About this blog

When I started this blog on a different site some time back, I had the naive perception that my views on global monetary policy were somewhat unique.

Ever since 1998, I have had the expectation that the US dollar would collapse due to high debt and large trading deficits, with massive inflation as a result, eventually leading to the demise of the dollar as the world's global transaction currency, and the US losing its status as the world's unchallenged economic super-power. A position it has held since the end of World War I.

When the Euro was introduced, I celebrated its creation, thinking it would gain strength as a credible alternative to the dollar, with the possibility of minimizing negative impact on the world economy as the dollar collapse progressed. The absence of sovereign control over monetary policy could only strengthen the currency's credibility, I thought, and considered it madness when the Euro dropped to close to 0.8 to the dollar four months after it was introduced on January 1st 2001.

When the Euro peaked at 1.6 against the dollar in early 2008 (with the value of Eurozone GDP reaching par with the US), I took it as a sign that the expected dollar collapse was happening before my eyes. At that time, the leverage in the US economy was unmatched, and had it not been for hyper-aggressive intervention by the Fed, the US banking system would have dis-integrated into a nasty long-lasting deflationary spiral, with the possible outcome of total and utter chaos. The gold-price also rallied together with the Euro, however, as the Euro's structural problems were yet to surface, the rally in gold took new turns when it surfaced that the Euro was a poorly regulated initiative, due to the ECB lacking supervision of domestic lending in member countries, and outright accounting fraud in the case of Greece.

In retrospect, the dollar collapse has largely taken place, but the transition has been gradual, little by little every year, and the major impact has been felt in the real economy, and to a lesser extent in financial markets. When measured in the relative purchasing power of the American consumer versus consumers in the countries of trading partners, there is still substantial room for the dollar to correct, as the US current account deficit is still 3% of GDP (though more than halved from its 7% peak in 2006). With debt fueled consumption re-ignited by Bernanke's QE measures, the current account deficit is again heading for an increase.

The dollar collapse has manifested itself primarily in rising wages (in USD terms) in developing economies with large current account surpluses (e.g. China, India, Gulf states, Latin America, Russia, etc), and secondarily in the prices of gold and oil, as wage increases in these economies have allowed consumers to purchase increasingly more of these commodities. To take gold as an example - in 1980, Europe and the US accounted for jointly 80% of global gold purchases. In 2012, the number was less than 20%, and is set for record lows in 2013 as ETF gold outflows are absorbed by buyers in what was previously characterized labelled as the "developing world".

In retrospect, Bernanke's QE measures should be celebrated rather than criticized, as they are allowing for a "soft" devaluation of the dollar, with export based economies gradually shifting towards more domestic consumption, rather than changes taking place through a brutal correction.

However, the changes are far from complete, and will continue to dominate the world economy for the next two decades to come. As the paradigm shift is happening gradually, and it is beyond doubt that the current up-tick in the US economy is just a blip against a long-term trend of continued demise.

Will the new paradigm be a bearparadigm? Yes, however perhaps not in the sense of being a financial bear market, as was reflected in the title initially intended for this blog.

It will more likely be a panda-bear paradigm.

No inflation yet? Wait and see.....

For those disappointed about the continued absence of substantial US price inflation, it is beneficial to recap a little bit of Economics 101.

Below is one of my favorite charts of all time, courtesy of Wikipedia.com. It is called the Philips curve, after the economist who invented it. This particular chart is plotting the relationship between Unemployment and Inflation (a proxy for the latter is Rate of Change of Money Wage Rates), for the United Kingdom every year between 1913 - 1948.

In short, the Philips curve states that high unemployment in an economy corresponds with low inflation, and vice versa. There has since Philips published his work been numerous refinements of the theory surrounding the Philips curve, however, there seem to be broad agreement on the key principles behind it.

Simply put: When general unemployment is above what economists define as the equilibrium unemployment rate, wage growth tends to slow, as the unemployed are competing for jobs. When unemployment is below, jobs are competing for the unemployed, bidding up wages. 

