Nov 26

China’s Gift to Oz

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Inflation? Why, it’s just what we always wanted…!

WITH THE U.S. markets shut down for Thanksgiving and a game of football, there was no Wall Street ‘lead’ for the local bourse to follow yesterday, writes Greg Canavan of Australia’s Sound Money, Sound Investments.

Just as well then that Reserve Bank governor Glenn Stevens gave investors something to focus on. In his ‘Opening Statement’ to the House of Representatives’ Standing Committee on Economics, Mr Stevens told the assembled bureaucrats that the price of money in Australia is just about right. The vibe of the speech was that rates would stay where they are for the time being, but further increases down the track were still on the cards.

Stevens is concerned about the cost of labor, which has a major bearing in the cost of money:

"Growth in labor costs, however, is no longer declining, but rising. The overall pace could not be described as alarming at this stage, but the turning point is behind us."

Wages are a big deal in the inflation equation. Price rises without compensating wage increases are actually deflationary. If the price of your electricity bill goes up (and it certainly has in New South Wales lately) for a given disposable income you have less to spend elsewhere. That’s not inflationary.

But if you bargain for a wage increase and do not increase your output, THAT is inflationary. Wages are the biggest expense for businesses so wage pressures are generally followed by price rises. Hence Stevens’ legitimate concerns.

So if the unions, the great protector of the worker, continue to have success in fighting for higher wage claims without offsetting productivity gains, you can expect to see inflationary pressures strengthen, and interest rates to rise again next year.

Speaking of productivity, or lack of it, we should point out that the government is contributing heavily to the upward pressure on wages. The latest figures from the ABS show that full time adult total earnings for the public sector rose a hefty 6% for the 12 months to August 2010 on a trend basis. This compares to private sector growth of 4.3%. The problem is, government workers do not produce anything of value. The productive part of the economy, the private sector, sustains the public sector via the taxes they pay. So the fact that wages are rising faster in the non-productive part of the economy is troubling.

What’s also troubling for Stevens and his mission of guessing the right level for the price of money in Australia is China. What happens there is the wildcard for interest rates. Credit conditions in Australia are very weak and do not call for interest rate tightening at all. Credit growth is down to an annual rate of 3.3% (all due to housing, by the way) while growth in M3 money supply is 5.8%.

The inflationary impetus is coming from China. While Stevens didn’t mention China directly, he mentioned its proxy, the ‘terms of trade’ on a few occasions.

"Measured in nominal terms, the rise in GDP is running at about 10% per annum just now, because of the rise in the terms of trade."

China’s credit boom (where growth in bank lending reached 33% in late 2009 and is still buzzing along at around 18%) is clearly spilling over into Australia via record high iron ore and coal prices.

As Stevens’ points out, this is due to very strong demand for steel. We all know the emerging economies are growing strongly/industrializing, hence the demand for steel.

But what is really causing it? If the developed economies of the west are struggling to recover from the credit crisis and experiencing below average levels of demand, why are the developing nations growing so fast? After all, isn’t the west meant to be the buyer of the emerging markets’ goods?

In China at least, the answer comes down to the lending binge that kicked off in late 2008. This was an unprecedented attempt to reflate the Chinese economy during the deflationary shock of the credit crisis.

It certainly worked. Get a load of this. In 2009, China’s banks lent out a whopping 9.6 trillion Yuan, equivalent to around US$1.44 trillion. The lending target for this year is 7.5 trillion Yuan (US$1.13 trillion) but that looks like being exceeded easily.

As the Chinese bureaucrats are now finding out, once a credit boom takes hold it is very hard to stop.

The majority of these loans are going into ‘fixed asset investment’. According to an article in Fortune: ‘Fixed-asset investment accounts for more than 60% of China’s overall GDP. No other major economy even comes close. And of that fixed investment, slightly less than a quarter is attributable to new real estate investment.

Fixed-asset investment means buildings, road, property. Tangible, ‘fixed’, objects. There’s your steel demand right there. That’s certainly good for Australia now and it is giving Stevens plenty of food for thought when it comes to setting interest rates. But surely he must be wondering what happens when the Chinese lending and fixed asset boom ends, as it surely will. (Or is it different, this time, in China?)

One thing is for certain. The bureaucrats in Canberra wont be asking Stevens about Australia’s very heavy reliance on China’s ongoing boom. More than likely they’ll be playing politics (it’s what they do) and asking why banks can’t make the price of money for housing cheaper than it should be.

After all, no one wants to see the end of a boom, especially politicians.

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Nov 23

Ireland: What a Mess!

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But it might just create a chance to Buy Gold and other hard assets on the cheap…

WELL THIS should be interesting, writes Dan Denning in his Daily Reckoning Australia.

The EU/IMF bailout of Ireland is not going off without a hitch. The UK’s Telegraph reports that the Green party, which currently forms the junior half of Ireland’s coalition, might withdraw that support and call for new elections in January. This would call into doubt the ability of the current government not only to execute a deal with the EU and the IMF but also to pursue its four-year austerity program.

What a mess! We’ll get to how Ireland and Australia are similar in a moment. But first, please recall the words of the great philosopher of the New York Yankees, Yogi Berra. He once said, "When you come to a fork in the road, take it."

Today’s fork in the financial road leads down two different paths. One path is continued US Dollar devaluation and a strategic migration to emerging market assets (under the assumption that the BRIICS nations will eventually have to allow for currency appreciation…or face rampant food and fuel inflation). This trade favors Buying Gold, commodities, and tangible assets in general.

But remember what happened in 2008? The Global Financial Crisis actually led to a massive rally in the US Dollar. Emerging markets got hammered. The "risk" trades financed with cheap greenbacks were reversed and commodities took a shellacking as well.

