Review of 2010 and Outlook for 2011
— Posted Friday, 31 December 2010
REVIEW OF 2010
2010 was a year that many will be glad to see the back of due to the deepening of the global economic crisis and the ensuing financial and economic hardship visited upon many. Worst hit were the unfortunately named PIGS with Portugal, Spain and particularly Greece and Ireland suffering the wrath of the bond vigilantes, austerity measures and deepening economic crises.
Gold was again one of the top performing assets and currencies as seen in our currency tables in US dollars and euros.
Bond, Stock and Commodity Markets
The belief that central banks controlled interest rates is increasingly doubted and there is a realisation that bond markets are the ultimate arbiter of interest rates globally. Concerns of sovereign defaults in Spain, Portugal, Ireland and Greece saw interest rates surge in these countries. This trend has not abated and recent days have seen interest rates in Greece rise above 12.5% and Ireland above 9%.
Indeed, informed speculation that the AAA rating of the US may come under pressure due to their massive nearly $14 trillion national debt and massive trillion-plus annual budget deficits saw US interest rates rise sharply in the final three months of the year (see chart above). Long term government debt has become far riskier which has important ramifications for prudent asset allocation.
Markets saw considerable volatility, particularly currency markets due to concerns about the dollar, the euro, sterling and the debasement of currencies internationally. The fragile economic recovery and continuing cheap money policies – near 0% interest rates and the latest quantitative easing initiative (QE2) – led to continuing risk appetite but also to growing concerns that inflation is beginning to get a foothold in the global economy. This led to stock markets and commodity markets internationally having positive performances (see chart above and below).
Commodity prices rose gradually in the second half of the year and the Thomson Reuters/ Jeffries CRB rose by 15.4%. Copper was particularly strong – up 28% and oil rose by 6% (NYMEX +6%; BRENT +10%).
Soft commodities and the price of basic foodstuffs such as wheat, corn, and sugar all rose as markets reacted to extreme weather events such as fires in Russia and floods in the US and Pakistan. Wheat prices rose 49pc over the year, corn was up 50pc, soya beans rose 35pc and sugar added 28pc. Cotton prices nearly doubled in the year due to high demand and restricted supply.
While nearly all commodities rose strongly in 2010 and are near record nominal highs – it is very important to realize that these are record nominal highs from more than 30 years ago. This means that the gains may well be sustainable as most commodities remain a fraction of their inflation adjusted price of more than 30 years ago.
The platinum group metals of platinum and palladium were strong. Platinum rose 19.4% to $1746/oz and palladium surged 94.2% to $790/oz. Both remain below their record highs of 2008 and 2001 respectively at $2166.50 and $1110.50/oz.
Gold and Currencies
Sovereign debt, currency debasement and inflation concerns led to continued safe haven demand for gold internationally and to gold recording its 10th consecutive year of rising prices. Gold rose some 28% in US dollar terms, 34.5% in sterling terms and 38% in euro terms and by similar amounts in other major currencies. The strongest currencies in the world in the year were the Japanese yen, Australian dollar and Swiss franc.
This shows how the price of gold is not rising per se rather fiat currencies are losing purchasing power and being devalued internationally. This increases the attraction of precious metals and hard assets that are finite and cannot be debased as inflation hedges – especially gold and more volatile silver.
As we suggested would happen, silver surged in 2010 and rose 81%. However, it remains more than 35% below its nominal high of 1980 at $50/oz (weekly close $49.45/oz – see chart below). The nominal high of 1980 remains a very viable long term price target and should 2011 see a repeat of 2010 then silver will surge past the 1980 high as gold has already done to its 1980 nominal high.
OUTLOOK FOR 2011
Last year we correctly indentified sovereign debt risk particularly in the Eurozone and a real risk to the euro as a reserve currency and to the euro itself as key themes to watch out for in 2010. These risks remain and have actually deepened in the final weeks of 2010.
The outlook for asset class performance in 2011, as ever, depends on what global macroeconomic conditions the world experiences. 2011 will be guided by the fundamental US macroeconomic situation, the outlook for the US dollar, the euro and the international monetary system and the health of China’s economy will also be important. As ever, whether deflation or inflation prevails will be of primary importance.
Other big picture global macroeconomic factors that could become important in 2011 are:
Global Macro – Inflation or Deflation
Crystal ball gazing based on future conditions remains foolish – particularly given the degree of uncertainty with regard to possible deflationary or inflationary global risks.
