End Game
By: Peter Schiff, CEO & Chief Global Strategist

Economic data over the past weeks, punctuated by last week's dismal employment reports, confirm the diminishing impact of the stimulus efforts orchestrated by the Obama Administration and the Federal Reserve. In what must be a huge disappointment to Keynesian enthusiasts, the record doses of both monetary and fiscal narcotics did not produce the desired results. In fact, the size and scope of the "recovery" of the past two years was weaker than would have been expected in a typical business cycle recovery without any stimulus whatsoever. Indeed our current recovery is the weakest on record, despite the biggest jolt of government stimulus ever administered. 

Central Bankruptcy – Why QE3 is Inevitable
By: Michael Pento, Senior Economist

As the U.S. economy seemingly limps out of the Great Recession most analysts now assume that the Federal Reserve will soon join the tide of other central banks and bring an end to the current era of unprecedented monetary expansion. Markets expect that Fed will begin withdrawing liquidity this summer, not too long after this latest round of the quantitative easing comes to an end. But this is simply a delusion.

There are many political and economic reasons why the Fed will find it extremely difficult to absorb the liquidity that it has relentlessly pumped into the economy since the beginning of the financial crisis. But its biggest problem may be that the ammunition it carries on its balance sheet is insufficient to the task.

In order to withdraw liquidity the Fed must sell most, if not all, of the assets on its balance sheet. The questions are: what types of assets will it sell, how fast will they sell them, who will buy, and what price will the market bear?

In December 2007, before the Great Recession began the Fed had an equity ratio of around 6% on a balance sheet that totaled approximately $900 billion. The assets it held at that time were almost exclusively comprised of short term Treasury debt. This had been the norm for the vast majority of Fed history. Given the size of the Treasury market and the bankability of its short term debt, the value of such a portfolio was considered virtually bulletproof.

But beginning in late 2008, as financial institutions careened towards insolvency, the alphabet soup of Fed lending facilities (TAF, TSLF, PDCF and the CPFF just to name a few) bought all kinds of assets that the Fed never before held. Through quantitative easing efforts alone, Ben Bernanke has added $1.8 trillion of longer term GSE debt and Mortgage Backed Securities (MBS). (In fact, the Fed now holds more of these mortgage instruments than their entire balance sheet before the crash.) This has drastically changed the complexion of the assets it must now sell.

But as the size of the Fed's balance sheet ballooned, the dollar amount of capital held at the Fed has remained fairly constant. Today, the Fed has $52.5 billion of capital backing a $2.7 trillion balance sheet. While the size of the portfolio expanded three fold (and the quality of its assets diminished), the Fed's equity ratio plunged from 6% to just 2%. Prior to the bursting of the credit bubble, the public was shocked to learn that our biggest investment banks were levered 30 to 1. When asset values fell, those banks were quickly wiped out. But now the Fed is holding many of the same types of assets and is levered 51 to 1! If the value of their portfolio were to fall by just 2% the Fed itself would be wiped out.

The Fed acknowledged this insolvency risk on January 6th when it modified its accounting rules to ensure that it never technically runs out of capital. In a system that would make Enron jealous, the new gimmickry allows Fed losses to be booked directly as Treasury liabilities. In other words, just throw it on the deficit pile with the rest of the Federal red ink. But fictional solvency has nothing to do with its ability to successfully withdraw liquidity.

What will happen to the value of the Fed's mortgage assets if rising inflation causes the Fed to sell in haste back to the primary dealers? In an environment of rising interest rates (that such a tightening pre-supposes) the value of the assets should fall. And, given the continued deterioration of the real estate market, there may be a weak market for low yielding mortgage debt.

If these financial institutions were forced to pay par for the Fed's mortgage assets, Bernanke would destroy a great deal of their capital and a new breed of zombie banks would re-emerge. There is certainly no political will in the United States to force the financial industry further into the public sector. If the assets are sold at the fair market price (which will likely be far below what the Fed paid), Bernanke would burn through his balance sheet before all of the prior Fed liquidity injections were neutralized.

Recently some Fed officials announced that they will likely raise interest rates before they sell assets. The truth is that without the ability to fully withdraw prior liquidity the Fed is incapable of significantly raising interest rates. After all, the Fed can't raise rates by fiat. It must sell assets to do so. Similarly, to support the dollar it must take money out of circulation, which is also accomplished by asset sales.

