Aug 19, 2010 It is all about (no) confidence Gijsbert Groenewegen 321gold

It is all about (no) confidence

Gijsbert Groenewegen
Aug 19, 2010

The widest yield gap in three decades will trigger a big sell off!

Interest rates are coming down and down. Late June the 10-Y interest rates fell below the 3% mark, whilst the forward earnings yield of the S&P 500 index is 8.1%, resulting in the widest yield gap in three decades. The dividend yield of the Dow Jones at 2.65% is equal to the 10-y Treasury yield. According to Morgan Stanley over the past 50 years the Dow's yield has only exceeded the 10-y Treasury yield at the end of 2008 when the financial crisis climaxed. What is this telling us? In our point of view it is indicative of two main trends. One is that the stimulus does not have its desired effect as confirmed by the Fed's statements and actions and secondly it means that the value of paper money is being eroded because it does not give any return (which makes perfect sense considering the dilution that has taken place), hence why gold has been so strong. This situation is perfectly illustrated by the difference in performance by the Dow/Gold chart versus the Dow chart measured in US dollars.

Dow/Dollar Chart

Dow/Gold Chart

What is happening is that paper money, which has two main functions i.e. a medium of exchange and a store of value, is being eroded. And this is especially applicable for its storage of value function hence the ever lower interest rates on the treasuries. There is hardly any return for lending money, the reason why gold is continuously increasing in value. Other asset classes also hardly generate any returns. If for that reason investors would invest money in equities they are likely to make the wrong decision for the wrong reason i.e. chasing return. According to an article in the Financial Times of August 12, 2010 hedge funds now represent 25% of the trading in the $10trn Treasury market versus only 3% in 2009. Keep an close eye on this since we believe that the bond market is blowing itself up and with hedge funds representing such a large part of the Treasury market their exodus would create quite some havoc in the bond markets and equity markets. Next to that who will be left to pick up those Treasuries, China and Japan are more likely to be sellers than buyers!

In context of the yield gap we would like to mention that the current yield gap between muni bonds and best grade corporate bonds is historic. The is first time since 1937 that muni yields have spiked up above best grade taxable corporate bonds!! Is this telling us that someone is selling their muni bonds while they still can?

Paper money and gold are inversely correlated they are ruled by the different degrees of confidence. When the value of paper money goes down, gold will increase in value (see the chart of the Dow Jones index/Gold price chart of August 13, 2010 which has only increased 23% since March 2009 whilst the normal Dow Jones index has increased by 59%, clearly illustrating the devaluation of the fiat currency). Gold will only perform when all other asset classes are exhausted; otherwise, investors don't have to invest in gold (gold does not give any return) because they will be able to get a higher return investing in other asset classes. Low interest rates and increasing gold prices go hand in hand.

Under "normal" circumstances an extreme yield gap should trigger a massive shift from bonds into equities, though as a result of the uncertainty and lack of confidence about the economy, investors prefer bonds instead of equities. Again investors seek the safety (lower risk) of bonds instead of the higher return (risk) of equities because they don't believe the stimulus is having its desired effect. Therefore, following the FED decision for QE2 the even wider yield gap is, as expected, triggering a fall in equity prices with investors preferring the safety of bonds over equities because investors believe that the outlook for earnings could deteriorate even further and therefore makes equities too expensive.

It is, in our opinion, very much psychology that is determining the situation. Confidence is waning, hence why the economy does not have any traction. The following thought process stays valid; de-leveraging leads to lower asset prices which in turn, lead to less confidence, which leads to the rotation from intangible assets to tangible assets. We want to emphasize that a continued higher gold price is proving gold's increasing acceptance as the ultimate currency (the US dollar still is the world currency though this could change pretty quickly considering how much the currency is being undermined following the QE without any material effect). As mentioned in earlier blogs we believe that in the second leg down all asset classes will be sold off whereby investors take profits as quickly as they can and that the US dollar will strengthen substantially because investors will go "low risk". When the unwinding of this trade is completed and gold has been sold off investors will massively abandon the dollar and put their funds into gold because they will become aware of the "real value" of the US dollar.

