Archive for November, 2012
Friday, November 30th, 2012
A Trojan Horse?
by Jamie Hyndman, Mawer Investment Management
November 30, 2012
Sometime roughly three thousand years ago, it is said that a great wooden horse was laid outside the walls of the city of Troy. The Trojans, enamored by the sight of such a gift, celebrated in what they viewed was a sure sign of their victory and greatness. But as night fell, it was clear that all was not what it seemed – the clever Greeks had hidden a small cadre of men inside the faux horse, and under the cover of darkness, slipped into the city and opened the gates, leaving the great city of Troy exposed to the mighty Greek army. And, well, you know how that story ended.
The Trojan Horse is a cautionary, mythological tale that warns us that what we think we might be getting, could be something else entirely different. It is a lesson that applies well to investing, as throughout history investors have fallen in love with various companies or products, only to be deceived later on. Nowadays, it seems that many investors have fallen into a similar trap with passive investing.
To be sure, there is a place for passive investing in our world. Passive investing is based on the efficient market hypothesis, which states that prices reflect all publicly available information. It can be a sensible strategy for those that don’t have the resources or inclination to do the work necessary to identify active managers that do truly add value above and beyond passive indices. It may also be an approach that can be used alongside active investments to great effect. Yet this horse is by no means a panacea.
Some indices, for example, make little sense to track if you are a risk adverse investor. The S&P/TSX is one such index. How sensible is it to track an index that is dominated by just three sectors? Financials, Energy and Materials make up 70% of the S&P/TSX. While these sectors may do well during an economic upswing, we expect that all three would fare poorly should we experience economic malaise. And more generally, how much sense does it make to invest in a bad company or a troubled country simply because it is in the index? Many of the companies within the S&P/TSX for example are simply not wealth creating, and we suspect that investors that held a broad basket of Japanese equities over the last two decades would have been disappointed. When you spot a moldy strawberry at the grocery store, it does not make sense to buy that particular package of strawberries.
The concept furthermore ignores the potential for temporary mispricing in the market. Since passive investing blindly accepts the valuations of individual securities, owners of a passive index may at times find themselves owning an index that is dominated by overvalued securities. The technology bubble in the late 1990s was a great example of an era that saw major indices littered with overvalued securities. Some of you will remember that, at its height, the now defunct Nortel represented over 30% of the TSX. Regardless of where the market goes and how irrational it may become, passive investors are towed along for the ride.
A final point must be clarified as it relates to the benefits of passive investing. Despite their reputation, passive products are not costless and have varying degrees of tracking error relative to the underlying securities that they are supposed to mimic. As an example, the Canadian version of the iShares MSCI World Index Fund has an MER of 0.46% and had a tracking effort of 0.37% in 2011. In other words, the cost for an investor in this product was close to 0.83%, not an insignificant sum.
As an active manager, we admit we have some bias in writing this. We also concede that passive investing can and does play an important role in the portfolios of some investors. Nevertheless, with the drumbeat for passive investing growing ever louder, now seems like an appropriate time to cast a warning – don’t wheel a Trojan horse into your house.
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Friday, November 30th, 2012
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Friday, November 30th, 2012
Back-to-back days of 1.5%+ gains pushed India’s stock market to a new 52-week high today. As shown in the first chart below, the chart pattern couldn’t look any better for the India’s Sensex.
At the same time, China, India’s BRIC brother, made a new 52-week low today. As shown below, the chart pattern can’t get any worse for China’s Shanghai Composite.
The chart below shows just how long China’s stock market has been struggling. Back in late 2008, both China and India made their financial crisis lows at the same time. Both indices bounced 100%+ very quickly off of the lows, but the two countries have seen their stock markets take very different paths since late 2009. India has hung in there and is currently up 125% off of its lows, while China is now up just 13.95% from its low made back in October 2008. How much further will China fall before it finally sees some kind of sustained rally?
Copyright © Bespoke Investment Group
Friday, November 30th, 2012
by James Stafford, Oilprice.com
Shale Gas Will be the Next Bubble to Pop – An Interview with Arthur Berman
The “shale revolution” has been grabbing a great deal of headlines for some time now. A favourite topic of investors, sector commentators and analysts – many of whom claim we are about to enter a new energy era with cheap and abundant shale gas leading the charge. But on closer examination the incredible claims and figures behind many of the plays just don’t add up. To help us to look past the hype and take a critical look at whether shale really is the golden goose many believe it to be or just another over-hyped bubble that is about to pop, we were fortunate to speak with energy expert Arthur Berman.
Arthur is a geological consultant with thirty-four years of experience in petroleum exploration and production. He is currently consulting for several E&P companies and capital groups in the energy sector. He frequently gives keynote addresses for investment conferences and is interviewed about energy topics on television, radio, and national print and web publications including CNBC, CNN, Platt’s Energy Week, BNN, Bloomberg, Platt’s, Financial Times, and New York Times. You can find out more about Arthur by visiting his website: http://petroleumtruthreport.blogspot.com/
In the interview Arthur talks about:
· Why shale gas will be the next bubble to pop
· Why Japan can’t afford to abandon nuclear power
· Why the United States shouldn’t turn its back on Canada’s tar sands
· Why renewables won’t make a meaningful impact for many years
· Why the shale boom will not have a big impact on foreign policy
· Why Romney and Obama know next to nothing about fossil fuel energy
Interview conducted by James Stafford of Oilprice.com
James Stafford: How do you see the shale boom impacting U.S. foreign policy?
Arthur Berman: Well, not very much is my simple answer.
A lot of investors from other parts of the world, particularly the oil-rich parts have been making somewhat high-risk investments in the United States for many years and, for a long time, those investments were in real estate.
Now these people have shifted their focus and are putting cash into shale. There are two important things going on here, one is that the capital isn’t going to last forever, especially since shale gas is a commercial failure. Shale gas has lost hundreds of billions of dollars and investors will not keep on pumping money into something that doesn’t generate a return.
