we can help.

    Keep in mind the above analysis is simplistic in that it focuses on the US and ignores the major emerging economy of China, which is obviously hugely influential for the Australian economy. We’ll tackle that issue in a future report.

    But the US is still at the centre of the global economy. Like it or not, the manager of the world’s reserve currency has a huge influence on the economic fate of the rest of the world.

    Greg Canavan
    for The Daily Reckoning Australia

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  • Does Greece 2010 = Austria 1931?

    It is worth remembering that upheavals in Europe triggered the economic malaise that made the Great Depression ‘Great’. Although 1929 is etched into history as being synonymous with the Great Depression, the real tragedy did not get underway until 1931.

    The Austrian bank Boden-Kredit-Anstalt was rendered insolvent in the aftermath of the late 1920s credit boom. It was ‘saved’ in October 1929 by merging with the stronger Oesterreichische-Credit-Anstalt. An international syndicate headed by the Rothschild’s of Vienna, and including J.P Morgan and Company, injected new capital into the merged entity.

    The Austrian Government guaranteed the bad debts of the old bank and the merged entity spent 1930 ‘muddling through’. But then in May 1931, the Credit-Anstalt bank collapsed. Some blamed the political climate at the time, with the economic union between Germany and Austria (Zollverein) spooking France. Others simply stated that Austria had ‘consumed its capital’, with the result that a banking collapse was inevitable.

    Whatever the reason, the collapse of Credit-Anstalt triggered a run on German banks by French and US creditors, leading to the forced closure of the German banking system. London financiers were heavily exposed to German banks and industry, and were caught out by the banking sector shutdown, which effectively froze their assets.

    This in turn caused panic amongst London’s foreign creditors and a run on sterling, at the time the world’s (weakening) reserve currency, began. And so went the contagion that crippled the world economically and provided the impetus for Hitler’s rise and decades of economic and political turmoil.

    In the 1930’s, contagion went from the periphery to the core in very quick time. Austria folded in May 1931. By September of that year, Britain had gone off the gold exchange standard (a poor imitation of the classical gold standard) and devalued the pound sterling.

    The situation in the global economy today is eerily similar. Greece, a peripheral European economy, is close to defaulting on its debts. Any default would lead to contagion, as creditors pull funds from other highly indebted countries. The list of targets is well known; Spain, Portugal, Ireland, Italy…England.

    While the economic climate in Europe today has worrying parallels with the 1930s, importantly, there are huge political differences. In the 1930’s, France was the premier European power. Deeply scarred by WWI, the French were in no mood to ‘bail out’ Austria or Germany. And of course each country back then had their own sovereign currency, which increased the motivation to ‘bring funds home’.

    Today, Germany is the premier nation of the Eurozone. France is the second power and both are heavily motivated to keep the currency union together. The spirit of cooperation amongst European nations is far stronger than it was 80 years ago. But Germany, or anyone else for that matter, will not be bailing Greece out of its financial difficulty. To do so would irretrievably damage the euro project, not to mention the fact that such action would be legally and politically impossible.

    Very simply, a bailout, if feasible, would soothe the markets for a short period of time only. But then there would be an expectation that other struggling euro economies should receive assistance. Supporting the edges at the expense of the core is a strategy that, if followed, will lead to the long term demise of the euro.

    The best that Europe can do is buy more time for Greece to get its house in order. As things currently stand, that does not look like happening. The EU (European Union) has ordered Greece to cut its budget deficit from 12.7% to 3% of GDP in three years.

    As economic historian Niall Ferguson wrote in the Financial Times recently, that would be “one of the most excruciating fiscal squeezes in modern European history.”

    Generally, when a country builds up too much foreign debt, it devalues its currency. This is a type of default. Foreign creditors take a haircut because their debt, while nominally still the same, is denominated in a devalued currency.

    Being part of the Eurozone, Greece does not have the option to devalue. Granted, such a policy is not a panacea. Interest rates would skyrocket and asset prices plunge. The heavy lifting would be left to the export industry so the country could trade its way back to economic health.

