Doug Nolan
This might be the most fascinating market backdrop of my career. Not yet as dramatic as 1987, 1990, 1994, 1997, 1998, 1999, 2000, 2002, 2007, 2008, 2009 or 2012 – but, heck, we’re only two weeks into 2018 trading.

In the first nine trading sessions of the year, the DJIA tacked on almost 500 points. The S&P500 has advanced 4.2%, the Dow Transports 7.2%, the KBW Bank Index 6.0%, the Nasdaq100 5.7%, the Nasdaq Industrials 5.7%, the Nasdaq Bank Index 5.7%, the Nasdaq Composite 5.2%, the New York Arca Oil index 7.1%, the Philadelphia Oil Service Sector Index 9.8%, the Semiconductors (SOX) 5.5%, and the Biotechs (BTK) 6.3%.

It’s synchronized global speculation unlike anything I’ve witnessed. Italian stocks are up 7.2%, French 3.9%, Spanish 4.2%, German 2.5%, Portuguese 4.0%, Belgium 4.7%, Austrian 5.2%, Greek 6.1% and Icelandic 4.1%, European Bank stocks (STOXX600) have gained 5.4%, with Italian banks up double-digits. Hong Kong financials have gained 5.9%. Japan’s Topix Bank index is up 5.6%. Japan’s Nikkei has gained 3.9%, Hong Kong’s Hang Seng 5.0%, and China’s CSI 300 4.8%. Stocks are up 7.2% in Russia, 6.7% in Romania, 4.8% in Bulgaria and 5.8% in Ukraine. In Latin America, major equities indexes are up 3.9% in Brazil, 3.0% in Chile, 4.0% in Peru and 8.8% in Argentina.

It’s evolved into a full-fledged speculative Bubble and intense Mania. This type of euphoria, while fun and captivating, comes with unfortunate consequences. But there will be no worry for now. None of that. Once things have regressed to this point, negative news and troubling developments are easily disregarded. Speculation detached from reality.

I recall the speculative market that culminated in manic trading in the summer of 1998 – just weeks before the global system convulsed with the collapses of Russia and Long-Term Capital Management. There was the first quarter 2000 technology stock speculative melt-up - right in the face of deteriorating industry fundamentals. And how can we forget the fateful “subprime doesn’t matter” speculative run to all-time highs in the Autumn of 2007.

The backdrop is extraordinarily fascinating because of the intensity of speculative excess in the face of key developments that hold the potential to bring this party to a conclusion. Headlines from the week: “China Weighs Slowing or Halting Purchases of U.S. Treasuries.” “ECB Hawks Take the Lead on QE Debate as Doves Stay Quiet.” “Japan’s Central Bank Trims Bond Purchases, Prompting Taper Talk.” “Yen’s Spike Shows Taste of What Comes When BOJ Really Does Shift.” “ECB Joins Central Bank Chorus Hinting at Faster Tightening.” “Fed’s Dudley Warns That Tax Cuts Putting Economy on an 'Unsustainable Path'.” “U.S. Core Consumer Prices Post Biggest Gain in 11 months.” “Investors Spooked at Specter of Central Banks Halting Bond-Buying Spree.”

Not all that spooked. “Junk-Bond Funds See Largest Cash Inflows Since December 2016.” Investment-grade funds saw inflows of $4.186bn. And while 10-year Treasury yields were up 7 bps this week – and 14 bps to begin 2018 – there’s certainly no panic. Even the so-called bonds bears forecast the mildest of bear markets. I haven’t seen any predictions of a big backup in yields. A 1994 tightening cycle – 10-year Treasury yields up 250 bps – is today unimaginable. 

Yet excesses during ‘91-93 barely register when compared to the last nine years.

A Bloomberg News article, based on unnamed “senior government officials,” reported that China was considering slowing or halting purchases of U.S. Treasury securities. Though denied by Chinese authorities, this news resonated in the marketplace. The Bloomberg report followed by two days a Politico article, “White House Preparing for Trade Crackdown.”

It’s worth an additional look at pertinent Q3 Z.1 “flow of funds” analysis: “Rest of World holdings of U.S. Financial Assets jumped $724 billion (nominal) during the quarter to a record $26.347 TN. This puts growth over the most recent three quarters at a staggering $2.124 TN (16% annualized). What part of these flows has been associated with ongoing rapid expansion of global central bank Credit? It’s worth recalling that ROW holdings ended 2007 at $14.705 TN and 1999 at $5.639 TN. As a percentage of GDP, ROW holdings of U.S. Financial Assets ended 1999 at 57%, 2007 at 100%, and Q3 2017 at a record 135%.”

In a world awash in finance, and foreign “money” has been pouring into U.S. securities markets. China has been a major purchaser of Treasuries, as it recycles a massive and growing trade surplus with the U.S. (around $300bn in ’17). And as financial flows inundated EM in 2017, emerging central banks also turned significant buyers of U.S. government debt. At an estimated $2.7 TN, global QE played a major role in global liquidity abundance, “money” that at least partially circulated into booming U.S. securities markets.

There is a prevailing view in the U.S. that QE doesn’t matter. The Fed ended balance sheet expansion a few years back, and financial markets didn’t miss a beat. Better yet, the Fed is now contracting its balance sheet holdings and stock market gains have only accelerated. The reality is that it’s a global Bubble fueled by globalized liquidity. Central bank QE liquidity is fungible - $14 TN and counting.

Ten-year Treasury yields jumped to 2.60% on Wednesday’s China story, although they drifted back down on Chinese denials. And while the attention was on market yields, the more fascinating moves were in the currencies. The euro gained 1.4% this week on the rising prospect of an early end to the ECB’s QE program.