The second thing that nobody thinks very much about is the decline rates shale reservoirs experience. Well, I’ve looked at this. The decline rates are incredibly high. In the Eagleford shale, which is supposed to be the mother of all shale oil plays, the annual decline rate is higher than 42%.
They’re going to have to drill hundreds, almost 1000 wells in the Eagleford shale, every year, to keep production flat. Just for one play, we’re talking about $10 or $12 billion a year just to replace supply. I add all these things up and it starts to approach the amount of money needed to bail out the banking industry. Where is that money going to come from? Do you see what I’m saying?
James Stafford: You’ve been noted suggesting that shale gas will be the next bubble to collapse. How do you think this will occur and what will the effects be?
Arthur Berman: Well, it depends, as with all collapses, on how quickly the collapse occurs. I guess the worst-case scenario would be that several large companies find themselves in financial distress.
Chesapeake Energy recently had a very close call. They had to sell, I don’t know how many, billions of dollars worth of assets just to maintain paying their obligations, and that’s the kind of scenario I’m talking about. You may have a couple of big bankruptcies or takeovers and everybody pulls back, all the money evaporates, all the capital goes away. That’s the worst-case scenario.
James Stafford: Energy became a big part of the election race, but what did you make of the energy policies and promises that were being made by both candidates?
Arthur Berman: Mitt Romney, particularly, talked about how the United States would be able to achieve energy independence in five years. Well, that’s garbage.
Anybody who knows anything about oil, gas and coal, knows that that’s absurd. We were producing a little over 6 million barrels a day thanks to an all-out effort in the shale oil play. We consume 15 million barrels of oil a day and that leaves the gap of 9 million barrels per day. At the peak of U.S. production, in 1970, the U.S. produced 10.6 million barrels per day. Like I said, either the guy doesn’t know what he’s talking about, or is making a big joke of it.
Obama didn’t talk so much . . . He’s a hugely green agenda kind of president and I’m not opposed to that, but he’s certainly not for the oil and gas business. It wasn’t until he got serious about thinking about his re-election that he decided to take credit for what really happened.
James Stafford: Japan recently announced that they are going to be phasing out nuclear power. What are your views on nuclear? Are we in a position to abandon this energy source?
Arthur Berman: No. Japan is a special case. The disaster at Fukushima, the nuclear reactor, was right on top of a major fault. So, that was a dumb place to put it.
To wholesale abandon nuclear power because one reactor was incredibly stupidly planned, to me seems like a bit of a . . . well, I can’t tell people how they should react, but if I were a Japanese citizen, and the truth was that we have no oil, we have no coal, we have no natural gas, the next question is, “Well, if we get rid of nuclear, what are we going to do?”
It’s a really good question to ask. If you don’t have anything of your own, how are you going to get what you need? The answer is that they have to import LNG and that’s very expensive.
Right now, natural gas is selling in Japan for $17 per million BTUs. You can buy the same BTUs in Europe for $9 today, or in the US for $3.25
James Stafford: What about Germany’s decision to also phase out nuclear power?
Arthur Berman: For Germany to abandon nuclear… that decision is truly delusional because they haven’t had any problems over there. Nor is Germany particularly earthquake prone or tsunami prone. They have forced themselves into a love relationship with Russia.
James Stafford: What are your views on Canada’s tar sands? Are they a rich source of oil that the U.S. needs to exploit? Or do you think they’re a carbon bomb, which could do irreparable damage to the climate?
Arthur Berman: Well, that’s a very good question. I suppose they’re both, as are virtually all things that burn. Right? They’re a very rich source of oil. And they’re dirty. It requires a lot of natural gas heating to convert them into some usable form, a lot of processing, but here’s the thing, if the United States doesn’t buy that oil from Canada, do you think Canada’s just going to say, “Oh. Okay. Nevermind. We’ll forget about all this.”
No. They’re going to sell it somewhere else. They’ll probably sell it to Asia. So, the issue of the carbon bomb doesn’t get resolved by the United States not taking the oil.
So, to me, that’s off the table. Yes. I think it’s an incredibly sensible play to get your oil from a neighbour, and a neighbour who you trust, and it doesn’t require overseas transport and probably getting involved in periodic revolutions and civil uprisings.
James Stafford: Is there any technology, any development you see coming in the future that can help us get where we need to be? Is conservation really the only answer or do you have any hopes for some of the alternative energy technologies, such as solar or, even, some of these more advanced technologies such as Andrea Rossi’s E-cat machine?
Arthur Berman: Oh. I have all the enthusiasm for technology that you could ask for. I’m a scientist and I love technology but I heard a very good presentation several years ago on your exact question and the man who gave a talk said, “I’m going to give you a rule to live by. If it’s not on the shelf today, then a solution is no sooner than ten years in the future.” So, when you talk about E-cat and you talk about algae and all this kind of stuff, it’s not on the shelf today. So, that means it’s in some sort of pilot stage of testing.
Work harder guys
Friday, November 30th, 2012
Are Corporate Bonds Expensive?
November 2012 – Investment Strategy Group
As in the case of Treasury bonds, yields for U.S. corporate credits have fallen to historic lows as prices have risen. The yield on the Barclays Aggregate U.S. Investment Grade Bond Index was recently at 2.8% –far below levels achieved during the heady days of 2007. Obviously, this reflects overall interest rates, but is it also a sign that corporate issues may be overvalued? We explore the issues and consider how investors should position their portfolios for the current environment.
Policy-Driven Yields Decline
Currently low corporate bond yields are largely a function of the decline in U.S. Treasury rates, prompted by the Federal Reserve’s loose monetary policy. Comparing current corporate bond yields to levels in 2007 (a time when the economy still registered growth above 3% and the Federal Reserve maintained interest rates above 5%) the interest rate component of corporate bond yields has declined from 65% to 25% for high yield bonds and from 85% to 50% for investment grade corporate bonds.
By definition, this means that corporate bond yields are now compensating investors more, proportionally, for credit risk (or the possibility of default) than before. A better way to assess their valuations, however, is by looking at whether yield spreads (the difference between their yields and those of Treasuries) appropriately reflect expectations of defaults.
