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Where We Stand

Where we Stand

In 2008, the economic crash that I had been warning about for years and that had been predicted in stark detail in my 2007 book Crash Proof, finally began in earnest. In many speeches and media appearances in 2006 and 2007 I laid out the reasons why the crisis was inevitable. More importantly, I forecast the policy mistakes that the government would make in its aftermath.

For a while, at least, the illusion looked real. The surge in real estate prices made possible by non-existent underwriting standards, the wave of mortgage securitizations and, most importantly, by the ultra-low interest rates provided by the Federal Reserve (and the regulatory incentives provided by Federal housing programs), had convinced economists and investors that rising home prices would lead to permanent prosperity. But when the tide rolled out, millions of home borrowers defaulted on their mortgages, sparking a credit crisis that threatened the country's entire financial edifice. The panic and uncertainty led to a crash on Wall Street and a near doubling in the unemployment rate from 5% to 9.5% by mid-2009. In short, the nation found itself in the most severe economic crisis since the Great Depression.

In order to prevent the economy from spiraling further downward, the Federal Government and the Federal Reserve unleashed a series of unprecedented financial and economic measures. While those steps were actively debated at the time, they are now widely considered by economists to have been necessary. We disagreed then and we disagree now.

By 2010 the fury of the storm had apparently passed. And although most economists have celebrated the turning of the page, after four years of "recovery" the United States has not nearly returned to the semblance of economic health that it had shown before the Great Recession began. By many measures, we are worse off. According to the Bureau of Labor Statistics, in 2014 fewer Americans are working than in 2007 (many that still are have settled for lower-paying, part-time jobs), wages haven't kept pace with inflation, and real purchasing power is down. Americans seem to have come to accept that the glory days of the American economic miracle have passed.

But amidst the economic stagnation for the middle and lower income classes, there has been an apparent miracle of wealth creation and asset price gains for the wealthy. We see this as a sign that our economy remains fundamentally unhealthy and unstable.

Euro Pacific Capital does not construe the appearance of health with actual health. We see our current economy as a one-way experiment in monetary and fiscal stimulation that will end badly. We know that our economy is now addicted to cheap money, zero percent interest rates, and a backstop of Federal Reserve support. We are convinced that can't last forever and we are preparing investors for this eventuality. This does not mean that we advise Americans to avoid the stock market. To the contrary, we believe that the market offers one of the few pathways that may allow savers to preserve and expand their wealth in the times that we see ahead.

The governmental response to the last crisis has proven that the authorities will do anything and everything to keep asset prices from falling. This idea was not as widely accepted before the 2008 crash. Unlike the pre-crash era, the Fed's asset price protection arsenal is now more clearly defined and available to be deployed at a moment's notice. New Fed leadership under Janet Yellen is likely to be even more supportive than her predecessors under Ben Bernanke. So we do not expect a stock market crash like we had in 2008.

But while the Fed may be able to keep a floor under asset prices through additional floods of liquidity, it can only do so by debasing the dollar in the process. Americans unfortunately have become fixated on the nominal value of their assets and have forgotten that U.S. assets are priced in dollars, which we believe will become increasingly less valuable as a result of limitless debt and stimulus.

Over the last few years the level of support that the dollar has required from foreign governments has increased. If that support were removed, the dollar could have a very uncertain future. So while the current increases in stock and real estate prices may likely continue, albeit at a slower pace, the real value of these assets could fall if the U.S. dollar loses international support.

We believe that the next great economic realignment will occur when the world's creditor nations finally fully enjoy the fruits of their labor and the world's debtor nations suffer from their profligacy. The mechanism by which this change would occur will be a realignment of currency values. Although the fact is often ignored by mainstream analysts, an investment is only as good as the currency in which it is based.

As such, we believe American investors, for whom it is suitable, should seek greater non-dollar diversification. We continue to take comfort in the value and income we find overseas, and we prefer countries that are embracing free market capitalism and rejecting the socialist ideas that are gaining traction in Washington. We choose to invest in countries that do not follow the U.S. example of growth through debt. More importantly, we believe capital should go where it is treated best. That means we have a preference for countries with low taxes and a respect for corporations and shareholders.

