Here’s the news of the week – and how we see it here at McAlvany Wealth Management:
1. Help Wanted: Superheroes. This week we continued to see magnified concerns in various US and European banks. Is this a real concern for the average American? Unfortunately, in a deeply interconnected world, it is. There is no avoiding the implications of a banking crisis here or abroad. As we discussed in a recent audio commentary, banking crises and subsequent currency crises have been consistently related since 1972 (they have actually been closely correlated since 1914, but the frequency of their occurrence has been on the rise since 1972). The post-Bretton Woods era has been a dangerous period of monetary alchemy.
Credit default swaps – used to insure against bond default – are getting more expensive in Europe. This comes as no surprise, with sovereign bonds representing a large part of bank balance sheets in that part of the world. As sovereign paper circles the proverbial drain, the institutions holding such assets are preparing for the worst; so, it seems, is the investment community – by buying insurance against default. With two-year Greek paper now yielding over 42%, it’s easy to see the point of concern.
It won’t surprise you to know that many of the sick institutions are the same ones that needed bailout dollars just two years ago. Radical surgery was not performed then, and the patient still won’t acknowledge that a structural problem exists now – a problem of too much debt and too much leverage in the system.
While the deterioration in the bank sector has been extended over time, a major failure will occur quickly and surprise the masses and media pundits. Not to worry, the Fed will protect what it can – at the cost of currency stability. Will the institution to fail be Bank of America? Some other institution, perhaps? Liquidity concerns are rife at B of A, as we suspected a few weeks ago when they were scrambling to unload a large Chinese bank holding. Now the masked legend of Omaha is doling out much-needed cash as “Green Money Man.” We hope more heroics are not needed.
Gold price fluctuations were anticipated and welcome. As you are likely aware, the CME is responsible for keeping initial and maintenance margin requirements in line with the commodity in question. As prices rise and fall, so, too, should the margin requirements – preventing the speculative community from playing only with the house’s money. Raising margin requirements simply increases what a leveraged investor has to have as “skin in the game.”
Several weeks ago, CME raised the margin requirements by 22% for gold contracts, with virtually no impact on the market. The Shanghai Exchange raised rates this past Monday, followed by the CME with a 27% mid-week increase. Gold fell like a stone, only to recover much of the decline by Friday. It seems that CME’s efforts to cool the red-hot metals markets are less and less effective.
Expect corrections to remain relatively shallow, in percentage terms. We see $1700 as initial support, with a possibility of touching $1650-1675. We will be quite active in the markets over the next few weeks. Remember that corrections off of peak numbers have been getting shallower and shallower. Nothing could be better than seeing gold go lower in the next few weeks. Our sentiments on the matter won’t surprise our tenured clients.
Sentiment is quickly changing in favor of gold. Popularity is on the rise, with a recent Gallup poll putting it as a favored investment even above real estate and equities (though I doubt that many of those polled actually own any – do your own poll!).
So, with a crowd gathering in the precious metals space, the bull will now attempt to humiliate any and all atop its back. Bull markets are difficult to ride from beginning to end, and it’s precisely because of the mixed signals contained in the price action of the asset in question. A good correction, with high drama, is a healthy baptism for the newly initiated.
The reasons to own gold have not changed. The necessity of owning metals is reaffirmed each day the Fed and Treasury attempt to resurrect the dead. Not even a Ph.D. endows you with that skill set (as an aside, I’d bet there is an increase in prayers emanating from the various Fed banks).
But back to gold – the asset should be owned for the right reasons, not simply because the price is increasing. That is a side benefit, but not the justification for choosing a metals allocation. Asset preservation in volatile markets, insurance from monetary mismanagement, and insulation from political risk are all better reasons.
We are on the cusp of a global currency crisis, which will be sparked by the overwhelmed efforts of global central bankers to maintain the status quo. We believe we are positioned flexibly to go down this road, and certainly change course as and when conditions improve. Until then, we are in a code-red environment, not counting on the capes, masked legends, or other cartoon-like characters to save the day.
2. Fed: “Trust Us.” Apparently the anticipation of QE3 is enough to satisfy. Bernanke’s comments from Jackson Hole were a complete non-event. Instead, Bernanke reiterated that the “recovery” is still intact and that if the economy should worsen, the Fed has a vast number of “tools” (i.e., money printing) available to assist. Markets, based on their performance this week, were expecting a more definitive announcement regarding QE3. At first, the markets traded off sharply in disappointment on Friday, but then rebounded and finished in the green – on hopes the Fed would act in its upcoming two-day FOMC meeting in September.
Dreams of QE3 floated all boats, except the dollar which was virtually flat for the week. Stocks rose an average of 4% across the board, while bonds maintained themselves despite the good cheer, with the 30-year Treasury yield giving up only 14 basis points. Commodities rose, but barely, adding only 0.87%. The metals fell (due primarily to CME intervention), but rebounded nicely on the heels of Bernanke’s comments. Gold was off 2.23% and silver 4.07%.
US economic data was mixed – again. We still maintain that the lower rates produced by the rally in bonds is skewing these results in what would otherwise be a heightened contraction. Durable goods orders rose 4.0% vs. an expected 2.0%, but include a record $40B order placed by American Airlines with Boeing. Take away this order and defense contracts, and durable goods orders fell 1.5%. Initial Jobless claims rose to 417K, while personal consumption rose a much better than expected 0.4% – try making sense of that. Inflation data continued its tale of woe with the GDP price index rising a more than expected 2.4% (vs. 2.3%), while 2Q GDP growth was revised down 0.3% to 1.0%. Again, this downward trend is just a blip according to Bernanke.
As an aside, if you thought the government was serious about spending cuts, we wouldn’t advise holding your breath. The Wall Street Journal ran an article stating that spending for 2011 will hit a new all-time high of $3.6 trillion, up $141 billion from 2010.
Overseas, matters concerning the fiscal condition of the EU have taken a back seat in the recent week, but this does not mean things are getting better – quite the contrary. David M. mentioned the increasing cost of credit default swaps there. Additionally, Greek two-year government debt is now yielding in excess of 40% as its economy contracted yet again – sealing in a default scenario. France cut its economic growth forecast for the year by 0.25% (to 1.75%) and the ban on short selling bank stocks has been extended across the exchanges – which ironically cures very little.
It was also interesting to see, for the first time in a long time, that inflation has re-emerged in Japan. The core consumer price index rose 0.1% in July compared to a year earlier. Whether as a consequence or because of the fact that Japan is the second largest debtor nation in the world – Moody’s lowered Japan’s credit rating to Aa3 from Aa2.
With the funding crisis gaining speed overseas, it’s now only a matter of time until conditions worsen here in the US. For that reason we can’t see the Fed holding off on another round of QE for very much longer. That said, we also don’t believe it will have as great an impact as it did from 2008 onward, since inflation is a far greater force to be reckoned with than before.
Along those lines, the Gallup poll Dave M. mentioned above may be supported by the fact that the SPDR Gold Fund has just surpassed the SPDR S&P 500 ETF Trust as the largest ETF on the market.
Best regards,
David McAlvany
President and CEO
MWM LLLP
David Burgess
VP Investment Management
MWM LL