Investment Grade Bonds
As of November 15, spreads for investment grade bonds were trading at around 150 basis points (bps), higher than the historical average of around 130 bps and significantly higher than pre-crisis lows of 76 bps in February 2007. By this measure, investment grade corporate bonds continue to look attractive as defaults remain low. Despite the fact that some credit metrics such as revenue and earnings growth appear to have marginally weakened in the third quarter, corporate balance sheets remain robust with high cash balances and strong interest coverage ratios. This is a result of prudent fiscal management by many companies in the past few years as macroeconomic concerns persisted. Given the strength of their balance sheets, we expect corporate bonds generally to be fairly resilient, even if the global economy slides into a deeper slump.
But the low yields have resulted in the emergence of a new risk. As corporations take advantage of cheap financing by issuing lower yielding and longer maturity securities, their bonds’ sensitivity to changes in interest rates (i.e., duration) has been rising steadily. Currently, the average duration of the Barclays Aggregate Investment Grade Bond Index is at around 7.2 years (see display), up from around 6.0 in 2002. This means that every percentage increase in Treasury rates will induce increasing losses in the index. While interest rates are likely to stay low in the near term, unexpected rises in economic growth or inflation could cause rates to reverse rapidly and have a potentially large negative impact on investment grade bonds even if defaults remain low.
INVESTMENT GRADE BONDS’ RISING SENSITIVITY TO INTEREST RATES
Source: Barclays Capital, ISG (Data through November 1, 2012)
High Yield Bonds
Like the investment grade market, high yield bonds have also had a very good run since the economic recovery began in 2009. This year, the high yield market has returned approximately 13% (through October 31), making it one of the best performing asset classes. Unlike investment grade bonds, however, spread historically accounts for the bulk of the yield on below-investment grade bonds. Still, the current spread of 579 bps (as of November 15) is elevated, indicating that investors continue to assign a significant risk premium to the asset class. In our view, this risk is overstated as default rates remain below their historical average (see display below). At these default rates, yields have historically traded closer to 400 bps.
COMPENSATION FOR DEFAULTS IN HIGH YIELD BONDS IS STILL HIGH
Source: Moody’s Investors Services, FactSet, ISG (Data through September 30, 2012)
It is reasonable for investors to wonder whether low yields might prompt corporates to leverage up, which could conceivably lead to deteriorating credit quality. However, the reality is that much of the recent issuance has been used for refinancing as corporations take advantage of the low rates. This actually has the effect of pushing out the timeline in which the bonds’ principals are repaid, which lowers default probabilities in the near term. In addition, the corporate leveraging cycle also generally takes years to build up and we see little sign of excessive practices so far in this roughly $1 trillion asset class.
Still, investors need to be aware that while valuation and fundamentals continue to look favorable, high yield bonds are sensitive to changes in investor sentiment. A deteriorating outlook, precipitated by nervousness around the fiscal cliff, might cause spreads to widen even if defaults do not rise. Moreover, high yield bonds are generally more volatile than traditional fixed income securities.
From an asset allocation point of view, we remain relatively positive on high yield bonds due to strong fundamentals and spreads that are above the historical average, but we are less sanguine on investment grade bonds due to their low yield and increasing sensitivity to Treasury rates. Should growth remain steady and Fed policies accommodative, both high yield and investment grade spreads should compress further. But at lower yields, returns are likely to be less impressive than the past few years.
Another important factor is the level of Treasury yields. In the recent past, declines have provided a tailwind for corporate bonds, but that could be reversed if growth accelerates or inflation begins to make a comeback. This does not necessarily mean investors should radically reduce corporate bond holdings; in fact our Asset Allocation Committee favors a reduced allocation to Treasuries instead. In addition, the Committee currently prefers securities such as bank loans, Master Limited Partnerships (MLPs) and Real Estate Investment Trusts (REITs) for income generation as they tend to be less sensitive to rising interest rates.
Friday, November 30th, 2012
by Patrick Rudden, AllianceBernstein
For years, we’ve advised clients to hold diversified portfolios with balanced allocations to stocks, bonds and other assets. Lately, it’s been a hard sell, especially after years of underperformance by active equity managers. But the tide may be turning.
We understand why clients are skeptical:
- Firstly, equities have underperformed bonds and actively managed equities have struggled to beat passively managed equities. Investors tend to sell what’s done badly and buy what’s done well. And in recent years, hundreds of billions of dollars have moved out of active equities into passive equities and bonds.
- Secondly, changes in accounting rules and regulations have raised the cost of holding equities, causing investors to reduce their allocations.
- Thirdly, the quantity and speed of information keeps accelerating. A decade ago, an investor would have to wait a few days after month end to see their performance. Now they can get an update every day and even every minute. Psychologists have shown that people tend to manage what they can measure, so as measurement has got quicker, investors’ focus has become increasingly short term.
Which of these factors might be cyclical and which are more likely to stay? I think performance is cyclical, as it tends to be mean-reverting: bad performance is often followed by good and vice versa. So the fact that equities have underperformed bonds for the last 10 years increases the likelihood that equities will outperform bonds over the next decade. The same can be said for many active managers’ strategies after several years of underperformance.
Moreover, I think that a swing in the cycle could be imminent. Our models, which rely on a huge range of past experience and likely future linkages between economic and financial factors, suggest that equities are very attractive. Whether you look at the so-called equity-risk premium—the extra returns offered by shares over “risk-free” investments like government bonds—or the price-to-book ratio—a measure of value—equities look cheap. Similarly, with yields at historic lows, bonds look expensive (bar some specialist areas such as high yield). All this, we believe, augurs well for sentiment to swing back in favor of active managers in the near future.
Of course, some factors on my list are likely to be permanent, such as changes in accounting rules and regulations. And given technological developments, it’s highly likely that we’ll be getting more information at faster speeds, for better or worse.