The U.S. Economy

The U.S. economy has been so bad for so long that we believe most analysts have simply forgotten what real economic health looks like. Instead, they construe meaningless and manipulated statistics as evidence of strength. They believe that high asset prices (stocks, bonds, and real estate) are the fuel for a strong economy, and not the result of it. Consequently, they fully embrace any policy that looks to push up asset prices. Inflation used to be a bad word, now it's a prayer.

When President Obama took office at the end of 2008, the national debt stood at about $10 trillion. Just five years later it stands at a staggering $17.6 trillion. The raw increase is roughly equivalent to all the Federal debt accumulated up to 2004. This new debt equates to more than $22,500 for every living American. That is a staggering rate of increase. At the same time, the Federal Reserve has held short-term interest rates at "zero" since the end of 2008. In addition, through a multi-year "Quantitative Easing" program, the Federal Reserve has taken on more than three and a half trillion in new assets on its balance sheet. And despite the much heralded "taper", it continues to accumulate assets at an alarming pace.

According to the CBO, between 2009 and 2012, the U.S. Government posted four years of consecutive $1 trillion plus budget deficits. And although the annual red ink has since fallen below that level, most independent observers see deficits getting much worse over the medium to long term. But despite the clear and present danger, Washington has done nothing substantial to put the country on a more sustainable fiscal path. This has obliged the United States to borrow on the global stage. For now at least, the rest of the world seems obliged to lend. They have done so in an irrational attempt to prevent their currencies from rising against the dollar. However, we do not think these patterns can last. We work to prepare accordingly.

We believe that zero percent interest rates and new debt have been the main drivers in the formation of new bubbles in stocks, bonds and real estate. The wealth effect they create has lent the country the semblance of health. But these high asset prices remain vulnerable to higher interest rates.

These policies have locked in place the debt-fueled growth model that got us into trouble in the first place and have prevented a dynamic and sustainable economy from taking its place. As a result, the United States has lost a good portion of the well-paying middle class jobs that used to be the hallmark of our prosperity. (This is why almost all the income gains since the official end of the recession have gone to the top 1%. President Obama can point as many accusatory fingers as he wants, but we believe his policies are largely responsible for the widening income inequality.)

Yet somehow the mainstream believes that the Federal Reserve can end its stimulation, reduce the size of its balance sheet, and raise interest rates from zero without collapsing asset prices and bringing on the kind of contraction that the policies interrupted six years ago. We believe this to be wishful thinking.

The Global Economy

The period since the Crash of 2008 has become an era of intense cooperation between the world's central banks. The Federal Reserve, the European Central Bank, the Bank of England and the Bank of Japan have shown a tremendous willingness to coordinate policy in order to maintain relative currency valuations and to keep the U.S. dollar from falling. Over that time, foreign entities (primarily central banks) have purchased trillions of dollars of U.S. government debt. This has created an international "currency war" in which countries compete to destroy their currencies the fastest. We believe this will ultimately lead to a complete loss of confidence in a system of fiat paper money, and will set the stage for a fundamental reorganization of the world's monetary system.

The mainstream believes that American spending is the prime mover of the global economy. That's why they argue that a slowdown in the U.S. economy will be felt more keenly abroad, especially in the emerging markets that export goods to America. But spending without production creates the cul-de-sac of debt that we have driven into. Sustainable economies look very different. They finance production with savings and consumption with production.

Marketplace freedom is the best means to create prosperity, and on that score the United States is falling behind. For the past 20 years, The Heritage Foundation has published annual global rankings of the "Index of Economic Freedom." In its first report in 1995, the United States ranked #4 among the nearly 180 countries analyzed, and ranked #5 as late as 2008. After declining for the last five consecutive years, in 2014 the U.S. ranks #12. This should be taken as a clear sign that our leadership is moving the country in the wrong direction. We target countries that are much higher on that list. We believe those markets are better prepared to outperform the United States over the long term.

Europe

In our opinion the developed European nations remain problematic investment targets. Both the flawed structure of the European Union, the socialistic tendencies of the major European governments, and the challenging demographics of the population present headwinds to investors. However, we see Europe as fundamentally healthier than the United States. That's because the federal nature of its monetary union prevents individual countries from the outright debt monetization that is being practiced by the Federal Reserve. The economy of the EU currently is largely driven by Germany, which we view as far more fundamentally sound than the United States. The Germans still believe in balanced budgets, balanced trade, and high savings.