Disconnect Wall Street and Main Street

We believe that there is a big disconnect between Wall Street and Main Street. The indices have been going up, following the better than expected results stemming from having cut costs to the bone (at the cost of employment) and international earnings. Though volumes are extremely low, today's volume of the S&P mini futures is about the worst it has been in, well, ever, at 50% below average. According to the FT, banks are starting to panic that as a result of collapsing trade volumes, massive layoffs are just around the corner (Barclays and Credit Suisse are the first banks to announce layoffs). US banks with Wall Street operations are bracing for a slump in trading profits this year after the third quarter got off to a poor start, with global economic uncertainty and Europe's sovereign debt woes leading to a slowdown in market activity in July. Next to that banks are not lending, and the yield curve is flattening following another round of QE which will further reduce banks profits. The banks will suffer again. We have not even started to consider what the effect of the flattening of the yield curve will be on the pension's schemes! The pension companies, who use an actuarial interest rate of 8%, will have to buy in interest in order to meet their payment obligations under the pension schemes, driving interest rates down further.

On Main Street the distress is ongoing; one just has to read the stories in the newspapers. ! Next to that the small to medium sized companies are not hiring because there is no visibility vis a vis future economic activity. It should be noted that some 60% of all employees hired over the last 20 years were hired by companies with less than 250 employees. Of the 8m jobs lost since 2007, some 6m were lost by the small businesses. According to a statement of the San Francisco Fed: "An unstable economic environment has rekindled talk of a double-dip recession". Remember only when all the circumstances are in place the double-dip will happen and it is time.

In our point of view what is happening is that we have massive asset deflation which is accelerating again, following the expiration of the housing stimulus. We also believe that the deterioration in the unemployment situation will continue, just think about the entire stimulus and what the effect has been on the creation of jobs (hence why there were only 71,000 jobs created in the private sector in July). As we have emphasized before, the economy will not recover because of three factors: 1)- deteriorating housing market; we are at a 50 year low in the housing market and the June new home sales increased by 23% to a 330k annual rate versus May, though this figure was still the second worst figure since recording started in 1963 (in our opinion housing prices will fall with at least another 50%). Q-o-Q mortgages underwater declined from 23.3% to 21.5% in the second quarter, probably as a result of the temporarily upward pressure on housing prices following the positive effect of the tax credits; 2)-unemployment will rise to 15-20% (we have lost some 8m jobs since 2007); and 3)-the massive debt levels we are still facing. The central US government ($13trn), the US companies ($7.2trn), as well as the US households are all at record debt levels. Consumer installment debt hit a record of almost $2.6trn in September 2008, and consumers still have a whopping $2.4trn of personal debt on their credit cards here in August 2010, paying down a measly $200bn!

We can't emphasize enough the importance of the deteriorating housing market on the economic situation. In fact the continuous onslaught on house prices is severely affecting consumer confidence. Some 75% of consumer confidence is determined by the overvalue or negative value of their house. And consumer confidence, in turn, determines 2/3 of consumer spending, which accounts for 75% of GDP in the US. In other words, declining house prices have a major effect on consumer spending and ultimately on employment. Therefore, as long as house prices keep on falling, which they will, because home owners can walk away from their obligations, we don't expect an improvement in unemployment. And since many homeowners don't have the obligation to repay their mortgage and can just walk away from their house, there is no safety net keeping a floor in home prices. As a result of these declining prices, many home owners saw their equity or at least a large part of their equity wiped out leading to further de-leveraging i.e. deflation.

Deflation versus Hyperinflation

Assuming a further accelerating asset deflation, wealth will be destroyed in a way unknown to the majority of the population. In the history of mankind most hyperinflation periods have lead to revolutions because only the rich survived and the rest did not have any choice but to rebel in order to survive. Whilst in deflationary period everybody, poor and rich, suffers.

The current situation in the US draws parallels with the end of the Roman Empire. The Romans expanded their territory in order to secure their wheat supply and therefore developed a strong army protecting their interests. Ultimately the Romans lost against the Persians. And see what is happening currently with respect to the US; the US is securing its oil supply worldwide! Though its competitive edge is waning, the low hanging fruit is gone. Next to that the US is getting a lot of competition from countries such as China and India. In a way we are in the same kind of ironic situation again with Persia.

Often comparisons are made between the deflationary situation in Japan and the possible deflationary situation in the US. Although Japan has a debt to GDP ratio in excess of 200%, Japan was thus far able to finance its deficits because the Japanese were big savers (although their savings rate now stands at a meager 3% versus approx 5% for the US household), secondly the Japanese deficit was financed mainly internally with the BOJ instructing the banks to purchase the JGBs (foreigners are estimated to hold only 7% of the JGBs outstanding totaling some Y684trn. Next to that the Japanese financial institutions don't really dispose of their holdings, but keep them to maturity). The U.S. Department of Commerce's Bureau of Economic Analysis has kept a record of the personal savings rate since 1959. Since then, the personal savings rate has averaged 6.98% with a standard deviation of 2.75%. In the past 20 years, Americans have saved at a much lower rate of 4.18%. The US, for the financing of its deficits, has been much more dependent on the willingness of foreign investors (some 45%).