Against this backdrop, active managers are trying to help clients deal with risk as well as return. For example, they’re offering “insurance” to protect portfolios from tail risks, such as many equity investors suffered in 2008-2009, by using derivatives or counterbalancing portfolios. Active managers are also constructing portfolios to protect against inflation risk—when conventional bonds tend to suffer—by including assets such as commodities, index-linked bonds and equities. And in their search for good risk-adjusted returns, active managers are exploring new territory like emerging markets, and mastering new techniques, like asset allocation, as multi-asset or diversified growth funds come into vogue.
So while it’s been a tough decade for active equity managers, we think the tide is turning. There are plenty of signs suggesting that now is not the time to give up on either equities or those charged with piloting them.
The views expressed herein do not constitute research, investment advice or trade recommendations and do not necessarily represent the views of all AllianceBernstein portfolio management teams.
Patrick Rudden is Head of Blend Strategies at AllianceBernstein.
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Friday, November 30th, 2012
The nationalization debate has been sizzling on France’s front burner since last week when Industry Minister Arnaud Montebourg lashed out at the world’s largest steelmaker, ArcelorMittal. He threatened to nationalize its plant in Florange where some old blast furnaces had been shut down for a year-and-a-half. At stake were 2,500 jobs. “We no longer want Mittal in France,” he told the Indian owners—though the company has 20,000 employees in France.
Breaking into a cold sweat, executives around France reevaluated their investment plans. Just then, unemployment hit a 14-year high. Creating jobs was needed more than anything. Scaring off investment was not. Whether his threat was a form of extortion or an announcement of a hostile takeover remains to be seen. But it opened the door for unions at another troubled company to demand nationalization, and the socialist government might not be able to resist.
The three unions—CFTC, Solidaires, and Force Ouvrière—that represent the workers at the shipyard Chantiers de l’Atlantique at Saint-Nazaire on the Atlantic coast demanded in a joint statement today that the government “must become totally involved to guarantee the future of the shipyards” and must become “a majority shareholder.” Jean-Marc Perez, Deputy Secretary of the Force Ouvrière, clarified: “Nationalization is unavoidable.”
Chantiers de l’Atlantique is famous for building the largest cruise ships and supertankers in the world, including the Queen Mary 2, the largest ocean liner ever. But it’s in trouble. Its future is uncertain. Its order books are empty; no new orders are coming in. By 2013, after finishing the current projects, it will be practically without work.
MSC Croisières, its largest customer, put on hold any further investments in cruise ships. Last April, Viking Ocean Cruises cancelled its two cruise-ship orders that had been announced with fanfare just a few months earlier. And a proposal for new ferries for SNCM, a ferry operator in the Mediterranean, isn’t likely to go anywhere—SNCM was privatized in 2006, though the French government still owns 25%. And if the shipyard wants to diversify into offshore oil and gas rigs and windmills, two of the few sectors still doing well, it will face competition from companies around Europe that have specialized in it for a long time.
Employment at the shipyard is down to 2,100 workers, the lowest in its history. Of those, about 1,000 are on partial unemployment. Of the 4,000 subcontractors who still worked there a few months ago, only a little over 1,000 are left. It’s tough for companies in France [Stimulating The Public Sector, Suffocating the Private Sector].
In their desperation, the unions appealed to Montebourg for help, initially last June. Over the summer, they asked for another meeting. Without response. To draw attention to the “silence of the government,” 500 workers went on a one-hour strike at the end of September. Voilà, on October 15, when Montebourg was in Nantes for another event, the union leaders got their meeting.
Afterwards, instead of making earthshaking announcements, he only said that the government would do “its utmost” to defend the shipyard. “Our position is to find economic solutions, in other words, work,” he said. That was a bit too wishy-washy for the union leaders.
But they did sense that he was determined to maintain the shipyards and the special skill sets. Hence hope that the shipyard might not be closed and that a government sponsored program could retrain workers to build offshore oil and gas rigs or windmills. But diversification, if at all possible, would take time. The immediate solution was nationalization. Once the state owned it, closing the shipyard and laying off workers would become, for a socialist government, politically infeasible.
But ownership is already complicated. One of the largest shipbuilders globally, STX Europe owns 66.66% of the shipyard. Headquartered in Oslo, it owns 15 shipyards around the world. It, in turn, is owned by the Korean group, STX Corporation. And who owns the remaining 33.34%? The usual suspect: the French government.
The unions are blaming the majority owners, “the Koreans,” a convenient and distant target. “We don’t see the Koreans, they have done nothing. It’s the state, a minority shareholder, that finds itself playing substitute boss, even though that’s not its role,” said several union sources.
So begins another melancholic chapter in the deindustrialization of France. While privatizing state-owned companies has been all the rage since the mid-nineties, by socialist and conservative governments alike, the current morass in the private sector has stopped that process. The dominoes are lined up. Nationalization is being brandished as a solution.
The government, once it owns a controlling share, could force companies to continue operating and employ people, whether or not they have any work. But it’s an illusory solution. The government already owns a third of Chantiers de l’Atlantique, as it owns major stakes in many large companies. Some, like mega utility EDF, it owns outright. Despite—and cynics say, because of— this profound government ownership, the private sector is in deep trouble, and even more government ownership is unlikely to cure its ills, but might strangle it altogether.
In France, socialism isn’t a political movement that swept the elections. And it isn’t an economic philosophy that moved once again to the forefront. But it’s part of the DNA of much of the population. And it produces some classic reactions. Read… Nationalizing Companies Is Part Of The French DNA.
And here is another government-company saga: the folks at Gazprom, majority-owned by the Russian government, are reveling in the mockery that has been made of a Ukraine-Spain gas deal that would have loosened Russia’s stranglehold on Kiev. But this is what happens when you mess with Gazprom. Read…. Ukraine Crushed in $1.1bn Fake Gas Deal.
