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June 1st, 2008
Despite the biggest jump in food prices in 18 years, the U.S. Labor Department reported that April's "core" inflation rate was an understated 2.3 percent. The benchmark excludes food and energy and thus bears no relation to prices, since it excludes such items as the year-over-year increase in bread of 14 percent, in milk of 13 percent and in gasoline of 21 percent. The Consumer Price Index (CPI) is widely used by governments, so the cost-of-living adjustment from pensions to tax rates alone can cost the government billions. However, you can only fool people for so long. Britain's "core" inflation rose 4.6 percent in April, the highest level since 1995. Consumer prices in Japan, excluding energy and food, rose for the first time since 1988, triggering the biggest one-day rout of the Japanese bond market in five years. Now the government is under pressure to change the makeup of the index.
The root of our problems started more than a decade ago when the U.S.-led liquidity- driven global boom provided cheap financing for America's persistent current account deficits and chronic budgetary deficits. The world was awash in dollars. The dollar surpluses were supposed to be recycled into the US but instead provided the cheap money for the build-up of the housing, oil and credit bubbles. A wall of money sought higher returns in a world of low rates. The real question is not if the credit boom has ended but what will it cost the United States to extract itself from the financial morass? After all, it took more than 10 years and billions for Japan to recover from its asset bubble implosion.
Today, the financial markets are in limbo. With luck and bold measures, there will be a new equilibrium. However, the transition is proving much more costly and painful than anyone had expected. The Great Inflation of the 1970s showed us that monetary policy was the important enabler - as it is today. And it is behind the surge in the price of commodities from oil to food.
In 1798, economist Thomas Malthus wrote in his "Essay on the Principles of Population" that population growth would be checked by many factors such as disease, war, disasters, vice and famine. Malthus developed his ideas before the Industrial Revolution, but agricultural limitations were an important factor. Now, more than 200 years later, a wave of food-price inflation has become headline news as the prices spiral upward, spurred by rising consumption trends in developing countries such as China and India. Malthus' theories are particularly relevant if we substitute food for energy. Energy consumption is increasing much faster and prices have outpaced consumption while the population remains static. Like energy, the world isn't running short of food, just cheap food. Fewer give heed to the implications for inflation.
We believe the escalation in food inflation is a direct consequence of the growth in money. This most important force shifted capital into land, hogs and fertilizer in the belief that the prices will go higher. The soaring prices of oil and metals signaled what would happen to food, though almost every commodity is experiencing some supply issues. Though steady demand from emerging markets is a factor, food supply is riddled with government intervention - from subsidies to taxes to quotas to trade barriers. Even so, faced with sky-high oil prices, our lawmakers subsidized the production of ethanol, a gasoline substitute made from corn and other grains. However, in the past couple of years, President Bush's bio-fuel policy had farmers turn food into fuel, which not only pushed up grain prices but caused a shortage in other grains as demand increased. Record U.S. corn prices are up more than 60 per cent in the past year, yet the United States is importing more oil and Americans are paying higher prices for grain.
The price of rice, a staple for half of the world, recently reached a record. Meantime, inflation in many areas has also skyrocketed and the World Bank reports there have been food riots in 33 countries. Rice prices in Thailand, the world's biggest rice exporter, have already doubled this year. Six years of drought have dried up 98 per cent of Australia's rice crop. Egypt has limited exports of rice, causing further dislocations. Vietnam, the world's third biggest rice exporter, said it would cut rice exports this year in order to satisfy domestic demand. In sum, the world is facing a food crisis.
Trade Protectionism: The Shoe Is On The Other Foot
Similar to the "Dirty Thirties," when trade barriers were erected on goods, barriers are being erected on food. Every country is protecting itself and the trade barriers are being stacked higher and higher as food prices climb. Self-sufficiency has become a priority as countries build stockpiles and buffers against possible crop failures and even higher prices. Food, like oil, has become a global commodity. Meantime, some governments have slashed import taxes on a range of food products. Saudi Arabia cut taxes on poultry, dairy produce and vegetable oils. Most important, wheat taxes were dropped to zero from 25 percent.
