China’s Appetite for Gold

Wednesday, March 31st, 2010

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By Frank Holmes, U.S. Global Investors

March 30, 2010

What would happen to the price of gold if China’s annual consumption went up tenfold?

That’s the high-end demand case laid out by the World Gold Council (WGC) in its new report “Gold in the Year of the Tiger,” which focuses on China.

The WGC says China’s gold consumption of 423 tonnes in 2009 works out to about one-quarter of a gram per person, which is lower than other Asian countries with cultural affinity for gold (chart). The Saudis consume more than three grams per person, and in Hong Kong, it’s more than two grams.

“If gold were consumed in China at the same rate per capita as in India, Hong Kong or Saudi Arabia, annual Chinese demand could increase by at least 100 tonnes to as much as 4,000 tonnes in the jewelry sector alone,” the WGC writes.

OK, 4,000 tonnes (128.6 million troy ounces) looks pretty extreme, even for the most enthusiastic gold devotees. The WGC offers a more reasonable but nonetheless bullish outlook: China’s gold demand has nearly doubled over the past five years (13 percent growth per year), so it would not be a huge stretch for a doubling to roughly 850 tonnes per year in the next decade.

Gold demand is rising as China’s middle class expands, and while the nation is the world’s largest producer, domestic supply falls short of demand by some 100 tonnes per year and that gap will almost certainly widen with rising demand.

As more foreign gold is diverted to the Chinese market, the impact on world prices could be significant.

Tags: Asian Countries, Bullish Outlook, Capita, China, Chinese Demand, Chinese Market, Devotees, Frank Holmes, Gap, Gold Chart, Gold Consumption, Gold Demand, India, Price Of Gold, Saudi Arabia, Saudis, Tonnes, Troy Ounces, U S Global Investors, Wgc, World Gold Council, Year Of The Tiger
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The Price of Emotion

Tuesday, March 30th, 2010

Successful investing is built on twin pillars – diversification and self-control. Crafting a thoughtfully diversified strategy but not sticking to it is like having a fitness program without discipline – long on promise and short on results. Behavioural finance experts have identified a litany of cognitive biases that can distort investor decision-making and disrupt adherence to a sound strategy. Some of the principal ones include:

• Overconfidence – the tendency to overestimate one’s abilities, knowledge and the reliability of the information used in decision-making.
  

• Confirmation bias – the predisposition to look for and interpret information in a manner that confirms one’s preconceptions.
  

• Myopic Framing – the inclination to view facts in a narrow context.
  

• Outcome bias – the tendency of people to expect to get what they want.
  

• Herding – the tendency of individuals to follow the crowd.
  

As the market moves through bull and bear cycles, investor sentiment swings from optimism and hope to anxiety and fear. Emotions inevitably interplay with cognitive biases leading to adverse outcomes in which investors end up “buying high” and “selling low”. Warren Buffett summed it up best with his observation that, “Success in investing doesn’t correlate with I.Q. once you’re above the level of 25. Once you have ordinary intelligence, what you need is the temperament to control the urges that get other people into trouble in investing.”

A number of academic studies have attempted to measure the returns earned by a typical investor and compare them to market returns in order to estimate the cost of emotionally-driven buying and selling. Although not a perfect proxy, the dollar-weighted returns of mutual funds, a calculation that accounts for the timing and size of cash flows in and out of funds, has been used as an estimate of the average investor’s returns. These dollar-weighted returns are then compared against the returns of the funds themselves, a time-weighted calculation that ignores the effects of cash flow timing.

One of the first studies compared the dollar and time-weighted returns of U.S. mutual funds from December 31, 1983 to August 31, 1994. The author found that in every fund category – equities, bond, balanced and precious metals, investors suffered a chronic shortfall in return because of ill-timed movements in and out and between mutual funds. Overall, this inopportune timing of cash flows reduced returns to investors by 1.08% a year.

In another study, John Bogle, the founder of Vanguard, compared the dollar and time-weighted returns of U.S. equity funds from 1980 to 2005. He found that poorly timed moves in, out and between funds by investors resulted in a shortfall of 2.7% a year. Unquestionably, the herd mentality associated with the tech bubble and its subsequent collapse added to the underperformance of investors during this period. Many investors went from piling into the hottest growth fund to hiding out in money market funds.

Asset bubbles such as the tech boom induce greater emotionally-driven buying and selling, and hence, more damage to investors’ portfolio results. In confirmation, one study found that whereas U.S. fund investors lagged fund returns by 1.2% a year from 1984-1990, this performance gap climbed to 2.67% a year for the period 1991 to 2003.

At its recent asset allocation conference, Morningstar disclosed its findings from comparing the dollar and time-weighted returns of U.S. mutual funds from 2000 to 2009. Overall, the shortfall experienced by investors was 1.5% per annum. The timing of bond fund purchases and sales was no better than equity funds; in fact, investors in municipal bond funds had the highest shortfall at 1.61% annually.

Interestingly, investors in exchange-traded funds (ETFs) seem to suffer from greater timing shortfalls than their mutual fund brethren. Bogle analyzed 79 ETFs in a variety of asset classes over a five-year period and found that investors in 68 ETFs underperformed. On average, investors’ returns lagged the funds themselves by a whopping 4.5% annually. The annual underperformance ranged from 0.4% for large-cap value funds to 17.9% for financial sector funds. The hair-trigger trading capability of ETFs may contribute to more emotionally-driven buying and selling.