Could that happen again? The boys at Knight Research think it’s going to happen again, but even bigger and badder this time around. In a recent research note, they wrote:

"We believe the structural and cyclical terms of global trade have finally reached their tipping point. This will catalyse a wholesale change in sentiment and a historic repositioning of risk assets. The emerging market global growth story is over."

This is the fork Murray has been preparing for in the Slipstream Trader for our subscribers  It would mean falling indexes in Australia, which would of course mean falling components of those indexes. Knight Research elaborates on this fork:

"The game is over. Presently, we believe that the broad-based resurgence of investor confidence in the emerging market and secular bull market in commodities will end badly; proving that the rally which commenced in Q2 2009, was in fact an ‘echo bubble’ facilitated by massive-and unsustainable-stimuli from the Chinese government.

"We believe that the end of the Great Consumer Credit Cycle and the vast structural differences in the terms of trade between the United States, the EU, and China, have finally caught up with the secular bull thesis on emerging market and commodities.

"Quite ironically, the Fed’s aggressive policies will likely prove to be the catalyst which breaks China’s unbridled expansion of credit and non-economic growth, ushering in a wholesale rebalancing of risk assets."

This is not a lukewarm prediction. It would quite obviously be mega bearish for the Aussie Dollar and for commodities. And thus far, there’s not much evidence to support that giant reversal is afoot that is more bearish for emerging markets than it is for the US Dollar. It’s a fork in the road, though. So we have to take it and see where it leads.

There ARE a few factors supporting the "Game Over" theme. One is that Ireland’s woes are not the last o the Eurozone’s problems. There is Greece. There is Spain. And really, Ireland is not even done and dusted yet. To some extent, Euro weakness is dollar bullish and contributes to the "Game Over" theme.

But the bigger factor is Chinese tightening, or just your basic traditional popping massive credit bubble. There are early signs of that. Last week China raised reserve requirements on banks again. And Citigroup agrees with our assessment that rising food prices in China could be bearish for metals.

China’s State Council is talking a big game on controlling inflation. Does it mean China is quickly shifting away from a bias toward export growth toward an inflation fighting bias? That’s the big question. If it does mean that, you can expect lower commodity prices.

For example, three-month copper on the London Metals Exchange fell overnight. The news preceding the drop was that refined copper imports to China fell by a third last month. Comex December copper traded lower too, near $3.75/lb.

We’re going to have Dr. Alex what he thinks about this. But we can guess. He probably loves it. He just got back from another site visit in Africa to a copper project. If you’re a Diggers and Drillers reader don’t worry. You’ve already read about this company. It’s not a new recommendation.

Alex has done his homework on the companies he’s recommended. Weakness in the copper price invariably follows through to the shares. If you’re a secular metals bull, you believe this lowers your average purchase price on the shares most likely to benefit from rising prices.

If you’re a bear on copper, well…you’re a bear. Go dance. Alex, of course, has taken the other fork in the road. This fork is for those who’ve realized the end of the Dollar Standard in the global money system is likely to be bullish for real assets, despite your reflexive US Dollar rallies. Europe’s chronic and structural problems add an element of Dollar support. But the long term story on this fork is to favor "real assets" over paper money.

Which brings us back to Ireland and Australia. Irelands bank’s went all in on the Irish property market. When the bubble burst, the banks were left holding the bag (a huge mortgage book). The bag was so heavy, in fact, it broke their back. So the government had to pick them up. And the bag was too big for the government to pick up too, especially given rising borrowing costs for countries at Europe’s periphery.

Could that ever happen in Australia? Could banks with massive over-exposure to domestic property be caught out by losses and unable to borrow from overseas except at much higher rates? And could the government be forced to step in and cover the bank at the cost of its own good credit?

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Nov 19

Banking Fungus, Inflation Virus

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Contagion risk is everywhere rightnow…

THERE’S A fungus among us. But is itthe banks? Or is it a caterpillar fungus that boosts sex drive and issoaring in price as China imports Ben Bernanke’s inflation virus? asks Dan Denning in his Daily Reckoning Australia.

You didn’t have to know there wasmore trouble coming from Ireland. Just have a pint at any of the pubshere in St. Kilda and you’ll hear a veritable symphony of Irishaccents. Most of the girls are behind the bar serving drinks. Most ofthe boys are at the bar drinking drinks. All of them seem to behaving a pretty good time, even if they are a long way from home.

Meanwhile, back in Ireland, a Europeandrama is playing out. It’s putting pressure on the Euro and justlike back in may, that word “contagion” is being thrown aroundagain. The U.S. dollar is moving ahead while commodities cool off.

But what about the Irish? Thegovernment has a deficit equal to 32% of GDP which it’s rapidlytrying to bring down through spending cuts. And if interest rates onsovereign Irish debt weren’t rising (they are) the governmentdoesn’t appear to be in any kind of immediate funding crisis.

Down the track though, investors arelooking at the Irish banks and realising the Irish banks are stillstuffed with heaps of toxic assets. Irish banks have been borrowingfrom the European Central Bank in order to refinance theirobligations to other lenders. But ultimately, Ireland’s governmentis on the hook for bailing out the banks (again). And if Ireland’sgovernment doesn’t have the money to do it (it doesn’t) then thetask falls to the ECB.

Of course it’s possible the Irishgovernment finally stops the madness and says to its banks, getstuffed. Based on the number of punch ups we’ve seen at pubs in thelast year, we know the Irish aren’t afraid of a fight or a littlerebellion now and then. But the rest of Europe—especially Greece,Spain and Portugal—are keen for Ireland to agree to an ECB plan andhalt an investor run on the euro and on European sovereign debt.

Does any of this really matter toAustralia? Well, aside from expecting even more Irish to invade St.Kilda if the Irish banks fold, the weaker euro is leading to arelatively stronger dollar. That’s causing carry traders whoborrowed in cheap USD to take profits on their “risk” trades inhigher yielding assets like the Aussie dollar, which you can now buyfor ninety six US cents.