But the flaws of the common currency convince us to look in Europe outside the EU. This can be done in countries such as Sweden, Norway, Finland, Switzerland and select eastern European countries.

Asia

We believe that the rise of China, and to a lesser extent India, will continue to be the dominant theme in the global economy for years to come. While many U.S.-centric analysts point to slowing growth in China, we continue to be impressed by the better than 7% annualized growth rates that the country has been reporting. In 2014, China continued to report record trade surpluses. Although we are aware of China's deep political shortcomings, we believe that its economy right now is in many ways more hospitable to entrepreneurism than the United States. And while it is difficult, and often problematic, to invest directly in China or India, we tend to prefer the developed or developing Asian economies, such as Singapore, Thailand, South Korea, Vietnam, the Philippines, Indonesia, Malaysia, and Hong Kong.

At the same time, we continue to be deeply critical of the current drift of the Japanese economy under Prime Minister Shinzo Abe. Abe has embraced all the misguided economic doctrines of the Keynesian playbook, and he is endeavoring to print Japan back into prosperity. We believe these policies will ruin whatever economic vitality remains in Japan.

Resource Economics

We believe that in a world awash in debased currencies, the natural resources and commodities that fuel the industrialized world will continue to retain real value. As a result, we believe that companies that make money by producing commodities will provide investors with some protection against the ravages of inflation. We also place particular focus on those "resource economies" that show respect for the interests of investors, that have low political risks, low debt, and responsible monetary policy. These nations include Australia, New Zealand, Canada, Norway, and Sweden.

Emerging Markets

While we remain bullish on the overall prospects of emerging markets in Asia, Eastern Europe and Latin America, we believe that investments there inherently involve higher risk and should be the province of more speculative investors who can handle the volatility.

U.S. Dollar

Since 2008 the dollar has traded in a fairly tight range. We believe that this results from ongoing and sustained dollar purchases by foreign central banks. We believe that these purchases result from political rather than investment calculations. Foreign governments have decided that their exports would be hurt if their currencies were to appreciate against the dollar. They are also afraid of the disruptions that could result from freer movements in currency valuations. Absent this support, we believe the dollar would have continued the downward trajectory that it had experienced before the Crash of 2008.

While future financial panics may cause some investors to temporarily run to the dollar as a safe haven asset, we believe that the greenback will lose this appeal as it becomes increasingly more apparent that the Federal Reserve has no credible exit plan to wind down its stimulus, and the Federal Government has no credible plan to bring the deficits under control.

Eventually the forces weighing heavily on the dollar will overwhelm the ability of the world's central banks to support it.

U.S. Stocks

We see many signs that convince us that U.S. stocks are severely overvalued. In 2013, for instance, the S&P 500 returned 29%, its best performance in 16 years. That rally capped a four-year rise that took U.S. stocks up more than 150% from a low seen in March 2009. But unlike past rallies of such magnitude, the surging stock market did not occur alongside a surging economy. From 2009-2013, GDP growth averaged just 1.24% since January, one of the weakest periods on record. Nor were investors likely inspired by productivity growth, which since 2011 has been only half its historic rate. The unjustified surge in stock prices has also brought about another facet of the tech stock bubble, with tenuous social media start-ups commanding wildly excessive valuations.

We believe that the surge is nearly completely a function of Fed stimulus. This bodes poorly for the long-term value prognosis for U.S. stocks. We also believe that much of the gains in earnings per share have resulted from massive share buy-back plans, and do not stem from legitimate top-line revenue growth. Much of the cash currently on corporate balance sheets has been borrowed rather than earned. This leaves U.S. stock prices highly vulnerable to higher interest rates.

While there are certainly strong sectors in the U.S. markets and good U.S. companies worthy of investment, we continue to find much better values, higher dividend payments, better earnings growth, and more sustainable business models abroad. Also, given that interest rates are often higher abroad than they are in the United States, we believe that U.S. stocks would be more vulnerable to price corrections in an environment of rising interest rates.

U.S. Residential Real Estate

We do not believe that the 35% correction in real estate, according to the S&P Case-Shiller Index that occurred from 2007-2012, was sufficient to rebalance the market after the 180% gain that occurred in the prior decade. We believe that monetary and regulatory support from the government cut short the correction before the market could find its true support. As a result, we believe that another leg down in the real estate market is likely. This could make a large impact on the overall economy.

