By: Peter Schiff, President & Chief Global Strategist
Euro Pacific Capital

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In a commentary about a month ago, I described how the economic world seemed to be drifting into two opposing camps: the Washington-based “Stimulators,” who insist that more government debt is the best means to end the financial crisis, and the Berlin- and London-based “Austerians,” who argue that debt is the crisis itself. If recent economic data and currency movements can be considered votes of confidence, then the Stimulators should be sweating. Moreover, these recent signals should provide economic analysts and investors with a road map for the future. 

To start, the latest economic news for the US has been bleak. Although 2Q GDP figures show the economy to be “expanding” by 2.4%, the pace is little more than half the average rate over the previous two quarters. What’s worse, US debt levels are expanding faster than GDP.

As everyone with a credit card knows, it’s easy to expand spending if you charge it. But even this borrowed growth has failed to make a meaningful dent in persistent US unemployment. The just-released July payroll report shows the American economy shed another 131 thousand jobs, marking three full years of private sector layoffs.

Almost lost in the news is the disappointing reversal of US trade flows, which in May unexpectedly widened to the highest level in 18 months. In other words, the weaknesses that pushed our economy into crisis in the first place show no sign of abating.    

In countries which have decided that further government economic stimulation will produce more harm than good, the story is markedly different.

Spurred by robust exports and strong corporate earnings, the German economy is experiencing a bona fide recovery. This comes despite stringent fiscal moves by the anxious German government. Unemployment there has fallen back to almost pre-crisis levels.

In China, 2Q GDP figures show that the country has likely passed Japan to become the world’s second largest economy. Strong earnings and stock market performance seem to confirm that China’s efforts to rein in debt have been effective.

Meanwhile, just this week, the Stimulators in Washington got some moral support from St. Louis Federal Reserve President James Bullard, who was formerly known as a monetary hawk. Bullard issued warnings that unforeseen “negative shocks” could lead to an inescapable deflationary quagmire. In such a scenario, warned Bullard, the Fed must be willing to buy up to $2 trillion of government debt in a process academically known as “quantitative easing” – and popularly known as “money printing.” 

With the monetary cards now so clearly on the table, currency traders have placed their bets, and the smart money is quickly running away from the greenback. If current trends hold, we are facing an eighth consecutive weekly decline in the Dollar Index.

This week the Japanese Yen hit a fifteen-year high, with the dollar now buying fewer than 86 yen. The yen is up more than 10% since the beginning of May. The euro, after being written off for dead in the days of the Greek currency crisis, has staged a similar rally, and is now up 11% from its June lows.

As a result of the falling dollar, the commodities market has reignited.

Gold has rallied 2.5% in the last week, after declining 6.5% in July (a pullback that had some pundits loudly chortling about the popping of the “gold bubble”).

But the oil market holds far more near-term significance. On Monday, oil busted through the $80 price ceiling that had held since May. Any additional breaks to the upside would be extremely significant and could potentially send crude up to the mid-$90s before another correction takes hold. The danger for the dollar is that rising oil prices could be considered one of the unforeseen “negative shocks” of which Fed President Bullard warns, triggering a new round of inflation.

If the government fears the “recovery” will be derailed by higher energy prices, then look for quantitative easing to become the driving force of our economic policy. The Fed will perversely argue that rising oil prices are deflationary, as they will cause cash-strapped consumers to reduce spending on other goods. In reality, higher oil prices are merely evidence of the inflation the Fed itself has been creating. Instead of solving our problems, quantitative easing could tip the dollar into a death spiral.

The only thing that could prevent a devastating decline in the dollar at that point would be foreign intervention from the Chinese. But given that China is already slowly but steadily reducing its purchases of US Treasuries, it is likely not interested in playing crutch to the US forever.

Investors who are aware of these developing trends have an opportunity to position their assets accordingly. The current issue of the Global Investor takes a look at economic developments in China and Canada, and gives overviews of two companies we think have great potential in this changing world. The esteemed John Browne also provides some thoughts on the just-passed Financial Regulation law. I hope you find this issue informative and thought-provoking. As always, Euro Pacific Investment Consultants are ready to answer any questions you may have at (800) 727-7922 (U.S.A) or 1-888-216-9779 (CA).