But the Fed's arsenal is no longer stocked with high grade weaponry. Given what is has on hand, the Fed will be unable to raise interest rates and support the currency. In essence, they have become impotent in removing the inflation they have so diligently created.

In the end, any meaningful attempt to withdraw liquidity will not only bankrupt the institution but also zero out their remaining credibility. That's why they'll never even make an honest attempt.

Michael Pento is Senior Economist with Euro Pacific Capital.

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Hi-Lo Silver
By: Neeraj Chaudhary, Investment Consultant and Hemant Kathuria, Managing Director

There is no doubt that May’s 33% correction in silver threw many investors for a loop. It was not just the magnitude of the drop, but the speed. After appreciating nearly 70% from February to late April of 2011 (peaking at just above $49 per ounce on April 28^th), silver plunged to just $32 a scant two weeks later. Almost on cue, silver bears jumped on the price action as evidence that the 10-year bull market was over, and that the drop in silver would continue until silver bulls were finally crushed. One widely-followed website even predicted that the price of silver would eventually drop down into the single-digits.

Although the causes of short-term price movements in any market are notoriously difficult to pin-down, the cause of this particular drop seems to be quite clear—specifically, COMEX (the primary market for trading metals in the US) raised margin requirements for silver futures contracts five times by a total of 84% within a span of just two weeks. Raising these requirements meant that traders had to put up a minimum $21,600 to buy a silver futures contract, up from $11,745 before the hikes.

Instead of scraping together tens of thousands of extra dollars merely to hold onto their existing positions, many traders simply closed out their positions and booked their profits. The data bear this out, as the CME (parent of COMEX) reported that open interest in silver futures contracts fell nearly 15% during this period. Of course the inevitable consequence of this rapid closing of positions (also known as selling) was a severe drop in price.  Some market observers have found these developments troubling.

Manipulation

In the week prior to COMEX’s raising of the margin requirements for silver futures contracts, there was a dramatic decline of nearly 20% in the amount of silver available for delivery to fulfill silver futures contracts on the COMEX market. This may be due to futures investors showing an increasing desire to take physical delivery of silver instead of settling contracts in cash. Such unusual moves had tended to merge the physical and paper silver markets and thereby weakened the ability of large players to exaggerate movements in the market through futures investing. By reducing the total size of the paper market, COMEX was able to relieve some of the pressure on remaining stocks of physical silver and restore the power of the big players to move markets.

It is important to understand that silver bullishness is generally associated with what many would call fringe investment sentiment. Mainstream players have been much more skeptical, and have often viewed precious metals as an irrational and bubble-prone asset class. As a result, these two groups tend to be on opposite sides of the silver trade.

It has been reported within the precious metals community that four parties are short a large percentage of “paper silver” (as the futures market is known).  It was widely rumored that JP Morgan had the largest short position. Over the first four months of 2011, when silver rallied from $30 per ounce to near $50, anyone with short positions had suffered severely.

There is rampant speculation that COMEX deliberately hiked reserve requirements rapidly and steeply to benefit large market players. Given that large financial institutions are the biggest users of the futures exchanges, some see glaring incentives that would explain preferential treatment. It is important to note that there is no proof to these allegations. But there is circumstantial evidence.

In particular, JP Morgan used the sharp contraction in price to exit its short positions at much more favorable prices than what otherwise may have been the case. The price stabilization of silver in early-mid May corresponds neatly to the closing out of substantial numbers of JP Morgan’s open short positions. In retrospect, its timing appears to be preternaturally accurate.

Who Cares?

And yet, long-time followers of silver are well aware that the silver market is subject to unnatural movements.  In fact, in its last 10 years of bullish movement, silver has suffered no fewer than four corrections of 30% or more. But during that same time, silver has continually marched higher, clocking in an impressive ten-fold gain since 2001. Investors who simply bought silver in 2001 and held through all of the volatility – whether caused by the exchange or not – have been rewarded. For long term investors the impact that can be made by manipulators is merely a side show, not the main story line.