As ever, the titanic battle between deflationary pressures and inflationary pressures continue. The extent of deflation experienced in most economies has been exaggerated. It is often used by uber- Keynesian economists and governments as an excuse to print and spend money profligately.
Deflation in most western economies has been confined to property markets and consumer purchases such as cars and other expensive consumer items such as electrical appliances etc. Deflation has largely been seen in goods and assets that are debt based or have been purchased using credit. The lack of credit or tightening of credit has led to falling prices. These are healthy and necessary adjustments – as many property markets remain well above their long term average and average house prices remain unaffordable to those on average industrial wages.
The price of essentials such as food and energy have not fallen in recent years and many have risen this year and there are growing inflationary pressures being seen to different degrees in economies internationally.
Should the US and the global economy experience a double dip recession there could come another bout of deflationary pressure particularly in vulnerable property markets. This could lead to weakness in equity and commodity markets which would again contain inflation for a period. However, dollar debasement and international competitive currency devaluations should see commodities remain robust especially given the increasing strong supply demand fundamentals of many commodities.
Global Currency Wars
The initial skirmishes of what is being called a ‘global currency war’ have been seen in 2010. These currency wars involve competitive currency devaluation and currency debasement as governments and central banks internationally devalue their currencies in order to maintain job sustaining export growth and maintain fragile economic recoveries.
The importance of the currency crisis is not realized by much of the media and the man in the street yet. But it is clearly seen in the fact that World Bank President Robert Zoellick reaffirmed his proposal to use gold as a “reference point” to reform the current international monetary system. Senior policy makers are worried about the dollar’s ability to remain a stable reserve currency. Zoellick said a return to some sort of currency link to gold would be “practical and feasible, not radical.” Zoellick’s article in FT came three days after Ben Bernanke’s announcement of QE2.
U.S. Chinese Tensions
Besides the risk of currency wars, there are also geopolitical risks as the relative power of the US and China, lessen and increase respectively.
Yesterday, China’s defense minister says his armed forces are preparing for conflict “in every direction,” and that times of peace should not dissuade the military from readiness. Chinese defense chief Liang Guanglie told state media that over the next five years, “our military will push forward preparations for military conflict in every strategic direction. “We may be living in peaceful times, but we can never forget war, never send the horses south or put the bayonets and guns away,” he said.
His comments come ahead of a visit to China by U.S. Defense Secretary Robert Gates, who is expected to address U.S.-China military relations as tensions flare on the Korean peninsula and Taiwan, a U.S. ally, remains on Beijing’s radar. There is also the delicate issue of Tibet.
While there is little risk of a direct military confrontation between the superpower and emerging superpower, there is a risk of war being waged through proxies and of economic war involving economic protectionism and currency wars.
China’s Increasing Importance to Gold
2010 will be remembered as an important year in the process of China becoming a dominant economic power and it was also the year that China’s growing importance to the gold market was realized.
Gold is deeply rooted in the psyche of the Chinese people. Gold is considered a symbol of prosperity and good fortune in China and a means to increase and preserve one’s family’s wealth through the generations. This comes from a powerful mix of cultural, social and economic associations. Gold’s importance has been augmented by the country’s experience of totalitarian government.
Just this month came news that China should consider adding to its gold reserves as a long-term strategy to pave the way for the yuan’s internationalization. So wrote central bank adviser Xia Bin in the influential China Business News. Premier Wen Jiabao said in March he is “worried” about holdings of assets denominated in the greenback. The country must revise its foreign-reserves management principle, Xia wrote.
Building gold as the basis of solvency has been used through history, PBOC adviser Xia wrote. Having a corresponding amount of solvency is a necessary precondition and indispensible safeguard in the long-term strategy for the internationalization of the yuan, Xia wrote. China should raise its gold holdings and the 1,054 tons of reserves are inadequate compared with the 8,133 tons held by the U.S. and 3,408 tons by Germany, Meng Qingfa, a researcher at the China Chamber of International Commerce said in October.
China is the world’s largest producer and second-biggest user of gold and has a world-record $2.65 trillion in foreign-exchange reserves. Gold accounts for only 1.6 percent of the nation’s reserves held by the People’s Bank of China, according to the World Gold Council. The country increased gold reserves by 454 tons to 1,054 tons since 2003, the State Administration of Foreign Exchange said last April.
