A View from the Trenches, March 5th, 2012: "Another lesson in the law of unintended consequences"
Please, click here to read this article in pdf format: March 5 2012
Let’s start by confirming that we remain long-term bullish of gold, near-term neutral of stocks (and long-term bearish of stocks), bullish of corporate credit risk, neutral of sovereign risk (European and US). We are neutral on the EURUSD (but if we had to make only one trade and hold on to it, we would be bearish) and surprised by the latest performance of the Canadian dollar (happily surprised, of course, as we are long of this currency).
It is a widespread rumor by now that the huge sell off at theLondonfixing on Wednesday February 29th was not driven by Bernanke’s comments before the US Congress, but by plain manipulation, likely from a non-private seller. We, having seen no reaction in 30-yr Treasuries, decided to buy the dip, for we think that in this context one can only buy and hold gold, sitting tight in the face of all this volatility, or risking to lose one’s position in the bull trend.
Someone asked us why, if we were such believers in gold, did not buy stocks of mining companies. To answer this, we will have to first understand why we buy gold. It is not because of anything intrinsic to gold. We don’t care that we cannot eat gold or that it doesn’t give you a dividend. You cannot eat US Federal Reserve notes either and these, rather than give you a dividend…depreciate.
We have to understand that one of the services rendered by money, namely the storage of value, is no longer attached to fiat currencies. And the world needs that service. There is demand for a reserve asset and gold can address it. Is it the only asset fit for that? No! The only thing we care is that in the long run, the demand for that service will keep increasing and at the margin, even competing with other assets, gold will get a bid. It is that simple.
Now, we can dig a bit deeper and ask ourselves what are the causes and implications of witnessing fiat currencies lose their demand as a reserve asset. The causes are clear to all of us, but not the implications. The one least understood is the distortion in relative prices caused by the intervention of central banks. We write more about it below but for now, think of this: In the past 10 years, you have seen the S&P500 index fluctuate, nominally, without making any “improvement”. This has huge ramifications and one of them is that businessmen who would want to monetize the fruit of their labour would not be able to do so, on average, because if they are lucky, they only break even when they sell their businesses. If you were one of them, what would you do in the face of the recent monetary expansion?
I for one would leverage my company with cheap credit lines and distribute (or increase the distribution of) dividends, to cash out. And this is precisely what we are seeing and will continue to see: Leverage seems to have bottomed and now is reverting in corporates. This is not positive for growth and hence, we don’t want to own shares. We don’t want to own mining companies. We understand that the recent rally was fully driven by the expansion of the Fed (via swaps) and the European Central Bank (via Long-Term Refinancing Operations). We are simple investors and are humble enough to know that we will not be able to call the exact day in which the reversal in stocks takes place. We can intuit when it is going to happen, but will only be lucky in actually calling it. However, with gold, it is different. Hence, our buy and hold approach. We’ve seen it before: When decadence arrives with inflation, people want to own the product, not the producer. We want to own gold, not miners.
And some have brought to our attention that by doing so, we lose the leverage provided by stocks. We disagree and think that the price action in mining stocks speaks for itself. Besides, should one want to lever the bet in gold, the only thing required is to borrow and buy more gold. It is more efficient: One knows ex-ante the leverage one wants and will end up with!
Now, let’s address the distortions generated lately by central banks (We will focus on the Fed and the European Central Bank, but we could also write about the intervention of the Japanese Yen and the scary fall in Yuan deposits in China, that is forcing a steady cut in reserve requirements over there. But these are underlying, long term problems. We will have to deal with them later). When the Fed provided the currency swap at 50bps to the European Central Bank in December, US dollars that were needed to fund EU banks, all of a sudden, were no longer needed. We are speaking here of more than $90billion. This is no small change! Also in the December and a few days ago, we had two 3-yr refinancing operations by the European Central Bank. In all, more than a trillion Euros were printed to, among other things, repay previous funding, some of which was in US dollars too. As you see, suddenly, the providers of US dollar funding saw themselves with a lot of cash in their hands.
They could not offer cheaper funding to EU banks or sovereigns because a) the Euro funds from the central bank are against collateral, which deeply subordinated USD unsecured debt, and b) the latest decision by the ISDA, which considers the swap of Greek bonds with the ECB not to trigger a credit event, further guarantees the subordination of private sovereign debt holders going forward.
What did they do? They poured the money into equities, corporate bonds, commodities. But in the Eurozone, the banks that now count with cheap Euro financing, will not take risks. If they take risks, it will be in the form of sovereign risk, buying sovereign bonds. They have been doing this since January and will continue to do so. All this means that the private sector in the Eurozone will remain affected by a credit crunch, unless…..well, unless those who were previously providing US dollar funding to EU banks now use their excess balances to fund EU corporates. This, we think, is going to be the case as USD denominated debt (Yankee issuance) will be increasingly issued by EU corporates. This is why we said at the beginning that we are bullish of corporate credit risk. We make this more visual in the chart below:
The problem with this new situation is that eventually, we shall see a wave of EU corporates defaulting: Compared to US corporates, EU companies are exposed to higher taxes, an overvalued currency, institutional uncertainty and the benchmark rate ( i.e. sovereign spreads) is higher than that for US companies (i.e. US Treasuries). However, the hunger for yield these last two central bank interventions has generated is pushing US financials to chase riskier assets and high yield EU corporates look today like sweet, low hanging fruit ready to be picked. Who’s going to be in the way??? Nobody, as this is an election year and nobody ruins parties in election years!
But, if that wave of defaults occurred…who would be bailing out theUSinstitutions that financed the EU corporates? Yes, you guessed right: The Fed! No, Bernanke did not mention QE3 last Wednesday, but we don’t need him printing monetary base to create the next bubble. All we need is a good currency swap, cheap Euro rates, a zombie EU financial system and the commitment to keep USD real rates in negative territory until at least 2014.
Martin Sibileau
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