What the equilibrium unemployment rate is for an economy is dependent on a range of different factors. Unemployment benefits, minimum wages, laws that regulate hiring/firing, general ease/difficulty of doing business, quality of labor in a work-force etc, are general factors influencing supply and demand for labor. Generally, the more efficient/ the less restricted the labor market is, the lower is the equilibrium unemployment rate. Labor market rigidities explain why for example Spain was experiencing material wage inflation when it had 10% unemployment, while similar unemployment rates in the US on average led to declining wages.

Several analysts have estimated the US equilibrium unemployment rate to be north of 6%. This is up from its long term average between 4-5%, and reflects that long-term unemployment in the US have left more people less employable.

Currently, the US unemployment rate is 7.4%. This is still well above 6%. Hence, there is still higher supply of deplorable labor than there is demand, and on average no sign of inflationary pressure in wages.

As Uncle Ben Bernanke has promised us that he will keep printing money until US unemployment reaches 6%, he will create inflation for sure. At the going speed of unemployed being hired, this point should be reached in about 12 months time. Until then, gold will continue to give good buying opportunities.

Portfolio up 40%. Some reflections.

My model portfolio has in this moment an implied return of 40% since its initiation in November (see below).  Which, I presume, is quite good by any benchmark.



The position which continues to disappoint in the model portfolio, is long gold. After having reached an intra-day low of $ 1321/oz on April 16th, only to rebound to reach intra-day prices of $1490/oz around May 3rd, it has now broken through the bottom of its 4 week trading range, signalling further short-term decline. Chartists will probably start seeing "head-shoulder" formations if the price reaches 1350 (which I expect it to do), creating further self-fulling expectations about price declines.

Furthermore, price declines now seem to be expected even among the most stubborn gold bulls, which have a history of impacting the buyers sentiment (Marc Faber has become more quiet after his predicted stock market crash did not materialize in April, and after he proclaimed gold was a good buy at 1600, only to see it becoming an even better buy at $1400/oz a few weeks later, Jim Rogers, recently proclaimed he has buy orders on gold all the way down to the $1100/oz mark. Previously, before the decline, he advocated $1200/oz as a possible floor).

Support from physical gold buyers is unlikely to show the same strength around a second dip, at least not retail demand. To use myself as an example, I was among those that took the opportunity to load up on physical metal right after the floor bottomed out in mid-April (my entry point was $1380/oz, to be exact). Now, I have less cash to deploy when a similar opportunity comes along again, and need even lower prices to engage. A similar rush to buy, with the $1400/oz mark in fresh memory of physical gold buyers, is unlikely to materialize unless gold falls to around $1250/oz.

Paradoxically, the fundamentals for owning gold have not been as good as they are now for as far as I can remember. South African cash cost for gold production is around the $1400/oz mark (with China, US other producers ranging between $900-1300/oz). If the gold price falls to the $1250/oz mark, many of these will be in a lot of financial pain, impacting market expectations about supply, and thus both the sentiment of buyers and sellers. Not to forget (if at all possible) that all the major central banks in the world seem engaged in a competition about who can add most to their currency supply.

The long-ago expected (but still missing) trigger to revive the secular bull market in gold would be signs of inflation finally materializing in the US (as other economies experiencing substantial inflation, China, India, and Iran, who is buying via Turkey, have been the key buyers of gold).

With US un-employment still hoovering north of 7.4%, general inflation, as measured by the CPI, is unlikely to materialize at least for another 12 months, and will be subsequent to statistics showing sizable development in credit expansion, and increases in the velocity of money. Until this point is reached, the gold price is likely to go sideways, my guess is with a solid floor around $1150/oz, $1400 to form the upper range of the band.

Chinese Wage Inflation Will Eat Apple's Margins

Apple's (AAPL) Baseline Scenario is Negative Growth

Apple stock has had turbulent fall from it's all time high of $700 per share in September 2012. The share price has continued its decline throughout the first quarter of 2013, in spite of the company announcing record profits in January for q4 2012.