Thirty years ago China held 95% of its foreign reserves in gold. China’s gold reserve of only 1.6% of total reserves is a figure well below the average minimum 3%-5% adopted in many other countries. China with an estimated gold reserve of 1,054 tonnes has a fraction of that believed held in the U.S. and many analysts believe that China will gradually try to increase its reserves to the levels held by the U.S.
It is often forgotten that the Chinese gold market was only reopened in 2002. That was the first time in over 50 years (since 1949) that Chinese individuals could buy gold in either jewellery or bullion format.
According to the World Gold Council China’s per capita consumption of gold remains the lowest amongst the emerging Asian economies. For China to consume as much gold as say India, which many observers believe likely over the long term, consumption would need to rise by some 250%.
In China, consumer price inflation is now running at 5.5% (according to official statistics) and yet deposits only yield some 2.5%. Until real interest rates offer Chinese savers a real yield and are not negative, Chinese demand will remain strong.
Increasing Sovereign Risk
Jitters abound in government debt markets about the massive issuance of government debt in 2011 – starting in January 2011. Dubai, Greece and more recently Ireland have been the first sovereign casualties and there is a growing risk of contagion particularly in the Eurozone. Besides Greece and Ireland there are many other countries in the EU facing possible sovereign debt crisis – including Portugal, Spain, Italy and Belgium.
Contagion remains the real concern and there is a real risk that these periphery economies are canaries in the coalmines and herald coming problems for larger industrial nations such as Germany, Japan, China, the UK and the U.S. So far their markets and economies have maintained fragile economic growth and their bond markets have not suffered the sell offs seen in the weaker Eurozone nations.
Unfortunately, there are many more countries with poor and deteriorating public finances – including some of the leading AAA rated industrialized nations – with even the possibility of downgrading of the sovereign debt of Japan, France, the UK and the U.S.
Should this happen long term interest rates would likely rise from the unsustainable record low levels seen today.
Rising Interest Rates
The prospect of a possible rise in interest rates in the second half of 2011 is quite real. This may be necessary to protect the value of the dollar and other fiat currencies and contain inflationary pressures that are emerging.
The markets have become addicted to cheap money and eliminating this dangerous narcotic may cause serious withdrawal symptoms with obvious ramifications for already vulnerable residential and commercial property markets.
European Economies and the Euro
The Euro looks set to experience its first major challenge as increasing Eurozone debt and sovereign default risk (Greece etc.) could see the single currency come under pressure. There are some who would welcome a fall in the value of the euro so that European economies can compete for exports with the UK, the US, Asian and economies internationally. However, there is a risk of a disorderly adjustment and a currency crisis. Hopes that the Euro would supplant the dollar as the global reserve currency are gone.
Falling commercial property prices and yields and the huge liabilities in this sector (particularly in the UK and US) continue to pose real risks. This could easily lead to the next phase 0f the global financial crisis and could pose a risk as great, if not greater, than that of the subprime meltdown, and poses real risks to many banks solvency which could lead to further credit and systemic risk.
US Economy and US Consumer
As ever the strength of the US economy will be important to the global economy and the performance of asset classes. The US economy remains highly dependent on the buying habits of the pressured US consumer who remains heavily indebted.
2011 could be the year when the Chinese economic miracle comes into question. Is the massive economic growth in China real and sustainable or based on bogus and adjusted economic statistics and cheap money and stimulus? Some question the ability of the Chinese authorities to manage an economic contraction similar to those faced by many western economies.
Geopolitical risk from terrorism and war remains high with Taiwan, Venezuela, Afghanistan, Pakistan, Israel and Iran and the Koreas some of the potential flashpoints.
BLACK SWANS IN 2011 AND 2012
War in Middle East – Global Flu Pandemic – Large Volcanic Eruption – European Sovereign Default – Crack Up Boom and Hyperinflation
War in the Middle East
Tensions between Iran and Israel and the U.S. could lead to a military incident (akin to the recent flare up on the Korean peninsula) that degenerates into a regional conflict in the Middle East.
Just this week the US imposed new sanctions against Iran, in a move that highlights Washington’s drive to keep pressure on the Islamic Republic ahead of a new round of negotiations with Tehran in January 2011. The recent announcement by the Treasury department shows how the US is now using sanctions to affect Iran’s overall economy.
Yesterday, the FT reported that US officials are worried Iran could use new technology in coming months that would shorten the time needed to reach nuclear weapon status and reduce the scope for diplomacy. Washington says it is concerned that Tehran might deploy a new generation of centrifuges to enrich uranium, a process that can yield nuclear fuel and weapons-grade material.