Most investors appear blithely unaware of how much damage emotionally-driven buying and selling can wreak on their portfolios over time. Instead their perspective is dominated by short-term emotional gratification. Unfortunately, the scale of emotionally-induced diminution is that much greater when shortfalls are deducted from real returns (i.e. returns net of inflation) and compounded over time.

In illustration, the following graph compares the cumulative real growth of $1.00 invested in both a “buy and hold” (in red) and an “emotionally-driven” portfolio
(in green) from 1970 through 2009. Each portfolio is comprised of 40% intermediate term government bonds and 60% large company stocks but it is assumed the return of “emotionally-driven” portfolio lags the “buy and hold” portfolio by 1.5% annually.

Emotionally-driven decisions extract a huge price on a portfolio over time. In this illustration, the cumulative real value of the portfolio is almost cut in half.

The antidote is a threefold exercise. First, an investor’s ability to tolerate risk in financial and psychological terms must be clarified; this risk profile then serves as the primary input into portfolio design. Second, the asset class performance of the recommended portfolio should be back-tested. The 1973/74 and 2008/09 downturns provide historic stress tests that should be reviewed in-depth and in dollar terms. There is a world of difference between saying you can tolerate a 20 percent portfolio decline and saying you can watch your $5 million portfolio shrink by $1 million.

Finally, the investment strategy must be documented in writing. As Charles Ellis wrote in his investment classic “Investment Policy: How to Win the Loser’s Game”, “The primary reason for articulating long-term policy explicitly and in writing is to enable the client and the portfolio manager to protect the portfolio from ad hoc revisions of sound long-term policy, and to help them hold to long-term policy when short-term exigencies are most distressing and the policy is most in doubt.”

March 30, 2010

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Tags: Academic Studies, Adherence, Bull And Bear, Cognitive Biases, Confirmation Bias, Diversification, ETF, ETFs, Fitness Program, Inclination, Interplay, Investor Sentiment, Litany, Market Moves, Narrow Context, Preconceptions, Predisposition, Self Control, Sound Strategy, Twin Pillars, Typical Investor, Warren Buffet, Warren Buffett
Posted in ETFs, Markets, US Stocks | Comments Off

Why Gold will Not Make New Highs or Lows This Year

Tuesday, March 30th, 2010

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This article is a guest contribution by Adam Hewison, CEO of MarketClub.

Title: Why gold will not make new highs or lows this year

Gold has had some dramatic moves in the last eighteen months and we expect it will have some equally dramatic moves in the future, but not right now.

Click on the image to view:

While I recognize that gold is one of the few commodity markets that people are really passionate about; the purpose of this article is not to take sides either with the gold bugs or those who reject the argument that gold is forever.  Rather, I want to discuss my interpretation of the markets cycle.

After spot gold made an all-time high against the dollar on December 2 at $1,226.37, gold has been in retreat mode. For the for the past several months gold has been in a broad trading range, seemingly unable to move one way or another. This process has created frustration from bulls and bears alike.

Here is the dirty little secret about the gold market. It can be a horrible investment and here’s why:

Gold first started trading in the 80s while I was on the floor of the Chicago Mercantile Exchange in Chicago as a member of the International Monetary Market, (IMM) which was at that time a division of the CME now the CME Group.  When gold opened up the public clamored to buy into the gold futures market and guess who sold it to them? That’s right it was the pros- the guys who made their living trading. As a result, gold hit an all-time high of around $850 an ounce back then and it took almost 25 years for gold to move over that level, at least in dollar terms. I don’t know what your timeline is, but 25 to 30 years is an awful long time to get even again.

So what is really happening in this market?

Everyone is aware of the problems in Europe with Greece, Portugal and a host of yet to be named countries. We all know that the huge amount of money being printed, coupled with the bank failures abroad contribute to the dollars declining value. These events, in conjunction with the American governments actions, also contribute to the devaluation of the dollar. The government claims that this is beneficial to exports, but the bottom line is that the purchasing power of the American dollar continues to erode in world markets.

Based on the declining value of world currency against gold you might ask – why isn’t gold trading at $2,000 or even $3,000 an ounce? What is wrong with this market? This is because a great deal of what goes into the gold market is psychological and reacts to cyclic trends driven by both psychological and economic factors.

So what does all this have to do with the price of gold now? It has everything to do with gold and nothing to do with gold.

Here is what I’ve been able to observe in the last several years in gold and seems to be holding true.  It is something that you should pay attention to if you’re interested in the next big move in the gold market.

Before gold can move higher it needs to create what I call an “energy field”.  The most recent energy fields in gold were between May 12, 2006 and September 20, 2007. This 17 month energy field saw gold prices oscillate between a broad trading range bound by $730.08 (upside) and $541.80 (downside).  That energy field produced enough power to propel gold to the new high of $1,012.40 on March 17, 2008. This marked the first time gold exceeded, in dollar terms, the highs set in the early 80s mentioned earlier.