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Friday, November 30th, 2012
Market Insights (November 29, 2012)
Gold: Solution to the Banking Crisis
by Eric Sprott and David Baker, Sprott Asset Management
The Basel Committee on Banking Supervision is an exclusive and somewhat mysterious entity that issues banking guidelines for the world’s largest financial institutions. It is part of the Bank of International Settlements (BIS) and is often referred to as the Central Banks’ central bank. Ever since the financial meltdown four years ago, the Basel Committee has been hard at work devising new international regulatory rules designed to minimize the potential for another large-scale financial meltdown. The Committee’s latest ‘framework’, as they call it, is referred to as “Basel III”, and involves tougher capital rules that will force all banks to more than triple the amount of core capital they hold from 2% to 7% in order to avoid future taxpayer bailouts. It doesn’t sound like much of an increase, and according to the Basel group’s own survey, the 100 largest global banks will only require approximately €370 billion in additional reserves to comply with the new regulations by 2019.1 Given that the Spanish banks alone are believed to need well over €100 billion today simply to keep their capital ratios in check, it is hard to believe €370 billion will be enough protect the world’s “too-big-to-fail” banks from future crises, but it is indeed a step in the right direction.2
Initial implementation of Basel III’s capital rules was expected to come into effect on January 1, 2013, but US banking regulators issued a press release on November 9th stating that they wouldn’t meet the deadline, citing a large volume of letters (ie. complaints) received from bank participants and a “wide range of views expressed during the comment period”.3 It has also been revealed that smaller US regional banks are loath to adopt the new rules, which they view as overly complicated and potentially devastating to their bottom lines. The Independent Community Bankers of America has even requested a Basel III exemption for all banks with less than $50 billion in assets,“in order to avoid large-scale industry concentration that would curtail credit for consumers and business borrowers, especially in small communities.”4 The long-term implementation period for all Basel III measures actually extends to 2019, so the delays are not necessarily meaningful news, but they do illustrate the growing rift between the US banking cartel and its European counterpart regarding the Basel III framework. JP Morgan’s CEO Jamie Dimon is on record having referred to Basel III regulations as “un-American” for their favourable treatment of European covered bonds over US mortgage-backed securities.5 Readers may also remember when Dimon was caught yelling at Mark Carney, Canada’s (soon to be former) Central Bank Governor and head of the Financial Stability Board, during a meeting in Washington to discuss the same topic.6 More recently, Deutsche Bank’s co-chief executive Juergen Fitschen suggested that the US regulators’ delay was “hurting trans-Atlantic relations” and creating distrust… stating, “when the whole thing is called un-American, I can only say in disbelief, who can still believe in this day and age that there can be purely European or American rules.”7 Suffice it to say that Basel III implementation has not gone as smoothly as planned.
One of the more relevant aspects of Basel III for our portfolios is its treatment of gold as an asset class. Documents posted by the Bank of International Settlements (which houses the Basel Committee) and the United States FDIC have both referenced gold as a “zero percent risk-weighted item” in their proposed frameworks, which has launched spirited rumours within the gold community that Basel III may define gold as a “Tier 1” asset, along with cash and AAA-government securities.8,9 We have discovered in delving further that gold’s treatment in Basel III is far more complicated than the rumours suggest, and is still, for all intents and purposes, very much undecided. Without burdening our readers with the turgid details, it turns out that the reference to gold as a “zero-percent risk-weighted item” only relates to its treatment in specific Basel III regulation related to the liquidity of bank assets vs. its liabilities. (For a more comprehensive explanation of Basel III’s treatment of gold, please see the Appendix). But what the Basel III proposals do confirm is the regulators’ desire for banks to improve their liquidity position by holding a larger amount of “high-quality”, liquid assets in order to improve their overall solvency in the event of another crisis.
Herein lies the problem, however: the Basel III regulators have stubbornly held to the view that AAA-government securities constitute the bulk of those high quality assets, even as the rest of the financial world increasingly realizes they are anything but that. As banks move forward in their Basel III compliance efforts, they will be forced to buy ever-increasing amounts of AAA-rated government bonds to meet post Basel III-compliant liquidity and capital ratios. As we discussed in our August newsletter entitled, “NIRP: The Financial System’s Death Knell”, the problem with all this regulation-induced buying is that it ultimately pushes government bond yields into negative territory – as banks buy more and more of them not because they want to but because they have to in order to meet the new regulations. Although we have no doubt in the ability of governments’ issue more and more debt to satiate that demand, the captive purchases by the world’s largest banks may turn out to be surprisingly high. Add to this the additional demand for bonds from governments themselves through various Quantitative Easing programs… AND the new Dodd Frank rules, which will require more government bonds to be held on top of what’s required under Basel III, and we may soon have a situation where government bond yields are so low that they simply make no sense to hold at all.10,11 This is where gold comes into play.
If the Basel Committee decides to grant gold a favourable liquidity profile under its proposed Basel III framework, it will open the door for gold to compete with cash and government bonds on bank balance sheets – and provide banks with an asset that actually has the chance to appreciate. Given that US Treasury bonds pay little to no yield today, if offered the choice between the “liquidity trifecta” of cash, government bonds or gold to meet Basel III liquidity requirements, why wouldn’t a bank choose gold? From a purely ‘opportunity cost’ perspective, it makes much more sense for a bank to improve its balance sheet liquidity profile through the addition of gold than it does by holding more cash or government bonds – if the banks are given the freedom to choose.
The world’s non-Western central banks have already embraced this concept with their foreign exchange reserves, which are vulnerable to erosion from ‘Central Planning’ printing programs. This is why non-Western central banks are on track to buy at least 500 tonnes of net new physical gold this year, adding to the 440 tonnes they collectively purchased in 2011.12 In the un-regulated world of central banking, gold has already been accepted as the de-facto forex diversifier of choice, so why shouldn’t the regulated commercial banks be taking note and following suit with their balance sheets? Gold is, after all, one of the only assets they can all own simultaneously that will actually benefit from their respective participation through pure price appreciation. If banks all bought gold as the non-Western central banks have, it is likely that they would all profit while simultaneously improving their liquidity ratios. If they all acted in concert, gold could become the salvation of the banking system. (Highly unlikely… but just a thought).
