Gold: Rich Country, Poor Country
John IngObituary writers are already preparing the death notices for commodities. Once a beneficiary of hot money, commodities began the New Year by crashing. Oil dropped more than 11 percent. Base metals also collapsed, with copper breaking $3 a pound on the doubling of LME inventories. Like Nelson Bunker Hunt more than a quarter of a century ago, hedge and commodity players attempted to corner the physical markets. Linked by computer screens, traders bought up supplies using complex derivatives to drive up prices. Non-industry players controlled large supplies, from natural gas to uranium to nickel. The spectacular failures of hedge funds Amaranth and Red Kite may be only the tip of the iceberg. Then, trigger-happy hedge funds headed for the exits en masse on fears of an economic slowdown. But we believe that fears of a slowdown are overblown. Asia, the new paradigm, remains strong and, with a large part of the world's $4.5-trillion of savings, is well financed for the largest infrastructure spending spree in the world. The commodity super cycle not only is intact but will last for several years. And no one yet has written an obituary for liquidity.
The US dollar plunged sharply in the fourth quarter but has since rebounded in a bear market rally. We believe that bounce is temporary and the greenback will soon take out the previous record low. The trouble is that such a drop will disrupt capital flows, push up US inflation and take out the underpinnings of the stock market boom. Last year, gold gained 23 percent while the dollar fell 10 percent against the euro. America's huge $1-trillion current account deficit continues to grow at seven percent of GDP. At that level, the US requires $2.5 billion a day in foreign borrowings to finance its indebtedness and thus has pursued a policy of currency debasement. However, those borrowings have caused a huge glut of liquidity in the global markets.
Printing Presses Are Working Overtime
Central banks have played a major part in flooding the system with money. Because the US consumes more than it produces and owes more than it owns, the Federal Reserve has flooded the world with dollars. President Bush proposes spending a whopping three quarter of a trillion dollars this year in his $2.9-trillion budget. The world's biggest debtor created greater quantities of dollars to finance its massive savings shortfall. As a result, the more thrifty Asians have dollars piled sky-high and the oil producers in the Middle East have even greater piles of petrodollars. The world's insatiable demand for energy has given the Middle East, Turkmenistan and Russia a new strategic importance and a new route for global influence. Asia, OPEC and Russia have in essence provided the United States with an annual multibillion-dollar subsidy to finance America's living standards. Despite its riches, America's personal savings rate is now a negative one percent, the lowest since the Great Depression.
America's indebtedness is due to its addiction to cheap money and cheap oil and the desire to subsidize its consumption with offshore debt. That is ending. According to Treasury Department data, OPEC nations in the latest quarter dumped $10.1 billion of treasuries or 9.4 percent of what they held. Only Japan, China and the United Kingdom own more treasuries than OPEC but China, too, pared its purchases by 1.7 percent in the same quarter. Thus, the huge dollar overhang is ripe for a correction.
According to the Bank of International Settlements (BIS), central bank holdings of US dollars have fallen almost 16 percent of 59 percent of the deposits held as of the first quarter of 2006. Since then, the US dollar has fallen further, suggesting that central bankers have had enough dollars. Oil-producing nations, such as Russia and the OPEC countries, have diversified their revenues into euros, yen and sterling, according to data from BIS. The latest BIS review shows that the oil producers unloaded $10.4 billion of US treasuries at the fastest pace in more than three years, while at the same time boosting their holdings of euros to 22 percent from 20 percent. The last time oil-exporting countries reduced their exposure to the dollar - in 2003 - it pushed the euro to a record. And for the second year in a row, the euro has displaced the greenback as the world's top currency in international bond markets. According to the International Bond Association, outstanding euro-debt was $4.836 billion, compared with $3.892 billion for the greenback. Today, the value of euro-notes, at $828 billion, exceeds the almighty dollar value at $753 billion. After the displacement of the greenback in the bond market, are the currency markets next?
The US twin deficits - federal budget and trade - keep rising, with gross government liabilities as a share of GDP at 65 percent. The UK has just repaid the United States and Canada for its last installment for the Second World War, which cost $600 billion. The Vietnam War, which ended in 1975, was America's longest, killing 58,000 Americans and costing more than $660 billion in today's dollars. The Iraq war, while shorter, is already in the midst of a third request by the Bush administration for another $100 billion. Since 2001, Congress has spent more than $500 billion on appropriations for Iraq and Afghanistan. The price-tag of the Iraq and Afghanistan conflict is not even included in the budget presented by Mr. Bush, who has been caught in a sectarian vise. That price-tag is also rising. Unfortunately, with the increased escalation of violence, there is no end in sight. Combined with the conflict in Afghanistan, America's involvement is growing at $10 billion a month.