The energy fields I have observed for gold are taking somewhere between 17 and 18 months to complete. If the energy field holds, then the December 3rd 2009 high of $1,226.37 should remain in place for quite some time. If the same cycle remains true then the recent lows that we witnessed, at $1,050, should also remain intact as they represent the 15 to 16 month cycle low.

To summarize: I expect gold to be locked in a broad trading range for the next 12 months bounded by the December 09 highs of 1,226.37 and the lows of $1,050.00. If the gold cycle holds true, we expect that gold tops the $1,226.37 marker by April or May of 2011.

On the on the upside we will also be looking for gold to make a nature cyclic high in October or November of 2011. It’s impossible to predict the future with any degree of accuracy; however when we look at the cycles in gold this reads as a pretty good bet.

No matter what happens we expect gold will offer some great trading opportunities that investors and traders should be able to take advantage of.

As I always discuss- in trading one should approach gold or any other market with a game plan and proper money management stops. The key to success in this decade will be an investors willingness to move in and out of asset classes such as gold and be well diversified into more than one asset class. That way you wont be left holding the bag for the next 25 years. Our World Commodity Portfolio is a good example of this approach and one I believe will serve investors well in the coming years.

Tags: 80s, Amount Of Money, Bank Failures, Bulls, Bulls And Bears, Chicago Mercantile Exchange, CME, Commodity Markets, Dirty Little Secret, Dollar Terms, Frustration, Gold, Gold Bugs, Gold Commodity, Gold Futures Market, Gold Market, International Monetary Market, Lows, Move One, New Highs, Ounce, Spot Gold, Timeline
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Three reasons analysts have rose-coloured glasses on Chinese bubble

Tuesday, March 30th, 2010

This article is a guest post by Ed Harrison of Credit Writedowns.
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China is in the midst of an asset bubble. The evidence is clear that China’s aggressive fiscal and monetary policy is causing the Chinese economy to overheat, with some predicting 12% growth for the Q1 2010. According to Marshall Auerback, researchers at Lombard Street think GDP growth hit an annualized 25% in the second half of 2009 (20% real and 5% inflation) but that the year-on-year data obscured this. Chinese policy makers are looking to rein all of this in for fear of a hard landing.

Analysts like Edward Chancellor of Grantham, Mayo, Van Otterloo & Co. LLC have written well-constructed arguments why we should be cautious, pointing to the age-old signs of a financial bubble. Nevertheless, others are making excuses.

Cait Murphy explains quite well that these excuses tend to fall into three specific camps. I will quote her below and add some extra commentary.

1. China’s asset price rises are not underpinned by debt.

About half of apartments are paid for in cash, and for those who get mortgages, the down-payment is typically  50%. Mortgage debts, which make up about 10% of Chinese GDP (compared to more than 100% in the U.S.), are not securitized and are kept on the books of the banks that issued them…

But just because China is not leveraged the way the U.S. was does not mean it is not leveraged at all. Developers, for example, take on debt to start projects and these are largely based on a calculation of future property values, which of course are assumed to always be rising….

Murphy goes on to point out that all bubbles are equal, but some bubbles are more equal than others. And this is the crux of the argument here – bubbles underpinned by debt are assumed to be damaging and ones not underpinned by debt are not. This does not sit well. Unlike former Fed member Frederic Mishkin, I believe potential asset-prices bubbles are always dangerous because of the misallocation of economic resources they induce.

However, here debt is indeed the problem. Just because property price excesses are not financed by high debt levels in the household sector doesn’t mean there isn’t a debt problem. If you recall, in Japan, it was the business sector’s property-related debt which created Japan’s balance sheet malaise. In China, the same is true again.

2. China has a huge cache of reserves

China has $2.4 trillion in reserves. As Thomas Friedman put it, with ghastly roguishness, “First, a simple rule of investing that has always served me well: Never short a country with $2 trillion in foreign currency reserves.” Having a lot of reserves does not mean there cannot be a bubble. Just two quick examples:America in the 1920s and Japan in the 1980s had reserves about the equivalent, in global GDP terms, as China does now. We know how that worked out.  But if there is more supply than demand, and if prices keep going up faster than income and if there is something like hysteria about getting into the game — all characteristics of a bubble, all too true in China right now — the market is going to correct. Period.

Reserves protect the value of a currency and are good for a country’s credit; they are a force for financial stability. But they cannot prevent the formation of a bubble. If anything, huge reserves can be a symptom of underlying economic imbalances, notes Michael Pettis, a specialist in financial markets at Beijing’s Guanghua School of Management, in the form of “a too-quick expansion of domestic money and credit.”

The reserves are irrelevant. What I discussed in the links this morning regarding Argentina is highly relevant here. Argentina’s President Cristina Fernandez de Kirchner has demanded the central bank to use foreign currency reserves to pay public debt maturities. This is what people are saying the Chinese could do. But it is not as simple as that because the central bank has a balance sheet just like any other company. The reserve assets are underpinned by currency liabilities. Pettis says:

…the PBoC has a balance sheet consisting on one side of dollar assets (and here “dollar” is short-hand for all foreign assets).   Against this and on the other side it has a roughly equivalent amount of RMB liabilities…

…China’s reserves are often thought of as if they were a treasure trove available for spending.  They are not.  They are simply the asset side of the mismatched balance sheet.  If the PBoC wanted to “spend” $100, say for example to recapitalize a bank, it could do so, but this would automatically create a $100 dollar hole in its balance sheet. – it would still owe the RMB that it borrowed originally to purchase the $100…

Can PBoC reserves protect China?