 

China Can Deal With Its Asset Bubble
By: Russell E. Hoss, CFA, Portfolio Manager
Euro Pacific Halter China Fund (EPHCX)

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Although most other countries would have envied the economic indicators coming from China in the first half of 2010, the results were nevertheless disappointing given high investor expectations. Growth was slowing, inflation rising, and monetary policy became more restrictive. These factors pressured China’s equity markets. Global risk aversion, driven primarily by the European sovereign debt crisis, further pressured Chinese stocks. As a result, the Shanghai Composite was down 26% in the first half of 2010– making it one of the worst performing markets in the world. 

Many prominent market commentators have since suggested that China’s debt levels may pose an increased risk to the overall economy. These headline-grabbing reports have been widely echoed in the financial media and have grabbed the attention of investors, many of whom well remember how debt crises can ravage stocks. 

For those investors who believe that China will be the dominant economic player on the world stage for years to come, and who have structured their portfolios accordingly, this issue does not merely make for interesting cocktail party conversation; it’s a matter of utmost financial importance.

While China’s economy isn’t without a number of complex challenges, we don’t see a credit-induced asset bubble that is ready to burst. Instead, we see an economy that has rapidly emerged from the global recession of 2008 and is now transforming itself from an investment- and export-driven economy to a more balanced model, whereby services and consumption account for a larger portion of gross domestic product. The transition will not be without volatility, but some shocks are the unavoidable growing pains of a strengthening economy. 

Most of the predictions of the impending bubble bursting in China are derived from the massive credit expansion that began in late 2008. When global liquidity dried up due to the failing financial system in the US in the fall of 2008, the Chinese government announced a massive US$586 billion stimulus package to help break the negative feedback loop that had seized world markets. Subsequently, in late November 2008, the Shanghai Composite reached a bottom at 1,665.

Much of the Chinese stimulus was earmarked for infrastructure spending. In total, Chinese banks lent 9.6 trillion yuan ($1.4 trillion US) in 2009, compared to 4.2 trillion yuan ($620 billion US) in 2008– a significant and unsustainable increase. Meanwhile, because Chinese municipalities cannot borrow directly from banks, local government financing platforms (LGFPs) were created to borrow from banks and disburse funds for local infrastructure projects. Unfortunately, local municipality financial statements are not publicly available, which prompted speculation that the LGFP debt might be as high as 11-12 trillion yuan. Recently, China’s banking regulator said these outstanding loans were 7.38 trillion yuan at the end of 2009. Although less than many of the previous estimates, these debt levels are 70% higher than those in 2008, which has reinforced investor concerns about non-performing loans. 

We believe there are two key characteristics of the Chinese financial system that should be addressed when assessing China’s credit expansion. 

First, Chinese capital markets are still relatively simple compared to other developed markets. Because of the simple structure, Chinese banks and LGFPs act as the primary financial intermediaries, rather than bond or equity markets. According to CEIC and Morgan Stanley Research, in the US, over 60% of financial intermediation is completed through the bond market and over 20% through the equity market, versus only 5% and 10% respectively in China. In other words, China doesn’t rely on capital markets for funding but rather relies on its own commercial banking system. Because the structure of their capital systems are so different, a direct comparison between the US and China is misleading. 

Second, Chinese external debt levels are less than 10% of GDP– one of the lowest levels in the world. Typically, high levels of external debt lead to sovereign debt crises because governments can’t control currency exchange rates or international interest rates. Because China has run such a large trade surplus for so many years, its external debt is negligible when compared to its reserves. 

