GOLD GONE WILD
John Ing
Neither a borrower nor a lender be. And yet, if you have to choose, it is better to be a creditor. Why? America is about to discover the dangers of becoming a debtor. The U.S. debt load has climbed to $44.5 trillion or roughly three times the country's yearly GDP, exceeding levels last seen in the Great Depression and that does not include the trillions of dollars of unfunded liabilities from Medicare, Medicaid and Social Security. The global economy in total is only $51 trillion. Easy central bank policies led by the United States have triggered a deluge of money that has washed over financial markets in recent years. This massive injection of liquidity lowered interest rates and remade America's corporate world as debt-inflated super buyouts, caused a boom that has surpassed even the dot-com era. With record debt burdens and record debt ratios, the United States has become overly dependent on outsiders to finance its standard of living. America's hunger for dollars is quite simply self-destructive.
Despite America's dependency on overseas financing, the White House has slapped tariffs on China for the first time since 1991, filing two cases against that country over pirated movies, music and books. Ironically, America's fate may be similar to the 1997
Asian Contagion Crash, when exchange rates fell, equities collapsed and land prices plummeted, causing huge losses. Today, there are parallels and warning signs like big trade deficits, big budget deficits and rising debt burdens. The trigger for the crisis? Exchange rates fell due largely to the sharp reversal of capital flows, as investors stampeded for the exits. Today, the shoe is on the other foot. It is the US dollar that has become highly vulnerable to capital outflows, hitting a 26-year low against the pound and another record low against the euro. The dollar's days as a reserve currency is over.
US Needs to Import Even More Savings
America's savings shortfall is the yang of chronic trade deficits, making the country increasingly reliant on others. The United States must attract more than $2 billion a day of capital inflows to finance its current account deficit. In December, U.S. capital inflows collapsed to $14.3 billion, which is far short of what's needed to fund the deficit. America's imports are more than seven percent larger than exports, as it continues to consume far more than it produces. Meantime, the world's largest debtor nation has a bigger problem: The savings rate has dropped to the lowest level since the Great Depression. So in order for America to continue to grow, it is left with no choice but to import surplus savings from abroad. Without this, the dollar will fall further. Debt on debt is not good.
The United States' two biggest trade deficits are with China and Japan. In the past few years, the reliance on Asian central banks' purchases of US debt has been enormous, resulting in mammoth holdings of foreign exchange in Asia and elsewhere. So this new round of protectionist pork-barrel politicking has Americans believing that the problem is with China and the need to revalue the renminbi. Wrong. This is not about an undervalued renminbi. This is about the fact that Americans continue to spend more than they produce and have an insatiable appetite for debt to finance their consumption. So it may well be that this old-fashioned protectionism will cut the lifeline connecting the market and the United States.
And Then There Is China
China has displaced the US as Japan's largest trading partner. China is the US' second largest trading partner after Canada and holds over $400 billion of US debt. China's reliance on America has lessened as it rebalances its economy to better accommodate the
growth of its middle class, which has been fuelled by the massive resettlement of the rural population to the cities. China's per-capita income has doubled in less than 10 years. Today, China's middle class is bigger than the population of the United States. Against this backdrop, the U.S. administration is facing pressure from the Democrats, who have lodged complaints against China three times in the past three months serving to weaken Treasury Secretary Henry Paulson's new China policy. The last thing a country with a record debt can afford is to hurt its bankers, particularly when it has no savings.
Meantime, the recent selloff in global markets should not be ignored. We believe the days of low volatility, cheap money and the massive glut of liquidity are over. An increase in global interest rates has also caused a slowdown of the "carry trade", whereby investors borrowed Japanese yen and invested the proceeds in higher-yielding US assets. The recent uptick in interest rates has made this carry trade less profitable, leading to an increased risk premium. At the same time, inflation is back, driven by supply shortages, an emerging Asian superpower, global liquidity and the slumping dollar. Further, the U.S. consumer price index with food and energy calculated back-in, is running at an annualized 7.2 percent. Tellingly that's not good for the dollar, but good for gold.