Ireland “matters” in the largersense that it’s also a test of popular tolerance for socialisingthe losses of the banks. No one knows what the consequence ofallowing major Irish (or any other) banks to fail. But we are told,mostly by the bankers, that it would be such a disaster for theeconomy that the government simply must assume those bad debts andthe central bank must print more money to recapitalise the banks.

The problem is really the same now asit was two years ago—way too much bad debt that cannot be cancelledout by issuing more debt. The “solution” offered by theauthorities doesn’t really seem like a solution. It just seems likea get out of jail free card for the bankers and endless more debt asfar as the eye can see.

There’s no doubt there’d be somereal havoc in financial markets and the economy with a real reckoningin the banking sector. But the situation we have right now is prettylousy too. Could allowing the banks to fail be much worse? At somepoint the debt is going to have to be liquidated or restructured.

Closer to home here in Australia is thenews that China is trying to choke down inflation by reducing loansto property developers. Bloomberg reports that China’s four biggestbanks–Industrial & Commercial Bank of China Ltd., ChinaConstruction Bank Corp, Bank of China Ltd. and Agricultural Bank ofChina Ltd.—have all met their lending targets this year and won’tbe making any more loans. China’s M2 measure of money supply rose19.3% over the last year, according to figures released last month.

That kind of lending boom leadsto 15-story hotels allegedly being built in six days. Italso leads to politically destabilising inflation in the goods peoplebuy every day. For instance prices in Shenzhen are now growing muchfaster than prices in Hong Kong, which is a reversal of thetraditional relationship. “Shoppers report that certain food andgrocery items can be to 40% cheaper in Hong Kong,” reports ColleenRyan in yesterday’s Australian Financial Review.

“It is not just fresh fruit andvegetables. Even items like Dove soap, which is manufactured in Anhuiprovince in China, is 25% cheaper in Hong Kong…The increase hasbeen more than 300% for a small group of herbs. Caterpillar fungus,said to slow down the ageing process and boost sex drive, has beenone of the top performers.”

The other obvious inflation China is inthe share market. It’s turned down in the last two days, droppingover 4% Tuesday, with metals producers and property developers hitthe hardest. Note also that the Aussie market (the All Ords in thegold line) has pretty much tracked the Shanghai Stock Exchange. TheAussie Dollar looks pretty elevated compared to both.

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Nov 15

This Week on "States in Crisis"

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Ireland, Gold Futures, commodity speculation, and the rest of this week’s news – in advance…!

THIS WEEK’s episode of “The WelfareState in Crisis” features a guest appearance by the Emerald Isle,currently seeking about $110 billion in bailout money from theEuropean Union, writes Dan Denning in his Daily Reckoning Australia.

Actually, Ireland is not seeking that money, and that appears to be a part of the problem. The Irishgovernment is content that it’s managing its problems well,independent of European meddling.

But with 10-year Irish bond yieldsblowing out to a spread of 646 basis points over 10-year German debtlast week, European officials are worried that problems in Irelandare problems for the Euro. And if problems for the Euro get worse,that means problems for Portugal and Spain too.

No wonder the US Dollar quit fallinglast week. And no wonder commodities fell like a stone. Friday was anugly day for commodities speculators. The CRB Index in New York fell3.6%. Every single one of its 19 components was down. Sugar contractsfell 12% in London and corn and soybeans traded limit down.

Part of the shocking action incommodities futures markets is the raising of margin requirements byexchanges. It happened in silver last week. And it happened for sugartoo, when the ICE futures boosted margins on sugar contracts by 81%to shake out speculators. It will probably happen on Gold Futurestoo, and that might explain the $40 thud last Friday, among otherthings.

No one is forced to speculate, ofcourse. But this is what the Bernanke Fed has wrought. ItsQuantitative Easing action has put dollar owners in the position ofdoing nothing and losing money to inflation, or speculating intangible assets that go up in price relative to the dollar. And it’s not just commodities. It’s currencies too.

The G-20 summit in Seoul failed toproduce any result on competitive currency devaluations. No onereally expected it to. But what’s next? Since there is no quick andeasy solution to replacing a broken world currency system, the slow,difficult, and ugly scenario must take place. It will probably beslow, difficult, and ugly.

One thing you should expect more of isan escalating level of capital controls. Ironically, the firstmanifestation of this has been in export-oriented economies likeBrazil, where the government tripled a tax on foreign investment inlocal bonds from 2% to 6%. It was designed to prevent furtherappreciation in Brazil’s currency, which yields over 10% and is up35% in trade-weighted terms since last year.

China, South Korea and other countriesare taking similar measures. For big exporters, a stronger currencytranslates into a loss of competitiveness. And when capital marketsare wide open and you find yourself on the receiving end of hugeinflows, it can lead to rapid asset price appreciation and otherforms of less desirable inflation.

By the way, this shows you how everyoneis complicit in trying to return to the status quo ante GFC. Theexport-driven BRIICs want to pretend that the credit-financed Welfarestates don’t have real structural deficit and demographic issuesthat prevent a return to “normal” rates of consumption. They wantthe world be the way it was.

Here in Australia, other than houseprices being utterly unaffordable, it looks like things have neverbeen better. The rising Aussie dollar (up 17% since the end of Junealone) helps “contain” some of the inflation from booming coaland iron ore exports. That’s why the Reserve Bank of Australia isone of the only central banks in the world that does not appear to beactively trying to weaken its currency.

Maybe the RBA agrees with Bloombergthat on a purchasing power parity basis, the Aussie is trading at a30% premium to fair value. That makes it the most over-valuedcurrency in the world at the moment. If it’s a short-term trade(instead of long-term or secular trend in which the Aussie surpassesthe USD), the currency will weaken and not do any permanent damage toAustralia’s own export competitiveness by making Aussie exportsmore expensive than alternatives from Africa.