    As harsh as this option sounds it would be easier to bear politically than the current EU austerity plan. It may not be long before calls for a return drachma grow louder.

    Why?

    Consider that Greece is being asked to effectively endure an extremely painful deflation. Only countries with very flexible labour markets and minimal government involvement can handle such an economic adjustment without social upheaval.

    But Greece’s economy is woefully inflexible. The government employs one in three workers and the black economy is huge, eroding the tax base. In other word’s around 33% of the economy is unproductive and feeds on the rest of the country’s productive capacity (and foreign credit, we might add).

    And the unions are very vocal and very strong. With this many people, supported by economically illiterate unions, sheltered from the real world, we think it extremely unlikely that Greece will be able to cut its deficit as quickly as the EU expects.

    If we return to the 1930s, we can see parallels with England abandoning gold at the time. The currency, the pound sterling, was overvalued, rendering England’s major export industries uncompetitive. Unions were heavily represented in these industries and refused a proposal to cut wages. Unemployment was high and the structure of the whole economy was inefficient.

    England had two choices – austerity or devaluation. She chose devaluation because the politics of austerity were too hard.

    Perhaps they might be for Greece as well.

    Should Greece return to the drachma, there is a risk that others might follow and bring the euro experiment undone. This would also usher in another sharp global slowdown as European banks would be pushed towards insolvency by the associated writedowns on sovereign debt.

    There is a chance that even if Greece left the Eurozone the other nations (Spain, Portugal etc) would aim for fiscal discipline and stick with the euro. After all, the long term benefits are enormous – lower borrowing costs for both the public and private sector. In such an outcome, the euro could actually benefit as member states vote implicitly for sound economic policy.

    Or as Otmar Issing, former member of the European Central Bank, wrote in the Financial Times this week “This is a big chance – probably the last for Greece, and others – to adapt fully to a regime of stable money and solid public finances”.

    The EU’s monetary leaders are advocates of sound money practices. If they can convince the peripheral European countries of the benefits of pursuing such polices, the euro may well have a strong future. But the road ahead looks very difficult indeed.

    What does this mean for investment markets?

    Suffice to say, any news of default, a collapse of a Greek bank, or statements around a return to the drachma would have adverse consequences indeed. The global economy is in the middle of a historic reflation attempt. This is built on liquidity and confidence.

    Bad news from Greece would damage confidence, which would in turn impact liquidity and all risk assets. European and British banks would again come under pressure and with government finances stretched from the 2008/09 bailouts, the outcome could be very different to the last episode of risk aversion. In what ways we do not know.

    Markets today are ‘concerned’ about Greece and the possibility of contagion. However, we feel there is an underlying attitude that things will work out without too much drama. We certainly hope this is the case.

    But hope is not an investment strategy and we continue to see a poor risk/reward outcome with the market at these levels. We would prefer to be taking money out of the market at the moment rather than putting it in.

    Absent any major new development, Greece will soon suffer from headline fatigue and move off the front pages of the business news. Does this mean ‘crisis averted’? No.

    As we have pointed out above, there are no easy solutions. The best we can hope for is that the EU gives Greece more time to get its fiscal house in order. Something will need to happen soon to reassure markets. Greece needs to refinance €30 billion by June.

    An interesting few months awaits us.

    Greg Canavan
    for The Daily Reckoning Australia

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  • How Mr Market Influences a Stock Price

    A company’s stock price is determined by two factors – earnings and emotion. The earnings part of the equation is what investors should focus on. Earnings (relative to invested capital) drive a company’s intrinsic value.

    For most companies, changes in earnings and intrinsic value occur very slowly – much more slowly than suggested by the daily fluctuations of stock prices.

    Investor emotion accounts for these fluctuations. Many years ago, Benjamin Graham characterised this emotion as ‘Mr Market’. Sometimes Mr Market was very happy and positive about the future and was willing to pay handsomely to buy shares. At other times, Mr Market thought the sky was falling in and wanted to give those same shares away at bargain prices.