Apple is now valued at a trailing P/E multiple of just 7, when adjusting for the net cash position. A simple approach to valuing the company, using a Gordon Growth formula on 2012 Free Cash Flow ($ 41 billion) suggests that in order to justify the current valuation levels, growth must be 5% negative per year to eternity.

If you are familiar with this approach, skip to the next section of this article. If you have no idea what I am talking about, read on.

Using the Gordon Growth Formula to value equity on equity cash flows assumes that

V = FCF*(1+g) /(Ke - g)

where V is the current value of future cash flows to equity adjusted for current cash position, FCF is the current Free Cash Flow to equity, Ke is the cost of equity, and g the expected growth rate.
Solving for g yields (using rounded numbers for Ke, V, g)

g = ((V * Ke) - FCF/ (V + FCF) = (($300Bn * 8%) - $41Bn)/ ($300Bn + $41Bn) = - 5%

Assuming an expected inflation rate of 2.5%, this is a 7.5% real decline per year.

Both Increased Competition And Increased Production Cost Is A Superbearish Cocktail

In spite of annualized sales being up 18% year on year in the forth quarter of 2012, earnings per share have decreased (-0.5%), mainly due to gross margin erosion (38.6% vs. 44.7% just one year ago).

Corporate guidance is suggesting both lower sales and lower margin for the 2nd quarter of 2013, corresponding to about $ 9.3 billion in net profits (mid-range of guidance), which is a decline of roughly 30% on q2 2012.

Apple has a history of under-promising and over-delivering. Though this is a lot easier to do when things are going well, management guidance probably has a buffer baked into the numbers, which are due in the last weeks of April. Though certain analysts (Citygroup, Jeffries) are highlighting there is significant risk that Apple will come short of its own bearish guidance, it may be reasonable to expect actual earnings to be around 5% above corporate guidance.

However, it is without a doubt that in addition to sales cannibalization from Android devices, Windows equipped Nokia (NOK), and a revamped BlackBerry (BBRY) hand-set, continued margin erosion is inevitable.

The three most important factors driving the margin erosion are:

1. A shift in product mix towards lower margin products (the iPad mini, budget iPhone rumored to be due in June)
2. Expansion of sales in more price sensitive emerging markets, where Apple is lagging Samsung (EWY) and Nokia in sales and distribution
3. Higher production cost in China due to wage inflation

Of these three factors, the third is the most ignored and underestimated, and most difficult to control and predict for Apple management.

A Closer Look at Chinese Wage Inflation

Chinese real wages have almost doubled since 2008 (see below chart, courtesy of Itulip.com). This as a direct consequence of the aggressive quantitative easing policy undertaken by the US Federal Reserve, a gigantic (though now decreasing) US current account deficit vs. China, and the Chinese policy of keeping the yuan in a narrow trading range against the USD.



As QE3 is continuing, so will Chinese wage inflation. Foxconn, that manufacturers iPad, iPhone and iPod has over 1.2 million workers in China and is periodically experiencing workers unrest due to demands for higher pay. Earlier this year, reports emerged that Foxconn had halted new hiring at its factories in China.

It it worth noting that Foxconn reported record earnings for the 4th quarter of 2012, at $1.21 billion, a 5.6% increase on the previous year, but also that the increase came at the expense of a minor decrease of it's net profit margin (from 3.24% to 3.23%).

Moving Production to Other Low Cost Geographies Will Take Time And Effort

Among the company's top 800 suppliers, almost 400 are in China (below distribution of Apple's suppliers, courtesy of Chinafile.com)



As Foxconn operates global production facilities, a shift in production over time to lower cost geographies is likely to be expected.

Bank of America Merrill Lynch this week estimated that Mexico's labor costs are now 19.6 percent lower than China's. Foxconn has existing operations in Chihuahua City, Guadalajara, Reynosa and Tijuana, which can be used as base locations also to produce Apple products.