For now, the Aussie is the placeeveryone wants to be as well; a high-yield commodity currency from acountry with comparatively low public sector debt (although highhousehold debt), low unemployment, and economic growth correlated toAsia. What could possible go wrong when things can’t’ get anybetter?

Speaking of Asia, the other non-Irishnews that rocked commodity markets last week was that China againraised reserve requirements at key banks and may raise interest ratesto ward off inflation being poured into China from the U.S. Stocksand commodities fell hard.

What do you make of all this mess?

To us, it means that anxiety about theAussie being too strong for too long may be short-lived. China couldbe doing a dress-rehearsal for a much more dramatic fall in assetprices as the authorities try to prevent inflation from surging. Thishas obvious and bearish implications for commodity prices.

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Nov 04

Après le Fed, the Deluge

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$100 billion here…$900 billion there…and none of it real money…

AND NOW, the deluge. Or should we call it the Torrent Signal that our mate Kris Sayce has been banging on about for the last week? asks Dan Denning in his Daily Reckoning Australia.

That’s right – that gushing, gurgling, sputtering, splurging sound you hear is the sound of hundreds of billions of new US Dollars flooding into the economy and the stock market. Over the next eight months, the Federal Reserve will spend an additional $600 billion it doesn’t have buying US bonds in the name of "price stability".

If Kris is right, price stability is the last thing you’ll see at the small-cap end of town in resource-rich Australia. For a variety of reasons, Fed policy doesn’t seem to just trickle down into the small caps and junior Gold Mining and resource sectors. It rages on through like Old Man River.

All up, the Fed is going to chuck in about $100 billion a month into the market. It said more large-scale asset purchases were possible if inflation was too low or unemployment too high. Remember, the Fed has a dual mandate of price stability and full employment. These days, price stability apparently means creating enough money to support asset prices, lest they crash.

Even though we’ve said it before, it’s worth repeating: Everything the Fed does these days is designed to support US banks. Monetizing US government debt doesn’t do a lick of a good to improve the quality of the assets on US bank balance sheets. The Fed is merely trying to keep interest rates from spiking; an event which would send even more banks into terminal decline because of its affect on the housing market (which is already in serious trouble) and would put households in further defensive mode.

As far as the stock market is concerned, there are a lot of green numbers on the screen this morning. Because this $600 billion announcement was in the Goldilocks spot – not too large, not too small…just big enough to please the market without being so big it scared anyone about how inflationary it really is.

Please note that the Aussie Dollar moved above parity on the Fed move and stayed there. Is parity the new normal for the Aussie? Maybe. Speaking for ourselves, we’ve been waiting for a big correction in silver and gold to add to our precious metals holdings. But it just hasn’t come yet.

What could this mean? It could mean that the inter-market relationships that seemed to govern the movement of the Aussie Dollar, the US Dollar, and precious metals prices are breaking down. The greenback is getting weaker relative to everything else. The Fed contributes to this with its march to restore monetary insanity. Two years of grid-locked Washington dealing with a fiscal nightmare probably add fuel to the Dollar’s fire.

By the way, the real amount of QE, when you add in the Fed rolling over mortgage purchases, is closer to $900 billion. That’s almost enough to start a new war. But what’s a few hundred billion here and there when it’s not real money anyway?

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Nov 01

Financial Extremists

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Financialization has led to a world of useless analysts and "extremist" naysayers…

OH WOULD the International Monetary Fund please shut up and leave Australia alone? asks Dan Denning in his Daily Reckoning Australia.

According to a report in The Age, the IMF is about to release a report in which it reveals that Australian house prices are "moderately" overvalued by 15%. This is not nearly extreme enough, in our view…which makes us an "extremist" to use the words of our friend Rory Robertson, with whom we debated about house prices a few months ago.

Rory used the word like it was a bad thing, which, we suppose, it IS, when you’re using about people who blow things up for religious reasons (probably the image/impression he wanted to conjure). But we’ll let you in on a little secret…

When asset prices become unhinged from values – as they do in a worldwide credit boom – the world has become an extreme place. Extreme asset values are the rule and not the exception during a credit boom.

We are all extremists now, Rory. Because the Fed has forced us to be.

Incidentally, this is why returns on most asset classes are so tightly correlated during a crack up boom. There’s no point in differentiating between what’s cheap and what’s dear when everything goes up. Thus, bad credit (or too much credit) clouds good judgment.

To follow up on this thought, this explains how too much credit perverted Wall Street. Yes, the money was easy which probably lowered the threshold for committing fraud on a mass scale (subprime mortgage lending and securitisation). But if credit elevates asset values, then there is no need to an analyst anymore. You can’t distinguish yourself by virtue of the quality of your work. In fact, the quality of your work has less and less influence over the result, which is foreordained because of the flow of money into markets. This is why Wall Street (and America, and a lot of the Western world) have moved from a culture of merit-based achievement to a culture of "who can legally loot the most money."

This gradual corruption of the value of honest work and honest money is the result of the financialization of our economies. We’d argue that it all stems from the corruption of our money (fiat money). When the basic unit of value and of conducting transactions for goods and services becomes unreliable, unstable, and is designed to erode over time, is it any surprise that other values erode too?

Gold, which as a noble metal does not rust (or erode), is currently trading at US$1341. Everyone is wondering what the Fed will say next week. Everyone is expecting "the big one". But as our colleague Murray Dawes notes, the Fed is probably going to drip-feed support markets (through large-scale asset purchases) on an as-needed basis. This month could be a big fat nothing-burger if you’re expecting…a big fat policy announcement.

Or, in narcotic terms, the markets are looking for their next big hit. They are already nervous that if the Fed doesn’t bring more liquidity (smack) the big indexes will correct (come down) to reflect how they have mis-priced the Fed’s actual efforts. The Fed has left everyone guessing, but generally buying, which is probably what it wanted.

