The just-concluded Group 20 (G20) meeting left us with a chorus of very "prudent" governments and central bankers singing the praises of easy monetary and fiscal conditions.
So where can we take refuge when all the central banks in the world print money and governments run deficits in order to spend like drunken sailors?
The answer is gold.
Fortunately for us, we foresaw this scenario a while ago. On April 20, I recommended that investors diversify their portfolios by adding the SPDR Gold Trust ETF (NYSE: GLD). The fund is up about 14% since that recommendation, but it’s not yet time to sell, as there are still a number of factors working in gold’s favor.
For starters, there is more and more talk of the U.S. dollar losing some of its luster as a reserve currency. But this debate is moot for the moment. The reality is that it will take a long time to reduce the preeminent role of the dollar as the store of value of choice for central banks around the world.
Earlier in March and later in June, Zhou Xiaochuan, governor of the People’s Bank of China made a pitch for the creation of an international global currency delinked from sovereign currencies. This increased speculation about the probability of China deemphasizing the dollar within their extraordinary high foreign reserves of almost $2 trillion.
Some 64% of global reserves are in U.S. dollars, according to the International Monetary Fund (IMF). So if China and other holders of U.S. debt were to reduce their holdings, it would have a substantial impact on the greenback’s value, as well as on U.S. interest rates, given that those countries would be selling U.S. Treasuries.
Zhou suggested the use of the IMF’s Special Drawing Rights (SDRs) as an alternative. The SDR is a currency linked to a basket of four major international currencies in the following approximate weightings: U.S. dollar (44%), euro (34%), Japanese yen (11%) and British pound (11%).
But the reality is that this would be highly impractical. To begin with, there are almost no instruments denominated in SDRs that China and other countries could invest their reserves. And if the IMF issues the instruments, then it would be taking the other side of the trade, which means it would have to start lending in SDRs, too. This is very unlikely.
Furthermore, no other currency on the planet is large enough to serve as the world’s main reserve currency. The sole exception, in terms of having a comparable size of the economy, is the euro. The euro serves 16 members countries of the European Union (EU) and a few others peg their currency to it. But the problem with the euro is that even though the entire EU is comparable in size to the United States, it is comprised of many countries with very different fundamental strengths and weaknesses.
Therefore, each of these countries issues bonds and each of these, by themselves, are too small and offer too little liquidity for central banks to accumulate as reserves.
But right now – given the large size of the current and projected U.S. deficits and the easy monetary policy – the incentives for holding dollars have diminished. The risk that inflationary pressures will build up next year, and in turn lead to higher interest rates, are not negligible, even though the U.S. Federal Reserve keeps assuring the markets that it will stifle these pressures before they materialize.
Last Friday, John Taylor, a renowned economist and an expert in monetary policy, opined that the Fed would need to start raising interest rates in early 2010 in order to stem price pressures.
In the meantime, emerging markets such as China and Russia complain about the vulnerabilities of the U.S. dollar. But these visible complaints have to be construed merely as verbal intervention. These countries are acting in their own self-interest, because they have very large holdings of U.S. Treasury bonds. They are trying to "encourage" both the Fed and the U.S. government to act very prudently and conservatively with monetary and fiscal policy.
The United States has offered plenty of assurances to China that it will remain vigilant about inflation. But the trick is being able to identify these inflationary pressures and to take action way before the actual inflationary pressures become entrenched in the economy. And the Fed will need to rely on its projections to do that.
In this uncertain environment, making economic projections is much easier said than done. And one would rather err on the side of being a bit late in raising interest rates and reducing quantitative easing. If the Fed is slower than needed, and some inflationary pressures build, it they can resort to raising rates a bit faster and resolve the problem. But if the central bank raises rates – and reduces the quantitative easing policy too soon – it could send the economy into another recession.
This could be problematic since it would increase the risk of the U.S. economy falling into a deflationary spiral and put additional pressure on the U.S. financial system. Therefore, it seems reasonable to assume that the Fed has greater incentive to err on the lenient side than on the hawkish side.
Remember that we are not out of the woods by any means. Unemployment, which is a lagging indicator, is still increasing and there are many other large problems to resolve in the economy. Without even considering the impact that healthcare reform will have on the U.S. budget deficit, we see the following important headwinds:
- Consumers are very weak. It’s not just the jobless that have been affected. The uncertainty about continued employment for those who still have jobs led to an increase savings rates as would be consumers postpone spending.
- The huge drop in home prices has put about one in four homes in an "upside down" mortgage situation. That means consumers cannot sell their houses without taking a loss, and cannot borrow against their homes to make other expenditures.
- The drop in home values has had another effect: It has increased the need for consumers to save. This need has been reinforced by the large hit to 401(k) savings and other retirement plans. As a result, savings rates have zoomed to 7% of personal income. The savings rate could even hit 10% as consumers strive to rebuild their nest eggs. Additionally, the "Baby Boom" generation has saved too little and retirement is just around the corner. Consumers make some two thirds of the U.S. economy, so this new predisposition to saving will be a drag on consumption for a long time.
- Capacity utilization is still low, which greatly reduces producer pricing power. This, along with very high unemployment, gives the Fed time for now. Low capacity utilization also keeps investments in factory expansion low.
