Weathering the Storm — July 24, 2008
Patience is key for investors who want to protect their assets in the current markets, in which we are seeing logic and emotion clashing continuously: progress is two steps forward, one step back. This week we are finally getting a much needed reprieve on commodity prices. We must remember that a year ago oil was at $65 a barrel, gold was at $650 an ounce, and the US Banking Index was $115. Today oil is at $131 a barrel, gold is at $956 an ounce, and the US Banking index is at $61. Shockingly, Wall Street pundits are still in disbelief over the increase in the prices of real assets (e.g. gold, food), and see the decline of the banking sector as a buying opportunity that could not possibly go any lower. Given all this mixed messaging and other confusions, it's time to review the big picture so that we can assess our investment stance for the remainder of the year.
TWO INFLATIONARY STORMS
In a nutshell, the big picture still consists of the two brewing inflationary storms: the global banking mess and the lack of supply of resources needed to satisfy the quality of life for the world's 6.5 billion people.
CURING THE SUB-PRIME MESS: FIRST INFLATIONARY STORM
For several years I have been tracking the inflationary effects of correcting the banking mess. The low level of interest rates during this decade meant that in order to increase earnings bankers needed to seek other areas of business. To everyone's chagrin they chose to increase earnings by extending credit to many people that could not afford such levels of indebtedness, and to repackage these worthless mortgages and sell them throughout the global economy for ridiculous fees. These fees fueled banking earnings and the stock prices followed, however the excesses of debt that resulted have, and will, generate much inflation in years to come as the Central Banks flood the system with money to keep the banking system alive. According to the latest figures from the International Monetary Fund, current global money creation is tracking 16% a year among emerging countries and 6% among developed ones. Last time I checked inflation was still the result of an increase in the levels of money in the system, resulting in the increase in the price of real assets.
This inflationary trend will continue to fuel itself as the G7 Central Banks inflate to bailout their banking sectors, and the remaining Central Banks inflate to deal with the inflationary effects of the cure for the banking sector. From history we have learned that the beginning of the end of this inflationary storm will come when interest rates are finally allowed to rise, and this seems unlikely anytime soon. Two years ago these warnings were only being raised by analyst like Don Coxe who recognized that the US's home-equity-ATM could not continue forever, and that the US consumers' ability to assume greater amounts of debt was limited. A year ago the Bank of International Settlement (BIS)—the "Bank of the Central Banks"—warned that the global debt situation had reached unprecedented levels and something had to give. In June of this year the BIS warned that government intervention in the banking system would only makes things worse;
Should governments feel it necessary to take direct action to alleviate debt burdens, it is crucial that they understand one thing beforehand. If asset prices are unrealistically high, they must fall. If savings rates are unrealistically low, they must rise. If debt cannot be serviced, they must be written off. To deny this through the use of gimmicks and palliatives will only make things worse in the end[.]
In other words, the "Bank of the Central Banks" is warning members that the current policy will only postpone and worsen the inevitable pain. These warnings are falling on deaf ears in the US, as the US government is doing whatever it can to postpone the inevitable (and so has transferred the current liabilities of the banking sector to future generations of tax payers). The world is taking note of these changes. Last week the US Dollar and the long US bond index (TLT) fell in price, signaling increasing global concern with the situation in the US. It is becoming clear that the US has chosen to inflate in order to postpone the inevitable, making it very inflationary for the world and forcing the US Dollar to decline further.
The only rational conclusion for investors to make about the current policy of the G7 Central Banks is that the US dollar will go lower, inflation will increase, and gold will appreciate until rates are finally allowed to increase.
OPPORTUNITIES: GOLD
It is important to understand why the value of gold rises during times of financial uncertainty. Gold is the only financial asset that is nobody's liability, as such it offers insurance against inflating currencies since it cannot be duplicated (i.e. reprinted or reproduced when needed) . Throughout history, going back to Ancient Egypt, Ancient Rome, the Byzantine Empire , the Middle Ages, and forward, gold has always retained its value during times of financial turmoil. I do not understand why Wall Street pundits are fighting years of history and insist that it is different this time. As a result of this financial mess all rational investors should consider gold for a percentage of their portfolios. Furthermore, I would also suggest greater consideration of the producers of gold, as their stock prices have not yet appreciated in relation to the price of gold—an imbalance that should correct itself as global investors wake up to the earnings potential of these companies. Even PIMCO, the world's largest pension manager, announced in their June 2008 Investment Outlook that they are lowering their exposure to the US and are considering greater investments in the economies of real asset producing countries because they recognize that the inflationary picture will only get worse. And this mess will only worsen the other inflationary storm that is currently starting to affect the global economy: the lack of supply of resources to maintain our consumer based economies.