January 7 – Reuters (Sam Edwards): “The European Central Bank should set a date to end its asset-buying program, the head of Germany’s Bundesbank, Jens Weidmann, told Spanish newspaper El Mundo. Tipped as a potential candidate to succeed ECB President Mario Draghi when his term expires at the end of October 2019, Weidmann is a vocal critic of the bank’s quantitative easing program. ‘The prospects for the evolution of prices correspond to a return of inflation to a level sufficient to maintain the stability of prices. For this reason, in my opinion, it would be justifiable to put a clear end to the buying of debt bonds by establishing a concrete date (for ending the program),’ Weidmann said…”

The euro’s gain this week was overshadowed by the 1.8% surge in the Japanese yen.

January 8 – Bloomberg (Chris Anstey): “A minor tweak in a regular Bank of Japan bond-purchase operation on Tuesday was enough to send the yen climbing the most in almost a month, even though evidence weighs overwhelmingly against the adjustment signifying anything meaningful. What the yen’s spike does show is just how big a move will come whenever the central bank does telegraph a fine-tuning in its stimulus program. Tuesday’s gain was as big as 0.5% against the dollar, in wake of the BOJ trimming purchases of bonds dated in 10-to-25 years by 10 billion yen ($89 million) compared with its previous operation.”

By their nature, speculative Bubbles and melt-ups are at heightened risk to unexpected developments. The current environment is so fascinating specifically because there are anticipated developments capable of bringing this long party to an end. The Trump administration appears determined to focus on trade in 2018, with China in the crosshairs. 

China has more than ample Treasury holdings to sell if it decides to make a point.

Meanwhile, it’s no coincidence that with global markets going nuts we are beginning to hear more decisive hawkish talk from around the world of central banking. Bundesbank president Jens Weidmann’s preference for a “clear end” to bond purchases should not be dismissed. The likelihood that ECB purchases end completely in October are rising. Moreover, I would expect growing momentum within the executive board for ending the open-ended nature of Draghi’s stimulus doctrine. Mr. Weidmann is a leading candidate to head the ECB next year at the completion of Draghi’s term. Even if a German is not soon at the helm of the European Central Bank, expect a push to return to traditional monetary management. I’m not anticipating an immediate return to “the ECB does not pre-commit.” But perhaps it’s time for the markets to become less complacent with regard to assurances of open-ended market support and permanently very low rates.

Prospects are growing for a 2018 tightening of global financial conditions. But with stocks rising percentage points by the week, there’s great incentive to focus on the here and now of over-liquefied market conditions. Besides, won’t the potential for a destabilizing spike in the yen keep Kuroda on full throttle? Don’t the doves still hold the majority at the ECB? Won’t the risk of a looming trade war with China (and others) ensure the Fed remains cautious, placing a lid on Treasury yields? Besides, the Chinese are too smart for the type of wound to be self-inflicted from threatening to dump Treasuries – aren’t they?

Markets are sure willing to assume a lot and ignore even more. There remains overwhelming confidence that global central bankers will work in concert to ensure markets don’t buckle, at least so long as inflation stays well-contained. Rising inflationary pressures are one of my Themes 2018. WTI crude traded to $64.30, up 6.4% in two weeks to a near three-year high. 

The GSCI Commodities Index rose 2.1% this week. The dollar index has declined 1.2% to begin the new year.  Interestingly, Gold is up a quick 2.7%.

General inflationary pressures have gained some momentum. The global economy has attained strong momentum. And markets these days are left to contemplate how a runaway global risk market melt-up could impact economic activity and what an outright boom might mean to inflation dynamics.

German 10-year bund yields jumped 15 bps this week to a near two-year high 58 bps. Yields rose 11 bps in Switzerland, and 10 bps in Sweden, the UK, and Australia. Mexico yields surged 22 bps, Russia 27 bps and Brazil eight bps.
There’s the old market adage that you know you’re commencing a bear market when prices decline yet people are feeling pretty good about it.   

The Moment of Truth for the Secular Bond Bull Market Has Arrived

By John Mauldin

The moment of truth has arrived for [the] secular bond bull market! [Bonds] need to start rallying effective immediately or obituaries need to be written.”  
—Jeffrey Gundlach
Jeffrey started his career as a nearly broke rock and roll drummer, now he goes under the nickname the Bond King. What he says and does literally moves markets” 
—Bethany McLean

Welcome to the first installment of this five-part series on the individuals and ideas informing my worldview as of late. My goal with this series is to highlight the ideas which have been deeply influential on me, and share with you what I’ve learned.

I mentioned in my email to you yesterday that this series will start with a bang, and the following fact certainly hit me like a ton of bricks: Anyone who started investing after 1981 has never experienced a bear market in Treasuries. The vast majority of today’s investors have only ever invested when Treasury yields are falling.

Sources: St Louis Fed
The secular decline in bond yields is one of the most definable trends in financial markets, and also one of the most important. As you know, US Treasury yields are the bellwether for global interest rates. Almost every market and asset class in the world is affected by them.

At every opportunity, I like to point out that interest rates are the cost of money. Unfortunately, at 68, I’m old enough to remember when the cost of money was high.

In the early 1980s, I took out a business loan with an 18% interest rate. The repayments were no fun, but I was one of the lucky ones who could actually afford to borrow money at that time.

Those rates created an insurmountable hurdle for most entrepreneurs, and banks were not willing to lend like they are today.

