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Who’s Afraid of the Big Bad Sovereign Debt Wolf?

Who’s Afraid of the Big Bad Sovereign Debt Wolf?

Last Friday, the sovereign debt of nine European nations—including France and Italy—was downgraded by S&P.  Now, there are only four European nations whose sovereign bonds carry the highest AAA rating: Finland, Germany, Luxemburg and the Netherlands.  Since the sovereign debt refinancing and potential default problem still goes unsolved, we foresee the markets having to keep digesting more waves of bad news.

Yet the fear created by such news is diminishing—not because of a shortage of negative news headlines—but because European banks are more protected by the many lifelines that central banks keep throwing them.

 

Many Lifelines Bolster the European Banking System

We see the protection of the banking system as more important than certain governments’ ability to borrow.  Stock markets seem to agree.  They appear to have discounted much of this week’s sovereign debt news.  A few months ago, headlines highlighting rating agency downgrades—like last Friday’s—would have caused violent drops in the U.S. and European markets.  Yet when Friday the 13th’s news of the downgrades was announced, the same markets declined less than 1 percent…and in the following trading sessions, the markets rallied, some even rising more than 1 percent.

Good and bad news go hand in hand in this business, especially in a situation like this…and good and bad news can come simultaneously.  Sovereign debts get devalued, and new countries offer more liquidity or support for the European Central Bank (ECB).  It all boils down to the problem continuing, while resources to repair it are being accumulated.

Good for Gold

Why would gold rise if inflation is falling?  Because the Euro and the U.S. dollar are being debased as more liquidity injections, aka Quantitative Easing (QE) programs, are instituted.  As this additional liquidity is being offered to the banking system by many governments, it increases the supply of currencies and thus decreases their values.

Here’s what we think: the long-term trend of rising inflation will not end until the poorly managed nations begin to make rational fiscal decisions. They should move toward balanced budgets, and they should create an environment where new businesses can start and flourish. This is what is needed to increase employment and tax revenues. When poorly managed nations achieve these milestones, they will cease to be poorly managed.

Investors continue to wonder how to protect buying power when their national currency is being debased.  A solution chosen by many investors is to buy insurance in the form of gold as a hedge against the declining buying power of their money.  We agree—gold can be an excellent insurance policy against unwise behaviors by government officials.  Countries do this too; gold continues to be demanded by many nations.  Last year many countries, including South Korea, Thailand, Turkey, and Russia, all added to their national gold reserves.  Recently, some well-respected technical analysts have written that the correction in gold has ended and a new uptrend will begin soon.  We are not technical analysts—but our fundamental research continues to make us bullish on gold.

What does this mean for me?

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A Note About Hoarding

Governments over the last few years have raised interest rates, in part to stop speculation in commodities which were being hoarded.  The price rises and subsequent hoarding contributed to the inflation problem that gripped many countries in late 2010 and early 2011.  Now, lower prices are a sign of little hoarding and thus a more effective system of resource allocation.

Inflation Rates – Shorter Term: Lower…Longer Term: Higher

Grocery baskets may have been fuller in 2011 than in 2010, but how long will that last?  Food inflation is moderating slightly in China, India, and most other Asian nations, in part due to larger food crops in Asia—but this moderation is nothing huge, and we do not expect it is permanent.

It can be misleading to only look at year-over-year inflation statistics, since they don’t always capture the larger trends.  For an example, we will use a fictitious country.  Let’s call it Chindia. In Chindia, the inflation rates went up 10 percent in 2010 and 5 percent in 2011.  Government officials in Chindia will measure this as a moderating rate of inflation.  This decline in the inflation rate will allow for a decline in interest rates.  However, the reality is that despite the fall in the rate of inflation, the goods being sold on January 1, 2012 are still 15.5 percent higher than they were on January 1, 2010.  Chindians may feel a little relief, but they will know that prices are still rising.


Reasons for the Slowdown

The slowing growth in the developed world and the tighter monetary policies in the emerging world were two reasons why 2011 saw a slowdown in inflation rates.  Another reason was general fear about Europe, which slowed bank lending and corporate expansion.

Brazil started cutting rates in late 201…reducing their SELIC rate


China also began loosening…reducing their high banking Required Reserve Ratio(RRR)…we expect more of this in coming weeks and months

Causes of the Inflation

If you have read our past commentaries, you’ll remember us saying previously that the food inflation was caused by the expansion of wealth among citizens in many countries—China, Brazil, Thailand, Indonesia, Philippines, Malaysia, Chile and India to name a few—over the last few decades.  As the poor of these countries have grown wealthier, they have desired food in larger quantity and variety.  The first wave of demand was for more grains, and secondly, more meat protein—which, in turn, increased demand for feed grain—because animal protein has higher grain and water requirements than other sources of protein.  The general rule states that every pound of chicken requires four pounds of grain; a pound of pork, six pounds of grain; and beef, eight pounds of grain.  Therefore, countries shifting from a vegetarian-based diet to an animal-protein-based diet must feed animals between four and eight pounds of feed grain to produce every pound of animal protein.  Clearly, as more animal protein is demanded, more consumption of grains is necessary.