In the 1960s, President Lyndon Johnson was blamed for triggering inflation by spending on both "guns and butter" to pay for his "Great Society" initatives while at the same time fighting the war in Vietnam. He failed. Rampant inflation ensued and gold subsequently hit $850 an ounce amid the legacy of red ink from the war. History is repeating itself. The parallel with the '60s is that Mr. Bush is pursuing the same "guns and butter" policy, refusing to raise taxes and borrowing more. America is living on borrowed money, energy and time.
Savings-short Americans have absorbed about 75 percent of the excess savings of the rest of the world. The United States appears to be dropping money from helicopters, as once suggested not entirely tongue-in-cheek by Federal Reserve chairman Ben Bernanke. Money supply is an indicator of future inflation. The Godfather of Money, Milton Friedman, died last Thanksgiving. However, his market legacy continues as the inevitable result of central bank profligacy is borne out in higher rates of inflation. For those who think differently, they only need look at Zimbabwe, where the current inflation rate is 1,500 percent, in line with a similar growth in money supply.
And central banks today continue to expand the supply of money. Consider the growth in money supply elsewhere. For example, broadly based money supply stands at 9.7 percent in Europe, 13 percent in the UK, 17 percent in China, 19.5 percent in India, 13 percent in Mexico, 10 percent in the United States, 8.4 percent in Canada and 9.5 percent in - a three-year high. Although the world's central banks' rhetoric had been about tightening, the proof in the pudding is that global liquidity remains overly expansive. Unfortunately, a large part of the money flow is ending up in the wrong places.
The spike in energy prices resulted in Middle East current account surpluses twice as big as the peak of the '70s. The cumulative surpluses of oil exporters could amount to $1.7-trillion in 2007, eclipsing China's surplus of some $700 billion, according to the IMF. The economic boom in the Gulf has also caused a surge in financial liquidity greater than the oil bonanzas of the '70s and '80s. Unlike the Chinese, who now hold about two-thirds of their surplus in US treasuries, the Gulf oil producers have shifted funds from dollars to euros, gold and yen. The surpluses have been recycled internally and undoubtedly have sloshed over into their capital markets. Having been burnt in the '70s, Middle East players have not acquired American trophy real estate or paintings, but instead have been big backers of European capital markets, financing the huge increase in hedge funds, private equity and stock markets.
Not only has the spike in oil prices helped the oil-rich Middle East, it has created a new axis of wannabe superpowers such as Russia, Iran and Venezuela that can thumb their noses at the West without financial retribution. Newly assertive Russia has hinted at a natural gas OPEC, wielding its petropower in order to consolidate its energy interests. Venezuela has used its petropower to consolidate its influence in Latin America. The oil producers are also reviewing whether to leave the dollar peg in place in light of the falling US dollar, which increases the cost of their imports. In true globalization fashion, America's addiction to cheap oil is actually transferring wealth from the richest nations to the poor. The question to ponder now is whether the United States is a rich country or a poor one?
And What About Asia?
Asia now contributes about 35-40 percent of the world's GDP, America's profligate spending contributing to a swing in wealth from the West to the East. Indeed, the combined financial reserves of China and Japan now underpin the deficits of the West. China's imports exceed that of the US, so America's huffing and puffing about revaluing the renminbi has little impact. China's GDP has grown at 10 percent plus annually for the past 20 years, with industrial production growing at 10 percent and foreign reserves reaching $1-trillion. More amazing, China's savings rate exceeds that of its huge investment hoard. This surplus is a big headache, exposing the central bank to big losses if the dollar collapses. As such, newly rich China has shifted some of its cash hoard, trimming purchases of US government debt by 1.7 percent in the first 10 months of 2006 to $346.5 billion. While Beijing and Washington appear set on a collision course over the renminbi, China has even fewer reasons to bankroll the world's richest economy.
America's xenophobic fear of a rising China threatens America's future as the sole superpower. But whether Americans like it or not, their countries' economies have become interdependent and their politics are oriented around the goal of energy security. Treasury Secretary Paulson led the largest ever US government delegation to China, awakening new xenophobic concerns in Congress. Chinese Vice-Premier Wu Yi admonished the Americans for "misunderstanding" China and reminded Fed chairman Bernanke of 5,000 years of Chinese history. China requires an economy strong enough to create 300 million new jobs, equal to the population of the United States. The history lesson was lost on Mr. Bernanke, who adopted the hard-line position echoed by a protectionist Congress. Of course, Mr. Bernanke overlooked the important fact that China's recycling of its surplus keeps US interest rates low, as well as providing the necessary liquidity to keep the American financial system afloat.