So far there have only been two banking jurisdictions that have openly incorporated gold into their capital structures. The first, which may surprise you, is Turkey. In an unconventional effort to increase the country’s savings rate and propel loan growth, Turkish Central Bank Governor Erdem Basci has enacted new policies to promote gold within the Turkish banking system. He recently raised the proportion of reserves Turkish banks can keep in gold from 25 percent to 30 percent in an effort to attract more bullion into Turkish bank accounts. Turkiye Garanti Bankasi AS, Turkey’s largest lender, now offers gold-backed loans, where “customers can bring jewelry or coins to the bank and take out loans against their value.” The same bank will also soon “enable customers to withdraw their savings in gold, instead of Turkish lira or foreign exchange.”13 Basci’s policies have produced dramatic results for the Turkish banks, which have attracted US$8.3 billion in new deposits through gold programs over the past 12 months – which they can now extend for credit.14 Governor Basci has even stated he may make adjusting the banks’ gold ratio his main monetary policy tool.15
The other banking jurisdiction is of course that of China, which has long encouraged its citizens to own physical gold. Recent reports indicate that the Shanghai Gold Exchange is planning to launch an interbank gold market in early December that will “pilot with Chinese banks and eventually be open to all.”16 Xie Duo, general director of the financial market department of the People’s Bank of China has stated that, “[China] should actively create conditions for the gold market to become integrated with the international gold market,” which suggests that the Chinese authorities have plans to capitalize on their growing gold stockpile.17 It is also interesting to note that China, of all countries, has been adamant that its 16 largest banks will meet the Basel III deadline on January 1, 2013.18 We can’t help but wonder if there is any connection between that effort and China’s recent increase in physical gold imports. Could China be positioning itself for the day Western banks finally realize they’d prefer gold over Treasuries? Possibly – and by the time banks figure it out, China may have already cornered most of the world’s physical gold supply.
If global banks’ are realistically going to improve their balance sheet diversification and liquidity profiles, gold will have to be part of that process. It is ludicrous to expect the global banking system to regain a sure footing through the increased ownership of government securities. If anything, we are now at a time when banks should do their utmost to diversify away from them, before the biggest “crowded trade” of all time begins to unravel itself. Basel III liquidity rules may be the start of gold’s re-emergence into mainstream commercial banking, although it is still not guaranteed that the US banking cartel will adopt all of the Basel III measures, and they still have years to hammer out the details. If regulators hold firm in applying stricter liquidity rules, however, gold is the only financial asset that can satisfy those liquidity requirements while freeing banks from the constraints of negative-yielding government bonds. And while it strikes us as somewhat ironic that the banking system may be forced to turn to gold out of sheer regulatory necessity, that’s where we see the potential in Basel III. After all – if the banks are ultimately interested in restoring stability and confidence, they could do worse than holding an asset that has gone up by an average of 17% per year for the last 12 years and represented ‘sound money’ throughout history.
Appendix: Gold’s treatment in Basel III
Basel III is a much more complex “framework” than Basel I or II, although we do not claim to be experts on either. It should also be mentioned that Basel II only came into effect in early 2008, and wasn’t even adopted by the US banks on its launch. Post-meltdown, Basel III is the Basel Committee’s attempt to get it right once and for all, and is designed to provide an all-encompassing, international set of banking regulations designed to avoid future bailouts of the “too-big to fail” banks in the event of another financial crisis.
Without going into cumbersome details, under the older Basel framework (Basel I), the lower the “risk weighting” regulators applied to an asset class, the less capital the banks had to set aside in order to hold it. CNBC’s John Carney writes, “The earlier round of capital regulations… government-rated bonds rated BBB were given 50 percent riskweightings. A-rated bonds were given 20 percent risk weightings. Double A and Triple A were given zero risk weightings — meaning banks did not have to set aside any capital at all for the government bonds they held.”19 Critics of Basel I argued that the risk-weighting system compelled banks to overweight their exposure to assets that had the lowest riskweightings, which created a herd-like move into same assets. This was most evident in their gradual overexposure to European sovereign debt and mortgage-backed securities, which the regulators had erroneously defined as “low-risk” before the meltdown proved them to be otherwise. The banks and governments learned that lesson the hard way.
Basel III (and Basel II) takes the same idea and complicates it further by dividing bank assets into two risk categories (credit and market risk) and risk-weighting them depending on their attributes. Just like Basel I, the higher the “riskweight” applied to an asset class, the more capital the bank is required to hold to offset them.
It is our understanding that gold’s reference as a “zero percent risk-weighted asset” in the FDIC and BIS literature only applies to gold’s “credit risk” – which makes perfect sense given that gold isn’t anyone’s counterparty and cannot default in any way. Gold still has “market-risk” however, which stems from its price fluctuations, and this results in the bank having to set aside capital in order to hold it. So for banks who hold physical gold on their balance sheet (and we don’t know of any who do, other than the bullion dealers), the gold would not be treated the same as cash or AAA-bonds for the purposes of calculating their Tier 1 ratio. This is where the gold community’s conjecture on gold as a “Tier 1” asset has been misleading. There really isn’t such a thing as a “Tier 1” asset under Basel III. Instead, “Tier 1” is merely the ratio that reflects the capital supporting a bank’s risk-weighted assets.
HOWEVER, Basel III will also be adding an entirely new layer of regulation concerning the relative liquidity of the bank’s assets and liabilities. This will be reflected in two new ratios banks must calculate starting in 2015: the Liquidity Coverage Ratio (LCR) and Net Stable Funding Ratio (NSFR).
Just as Basel III requires risk-weights for the asset side of a bank’s balance sheet (based on credit risk and market risk), Basel III will also soon require the application of risk-weights to be applied to the LIQUIDITY profile of both the assets and liabilities held by the bank. The idea here is to address the liquidity constraints that arose during the 2008 meltdown, when banks suffered widespread deposit withdrawals just as their access to wholesale funding dried up.