In the 36 years since then, the cost of money has fallen sharply—and demand for it has skyrocketed. Today’s US financial infrastructure is addicted to “easy money.”
  • Government: Low interest rates have enabled the Federal government to increase their total debt by 113% since 2008, yet interest payments have risen by only 5%.
  • Corporations: Corporations have borrowed huge amounts of debt to fund stock buybacks and increases in their dividends. Today, nonfinancial corporate debt is 79% higher than it was in 2008.
  • Households: The New York Fed’s latest quarterly report on household debt showed that US households have a total of $12.96 trillion in debt outstanding. That’s $280 billion higher than the previous all-time peak in Q3 2008.
The US economy has become heavily reliant on easy money, which leads to the question, “what would happen if interest rates increased substantially?”

One famed investor who has explored this question is “Bond King” Jeffrey Gundlach. The man needs no introduction, but I’ll give him one anyway. Jeffrey is the CEO of DoubleLine Capital, where he manages $116 billion—and has a stellar track record. Jeffrey has outperformed 92% of his peers over the last five years. His flagship DoubleLine Total Return Bond Fund (DBLTX) has also outperformed its benchmark by a wide margin over the same period.

Although Jeffrey manages one of the world’s largest bond funds, he is an independent thinker who has courage and conviction in his beliefs—maybe because he comes out of left field. Jeffrey holds degrees in mathematics and philosophy from Dartmouth College and was once the lead for a new-wave rock band, back when Paul Volcker had me paying 18% interest on that loan.

Jeffrey has had an ultra-successful investment career and has been spot-on with market timing, especially in 2017. He has called the direction of Treasuries and the US dollar, to almost the exact tick.

However, by far his biggest call, possibly in his entire career, is that the secular bond bull market is over, and that the US 10-year Treasury yield will hit 6% by 2020.

I want to dissect Jeffrey’s thought process behind this call. Let’s look at the three reasons why he believes the secular bond bull market is over and that we are headed into a period of rising interest rates.

Growth is good, but not for bonds

In a December interview with CNBC, Jeffrey commented on the recent economic growth numbers:
We’ve had 2% real [GDP growth] for three quarters in a row. GDP NOW at the Atlanta Fed is around 3% for the [Fourth] quarter. It seems to me that interest rates should continue to rise as we move into 2018, because bonds don’t like economic growth.
For the first time since 2007, not one of the 45 economies included in the OECD Expansion Contraction Growth Indicator is contracting. The below chart from a recent presentation Jeffrey gave shows this.

Sources: DoubleLine Funds

By this measure, the global economy is in a synchronized upswing for the first time in a decade—and the short-term outlook is positive. Leading economic indicators in all major regions are flashing green. In the US and Europe, the purchasing managers indices (PMIs) are at multi-year highs. This is good news for everything, except bond prices.

Higher economic growth means more demand for credit, which drives up its cost. In this case, the cost is interest rates. This relationship between economic growth and interest rates is why, over time, bond yields track nominal GDP growth.

The below chart from the recent presentation by Jeffrey shows that when the 7-year moving average of nominal GDP growth is higher than the US 10-year Treasury yield, yields should rise. The current setup suggests that bond yields should now be rising.

Sources: DoubleLine Funds

I have my doubts about the sustainability of growth in the US because of the rising debt burden and anemic growth in productivity and the working age population. With these headwinds, I believe it will be almost impossible to achieve sustained growth, like what we experienced in the 1990s. However, I concede that growth could continue to rise over the next 2–3 years.

Along with rising economic growth, Jeffrey sees the return of inflation as the second “building-block” to higher bond yields.

An arch enemy returns to the fray

In his December webcast, Jeffrey gave his thoughts on the current inflation numbers:
If [inflation] continues to rise, the Fed would have ample reason to follow through on its indicated three rate hikes in 2018.
Despite the best efforts of central banks, inflation has remained largely absent from the US and other advanced economies over the past decade. In 2015, the US CPI annualized at just 0.11%.

Finally, it appears that bonds’ arch enemy may be making a comeback.

Inflation, as measured by the CPI, is on track for its highest annual growth rate since 2011. It is also at multi-year highs in Europe, the UK, and Japan. Longtime readers know I have been a critic of the CPI, for a host of reasons I won’t go into now.

The indicator I use to get a broader, real-time measure of inflation is the New York Fed’s Underlying Inflation Gauge (UIG). This gauge captures sustained movements in inflation from information contained in a broad set of price, real activity, and financial data. In December, the UIG hit its highest level since August 2006, as the below chart shows.

Sources: New York Federal Reserve
We know that inflation erodes purchasing power. Therefore, if it continues to rise, bond yields will have to move higher to meet investor expectations. Remember, when the 10-year Treasury yielded 15% in 1981, inflation was running at 11%.

Since 1960, the average spread between the 10-year Treasury and the CPI is 2.4%. Today, it is just 0.15%. It’s likely to widen as investors’ inflation expectations increase.

Furthermore, at their December meeting, the Fed hinted that they are willing to let inflation run a little over their 2% target. Although they upgraded GDP growth, their forecast for three hikes in 2017 remained unchanged. Given that Janet Yellen once said, “To me, a wise policy is occasionally to let inflation rise even when inflation is running above target,” this is no surprise.

The last building block to higher bond yields, which Jeffrey has identified, is the coming tidal wave of supply in the bond market.

Price is a function of supply and demand

Jeffrey provided insight into how the supply and demand dynamics of the bond market are going to change in his December webcast:
One thing that has helped rates stay low is the lack of [bond] supply. For the last three years, there was negative net supply of bonds from the G3 central banks, and that’s about to change with quantitative tightening. There is a lot of bond supply coming.
The third reason Jeffrey believes the secular bond bull market is over is the coming tsunami of supply about to hit the bond market.