In recent years the Fed has purchased up to 90% of new mortgage loans, which had helped drive 30-year fixed mortgages down to nearly 3% in 2012 and 2013, a level far lower than what was available before the crash. The low rates allowed buyers to bid up the total value of U.S. residential real estate by about $3.5 trillion since the depths of the market in 2011. This has made residential real estate far more dependent on low rates than it has ever been in the past. Even more troubling now is the percentage of homes being purchased by hedge funds and private equity firms. In December of 2013, more than 40% of all U.S. homes were purchased for all cash according to RealtyTrac. This is more than double the historic rate.

In markets like Florida, the figure exceeded 60%. Since Americans' savings rates and incomes are still down, there is little doubt that these all-cash buyers are institutional speculators looking to generate cash flow by renting houses to Americans who can no longer afford to buy. It is no coincidence that homeownership rates are now at generational lows, and that the percentage of homes being purchased by first-time buyers is at a low since 2009.

The end of 2013 and early 2014 provided significant evidence that the current rally in real estate is coming to a close. Institutional investors appear to have slowed their buying substantially. Many of the homes they already own sit vacant. When interest rates rise, and other carrying costs such as taxes, maintenance, and management fees take their toll, these properties may be placed back on the market en masse. 2014 has also shown a sharp downturn in new home construction, and price appreciation has leveled off. Material increases in mortgage rates could be the final straw that initiates another sharp leg down in housing.

Any downturns in housing may come to inflict the same kind of economic damage that occurred in 2007 and 2008. This is why we believe the Federal Reserve will keep the monetary spigots wide open indefinitely.

Bonds

Many investors have come to believe that U.S. Treasury bonds are risk-free investments. But of all markets, we believe that Treasury bonds, and the entire corporate debt structure that it supports, may be the most highly distorted by the Federal Reserve. Since the Crash of 2008, Treasury yields have continued downward into unexplored territory. In mid-2014, 10-year yields dipped below 2.5%. But as with other markets, this has resulted from Federal Reserve intervention. At current valuation, and given the long-term outlook for inflation, we see long-dated U.S. Treasuries as return-free risk, rather than the other way around.

Additionally, the hunger for yield has created distortions in bonds that are not purchased directly by the Fed. In particular, high-yield corporate debt has become an increasingly popular asset class among institutional investors. The interest has pushed yields to record lows and has enticed corporate issuers to load up on debt. Many of these loans carry the same type of generous covenants and easy terms that helped to generate the credit crisis of 2008. Any material increases in interest rates may inflict heavy losses to the corporate debt market and will adversely affect business conditions for issuers.

We counsel our clients to avoid U.S. dollar-denominated debt and instead look for sovereign and corporate debt issued in non-U.S. dollar currencies in stable economies. But given our overall outlook for bonds, we continue to favor shorter maturity debt that will be less sensitive to sudden increases in interest rates. Equities offer better sources of yield in the current environment.

Gold

After 12 consecutive years of price increase, gold saw a significant 30% decline in 2013. Most mainstream analysts considered the drop to mark the end of gold's epic bull run. Many predicted that the improving economy had eliminated the metal's investment appeal and that it would drift steadily lower for years, ultimately falling back to pre-crash levels. In contrast, we see the 2013 sell-off as a correction primarily caused by a fundamental misreading of the strength of the U.S. recovery. We do not expect that gold will fall significantly below the levels seen at the end of 2013. But when it becomes more and more apparent to the mass of investors that the economy remains weak, and that the Fed will not be able to exit from its stimulus, gold may resume its upward trajectory. Many investors who share our concerns are tempted to put all of their wealth into gold or silver. However, we do not believe precious metals should be the dominant asset in a properly diversified portfolio.

Properly speaking, gold is not an investment but a store of value. Although its price may fluctuate in dollar terms from day to day, we believe that there is much greater chance that gold will hold its value over the very long term. In the last 100 years of Fed debasement, the U.S. dollar has lost more than 97% of its value when measured against gold. In that sense, we believe gold qualifies as a better form of long-term cash.

So while we believe people should maintain some exposure to gold bullion, we also believe people should maintain an allocation to equities. Based on our feelings about likely increases in gold prices, we find that sector to be particularly compelling. This is particularly true after the strong 2013 sell-off.