On the other hand, domestic debt levels can still be problematic if not managed properly, particularly if assets are too small or illiquid relative to liabilities. Fortunately, in China, government assets are larger than any worst-case debt scenarios that we’ve seen. Its equity holdings in publicly traded state-owned enterprises (SOEs) alone are larger than the aggregate level of domestic debt (and we aren’t even considering the annual cash flows of those equity holdings). Additionally, according to Morgan Stanley Research, the government has approximately 2.5 trillion yuan in foreign currency reserves, approximately 3 trillion yuan of cash deposits by other government and public agencies, and significant land holdings (land sales from 2004-2009 amounted to 5.7 trillion yuan). 

We would be naïve to assume that all Chinese local municipalities are in strong financial condition and will avoid cash constraints as non-performing loans increase over the coming years. Much like the problems associated with off-balance sheets arrangements experienced in the US, the lack of transparency and appropriate financial disclosures will create uncertainty regarding the financial health of many municipalities. Clearly lending standards were relaxed as the government flooded the banking system with liquidity; however, we believe the central government has the willingness and ability to mitigate the risk of a debt-induced crisis. 

Recent reports out of China suggest that the government is addressing the situation by limiting lending to municipalities, tightening credit standards, and requiring more comprehensive disclosures. While these measures are creating a slowdown of economic activity at present, they will lead to a healthier banking system that can support more sustainable growth in the long-term. 

As long as the Chinese economy continues to grow at a brisk pace, we believe its debt levels are manageable. The bigger challenge is balancing growth against inflation and social unrest, while reducing dependency on business investment spending and exports.  Investment spending has slowed meaningfully in 2010, with current spending focused primarily on enhancing Western China’s infrastructure. Export growth is unlikely to rebound to peak levels reached prior to the financial crisis, as demand from developed economies remains sluggish. Further dampening the export industry is a strengthening currency and rapidly increasing wages, which make exports less competitive. As a corollary, these trends have improved the fundamentals for those companies focused on domestic consumption and services. We expect the Chinese consumer market to remain strong for many years into the future as wage growth accelerates, the yuan strengthens, and consumer-oriented government policies persist.  

We anticipate economic growth to stabilize at 8-9%, inflation to peak at 3-4%, the yuan to continue strengthening, and monetary policy to move towards neutral. While there are still external and internal risks to the economy and equity markets, we are optimistic regarding China’s economic future and believe that we can generate positive returns over the long-term for shareholders. 

Despite the noise created by those who see danger in China, we still see it as one of the best places for Americans to direct investment assets. 

 

Investment Opportunities

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If you decide to make investments in the Far East, it is important to seek promising stocks to help maximize return. Although Asian equities can offer relatively high dividend yields (along with higher risk), it may be surprising to many that dividend yield in the Far East can be found in sectors rarely associated with yield. For instance, we currently think that two technology stocks in this region offer high yields and good prospects for potential growth.

Company #1

Company #1 mainly designs mobile phones and bluetooth chipsets. It is a global provider of testing, hardware, software, and exterior design solutions. The company lists its stock on the Singapore Exchange. It sells its products globally, but more than half of its revenue is generated within the Chinese market alone.

Investment Highlights

A fast-growing company, its recent quarterly sales were double those of the same period last year. We like this company for its exposure to the growing market for 3G handsets throughout Asia. This small-cap company trades at a single-digit valuation and has offered consistent dividend payout for many years. At current prices and projected distributions, the dividend yield is approximately 5%. Its 52-week high was 78 Singapore cents, and its 52-week low was 38 Singapore cents. 

Risks

Risks in owning this company are: competition from other mobile handset designers, dropping prices if the market becomes saturated, and a general slowdown in purchases if a recession develops.

 

INTERNATIONAL INVESTING MAY NOT BE SUITABLE FOR ALL INVESTORS. 

CLICK HERE TO RECEIVE MORE INFORMATION ABOUT THIS COMPANY, AND TO SEE IF IT IS SUITABLE FOR YOUR INVESTMENT OBJECTIVES AND RISK TOLERANCE, OR CALL 1-800-727-7922(U.S.A) or 1-888-216-9779 (CA) TO SPEAK TO AN INVESTMENT CONSULTANT. 

