The tone for 2012 was set in 2011. The Euro and Euro backed paper are currently trading at a discount in banking circles and Europeans are saving in gold or fleeing wherever possible. The world is in a deflationary period for many asset classes due to deleveraging. Histories largest debt bubble is deflating. Europe emerged as the epicenter of the financial storm in 2011 and this now continues. I do not use these words flippantly, this is extremely serious.
We also find ourselves in a liquidity trap and therefore, against all logic austerity is currently the wrong solution. The time for austerity and balanced budgets was during the growth years, during the building of the debt bubble not now. This horse bolted long ago.
Liquidity traps are characterized by:
- failure of stimulus (QE, Twist etc.) to create growth
- low interest rates failing to stimulate growth
- private and corporate savings rise in response to fear; money hoarding
- expansion of the money base fails to translate into inflation
- unlimited demand for money—in this case mostly in the Government sector for Public Sector payrolls, QE in various forms, debt servicing and debt roll overs
The US Fed has changed their definition of a liquidity trap and if anybody can make sense of their document on the subject they are doing extremely well. In my understanding; if a thesis is not succinct and easily understood it is not worth the paper it is written on. In my end of year briefing to clients I explained all this and stated that "it quacks, walks and looks like a duck—therefore it is a duck". Yes we are in a liquidity trap. Right now the government sector demand for borrowings is choking off growth and so many B list clients fail to get funding. The A list gets the cash and the B list doesn't sending some companies to the wall. We are seeing more of this now and it will continue in 2012. Gold stocks that are not funded to production are at increased risk although I have noticed an unsurprising ability for solid gold stocks and even exploration plays to attract adequate funds in this economic environment.
Due to the existence of the liquidity trap and associated economic conditions it seems obvious that low interest rates and various incarnations of QE will need to continue. Of course the spread paid by lower class borrowers, over and above the Fed rate can grow larger pushing up stress levels for these borrowers. Continued capital destruction will offset new cash creation which will be soaked up by government demand. This creates all sorts of challenges and extreme risk of major upheaval, not just default as sovereign borrowing costs soar.
We also have a banking crisis due to sovereign debt exposure in this sector in addition to the deleveraging process itself. As certain asset values fall loans flip to negative equity. As the spread on loans increase for SME's and other clients the debt servicing stretches the business or individuals to the limit. This is not a good environment for business expansion and jobs growth.
What does this have to do with gold? Everything. Gold was sought as a safe haven and will be again. As upheaval increases the environment for gold improves. Then you have negative real interest rates. The interest rates are lower than cost inflation even if many asset prices are falling (deflation). Inflation for energy and food combines with deflation to create stagflation. Negative real interest rates are great for gold.
The current stagflation will be met by QE, read that as money printing which will also be needed to fund government debt roll over. Governments will not unwind this it has to blow up first; this has been the way of history and I see no change due here.
I interviewed an officer of a major London bank who confirmed this 'distress and deleveraging' thesis recently. They are offloading assets and talking clients into allowing same. They are taking 50%+ haircuts and glad to get this level of return while they can. Their view on the coming few years is for a protracted period of deleveraging and default. Other costs are rising, which combines to increase foreclosures and bankruptcies which are still very high and this will continue also.
The Ratings agencies faced a major change to their business model (legal and in effect operational) in 2010 so they are now forced to apply more honest assessments on their own clients and financial products. This was seen as disruptive, for instance USA down grade from AAA mid last year and the recent threat of a down grade on France and several banks. However they have no choice so expect this to continue to create 'news headline volatility' and reflect risk more appropriately.
There was also serious trouble in the Credit Default Swap markets in 2011 as Greece was classified as a voluntary restructure which the banks decided did not trigger payouts 'on default' to bond holders. This caused bond yields to rise and increased doubt in the inherently risk adverse debt markets. Debt markets are in a bubble in the stronger economies as capital was hoarded in this asset class for 'safer' keeping during 2011. A major top has been formed or is forming signaling the end of this Bull Run for this asset class.
This no longer remains safe when rates are at record lows—nothing but down side risk for bond holders. This can create a massive wave of capital and disrupt the debt roll over process forcing monetization of national debt to continue. This can be classified as QE. Defaults and haircuts will result in massive capital destruction. The question is where can the wave of capital go? We have a banking crisis and therefore bank deposits seen as low risk aren't what they seem to be. First tier banks are a safer option, choose carefully and spread savings here and across asset classes.
These bank deposits are nothing more than unsecured loans, in many cases to questionable institutions who have not maintained loan book valuations at realistic market value. As an asset class real estate requires demand (in a falling price environment?) and supply of loans by banks to flourish. Yet banks are trying to balance bad debt write offs, rising unemployment / fresh loan defaults , tighter loan qualification measures and the looming Basel3 capital adequacy requirements. This last measure forces tighter management of reserve ratios and higher reserve levels on this sector, thus restricting their loan book growth and freedom.
Equities may just surprise investors in this environment. The balance sheets of some corporations and their current earning spread across China and emerging economies make them attractive safer havens. Earnings multiples are low however caution; research will show you that earnings will also fall for some companies. Many opportunities exist in emerging markets and the equities in general and this will start the capital flow in this direction once the bottom is found.
Here lies the quandary for 2012; where is the bottom? The C wave down appears to be a foregone conclusion as deleveraging gathers steam. The capital requirement for the USA and Europe, just to roll over old debt is staggeringly high. This sucks capital away from business.
Gold has been correcting after a large rise which failed to stimulate more than the most elite gold stocks in Australia. Demand for gold and silver in Europe is high and it is growing in China and in many other areas. Investment demand will soon re-emerge as investors seek a new safer haven other than the USD and U.S. Government or other sovereign Bonds.
For now there is downside risk for gold however this is limited, in part because of the already mature 20% correction. Gold and silver can both put in major upside this year due to Europe and so can the other white metals on disruption in Africa. I am following gold short term for clients and decline to make a prediction at this stage.
Europe will falter and if this spreads and becomes disorderly (understatement) then we can see a forceful deleveraging event pushing the metals to short term lows ahead of a resumption of the upward trend. If this is not as disorderly then gold can trend sideways along the lines of the step up fractal pattern which has characterized the rally since 2001. The outcome will determine the action on the gold stocks and Australian dollar.
Some Australian and ASX listed gold and precious metal stocks appear to show signs of a turn around here. A full run down of Larger Producers and the Mid-Tier Producers list now follows for subscribers…
Good trading / investing
Neil Charnock is not a registered investment adviser. He is an experienced private investor who, in addition to his essay publication offerings, has now assembled a highly experienced panel to assist in the presentation of various research information services. The opinions and statements made in the above publication are the result of extensive research and are believed to be accurate and from reliable sources. The contents are his current opinion only, further more conditions may cause these opinions to change without notice. The insights herein published are made solely for international and educational purposes. The contents in this publication are not to be construed as solicitation or recommendation to be used for formulation of investment decisions in any type of market whatsoever. WARNING share market investment or speculation is a high risk activity. Investors enter such activity at their own risk and must conduct their own due diligence to research and verify all aspects of any investment decision, if necessary seeking competent professional assistance.