Europe Will Be the Next Region to Create Liquidity for the World

The coming European bailout of Ireland and Portugal will have to include some method of quantitative easing (QE), or the printing of new money.  The European Central bank will claim they are not using QE, but using newly created money must be a part of the plan.  Often, when hiding their bond-buying, governments will use means to disguise their actions.  Clearly, very few professional investors have an appetite for Portuguese or Irish bonds unless they are put under some political pressure, so the buyer of last resort will be the governments and European Central Bank.

Europe’s banks own too much debt of the weak European periphery nations, including Greece, Portugal, Ireland, Italy, Spain, and others.  Even French debt is a potential danger.  The socialist model that much of Western Europe has followed for the last forty years is in question.  Europe will either have to discover a method to grow their economies much faster or cut their citizens’ expectations of social assistance.  In our opinion, many European countries will require debt restructuring and bailouts in coming months and years.  These bailouts will be done partially with QE, and/or partially with loans or purchases of European government bonds by China.

China has announced an interest and they will make the purchases to ensure continuing and strengthening trade (i.e., the consumption of Chinese products) in Europe for decades to come.  China’s plans for the long-term include their intention to have the world’s reserve currency and the world’s most powerful economy.

It is interesting that as Europe re-enters a QE program, in the U.S., both the left and the right are attacking the Federal Reserve’s QE program, which may have the effect of slowing liquidity creation in the U.S.

Inflation Is In the News Everywhere

In much of Asia and Latin America, inflation is rising.  Although it is not yet rising as rapidly in the developed world, it will soon arrive in the U.S. and Europe.  Why is this?  Consumer price reporting in developing Asia is actually done in a manner that reflects the cost of living of the consumer.  In most Asian countries about 30% of the cost of living index is food.

In the U.S. and some other developed countries, food and energy are not considered crucial; they are considered non-core costs.  This does not mean that food inflation is not impacting consumers’ budgets in the developed world—clearly, food prices are rising and consumers are very much aware.  It is only a matter of time until the politicians and bureaucrats who have been misstating and statistically understating the costs of living in the developed world will be called to account.  The public is not stupid, and they are becoming more informed with each passing day. 

We believe the inflationary outcome will create profits for those who hold gold, commodities, selected foreign and U.S. stocks, and selected foreign currencies.  The current period of price decline may be an opportune time to acquire these investments.  We still believe investors should avoid U.S. bonds.  Regular readers will remember our long-term concern about bonds.  Long-term bonds have been moving lower and municipal bonds in the U.S. suffered a substantial decline recently.  Those of you who own intermediate and long-term bonds including municipal bonds please heed our warning.

Imagine a Decades-Long Steeplechase

To describe the future of the world economy and the placement of the major nations within this economy, we imagine a long steeplechase horse race that will take a decade or two to complete.  Let us imagine a course with hedges and fences to jump, water hazards to negotiate, and other contenders using creative tactics and strategies to improve their position in a long, tiring, multi-year run. 

Countries enter the race to ultimately have their currency become the world reserve currency.  Reserve currency status brings responsibility, power, and the parent country of the world’s reserve currency may be afforded with an elevated standard of living as a result. 

The hedges and fences on the course might be the requirements for developing and maintaining a strong banking system, a strong military, and active commercial interests in many world markets, where the nation is both a seller of goods and services and a buyer of the goods and services of others.

The trainers and jockeys on every horse represent the administrations and/or parliaments that make the rules, laws, and plans for the country’s progress.  They make the final decisions on how to train and prepare for the race.  They must assess the condition of the track (the world economy) and the other horses (the competing nations).  Sometimes when they are replaced mid-race it causes the country to fall back, and sometimes it helps the horse pick up the pace. 

Rumors Have It That The Old Champ Has Been Unwilling To Undertake The Disciplined Training Necessary To Maintain The Crown. 

China has heard the rumors and is getting in position to make its move on the leader.  The race’s current leader, the U.S. is showing signs of tiredness and is burdened by big budget and trade deficits.   Perhaps seeing the challenger gaining on them, voters, and therefore politicians have finally begun talking about these issues.  We have been discussing these issues for many years, and they are now finally being prominently mentioned in the U.S. news.

In the U.S. case, Congress cannot make up its mind about how to prepare.  They cannot decide whether they should train vigorously or perhaps take it easy and rely on their ability to employ sharp tactics during the race itself such as using their reserve currency status to change the rules once the race has begun.  Manipulating their currency is easier than the hard training it takes to stay fit. 

The diet and training regimen are keys to success.  In the U.S., Congress has to decide the proper diet for the economy, i.e. horse.  Will they over-feed the race horse with too much deficit spending, or will they starve it with high regulation and high taxes?  Will they under-train the horse and rely on government regulation and other tactics to hide a lack of competiveness?  Or will they train it too hard by creating excessive unsustainable growth, causing the horse to exhaust itself before the race is over?

The Race Is Still In Its Early Stages; Here’s How the Announcer’s Call May Sound

The U.S. is currently in the lead, and China, after giving up a nearly 60 year head start has been moving much faster in the last 20 years.  They have a lot of ground to make up but it is astonishing how rapidly they are moving.  They have passed Japan, Europe, and the other horses in the race.  As they approach the first jump of this very long course, it does look like it has become a two-horse-race.