Conflict with Iran would likely involve both Israel and the US and could lead to a wider conflagration in the Middle East that involves Lebanon, Syria and other countries. Oil prices would rise very sharply due to the closure of the vital Straits of Hormuz which could lead to a new oil crisis akin to the one seen in the 1970’s.
Global Flu Pandemic
Much of the public and many investment professionals have become somewhat cynical regarding the threat posed by a flu pandemic. After much somewhat hysterical reporting there is an element of the “boy who cried wolf”. The risk is that at some stage a flu virus will actually mutate and governments and pharmaceutical companies may not be able to respond in time to a real pandemic.
Just this last week, Northern hemisphere countries were told by health experts to brace themselves for flu outbreaks. There has been a surge of cases in the UK during December with swine flu appearing to be the dominant of the three strains circulating. The European Centre for Disease Prevention and Control warned much of the rest of Europe was also beginning to see increases too. Meanwhile, parts of the US and Canada have reported higher levels of swine flu.
A real pandemic would involve thousands of deaths and could see travel restrictions and quarantine measures. This would likely severely impact the already fragile global economic recovery.
Large Volcanic Eruption
The volcano in Iceland led to wide scale travel disruption in Europe this year. But volcanologists warn that the planet is due another major volcanic eruption. Such a volcanic eruption could lead to a longer period of travel chaos and negatively impact the global economy. Not to mention the risk that it could lead to a very severe and prolonged cold spell which would lead to much higher food and energy prices.
The record-breaking cold snap that brought chaos the UK and Ireland and much of Northern Europe this month was mild compared to the brutal winter experienced in Northern Europe from 1739 to 1741. In Ireland, it killed more than a third of the population. The mini “Ice Age” remains the longest period of extreme cold in modern European history. It is difficult to be categoric about the extremely complex science of meteorology but some believe that the Arctic winters may have come about after a major volcanic eruption in the Kamchatka peninsula in Russia led to the upper atmosphere being suffocated with tens of thousands of tonnes of volcanic dust.
It wreaked devastation across much of Europe and especially Ireland which experienced food riots, famine and epidemics. The mini ‘Ice Age’ is now seen as the last serious cold period at the end of the Little Ice Age between 1400–1800.
Crack Up Boom and Hyperinflation
Extremely loose monetary and fiscal policies and quantitative easing have the potential to cause what the Austrian economist Ludwig Von Mises called a “crack up boom”.
“The credit expansion boom is built on the sands of banknotes and deposits. It must collapse. If the credit expansion is not stopped in time, the boom turns into the crack-up boom; the flight into real values begins, and the whole monetary system founders. Continuous inflation (credit expansion) must finally end in the crack-up boom and the complete breakdown of the currency system.
Should the dollar and other debt laden currencies and government bonds fall sharply in value due to a panic and wholesale liquidation we could experience hyperinflation. In this scenario paper assets will be shunned and people will protect themselves by buying hard assets such as real estate, commodities and gold and silver bullion.
In such a scenario, gold and silver surge would quickly reach their inflation adjusted 1980 high of $2,300/oz and $130/oz before overshooting to much higher levels as was seen in Weimar Germany and more recently in Zimbabwe.
It has never been more important for investors and savers internationally to have diversified portfolios. Lack of diversification and being overweight equities and property and the use of leverage and speculation led to much wealth destruction in recent years.
Today, many investors and savers are overweight cash deposits and long term government bonds and this lack of diversification may also be seen as imprudent in the coming years.
It is important to acknowledge the risks posed to the euro due to potential sovereign default and to the dollar, sterling and other currencies due to currency devaluations and debasement. Loose monetary and fiscal policies internationally mean that gold is likely to again perform strongly in 2011 and therefore merits an allocation in the majority of portfolios.
Many savers concerned about their savings and the risks posed by the depreciation of fiat currencies are diversifying into gold and silver. Gold is increasingly being seen as a currency and not as a commodity and this is why the largest buyers of gold today are central banks in China, India, Saudi Arabia, Russia and internationally. This trend is not going to go away anytime soon and looks set to continue into 2011 and until at least 2012.
Given the variety of macroeconomic risks in the world today, owning a genuinely diversified portfolio passively which includes international equities, international bonds (high credit; short dated) cash and gold has never been more important.
Undiversified savings and investment portfolios, unsafe counterparties, leverage, attempting to time markets and speculation should as ever be avoided.
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