The Amphora Report's 2010 Topics in Review (2 of 4)
[Introduction below, and then continuing from Part 1.]
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.
HOW WOULD EINSTEIN VALUE FINANCIAL ASSETS? VOL 1/5
With this brief topic we presented the idea that assets can only be valued relative to other assets, rather than in absolute terms, as things only have an identifiable, quantifiable value if they are exchanged for something else. All other measures of value are ultimately subjective to the individual rather than objective in the marketplace. Einstein showed that the speed of light was the only constant against the universe against which all else could be measured. In financial markets, the only constant is the time value of money, as represented by the term structure of interest rates. If a central bank sets interest rates at an artificial level, asset prices will become distorted and resources misallocated, with potentially severe economic consequences.
While highly theoretical, this topic becomes more relevant as the US Fed becomes increasingly desperate in its desire to stimulate economic activity. Previously considered a fringe view, it is now widely believed that US financial asset prices are distorted in some way by Fed policy actions. Indeed, in a recent op-ed published in the Washington Post, Fed Chairman Bernanke made explicit that monetary stimulus was likely to support the stock market which, in turn, was likely to stimulate economic activity. But if asset prices are distorted, are resources being misallocated? We believe so. These misallocations will only increase in 2011 as more and more artificially stimulus is thrown at the economy.
THE ASSET-PRICING IMPLICATIONS OF THE GREAT BAILOUT | VOL 1/5
Moving from theory and into practice, we investigate in detail just how we believe asset prices are being distorted by various forms of economic stimulus. In general, we find that the assets for which values are most likely distorted to the upside are those with relatively uncertain and long-dated cash flows. Investors should therefore be underweight growth vs. value assets and underweight nominal vs. real assets. In this regard, investors should be particularly concerned about recent developments in euro-area and US state and municipal debt markets.
Since we wrote this edition, asset prices in general have risen in value, with the exception of the sovereign and US state and municipal debt markets, where prices are generally lower, in some cases dramatically so. Also, real assets such as commodities have outperformed nominal quite substantially in the second half of the year. As recent moves to add additional stimulus to the US economy are likely to reinforce existing distortions in asset prices, we expect these trends, in general, to continue in 2011, although probably at a more gradual rate following the rather dramatic developments in recent months.
IS THIS THE BEGINNING OF THE NEXT CRISIS? VOL 1/6
No. The great financial crisis of 2008 never ended. It merely changed form. When public authorities stepped in to prevent a further deleveraging of the financial system, they explicitly or implicitly assumed responsibility for much of the debt that was collapsing in value. In doing so, they issued more of their own and also raised expectations for future issuance. It is obvious that this is unsustainable. No realistic real growth assumption would allow this debt to be paid pack at its present value. These debts are going to be devalued either by inflation or some form of default.
Where others observe a series of separate crises, ranging from US subprime mortgage debt to euro-area sovereign debt, we see a continuum. The financial risk of bad lending decisions, once originated in the form of debt, has never left the system but rather has moved from place to place. Ireland is a clear example of this, as back when the banks were at risk of failure, the government stepped in and guaranteed not just deposits but the complete liabilities of its entire banking system. It may have taken a number of months but the financial markets finally figured out that the debt was still there, only in sovereign form. This sort of debt “shell game” is being played over much of the world and will not end until there is a proper deleveraging of the global financial system, through some combination of debt default and currency devaluation. We have a long way to go yet.
REAR-VIEW MIRROR MYOPIA | VOL 1/6
The dramatic rise in the price of gold in recent years finally began to receive attention in the mainstream financial press in 2010. But rather than analyze the fundamental reasons behind this trend, much commentary has suggested that gold may now be in a “bubble”. When looking at the past 20 years or so, gold does look expensive when compared to financial assets. But given that the risks of a general global sovereign debt and fiat currency crisis are without doubt the highest they have been for many decades, to focus only on the past 20 years is to demonstrate severe rear-view mirror myopia.
Gold continues to feature as a popular topic in the mainstream financial press, although it still receives far less attention than traditional financial assets. Certainly the rally in gold has gone a long way and a growing number of investors have no doubt acquired some position in the metal, either as physical bullion or via ETFs, futures, or other forms of “paper” gold. But let’s put this in perspective: According to the World Gold Council, the total value of investment gold is only some 2% of the total value of global financial assets, far below historical averages. Yet central banks continue to expand their balance sheets, aggressively in the case of the US Fed, and sovereign debt crises are spreading. The risks of devaluation and/or default continue to increase. In this context, we expect the gold price to continue to rise in 2011, not only in dollar terms but also in that of most global currencies.