The United States is the world's largest food exporter, but it, too, is subsidizing farmers by some $2 billion a year. America has responded to high prices in familiar fashion, with Congress passing yet another pro-tariff farm bill. Supply disruptions and increased taxes are the developing world's response to OPEC and soaring oil prices. We believe that the "cartelism" of food today is not dissimilar to the protectionism of the 1930s and that it is payback time for the developing world. Unfortunately, this time, the Americans are not in a strong position to lead since their economic position has been weakened so much by the weakness in their financial markets.
It Has Happened Before
Summer has arrived and investors are still coping with the reversal of fortunes and financial losses. They are also coping with an economic boom that ended in a painful bust and a collapsing currency. In addition, the banking sector is under siege and some people believe they are victims of foreign speculators. Indeed, investors remain concerned that the banks are at risk of defaulting on their huge foreign loans. And traders are speculating against the currency, which has already had a huge correction.
But that country is not the United States. It is tiny Iceland, which is struggling to contain its worst financial crisis.
Iceland was once a once popular destination for the hedge funds, which took advantage of wide interest rate spreads. Today, Iceland's debt is almost 10 times its GDP. Its central bank, the Sedlabanki, has raised interest rates to a record 15.5 percent not only to curb inflation but also to support the krona, which lost 27 percent of its value against the dollar. The problems of Iceland's banks were sparked by the contagion in the financial markets and the subsequent unwinding of billions of debt is taking a huge toll on the economy. Inflation in Iceland was 5.7 percent last year. In May inflation was 12.3 percent.
Of concern is that Iceland's problems mirror America's problems. For years, the United States has spent more than it earns. Like Iceland, America also depends on foreign largesse. America is not only the world's biggest economy, it is also the world's biggest borrower, relying on credit to fuel everything from house purchases to tanks in Iraq. As a share of GDP, U.S. net debt stands at more than 20 percent compared with the United Kingdom's at 17 percent of GDP and the European Union's at 15 percent. Oh yes, Iceland's deficit is 16 percent of GDP. The greenback has been sliding for five years and has fallen further as America lowered rates. The U.S. Treasury recently reported that the annual federal budget deficit will hit almost $400 billion as defence spending keeps climbing. The ever larger annual current account deficit is at seven percent of gross domestic product. And because of its zero savings rate, America needs $2.5 billion a day from foreigners to underwrite its deficits. The United States is the world's biggest oil importer, with an annual import bill of more than $500billion and its oil addiction is the single largest contributor to its balance-of-payment deficit. Thus, Americans remain addicted to cheap oil and debt.
Hooked On Debt
We believe that the United States and its households must reduce their dependence on foreign capital as soon as possible or suffer Iceland's sad experience. The alternative is a massive default and, even worse, higher inflation. The country must get over its debt addiction. As an example, in bailing out Wall Street, the government has become the lender (or garbage collector) of last resort, which simply piles debt upon debt. With a substantial part of U.S. debt held abroad, the erosion of the dollar will cause further shifts from that currency, sending the country into that much feared recession. This has already started, with Middle East investors repatriating their assets and reinvesting in their own regions.
To be sure, the United States' debasement of its currency in order to pay its bills has an inflationary impact at home and abroad. The biggest danger is that it created new bubbles in energy and now food. Ironically, by slashing interest rates, the Federal Reserve has removed one of its key inflation fighters. The rate cuts have also encouraged speculation in other hard assets as the lower currency pushes up the price of dollar-denominated commodities such as oil, copper and gold. A further irony is that the cuts have uncorked an inflation bubble that will force the Fed to raise rates, which, of course, will disrupt fragile credit and mortgage markets.