By purchasing a huge amount of sovereign bonds through quantitative easing (QE), central banks have suppressed bond yields over the past decade. For example, demand for sovereign bonds exceeded issuance by around $250 trillion in 2017, thanks to QE by the G3 central banks.

With the Fed now reducing the size of their balance sheet by $30 billion per month, and the European Central Bank scaling back bond purchases by $20 billion per month, this dynamic is going to change, radically. There will be a shift from a $250 billion net demand in 2017, to a $550 billion net supply in 2018. As the below chart shows, that is quite a large swing.

Sources: DoubleLine Funds
There will be an additional $800 billion in sovereign bond supply in 2018, compared to 2017. Econ 101 tells us that this will push bond yields up. But central banks stepping off the gas is not the only trend that is going to contribute to a glut of supply in the bond market. We also have higher budget deficits to factor in.

According to the Congressional Research Service, mandatory Federal spending is set to increase $1.56 trillion by 2026. To pay for this additional spending, more bonds will be issued.

For me, the increasing supply of bonds is the most compelling reason for the end of the secular bond bull market. I have no doubt that quantitative tightening will cause interest rates to rise. Plus, increases in mandatory Federal spending are baked in the cake.

Along with providing reasons why he thinks the secular bond bull market is over, Jeffrey has given insight into how he thinks it will happen. One of his favorite anecdotes about how he sees it playing out is a famous dialogue from Ernest Hemingway’s 1926 novel, The Sun Also Rises.
How did you go bankrupt?” Bill asked.
Two ways,” Mike said. “Gradually and then suddenly.”
In other words, interest rates will rise gradually over several years, and then everyone will notice, suddenly.

If Jeffrey is correct, and the secular bond bull market is over, the entire financial infrastructure will change.

For starters, how will the governments, corporations, and households who have become dependent on cheap money, react? In 2008, we saw forced deleveraging in action—and it wasn’t pretty.

What will happen to global stock markets if interest rates continue to rise? As Warren Buffett said in a recent interview, “Measured against interest rates, stocks actually are on the cheap side compared to historic valuations. But the risk always is that interest rates go up, and that brings stocks down.”

Now, a world with a 6% yield on the 10-year Treasury is hard to imagine. Saying that, if you had told me when I took out that business loan in the early 1980s that in 30 years, the 10-year yield would be less than 2%, I would have called you crazy.

Jeffrey thinks that we are headed into a much tougher environment because “the Central Bank balance sheets will stop growing at the beginning of 2018, [and] the liquidity that’s helped drive the market is going to reverse. That is not favorable for risk markets.” As such, Jeffrey and his team at DoubleLine have been de-risking their portfolios and have cautioned investors to do the same.

However, the Bond King is not bearish on everything. Jeffrey made a big multi-year call on emerging markets earlier this year and just came out with his top trade idea for 2018: add commodities to your portfolio.

Getting back to Jeffrey’s call on the end of the secular bond bull market, given its wide-ranging implications, it might be the biggest call of his investment career.

Where interest rates go from here will change how we invest and how society functions. I don’t think that’s an exaggeration given the amount of debt in the system and the expectations that the era of easy money will continue, indefinitely.

Because of this, I want to get Jeffrey’s most up-to-date thoughts on how it may play out, and what he believes the implications will be for investors and the economy. That’s why I’ve asked him to give a keynote speech at my Strategic Investment Conference in San Diego, next March.

Jeffrey is a truly independent thinker who is never afraid to make bold, out-of-consensus calls.

That’s why I know when he takes the stage at the SIC, he will provide insight into much more than the secular bond bull market. I’m really excited to welcome Jeffrey back to the SIC, and I hope you can be there with me to experience it, first-hand.
I’ll admit I was somewhat skeptical when you claimed it was the “best conference,” but after last year, I couldn’t praise the SIC enough to my colleagues. (I think they actually got tired of me talking about it.) As a principle, I try NOT to attend the same events but rather experience new and different forums. However, I couldn’t resist returning for the SIC and have once again talked the ears off my fellow traders on the desk.
—Danny A. (past SIC attendee)
That wraps up the first part of this series. In the next installment, you’ll get my thoughts on George Gilder and his new theory of economics.

Your wondering where yields go from here analyst,

John Mauldin

Emerging markets

Countries rarely default on their debts

Venezuela is the exception to the rule

VENEZUELA is an unusual country. It is home to the world’s largest reserves of oil and its highest rate of inflation. It is known for its unusual number of beauty queens and its frightening rate of murders. Its bitterest foe, America, is also its biggest customer, buying a third of its exports.

In defaulting on its sovereign bonds last month (it failed to pay interest on two dollar-denominated bonds by the end of a grace period on November 13th), Venezuela is also increasingly unusual. The number of governments in default to private creditors fell last year to its lowest level since 1977, according to the Bank of Canada’s database. Of the 131 sovereigns tracked by S&P Global, a rating agency, Mozambique is the only other country in default, having missed payments on its Eurobond (and failed to make good on guaranteed loans to two state-owned enterprises). Walter Wriston, a former chairman of Citibank, earned ridicule for once declaring that “countries don’t go bust”. But they don’t much anymore.