- Recent banking data revealed that many smaller U.S. banks will be closing their doors, taxing the already overstretched resources of the Federal Deposit Insurance Corp. (FDIC), which will have to be recapitalized, adding to the U.S. fiscal deficit.
- We have not yet seen the fallout from the commercial real estate drop, which Money Morning has warned will be severe. Since the U.S. consumer is not buying as much, many properties will not be able to keep up with their payments and will default on their loans. Commercial real estate generally follows the trends in residential real estate with one or two years of lag.
- Last, but not least, we are going to see an economic acceleration in the United States in the third quarter, but that acceleration might be driven to a large extent by inventory rebuilding. The U.S. economy will probably surprise to the upside in the third quarter with growth. Among other things, the government’s Car Allowance Rebate System (CARS), popularly known as "Cash for Clunkers," should show up positively in the numbers. But once the levels of inventories are brought up to their necessary levels, that extra growth will not be present in the following quarter. And the demand from Cash for Clunkers will cease to be a factor.
All of these reasons warrant caution for the Fed. Some economists, including Nobel Prize winner and former World Bank Chief Economist Joseph Stiglitz, have highlighted the risk of a "W-shaped” recession/recovery scenario, and have even suggested the need for another stimulus package. While that might do more harm than good, this position highlights the dovish bias that the Fed is likely to maintain.
What About the Rest of the World?
China enjoys many degrees of freedom to move its economy forward and has had resounding success in doing so. It has no debt and more than $2 trillion in foreign currency reserves. Its banking system is small in relation to the size of its economy, which gives the country a lot of room to expand credit, and the savings rate of its consumers is sky-high. This leaves China with the capital resources to deploy growth strategies. Since the largest companies are all government-owned, when the government decides to deploy capital, it gets done swiftly and powerfully throughout the economy, with great effect on growth.
As a result, China’s economy grew at the breakneck annualized pace of 14% in the second quarter.
Other emerging markets, like Brazil and India, are in similar, though not as potent, positions to move their economies forward. And they are doing so aggressively. India is expected to post on average 7% plus of annual gross domestic product (GDP) growth.
Emerging economies – those that did not splurge the bonanza of the prior five years of strong growth in commodity prices and other exports — are now in the position of stimulating their economies with easy monetary and fiscal policies.
Massive stimulus packages, the scorching demand growth from capital investments, and reborn consumers in emerging Asia, have combined to rekindle global growth.
Resurgent Growth in Europe
Both Europe and Japan are emerging from their recessions – even though Japan may post a negative growth number in the fourth quarter – and Britain and Italy are lagging behind in the recovery. But the most important European economies, led by Germany and France, are pulling ahead.
It is understandable that European Central Bank (ECB) President Jean Claude Trichet, recently mentioned that the recovery was uneven in Europe. Most market pundits took this as a sign that Europe would not be raising rates as fast as previously anticipated.
However, keeping interest rates low is much harder to do than it is to say. Unlike the Fed, which has symmetric objectives – promoting economic growth and controlling inflation – the ECB's only mandate is to control inflation. The reason for this notable difference in objectives is that the European economy is much less flexible than the American economy, mainly due to its very rigid labor laws and other regulations.
Thus, the Europeans start running into inflationary problems when their economy grows above 2.5%.
The ECB just raised its own growth forecasts. Similarly, the Organization for Economic Cooperation and Development (OECD), which comprises the 30 most influential free-market representative democracies, indicated that the global recession is coming to an end much faster then they previously thought, but said that the recovery will rely on massive spending and low interest rates for some time. The OECD cited the strong rebound in Asian economies as having jumpstarted this global reacceleration.
Because the Federal Reserve will have to err on the cautious side, and because of the institutions’ differing mandates, the ECB will probably tighten monetary policy before the U.S. central bank does. That means the euro and emerging market currencies will keep appreciating against the U.S. dollar and the price of gold will soar.
The protests that will come from time to time from Chin and Russia will be just that: verbal intervention. They will not resort to sudden changes in the composition of their foreign reserves, at the risk of doing further damage to the dollar.
In fact, China and other countries generate some 90% of their large current account surpluses in U.S. dollars. But their holdings of dollar-denominated assets are only about 64% of their total reserves. That means they already consistently sell the difference, and this selling so far has not decimated the dollar.
So do not expect a sudden devaluation of the greenback, nor fear China currency reallocations.
But we can and do expect a gradual weakening of the U.S. dollar to occur next year.
And as much as we all hate it, we will be able to take comfort in the fact that we avoided a much worse evil: Deflation.
So we are going to remain playing it with gold. Also, this "currency" play gives us added diversification to the portfolio.
Recommendation: Buy SPDR Gold Trust ETF (NYSE: GLD) (**).
(**) – Special Note of Disclosure: Horacio Marquez holds no interest in iShares SPDR Gold Trust ETF.
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In a new free report, Marquez has identified a category of stocks he has labeled "rocket stocks," which display key characteristics hinting that they're ready to move. One such characteristic: Heavy insider buying. In fact, one particular sector right now is seeing especially heavy insider buying – and many investors will be surprised to discover just what sector it is, and what companies top executives are buying into. For a free report that details these "rocket stock" plays, and that outlines this torrent of insider buying, please click here.]
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