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Sunday, June 30, 2013

Dollar collapse....finally?

The key dynamics of the most recent global macroeconomic paradigm (e.g. the last 40 years) can be summarized in a few points:

1. In 1971 the US dollar was taken off the gold standard, enabling America to issue unlimited quantities of new currency at will. The United States has been running a deficit on its balance of trade since then, accumulating debt to foreigners. In 40 years, the dollar has not once depreciated enough to allow for the trade-balance to turn into a surplus.

2. The early 1970s was also when China followed Japan, Taiwan, Hong Kong and others in adopting an economic growth strategy based on exports, mainly to the United States. The main component of the strategy was having their central banks matching cash flows from the exports of goods with purchases of financial assets in the United States (e.g. government bonds) to avoid their currencies from appreciating (which would hurt the exports).

3. The impact on the US and Asian economies of the above policy choices has been two-fold:

(i) Asian central banks placing their dollars balances drove the 30 year bull-run in the market for government bonds, pushed yields below levels needed for the preservation of the purchasing power of money invested, helped creating the US asset bubble in housing, as well as pushed up US stock market valuations. Currently, total financial assets held by foreigners amount to more than 9 trillion dollars, nearly 2/3rds of all government debt and almost 60% of US GDP.

(ii) Avoiding appreciating domestic currencies required the Asian central banks to issue new currency to pay for the dollars that were bought. As the proceeds from exports went to domestic producers who redeployed it in the economy, the policy resulted in increasing the domestic monetary supply, creating significant inflation and massive credit expansion in Japan in the 1980s (leading to the largest asset bubble the world has ever seen), and massive inflation and credit expansion in China in the last decade (and another huge asset bubble, the full consequences are yet to be seen). 

Now, all that's in the past. How much longer can the current paradigm be extended, e.g. what about the future?

It is highly relevant to note that the two economies that have played the largest role in supporting the value of the dollar for the past 40 years currently are in the process of experiencing dramatic economic reversals, which are directly related to the long-term consequences of their past policy choices.

After a decade of deflation, Japan has recently resorted to a policy of hyper-aggressive monetary and fiscal expansion ("Abenomics"), aimed at stimulating the public to spend and invest as their cash holdings will yield negative returns when inflation increases. This policy has sent the currency down 20% vs the dollar, boosted consumer spending (+3.5%) and stock market valuations (up 55% for the year).

China's domestic inflation problems have eroded the competitiveness of Chinese producers, as dollar denominated wages have doubled between 2008 and 2013 to currently averaging around $8000 p.a., nearly 20% above wage levels in for example Mexico. Simultaneously, the shadow banking system, which has managed the majority of Chinese savings, is collapsing due to falling real estate valuations, implying China is going from rapid credit expansion to rapid credit contraction. Money is being pulled out of the shadow banking system and invested into gold and other assets that still allow an escape from the tax man, a major factor contributing to China becoming the largest buyer of gold globally in the first quarter of 2013.

In other words, Japan has already stopped supporting the dollar. With its domestic sector collapsing, China is becoming even more dependent on exports for growth, and is likely to continue with asset purchases in the United States off-setting export cash flows, whilst pursuing aggressive domestic monetary policies to bail out it's banks (like Japan did in the 1990s).

Wednesday, June 5, 2013

Betting against Roubini

Nouriel Roubini recently came out with an article predicting gold prices to reach $1000/oz by 2015. He is not the only one being bearish. As a matter of fact, his views seem to be shared by an overwhelming majority of opinion leaders and investment banks.

For example:

Desjardins Economic Studies - target $1200
Commerzbank  - target $1227
Bank of America Merrill Lynch - target $1200
Goldman Sachs - $1270

As mentioned in a previous post, even notorious gold bulls, like Jim Rogers and Marc Faber, have mentioned $1200/oz as a possible floor for the drop in the gold price.

So, will Nouriel "I predicted the financial crisis" Roubini be correct about his gold price predictions? The arguments he is providing can be interpreted as follows:

1. The serious geopolitical risk has subsided and Gold as a "fear trade" is loosing triggers
2. Inflation has remained low in spite of massive monetary easing
3. Gold earns no income
4. Interest rates will rise (increasing the alternative cost of holding no-income assets)
5. Central banks of more indebted nations (such as Italy) may need to liquidate their gold holdings
6. Gold has been over-hyped by conservative US politicians

Just like everything else coming out of Roubini, his analysis is highly superficial, and just in line with US mainstream view (sorry Nouriel, you were not the only one, and definitely not the first one "predicting the financial crisis").

That does not necessarily mean he is wrong about his prediction, though his arguments certainly are flawed (as I will elaborate on below). Price formation for investment assets (gold, stocks or real estate) is largely determined by mainstream's expectations about future prices. If a majority of market players expect the price to go to $1200/oz, then the price will go to $1200/oz, as buyers will stop buying anticipating the price decline, and sellers will continue selling as long as the current price is above the expected future price.

As expectations are concerned, the US and European public go in tandem, with Europe usually lagging US consensus views.

What US and European public opinion leaders seem to have ignored, is that the market for gold has undergone massive structural shifts in demand over the last 12 years, dramatically changing the dynamics of the market. In q1 2013 the US accounted for a measly 4% of global gold demand, and Europe for only 6%. China accounted for a whopping 33% of global gold demand, and India for 28% according to the World Gold Council, with other mostly emerging economies accounting for the rest. Furthermore, ETF demand was only 6% of total demand.

Do US commentators still think we are in the 1980s, when the US and Europe accounted for nearly 80% of global gold demand? Roubini certainly seems to think so; all of his arguments would hold true if that was the case.

But the fact still remains that with new supply of gold increasing only a few percentage points per year, the price of gold is overwhelmingly determined by Asian buyers. It is highly questionable how much they worry about US recession risk, US inflation- and interest rate expectations, and how much they listen to Ron Paul and other ultra-conservative US politicians. They are likely to be much more preoccupied with the preservation of their domestic purchasing power, local traditions, and increases in the price of gold in their domestic currencies (which, for example in Iran, has been astronomical due to hyperinflation, contributing to Turkey becoming the third largest gold buyer in q1 2013, as Iranians cannot buy directly due to the international trade embargo).

It is the Asian buyers who predominantly have driven a five-fold increase in the gold price since 2001. And they have bought more gold because they could afford to do so. For example, average dollar wages in China doubled from 2008 to 2013. And official inflation numbers in India averaged nearly 10%, unofficially estimated by some to be at least 5% points above that. As the informed reader will know, the gold price doubled over the same period. With the recent price decline, gold has never been cheaper for the Chinese and Indian public as measured by how much gold they are able to buy. Get it? The implication of this is so important that I will repeat it: For more than 2 BILLION PEOPLE, the price of gold is at an ALL TIME LOW!

And, unless prices resume their ascent, gold will become cheaper still. McKinsey and the Boston Consulting Group have both published reports projecting Chinese wages to reach close to $20,000 by 2030.

In the near term, with central banks in the US, Europe and Japan printing money like mad to stimulate their economies in response to economic declines primarily caused by increased competition from the emerging world, domestic spending and consumption is set to increase. This is likely to result in even more imports from Asia, further fueling wages in export oriented economies.

And the gold price? Once the sell-offs by the American and European public have subsided (perhaps in a few more months), gold will resume its long term surge. At end of this blog, I allow myself to express how thankful I am for the contributions of Roubini and other egocentric imbeciles addicted to media attention (Henry Blodget of CNBC - a big thank you to you as well!). They are helping to create a major sell-off in gold when the fundamentals for owning gold are the best in 30 years. Thank you. Thank you. Thank you.