Though it is possible for Apple to shift production over time to other locations, it is a painfully slow process due to the sheer size of local operations and the complexity of the supply-chain. Besides keeping tight control on the quality of work and components (which requires extensive training of suppliers), a key requirement of the Apple supply chain is to make new products quickly enough after launch to meet consumer demand.

Chinese wage inflation will eat Apple's margins, for many years to come.

Portfolio up 30% since November

My position in BAC, GOOG and AAPL are moving in the right direction, though gold keeps under-performing (will probably not see any positive movement here until mid-2014).

Cyprus - chapter one of the Great Unwind

Yesterday, it was announced that Cyprus has stricken a deal with the Troika on how to secure financing for its banks. The proposal implies the bankruptcy of the country's second largest bank (Laiki), and government confiscation of un-insured deposits (though only 35% of these for Bank of Cyprus, the country's largest bank).

Good news of bad news? Does it matter in the end? Its just news.

What is happening in Cyprus is a gunshot in the air. The EUR 5 billion the Troika refused to finance are peanuts compared to the 240 billion that Greece has already received, the 68 billion received by Ireland, the 78 billion received by Portugal, or the 100 billion received by Spain. It is a sign to Italy that any Italian bailout will be on tough conditions, after all, why should Italy be treated better than Cyprus? Furthermore, a looming economic disaster is France, who's external debt position in increasing and increasing, likely to produce a crisis within two years on the current economic trajectory.

A more interesting question is, why (except for within extremist parties) is there no wide-spread recognition of the need to dismantle the Euro? Countries like France (which still have not reached the extreme un-employment levels of Spain) or Italy (which has a surplus on its current account balance) still have a chance to avoid an even bigger disaster in the future if they act now.

Dis-mantling of common currency areas have been done many times without any major difficulties (the break-up of the Soviet Union is a recent example). What makes the situation different in the Euro area are the extreme amounts of external debt held by each country. However, if debt holders take a hair-cut through currency devaluation or a hard hair-cut, does it really make any material difference for them? Until these economies have been de-risked, they will struggle to find financing and as assets values continue to deteriorate, trigger capital flight from the periphery to the center.

Capital controls are inevitable regardless of a euro de-peg. Capital will seek to fly if the country stays within the Euro (banks perceived as risky) or if there is the chance of a de-peg (devaluation). International coordination with European governments and central banks are the remedy in either situation.

It is in the interest of everyone to stabilize the periphery as soon as possible, and a currency devaluation might be the preferred route to avoid overshooting as society disintegrates in the periphery and financial bubbles are created in the center.

It continues to puzzle me that politicians still have not realized that what is happening in these countries is Europe's version of the Great Depression. The main challenge during the Great Depression was the Gold Standard. Cyprus, Spain etc have the Deutschmark standard, which is more or less the same thing.

The Great Depression did not end until all countries affected left the gold standard, which allowed them to debase their currency. The UK left the gold standard in 1931, the US held on until 1933. In the process, the US confiscated public gold, which is the same what has been happening in Cyprus, with politicians confiscating Euro's held by depositors. Subsequent research on the Great Depression documents that the earliness with which a country left the gold standard reliably predicted its economic recovery.

Do we need a major breakdown of society, with rise of political extremism, hunger, and social unrest before one realizes the need to dissolve the Euro? Or can it be done in a planned manner that preserves the value of existing economic structures of society and minimizes volatility?

Until European politicians recognize the Euro mess for what it is and plan together for how to solve it (e.g. dissolve the Euro) I will maintain and increase my gold position.

Appropriate asset strategies for inflation

What assets will appreciate faster than inflation in a high-inflation environment?  