The most dangerous aspect will be that people will only realize, and, or accept the severity of the situation when it is too late.

According to a Chinese official, treasuries and the dollar lack safety

According to a Bloomberg story of August 3, 2010, Yu Yongding, a former central bank adviser said that U.S. Treasuries fail to provide safety or liquidity when it comes to managing China's $2.45 trillion foreign-exchange reserves. "I do not think U.S. Treasuries are safe in the medium-and long-run. China is unable to sell the securities in a "big way" and a "scary trajectory" of budget deficits and a growing supply of U.S. dollars put their value at risk", he said. China's holdings of Treasuries, the largest outside of the U.S., totaled $867.7 billion at the end of May, down from $900.2 billion in April and a record $939.9 billion in July 2009.

Yu wrote "Only God knows how much value that China has stored in the U.S. government securities will be left in the future when China needs to run down its reserves. The U.S. government has strong incentives to reduce its real burden of debt through inflation and dollar devaluation. Whichever way it is, the Yuan-recorded market value of Treasuries will fall, causing huge capital losses to China's central bank." Trying to diversify its holdings, China bought a net Yen 735.2bn, or $8.3bn of Japanese bonds in May, doubling purchases for this year. Since early June the dollar has weakened 12% against the Euro and 7% against the Yen. The White House predicts the U.S. budget deficit will hit a record $1.47 trillion this year, about 10 percent of GDP.

Despite cash levels of almost $2trn US companies owe $7.2 trillion, the most ever

Contrary to the consensus that U.S. companies have emerged from the financial crisis in robust health, sitting on growing piles of cash to the amount of almost $2trn, they are more indebted than ever. The reason US companies have hoarded so much cash is because they are fearful for the economy and because they have learned from the 2007/2008 crisis how quickly credit can dry up. Next to that banks are still not willing to lend.

Data of the Federal Reserve show that the debts of US companies have been rising, not falling. By some measures, they are now more leveraged than at any time since the Great Depression. According to the Federal Reserve, nonfinancial firms borrowed another $289 billion in the first quarter, taking their total domestic debts to $7.2 trillion, the highest level ever. That's up by $1.1 trillion since the first quarter of 2007; it's twice the level seen in the late 1990s.

Central bank and Commerce Department data reveal that gross domestic debts (taking into account assets and liabilities of companies within the United States) of nonfinancial corporations now amount to 50% of GDP. That's a postwar record. In 1945, it was just 20%. Even at the credit-bubble peaks in the late 1980s and 2005-06, it was only around 45%.

The Fed data "underline the poor state of the U.S. private sector's balance sheets." Non financials' corporate debt, whether measured gross or after netting off bank deposits and other interest-bearing assets, is at peak levels."

This is likely to be another reason why the widest yield gap in three decades is not triggering the shift from investors' money from bonds into equities, and clearly is bad news for jobs and the economy.

Stimulus measures are also not missing their effect on creating a real estate bubble in China

The Chinese media recently floated a story -- denied by power companies -- that 64.5 million urban electricity meters registered zero consumption over a recent, six-month period, i.e. these are empty apartments/houses. To put this in perspective it would enable China to house 200 million people.

As we know accurate data is hard to come by in the West (in the US figures are constantly revised) as well as in China where it is even harder to obtain accurate Chinese data. The potential developing quantity bubble burdening the real estate market could have serious consequences for the banking system. China is uncomfortable with the current situation and China's banking regulator instructed lenders last month to conduct a new round of stress tests to gauge the impact of residential property prices falling as much as 60% (previous stress tests assumed falls of 30%) in cities where prices have risen excessively following record new loans of $1.4trn. Residential real estate prices soared 68% in the first quarter y-o-y. Measures taken to cool property-price gains, included raising minimum mortgage rates and down-payment ratios for second-home purchases, and a suspension of lending for third homes.