So the PBoC cannot give away the reserves without causing an increase in its net indebtedness.  …Beijing cannot just recapitalize the banks with reserves.  A substantial amount of NPLs will one way or another increase government debt.  The only way Beijing can recapitalize the banks is by borrowing, or by raising direct (or hidden) taxes.  Having the PBoC recapitalize the banks is just another way for the government to borrow, and since almost everyone would agree that losses in the banking system should be paid directly out of fiscal revenues, and not indirectly by the central bank, it would be a very inefficient way of doing so.

So what are reserves good for?  As long as China maintains its own currency and denominates all domestic transactions in RMB, the PBoC reserves cannot be used in China.  They cannot go to pay doctors’ salaries, to build bridges, to lower taxes or to subsidize consumption.  They can only be used to purchase or pay for things from outside China.  This means that reserves ensure that China can import foreign commodities and other goods as long as it can pay for them domestically.  It also means that the PBoC can ensure the availability of dollars to repay foreign debt and foreign investment.

So the point is that the reserves are meaningless in the context of asset bubbles.

The government won’t let it happen. It’s true that the Chinese government, unencumbered by trivia like freedom, can do big, difficult stuff more readily. For example, China’s stimulus program was triple, in relative terms, that of the U.S., and because their planners did not have to deal with things like public opinion to any significant degree, lots got spent quickly. Moreover, the government owns the banks, so it should be able to exert control over them. And yes, it’s true (as noted above) that the government is aware of the problem. In fact, Beijing has done a couple of things to try to cool down the market, such as requiring banks to raise their reserves; making the purchase of second (or third or fourth…) homes more difficult; and reducing the mortgage interest discount.

So what? Animal spirits are well established already. I would argue that, once the animal spirits of an asset bubble have taken over, the central bank must go well beyond policy normalization and institute a very restrictive monetary policy to rein in excesses. This risks a hard landing. In fact, this is the very same ‘conundrum‘ Alan Greenspan faced with his baby step 25 basis point increases in the Fed Funds rate.

And I am not confident in the least that Chinese officials are any better at reining in asset bubbles. Willem Buiter and and Shen Minggao have it right.

“This time is unlikely to be different unless the authorities in China act differently from the authorities in China and elsewhere in the past,” Buiter and Shen said.

Policy makers probably won’t temper investors’ exuberance because they don’t want to lose political support or hurt the investment growth they view as necessary to ensuring the economy maintains an 8 percent growth rate and spurs employment, Citigroup said.

“Few politicians have been successful running against asset booms and bubbles,” the report said.

When the asset bubble does break, the impact will be painful for China and its trading partners, Buiter and Shen said. It may still not derail China’s economic expansion so long as the nation’s leaders seek to make the economy more reliant on domestic demand…

Sources

Yes, Virginia, China Does Have a Bubble – Cait Murphy

Citigroup’s Buiter Warns China Facing ‘Boom, Bubble and Bust’ – Business Week

Source: CreditWritedowns.com

Edward Harrison is a finance specialist at Global Macro Advisors. He was a strategy and finance executive at Deutsche Bank, Bain, and Yahoo. Edward started his career as a diplomat and speaks German, Dutch, Swedish, Spanish and French. He holds an MBA from Columbia University and a BA in economics from Dartmouth College. Edward also write the blog Credit Writedowns. Follow him on Twitter at twitter.com/edwardnh to receive all updates on finance news from around the web.

Tags: Asset Price, Asset Prices, Bubbles, Cait Murphy, China, Chinese Economy, Chinese Policy, Coloured Glasses, Commodities, Crux, Ed Harrison, Edward Chancellor, Financial Bubble, Fiscal And Monetary Policy, GDP, GDP Growth, Grantham Mayo Van Otterloo, Lombard Street, Marshall Auerback, Midst, Mortgage Debts, Property Values, Q1
Posted in Commodities, Markets | Comments Off

I’m still confused about this whole Eurozone thing…

Tuesday, March 30th, 2010

This is a post about my confusion, rather than my reporting, of the Eurozone saga. Here are some pieces worth reading if you want to catch up:

The NY Times (the basics); Ed Harrison (via Naked Capitalism); From the billy blog; The Financial Times (Martin Wolf, a must read); The Economist (will reference below).

Okay, a conditional guarantee for possible lending, maybe, with consultation from the IMF has been agreed upon by the Eurozone countries (Germany and France, really). But what I don’t understand is pretty well stated in the Economist article:

The Greek government has somehow to keep its economy on an even keel while pushing through a huge fiscal tightening. Countries that seek IMF help generally have to endure brutal cuts in public spending, which deepen recessions. To counter that effect, the IMF typically counsels a weaker currency. Sadly, this is not an option for Greece. Stuck in the euro, its exchange rate with its main trading partners is fixed. Greece cannot devalue, so it needs more time to adjust than the three years it has agreed with its EU partners—and a bigger safety net while it does.

Sadly? This is not an option? The Economist completely skips over the VERY LARGE issue of a singular currency and on to the competitiveness story, one that must be derived through internal devaluation, i.e., dropping wages and other nominal variables.