Many wonder if the U.S. champion can make all of the jumps and hazards that this race will demand.  The U.S. is an experienced and durable competitor but may be tired or too poorly disciplined to cover the long course in a steady and reliable manner.

China appears to have a plan and has been preparing for a long race.  Spectators will have to wait and see as only time will tell.  China looks organized, consistent, and is approaching the race with a rational plan.  It has not catered to the many special interests.  Its team is a compact, strategically clear group of engineers that has thus far stayed focused on the national interests as they see them. 

By comparison, the U.S. team has many “cooks in the kitchen” (Congress) making and designing its plan.  Their slow process towards building political consensus in the U.S. leaves lots of room for many special interests to get their meal at the public trough, while the average citizen is often ignored.  For this race, the U.S. does not seem to have a plan.  The team’s execution is ad hoc and the horse is just going to have to read and react to the course and figure out how to run and jump without clear direction from the jockey.

As the lead horse, the U S. is still able to pull tricks on the competitors like lowering their currency…while criticizing others for not raising theirs.  This is a smoke screen and part of the on-track tactics that lack an ethical basis; but this is a ruthless race, and ethical conduct on the track is not the norm.

China is gaining fast, but the horse has one major problem that could hurt its chances.  The business environment underpinning the Chinese economy is rife with corruption and questionable business practices. 

The U.S. has one great advantage, the individual entrepreneurship and skill of the many business leaders and highly intelligent technological people in the U.S.  If they are allowed to compete, build businesses and innovate the way they have for decades, the U.S. can win this race.  If they are impeded by favoritism, special interests, and government intervention, it would appear the Chinese challenger has the inside track to victory.

Important Note—It Is The Actions That Count.

Complaints about currency values, trade policies and the Federal Reserve are for domestic political consumption.  We should not pay too much attention to the talk.  It is the actions that count.  Let us see if the U.S. and Europe can take the actions necessary to compete in the future.

Volatility Sets In For Commodities and Gold—Do You Have a Plan?

Prepare for more volatility, and buy the dips.  It is typical of a bull market that is in its middle-age to develop more volatility.  This pattern of increased volatility will persist until the peak at some future date.  At that time, we expect to see the price of gold rising and falling by $100 or more per day.  The chart of the gold price will show an upward spiking pattern and we plan to take profits at that time.  The day will eventually come when we will say sell gold and many other commodities as well.  However, that day is not here yet.

What does a top in gold look like?  Here is a chart of gold from 1979-1980.  Note the big volatility as gold neared the top. 

gold-1.jpg picture by gimmarketing


Summary and Recommendations

Investors should continue to hold gold for long-term investment.  We have been bullish on gold since June 25, 2002 when it was selling at about $325 per ounce.  In our opinion, it will move to $1,500 and then higher.  Traders should sell spikes and buy dips.  Even after its recent pullback, gold is still up 312% since June 25, 2002.

Investors should continue to hold oil-related investments. A negative news event is that there will be an increasing supply from Iraq.  We have been bullish on oil since February 11, 2009, at which time oil was trading at $35.94 per barrel.  After the recent pullback, oil is trading at $82.51 per barrel, which is up about 129%.

Currencies:  For long-term investment, we do not like the U.S. dollar, Japanese yen, British pound, or the euro.  As we mentioned in our September 14th letter, we like the Singapore, Thai, Canadian, Swiss, Brazilian, Chinese, and Australian currencies.  We would use the current pull-backs in these currencies as an opportunity to establish long-term positions.  Since September 14, 2010, these currencies have appreciated or depreciated versus the U.S. dollar by the following percentage: Singapore dollar +2.4%, Thai baht +8.1%, Canadian dollar +0.5%, Swiss franc +1.0%, Brazilian Real -1.7%, Chinese Yuan +1.6%, and Australian dollar +4.2%.

Investors should continue to hold shares of growing companies in India, China, Singapore, Malaysia, Thailand, Indonesia, Colombia, Chile, and Peru.  We have been recommending these markets in these commentaries since September 14, 2010, and we would use any pullbacks as an opportunity to add or initiate positions for long-term investors.  Stocks in these countries have appreciated in U.S. dollar terms by the following percentages since September 14, 2010:

Singapore 7.6%
Malaysia 1.0%
India 6.1%
China 9.7%
Indonesia 13.6%
Thailand 9.6%
Columbia -1.1%
Chile 3.8%
Peru 17.5

We believe long-term investors should continue to hold food-related shares such as grains, wheat, corn, soybeans, and farm suppliers.  Since we said the grains had bottomed on December 31, 2008, these have all appreciated substantially.  We see more price rises ahead.  Since December 31, 2008 the price of corn is up about 29%, wheat is up about 2%, and soybeans are up about 24%.

We believe U.S. stocks can rally further.  Our reason for becoming more bullish on U.S. stocks on September 9, 2010 is that over the longer-term, liquidity formation through QE will create demand for many assets, including U.S. stocks.  Since September 9th, the S&P 500 is up about 6.6%.

Thanks for listening.