Here’s the news of the week – and how we see it here at McAlvany Wealth Management:
1. Moment of Truth for the Euro: Volatility is increasing. Bond and stock markets in the eurozone have been performing in rollercoaster fashion, oscillating between hope and despair from one day to the next. Austerity measures, electing new officials, and grand plans to restructure and strengthen the eurozone have all been implemented in a hurry-up-offense style to stave off disaster. The question, of course, is whether they can succeed. If they can, they will accomplish what no central power has done inside a century, which is to bypass the negative aspects of the business cycle – and to this we say, good luck.
As we have noted here many times before, costs have been increasing within the context of inflation for nearly a decade. Now it seems that the very authors of this inflation (central banks and respective governments) are choking on their own medicine. The gagging has been reserved to the nations with the weakest of financial profiles (i.e. the PIIGS and the Middle East), but this well-known fact is changing – or should we say migrating?
While the focus was on Greece, Italy, and Spain this week, the media missed the fact that French spreads to German bunds now stand at an all-time record high. In short, French bonds, or OATs as they call them, are being discarded in exchange for German bunds as the safe haven in the crisis. French government solvency now appears to be on trial.
This was clearly not the case just two months ago when all “Aaa” sovereign rated debt was lusted after equally. You could blame the problem on S&P, which “accidentally” downgraded the French on Thursday to AA+, but French OATs were diverging from bunds long before the downgrade was released. The French 10-year has given up a little over 100 basis points since September, whereas German and US bonds have retreated only 25 and 30 basis points, respectively.
What we are suggesting here is that no one is exempt from the necessary adjustments that inflation and preceding manias will ultimately demand from the marketplace. Very few will come out unscathed, including possibly the euro as a currency. That said, it will be only a matter of time (maybe weeks) until these bond market pressures (higher rates) infect both Germany and the US. Along those lines, the US Treasury market, downgraded by S&P to Aa, has also begun to underperform the German bunds – but only marginally thus far.
Stock markets around the globe may want to heed the warnings. Higher rates cause economic decline and subsequently lower earnings. Spanish GDP has already stalled, unchanged from the previous quarter, when it expanded 0.2%. Slower growth stemming from Asia Pacific nations also trumped the excitement generated from Europe’s “solutions” during the week. As we said last week, stocks are “running on fumes,” but then again the bulls/speculators in stocks have lately been the last to catch on to the dangers at hand.
2. The Bond-for-Gold Swap: Part 1: Echoes of 2008 still trouble the minds of investors today as they view the recent crash in gold prices that was systemic to the fall in stocks. But this is not 2008, economically speaking, for at least two reasons: First, government solvency was not an issue in 2008, and second, inflation was less interwoven in the economic fabric back then.
Said another way, in 2008 investors could reasonably expect to flee to the bond markets for safety vs., say, gold. However, signs that this “habit” is changing are afoot. Bloomberg ran an article this week titled “Investors Fleeing Bonds Spur Record Gold Inflows,” which we believe says it all. The article highlights India’s appetite for gold instead of bonds as an inflation hedge. Indian capital flows showed a 4% outflow in government bond funds versus an 8% increase (now at an all-time high) in purchases related to gold.
China may be following India’s lead (or vice versa). Imports from Hong Kong, a proxy for China’s overall foreign buying, leapt to a record high in September. Monthly purchases matched almost half of 2010’s total. Germany also seems to favor the yellow metal, refusing requests from fellow eurozone members to pledge German gold as collateral for EFSF loans.
These events occurred within the context of the recent decline in metals prices. Thus, sadly, investors in the US may be among the unfortunate few parting with the metals as others around the world acquire them – the latter, for all the right reasons, we believe. Bonds are no place to hide from inflation.
Best regards,
David Burgess
VP Investment Management
MWM LLLP
