May 20, 2013 9:41 am

We should listen to what gold is really telling us

Like Apple, valuation has become divorced from fundamentals, writes Mohamed El-Erian

There is no better topic than gold to polarise an investment discussion. So the recent sharp drop in the metal’s price has pushed to fever pitch the debate between two camps with deeply held convictions: those who view gold as overvalued and lacking both income and capital appreciation attributes; and those who feel it is only a matter of time before others appreciate again gold’s unique role as an antidote for virtually any economic ill that could hit a diversified investment portfolio.

As interesting as this debate is, it understates the potential significance of what has taken place. The recent volatility speaks to a dynamic that has played out elsewhere and, more importantly, underpins the gradually widening phenomenon of western market-based systems that have been operating with artificial pricing for an unusually prolonged period.

The consensus gold narrative is a familiar one. In an increasingly fluid ecosystem, and a world in which a growing number of central banks have ballooned their balance sheets aggressively, investors rushed into gold as a means to hedge against identifiable risks (inflation), as well as to counter nervousness about big uncertainties (including previously unthinkable disruptions to economic systems).

Rising prices generated even higher prices, significantly disconnecting valuation from underlying fundamentals of physical demand and supply – that is until an otherwise insignificant bit of news pulled the rug from under the operating paradigm.

While lower inflationary expectations and surging equities played a role, the real catalyst for the dramatic price drop was a rumour that Cyprus could be forced to sell its holdings by its European partners. This involved a tiny amount of gold (valued at less than $1bn at the time), but it made investors suddenly pay attention to the possibility of significant supply hitting the markets from other European economies (particularly Italy with holdings of some $130bn).

This simple change was enough to bring the gold price down 15 per cent in less than a week. Since then, the metal has struggled to re-establish a firm footing, (it is currently trading at about $1,345 a troy ounce).

In corporate terms, think of the underlying dynamic as one of a powerful brand where valuation has become completely divorced from the intrinsic attributes of the product – thus rendering it vulnerable to any change in conventional wisdom (or what economists would characterise as a stable disequilibrium).

Over the past year, a similar dynamic has played out in Apple and Facebook shares.

After a steady increase to just over $700, Apple’s share price hit a dramatic air pocket. Its price collapsed to less than $400. Today, it trades at around $435. Why? Basically because, as powerful as it is, the brand’s “enchantment” (to use a term coined by author and former Apple employee Guy Kawasaki) ended up inducing investors (inadvertently) to disconnect valuation from the reality of the furious catch-up on the part of Apple’s competitors.

In the case of Facebook, it was widespread familiarity with the name, and the associated hype, that persuaded investors to oversubscribe to an IPO that valued the company at $38. The stock traded up briefly before dropping below $20 as a large number of professionals resisted the massive and blatant disconnect between valuation and fundamentals. Today it is trading around $26.

Of course, these are name specific examples; and, to the extent that insights can be generalised, they point to the fact that financial markets overshoot on both sides. Yet, today, I believe there is an additional insight from gold in a world where central banks, pursuing higher growth and greater job creation, have inserted a sizeable wedge between financial markets and economic fundamentals.

Firm and repeated central-bank commitment to asset purchases has done more than push a growing number of investors to add portfolio risk at evermore elevated prices. It has also repressed market volatility, lowered correlations and given the illusion of stability – all in the context of a complicated ecosystem characterised by unusual sovereign dynamics, changing regulations, considerable tail risks, widespread need for new growth and job models, and innovation that accentuates rather than contains worrying inequalities.

Essentially, today’s global economy is in the midst of its own stable disequilibrium; and markets have outpaced fundamentals on the expectation that western central banks, together with a more functional political system, will deliver higher growth. If this fails to materialise, investors will worry about a lot more than the intrinsic value of gold.

America by Proxy?

Dominique Moisi

20 May 2013

PARIS – The demise of the Roman Empire resulted from a combination of strategic overreach and excessive delegation of security responsibilities to newcomers. Without making undue comparisons, the question for the United States today is whether it can remain the world’s leading power while delegating to others or to technological tools the task of protecting its global influence.

Drones and allies – non-human weapons and non-American soldiers – have become central to America’s military doctrine. Leading the world in technological prowess while leading it from behind in terms of combat forces on the ground, if not in the air, America’s shift of emphasis is impossible to ignore.

First there was the combined French and British action in Libya that led to the overthrow of Colonel Muammar el-Qaddafi’s regime; then came French intervention in Mali, and now Israeli airstrikes in Syria. Each case is, of course, utterly different, but all have something in common: America has not been on the front line of intervention. Yet, without direct US military support or indirect (and in some cases implicit) political support, it is difficult to imagine that such risky operations would have been launched. Have the British, French, and even Israelis become armed extensions of the US in their respective spheres of influence?