This dearth of distress is surprising, given the turmoil emerging economies have endured in recent years. The collapse in commodity prices that undid Venezuela was accompanied by a sharp reversal of capital flows to emerging economies that began in 2011 and gathered pace during the “taper tantrum” of 2013. There have been 14 such capital “busts” in the past 200 years, according to Carmen Reinhart of Harvard University, Vincent Reinhart of Standish Mellon Asset Management and Christoph Trebesch of the Kiel Institute for the World Economy. The most recent bust was the second-biggest of the lot. But it led to less distress than usual. If past patterns had held, such a severe setback would have resulted in 15-20 more defaults than actually transpired, the three scholars calculate.

What explains these “missing” defaults? Some may be hidden. China, for example, may have rescheduled or replenished some of its sizeable loans to emerging economies without ever declaring them bad. Indeed, China’s willingness to roll over its loans to Venezuela delayed, even if it did not ultimately prevent, the Bolivarian republic’s default on some of its other debts.

Distress also now manifests itself in other ways, points out Gabriel Sterne of Oxford Economics, a consultancy. The governments of emerging economies increasingly borrow in their own currencies. These are no longer tightly pegged to the dollar, as many were in the 1980s and 1990s, or to gold, as in the 19th century. Of 54 emerging markets Mr Sterne has examined, only 11 have foreign-currency bonds worth more than 20% of their GDP (see chart). So defaulting on hard-currency debt is neither as necessary nor as helpful as it was. Even if a sovereign were to forswear a big chunk of its dollar obligations, imposing a steep loss on creditors, it would only save a large percentage of a small amount.

The costs of default, on the other hand, are somewhat fixed. Default is, in legal terms, a discrete event. Reneging on debt worth 10% of GDP may be just as damaging to a country’s reputation as reneging on debt worth twice as much. And the costs are not just financial. “You have to negotiate with the creditor committees. You’re going to get all the hedgies (hedge funds) potentially ganging up on you. And that’s a pain in the backside,” notes Mr Sterne. In a growing number of emerging markets, including past offenders like Brazil, Mexico and Peru, default on foreign-currency debt is no longer imaginable, he says.

What about the local-currency securities that have grown in importance? Since governments have the power to print the money they owe on these bonds, default is never technically necessary. Currency depreciation and inflation offer a more surreptitious way to erode creditors’ claims: less discrete, more discreet.

Ukraine offers one instructive example, argues Mr Sterne. The holders of its foreign-currency debt emerged largely unscathed from its wartime wobbles (generous coupon payments more than offset a 15% cut in the net present value of their claims). On the other hand, those unlucky enough to hold bonds or deposits denominated in Ukrainian hryvnia suffered a 30% loss in dollar terms, by his calculations.

Although default on local-currency bonds is never technically necessary, is it nonetheless possible? The rating agencies think so, reserving triple-A ratings for only a small fraction of such bonds. And even the financial markets perceive some danger of default. The yield they demand on this government paper is higher than the implicit “risk-free” rate that can be calculated from currency swaps, point out Wenxin Du of the Federal Reserve and Jesse Schreger of Columbia Business School.

In some cases, the two economists argue, a government may prefer default to the alternatives of depreciation and inflation. Suppose, for example, that the country’s companies have borrowed heavily in dollars, even if the government itself has not. In such scenarios, a falling currency may wreak more economic havoc than a formal breach of government obligations.

Venezuela again provides a cautionary example. It has so far kept up payments on its local-currency debt, retaining a stronger credit rating on these liabilities than on its dollar paper. Meanwhile the country is going to ruin. Much of the population cannot afford enough food, medicines must be smuggled in from Colombia, and the currency lost 60% of its value last month. The republic may not have defaulted on its local debt. But it has defaulted most violently on its social contract.

Gold - What Are We Waiting For?

By: Kelsey Williams

The other shoe to drop? The next big move? Up or down?

Gold’s reign as the “next big thing” ended seven years ago. Too many people don’t want to admit that, but its true. Those who are ‘bullish’ on gold cannot let go.

Their behavior is typical of those who have missed the boat. And they don’t want to admit it, or believe it. And their problem is compounded by the fact that they originally viewed gold as a quality investment. Now they continue to point out all of the fundamental reasons gold should go much higher. We are told it is undervalued, unappreciated, unloved. And, of course, the price is manipulated, too.

Those things may provide a bit of consolation, but they don’t mask the pain of losing big bucks. And the interminable wait drags on.

We could say it was simply a matter of (poor) timing. However, most people who have a basic understanding of investment fundamentals would argue otherwise.

And they would be right. In the long-term, time works in our favor – not against us. An investment with good fundamentals – over time – becomes more valuable, not less valuable.

And that relentless march upwards helps protect us against our own timing errors.

We don’t have to be perfect market-timers to be successful investors.

And it isn’t that gold’s price can’t go a lot higher, either. It can. And it probably will. And it has done so in the past.

After peaking at $850.00 per ounce in January 1980, the price of gold dropped as low as $250.00 per ounce twenty years later and then soared to $1900.oo per ounce in August 2011. But will you (or can you) wait thirty-one years to be vindicated?

There is a better explanation.

At the heart of disappointment regarding gold’s price action is the specter of unrealistic expectations:

“believing that rational individuals would sooner or later realize the trend and take it into account in forming their (opinions)”

But there is more to it. Much more. And it involves fundamentals. And an understanding of price versus value.

To wit, gold has only one basic fundamental: it is real money.

To further clarify, this means that gold is not an investment.

Do people view gold as an investment? Absolutely. Which is why they are continually surprised and confused at their investment results. They buy gold because they expect the price to go up; and logically so.