Sub-Prime Crisis Gets Worse
The final body blow was the implosion of the sub-prime market in the United States. Junk mortgages were repackaged through collateralized debt obligations (CDOs) and then sold to investors. Sub-prime mortgages accounted for eight percent of all outstanding mortgages and fully 23 percent of last year's volume. According to the Mortgage Bankers Association, more than 2.1 million U.S. families with home loans missed at least one payment last year. This year it will be worse. About 14 percent of the $1.2 trillion in outstanding sub-prime mortgages is now in default. Sub-prime loans were aimed at those with poor credit records, and today many borrowers are finding they can no longer afford their payments, thus making it even harder for those with tarnished credit to refinance. The tightening of credit follows the uptick in rates and the accompanying glut of houses on the market has triggered a fall in home prices. Home equity is a key foundation of consumer spending, which makes up 70 percent of U.S. GDP. With 70 percent of Americans owning their own homes, the absence of the home equity "wealth effect" will lead to a further slowing of the U.S. economy.
Junk loans, The Bedrock of Fault-ridden Derivatives
The big problem is that Wall Street securitized these sub-prime mortgages by "slicing and dicing" and repackaged the loans, which were then sold back to investors such as hedge funds and private equity groups looking for better returns. Of course, to boost the volume in fees, lending restrictions were relaxed further and an abundance of capital chased this sector. As a result, these junk loans became the fault-ridden bedrock of a synchronized global binge of cheap loans, derivatives, and leveraged credit. Lenders to highly indebted companies are making the same mistakes, of too high debt, too loose standards and falling risk premiums that undermined the sub-prime debt market.
In a form of deja vu there was another time when there was another period of declining property values, cycle of foreclosures, reduced consumption demand, rising unemployment and more delinquencies.. That was in the Dirty Thirties when balloon mortgages came due and householders could not refinance. Then the banks were taught a lesson and mortgages became instead vanilla self-liquidating forms of debt. Today, sub-prime bonds are the underlying layer of trillions of obligations that were created by Wall Street. Mortgages are set to be renegotiated again. Hence the debt market is set for a rude awakening. So the ripple effect from the sub-prime crisis has now cast doubt on whether holding U.S. dollar obligations is such a good thing, particularly as the US economy absorbs declines in house and auto sales.
Furthermore, the sub-prime crisis threatens to spread to higher quality debt, triggering a wave of defaults that could sink the U.S. economy and the greenback. Central banks appear to be willing to accumulate euros to dollars and gold to anything but dollars. It appears dollars are not such a good holding anymore. Is a new reserve currency in the making?
A China-Centric World
And what if there were a trade war? China has more than $1 trillion of foreign reserves, Japan $909 billion. The United States has no savings and foreign exchange reserves of only $41 billion, fewer than Indonesia's $46 billion. With numbers like that, more and more of America's funding partners are getting the message. According to the International Monetary Fund, U.S. dollar holdings fell to 64.7 percent in the 2006 fourth quarter from 72.6 percent in mid-2001. Amazingly the euro, launched in 1999, is increasingly a replacement for greenback holdings, with its share at 25.8 percent. Is the euro the new reserve currency? The world's biggest debtor nation simply cannot afford to launch a trade war with the world's most important creditor. The gyrations in the currency markets threaten to become a full-blown dollar crisis.
New Worries
So while the Shanghai stock market gyrations may have caused palpitations, it also focused investors on the real problem and that is America's indebtedness and its dependence upon precarious financial markets. Don't worry about the Chinese because they have a savings rate of more than 30 percent, with savings in excess of $2 trillion. Worry about America's consumption binge with too little savings and too much debt. Worry about the dollar's diminished role as a reserve money. Worry that there are more euros in circulation than dollars. Worry that the international debt market has even more eurobonds than dollar bonds. Worry that Wall Street's stock market capitalization has now been eclipsed by Europe and China. Worry if you're not holding gold because gold is the very hedge against the printing presses.