Financial crises, especially those in small-open economies (Sweden, for example), generally end with a massive currency devaluation that drives export growth (provided there is external demand to suffice). I honestly don’t see how a sufficient export-generated rebound is even a possibility, given that the rest of the Eurozone is essentially trying the “internal devaluation” bit simultaneously (chart above).

And who’s going to pick up the slack? In 2008, 64% of Greece’s export income was derived by the EU 27 countries, 70% for Spain, and 74% for Portugal. If the Eurozone as a whole is using this same internal deflation mechanism to spur export growth, only the “zone” as a whole really benefits, not any one country.

WIHTOUT a massive surge in export-driven GDP growth no “zone” country can drop its financial deficit without incurring behemoth debt burden growth (in the case of the Eurozone, the term “burden” actually applies since Greece, nor any one economy, can print its own money).

Look at the government’s period budget constraint (left), where the lower-case letters “d” and “p” stand for the debt and primary deficit as a share of GDP, respectively. r is the nominal interest rate, and (1+g) is the rate of NOMINAL GDP growth (including price appreciation). (Email me if you want the algebra.)

When Greece starts dropping p (the primary deficit), the fundamentals of the economy (i.e., nominal gdp growth (1+g)) must be robust enough to prevent a surging debt burden. And here’s the cycle: to drop the primary deficit, it does so by reducing G and raising T, which drags Y (as of Y = C + I + G + Ex – Im) and growth of Y, (1+g), since export growth is unlikely to be there to offset the decline in private spending; these effects then flow back to the primary deficit to raise p.

And likewise, only under the circumstances of heroic export growth can the government reduce its fiscal deficit to 3% WITHOUT the private sector levering up their balance sheets and contributing to a larger default risk (of the depressionary type). I’m confused.

All I’m saying is that this plan, in its current form, is really not much of a plan at all. The internal devaluation model has a lot of holes.

Rebecca Wilder

Tags: Competitiveness, Conditional Guarantee, Currency Devaluation, Ed Harrison, Eurozone Countries, Even Keel, Export Income, Financial Crises, Financial Times, Greek Government, Imf, Martin Wolf, Nominal Variables, Ny Times, Open Economies, Public Spending, Recessions, Safety Net, Trading Partners, Worth Reading
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Latin America: Leadership in Chile and Brazil (Mark Mobius)

Monday, March 29th, 2010

This article is a guest contribution by Mark Mobius, Executive Chairman, Franklin Templeton Investments.

Latin America is set to witness eight elections this year, including four presidential elections in Chile, Costa Rica, Colombia, and Brazil. We recently traveled to the region to research investment opportunities there and to get a sense of the ‘mood on the ground’. We came away with a general impression of optimism, particularly in Brazil, and we think this will spread to other countries in Latin America.

Chile
We had visited Santiago, Chile, and so I was shocked and saddened to hear of the impact of the powerful earthquake that hit central Chile shortly after I left. I have an apartment in Chile and although the building was not destroyed and is structurally sound, cracks formed in various parts of the unit. Since copper and other minerals are Chile’s major exports, it was important to learn that the mining industry in the north of the country was not impacted by the earthquake.

The swift response by the Chilean government as well as international aid agencies to provide assistance is reassuring, but there is much that still needs to be done. We must accept that earthquakes, volcanic eruptions and other natural phenomena have been with us in the past and will continue in the future. Chile, too, has experienced such events and has been able to recover and prosper. We believe this will be the case this time as well.

Chile is a leader among Latin American countries in terms of its management of the economy, its encouragement of investment both local and foreign, and its stable policies. In mid-January, Chile elected Harvard University-educated economist Sebastian Pinera as head of state – the first conservative, elected president of Chile in over 50 years. The new government stepped into office on March 11. As noted, we believe Chile’s previous government managed their economy very well and we would look forward to a continuation of the current economic policies. We would also encourage the new government to further support small and entrepreneurial businesses, which could likely help the economy as well as capital markets. On a broad basis, we think that the new government may even augment new investment opportunities in Chile.

Brazil
When we arrived in Brazil, the summer air was thick with humidity, and the traffic from the airport underscored the countries rapid economic expansion and optimism. I had always enjoyed the annual Carnival in Rio de Janeiro, which reflects the culture of a people who seem to embrace everything with great passion. Brazil’s presidential elections are scheduled for October of this year. From our conversations with individuals and companies, expectations are that the new government’s policies should be ‘more of the same’. Most people believe that the new president should not change policies that are going well in the country. We concur. Looking back, we were all pleasantly surprised by President Lula – contrary to expectations before he took office, President Lula cut government expenses in January 2003, helping trim the deficit from 4.2% of gross domestic product (GDP) in 2002 to 2.4% of GDP by 2004.[1] He has held the deficit under 4% of GDP every year since then, helping the country earn investment-grade credit ratings from Standard & Poor’s and Moody’s Investors Service.[2] As he nears the end of his term, I would consider awarding this president high scores for the way he has steered the country and its economy. In my opinion, he has been a wise visionary, with his emphasis on education and homes for low-income individuals, and if these continue to be emphasized, we believe it will be very positive for Brazil.