If so, the contrast with the recent past could hardly be starker. In the aftermath of the terror attacks of September 11, 2001, Americans simply could not envisage sharing their security responsibilities with others. At best, Europeans could be America’s “cleaning ladies,” to use the indelicate analogy coined at the time by some neo-conservative thinkers during George W. Bush’s first term in office.

But, even before September 2001, some US conservatives had expressed disdain toward their European allies. I still remember the warning uttered by a top US diplomat in Strasbourg in the early 1990’s, on the eve of the Balkan wars. “If we leave Europeans in charge of themselves, they will prove irresponsible, divisive, and suicidal, and then we will have to rescue them from themselves.” Today, Americans are only too happy to rely on the military competence and interventionist inclinations of some (in fact, very few) of their European friends.

It would be easy to interpret this shift as a response to the human and economic cost of America’s interventions in Afghanistan and Iraq. The reality is more complex.

America’s newfound taste for delegating military responsibilities to others is not the result of a series of events, but the product of a long-term process driven by America’s simultaneous ambivalence toward the world and active engagement with it. Is it worth fighting for a world that cannot be saved, and that only invites murky, inconclusive entanglements?

From this perspective, America’s involvement in World War I and, even more so, in World War II, are exceptions to the rule. The US troops that landed on Normandy beaches in June 1944 were animated by a strong sense of mission. They knew that they were fighting evil in an environment that was historically and culturally familiar.

In Vietnam, US soldiers, many of them black, often did not understand why they were fighting. In Iraq, their equivalents were very often Latinos for whom integration into American society – including, for many, the promise of permanent residence or citizenship – was at least as important as toppling Saddam Hussein.

When a country engages in the world, its authority stems from its willingness and ability to take “personal” risks. Its authority is diminished when the perceived gap between the value of its population’s lives and the lives of its enemies is too wide.

In this respect, drone warfare reinforces the perverse nature of “asymmetrical wars.” In her recent book Drone Warfare: Killing by Remote Control, Medea Benjamin, a peace activist and shrewd observer of international relations, makes a crucial point: “While drones make it easier to kill some bad guys, they also make it easier to go to war.”

Likewise, delegating security to allies can have perverse psychological effects. This is particularly true in the Middle East. How can the US exert pressure on Israel to engage in serious negotiations with the Palestinians, or to refrain from attacking Iran, when it offers encouragement – if only through public silence – to Israeli military intervention in Syria? If America’s purpose is to deliver a message to Iran – “Beware, you could be the next target” – many will question its sincerity about restraining Israel.

For some, the US has moved from too much engagement under Bush to doing too little under Barack Obama. For others, Obama is merely pursuing Bush’s foreign policy through other means – drones instead of soldiers.

The reality is probably somewhere in between. But it is clearly not beneficial to the US, its allies, or global stability. Precisely because America remains indispensable to international security, one wishes that its leaders would act in a more discerning way. In international politics, as in education, there is no such thing as care by proxy. If responsibility is to be exercised effectively, it cannot be delegated to machines or other countries.

Dominique Moisi is Senior Adviser at IFRI (The French Institute for International Affairs) and a professor at L'Institut d’études politiques de Paris (Sciences Po). He is the author of The Geopolitics of Emotion: How Cultures of Fear, Humiliation, and Hope are Reshaping the World.

May 19, 2013 7:49 pm

It doesn’t make much sense but I’m a eurofanatic

By Wolfgang Münchau

It is better to make the case for the EU on the basis of geopolitics rather than economic efficiency

Whatever the reasons for Britain’s EU membership, I concluded last week, they cannot be economic. So have I turned into a newly converted eurosceptic? Far from it. I remain an unrepentant EU fanatic.

Where I differ from many pro-Europeans in the UK is that I simply do not need any economic reason to arrive at this position, or any rational reason at all for that matter. I am like a six year old in this respect. I want the EU because I want it. Maybe it is a cultural thing, maybe the result of learning Latin as a first foreign language, some trip abroad in my youth or a long forgotten encounter. I have no idea. Whatever it was that turned me into a pro-European a few decades back, it was not the joyful anticipation of productivity gains from a single market.

There is a big difference between why we are who we are, and how we rationalise our position later on. In the 1980s, pro-Europeans could still shut up an average eurosceptic with the nuclear argument that the EU has brought peace. Who could be against peace? By the time this was no longer considered sufficiently sophisticated, the argument became increasingly economic.

In the late 1980s, pro-Europeans would pull out a very important looking research document showing, beyond reasonable doubt, that the single market would bring a rise in gross domestic product by 2 per cent. Who could be against getting richer? It was all bogus, of course, but persuasive for a while. When the euro debate started, the same happened again. The euro was indefensible on economics alone. But this did not stop some of its advocates from defending it in those terms. The EU’s history is littered with economic errors. Remember the exchange rate mechanism?