Company #2

Company #2 provides solutions in the desktop monitor and LCD TV markets. Listed on both the Hong Kong and Singapore stock exchanges, the company has a $1.4 billion US market capitalization and is the largest monitor maker in the world. It commands a strong position in China, with major customers including: Dell, HPQ, IBM, Lenovo, and Fujitsu-Siemens.

Investment Highlights

We like this monitor manufacturer for its position in China, a key growth driver in the global demand for both monitors and LCD TVs. According to the company, last year PC monitor shipments in China surged 33.7 % year-over-year, while China’s overall demand for LCD TVs increased by 106.4 %.

The company’s cost management is impressive. Though revenue was down in 2009 over 2008, internal cost cutting resulted in gross income rising 9% year-over-year. Based on the prior two semiannual payouts, the company offers a dividend yield of just under 3%.

Risks

Risks in owning this company are: a market shift away from LCD products, increased competition eroding pricing power, and a world-wide recession affecting sales.

INTERNATIONAL INVESTING MAY NOT BE SUITABLE FOR ALL INVESTORS. 

CLICK HERE TO RECEIVE MORE INFORMATION ABOUT THIS COMPANY, AND TO SEE IF IT IS SUITABLE FOR YOUR INVESTMENT OBJECTIVES AND RISK TOLERANCE, OR CALL 1-800-727-7922 (U.S.A) or1-888-216-9779 (CA) TO SPEAK TO AN INVESTMENT CONSULTANT. 

Dividend yields change as stock prices change, and companies may change or cancel dividend payments in the future. The fluctuation of foreign currency exchange rates will impact your investment returns. Past performance does not guarantee future returns, investments may increase or decrease in value and you may lose money.

Investing in foreign securities involves additional risks specific to international investing, such as currency fluctuation and political risks. There can be no guarantees of success in pursuing any of the strategies we recommend, or that any of the specific companies will gain in value. Risks include an economic slowdown, or worse, which would adversely impact economic growth, profits, and investment flows; a terrorist attack; any developments impeding globalization (protectionism); and currency volatility/weakness. While every effort has been made to assure that the accuracy of the material contained in this report is correct, Euro Pacific cannot be held liable for errors, omissions or inaccuracies. Euro Pacific has not independently verified the information supplied by the company, and cannot make any representations as to its accuracy. This material is for private use of the subscriber; it may not be reprinted without permission. The opinions provided in these articles are not intended as individual investment advice.

Why don't we provide the company names?
Under FINRA Rule 2310, broker-dealers are required to make sure that every investment recommendation is suitable for each client's unique investment objectives and risk tolerance. The company overviews provided here are meant to give an indication of the type of recommendations a Euro Pacific Investment Consultant may make, depending upon your unique investment goals, risk tolerance, and profile. If you have questions about the companies described in this report, or think they may be suitable for your portfolio, please call (800) 727-7922 and a Euro Pacific Investment Consultant will assist you, with no obligation to purchase from us.

 

Canada: A Bridge to the Future 
By: Stephen Johnston, Managing Partner
Petrocapita Income Trust & Agcapita Farmland Investment Partnership

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In this hostile financial climate, long-term investors must now give more thought than ever to capital preservation and sustainable growth. It is not a profound observation that growth is not sustainable if it is driven by debt-fueled consumption. Sound fundamentals for growth include:

• Favorable demographics;
• Low national debt levels;
• High savings rates; and
• Persistent trade surpluses.

Many emerging economies have all of these characteristics, while the so-called ‘developed’ economies have virtually none of them. Take Canada as an example. It can be argued that Canada suffers from many of the problems of the typical developed nation, though to a lesser degree than its G8 brethren. Canada is the best of the worst, so to speak. Still, it has familiar developed-economy problems, including:

• Aging population, with unfunded liabilities for social benefits;
• High debt-to-GDP levels;
• Low savings rates;
• Increasing government regulation and intervention in the economy;
• Large fiscal deficits; and
• An overly accommodative monetary authority.