We would be concerned if the government were to impose restrictions on business growth, elevate taxes or restrict licenses. However we have not seen this happening, which is good news to us. We also think that the government’s idea of creating “national champions”, domestically-owned companies who are top in their respective industry, is good. The government, wisely, is not just looking at Brazil but also at the global environment, and it sees that this country needs strong companies that can compete on a global scale. The biggest energy company in Brazil currently ranks as one of the top 10 largest corporations worldwide. Many of these “national champions” were former state-owned enterprises, which had since been privatized.

We think that Brazil is the largest investable market in Latin America. It is a strong commodity producer and exporter, and it is likely to benefit from rising global demand for energy, metals and other commodities. With its tremendous resources, not only mineral but agricultural as well, Brazil’s economy is less dependant on external forces than, for example, China’s, because Brazil has to import very little of the resources identified above.

Historically, political change and financial markets in Latin America have had a rocky relationship. But the region has progressed significantly since a decade ago, with better regulatory systems, higher foreign reserves and robust economic growth in many countries. This year, we expect to see Latin American markets continuing their secular bull trend, though of course, there may be corrections along the way.

[2] Source: EIU, as of September 2009

Source: Latin America: Leadership in Chile and Brazil

Tags: Brazil, Central Chile, Chilean Government, Commodities, Countries In Latin America, Elections In Chile, energy, Executive Chairman, Franklin Templeton Investments, Harvard University, Head Of State, Latin American Countries, Major Exports, Mark Mobius, Mining Industry, Natural Phenomena, Natural Resources, President Of Chile, Presidential Elections, Research Investment, Santiago Chile, Sebastian Pinera, Swift Response, Volcanic Eruptions
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Francis Chou: “Comments on the Market”

Monday, March 29th, 2010

This is an excerpt from Chou Associates’ Francis Chou’s letter to shareholders for 2009 which was recently published in the fund company’s Annual Report for 2009.

General Comments on the Market

SOVEREIGN GOVERNMENTS DO NOT DEFAULT ON THEIR DEBT?: It is hard to believe that governments can and do default on their debts and, as the following table shows, even with their power of taxation and the ability to print money, governments have to obey the laws of economics. Just like an individual or a corporation, if governments cannot service their debt, they either default or have their debt rescheduled. As the table also shows, it is not only poor emerging third world or African countries run by dictators that default, but also long established democracies with duly elected governments that are governed by a rule of law and that are considered modern economies. It is an eye opener to see that since the year 1800, Greece has spent roughly 50% of its time either in default or debt rescheduling; Spain has spent approximately 23% of its time in default; and Mexico and Russia around 40%.

Source: This time is different Eight centuries of financial folly by Reinhart & Rogoff

The table is important because it demonstrates that it is not too farfetched to think that well-known democratic countries can and do default on their sovereign debt.

WAS THE GREAT STIMULUS A SILVER BULLET? – THINK AGAIN: It now appears that the great stimulus provided by almost all governments has averted the second Great Depression and the North American economy may well be on its way to recovery. However, looking forward, unless we find a credible way to repay or at least comfortably service the enormous and growing burden of government debt, we are going to face immense challenges. By overloading governments with too much debt, the stimulus may have pushed the problem from the private sector to the government sector and may have made it worse. If we take a snapshot of the growing gross debt as a percentage of GDP before and after the meltdown, we get a pretty good picture of the potential trouble some countries may face in the future.

Source: JP Morgan provided data on Brazil, China, India and Russia. All other data obtained from the OECD.

At some level, debt becomes an intolerable burden and increases the chance of a default. Historically, when gross debt exceeds 70% of a country’s GDP, the warning signs start flashing.

While we all wished the great stimulus would prove to be a silver bullet that would resolve all the problems stemming from the world financial crisis, that has hardly been the case. If history is any guide, it takes a long time for countries to successfully emerge from a financial crisis. They must deal with a huge increase in unemployment along with a profound increase in government debt. The problem is exacerbated by lower tax revenues in the future caused by lower output and unemployment. We think the next few years will be rocky, with economies lurching from one crisis to another.

As an investor, we believe there will be enormous opportunities but the key to investment success will depend on how we avoid some of the inevitable potholes we will find in our path.

We would also like to add a caveat to those who are investing in the Chou Funds: markets are inherently volatile in the short term and can adversely affect the Chou Funds. Therefore, investors should be comfortable that their financial position can withstand a significant decline – say, 50% – in the value of their investment.

TOO BIG OR TOO WELL CONNECTED TO FAIL: One would imagine that the great financial crisis would precipitate meaningful banking and financial reform but I doubt that will be the case. As long as the financial institutions are too big or so well inter-connected to the financial system that their failure may precipitate a chain reaction that threatens the world financial system, the government will protect them from failure. The rescue of AIG turned out to be essentially a bailout of the investment banks. When executives, especially CEOs, suffer no serious financial consequences when their actions bankrupt or put their companies in deep financial distress, it encourages risky and unethical behaviour. Such perverse incentives need to be discouraged. The Board of Directors is supposed to protect shareholders but more often than not, directors are just patsies for the CEOs. In a damning 2,200 page report, written by bankruptcy examiner Anton Valukas on Lehman Brothers, he wrote of one episode on March 20, 2007, where the chief administrative officer, Lana Franks Harber of Lehman’s Mortgage Capital division, e-mailed a colleague to summarize her discussion with Lehman President Joseph Gregory with regard to her presentation to the Board of Directors: “Board is not sophisticated around subprime market — Joe doesn’t want too much detail. He wants to candidly talk about the risks to Lehman but be optimistic and constructive – talk about the opportunities that this market creates and how we are uniquely positioned to take advantage of them.” (italics emphasis added). The report then states, “Consistent with this direction, the Board presentation emphasized that Lehman’s management considered the crisis an opportunity to pursue a countercyclical strategy…. Management informed the Board that the down cycle in subprime presented substantial opportunities for Lehman.”