Victory At Last
Nonetheless, the central banks have signalled victory by proclaiming an end to the global credit crisis. Today, investors are celebrating a new recovery. Stocks are up, but so is leverage. There have been some quick policy responses from the central banks here, a stimulus package in the United States there and needed write-offs everywhere. Even the Dow Jones industrial average closed for a moment above 13,000 for the first time since January. The Bank of England had already declared victory and even lambasted the International Monetary Fund for its forecast of expected financial sector losses of more than $1 trillion, citing the figures as "misleading." The Fed, too, has hinted at a pause after slashing rates seven times to 2 percent from 5.25 percent since last September.
Is the worse over? No. We believe the central banks are simply talking up their "book."
What's happening now is the consequence of the reckless borrowing of the past few years. There was simply too much liquidity chasing too big fees, with too much leverage. Instead of depending on low yielding depositor funds, the big banks took upon ever higher amounts of leverage, creating new products and even buying their own products in order to boost returns. Greed and easy money together with loosened standards resulted in the "mother of all booms" producing immense wealth. To sustain this growth, Fed chairman Alan Greenspan and his successor, Ben Bernanke, embarked on a policy of "easy money," thereby creating a financial house of cards. That, of course, led to the securitization of risk by the creation of structured products and other exotic derivatives. Wall Street's alchemy simply created more money from nothing. Credit default swaps were only created in the 1990s and now total $62 trillion in a largely unregulated market whose growth continues despite the credit crunch. The explosion in the use of derivatives has become a global phenomenon. Banks and hedge funds around the world are now often on opposite sides of contracts tied to interest rates, debt, stock indexes, etc. And the debt-fuelled implosion of one counterparty can have repercussions on the other side of the street or the world since this leverage culture had been exported to far-off corners of the globe.
Almost overnight, investors woke up to the potential default of over $1 trillion of so-called assets that were not only illiquid but of little value, triggering the credit bust and the forced takeover of Bear Stearns. A revaluation of risk has taken place in the capital markets. The U.S. housing market is still falling, exacerbated by an accelerating rate of price declines, increasing foreclosures and a doubling in the rate of unsold housing inventory. Overall home sales are off 20 percent from a year ago and 11 million families have either no equity or negative equity in their homes. Japan suffered a 13 year collapse of real estate prices that left much of the land valued at a third of its 1990 peak. So U.S. prices still have downside.
Too Much Leverage, Not Enough Capital
Financial giant Carlyle Group's mortgage bond fund went bankrupt due to over-leveraging. Carlyle Capital defaulted on $16.6 billion of debt with only $670 million in equity or 31 times leverage (i.e. total assets were 31 times the value of shareholder equity). The investments were graded AA-rated mortgage securities. Carlyle Group itself lost $150 million, but the damage to its reputation was even more significant. Of wider significance, however, is the fact that Carlyle Group's business model was no different from that of Bear Stearns or others that used massive amounts of cheap borrowings to invest in higher-yielding derivative securities.
The financial institutions' ratios are simply too low. Despite recent capital infusions and the loosening of central banks' policy, estimates of global subprime losses alone run at $400 billion and 10 months later the meter is still running.
Central Banks Become The Garbage Collectors Of Last Resort
The Federal Reserve now lends directly to investment banks, allowing them to put up credit card debt, car loans and student loans as collateral. The Fed also increased the size of its credit auction facility to a whopping $250 billion from $50 billion. In addition, the European Central Bank and Swiss National Bank announced an increase in currency swaps, putting more liquidity into the system. Yet the big banks are still hoarding cash in an attempt to bolster their balance sheets and in so doing have starved the system of cash. Central banks have found themselves pushing on a string as they attempt to alleviate the strains in the short-term market to avoid a systemic bank credit default. Hence, the central bankers have become the garbage collectors of last resort.
The financial system is still frozen. On the other hand, regulators are tinkering with Basel II, which established new capital rules for banks. There is no question that a revamp is needed, particularly when Canadian banks' tier one capital requirement is close to nine percent while many European banks are half of that. But Basel II does not address the usage of leverage, and the problem is that Basel II is treated differently across different jurisdictions and banks. The bottom line is that the banking community still does not have enough capital to cushion its potential losses and the bailouts will come at a heavy price for the banks. Taxpayers, on the other hand, will unfortunately be left with billions of losses.