This raises the question: why should investors emphasize investments in developed economies such as Canada over emerging economies? The fact is that direct investments in emerging economies often come with higher levels of political risk – see Russia's expropriation of oil assets or Argentina’s punitive export tariffs on agricultural commodities during its 2008 food crisis. The challenge becomes how to obtain emerging economy growth with developed economy risk.

That is the investment draw of Canada. Even though it faces many of the issues of the rest of the developed world, there is an opportunity to capture emerging market returns in Canada due to its uniquely bifurcated economy.

Eastern Canada, represented by Ontario and Quebec, is heavily exposed to deteriorating US demand through its automotive and aerospace industries. To put it simply, Eastern Canada imports what the emerging economies need and exports what they make – putting it under pressure on both the cost and revenue side of the equation.

Meanwhile Western Canada, represented by British Columbia, Alberta, Saskatchewan and Manitoba, is in the enviable position of exporting what the emerging economies need and importing what they make. What do I mean by this?  It’s a well-understood process that energy and food consumption undergo rapid growth as a developing economy makes the transition to a middle class standard of living. Energy and agriculture are Western Canada’s dominant industries – and this region, with only 10 million inhabitants, is one of the world’s largest net exporters of both energy and agricultural commodities.  Here’s a breakdown:

Energy –

• Oil (13% of world reserves; 4% of world production)
• Uranium (8% of world reserves; 20% of world production) 

Agriculture –

• Potash (60% of world reserves; 30% of world production)
• Wheat, coarse grains, oilseeds (21% of the world export market for wheat; 10% for oilseeds) 
• Farmland (80% of Canadian total) 

Therefore, investing in Western Canada provides exposure to emerging market growth in energy and agriculture within one of the most politically stable markets on Earth. In addition, investors who have a ‘value’ orientation have been provided what I believe are attractive entry points into the Western Canadian market by some recent events. 

In the energy sector, the credit crisis has caused financing to become scarce for junior oil & gas companies while low natural gas prices are reducing their profitability. They are being forced to sell assets to stay in business. This has created a buyers’ market for the acquisition of smaller oil production assets – assets that are highly cash-flow positive at current oil prices. 

In the agriculture sector, the regulatory barriers that made it difficult to invest in Saskatchewan farmland have recently been liberalized, allowing capital to move in and acquire the cheapest farmland (on a productivity basis) in Canada and perhaps the world.

We all expect China to overtake the US as the world’s leading economy, but I think Canada’s fortunes will surprise many. We have grown side-by-side with our North American neighbors for nearly a century, but we will not let them steer us off a cliff. Instead, Canada’s uniquely bifurcated economy can serve as a bridge from the developed to the developing world – at least for investors wise enough to cross it.

Stephen Johnston is the founder and managing partner of Agcapita (one of Canada's largest direct farmland investment funds) and Petrocapita (a private energy royalty trust). Formerly, Stephen was the head of the private equity team at Societe Generale Asset Management - Emerging Markets UK. In this capacity, he was responsible for the private equity allocation of closed-end funds covering the Baltics, Central and Eastern Europe, and the Middle East, with C$500 million under management. Stephen has a BSc. and an LLB from the University of Alberta and an MBA (1994) from the London Business School.

Please note: Neither Stephen Johnston, Agcapita, nor Petrocapita are affiliated with Euro Pacific Capital. This material is authored by a third party. Euro Pacific does not guarantee the accuracy and completeness of third-party authored content. In addition, any opinions expressed are solely those of the third party.

 

More Strings, Less Net
By: John Browne, Senior Market Strategist
Euro Pacific Capital

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In 1999, the Depression-era Glass-Steagall Act, which had prevented commercial banks from taking high risks with federally-insured deposits, was repealed. I believe this set the stage for the financial crisis of 2008. In the decade following the repeal, bank deposits were put at risk by gamblers masquerading as bankers, confidence men posing as politicians, and yes-men making a mockery of rating agency reliability.

By removing the limitations of Glass-Steagall, without enabling any market mechanisms to engender restraint, the federal government made massive bailouts inevitable. As the public looks to lay blame for the worst financial collapse in 80 years, tremendous pressure has been placed on Congress and the Administration to ‘fix’ the system.

