America’s cliffhanger

The US fiscal cliff agreement, which passed through Congress on the first day of the year, showed most US politicians in a bad light.  Only at the very last minute before significant tax increases and spending cuts would have taken effect, did all participants agree to (i) a deferral of these measures for two months, (ii) a 4.6% tax increase on all incomes over $450,000, and (iii) a 2% payroll tax increase on all incomes up to $107,000.  Obama got the tax increase for the top 1% of earners that he had campaigned for, which will raise about $60bn a year, and the Republicans demanded no further extension of the payroll tax cut, which will raise about $125bn a year.  Together these measures will reduce US consumer incomes by a little over 1% of GDP in 2013.

This was just about the minimum possible level of agreement, and the fact that it took until 1st January to get to that point does not bode well for the chances of securing a more substantial and longer term agreement on government finances ahead of the next fiscal cliff deadline which is now 1st March.  However, several important conclusions can be drawn from recent events:

  1. All US politicians do now understand that the fiscal cliff deadline would have sent the US economy into recession if no agreement had been forthcoming, and that a failure to extend the US debt ceiling would lead to a technical default on US Treasuries with very negative consequences for markets.  Neither side wish to be seen as responsible for either of these events therefore future agreements will likely be made in time.
  2. Markets believe that agreements will always be made in time and so much less inclined to panic ahead of the fiscal deadlines.  Without markets exhibiting any such fear, the politicians have less reason to give ground in the negotiations until the very last minute.
  3. Obama has continued the style of his first term of not being prepared to engage directly with the Republican leaders in negotiations, preferring instead to call them to the White House in order to lecture them, and then leaving negotiations to others in his cabinet.  This is not helping to build goodwill and gather support, making substantive future agreements more difficult to achieve.
  4. Neither Republicans nor Democrats are actually very concerned about the levels of public debt ($16tr, more than 100% of GDP) and the budget deficit ($1tr a year) per se.  The Republicans are essentially opposed to any tax increases, which would tend to harm their supporters, and the Democrats are essentially opposed to any spending cuts, which would tend to harm their supporters.  There is some scope for tit-for-tat concessions here, but getting beyond the minimum acceptable levels to avoid market crises will be very difficult.
  5. This lack of strong commitment to deficit reduction makes it likely that there will be no meaningful austerity in the US until there are difficulties in selling the Treasury Bonds necessary to finance the deficits.  Given the weakness of the European economy following its efforts at austerity, this should support the US economy in the short term.
  6. The policy of the Federal Reserve is currently one of Quantitative Easing of $1 trillion per annum until further notice.  The Fed is providing the markets with enough new money to finance the budget deficit.  Ultimately, such a policy will lead to inflation and a collapse of confidence in the dollar.

The investment implications of the above are that US financial markets continue to be supported, in the short term, by a lack of austerity and continued printing of money, but that in the longer term, these same policies will lead to inflation and a credit crisis. With this outlook, investors should broadly remain invested in company shares, wary of bonds with fixed coupons and insured with gold.

The tectonic plates are moving beneath the Japanese markets

For many investors Japan has become a market they have felt happy to ignore for some time now. It can be argued that nothing has happened in the Japanese economy over the last 20 years as nominal GDP growth has been essentially zero over the period, although this disguises real growth of about 1% per annum offset by deflation of a similar amount. The budget deficit has been allowed to run at very high levels as the private sector has chosen to run a large financial surplus and moved from being very highly geared in 1990 to now having substantial net cash on its balance sheet. These deficits have been almost entirely financed by Japanese institutions, content to own JGBs yielding 1% or less, because the deflation still gave them reasonable real returns. The yen has benefited from these real returns, the continued trade surplus and the lack of enthusiasm displayed by the Bank of Japan to engage seriously in Quantitative Easing, in sharp contrast to the Central Banks in the other Western economies. The Nikkei stock market index fell more than 80% from its 39000 peak at the end of 1989 to its October 2008 low.

As with the devastating earthquake that did so much damage to Japan last year, so the tectonic plates beneath the Japanese financial markets now seem to be moving.

