Developments in Europe have dominated the world’s economic headlines in recent days and have obscured some good news from China. In this week’s newsletter, we will cover the background of these important events and their meaning to global investors.
Making Sense Of The European Chaos
We have long believed that the European currency union will not survive in its current form and that some governments will never pay off their huge bond debts. Recent news about the European sovereign debt crisis has been negative and supports our bleak evaluation of the situation. However, reporters and commentators alike tend to miss the one critical point that is essential for the investing community: the banking system will be bailed out.
The fear dominating the world markets today is “Made in Europe”. It exists because European nations are trying to reach a political compromise to solve crushing fiscal problems created by free spending, social service-oriented governments. For years, political leaders have nonchalantly exercised their power to tax, spend, and borrow without considering more than how their actions will impact their own chances in the next election. Such warped focus places a low priority on long-term responsibility to bond holders and now the bond holders are revolting.
In this skewed scenario, the very same bond holders who provided the politicians much of the capital with which to fund social service largess, are now seen as the enemy because they have lost faith in the politicians’ willingness to repay them. Bond holders have now voted with their feet – “fleeing from bondage”, so to speak – by cashing out and thus raising the cost to borrow. Spending-oriented politicians, of course, are angry. In turn, they do not trust the bond holders. There is now little mutual trust between traditional bedfellows.
As we look at Europe today, we see a stand-off situation. Many investors globally fear that the enmity towards bond holders on the part of European governments is so great that they may let the banks fail in order to teach the bond holders a lesson. Keep in mind that banks are among the biggest bond holders, and if bonds are not repaid, then banks will fail unless some entity steps in with large infusions of rescue capital. It is clear that European Sovereign debt will continue to be downgraded by the credit agencies. We expect not one but several European debt downgrades over the next few years.
Heard Only Here!
This is not the view you will see on TV, but this is what will probably occur. Some small banks may fail. It may be that one big bank will be allowed to fail, but the global banking system will be protected at all costs.
Why The European And Global Banking System Will Not Be Allowed To Fail
Banks provide many services that people either do not know exist or fail to fully appreciate. Here are a few of them:
Loans to companies to facilitate expansion and hiring.
Underwriting of stocks so companies can sell shares and further expand operations.
Handling the receipt and delivery of investments.
Clearing of transactions in bond, stock, and commodity markets as well as mutual funds and ETF industries, thus serving governments, companies and investors everywhere.
Holding assets in private banks that allow you to own gold, stocks, bonds and other commodities. This service allows you to buy gold without traveling to a mine in, say, Peru and then transporting the precious metal to your home. It allows you to buy and hold stocks without traveling to various company headquarters.
In addition, banks provide vital behind-the-scenes functions supporting credit cards, money transfers, dividend payments, interest payments of stocks and bonds, and numerous other functions.
Having accentuated the banking positives, there is no denying the negatives, namely the mortgage bond underwriting, sales, and in-house trading departments of some banks that violated the spirit and letter of fundamental banking principles. Their actions have resulted in terrible losses over the last few years for investors, taxpayers, other banks and overall global economic equilibrium. We strongly believe that banks that broke the law should be punished and their ability to repeat those wrongs should be removed. However, banks must continue to operate and perform their vital functions unless we want to return to a barter economy in the developed world.
Politicians want banks to survive. Without banks there is no mechanism of easily raising money through bond sales. They need agents to sell bonds. A strong banking sector is imperative for any country to prosper. This fact of life is understood clearly by the business, political, and investment community alike. For all these reasons, the ruling class will not allow the banking sector to sink. The big banks reeling with sovereign bond debt will be bailed out. We have no doubts about that.
Assessing Europe From An Investor’s Perspective
Our long held opinion is that the Euro currency union will not continue in its current form. The sovereign debts of many nations are in such a pickle that there cannot be a happy ending for some of them.
We expect a deep recession for distressed countries such as Italy, Spain, Greece, Ireland, and Portugal, and a lesser one for the rest of Europe. We anticipate a decline in European real GDP of 1-2 percent in 2012. That not good, but it’s not terrible. The U.K. has wisely continued to remain outside the Euro currency and the financial monitoring mechanism currently being formed.
If implemented and fiercely enforced, this program has a chance to work. The odds, however, favor politics trumping common sense and the program failing. Failure or success aside, we expect a bailout for the European banks.