Now that food inflation is moderating, has the food inflation problem been solved?  The answer: partially.  The problem has been addressed in part by: 1) Increasing the acreage of land under cultivation. Many countries are preparing for their citizens’ demand for a diet higher in animal protein. They are planning to grow more food and raise more animals.  2) When a country allows its currency to rise the higher currency acts to lower the cost of imported grains and meat.  For example, the Chinese currency, the Yuan, has risen by 8 percent against the U.S. dollar and 22 percent against the Euro since the January 1, 2010.  The rise in the value of the Yuan reduces the cost of imported food in Yuan terms.  3) Countries have started to address their water needs and are investing in and developing more water resources.

How Long Will Inflation Continue To Moderate?

That is a very good question, and we do not know the answer.  We will discover the answer by monitoring world political, social, and economic events.  We expect to identify signs as they appear…before the return of rising inflation.  Inflation in Asia is moderating now, and it is not vigorous as it was in other parts of the world.

History tells us that all of the ‘money printing’ that has been going on in many countries will cause the buying power of currencies to decline.  Decline in buying power of money is inflation. The shopping cart of food costs more dollars as the buying power of the dollar falls.  It is not hard to hide, but we will have our antenna out and we are monitoring inflation events carefully. You can count on us to report to you.

How Long Will Inflation Continue To Moderate?

That is a very good question, and we do not know the answer.  We will discover the answer by monitoring world political, social, and economic events.  We expect to identify signs as they appear…before the return of rising inflation.  Inflation in Asia is moderating now, and it is not vigorous as it was in other parts of the world.

History tells us that all of the ‘money printing’ that has been going on in many countries will cause the buying power of currencies to decline.  Decline in buying power of money is inflation. The shopping cart of food costs more dollars as the buying power of the dollar falls.  It is not hard to hide, but we will have our antenna out and we are monitoring inflation events carefully. You can count on us to report to you.


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Declining Food Inflation Shows Up In The Guild Basic Needs IndexTM …But As We Said Above, It Is Not Permanent

Available only in the Guild Global Market Commentary, the Guild Basic Needs Index (GBNI) tracks the changes in price of the essential needs for living; food, clothing, shelter, and energy. 

2011 saw prices of certain basic needs pull back.  Correspondingly we saw a reduction in the rapid rate at which the GBNI had been outpacing the U.S. inflation measure, the Consumer Price Index (CPI).  Longer term inflationary pressures are building, especially in food and energy, and we expect a re-acceleration of inflation will resume in years ahead.  The GBNI gives our readers insight into the subsurface inflationary trends that cannot easily be gleaned from the data offered by government statisticians.

In the twelve years since the new millennium started, the prices of the ingredients for life measured in the GBNI are up almost 70 percent, versus about 35 percent for the CPI.  To measure a decline in the standard of living, you can take either inflation measure, and compare it to the fact that over the same twelve years, wages in the U.S. have gone nowhere.

Our goal is to help readers and investors preserve the purchasing power of savings, and thus their standard of living.


Seeking Higher Yields As Part of The Investment Strategy Is Our Tradition

There has been a lot of hype and press about how high dividend paying stocks have outperformed.  Equity income investing is the new marketing buzz among many money managers.  As our investment management clients know, seeking higher yielding stocks has been one of our major strategies for decades, and we continue to use high yielding stocks in our aggressive growth, growth, and our income strategies. All of our strategies enjoy the benefits of owning companies with good yields and strong cash flow growth.  We monitor these companies carefully.  Guild’s principals and analysts speak with the managements of these companies regularly to understand their growth prospects, the visibility of their yields, and their potential for continued growth or shrinkage of the dividends.  We have followed many of these companies for years and we continue to keep a close eye on them and their competitors. This vigilance allows us to find new vehicles for investment.

The U.S. Dollar Continues Its Slow Loss of Influence in Global Trade

New Alliances China and Japan – In recent weeks, China and Japan began to trade without using the dollar as an intermediate currency.  A similar announcement came from Russia and Iran.  In the first case, it is for economic reasons of trade and practicality. In the second case, it is as much for political reasons; primarily to show scorn for the U.S. and its world influence.

China and Japan expect to be each other’s major trading partners for the next 100 years. They are located near each other, are the 2nd and 3rd largest economies in the world, are natural trading partners, and direct trade between their two currencies is a rational and practical idea.  It will save money, allow simpler trade and cause the overvaluation of the Japanese Yen to moderate.  The two nations benefit from each other and need to encourage more trade between themselves.  A side effect is that because the Yen is overvalued against the Yuan, Japan will buy more Yuan bonds and diversify its investment portfolio away from U.S. dollars.

Russia and Iran have entered into a similar arrangement which provides for them to trade with one another using their home currencies rather than the U.S. dollar as an intermediary currency.  This agreement was devised as the two countries’ response to new sanctions against Iran’s central bank.  The purpose is to cause Iran to suffer a loss of oil revenues. Oil transactions with Iran by western countries have to be processed through the Iranian central bank.  Loss of oil revenue further worsens Iran’s dismal internal economic situation.


We wish everyone a happy upcoming Lunar New Year (Chinese New Year)
Gong Hey Fat Choy

 

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