Losses Could Wipe Out Half The Banks' Capital
To date, Wall Street has raised some $244 billion in capital, but taken almost $330 billion in losses and write-downs. However, there is still an estimated $1 trillion-plus of losses still to come. Threatened with new rules, the sovereign wealth funds that were once the mainstay of the first tranche of financing are not lining up to invest this time. Foreign investors seem to have too many dollars already. The problem is that losses of $1 trillion would wipe out half of the capital of the world's biggest banks.
And what about the hedge funds and private equity funds? Leverage is used to amplify returns. Not only is there a lack of oversight, but these funds are also imploding and, unlike the investment banks, cannot avail themselves of the discount window. Nor do they have the reporting requirements of the investment banks and many require less margin, so their positions are that much larger. So far, the fringe players have been caught in a game of musical chairs that started with the demise Bear Stearns. Today there is one fewer chair.
Still to come are the actual tens of billions of defaults in not only the sub-prime sector but credit cards, car loans, level III assets and LBO loans. There is plenty of debt around. The Bank for International Settlements reported that the market for derivatives (debt, currencies, commodities, stocks and interest rats) expanded 44 percent to almost $600 trillion as investors sought protection from the global credit crunch. And, of course, there is the cost of preventing the world's biggest debtor, the United States, from collapsing as it finances the clean-up of the worst financial mess ever.
Strongest As The Weakest Link
Obviously, fresh capital is needed. But this comes at a time when there is a competition for funds. As a result, the Bush administration's response was to loosen regulations to allow Fannie Mae and Freddie Mac to take on even more debt. But the lawmakers did little to boost the companies' financial safety cushions. Indeed, by condoning a leveraged strategy that helped create the housing problem in the first place, they made it so that leverage is now supposed to be part of the solution. Wrong. No one, of course, has asked that should the losses continue, are Fannie's and Freddie's capital positions sufficient to absorb the losses? If not, taxpayers will be responsible for the trillions of dollars of commitments.
Fannie Mae and Freddie Mac are the biggest buyers of U.S. mortgages and own or guarantee about 40 percent of the $12 trillion of mortgages outstanding. But to underpin $5 trillion of debt, the combined capital cushion of Fannie Mae and Freddie Mac is a paltry $83 billion. To date, both institutions have taken at least $9 billion in mortgage-related losses for last year while raising and the companies have raised $13 billion from investors. Fannie Mae reported a $2.2 billion first-quarter loss for a third consecutive quarter in the red and raised $6 billion of new capital. After the infusion, Fannie expects to have $48 billion in capital but that number excludes large unrealized losses which if taken would see its net worth decline to $12.2 billion or less than 1.5 percent of $866.7 billion of assets. Freddie Mac's mark-to-market value is currently down to a negative $5.2 billion from $2.6 billion in the last quarter. The debt-to-asset ratio is a lofty 90 percent, or three times that of Bear Stearns. This year the losses are expected to be as high $19 billion, which should swamp the last infusion of cash.
Fannie and Freddie may be the only firefighters without a hose.
Conclusion: The Cost Of Providing A Safety Net
The United States is faced with a challenge of massive proportions that threatens the stability of the international financial markets. The historic Bretton Woods system arose out of financing the Second World War and ended when America went off the gold standard. This time, conditions are similar and we are in need of a Bretton Woods-like system. Real reform is needed, not another Basel II. Reducing leverage is crucial, as is some convertibility against a basket of currencies, including gold. Indeed, the remonetization of gold is an obvious solution.
Investment banks today have too much leverage and the unwinding of it is crucial because the sale of assets or cutting back lending is insufficient to support the deleveraging process. Even the usage of government-sponsored enterprises such as Fannie Mae and Freddie Mac has its limitations, given that they cannot raise sufficient capital to offset projected losses. Meantime, no one has addressed the fact that inflation is rising and food prices are threatening to get out of hand.