The Fight For The Next Reserve Currency
In recent years, hundred of billions of dollars have flooded into China's financial system through trade and foreign investment. After all, China is the world's fastest growing economy, causing a global financial shift of unprecedented proportions. Beijing has plans to diversify its foreign exchange reserves because they have too many dollars already, including now risky mortgage-backed securities. However, there simply is not enough oil, euros or yen to satisfy Beijing's appetite. So China is looking elsewhere because within four years its official reserves are expected to top $2 trillion.
We expect the Chinese to acquire more producing assets instead of paper. China will also create the world's largest investment company from some of those reserves. With about $200 billion at hand, China will not only diversify its holdings but use those holdings to strengthen its economy. Today, three Chinese banks rank in the top 10 global banks by market value. Japan, too, is establishing a special investment fund, following China and Singapore's lead. By investing in assets to diversify and get better returns, China will leave US investments and the dollar behind and help create the next new reserve currency.
China is an emerging super-power and beneficiary of globalization. In a less US-centric world, Beijing is about to show its hand. China has become the biggest consumer of copper, steel and iron ore, and is the second largest user of oil and energy. China is also the world's largest creditor. By establishing the largest investment fund in the world to make investments in everything from euros to gold, China is about to use its financial might to finance its bold economic blueprint.
We expect China to diversify further into other asset classes such as gold, which is a prime beneficiary because the country holds only less than two percent of its foreign reserves in the metal. We believe that China has just begun to acquire hard assets due partly because its growth dictates the need for oil, copper, wheat and zinc. And the world is also short of hard assets. In our last report, Rich Country, Poor Country, we noted that the liquidity glut caused by accommodative global monetary policies would flow over into hard assets and other asset classes such as metals, where there has been underinvestment and few discoveries - like gold. Gold is the ultimate reserve currency. Historically gold has served as the world's only true currency, retaining its store of wealth against paper and fiat currencies.
$1,000 Gold Is A Certainty
Gold is the ultimate safe haven against inflation and falling stock markets, and it is a hedge against a weaker U.S. dollar. Indeed, gold is a good index of currency fears. Given our expectation of continued favourable supply-demand fundamentals, we expect gold to retest the January 1980 high at $850 an ounce this year, with a new target at $1,000 an ounce. While $1000 may appear overly optimistic, it is important to remember that gold rose nearly 3,000 percent from 1971 to 1980 and is only up 166 percent from its low in 1999.
Gold-mining shares have not kept up with bullion due in part to the fundamental reason that gold-producing companies by and large have not been able to replace their production or even reserves. The senior gold players are stuck on a treadmill. The market fears that gold companies are simply harvesting their mines and thus have not accorded the group a growth multiple. In addition, costs have risen from $200 an ounce to more than $300 an ounce. But that is still leaves most companies able to make money. So what is the problem? The boom in exchange traded funds (ETFs) is part of the problem because they represent competition. There are now 600 tonnes - or $13.3 billion - of gold socked away in ETFs. There is no doubt that their buying tightened the physical market, yet we do not believe that ETFs are much competition.
Gold stocks' lagging performance will change because of the increase in the price of gold. Gold companies, at long last, have been churning out cash and many of them are trading at 20 times price/earnings versus the 30 or 40 multiples of the past. As such, many companies have acquired others in the quest for growth since it is still cheaper to buy ounces on Bay Street than explore for gold in the ground. While ounces have grown, per-share growth has been lacking. We believe higher gold prices will change that and the higher price level plus leverage will attract investors.
John R. Ing
Maison Placements Canada
130 Adelaide St. West - Suite 906
Toronto, Ont. M5H 3P5
(416) 947-6040
jing@maisonplacements.com
1 May 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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