For our money, and probably because we just wrapped the October issue of Australian Wealth Gameplan (AWG) in which we wrote about the matter extensively, the real game changer in the world currency scene will come from the slowly but inexorably imploding US mortgage market. The recapitalization of US banks and improving their earnings is the real target of the Fed’s Dollar devaluation policy – which makes perfect sense when you recall that the Fed is a cartel of those very same banks. Of course it would act to save its member banks, even if it cost US taxpayers hundreds of billions and a real loss in American standards of living as a result of the end of the Dollar standard and lower US purchasing power.

Australia seems to be perfectly positioned for Dollar devaluation to the extent that it’s a commodity producer (commodities are priced in Dollars and thus growing in value as the supply of Dollars increases). It doesn’t hurt that Australia – like Singapore and Malaysia – is also a kind of China-proxy.

That is, those currently exiting the Dollar may be looking for a currency with a chance of growing in purchasing power. That would be China’s currency – if and when it ever lets that happen. This is also an issue we covered in the AWG report. But if you can’t buy Chinese assets or own Chinese currency directly because of capital controls, you have to do the next best thing.

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Oct 19

"More Inflation Needed"

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Fed policy is creating a surge across raw material prices, not just in gold and silver…

SO MOST INVESTORS know that the Federal Reserve’s "easy money" policy is creating an enormous amount of new credit and new money, write Porter Stansberry and Braden Copeland at Stansberry & Associates.

And most people know this policy has created an explosion in the prices of gold and silver.

But most people have no idea where the bulk of the Fed’s new money is actually finding its home: in Asia. This has enormous implications for you as an investor, which I’ll show you in a moment…

According to Bill Gross, who manages the world’s largest pile of fixed-income assets at Pimco, the Federal Reserve is going to resume large-scale quantitative easing at the rate of $100 billion per month. News of this plan has been leaking out for the last two months following an important speech Bernanke gave in Jackson Hole, Wyoming this summer. He said, essentially, we needed a lot more inflation.

If the Fed does resume quantitative easing at the $100 billion-per-month range, it would be buying the equivalent of all of the new debt the US Treasury is issuing – all of it. This represents an increase of roughly 30% to the money supply in the first year…an extraordinary amount of new cash.

Trade and capital flows are transferring most of the inflation the Fed is creating to the Chinese economy. US politicians continue to stimulate consumption in the US, while most of the production to meet this demand comes from China. We borrow and spend. They produce and profit. Hopefully, you understand printing more money and buying government bonds won’t change this dynamic. It simply results in still more money being sent to China.

What will China do with the flood of capital? Lots of things. But one thing it will certainly do is build more coal-fired power plants. Coal-fired plants produce 80% of the electricity in China, and demand for electricity is growing roughly 9% a year. It’s hard to comprehend how fast demand for coal is growing in China, but consider these facts…

China is now the world’s second-largest consumer of electricity, after the United States. A decade ago, China’s installed generation base was only 315 gigawatts. Today, it’s 900 gigawatts – and 78% of its production is still coal-based.

Today, China consumes three times more coal than the US – more than three billion tons. But China only has about half of the US’s coal reserves. And that means it must import a lot of coal.

At current growth rates, China would exhaust its current reserves in only 16 years. Obviously that’s not going to happen – more mines will be dug. But just as obviously, it will take a long time to build the mines and lay the railroad infrastructure required. In the meantime, China will need a lot of coal.

Current market surveys show China will import 150 million tons of coal this year. That’s only 5% of China’s total coal demand, but it represents 15% of the total US demand. Right now, almost all of this coal comes from Australia, where China takes up about 60% of the export supply of coal.

And here’s the crucial fact: China’s coal imports doubled in the last year.

We know total power production in China is scheduled to double over the next eight years. It’s building a new coal-fired plant nearly every week. The United States has built only 12 new coal-fired power plants since 1990. Assuming China’s coal imports double again (and they will), Chinese demand will exhaust Australia’s export capacity. And when China’s import demand doubles again after that (to 600 million tons per year), it will exhaust the world’s total export supply.

China’s not the only problem…Don’t forget about India.

India’s installed power base exceeds 600 gigawatts, and demand is growing at about the same pace as in China. India also relies on coal for most of its power (70%). It currently burns 500 metric tons of coal a year, mostly from domestic sources. But Vinay Kumar Singh, the CEO of India’s Northern Coalfields, says the country will need to import at least 250 million tons of coal a year by 2020. India’s imports of coal from South Africa rose 74% last year.

It’s no exaggeration to say China and India’s demand for electricity is the future of global power. Already China’s coal production represents more than twice the amount of energy produced from all of Saudi Arabia’s oilfields.

What’s fueling all of this demand for coal-fired power plants? Huge urban populations in China and India. Consider these figures. In America, the baby boomers – the 50 million Americans born in the years after World War II – produced the demand for vast amounts of new infrastructure in America.

There are 300 million newly urban Chinese people. And 300 million newly urban Indians. That’s 600 million people moving out of the Stone Age and into the modern world – a group 12 times bigger than the baby boomers. While it’s true these people will want to buy lots of things – from Cokes to Buicks – the thing they need most is electricity.

Americans don’t yet realize the Fed’s attempts to paper over our debts come with serious consequences. As our money loses its purchasing power, costs will rise – especially power costs. Undoubtedly, our politicians will blame "speculators" for the soaring price of coal. But the truth is, the paper that will push prices higher came from the Federal Reserve, not from any hedge fund.

Whether we realize it or not, we compete with other nations around the world for resources. Historically, our currency – as the world’s reserve currency – has given us an enormous advantage. Coal, for example, is priced in Dollars. But we stand on the verge of losing that advantage…and the consequences will be drastic. We will face higher prices for coal, among other sources of energy.