Our concern is that the Fed's move to slash short-term interest rates and bail out Wall Street has piled debt on more debt, which will weaken the dollar further. Simply, the financial architecture of the last decade is imploding. America's solution of inflating its way out of its problems by printing increasing amounts of fiat currency will debase its currency and obligations. Further, there is now the real threat of a wage spiral.
The greenback has fallen 45 percent against the euro in the past six years, and its status as the world's reserve currency is at an end. Worrying parallels are seen between the dollar's fall and the decline of sterling as a reserve currency, more than a half a century ago As a store of wealth, the dollar's performance has been dismal and the flight out of it has picked up momentum. The Far East uses more and more foreign dollars because they have too many dollars. Foreign exchange stockpiles have tripled in the past decade. China alone has $1.7 trillion. Today, 40 per cent of Japan's exports are in yen, not dollars. And in Europe, the euro is held in 28 percent of developing countries' reserves, up from 19 percent. The Middle East and others are threatening to loosen the peg against the dollar or re-price their goods in euros.
Worse for the Americans, foreigners have slowed down their purchases of U.S. assets in the past six months. U.S. foreign direct investment inflows declined 13.4 percent in the 2007 fourth quarter from the year-earlier period. And the drop in foreign purchases came despite a weaker dollar.
In saving Wall Street, policymakers have created new problems. Inflation is the easiest way out for policymakers. The world has lost confidence in the currencies issued by the central banks. So investors are hedging their bets by buying oil, food, commodities and gold, suspecting Wall Street's problem will create more dollars they do not want. And there is fear that the next president will have inflationary policies, which would be bad for the dollar but good for gold.
There was a time when gold was money. In today's uncertain world of cheap money and inflation, gold is back in fashion as an attractive investment. We expect gold to recover and to trade as high as $1,200 an ounce this year en route to a high of $2,500. Part of gold's allure is its traditional status as a safe haven. Gold can't be printed, doesn't have counterparty risk and is the ultimate store of value. The remedies of today, such as devaluation, protectionism or inflation, will not work. Gold is money and is the solution to what ails us. We believe that as the global financial crisis unwinds, gold will rise, riding an inflation tide.
ABOUT THE AUTHOR
Disclaimer: This report is approved by Maison Placements Canada Inc. ("Maison") which is a Canadian investment- dealer and a member of the Toronto Stock Exchange and regulated by the Investment Dealers Association. The information contained in this report has been compiled by Maison from sources believed to be reliable, but no representation or warranty, express or implied, is made by Maison, its affiliates or any other person as to its accuracy, completeness or correctness. All estimates, opinions and other information contained in this report constitute Maison's judgment as of the date of this report, are subject not change without notice and are provided in good faith but without legal responsibility or liability. Maison and its affiliates may have an investment banking or other relationship with the company that is the subject of this report and may trade in any of the securities mentioned herein either for their own account or the accounts of their customers. Accordingly, Maison or their affiliates may at any time have a long or short position in any such securities, related securities or in options, futures, or other derivative instruments based thereon. This report is provided for informational purposes only and does not constitute an offer or solicitation to buy or sell any securities discussed herein in any jurisdiction where such offer or solicitation would be prohibited. As a result, the securities discussed in this report may not be eligible for sale in some jurisdictions. This report is not, and under no circumstances should be construed as, a solicitation to act as a securities broker or dealer in any jurisdiction by any person or company that is not legally permitted to carry on the business of a securities broker or dealer in that jurisdiction. This material is prepared for general circulation to clients and does not have regard to the investment objective, financial situation or particular needs of any particular person. Investors should obtain advice on their own individual circumstances before making an investment decision. To the fullest extent permitted by law, neither Maison, its affiliates nor any other person accepts any liability whatsoever for any direct or consequential loss arising from any use of the information contained in this report.
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