The Amphora Report's 2010 Topics in Review (1 of 4)

In 14 editions of the Amphora Report this year we have covered nearly 30 topics, many of which overlap in some way. What binds them all into a coherent set is our view that the economic policies being implemented in nearly all major countries are not just unsustainable but in some cases outright reckless. These countries include the US, the issuer of the world’s reserve currency. By implication, the dollar is likely to lose its pre-eminent reserve currency status in the coming years. The result is bound to be a period of global economic and financial market turmoil and, for most if not all traditional financial assets, underperformance in real, purchasing-power adjusted terms. What follows below is a list of all topics, including both a brief summary and an update of our thinking for 2011.


Imagine that, as in 1979, Paul Volcker is tasked with restoring global confidence in the US dollar and economy generally. We believe that, notwithstanding the best of intentions, it is unrealistic to expect that Mr Volcker, or anyone else for that matter, could possibly succeed at preventing a dramatic relative economic decline of the US in the coming years. To do so would require fundamental economic reform vast scope, far beyond what anyone in Washington, DC is willing to seriously consider or debate.

Our thinking on this topic has not changed one bit. If anything, our conclusions seem largely vindicated by recent developments in Washington, including the growing lack of fiscal discipline demonstrated by the extension of tax cuts and unemployment benefits. There is no serious talk of fundamental economic reform, even following the elections, in which deficit reduction was an important topic. Meanwhile, the Fed has embarked on an increasingly radical monetary course which does nothing to restore confidence in the dollar. The outperformance this year of emerging market economies, many of which are investing heavily in infrastructure and other capital stock, is a clear demonstration of relative US decline. We would expect this outperformance to continue in 2011 although it might well be less pronounced.


We generally take it for granted that cash in a government-guaranteed bank deposit account is a risk-free store of value. But is it? The fact is that the dollar, and all fiat currencies for that matter, tend to lose purchasing power over time, occasionally abruptly in a sharp decline or, even worse, in a hyperinflation. Given current global economic conditions, we believe that investors should be particularly wary of currencies as stores of value and should seek ways to preserve wealth outside of cash.

It is not surprising that, as policymakers have resorted to ever more desperate means to get their economies going, currencies in general have declined in value relative to commodities this year, including the historical cash substitutes, the precious metals. We are confident that this trend of rising commodities prices, not just in dollars but in most currencies, is going to continue in 2011, although quite possibly at a slower pace than in recent months, in the event that the global economy slows somewhat, as we expect.


As diversification is rightly considered to be the only “free-lunch” in economics, in this topic we explore how, in a world of both low interest rates and high uncertainty, investors should be inclined to seek rather more diversification than would ordinarily be the case. However, as financial assets are increasingly highly correlated with each other–a consequence of artificial monetary stimulus–diversification through financial assets alone is unusually limited. As such, investors should consider increasing their allocations to alternative investments, including liquid commodities.

Commodities have outperformed this year, most probably for a variety of reasons. There were some supply issues at times, in particular with grains and certain other agricultural commodities, but the strength was in fact quite broad-based and demonstrates both good demand from the more dynamic emerging markets but also, importantly, that global inflationary pressures are rising. While 2011 may not be as good a year for commodities as 2010–in part because there are signs that emerging market demand is now cooling–we nevertheless expect investors to continue to seek diversification in alternative assets.


Greece now finds itself under attack from the financial markets and unable to refinance its debt. We believe that Germany and France will not come to Greece’s rescue absent a dramatic fiscal consolidation. While Greece is certainly trying to reduce its deficit, success is far from assured and some sort of debt restructuring is probably inevitable. In any case, the Greek crisis has kicked off a round of general euro-area fiscal consolidation. This demonstrates that the euro-area can respond positively to market pressures. In time, this could be supportive of the euro.