To hedge yourself from this coming Fed disaster, buy coal stocks is our advice. They’re going to go much higher in the coming years.

Get the safest gold at the lowest prices – go to BullionVault now…

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Oct 15

Gold Without Crisis

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Top Gold Mining analyst questions the long-term support for gold, absent today’s "crisis mentality"…

A PhD METALLURGIST who began his career working with Xstrata (then MIM Holdings Limited) at Mt. Isa, Queensland, Tony Parry is now a senior analyst with Sydney, Australia-based Resource Capital Research.

Previously working as a mining equities analyst with James Capel Limited (now part of HSBC), as well as in equity sales and mining corporate finance – marketing to institutional clients in the UK and Europe – Tony Parry established his own consultancy in 1993, advising many small-medium enterprises on strategic planning.

Today, when building his long-term models for Australian junior Gold Mining companies, he uses a long term Gold Price of US$900 per ounce. But Tony thinks gold’s fundamentals are weak and that fear is artificially propping up the price, as he explains here to The Gold Report…

The Gold Report: Tony, you joined Resource Capital Research as a senior analyst in 2008. Tell us about your coverage sector.

Tony Parry: At Resource Capital Research, we cover exploration and development companies, typically those with emerging production profiles that have not been picked up by the market or major brokerage firms and need further research coverage.

We cover three sectors – gold, uranium and iron ore. We publish major reports each quarter covering a number of significant companies in those sectors, and these reports contain a commodity price outlook for the commodity we’re looking at.

TGR: On the gold side, Australia has quite a history of Gold Mining, especially in the Kalgoorlie area. But in other countries, gold has taken on something of a stigma in recent years. What’s the general sentiment toward Gold Mining right now in Australia?

Tony Parry: Australian mining is a very positive and somewhat booming sector. It’s growing strongly, and there’s no major resistance to further development, apart from the normal environmental and social concerns about developing mining operations.

TGR: What sort of play is gold receiving in Australia’s mainstream media? Is there a buzz about gold at $1300 an ounce?

Tony Parry: It’s exciting times for the gold market; $1300 an ounce is a pretty significant breakthrough and, of course, that’s getting a lot of play in the financial reporting sector. We’re seeing lots of articles on the Gold Price. Every article seems to be placing a bet on gold. So, yes, there’s quite a buzz in the press and there are a lot of people talking about gold.

TGR: Do you think the average Australian is aware that $1300 per ounce is really good for the Australian economy in terms of exports?

Tony Parry: Yes, I think they’re pretty in tune with what’s happening in the resources sector; as I say, it’s such a significant part of the Australian economy. Even in the largest cities there’s no doubt the Gold Price is widely visible.

If you got in a taxi in the capital city of Australia and talked to a taxi driver about what’s going on, he would probably talk to you about the Gold Price.

TGR: What are we looking at in terms of mining’s contribution to GDP there?

Tony Parry: I don’t have the exact numbers, but something like 30% of Australia’s total exports are made up of mining-related commodities. The three big exports in Australia are coal, iron ore and gold, in that order.

TGR: Your firm predicted an average Gold Price of just below $1200 an ounce for 2010; obviously that was a little low. What sort of fundamentals did you see in the gold market and in the global economy that led you to say in a recent report "take away the ‘crisis mentality’ and gold looks precarious"?

Tony Parry: What we were seeing and what we’re still seeing is that the "doomsday mentality" is driving investment demand in the gold market. The simple fact is the "crisis mentality" has not been removed from the equation since we made those forecasts. In fact, the "crisis mentality" is bubbling along very well, perhaps even increasing as European sovereign debt concerns continue to make headlines.

And we’re still seeing major concerns about the US economy and the issues surrounding quantitative easing, which are starting to have an impact on the US Dollar. There’s quite a bit of pressure on the US Dollar.

Perhaps we felt that there was going to be some easing of that crisis mentality in the coming quarter or two, but at the moment there’s no sign of that and it may very well be increasing.

TGR: But in looking through RCR’s September report on gold, your price estimates are quite conservative across the board. In your financial models, you’re now using a long-term Gold Price of $900 an ounce. That seems particularly bearish.

Tony Parry: It does in the current environment. We say in Australia that predicting the Gold Price is a bit of a mug’s game. The fundamentals are pretty tricky to go on, so you’ve really got to go on the psychology of the market. Gold doesn’t have enough underpinning it to make a projection on the fundamentals.

TGR: I agree, but you must see something in those supply and demand fundamentals to project such conservative prices.

Tony Parry: That’s right. At the end of the day we have to come up with some sort of basis for our forecasts. We asked ourselves: is $1300-an-ounce gold sustainable or is that a spike? We believe that in a few years’ time and once everything gets back to normal – and please don’t ask me when that is – we will see gold come off the top quite significantly.

Our argument is that the Gold Price is being sustained by strong "safe haven" investment demand. But if you take that demand away, we see weak fundamentals; jewelry demand is quite weak, which has been the main source of gold demand, before investment demand started challenging jewelry demand in recent times.

Gold Mining production is increasing because of the increased prices, so there’s more supply coming on the market. We’re also seeing increased scrap supply from recycled gold.

On the demand side, we’re seeing negligible purchases from central banks, perhaps because they just don’t want to buy more gold at these prices. And as I mentioned, we’ve seen the end producer de-hedging, which has been a demand-side factor in recent times. We may even see more hedging from producers.

If you put all that together, and significantly reduce investment demand, we see gold coming significantly off the top. We wouldn’t be expecting that in the short-to-medium term. But if you ask what’s the fundamental value of gold? At the moment, we say that’s about $900 to $1,000 an ounce. That is probably the ultimate baseline that gold will come back to when it’s safe to go back into the water with the other asset classes that people don’t really trust at the moment.