    Mr Market’s whims can have a far more important effect on a company’s share price than its actual earnings. So it pays to be aware when Mr Market is strutting around town offering high prices for shares, or when he is panicking about a company’s future prospects. Our aim is to take advantage of his moods.

    This is how Mr Market works. Say a company is trading on a price-to-earnings (PE) multiple of 10 times (which is the same as a 10% earnings yield). Let’s also assume that the share price is $10 and that this represents intrinsic value. In a rare example, investors have priced this company rationally.

    Then, the central bank decides the economy needs a boost, so they cut interest rates and unleash a flood of money into the financial system. Due to past indiscretions, the banking system is not too healthy and the real economy’s appetite for more debt is not so great. So instead of making new loans with the freshly created central bank money, the funds flow into asset markets. Stock markets are a prime beneficiary.

    Not realising (or ignoring) the fact that the new funds are policy induced, and not the result of sustainable economic recovery, Mr Market gets all excited and starts bidding up the price of shares. In a period of 12 months, our company goes from a PE multiple of 10 to 20 times, pushing the earnings yield down to 5%. Because the economy is stagnant, earnings do not rise. But Mr Market thinks they will eventually so his optimism has caused a doubling in the share price, to $20.

    The following year sees a little less government and central bank stimulus because of a slightly improving economy. Our company manages to produce a healthy 20% rise in earnings. For the sake of simplicity, lets say that the earnings increase has also produced a 20% rise in intrinsic value to $12.

    Unfortunately, the earnings increase is a little less than Mr Market was expecting. Suddenly, he begins to doubt his judgement. “What if things go wrong? What if fiscal and monetary stimulus really does nothing more than create the illusion of prosperity? The news out of China is not good – their economy is slowing more than I thought it would. What am I doing in stocks, get me outta here. Who wants to buy some shares?!”

    Mr Market is beginning to lose it. He is no longer prepared to put a premium on stock prices. Instead, over the course of 12 months, the earnings multiple on our company shrinks to 8 times (a 12.5% earnings yield). The share price plummets from $20 to $9.60, well below intrinsic value.

    In this hypothetical example, our company’s stock price has fluctuated wildly despite earnings increasing by 20%. This actually happened to many quality Australian companies during 2008/09. Earnings for the 2009 financial year showed modest increases on 2008 numbers, but the influence of Mr Market suggested anything but.

    Making fun of Mr Market’s apparent stupidity is easy in hindsight. But as investors, we are Mr Market too. Taking advantage of his mood swings can be incredibly difficult because the same emotions that are flowing through the market are the ones you are experiencing.

    So it’s best to treat Mr Market with respect, not contempt. Understand his influence without coming under his spell and you will a much better investor. You will learn to ignore the day to day noise and will not be pushed into making a stupid decision based on what everyone else is doing.

    Here’s another way to think about how emotion can help or hinder you. When the outlook was good, Mr Market priced stocks at 20 times earnings. Buying stocks at these levels is the same way as saying you are happy to accept a 5% earnings yield. No one in their right mind would accept a 5% return on a risky asset like equities, so the 5% now comes with the expectation of a higher yield later. Strong future earnings growth (the reason for the optimism in the first place) is meant to take care of that.

    But it rarely does, which is why paying too much for a stock almost never pays off. This is why we set our discount rate (another way of saying earnings yield) at a base rate of 12%. Discounting a company’s expected earnings by 12% ensures there is a reasonable risk/reward trade off. Knowing the value of a company based on a sensible discount rate helps to take the effect of emotion – the fear and greed we experience daily – out of our hands.

    This is an especially important consideration as 2010 gets underway. There is a lot of cheerleading in the financial services industry about how governments or central banks won’t let deflation happen or won’t let economies fall into recession.

    We would caution that artificial tinkering with the market only influences the short term. Long term healing and sustained economic growth can only be generated by the private sector – by profit maximising individuals. Greater government involvement in an economy will lower long term productivity. Mr Market will come to this conclusion slowly, and the price he is willing to pay for companies will decline. So make sure you’re not paying too high a price now.

    Greg Canavan
    for The Daily Reckoning Australia

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