SCARCITY: THE OTHER INFLATIONARY STORM
It is imperative to recognize that we have built a global economic system that is based on consumption. The winners of this model under normal circumstances of unending supply of materials for production are those that control the manufacturing and sales cycles. However, if this model is submitted to limited supply of things the gains will transfer from those that manufacture and sell to those that control the resources. This is exactly what is happening as our ability to maintain the consumption of 6.5 billion people is being restrained by our ability to produce the resources to fuel this consumption. There is no bubble in the levels of real assets globally, as their supply has been constantly declining during this decade. Not only is the price of goods increasing due to the decline of the US Dollar (since this is the currency we trade in globally) but also because of the low level of inventories. This is the real crisis facing the global economy in years to come.
OPPORTUNITIES: ENERGY
Oil production and demand are currently in balance at 86 million barrels per day. Going forward, the situation will worsen as we have not been finding enough new reserves to offset the new demand and decline of current reserves. Saudi Arabia , for example, has committed to increasing production by 1.3 million barrels per day over the next three years. This is great news but it has not affected the price of the commodity because it does not address the fact that by the time these fields come online it will barely replace the current depreciation of their already producing fields. According to the International Energy Agency (IEA), 54 out of 64 of the world's major oil fields are in decline. In its April 2008 report the IEA warned that the world could run out faster than expected, and that we currently face a supply demand imbalance crisis by the year 2015. Let's not forget that the IEA was established after the 70's oil crisis with a mandate to review the global energy situation and warn the world of any problems we might face in that area.
Politicians keep looking for a scapegoat and currently blame speculators for the price of energy. Once again, the rational investor should seriously consider the energy complex as these companies' stock prices have not yet increased in relation to the price of a commodity that will continue to appreciate. The earnings potential of this sector will continue as this is not a problem that will be solved by traditional means.
Canada stands to benefit greatly as we hold the largest politically risk-free oil reserves in the world. It is important to note that the SEC recently changed the ruling to include the tar sands as reserves held by oil producers for listing in the US . This change allows US companies to acquire Canadian oil companies and have those assets considered as reserves.
OPPORTUNITIES: AGRICULTURE
Tied to the energy situation is the global problem of food shortages. Not many recognize the connection between oil, food, and the value of the US dollar. Food production is very dependant on oil, for our ability to grow food is dependant on the production of carbon based fertilizers. The Green Revolution was possible only because of the discovery of oil.
Today, the growth of global populations and middle class incomes have greatly increased demand for food. According to the US Agriculture Department the world has only a month and a half of grain supply, yet we choose to divert our current corn production to ethanol in order to keep prices down at the pump. So far this year the World Bank has warned that 33 nations are at risk of food shortages. The United Nations Food and Agriculture Organization warns that the world cereal stocks will be at their lowest since 1982. Is it any wonder that in order to cope, many poorer countries have decided to stop the sale of their only real asset: food. This problem is further exacerbated by the fact that these poorer nations sell their food using the declining US dollar (the currency of most global trade), thereby further reducing their ability to deal with the inflationary storm. As the citizens of these countries demand action from their governments, the solution is sure to be inflationary reprinting of their respective currencies so it makes it worthwhile to exchange rice and other valuable real assets for US dollars.
In light of these facts the rational investor will be well served by considering companies that deal with the production of natural fertilizers and food, as their earnings should continue for some time.
WHAT'S NEXT?
Where do we go from here? Currently there is a lot of money sitting on the sidelines waiting to be invested. According to the IMF the world has $7.6 trillion in foreign currency reserves. With $2 trillion, China (including Taiwan) is the largest holder, followed by Japan with $996 billion, then Russia with $568 billion, and India with $310 billion. Sadly the US accounts for only under 1% of this sum with $75 billion in reserves. (With all this money only the Arab states have come to the rescue of the US banking sector—I wonder to what extent this is more tied to internal security concerns). On the other hand, the balance of this wealth is being used to hedge against the US and global inflationary storm, either by subsidizing energy and food, or acquiring companies that control real assets. This trend will continue as the foreign currency wealth of the nations listed earlier seeks to position itself in a way to participate at the receiving end of the transfer of wealth that is just starting to occur.
PORTFOLIO REALIGNMENT
Since moving to Blackmont Capital, I have recommended to my clients that they realign their portfolios to gain from the various growth opportunities that exist and are developing. A note of caution, there will be volatility over the coming years as we all enter into the two global inflationary storms I have discussed. It is important to understand that until we solve the banking mess and find solutions for the lack of resources, the price of real assets will continue to increase.
If you have any questions, please do not hesitate to contact me.
Jaime E. Carrasco, BA, CFP
Investment Advisor
T: 416-864-3623
C: 416-271-6630
E: jcarrasco@blackmont.com
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