The nuclear disaster at Fukushima has led to almost all of Japan’s nuclear electricity plants being closed down over the last year. This in turn has resulted in a shortage of domestically produced electricity and a strong rise in Japanese energy imports, to the extent that the long-acclaimed trade surplus has now turned into a deficit, removing one of the key props to a strong yen.

The demand and supply picture of the JGB market which for so long has seen a balance between the enormous supply from the large budget deficit and the heavy demand for bonds from domestic financial institutions is in danger of deteriorating as the aging of the population is reaching a critical point where net inflows of contributions into pension funds are now more than offset by payments of pensions to those who have retired. The largest pension fund, the Government Pension Fund has now reached this position, so that the core investor in JGBs for many decades is now a net seller and will remain so for many decades to come. The budget situation remains dire, normal expenditure of Y90 tr for fiscal 2012, revenues of only Y42 tr leaving a deficit of Y48tr ($600bn) before a further Y3.8tr of earthquake reconstruction expenditure. Annual debt interest of Y22tr is over half of tax revenues. Austerity moves to curtail the budget deficit are likely to send the economy back into recession and so attention has turned to the Bank of Japan and its historic determination to avoid unconventional monetary policies as the only route left to ease the situation.

With the retirement of BoJ Governor Shirakawa later this year, the vacancy for his successor has created a Monetary Policy Committee more amenable to carrying out the government’s wishes. February saw a new turn in Japanese monetary policy as the BoJ announced a firm inflation target of 1% and an intention to overcome deflation, to which end it announced a Y10tr increase in Quantitative Easing. It is committed to further such moves until its inflation goal is in sight.

Financial market movements in recent weeks indicate that this as a significant move. The Japanese bond markets are no longer pricing in deflation, the yen has fallen sharply and broken its long term uptrend against the other major currencies and the Japanese equity market has broken its 5 year downtrend. The Second Section of the Tokyo Stock Exchange where the smaller domestic Japanese companies are traded has risen every trading day for 6 weeks, beating the 1975 record which marked a new bull market from the late 1974 lows. Such market action is rare and typically indicates that all the potential sellers have sold their positions. Japanese markets should not be ignored – important changes are occurring – sell JGBs, buy the equity market and hedge the currency.

Reasons to be happy – if you own gold!

Gold is money whose supply is not decided at the whim of human leaders. Annual gold production is about 1.5% of the total amount of gold in existence, so it is the demand for gold which determines its price. In contrast the major paper monies of the world, the dollar, euro, yen, pound  and Swiss franc all have Central Banks whose job it is to determine how much of their currencies to be created. Before the crisis, the rate of increase of supply of a currency was kept roughly in line with the nominal growth rate of their economy, somewhere around the 3-6% per annum range. However in recent times, this has gone out of the window. The policies of Quantitative Easing seen in Japan, the US and the UK in the last few years have massively expanded the amount of money in their financial systems. In Switzerland, in response to the massive appreciation of the exchange rate, the Central Bank has made public on several occasions its intention to create unlimited amounts of Swiss francs in order to prevent further appreciation. The ECB (with its Germanic bias) has indicated that it would never a policy of Quantitative Easing, but within weeks of taking office as President, Mario Draghi announced 2 Long Term Repurchase Operations, which permit European banks to borrow unlimited amounts of money for 3 years at 1% and encouraged all banks to make full use of this facility – a policy which has similar short-term effects as QE. The supply of paper money across the Western world has increased sharply in recent years and the rhetoric of those in charge implies that they remain very happy to continue that policy for years to come if they feel it necessary.

Interest rates are very low. Gold brings no income return, and so tends to perform poorly when the income return on other assets is high. Today the opportunity cost of owning gold is very low since the return on other assets is so low. In addition, such low rates of interest tend to occur at times of low or tough rates of inflation and …

Gold is the best hedge against inflation. Recent analysis by Credit Suisse looking at the performance of different asset classes in times of rising inflation over the last 100 years, showed that gold delivered the best correlation to rising inflation. A relatively new asset class that might also do this is inflation-linked bonds, however were the inflation to be substantial the amount that would have to be repaid by governments would rise significantly and could cause a sovereign debt crisis. Gold is no one’s liability, unlike inflation-linked bonds, and in that sense remains the best inflation hedge.