This is where gold’s Basel III treatment becomes more interesting. Under the proposed LIQUIDITY component of Basel III, gold is currently labeled with a 50% liquidity “haircut”, which is the same haircut that is applied to equities and bonds. This implicitly assumes that gold cannot be easily converted into cash in a stressed period, which is exactly the opposite of what we observed during the crisis. It also requires the bank to maintain a much more stable source of funding in order to hold gold as an asset on its balance sheet. Fortunately, there is a strong chance that this liquidity definition for gold may be changed. The World Gold Council has in fact been lobbying the Basel Committee, the Federal Reserve and the FDIC on this issue as far back as 2009, and published a paper arguing that gold should enjoy the same liquidity profile as cash or AAA-government securities when calculating Basel III’s LCR and NSFR ratios.20 And as it turns out, the liquidity definitions that will guide banks’ LCR and NSFR calculations have not yet been finalized by the Basel Committee. The Basel III comment period that ended on October 22nd resulted in the deadline being pushed back to January 1, 2013, and given the recent delays with the US bank regulators, will likely be postponed even further next year. Of specific interest to us is how the Basel Committee will treat gold from a liquidity-risk perspective, and whether they decide to lower gold’s liquidity “haircut” from 50% to something more reasonable, given gold’s obvious liquidity superiority over that of equities and bonds.
The only hint we’ve heard thus far has come from the World Gold Council itself, which suggested in an April 2012 research paper, and re-iterated on a recent conference call, that gold will be given a 15% liquidity “haircut”, but we have not been able to confirm this with either the Basel Committee or the FDIC.21 In fact, all inquiries regarding gold’s treatment made to those groups by ourselves, and by other parties that we have spoken with, have been met with silence. We get the sense that the regulators have no interest in stirring the pot by mentioning anything related to gold out of turn. Given our discussion above, we can understand why they may be hesitant to address the issue, and only time will tell if gold gets the proper liquidity treatment it deserves.
1 Moshinsky, Ben (September 27, 2012) “Big EU Banks Faced $256 Billion Basel III Capital-Gap Last Year”. Bloomberg. Retrieved on November 20, 2012 from: http://www.bloomberg.com/news/2012-09-27/big-eu-banks-faced-256-billion-basel-iii-capital-gap-last-year.html
2 Campbell, Dakin (October 1, 2012) “Spanish Banks Need More Capital Than Tests Find, Moody’s Says”. Bloomberg. Retrieved on November 20, 2012 from: http://www.bloomberg.com/news/2012-10-01/spanish-banks-need-more-capital-than-tests-find-moody-s-says.html
3 Federal Reserve, FDIC and OCC Joint Release (November 9, 2012) “Agencies Provide Guidance on Regulatory Capital Rulemakings”. Office of the Comptroller of the Currency. Retrieved on November 15, 2012 from: http://occ.gov/news-issuances/news-releases/2012/nr-ia-2012-160.html
4 Hamilton, Jesse and Hopkins, Cheyenne (November 14, 2012) “Regulators Grilled Over Community Banks’ Basel Burden”. Bloomberg. Retrieved on November 20, 2012 from: http://www.bloomberg.com/news/2012-11-14/community-banks-basel-iii-burden-to-be-hearing-s-focus.html
5 La Roche, Julia (September 12, 2011) “Jamie Dimon Lashes Out, Calls Global Capital Rules “Anti-American”. Business Insider. Retrieved on November 20, 2012 from: http://www.businessinsider.com/jamie-dimon-calls-bank-rules-are-anti-us-and-us-should-withdrawl-from-basel-2011-9
6 Tencer, Daniel (October 5, 2011) “Jamie Dimon, JPMorgan Chief, Takes Criticism From Prominent Canadian Bankers After Mark Carney Spat.” Huffington Post. Retrieved on November 21, 2012 from: http://www.huffingtonpost.ca/2011/10/05/jamie-dimon-mark-carney-eric-sprott_n_996061.html
7 Reuters (November 15, 2012) “U.S. Basel III delays create distrust – Deutsche co-CEO”. Reuters. Retrieved on November 20, 2012 from: http://www.reuters.com/article/2012/11/15/deutschebank-france-basel-idUSL5E8MFL0020121115
8 http://www.bis.org/publ/bcbs128b.pdf (See footnote 32)
9 http://www.fdic.gov/news/board/2012/2012-06-12_notice_dis-d.pdf (See page 193)
10 Under Dodd-Frank rules, US bank derivative transactions will soon be made on Central Clearing Parties (CCPs) which will require additional US Treasury bonds to be posted as collateral in addition to what is required under Basel III.
11 McCormick, Liz Capo (November 14, 2012) “U.S. Rate Swap Spreads May Widen as Demand for Treasuries Rises”. Bloomberg. Retrieved on November 20, 2012 from: http://www.bloomberg.com/news/2012-11-15/u-s-rate-swap-spreads-may-widen-as-demand-for-treasuries-rises.html
12 Bullion Street (November 22, 2012) “Central banks Gold purchase to hit 500 tons in 2012”. BullionStreet. Retrieved on November 23, 2012 from: http://www.bullionstreet.com/news/central-banks-gold-purchase-to-hit-500-tons-in-2012/3419
13 Akbay, Sibel (October 29, 2012) “Turkish Banks Go for Gold to Lure $302 Billion Hoard”. Bloomberg. Retrieved on November 20, 2012 from: http://www.bloomberg.com/news/2012-10-29/turkish-banks-go-for-gold-to-lure-302-billion-hoard.html
14 O’Byrne, David (November 21, 2012) “Banking: Gold deposits could meet credit demand”. Financial Times. Retrieved on November 22, 2012 from: http://www.ft.com/intl/cms/s/0/f7e81ece-17af-11e2-8cbe-00144feabdc0.html
15 Akbay, Sibel (October 29, 2012) “Turkish Banks Go for Gold to Lure $302 Billion Hoard”. Bloomberg. Retrieved on November 20, 2012 from: http://www.bloomberg.com/news/2012-10-29/turkish-banks-go-for-gold-to-lure-302-billion-hoard.html
16 Reuters (November 12, 2012) “Shanghai plans ETFs as China seeks to open gold market further”. Financial Post. Retrieved on November 12, 2012 from: http://business.financialpost.com/2012/11/12/shanghai-plans-etfs-as-china-seeks-to-open-gold-market-further/
18 Xiaocen, Hu (November 14, 2012) “No delay for China’s banks on Basel III”. People’s Daily. Retrieved on November 20, 2012 from: http://english.peopledaily.com.cn/90778/8018050.html
19 Carney, John (January 13, 2012) “Jamie Dimon Confirms Worst Fears About Basel III”. CNBC. Retrieved on November 15, 2012 from: http://www.cnbc.com/id/45988683/Jamie_Dimon_Confirms_Worst_Fears_About_Basel_III
20 World Gold Council (April 2010) “Response to Basel Committee on banking supervision’s consultative document: “International framework for liquidity risk measurement, standards and monitoring, December 2009”. World Gold Council. Retrieved on November 15, 2012 from: http://www.gold.org/government_affairs/regulation/
21 World Gold Council (April 4, 2012) “Case study: Enhancing commercial bank liquidity buffers with gold”. World Gold Council. Retrieved on November 15, 2012 from: http://www.gold.org/government_affairs/research/
Friday, November 30th, 2012
Here are this week’s reading diversions for your personal enlightenment. Have a fantastic weekend!