IS GOLD ALL THAT GLITTERS? VOL 1/6
Notwithstanding the view above, that the gold price is likely to continue to rise in 2011, this does not imply that gold is going to outperform all other real assets. Indeed, in 2010, up about 30%, gold was far from the top performer. Silver rose by around twice as much, as did coffee. Cotton doubled in value. Certain rare earth minerals multiplied their value several times over.
While we would not presume to debate anyone touting the wealth-preserving properties of gold through the ages, it stands to basic economic reason that diversification should always play a prominent role in any defensive investment strategy. 2010 provides ample evidence of this. At times gold was the outperformer amongst commodities, yet during the summer agricultural commodities were the top performers and, beginning in September, silver began to surge. There are no doubt those out there who think they are able to pick the best asset at any point in time but we are of the opinion that holding a broad, well-diversified portfolio of liquid commodities is a better answer to the dilemma posed by global debt default and devaluation risks. As we enter 2011, nothing has changed our thinking in this regard.
THE BENCHMARK IS IN THE EYE OF THE BEHOLDER |VOL 1/7
How do we measure wealth? In some unit of account. Money is meant to function, among other things, as a unit of account, the denominator for any given asset value. But if the purchasing power of a currency is unstable, either due to inflation or deflation, this distorts the way in which real wealth is measured. For example, if your benchmark unit of account is the Zimbabwe dollar, you have made outrageous profits during the past few years almost regardless of your choice of investment.
Investment idiots are made to look like geniuses if measured against a chronically devaluing benchmark. As such, it is important for serious investors to choose a benchmark which is not and cannot be deliberately devalued. Well, now that the Fed is purchasing Treasuries in an attempt to prop up assets and also to place downward pressure on the dollar, is the dollar a sensible benchmark? Should investors measure their wealth and performance in dollars or in some other unit of account? We believe that the answers to these questions have become increasingly obvious as this year has progressed. The dollar is no longer an appropriate benchmark. We expect others to come to a similar conclusion in 2011.
WHEN IS A RISING STOCK MARKET ACTUALLY FALLING? VOL 1/7
In domestic currency terms, the Zimbabwe stock market was a fantastic investment over the past decade. In some years it rose more than tenfold in value. In particularly good months it rose by several hundreds of percent. No major stock market performed in such spectacular fashion during this time. But this was not due to positive economic developments in Zimbabwe. On the contrary, it was reflective of the severe hyperinflation that was taking place.
This topic is really just a corollary to that above. Yes, most stock markets have risen this year in dollar terms. But if the dollar is no longer a sensible benchmark, what does this really tell us? Did stock markets perform well or not? Did they rise in terms of purchasing power? Stock markets do appear to have risen with respect to price inflation, which will give comfort to some. But then valuations don’t look as attractive as before. In any case, looking forward into 2011, we suggest that investors consider measuring their performance in ways that reference more stable benchmarks than the dollar.
THE REAL ECONOMIC HORROR SHOW | VOL 1/7
As it becomes increasingly evident that the US economic recovery is not self-sustaining, but rather is going to require additional stimulus at some point, we explore what this implies for the future. One key implication is that, as the public sector is growing rapidly relative to the private, that the tax base is shrinking even as the government debt burden increases. This implies a lower future potential growth rate and lower standard of living. Curiously, given its free market traditions, the US is bucking a global trend toward fiscal austerity, as demonstrated by recent policy actions elsewhere.
It had already become clear by mid-summer that various countries, notably the UK and Germany, were increasingly opposed to using fiscal expansion to fight the deleveraging in credit markets and associated economic weakness. In other countries, including Greece and Ireland, debt crises had already forced governments’ hands toward dramatic fiscal tightening. It is true that, around that time, the work of the bipartisan US “deficit panel” was well underway, with the understanding that President Obama would most probably consider implementing at least a few of the recommendations. Well, in the event, not a single one of the recommendations has received serious consideration in Washington. Instead, the US as chosen to implement even more aggressive fiscal stimulus by extending both tax cuts and unemployment benefits. As such, even though growth in 2011 may be artificially supported, this is merely going to draw growth away from the future, at increasing cost. Indeed, with Treasury yields having spiked a full percentage point in recent weeks, interest expense is already rising.
To be continued…
[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.]