Gold is a great hedge against political uncertainty. The Arab Spring has brought enormous political instability into the Middle East. One of gold’s huge advantages over other tangible assets is it very high value to weight ratio – and this fact has meant it is very portable. If a rapid departure from home suddenly becomes necessary, the most convenient medium for taking your wealth with you is gold.

Gold is an indicator of wealth. Through the centuries in both China and India (representing one-third of today’s global population), gold has been the first port of call for household savings. However from 1952-2002, Chinese individuals could not buy gold. Indian per capita consumption is over twice that of China, so the Chinese still have some catching up to do. At a national level, the reserves of many Asian countries have historically been held in dollars with very little held in gold (in sharp contrast to the Western Central Banks which have always maintained very high weightings in gold).

There are about 5 billion ounces of gold in the world and about 7 billion people alive today – that is about $1250 or £800 worth of gold for each person. Do you have your share?


PS Note too that Greece’s credxitors were quick to ensure that they can seize Greek gold.

Is Quantitative Easing reaching its sell-by date?

Nearly 3 years ago the Federal Reserve and the Bank of England, having taken interest rates to  just about zero but still believing that they needed to make policy even easier, announced a new policy of Quantitative Easing (QE) as their preferred route to help their economies recover. Recovery did followed, although in keeping with previous post banking crisis environments, this recovery has been weak and inconsistent. This unconventional policy was pursued because the conventional interest rate tool had reached its physical limits and with fiscal debt and deficits so high, so too had fiscal stimulus as a policy. The unconventional policy, QE, was the only thing left.

There are good grounds now for believing that the QE approach adopted to date is also approaching sensible limits. In the UK, the Bank of England will shortly own over a third of all UK government bonds outstanding – amazing as it might appear with a  trillion pound national debt which has doubled in just 4 years, there is potentially a shortage of government bonds. This is due to new, post-crisis rules on capital adequacy for both banks and insurance companies which drive these institutions towards holding many more government bonds. With many gilts also held as the underpinning of pensioner annuity payments, a continued steady reduction in the budget deficit could mean that there are simply not enough gilts available to be bought if the Bank judged that much more QE was necessary

In the US the enormous market in mortgage bonds issued by what are effectively government entities makes this less of a problem than in the UK, but it was very noticeable that the second round of QE in the US in 2010/11 resulted in a surge in commodity prices, including gold, which pushed up inflation in the US, reduced disposable income and contributed to a weakening economy, as opposed to the economic stimulus that was intended.

So if further Quantitative Easing of monetary may now be either not implementable or counterproductive, then what can the Central Banks do if they decide that their economies require further stimulus. Both the Bank of Japan and Bernanke have previously suggested that a further tool that could be deployed is for the Central Bank to buy equities in the secondary market and so push up equity prices. Terrific for shares and all those executives with share options, but it is not clear that this then leads onto companies raising new equity finance in order to invest which is the rationale for such a policy.

The problem for all monetary policy approaches post a banking crisis is that there are two economies, a financial economy which requires reliquefication, recapitalisation and write-offs of bad assets and a real economy which cannot gain finance from the financial economy and produce growth until the financial economy is cleansed and functioning again. In economic jargon, the monetary transmission mechanism from financial sector to real economy is broken and so QE although in theory a logical policy, in practice only gets adopted when things are so bad that it will not work.

The aggressive Quantitative Easing solution, which Central Banks have not yet adopted is “helicopter money”. This is where the government prints new money and drops it out of helicopters (or via tax cuts and higher welfare payments) into the real economy. This is very likely to work in boosting the economy in the short term (people have more money in their pockets and so go out and spend some of it), but it will not be long before there is an inflation problem. This is clearly an economic policy beset with risk and the reason that Central Banks prefer to work through the financial system, even though it does not function well – in Zimbabwe this policy led ultimately to the printing of Z$100 trillion notes.

Quantitative Easing is near its sell-by date – something different will be tried next, and whatever that policy is, it will mean more government interference in the economy and more (long term) inflation. Stay long of gold!