The prospect of a collision with Washington makes Beijing unlikely to keep all its eggs in the dollar basket. In a speech that rocked the foreign exchange markets, Prime Minister Wen Jiaboa stated that China's policy is changing, with the country actively exploring new ways to open and expand the channels and methods for using its foreign exchange reserves, which are held mainly in American debt. First, China is to establish the State Foreign Exchange Investment Company - similar to Singapore's huge Government Investment Corporation, which has made investments in equities, fixed income, real estate, etc. The Ministry of Finance then hinted about a policy switch on foreign exchange to diversify its holdings. Such a move to diversify its stash of dollars would send the dollar sharply lower and the gold price significantly higher. The last currency crisis was in the fall of 1987, when the October stock market crash began with the collapse of the US dollar - déjà vu?
A Golden Renminbi
China has already diversified its holdings by buying euros, oil, and yen. Chinese gold consumption is expected to reach 350 tonnes this year - up from 300 tonnes last year - due to strong jewelry demand. India remains the largest consumer of gold followed by China, which is the world's fourth largest gold producer. Chinese production is not keeping pace even though it could reach 240 tonnes this year, up from 224 tonnes in 2006. The supply comes from more than 1,200 mines, but about 60 percent are "mom and pop" operations with daily ore capacity of only 50 tonnes. China is believed to have put in legislation to streamline the permitting of mines and pave the way for more consolidations.
We expect China to eventually build its gold holdings to about five percent, buying domestic gold as well as gold on the open market. China now has less than two percent of their foreign exchange reserves in gold - or 600 tonnes. A five percent holding would require China to purchase 1,857 tonnes, or almost all their production for the next seven years. The State Information Centre, a think- tank of China's central planner, the National Development and Reform Commission, proposed the accumulation of reserves by giving its people further access to foreign exchange as well as the building up strategic reserves of crude oil, metals and other strategic commodities. Vice-Premier Zeng Peiyan also said that China will use its massive foreign exchange reserves to purchase "strategic resources". And as if on cue, Larry Yung, head of China's biggest investment company, has acquired a two-percent stake in Anglo-American from the Oppenheimer dynasty for $800-million. Larry Yung apparently made a personal investment and is likely the second-biggest single non-institutional holder after the Oppenheimers. So the question is whether China is a rich country or a poor one?
So Much Money, Too Few Stocks
The glut in global liquidity has been further boosted by the explosion in mergers and acquisitions. Deals are growing bigger, more expensive and riskier. And they are in danger of suffering from the curse of overvaluations and excessive leverage, two classic symptoms of another bubble. Fewer company defaults, frenzied "club deals" and a stock market bubble have played a major role in pumping up equity prices, with record amounts pouring into the private-equity asset class.
Private-equity investors typically make money by buying control of companies in the hopes of quickly cashing out through a stock offering or outright sale. Private-equity funds were able to emulate Canada's income trusts by loading up their targets with debt and stripping the cash to pay investors and debt holders, which are often the same-private equity players. In many cases, companies devote more than half their yearly cash flow just to meet the interest payments on the new debt. To the private equity world, debt-to-cash flow ratios are often ignored. However, as more and more companies are being pushed to pile on increasingly heavier loads of debt, the risk of default increases. For example, HCA, the hospital operator, was recently taken private and now has debt of $28 billion or 6.5 times current cash flow. In one 24-hour period, there were more than $75 billion of deals, ranging from mining to commercial property to stock exchanges. Freeport McMoRan's mammoth $26 billion takeover deal for Phelps Dodge will create the world's largest publicly traded copper company, but with more than $15 billion of debt.
The Next Bubble to Burst
In our view, credit is too easily available and another bubble is in the making. According to DealLogic, the value of M&A deals was 16 percent higher last year than at the height of the dot-com boom in 2000. In the United States, the debt-fuelled M&A boom has been supported by the creation of derivatives that has replaced simple bank financing. In a sign of how important derivatives have become, Wall Street's biggest securities firms are playing a lead role, which is the main reason for their record profits and the multi-million-dollar bonuses paid out. Once exotic instruments, derivatives are today very much mainstream and the "enabling" tool for hedge funds and private equity. Those exotic derivative instruments transfer risk to somebody else. The risk hasn't disappeared but, as in the shuffling of a deck of cards, just distributed to someone else. The origins began with the classic mortgage business whereby local banks transferred that risk to Wall Street, which in turn passed it on to its clients. Has anyone noticed that America's mortgage behemoths, Fannie Mae and Freddie Mac, haven't yet released their financials and the last restatement was in the face of billions in losses? While there are always two sides to a transaction, derivatives inevitably face a future of failure or big default due to someone mispricing risk. HSBC, the world's third-largest bank, just took a big hit due to its exposure to mortgages. Prices are going up but future returns are going down.