More than once, under a bankruptcy restructuring, I have seen the very CEOs who ran the company into the ground getting 5% of the recapitalized company without putting up any of their own money. In most occupations, there are penalties for egregious failure but the CEOs of public financial companies are in a league of their own. Many get paid obscene amounts of money for risky and reckless behaviour. There is a joke on Wall Street: “Today, President Obama announced a salary cap of $500,000 for executives at banks and companies that have received taxpayer bailout money. And the CEOs asked: ‘Well, that’s $500,000 a week, right?’”.

DEBASEMENT OF CURRENCY: Almost all governments whose economies have been adversely affected by the financial crisis have been providing all kinds of stimulus funds to minimize the impact of the liquidity and credit crisis on their economies. They are all falling over (competing with) one another to see who can debase their currencies further.

INFLATION OR DEFLATION: The huge surplus of excess capacity in almost every sector in the world presents a strong case for deflation down the road. But with the explosion of government debt in most of the world, it is hard to believe that governments will let future generations deal with the enormous debt with currencies that will have a higher purchasing power than they have now. Historically, the easy way out for governments has been to inflate their way out of their debt problem.

NON-INVESTMENT AND INVESTMENT GRADE BONDS ARE FULLY PRICED NOW: The historically high spread between U.S. corporate debt and U.S. treasuries narrowed in 2009. Three years ago, the spread between U.S. corporate high-yield debt and U.S. treasuries was 311 basis points; at December 31, 2009 it was 657 basis points, down from its December 2008 peak of 1,900 basis points. Three years ago, the spread between U.S. investment grade bonds and U.S.

treasuries was about 85 basis points; at December 31, 2009 it was 162 basis points, down from its December 2008 peak of 592 basis points. (Source: JP Morgan)

Given the above, we believe that investment and non-investment grade corporate bonds are now fully priced.

It is similar with equities. Most stocks are now close to being fairly priced and it is harder to find bargains. Although we won’t likely see the lows that we saw in February/March of 2009, the risks of investing in equities are greater now.

Source: Chou 2009 Annual Report [PDF]

Tags: African Countries, American Economy, Brazil, BRIC, BRICs, Canadian Market, Chou Associates, Country Share, Democracies, Democratic Countries, Dictators, Eye Opener, Folly, Great Depression, India, Laws Of Economics, Letter To Shareholders, Power Of Taxation, Rule Of Law, Russia, Silver Bullet, Sovereign Debt, Sovereign Governments, Stimulus, Third World, Year 1800
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Have Commodities Outpaced Fundamentals?

Monday, March 29th, 2010

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Have metal prices and the prices of other commodities such as oil outrun the underlying fundamentals? The significant strength of the US dollar since December last year has capped rises in commodity prices. However, metal prices continue to be driven largely by Chinese demand, with China’s manufacturing PMI for new export orders and total new orders leading metal prices.

Although still indicating expansion, the PMI for new export orders had stabilised at the higher level, but weakened recently, probably as a result of the Chinese New Year holiday. It remains substantially below the highs achieved before March 2008, though. The manufacturing PMI for new orders approached previous peaks before the holiday affected the readings.

In the near term, it is likely that the Chinese authorities’ drive to cool the economy – through various monetary measures such as interest rate hikes and increasing bank reserve requirements – is likely to lead to a softer but still expanding PMI for new orders. Stock building as measured by China’s manufacturing PMI for stocks of major inputs is an important factor in the metals market. Although the purchasing managers were quite price sensitive up to May last year – varying their stocks according to price changes – the sensitivity has been absent since metal prices bottomed. The recent austerity measures implemented by the authorities are likely to lead to some excess inventories in China finding their way back to the marketplace and the purchasing managers again becoming more price sensitive. The Baltic Dry Index – a measure of global bulk freight rates – indicates that China’s manufacturing PMI picked up in March.

The risks of investing in commodities are increasing as we move forward. The metal markets currently smack of speculation and manipulation. Metal stocks on the London Metal Exchange are currently at levels similar to those at the height of the global liquidity crisis. No wonder the Commodities Futures Trading Commission (CFTC) has called on Congress to impose hard-cap position limits on metals to address excessive concentrations of positions that could lead to the manipulation of metal prices.

The termination of China’s accommodative monetary strategy, combined with the public debt malaise in the eurozone, is likely to reduce the speculative demand for industrial metals, especially in the second half of this year. Commodity prices could fall hard and fast should the double-dip scenario for the Western World become a reality, but a weaker US dollar may reduce the pain.