Certainly not stocks. Before inflation materializes, yes, but not when inflation has materialized. Inflation creates information inefficiencies, as corporate accounts become in-transparent, and it becomes very hard to see which company is profitable or not. Furthermore, due to high variability in prices, financial and operational planning becomes more difficult, tending to suppress investments. The real tax burden on companies increases, as profits become artificially inflated by timing differences. Finally, inflation will drive up interest rates, increasing the cost of capital for companies, making profits less valuable. In the inflationary period starting in the late 1960s (when Nixon was printing money to pay for Vietnam) the stock market was nearly flat until 1982 (though volatility was high), and corporate earnings increased less than inflation (average P/E multiples on the S&P 500 where in the range of 6-8).

Certainly not real estate. Cost of financing will increase, driving up required real estate yields and driving down valuations. As rents are adjusted with a time-lag, income from real estate asset will lag inflation. At current valuations (which in spite of the decline since 2008) house prices are still high in a historical context. Real estate will be worse investments than common stocks when it comes to preserving wealth. In the period up to when inflation materializes and interest cost adjust (which is what is happening now, foreseen to continue for at least 18 months) real estate will provide superior returns, but will be punished with a vengeance later on in the cycle. Back in 1978, my father paid for his first one-bed-room apartment with an amount corresponding to 6 month salary (and he was an entry level manager at the time).

And (for the sake of completeness) certainly not bonds or T-bills. If you among the few who might wonder why, google the term "bond duration" and you will know.

So, what is left then? Commodities? Farmland? Treasury Inflation Protected Securities???

Jim Rogers is a fan of the first two. His thesis is that purchasing power will increase more in Asia, leading to Asians eating more meat, which will push up the price of grain and increase yield on land. And there is some truth to it. Commodities performed relatively well during the high-inflationary period of 1968-1982, only to get hammered in the 30 years thereafter.

Treasury Inflation Protected Securities (TIPS) may provide some support, as the existing ones will be bid-up, as their (already very low) yields are likely to become even lower.

The key to survival in a high inflationary environment lies in capital allocation decisions. The optimal strategy is:

1. Purchase real estate with low maintenance and running cost, leverage your purchase to the max, and fix the interest rate for as long as you can. This is an asset that you can live in, and if you have a wood-fired oven to keep you warm, you can always manage variable costs....

2. Allocate a percentage of your remaining portfolio to precious metals (suggest 35%). A lot of people out there are very bullish on silver due to a favorable supply/ demand situation (usage in electronics keeps increasing, but supply from silver mines keeps experiencing larger and larger production cost). Also, in the extreme case of a hyper-inflation environment, where precious metals take over as currency (yes Armageddonists, you will love this!), Silver is more practical than gold, as coins can be used for everyday purchases due to lower value. Silver, however, has higher transaction cost when you want to buy and sell it and requires more storage. I prefer gold to silver, though gold has been very overbought and mid-term price direction is uncertain.

3. Allocate a percentage of your remaining portfolio to shorting US treasuries with long duration (suggest 20%). There is huge upside in such as position, as bond values converge to zero, you will at least double your money. Just remember to keep re-investing proceeds, to maintain the same exposure all the time (doubling the nominal value of your cash might not be enough to give you inflation protection).

4. Allocate a percentage of your remaining portfolio to financial service stocks (suggest 40%), especially financial brokers arranging ETFs, those that have proprietary trading activities in equities and commodities, and do NOT have bond market making activities. Money will pour into commodities, ETFs for all kinds of real assets, in a rather headless fashion, and investment and commercial banks will skim the margins. The size of their balance sheets, equity under management etc should increase with the rate of inflation, and inflation will reduce impairment risk of assets. When inflation is killed (no risk of this next 5-8 years though) banks will be in a pile of pooh-pooh, as they will have allocated a lot of capital to intrinsically unprofitable investments. However, whoever comes after Helikopter Ben needs to have a plan no cause a collapse, and warning signs will be ample.

5. Producers of farmland equipment can also be a good play for the next 5 years. Large-cap farming equipment producers with low P/E ratios have the potential to be re-priced as growth stocks when the market overshoots. And there will be acquisition plays as larger producers swallow the smaller ones with borrowed money.