It could be a number of years, but investment banks will be doing the same; they won’t be factoring the current Gold Prices into their long-term valuation models. And I think that’s fine because if we’re wrong, and a company still looks good on that basis, that’s pretty good news for the company.

But we do see the speculative element washing out in time.

TGR: In your report you said that in the future you could see a sustained inflationary uptrend that could ignite gold’s "store of value" demand. You added that it’s too far off to be a factor in the short-to-medium term. Could inflation prop up gold once this "crisis mentality" subsides?

Tony Parry: That’s a good question. There’s no doubt that inflation is in the melting pot as an argument for holding gold. Quantitative easing is the pump priming the US economy and other economies. The classic theory is that the more money you pump into the system, the higher inflation is going to be in the end. At the moment, we’re seeing more concern with deflation in the US and European economies. You’d have to say inflation is not a strong factor right now.

Longer term, yes, inflation could rear its head. But inflation would require some economic growth to become a real factor, and by then you may see equity markets back into the next bull phase. I have a hunch that by the time that is happening, some of the speculation in gold will have washed out. I see that as a bigger factor than the "big inflation" argument.

For the record, we just published our September quarterly gold report, and we’re feeling less bearish. Given the continued concerns in the market, we expect gold to keep pushing up into the first half of 2011. We’re looking at around $1335 to $1350 during that period.

TGR: In your June report you said that in the last five to seven years, one of the major trends in Gold Mining has been for gold producers to buy out their hedging contracts to gain more exposure to the spot price. But you also said in a recent report that the gold sector could see a "return to net producer hedging at Gold Prices above a $1000 an ounce driven by producer concern that the highs for gold may have been seen for now and the requirement by project financiers to lock in for future margins." That’s remarkable. Have you seen any evidence of hedging above $1000 per ounce?

Tony Parry: Well, I’ll be honest – not a lot at the moment. There’s no doubt that the producer hedge book has run down to virtually zero.

TGR: I’ve talked with a number of analysts who like Gold Mining juniors that are producing, but that also have some strong exploration upside. Do you follow companies that fit that description?

Tony Parry: Yes, but first I want to comment on that thesis. There’s no doubt that exploration is a tremendous driver of shareholder value for emerging companies. What we’re seeing is that a lot of the Australian companies in West Africa are having excellent exploration success. In fact, they’re getting huge gains on their share prices – 200 to 300% – due to exploration success. That’s happening because they are discovering gold at a discovery cost of around $10-$15 an ounce.

Equity markets, doing simplistic valuation multiples on gold resources and reserves, value them typically at $50-$100 an ounce once you’ve got a significant gold resource established, maybe 500,000 ounces or more. If your discovery cost is $10-$15 an ounce and you’re being valued by the market at $50-$100 an ounce, there are tremendous gains to be made through exploration success. You’re getting very high leverage on those exploration multiples. That’s the game at the moment.

TGR: Do you have some parting thoughts on the precious metals sector in Australia?

Tony Parry: Yes, obviously, the Gold Price is up 31%, in US Dollar terms, in the last 12 months. But the Gold Prices in producing countries haven’t been nearly as strong because of the appreciation of currencies. The Canadian Gold Price is up 23% in that 12-month period, as opposed to 31% for Gold Prices in US Dollars. And in Australia, the Gold Price is only up 19%.

But if you look at the performance of the indices over the same 12-month period, the US-based gold stocks, with the S&P gold index, are up 49% in that 12-month period. That’s performing better than the Gold Price, and that’s to be expected as there are no currency issues there.

In Canada, the gold index is up 18%; so, it’s actually underperformed the Gold Price. You’d have been better off holding gold rather than Canadian gold stocks in that period. That’s partly due to the fact that the Canadian Dollar Gold Price was up just over 20%.

But the Australian gold index in that 12-month period is up 43%, even though Australian Gold Price was up only 19%; so, Australian gold shares have been fantastic performers. And I am sort of bragging.

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Oct 14

Money Supply & the Dollar

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How differing rates of "money growth" are weakening the US Dollar…

AT THE END of September the price of the Euro in US Dollar terms closed at 1.357 – an increase of 7% from the end of August, writes Dr.Frank Shostak, chief economist at MF Global in Australia and a regular contributor to the Austrian-school Mises.org, for the Cobden Centre.

The yearly rate of growth of the price of Euro stood at minus 7.3% in September against minus 11.5% in the month before.

The currency rate of exchange seems to be moving in response to so
many factors that it makes it almost impossible to ascertain where the
rate of exchange is likely to be headed.  We suggest that rather than
paying attention to the multitude of apparent variables, it is more
sensible to focus on the essential variable. As far as currency rate of
exchange determination is concerned we suggest that this variable is the
relative changes in the purchasing power of various monies. In short,
it is the relative purchasing power of various monies that set the
underlying rate of exchange.

A price of a basket of goods is the amount of money paid for the
basket. We can also say that the amount of money paid for a basket of
goods is the purchasing power of money with respect to the basket of
goods. If in the US the price of a basket of goods is $1 and in Europe an identical basket of goods is sold for 2 euros then the rate of exchange between the US$ and the euro must be two euros per one dollar.

An important factor in setting the purchasing power of money is the
supply of money. If over time the rate of growth in the US money supply
exceeds the rate of growth of European money supply, all other things
being equal, this will put pressure on the US$. Since a price of a good
is the amount of money asked for the good, this now means that the
prices of goods in dollar terms will increase faster than prices in euro
terms, all other things being equal.

As a result an identical basket of goods is priced now, let us say at $2, as against 2.5 euro. This would imply that the exchange rate between the US$ and the euro will be now 1.25
euros per one dollar. Note the fact that changes in a money supply
affect its general purchasing power with a time lag means that changes
in relative money supply affect the currency rate of exchange also with a
time lag. (When money is injected into the economy it starts with a
particular market before it goes to other markets – this is the reason
for the lag. When it enters a particular market it pushes the price of a
good in this market higher – more money is spent on given goods than
before). This in turn means that past and present information about
money supply can be employed in ascertaining likely future moves in the
currency rate of exchange.