When you reduce EU membership to economics alone, you invariably end up where the UK is today. If you form your opinion about the EU on the basis of an input-output analysis, you may well arrive at the conclusion that the benefits are not there. That is especially so if you are from a large country with a relatively small manufacturing base, a net contributor to the EU budget and not in the eurozone. It is no accident that we are having this debate in the UK, for example, and not in Belgium.

The pro-Europeans are paying the price for failing to point out the non-rational reasons for membership. If you just base it on rationality, you may find that people consider it rational to enter into an alliance when the benefits are clear and then leave it when they are not. Without any emotional glue, the EU is very hard to defend as an institutional framework designed to last forever.

Why have pro-Europeans allowed themselves to be pushed into this pseudo-rational trap? Do they really believe that the single market has brought those benefits? Or that it is so wonderful for the City of London to be someone else’s financial centre? Or that one could shape the whole of Europe in the mould of a Thatcherite or Blairite Britain?

Maybe the pro-Europeans concluded a long time ago that the best way to win the argument against the eurosceptics would be to appear pragmatic. So they avoided talk about European unification, common citizenship, all the ceremonial stuff that one can find in the preambles of the European treaties. But those preambles matter, not in a legal sense, but because they express a sentiment and provide direction. If you do not share the sentiment, you are far more likely to agree to a divorce when the common destiny no longer seems expedient.

This is why I would be careful not to jump to the wrong conclusions from last week’s poll by Pew Research, which showed the EU’s approval rating to be even lower in France than in the UK. Do not think for a second that the French are about to leave the EU as well. Euroscepticism is clearly on the rise in France too but the support for the EU and its institutions runs emotionally much deeper. France was a founding member of the EU. Through the euro and passport-free travel, the EU has become part of everyday life.

There is a clear and present danger that Europeans may turn away from Europe if the serial mismanagement of the eurozone crisis continues. But sentiment in the UK and on continental Europe are worlds apart.

If one must have a rational reason in favour of EU membership, it is probably best to stick to politics, not economics. EU member states share common values and common interests that deserve global representation and enforcement. The best rational argument is thus the idea of the EU as a superpower – as opposed to a superstate.

There are clearly pan-European interests at stake in a world with many emerging industrial powers. The EU would be a far more stable and potent partner for the US and Russia than a panoply of midsized member states. If you want to make a rational case for the EU, it is better to make it on the basis of political power, not economic efficiency.

But even for such an argument to work, you need to have some notion of “Europeanness” as part of your citizenship. I struggle to think how those who have avoided precisely this type of argument in the past will of all sudden be able to pull together an emotionally and rationally coherent argument ahead of an increasingly certain referendum.

Copyright The Financial Times Limited 2013.

Last updated: May 19, 2013 9:39 pm

Demise of Swiss banking secrecy heralds new era

By James Shotter in Zurich

Over the past five years, Switzerland has fought tooth and claw to keep its 80-year-old tradition of protecting the secrecy of its banks’ clients alive. It is looking like an increasingly forlorn cause.

The latest blow came last week, when EU states – under mounting pressure to crack down on tax evasion following a rash of high-profile scandals – finally agreed to open negotiations on a new tax accord with Switzerland.

The precise nature of the EU’s demands is not yet clear. It seems likely, however, that the bloc will request that Swiss banks automatically share information about the offshore wealth stashed away in their vaults by EU citizens.
Such a move, says Stéphane Garelli, a professor at the IMD business school in Lausanne, would be the “final nail in the coffin” for the system of secrecy that has helped Swiss lenders suck in SFr2.7tn ($2.8tn) of foreign assets.
“Switzerland is now moving towards an orderly retreat,” he says.

Other observers are more circumspect. “Bank secrecy has certainly weakened,” says Rainer Skierka, a banking expert at Bank Sarasin in Zurich. “But I would hesitate to say that it is dead, because it is not clear that a deal with the EU would cover all types of assets, nor is it likely to cover the contents of safe deposit boxes.”

The direction of travel, though, is clear. Switzerland broke its taboo on data-sharing in February, when it agreed to implement Fatca, a piece of extraterritorial US legislation that requires foreign banks automatically to provide information on the offshore assets of US citizens.

Data exchange with the EU would be more important still, argues Martin Brown, professor of banking at St Gallen University. “Funds of American clients make up a significant proportion of the foreign wealth managed by Swiss banks. But the share of funds from EU countries is higher,” he says.

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The key question now, argues Prof Garelli, is what concessions the Swiss can wring from their European interlocutors in exchange for agreeing to automatic data-sharing.