In some cases the narcissistic sibling intimidates the parents so successfully that they sing to his tune. He is a despotic ruler of the household. In other instances the narcissistic mother/father colludes with the golden one and the two of them create an atmosphere of ongoing apprehension and fear in the home.
What could be harmful about health foods like grapefruit, licorice and kale?
Eating a grapefruit or drinking its juice can be a great way to get vitamin C, but it can also be dangerous when taking certain prescription drugs, researchers warn.
Heard the phrase “type 3 diabetes” yet? You’ll surely be hearing it more. For several years now, researchers have been calling Alzheimer’s disease a brain form of diabetes as they explore links between the diseases. Increasingly now, they’re fingering a poor diet as an influential culprit.
Chronic fatigue has many causes, including illnesses such as anemia and multiple sclerosis as well as depression and other psychiatric disorders. But it’s also often a side effect of drugs previously prescribed for other conditions. (I’m not talking here of the complicated disorder known as chronic fatigue syndrome, whose cause is unknown. This condition is characterized by extreme fatigue that can’t be explained by any underlying medical condition.)
The urges that drive cell phone and instant messaging addiction may be the same as those driving shopping addiction, a small new study suggests.
Generosity is no longer the selfless act we’ve long thought it to be. Studies now suggest that one of the biggest benefactors of generosity is the person who is dishing it out.
Forget elixirs and expensive serums. In his latest book, ‘The 17 Day Plan to Stop Aging’, Dr. Mike Moreno offers a few simple tricks to revitalize your body and mind from the inside out. Here’s a sneak peek just for you!
What do you need to live a long fulfilled life? Three simple things: love, companionship and commitment. A 74-year-long study by researchers at Harvard Medical School suggests that a dog, a happy marriage, and a supportive social network are the foundations of a long life.
Consuming high amounts of fructose (a type of sugar), artificial sweeteners, and sugar alcohols (another type of low-calorie sweetener) cause your gut bacteria to adapt in a way that interferes with your satiety signals and metabolism, according to a new paper in Obesity Reviews. (If you’ve noticed you’ve been feeling tired all the time and gaining weight, your metabolism may be slowing. Check out this plan to rev up your body’s fat-burning machine in 8 weeks!)
In the new study, multivitamins cut the chance of developing cancer by 8 per cent. That is less effective than a good diet, exercise and not smoking, each of which can lower cancer risk by 20 per cent to 30 per cent, cancer experts say.
High blood pressure increases your risk of having a heart attack or stroke, but there are things you can do to lower your blood pressure.
A variety of studies have established that inflammation and bacteria in the mouth and gums can find its way into the bloodstream, leading to thickening of the arteries and increasing the risk of a heart attack; while fatty plaques that build up on the inside of the vessels can break off, go to the brain and cause a stroke.
The presence of the following “alarm symptoms” of Crohn’s disease requires prompt consultation with a doctor:
As adults, we laugh about 15 times a day. Sounds pretty joyful – until you find out that children laugh about 400 times in a 24-hour go-round. That is a pretty big giggle gap!
When Crohn’s disease affects just the small intestine it results in diarrhea and undernourishment. When the large intestine is also inflamed, the diarrhea can be severe. Severe diarrhea combined with malnutrition often leads to problems. For example, a person with Crohn’s disease may suffer from anemia and have low levels of vitamin B12, folic acid, or iron.
RRSPs are the single best retirement savings vehicle available to Canadians, yet almost one-quarter of us don’’t bother to get into the driver’s seat and use them to steer our way to a financially sound retirement. To ensure your retirement plans aren’t at risk of stalling, here’s a refresher on the top eight reasons why you should contribute to an RRSP.
You may have heard some funny rumors about milk products. Here’s your chance to separate fact from fiction.
Friday, November 30th, 2012
SIA Charts Daily Stock Report (siacharts.com)
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AMGEN INC (AMGN) NASDAQ – Nov 30, 2012
GREEN – Favoured / Buy Zone
YELLOW – Neutral / Hold Zone
RED – Unfavoured / Sell / Avoid Zone
AMGEN INC (AMGN) NASDAQ – Nov 30, 2012 – On July 25, 2012, AMGN crossed into SIA’s green FAVOURED/BUY zone, it closed at $77.96. It closed yesterday at $88.61, up 13.66%
Amgen (AMGN) has now moved its way in to the Favored zone of the SIA S&P100 Report, in 25th spot. Resistance is overhead at $84.75, the high from back in 2005.
Support is at $72.33 and again below that at $62.97.
After a year long climb to the upside, Amgen (AMGN) has now pulled back to its first support level at $82.38. Further weakness then sees $73.15 as the next potential support. To the upside, resistance is now at $98.96 and again above that in the $188 area.
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