The problem is that the premise is wrong. When someone invests in gold, they are expecting the price to go up as a result of certain factors which they believe are “drivers of gold”. In other words, they believe that gold responds to certain factors. These factors may include interest rates, social unrest, political instability, government policies/actions, a weak economy, jewelry demand, and various ratios comparing gold to any number of other things.

But, again, that assumes that gold is an investment which is affected by the various things listed. It is not.

And when gold is characterized as an investment, the incorrect assumption leads to unexpected results regardless of the logic. If the basic premise is incorrect, even the best, most technically perfect logic will not lead to results that are consistent.

The price versus value issue is rooted in gold’s fundamental role as real money.

Gold is real money because it meets the qualifications of money. It is a medium of exchange, a measure of value, and a store of value.

The U.S. dollar is a substitute for real money. It is a medium of exchange and a measure of value. But it is not real money because it is not a store of value.

The U.S. dollar, in its role as ‘official’ money, has lost more than ninety-eight percent of its value over the past century.

The price of gold, on the other hand, has increased more than sixty times from $20.67 per ounce to in excess of $1300.00 per ounce.

Gold’s price increase does not mean that it increased in value by sixty-fold. Its price increase is a direct reflection of the ninety-eight percent decline of the U.S. dollar.

Gold is worth somewhere between $1000.00 per ounce and $2000.00 per ounce. This price range correlates to a decline in the U.S. dollar’s value of somewhere between ninety-eight and ninety-nine percent.

At $1300.00 per ounce, gold’s price reflects a decline of 98.3 percent in the value of the U.S. dollar since the inception of the U.S. Federal Reserve Bank in 1913.

Let’s recap.

Gold is real money. It is a store of value. The U.S. dollar (and all paper currencies) are substitutes for real money/original money; i.e., gold.

Gold’s characterization – incorrectly – as an investment (which it is not) leads to unrealistic expectations and unexpected results.

Gold’s value is in its role as real money. Its changing price (ever higher over time) is a direct reflection of changes in the value (ever lower over time) of the U.S. dollar.

As far as gold is concerned, nothing else matters.

A year in energy: what we have learnt in 2017

By Ed Crooks

“These were shadows of the things that have been,” the Ghost of Christmas Past tells Scrooge in A Christmas Carol. “That they are what they are, do not blame me!”  In that spirit, I am going to use the penultimate Energy Source of the year to look back at some of the key things that have been in 2017, and the lessons I think they have taught us.
1) Opec still has clout, when it has Friends
The end of Opec’s power has been proclaimed so often that announcing it has become a journalistic genre in its own right, but this year the cartel proved that it can still exert some influence over the oil market, at least for a while. The fact that Brent is hanging on above $60 per barrel, at a time when US shale production is surging and global crude inventories are expected to rise, testifies to Opec’s enduring authority. It has only been able to be this effective in its strategy of production restraint, however, because it has allies, above all Russia.
The “bromance” between Khalid al Falih and Alexander Novak, energy ministers of Saudi Arabia and Russia respectively, has been one of the more unlikely alliances of the year; their countries have long been strategic rivals. But in the face of the common threat from low oil prices, they have been remarkably effective in maintaining a more-or-less united front in assessing the problem in the market and agreeing the action needed to fix it. The relationship can be expected to come under more strain next year. Russian oil producers are eager to increase output, and if the International Energy Agency is right about world oil production exceeding consumption in the first half of next year, as US output booms, there will be renewed questions about Opec’s strategy. For now, though, the cartel can look back on 2017 as one of its more effective years.

2) Saudi Arabia’s crown prince is serious about changing his country

Crown Prince Mohammed bin Salman, widely known as MBS, was elevated to that title only in June and is just 32 years old, but already he has made a huge impact on the kingdom. The most dramatic sign of that was the swoop he ordered last month that detained dozens of leading Saudi figures, including princes, government officials and business leaders on corruption charges. There is no doubt that Saudi Arabia has a history of corruption, and some applauded the news that the authorities appeared to be prepared to act decisively against it. But as the FT editorial put it, “ this purge looks to be primarily about the crown prince consolidating his power.” One reason for him to want to strengthen his position is that he has started making some tentative but still controversial social reforms, including allowing women to drive and re-opening cinemas after a 35-year ban.
On the economic front, meanwhile, the crown prince hosted a conference for international investors dubbed “Davos in the desert”, launched a plan for a futuristic new city intended to attract $500bn of investment, and pressed ahead with plans for an IPO of Saudi Aramco, scheduled for next year. In between all that, he also found time to buy the world’s most expensive house, and possibly the world’s most expensive painting, too. (Although the story of who actually bought ‘Salvator Mundi’, and why, is somewhat mysterious.) The end point of all this change is uncertain. Saudi Arabia has remained stable by balancing competing interests, and Prince Mohammed has disturbed that equilibrium. History shows that authoritarian regimes can be at their most vulnerable when they try to make changes. But given the demographics of Saudi Arabia’s youthful population, and the long-term threat to its oil revenues from alternative energy, trying just to maintain the status quo forever does not look like a viable option. Prince Mohammed has set off on a risky course, but the dangers in his other possible routes may have been even worse.
3) Bringing back coal in the US is easier said than done...
On the campaign trail, the promise to “bring back coal” was one of President Donald Trump’s favourite themes. It was a slogan that served several purposes: as an attack to hurl at Barack Obama and Hillary Clinton, as a symbol of the kind of economy that Mr Trump wanted to revive, and as a direct vote-winner in the coal-producing states of Pennsylvania and Ohio. Mrs Clinton’s remarkably maladroit presentation of her policies for coal regions, appearing at one point to be eager to put miners out of work, was also a gift to Mr Trump’s campaign. He told a simple story about how Mr Obama was waging a “war on coal” with his policies to address the threat of climate change, and once the deathly grip of Washington was broken, the mines would come roaring back to life. As the past year has proved, that story was mostly a fairytale. As a study for Mr Trump’s own energy department concluded in the summer, the real war on coal was being fought — and won — by natural gas, which is a cheaper and cleaner fuel for power generation. The Clean Power Plan, the main set of regulations that Mr Obama proposed for addressing climate change, had not yet come into effect, having been stalled by the Supreme Court. Scrapping those regulations, as the Trump administration intends, may slow the decline of coal-fired power in the US, but cannot bring back the jobs that have been lost.