The sovereign debt crisis that began in Greece earlier this year has spread to Ireland, Portugal and Spain. In all four countries, governments are desperately trying to reduce deficits in return for financial assistance from France and Germany and also temporary funding support from the European Central Bank (ECB). Interestingly, however, notwithstanding the ongoing and widening crisis, the EUR/USD exchange rate, at 1.32 today, is essentially at the same level it was when the crisis broke in April this year. While we are not particularly optimistic for the economic future of the euro-area which, absent Germany and a few other pockets of regional strength, does not have a great deal going for it, we nevertheless think it is important to make a fair comparison between the euro-area and the US. This requires investors to look at the overall US fiscal situation, which continues to deteriorate amidst federal tax cut and unemployment benefit extensions. But don’t forget the brewing debt crisis in state and local governments either. California, New York and Illinois are all at risk and collectively are of comparable economic size to the entire euro-area periphery. Indeed, the US economy in aggregate, when evaluated according to the size of the public sector, the overall tax base and fiscal and current account balances, bears a far greater similarity to the euro-area periphery than to the core.


Policymakers tend to react to financial crises in ways that contribute to an even greater crisis down the road. Indeed, the reactions of policymakers and regulators are consistently disproportionate to the actions of financial markets. In sinister dialectical fashion, the powers assumed and mistakes made by policymakers tend to grow with each crisis, thereby ensuring that future crises become progressively more severe.

If you are stuck in a hole, so the old saw goes, you had better first stop digging. Well try telling that to the US government, which has just decided to accelerate the ongoing deterioration in its finances with a broad tax cut extension as well as extended unemployment benefits. Meanwhile, the Fed has embarked on another round of monetary expansion. This is yet another example of policymakers contributing to an even greater crisis down the road. Rather than get out of the way and let the economy restructure and rebuild in a natural, undistorted fashion by allowing asset prices to adjust lower to more sustainable levels and banks and corporations to be sensibly downsized and, where necessary, restructured, policymakers continue to dig an ever deeper hole, the legacy of multiple asset bubbles and busts.


Believe it or not, well prior to the great financial crisis of 2008, it was widely known among the educated financial elite that the standard risk management models and methods used by the major banks were woefully inadequate, with the consequence of systematically underestimating risk. But rather than take appropriate action to protect their firms with sensible risk management policies, senior executives chose instead to focus on short-term profitability: A healthy balance sheet became of secondary importance to a healthy income statement which, of course, justified healthy bonuses.

Much has been written this year about how the risk management culture on Wall Street was a key ingredient to the crisis of 2008. It is increasingly clear that most if not all financial executives were aware of the risks they were taking but were unwilling to confront the short-term, bonus-driven culture which had come to dominate a once conservative, partnership-based industry. Now that the industry has been bailed out and has returned to profitability–at least for a brief time–another important lesson has been learned: The more risks you take, the better, as policymakers will see to it that in the event of yet another crisis, the taxpayer comes to the rescue. Events this year have done nothing in our opinion to change this. Those firms already too big to fail in 2008 are now even bigger. The moral hazard of the system has grown. The seeds of the next crisis have been sown. Recent developments in Ireland should serve as an example of what happens to a country that underwrites the risks of its financial sector.


Back in the spring we noticed that inflation rates were picking up just about everywhere, including in China. However, as China is a huge importer of raw materials, rising global commodities prices implied that Chinese inflation was likely to increase further. As much of China is still a subsistence economy, food price inflation would most likely turn into wage inflation, which in turn would push up prices for Chinese manufactured goods generally and possibly lead China to revalue its currency versus the dollar. Eventually, as the US imports a huge amount from China, this would also push up prices in the US.

Chinese inflation has continued to rise all year. The spike in food prices over the summer has played a part, to be sure, but the underlying pressures were already in place. Additional fiscal and monetary stimulus in the US is most probably going to contribute to still more inflationary pressure in China and other more dynamic economies around the world. Indeed, China is just one of many countries which is now taking action to cool growth and keep prices under control. China and India have both recently raised interest rates. Brazil and South Korea are taxing foreign capital flows. These trends are likely to continue in 2011 and will contribute to “stagflationary” conditions in the US.

To be continued…


John Butler,
for The Daily Reckoning

[Editor’s Note: The above essay is excerpted from The Amphora Report, which is dedicated to providing the defensive investor with practical ideas for protecting wealth and maintaining liquidity in a world in which currencies are no longer reliable stores of value.]