The trading range chart below shows that the Reuters/Jeffries CRB Index (267.3) has been trading sideways since October and is at the moment neutral to somewhat oversold, being positioned between one (yellow shading) and two (blue) standard deviations below its 50-day moving average. Key levels to watch are the 200-day line – a mere 1 point away – and the February lows (258.6), levels that must hold in order for the cyclical bull market to remain intact. As always, I will be keeping a close eye on the situation, especially the new Chinese PMI report being released later this week.

Source: Plexus Asset Management (based on data from I-Net Bridge).

Tags: Austerity Measures, Baltic Dry Index, Chinese Authorities, Chinese Demand, Chinese New Year, Commodities, Commodity Prices, ETF, Excess Inventories, Export Orders, Freight Rates, Global Liquidity Crisis, Interest Rate Hikes, Investing In Commodities, Liqui, London Metal Exchange, Metal Markets, Metal Stocks, Metals Market, Monetary Measures, Pmi, Price Changes, Purchasing Managers, Speculation
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Bill Gross Prefers Stocks Over Bonds

Monday, March 29th, 2010

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Bill Gross, founder and co-CIO of Pimco, said in an interview with CNBC that, all things considered, he prefers stocks over bonds in the current investing climate.

“Let’s suggest the economy looks good, that risk assets – whether it’s high-yield bonds or whether it’s stocks – have a decent return relative to the potential of declining bond prices. I’ll go with the stock market,” said Gross.

From CNBC: “While sovereign issuance in countries with stronger economies and lower debt—Gross mentioned Germany and Canada specifically—look better, other countries such as the US and United Kingdom don’t offer the same promise.

“That brings up the health care situation and the $40 trillion worth of present value in terms of entitlements we have in the United States,” he said. “We just added in my opinion another $500 billion in terms of health care and the markets are beginning to look at that suspiciously.”

Gross spoke about an hour after a poorly received Treasury auction of five-year notes sent US debt prices down sharply and yields jumping higher.

With the Federal Reserve exiting its purchases of mortgage-backed securities, that will make the landscape even more challenging as the government looks for the funds to pay for health care and other expensive entitlement programs.

“It will be up to us, to the market…to finance the ongoing deficit,” Gross said. “So we’re just going to have to be a little more cautious in simply ascribing an A-plus or B-minus to a bond auction,” he said.

That could, at the same time, create a friendlier environment for stocks.

“All assets to some extent relate to the same conditions—economic growth, the potential for inflation, central bank policy,” he said. “To the extent that stocks are now basking in a growth revival,  more than green shoots, there is a chance that stocks keep going.”"

Source: CNBC, March 24, 2010.

Tags: Assets, Bill Gross, Bond Auction, Bond Prices, Canadian Market, Cape Town, Care Situation, Climate, Cnbc, Current, Debt Prices, Decent Return, Economic Growth, Economy, Entitlement Programs, ETF, Federal Reserve, High Yield Bonds, Investing, Investment, Issuance, Mortgage Backed Securities, PIMCO, Postcards, Present Value, Revival, risk, Stock Market, Stocks, Stocks Bonds, Target, Treasury Auction, Trillion
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China’s Internet Boom

Sunday, March 28th, 2010

by Frank Holmes, President & CEO, U.S. Global Investors
March 25, 2010

Lost in the scuffle between Google and the Chinese government is how fast China’s Internet use is growing.

The total number of Internet users in China grew by 86 million in 2009 to reach 384 million by year-end.  That’s well more than the entire population of the U.S. and Canada combined, and a 29 percent increase year-over-year.

Of that number, 90 percent had broadband connections, according to the China Internet Network Information Center (CNNIC).

Nearly 30 percent of Chinese are now Web users, and this sets the stage for explosive growth in the years ahead.

Once Internet penetration in the U.S. reached 20 percent, it took just six years to get to 60 percent. Japan needed only three years to go from 20 percent to 40 percent, and Brazil went from 20 percent penetration in 2005 to more than 35 percent by 2007.

While the highest penetration rates surround China’s largest cities, the mobile Internet is bringing the Web to rural and lower-income users. Mobile internet has lowered the cost of entry for consumers—smart phones are cheaper then desktops.

A surprising result from CNNIC: more than 45 percent of mobile Internet usage is from people with monthly income of 100 yuan ($14.65) or less.

A recent survey reported by McKinsey & Co. shows that people in China’s 60 largest cities spend around 70 percent of their leisure time on the Internet. Most of this usage is for games, entertainment and shopping.

On the commerce side, two of the biggest growth areas were online banking and e-commerce. Users who book travel online jumped 78 percent last year. McKinsey says a significant number of consumers ages 18 to 44 won’t purchase a product or service without first researching it on the Web.

As the Internet continues to expand its reach into the lives of Chinese people, keep an eye on how users leverage the technology to improve their living standards.

Disclosure:

The following securities mentioned in this post were held by one or more of U.S. Global Investors family of funds as of 12-31-09: Google Inc.

Tags: Book Travel, Brazil, Broadband Connections, Canadian Market, China, China Internet Network, Chinese Government, Explosive Growth, Frank Holmes, Google, Growth Areas, Internet Boom, Internet Network Information Center, Internet Penetration, Internet Usage, Internet Use, Largest Cities, Mckinsey, Mobile Internet, Network Information Center, Number Of Internet Users, Penetration Rates, U S Global Investors
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