The US coal industry has picked up this year, but that has been the result of the rebound in China’s consumption and a rise in US gas prices making coal-fired power somewhat more competitive again. And the recovery has been modest: US coal production this year will be about 9 per cent higher than last year, but is set to drop back again in 2018, according to the Energy Information Administration. Just 1,200 new coal mining jobs have been created since last year’s election, an increase of 2 per cent. The administration has now moved on from its belief that simply removing anti-coal regulations would bring the industry back, and has realised that it will have to impose pro-coal regulations in electricity markets to make a significant difference. The debate about those plans now going on at the Federal Energy Regulatory Commission will be one of the big issues to watch in US energy next year.
4) ...But getting off coal in China is tricky, too
As China’s coal consumption rebounded earlier this year, after three consecutive years of decline, cynics were quick to argue that it showed the government’s professed commitment to curbing local air pollution and greenhouse gas emissions was mostly a sham. In the past few months China’s government has given the lie to that criticism, making a determined attempt to shift homes in some of its most polluted regions away from coal and towards gas for heating. The difficulties that have been thrown up by this initiative, however, have been a reminder of just how dependent China is on coal, and how great an effort is required to break that dependence.

There have been shortages of gas for industry and reports of people freezing in their homes. Some of the restrictions on coal use had to be relaxed, and gas companies have been using desperate measures to increase supply to the regions that need it. China’s imports of LNG have soared, creating a bonanza for suppliers to Asian markets. The message for the world hoping to see China curb its emissions is mixed: the government’s determination to address its problems is real, but so is the scale of the challenge. Meanwhile, another trend to watch is surging coal demand in southeast Asia.

5) It is the private sector that is leading the way in decarbonising energy

The past month has brought a flurry of eye-catching announcements from governments about their plans to tackle climate change, from the initiative led by Britain and Canada for developed countries to stop using coal for power generation by 2030, to New York state’s plan to stop its pension fund making new investments in fossil fuel companies. The announcements all generally share a common intent: to send a signal that international action to curb emissions is still making progress, in spite of Mr Trump’s announcement that he plans to withdraw the US from the Paris climate agreement. For all of that governmental activity, though, some of the most consequential moves in terms of changing the world of energy are being made by the private sector. Investors are combining to put pressure on companies to curb emissions.

The plunging cost of renewable energy is making it a competitive option for power generation without subsidies in much of the world. Companies from outside the energy industry, from Apple to Walmart have been investing in renewables, storage and efficiency.  Fossil fuel producers including ExxonMobil and BHP Billiton have been discussing the need to address the threat of climate change, and although you could easily argue that there is a gap between their talk and their actions, the shift in communications in itself is significant. And Elon Musk’s Tesla has offered some ambitious ideas for how electric vehicles and batteries can shake up our energy system. However that company’s story ends up, it has taught some important lessons about the possibilities of the technology and the market.

Finally, you might be interested to see some of the most-clicked stories in Energy Source this year. Our most popular link was to the presentation by Michael Liebreich of Bloomberg New Energy Finance, which he gave at the firm’s summit in London in September. Other sweeping views of the landscape also attracted a lot of interest, including Royal Dutch Shell’s scenarios for modelling future energy trends, and the International Energy Agency’s presentation from June on trends in energy investment. The most-read report was the paper from Sustainable Energy for All on flows of finance  for access to electricity and clean cooking in low-income countries. The Calgary Herald’s excellent history of Alberta’s oil sands was one of the best-read stories from a non-FT news source, along with a Utility Dive story about compressed liquid air energy storage.

Among FT articles, Nick Butler’s blog reliably attracts the most attention, with Charles Clover on electric cars in China and Martin Wolf on climate change also well read. Some of the weirder items have also been very popular, including the monster fatberg blocking a London sewer, which could be a source of biodiesel. And the tenth most-clicked story from the email this year: the “connected cow”.

There will be one more Energy Source before the end of the year, when I will be looking ahead to 2018. Happy holidays!
Another view
Quote of the year
"We are planning to be leaving totally the dependency [on oil] that we have been living for the last 40, 50 years. Hopefully by even 2030, I wouldn't care if the oil price is zero." – Talking to CNN, Mohammed Al-Jadaan, finance minister of Saudi Arabia, set an ambitious goal for the country’s economic reform programme.
Chart of the year
From this year’s World Energy Outlook from the IEA, this shows shifts in energy use, comparing the past 25 years or so to expectations for the next 25. All sources are still expected to grow, but oil by much less than over the past two decades, and coal barely at all. The IEA has repeatedly underestimated the growth of renewable energy in the past, though. Will that prove true again?

Is This The Long-Awaited Gold Break-Out – Or Just Another Paper Market Head Fake? 

That was fun. Since mid-December gold has behaved like a tech stock, jumping from $1,240/oz to $1,337 and carrying a long list of gold mining stocks along for the ride.