Eveline Widmer-Schlumpf, the Swiss finance minister, said two weeks ago that she would be prepared to accept automatic information exchange if it were a globally applied standard, and if efforts were also made to shed light on the opaque trust structures popular in rival financial centres.

However, the importance of maintaining European market access for its banks means that the Alpine state’s negotiating position is not a strong one.

As a result, many Swiss private banks have already started adapting their models for a world in which they can no longer rely on secrecy as a source of competitive advantage.

Some have put up the fees they charge for managing their clients’ wealth, while others are attempting to shepherd clients out of discretionary and into advisory accounts, where banks can typically charge for a greater range of services.

The challenge of this approach, however, is that banks also have to offer services of a sufficient quality to justify the higher fees, says Prof Brown. “Not all banks will be in a position to do so, and they won’t be able to cater to all current clients,” he warns.

Banks that fail to make this change are likely to run into difficulties, and in the absence of buyers, smaller participants may even have to close.

Yet despite such upheavals, in the long run the demise of Switzerland’s tradition of bank secrecy ought to benefit both the country and its banking sector.

On an international level, it would resolve an issue that has soured Switzerland’s relations with its most important trading partner, the EU. And in doing so, says Mr Skierka, it would make it easier for Swiss banks to hunt for business abroad.

“Bankers will be able to go out again and focus on winning business, rather than worrying about the past. That is a big positive,” he says.

Prof Garelli is also confident that Switzerland’s banking sector can prosper without its mantle of secrecy. “Switzerland has a very diverse economy. It’s not just chocolate and watches. It is also pharma, mechanical engineering, food, tourism,” he says.

“All these sectors do extremely well internationally, not because they benefit from special laws, but because of their skills and competence. There is no reason why Swiss banks cannot do the same.”

Copyright The Financial Times Limited 2013.


May 19, 2013, 12:47 p.m. ET

Japan Discovers QE Has Risks

A debate breaks out over the 'bubbly' stock market.

Well, that was fast. Japanese Prime Minister Shinzo Abe's aggressive pro-inflation policy is only a few months old and a fight has erupted over its early effects. And this while there is no economy-wide inflation.

On Wednesday, the Nikkei 225 closed above 15000 for the first time since 2007. Former Vice Finance Minister Eisuke Sakakibara—known as "Mr. Yen" from his stint managing foreign-exchange policy—took to the airwaves to call the market "bubbly" and warn that "there will be some corrections . . . probably by the summer." Bank of Japan Governor Haruhiko Kuroda contested this bubble theory in parliamentary testimony, arguing that fundamentals support the market moves.

Then there's real bubble trouble in the market for Japanese government debt. Years of exceptionally loose monetary policy encouraged markets to value Japanese government bonds (JGBs) far above what one might expect for a highly leveraged government sitting atop an anemic economy with a shrinking population. Last week prices fell and yields for 10-year bonds rose to 0.92% on Wednesday from 0.6% the previous week, before the central bank stepped in to reduce yields slightly.

That yield is only a three-month high, but the speed of the move was surprising, and the warning is clear. If investors start to believe the pledges by Messrs. Abe and Kuroda to deliver inflation of 2%, they will demand higher returns on their investments. In a Japanese twist, looser money could lead to higher nominal interest rates.

This would have potentially serious consequences for the balance sheets of Japanese banks, insurers, pension funds and households that are the main holders of government debt that totals more than 200% of GDP. It also raises the sobering prospect that a rotation out of JGBs could come long before other parts of Abenomics have begun and a durable economic expansion that lifts revenues has taken hold.

Meanwhile, commentators are engaged in an esoteric debate about what sort of inflation Japan may develop. A growing chorus of observers suggests the economy is headed for "cost-push inflation," the kind that happens when a weaker yen causes import prices to rise and consumers bear the burden when their incomes don't increase proportionately.

Mr. Abe and his supporters are hoping for "demand-pull" inflation, in which companies would increase wages to boost purchasing power. Since a weak yen is increasing operating costs and the economy remains sluggish, there's little sign this is happening. Wage growth is still negligible.

Yet since inflation is by definition a rise in the general price level, not one set of prices, it's never as orderly as proponents of inflationary policies like to claim. It's hard for a central banker or anyone else to predict who will win or lose more. Meanwhile, investors are pouring into assets in search of a return for their loose cash, which takes us back to the rising stock market.

What ties all of this together is the desperate need for growth in the real economy, and not simply in the money supply. Growth will boost corporate earnings in ways that give stocks a sustainable reason to rise, make the government's debt burden repayable, and stimulate wage growth and consumer confidence.

Japanese are discovering that although their politicians often equate a return to inflation with a return to growth, the two are different. Mr. Abe has set his sights on inflation, and perhaps he's going to get some. But he'll regret that choice unless the other policy reforms he is promising succeed. As he announces his plans in the coming weeks, the stakes are high.

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