As a result of concerns about the current situation, property stocks have been the worst performers on the Shanghai Composite Index this year, with an average 21 percent drop, data compiled by Bloomberg shows. According to the Eurasia Group in Washington there is a perception in the real-estate development community that banks and the market cannot tolerate much more than a 25% to 30% drop in prices. Average prices may fall as much as 20% over the next 12 to 18 months, with declines of up to 40% in "big bubble" cities, Nomura Holdings Inc. said in a July 2 report. The impact on banks' asset quality will still be "limited" as long as borrowers have adequate income to keep paying their mortgages, Nomura said. "Special mention" real-estate development loans have climbed in Shanghai since April and rose by 1.4 billion Yuan ($207 million) in June, Xinhua News Agency reported Aug. 1. On top of the potential slowdown in real estate prices we shouldn't ignore the decreasing impact of slowing for Chinese export goods.`

The OECD is confirming the weak forecast for economic activity. According to a recently published OECD report of August 6 OECD composite leading indicators (CLIs) for June 2010 point to a possible peak in expansion. The CLI for the OECD area decreased by 0.1 point in June 2010. The CLIs for France, Italy, China and India all point to below trend growth in coming months, whilst the CLI for the United Kingdom points to a peak in the pace of expansion. Stronger signs of a peak in expansion have also emerged in Brazil and Canada, and in the United States the CLI has turned negative for the first time since February 2009. The CLIs for Japan and Russia point to future slowdowns in the pace of expansion but for Germany the CLI remains relatively robust as illustrated by its recently published second quarter GDP figure.

QE versus velocity of money and deflation versus inflation

Whilst the FED can control the money supply, it can't control the velocity of money, i.e. the level of transactions done in the economy. This again leads back to the same issue: confidence. If there is no confidence, companies and consumers will not enter into transactions. In other words the FED can pump all the money in the world in the economy, but if the lack of confidence limits the number of transactions done, there will be no inflation. You can bring a horse to the water, but you can't make it drink.

In case of inflation equities are normally the preferred investment whilst in the case of deflation, it is bonds; hence why bonds have outperformed equities (S&P500) this year by 12%. We would like to point out an extraordinary situation. As a result of lower asset prices (housing, cars, electronics) the purchasing power of the US dollar currency has gone up. And if we measure the performance of the Dow Jones index expressed in the gold price, we notice that the performance since March 2009 has only been 23%, versus 59%, for the regular Dow Jones.

This illustrates that measured in the gold price (the ultimate currency) instead of the US dollar, the deflation is even stronger, i.e. that the prices of houses have even gone down further, if measured in gold. In other words gold compared to US dollars would even enable buyers to buy the house at even cheaper prices. The purchasing power of gold is going up even more than US dollars in these deflationary times. Thus gold is not only an inflation hedge but also a deflation hedge!

Deflation is, in simplest terms, a decline in prices. Isolated deflation occurs all the time. Sometimes it's beneficial -- such as when oil gluts produce lower gasoline prices. And sometimes it hurts, like when housing bubbles pop.

But the kind of deflation that concerns economists involves a prolonged and steep decline in prices across the board, and means that the economy is contracting. It may sound like a consumer's paradise, at least at first. However, the long-term impacts of deflation are indeed worrisome. Corporations see their profits shrink, workers might be pressured into wage cuts or layoffs, and economic activity crumples as consumers delay spending for the inevitably lower prices of tomorrow.

Large, long-term debt commitments are a bad idea during deflation. You're paying back dollars that are more valuable than the ones you borrowed. Some stocks are more vulnerable to deflation than others. Companies sitting on piles of cash could actually benefit, but highly leveraged companies are vulnerable. Similarly, consumer goods makers are likely to lose their pricing power. Declining sales and profits would obviously put downward pressure on share prices.

Winning strategies include investments that pay you fixed income over the long term. Some examples are highquality corporate bonds and municipal bonds. Although we believe the default risks are increasing following the enormous amount of paper issuance. Another thought is the plain-vanilla FDIC-insured certificates of deposit. If prices are deflating 2 percent annually, a 2 percent CD is actually paying 4 percent. If you think deflation will last, lengthen your maturities.

As a rule, Treasuries are about as low a risk as you can get, though, again we think that we have entered a period where default risk can't be excluded anymore. Interest on the debt thus far is $375bn, which is very close to the $383 Billion for all of 2009. That is with five months left in the year. The estimated FY 2010 budget is $3.55trn with a forecast deficit of $1.4trn. The interest on the debt already comprises 10.56% of the entire budget.

Buy gold for the long term! The only "real" currency.

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