Now everybody’s asking the same question: Is this finally the start of the long-overdue run at gold’s (and silver’s) 2011 record high, or just a case of futures speculators once again panic-buying themselves into an untenable long position, only to be fleeced by the big banks that dominate the paper markets?

The commitment of traders (COT) report is not encouraging. In the current rally, the speculators (who are, remember, usually wrong at big turning points) have jumped back in with both feet and are now enthusiastically long while the commercials (usually right at big turning points) are once again aggressively short.

The next chart shows this visually. When the two columns converge, that’s bullish for gold.

When they diverge that’s bearish. Favorable conditions of early December have quickly morphed back to bearish.

Looking at just this one indicator, it would be reasonable to assume that gold’s all-too-brief run is about to end. But on the other side of this equation is the certainty that physical demand will eventually swamp these paper games and send gold and silver up in a bitcoin-worthy arc to their intrinsic values of $5,000/oz and $100/oz, respectively.

Therein lies the gold-bug’s dilemma. Precious metals will bounce around aimlessly – until they don’t – but the phase change won’t be obvious until after the fact. With that in mind, here are three possible approaches:
  • Avoid this asset class until a sustained uptrend is clearly established. That means waiting for, say, $1,500/oz before jumping in. So you give up a few hundred dollars an ounce in return for avoiding the pointless back-and-forth, but in the end still triple your money. Not bad.
  • Keep adding a little at a time. Each month buy a few silver coins or a few more gold mining shares and tune out the noise (such as this article), safe in the knowledge that eventually the dysfunctional global monetary system will come undone and capital will pour into the relative handful of safe haven assets like gold and silver, making the highs and lows of the before-times completely irrelevant. This is the best way to deal with incomplete knowledge of the future, and is therefore what most people should do.
  • Assume that this is it — that the current uptrend will soon go parabolic — and jump into precious metals with both feet. If it works, it’s one of those life-changing bets that everyone wishes they had the guts to make. If not, well, at least the downside is limited at this point.

The longer this goes on, the more attractive the third option becomes.


Intangible assets are changing investment

Forecasting profits is not as helpful as it used to be

WHEN you work as an equity analyst at an investment bank, your task is clear. It is to comb all the statements made by corporate executives, to scour the industry trends and arrive at an accurate forecast of the company’s profits. Achieve this and your clients will be happy and your bonus cheque will have many digits.

But is all this effort worthwhile? Not as much as it used to be, according to Feng Gu and Baruch Lev, writing in a recent issue of Financial Analysts Journal*. The authors imagined that investors could perfectly forecast the next quarter’s earnings for all companies. They then assumed that investors bought all the stocks that they expected to meet or beat the consensus of analysts’ forecasts; and that investors could short (ie, bet on a declining price) the stocks of those that were predicted not to reach their estimates. They made their investment two months before the end of a quarterly reporting period and got out of their positions one month after the quarter ended (by which time the earnings have been reported).

In the late 1980s and 1990s, this would have been a highly successful strategy, achieving excess returns (over those achieved by stocks of similar size) of 4% or more every quarter. But these abnormal returns have dropped: in recent years they have been only 2% a quarter. A similar effect appeared when examining the returns that would have been achieved by perfectly predicting those companies that achieved annual earnings growth.

Although an excess return of 2% a quarter would still be highly attractive, it would require a perfect forecasting record. That suggests the number-crunching performed by fallible analysts and investors produces much lower returns.

The intriguing question is why those returns have been falling. The authors argue that the decline is because of the rising importance of intangible investments in recent decades (in areas such as software or trademark development). Such investment may be a big driver of value growth.

Accountants have struggled to adapt. If a company buys an intangible asset, such as a patent, from another business, it is classed as an asset on the balance-sheet. But if they develop an intangible within the business, that is classed as an expense, and thus deducted from profits. As the authors note: “A company pursuing an innovation strategy based on acquisitions will appear more profitable and asset-rich than a similar enterprise developing its innovations internally.”

As a result, the authors argue, reported earnings are no longer such a good measure of a company’s profits, and thus may not be a useful guide to future share performance. To test this proposition, they divided companies into five quintiles based on their intangible investment. Sure enough, the more companies spent on intangibles, the lower the excess return available to those who correctly forecast the earnings.

The paper’s message echoes the themes of a new book** by Jonathan Haskel and Stian Westlake, which explores the impact of the growing importance of intangible assets in modern economies. The book finds a link between the poor productivity record of many leading economies since the crisis of 2008, and the sluggish rate of investment in intangible assets since then.

The problem is that intangibles have spillovers. A company may undertake expensive research and development, but the gains may be realised by other businesses. Only a few companies (the likes of Google) can achieve the scale needed to take reliable advantage of their intangible investments. Unlike machines and equipment, intangibles may have limited resale value. So the risks of failure may put businesses off intangible investment.

This is both good news and bad news for investors. On the one hand, it may explain why profits have remained high relative to GDP. In theory, high returns should have attracted a lot more investment and the resulting competition should have driven down profits. But the difficulty in exploiting intangibles may have prevented that. On the other hand, the reluctance of many businesses to invest in intangibles may restrict their scope for growth in future. Investors looking for growth stocks will face a restricted choice and such companies will be so apparent to everyone that they will command a very high valuation. Not so much the “nifty fifty” stocks that were fashionable in the early 1970s, as the nifty five or six.

* “Time to Change Your Investment Model”, Financial Analysts Journal, Vol 73, number 4

** “Capitalism without Capital: The Rise of the Intangible Economy”, published by Princeton University Press