What does all this mean to an investor not holding any European sovereign debt and who does not own stocks that will be hurt by a big recession in Europe? Let’s say you are an investor living in Australia, Asia, North America, South America or a European not at all invested in the European arena.
Expect to see temporary bond, stock, and commodity market volatility and fear in the short run, but little else in the long run as long as the European banking system is bailed out. European debt problems will take years to work out, and they may never really work out. Countries may renege on their debt and fall into deep, enduring recession. However, the world banking system will be rescued.
China – The Positive News
We consider China the growth engine of the world. As goes China, so goes the world. And we think things are going pretty good. Here’s our current roundup:
Export data is better than expected. Many had envisioned a steep drop in exports, yet the growth rate is humming at about 13.8 percent. We don’t expect this rate to continue. Eventually it will fall into single digit growth, but the growth will stay solidly on the positive side. Many argued that exports would collapse due to significant increases in wages (some coastal manufacturing hubs have seen wages rise 30 percent in the last couple years) and the continuing rise in the value of the Chinese currency, the renmimbi. This prediction has not materialized.
Imports remain strong and growing in the 15-20 percent range. Thus, the Chinese trade surplus is falling. Consumers have more money to purchase goods and services. Real estate prices have fallen in the last six months, so the frantic rush to buy homes has abated. Chinese citizens are saving cash that would normally go towards a 30 to 50 percent down payment, and are instead spending more on all kinds of consumer goods, from apparel and household appliances to luxury items and meals away from home.
Inflation for November was well below expectations. Food prices peaked a few months ago, but are now declining at both the wholesale and retail levels.
Interest rates have begun to fall. That’s because the government no longer needs to keep rates high to discourage real estate speculation. The decline in wholesale and retail inflation further permits cutting interest rates. With a lower interest rate, and banks now permitted to reduce their reserve requirement (as we reported last week), businesses now have greater access to more attractively-priced lending from banks rather than having to borrow from other companies or loan sharks. The impact will be more available capital for business expansion at less cost.
We do not fear a meltdown in property prices in China. As expected, nationally, home prices have stopped rising and are starting to retreat to more reasonable levels. This is positive and normal. The big run up in home prices was negative and has now been stopped. Homes are becoming more affordable especially for those entering the new middle class. Home prices remain stratospheric in Shanghai and Beijing, but most cities see home prices becoming more rational.
Russia – Not So Positive News
Vladimir Putin runs Russia like a modern day Czar, wielding tight control of the government through fear-based administration. Groups rising up to confront him and his allies in power are quickly quashed. The country is treated by him and his kleptocratic friends as their own personal property. Outside of the big oligarchs, Russian citizens in general continue to suffer.
For several years, we have warned investors about Russia. We are aware that periodically trading opportunities arise, and money can be made, but we are afraid to commit because of the corrupt courts system and accounting profession, the lack of legal redress, the theft of the businesses of companies critical of government activity, and the heavy-handed bureaucracy. It is too difficult to effectively evaluate reward and risk in Russia.
To those who do invest there, we wish you well. Your courage exceeds our own.
U.S. Federal Reserve 2008-2009 Crisis Actions Revealed
The U.S. Federal Reserve has made public its pattern of lending against bond collateral in the 2008-2009 period. During that crisis time, the U.S. supported global banks through loans, capital injections, and deposit guarantees to the tune of $7.7 trillion (including rollovers). On one day alone, $1.2 trillion was provided to banks in need, many of them European banks.
Based on such mega-money manipulations of the U.S. Fed by itself, imagine the massive potential of the European, Japanese, Canadian, U.K., and Swiss central banks. You will have plenty of buyers for the bad bonds of weak countries held by European banks. The U.S. and others have shown that they will lend at face value and a low rate of interest on mortgage bonds in the U.S. in 2008. Why would the central banking fraternity not lend on bad European debt today in a similar crisis? By the way the above list does not include China, the oil-producing nations, and hedge funds that would all love to buy cheap European assets once a bailout begins. For example, hedge fund mogul George Soros has invested $2 billion of family money in European government debt bought (presumably at a bargain price) during the liquidation of MF Global. Additional MF Global bond holdings were purchased by JP Morgan and another major hedge fund.
On the Gold Front
Day-to-day fluctuations aside, we believe that declines in the gold price provide buying opportunities. We have counseled buying gold on many declines in the past 8 years. The current decline offers another such opportunity.
*courtesy of Bloomberg
Summary
We are recommending using the gold market decline to add to gold positions, we continue to hold other long term positions.