Furthermore, in the United States, almost 16 percent of all bonds are rated triple C or below, which is reserved for junk status. While the amount of junk bonds issued has increased, derivative financial instruments have mushroomed at a faster pace and become a key part of the changing structure of the debt market. Indeed, mortgages packaged in bonds or collateralized debt obligations have joined the growing list of derivative products. I-bankers would have you believe this explosion is attributable to the sophistication of the financial world. However, low interest rates and investors' insatiable appetite for alpha returns are behind this orgy of lending. Of concern is that despite the ratcheting of interest rates, more and more of the derivative products are created with more and more leverage. But investors appear to have overlooked the fact that rising leverage levels and shrinking risk premiums stretch the financial system. These instruments have yet to be stress-tested by an uptick in interest rates, a geopolitical event or a sharp US economic slowdown. Despite the obvious risk of default, the underlying message is that hard assets are more valuable than financial assets.
At the recent forum in Davos, Switzerland, Zhu Min, a Bank of China executive, warned that the explosive growth in derivatives to $370-trillion has flooded the global system, making it too easy to acquire credit. "There is money everywhere," he warned. "You can get liquidity from the market every second for anything. Derivatives are eight times world GDP and much of the money is flowing to Asia, where people have no idea what risks they are taking." Plain English, but is anybody listening? Gold is a good thing to have.
Gold at $1,000 an Ounce
We expect gold to surpass its May peak at $731, when hedge funds and commodities funds steam-rolled into commodities. In our view, gold has broken out from the $645 level and appears poised to retest the May high on its way to $1,000 an ounce this year. Gold is an asset class whose performance has lagged other commodities, including nickel and oil. However, the socking away of almost $11.8 billion of gold into the seven ETFs has tightened the physical market, causing gold producers to reverse their gold hedges, adding further to the price rise. In terms of tonnage, ETFs now hold 567 tonnes of gold, which ranks them among the top 10 holders in the world. While central banks have been reducing their gold holdings, private investors have been taking up all the gold that is offered.
The expansion of the middle class in the developing world and the influx of petrodollars into the Middle East are having a positive impact on demand. Indeed, jewelry demand - particularly from India - is expected to take up all of the 2,700 tonnes of production in the West. Total demand for gold is almost 4,000 tonnes annually while mine output is expected to decline over the next couple years as ore bodies get deeper. The election of the Democrats and prospects of gridlock in Washington will further fuel spending. In addition, bullion has become an asset class of growing importance as an alternative investment.
Gold is simply a barometer of investor anxiety and there is much to be anxious about. The liquidity bubble is still growing and with the fiat dollars overvalued from endless printing, gold, which is limited in supply, is a natural hedge and store of value. Gold is an alternative investment to the dollar for many central banks and a superior form of wealth protection. The gold price has risen in the past three years by almost two-thirds, and as with the canary in the mine, the warning signal is clear. The need to fund America's deficit is dogging the dollar. We expect the dollar to sink further, with inflationary consequence this time. Debt on debt is not good.
The Bottom Line
Gold will continue to rise as long as the United States continues to debase its currency. When George W. Bush was inaugurated as President in 2001, the price of gold was $265. Six years later, the price broke through $650. That means the dollar has been devalued in terms of gold by almost 60 percent in almost six years. America's failure to address its growing reliance on cheap money and cheap oil has created systemic risks and economic dependence inconsistent with its super-power status. A dollar collapse is inevitable. Gold's bull market has only just begun.
John R. Ing
Maison Placements Canada
130 Adelaide St. West - Suite 906
Toronto, Ont. M5H 3P5
8 February 2007
The information contained herein has been obtained from sources which we believe reliable but we cannot guarantee its accuracy or completeness. This report is not and under no circumstances is to be construed as an offer to sell for the solicitation of an offer to buy any securities. This report is furnished on the basis and understanding that Maison Placements Canada Inc. is to be under no responsibility whatsoever in respect thereof. Directors, shareholders or employees of this company may be beneficial owners of the securities referred to herein.
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