Another important factor in driving the purchasing power of money and
the currency rate of exchange is the demand for money. For instance,
with an increase in the production of goods the demand for money will
follow suit. The demand for the services of the medium of exchange will
increase since more goods must now be exchanged. As a result, for a
given supply of money, the purchasing power of money will increase. 
Less money will be chasing more goods now. Various factors, such as the
interest rate differential, can cause a deviation of the currency rate
of exchange from the level dictated by relative purchasing power. Such
deviation, however, will set corrective forces in motion.

Let us say that the Fed raises its policy interest rate while the
European central bank keeps its policy rate unchanged. We have seen that
if the price of a basket of goods in the US is one dollar and in Europe
two euros, then according to the purchasing power framework the
currency rate of exchange should be one dollar for two euros. As a
result of a widening in the interest rate differential between the US
and the Euro-zone an increase in the demand for dollars pushes the
exchange rate in the market toward one dollar for three euros. This
means that the dollar is now overvalued as depicted by the relative
purchasing power of the dollar versus the euro.

In this situation it will pay to sell the basket of goods for dollars
then exchange dollars for euros and then buy the basket of goods with
euros – thus making a clear arbitrage gain. For example individuals will
sell a basket of goods for one dollar, exchange the one dollar for
three euros, and then exchange three euros for 1.5 basket, gaining 0.5
a basket of goods. The fact that the holder of dollars will increase
his/her demand for euros in order to profit from the arbitrage will make
euros more expensive in terms of dollars – pushing the exchange rate in
the direction of one dollar for two euros.  (We suggest that the
arbitrage will always be set in motion if the rate of exchange deviates,
for whatever reasons, from the underlying rate of exchange).

Since November 2009 the money growth differential between the US and
the Euro-zone has been in a visible increase. After closing at minus 24% in November 2009 the differential jumped to minus 4.2%
in August this year. We suggest that the strengthening in the
differential is the key reason for the underlying strengthening in the
Euro against the US$. Given the relatively more conservative Euro-zone
central bank versus the US central bank it is quite likely that the
money growth differential will continue to strengthen further – thus
providing further support to the Euro.

After closing at minus 3.7% in April the growth differential between
US and Euro-zone industrial production climbed to 0.11% in August. We
envisage that in the months ahead the differential is likely to
stabilize at the August figure. So from this perspective the slight
increase in the differential is likely to provide only marginal support
to the US$ versus the Euro. The differential between the federal funds
rate and the European central bank policy interest rate is likely to
stand at minus 0.75% in the months ahead. (The fed funds rate is
forecast at 0.25% while the ECB rate at 1%). So from this perspective it
is going to have neutral effect on the price of Euro in US dollar
terms.

Again we maintain that the strong support for the Euro versus the US$
is on account of a strengthening in the money growth differential since
November 2009. (Note again that the effect from changes in money supply
and the differential works on the currency rate of exchange
determination with a time lag). This means that the US$ is likely to
remain under pressure. An increase in the industrial production
differential is likely to mitigate the strengthening of the Euro against
the US$. On a short-term basis the price of the euro in US dollar terms
appears to be just about “right” as far as the valuation versus its
12-month moving average is concerned. The price to its 12-month moving
average ratio stood at 1.0 in September versus 0.9 in August. Note that in September last year the ratio stood at 1.08.

Prospects for the Yen against the US dollar

At the end of September the price of the US$ in Yen terms closed at 83.9 – a fall of 0.3% from the end of August. Year-on-year the price of the US$ in Yen terms fell by 6.5% in September after declining by 9.5%
in the month before. Observe that the Yen has been strengthening
against the US$ since July 2007. The price of the dollar to its 12-month
moving average stood at 0.94 in September the same figure as in August. Note that in September last year the ratio stood at 0.946.

Since November 2009 the money growth spread between the US and Japan has been trending up. The differential stood at 2.8% in August against 2.1% in July and minus 13% in November last year. Now after falling to minus 29.1% in February the industrial production growth spread between the US and Japan climbed to minus 9.2%
in August. In the months ahead we expect the growth spread to stabilize
at around the August figure. The interest rate spread doesn’t have much
importance at present given the policy rates in US and Japan are close
to nil. We suggest that in the months ahead the money growth
differential is likely to dominate the currency rate of exchange scene.
This implies that the price of the US$ in yen terms is likely to remain
under pressure.

Money growth differential continues to support Aussie dollar against the US dollar

At the end of September the price of the A$ in terms of US$ closed at 0.967 – an increase of 8.5%
from the end of August. The growth momentum of the price of the A$ has
also strengthened visibly. The yearly rate of growth jumped to 9.4% from 5.4% in August. The ratio of the A$/US$ to its 12-month moving average climbed to 1.076 in September from 0.999
in the month before – this could be interpreted that relatively to its
12- month moving average the price of the A$ in US$ terms is
over-stretched.

A major factor behind the strengthening in the A$ against the US$ is a
visible strengthening in the money growth differential between the US
and Australia. After falling to minus 15% in November last year the differential shot up to 9.1% in June before settling at 7.6%
in August. From the demand for Aussie dollars perspective a strong
increase in the price of gold provides important support for the
Australian currency versus the US dollar. From these two key factors we
suggest that for the time being the Aussie dollar is going to be well
supported in the months ahead, all other things being equal.

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Oct 01

Gold coins mark Mary MacKillop’s sainthood

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Gold coins produced by the Perth Mint are being launched in honour of Mary MacKillop, due to be canonised as a saint on October 17th, reports the Australian Associated Press.
She is due to become the first saint to come from Australia, following a process which began in 1926.
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