As a result, we are now the lucky recipients of the 2,300-page Frank-Dodd Financial Reform Act. Even its most ardent supporters have no idea what effects the bill will have on our financial markets. But students of past government regulatory efforts should know that any intended consequence will spawn many more. Putting that aside, many legislators and financial observers believe that even the bill’s expressed intentions are an expensive, vague, and highly complex attempt at window dressing.

Before getting into the details of our new regulatory environment, a little background is in order. For decades, politicians have been unabashed in the open purchase of votes with pork barrel add-ons and massive entitlement programs. Socialist-oriented Democrats and hypocritical Republicans (who claimed fealty to fiscal prudence while racking up unprecedented deficits) are equally guilty.

By flooding the US, and the world at large, with a torrent of cheap dollars, the Federal Reserve has been the prime enabler of our disastrous economic drift. The housing boom, which in reality was just a concentrated and more visible representation of our entire economy, was caused by the Fed’s loose monetary policy and Congressional pressure on mortgages lenders, such as Fannie Mae and Freddie Mac, to lend to non-viable borrowers.

When Wall Street bankers repackaged and securitized these mortgages, the regulators failed to act. The rating agencies, bought and paid for by Wall Street and given special protection by their friends on Capitol Hill, seemed to slap triple-A ratings on any mortgage-backed security that came down the pike. These worthless mortgages now form a cement block around our economic feet as we try desperately to swim up for air. To no small degree, the sovereign debt crisis, which attracted global attention in the first half of this year, resulted from the persistence of these questionable assets in bank investment portfolios.

Although a post-mortem on the financial crisis should be as simple as an autopsy of a skydiver with an unopened parachute, Congress and the Administration have nevertheless established a Financial Crisis Inquiry Commission to probe the “mystery.” Strangely, the same Congress supported the Financial Reform Act before that Commission had a chance to report its findings. So the new Act is not based on even notional evidentiary findings, but rather on the election-year political bias of people with little or no knowledge of economics or finance. Therefore, it is not surprising that the Act fails to address the problems that created the crisis. Consider what the Act does not cover:

• Fannie May and Freddie Mac, whose activities led to the ballooning and collapse of house prices, are not mentioned. In the last two years, the amount of mortgage debt held by both companies, which are now simply government bureaus, has skyrocketed. The vast majority of new housing loans now come from Fannie and Freddie, but Congress has done nothing to impose greater discipline.

• The Federal Reserve is not mentioned, save to increase its powers! Furthermore, the Fed successfully resisted a comprehensive audit of its multi-trillion dollar spending of citizens’ funds.

• The SEC and other regulators, who were asleep at the switch, are not covered. It was their blindness which allowed the banks to gamble with depositors’ funds.

• The rating agencies escaped major reform. In fact, the same system of mandates, which require issuers to utilize only federally-approved providers, remains in place. This will make it more difficult for new, independent agencies to gain traction in the marketplace. The Act also makes no provision to change the system of rating agency compensation, leaving in place several conflicts of interest. 

• Major banks labeled as ‘too big to fail’ are still allowed to hide their toxic assets and can still trade in the highly risky derivatives market. Although the term ‘bail-out’ has been replaced by ‘wind-down,’ the bill ensures that failures at major financial firms will be paid for by taxpayers forevermore.

Given all of these shortcomings, it is unlikely that the longwinded legislation will correct any of the abuses and market perversions that it was meant to address. On the other hand, two things are certain: the Act will create a vast new bureaucracy with vast new funding requirements, and the Act has created such regime uncertainty that it risks pushing our country from recession into depression. 

 

Euro Pac in the News
Recent Articles in which Peter Schiff was interviewed or quoted:

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Gold Prices Extend Rally as ‘Odious’ Dollar Drops Versus Euro: Bloomberg Businessweek | August 6, 2010

Laar and the dilemma of monetarism: Baltic Reports | August 2, 2010

Fed chair Ben Bernanke isn't all doom and gloom: Chicago Sun-Times | July 25, 2010