Physical Demand-Supply Imbalance

All of this brings us to the long-term outlook for silver. Unlike gold – which for the most part is simply bought and held in storage or worn as jewelry – silver has a wide variety of industrial applications. According to the Silver Institute, nearly 879 million ounces of silver were consumed in 2010 alone, across industries as diverse as batteries and electronics manufacturing, imaging, and silverware. In addition, silver is vital to applications in medical technology, water purification, and solar energy.

Of course, there is tremendous production of silver as well, not just from silver mines but as a by-product of mining other metals including copper, gold, and lead. But despite a variety of production sources, miners were able to produce just 736 million ounces of silver last year. In other words, despite rising silver prices over the last 10 years production fell short of demand by 143 million ounces in 2010. This supply deficit is currently met by what are known as “above-ground” sources, essentially, a drawdown of existing stockpiles held by governments and private parties (including scrap silver).

Estimates of above-ground supplies of silver range from a low of 300 million ounces, to a high of 1 billion ounces or more. But regardless of whether we have two years supply or ten, the constant liquidation of inventories and other above-ground supply should continue to support prices.

Investment Demand

But the biggest lift to prices may come from investment demand rather than physical demand. With the increasing strain on the US dollar-centric international monetary system, investors are constantly on the lookout for means to preserve wealth. Historically, investors look first to gold as a store of value. But as the price of gold rises, investors turn to the poor man’s gold—silver—to store their wealth.

In nominal dollars, silver peaked at roughly $50/oz in 1980. But in inflation-adjusted terms, silver would have to reach $131/oz just to get back to its 1980 high.  And that only counts inflation to the present day. With The Fed seemingly determined to debase the US dollar for the foreseeable future, the ultimate destination for a new inflation adjusted high becomes hard to estimate.

Of course, no market moves in a straight line. Recent gyrations should remind us that silver can be a wild ride, with movements often exacerbated by possible market manipulation. But in our view, the moves in the silver market over the last two months do not invalidate our long-term outlook. For those who can stomach the thrills, silver remains a means to simultaneously gain protection from dollar devaluation while harnessing the benefits of global economic growth. The big boys may push and pull the market to their own temporary advantage, but they can’t alter its fundamental direction.

Past performance is no guarantee of future results.

Neeraj Chaudhary is an Investment Consultant with Euro Pacific Capital and Hemant Kathuria is the Managing Director of the Los Angeles branch of Euro Pacific Capital.

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In Gun-Free Canada, We Dodged a Bullet
By: John Downs, Vice President and Investment Consultant, Euro Pacific Capital, Los Angeles branch

This may be news to you, but Canada held national elections on May 2nd…seriously. Being the fifth Canadian election in 11 years, don’t beat yourself up if you failed to pay close attention. To be honest, most Canadians didn’t expect much either because it was widely expected that the election would mirror the previous two: a Conservative-minority government would return to office, and be opposed by a sizable Liberal block, which would forestall the chance for major reforms. Polls showed that little would change for the next parliament. But, being global investors, Euro Pacific kept an eye out for any excitement. Unexpectedly, we got a roller coaster.

After all, since the Conservatives were last elected, the Canadian dollar has risen 24.75% against the US dollar; Canadian banks emerged from the credit crunch largely unscathed and are now considered among the best capitalized in the world; and, Canada has positioned itself as a preeminent resource supplier to the booming emerging markets. Meanwhile, the government ran low budget deficits, introduced competition to the telecom industry, and has avoided costly foreign entanglements. That’s not to say the country is perfect, but in the scheme of Western governments in the year 2011, it’s a pretty enviable record.

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Rare Opportunity: A Look at Rare Earth Elements
By: Tony Hayes, CFA, Metals and Mining Analyst, Euro Pacific Canada

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Of all the commodity sectors that have experienced significant gains over the last few years perhaps none has gathered more interest, and generated more head scratching, than rare earth elements (REE’s).  The futuristic sounding commodities are a group of 15 unpronounceable minerals e.g. lanthanum, cerium, praseodymium, and of course the squint-inducing, yttrium). Contrary to what their collective name implies, some of these minerals are not all that rare. In fact one rare earth, cerium, is about as abundant as copper. But they are very hard to find in concentrations high enough for profitable mining and extraction. Hence the rarity.

However, limited supply means nothing without demand. And demand is growing. The sector has recently been energized by the development of many cutting edge industrial applications that need these elements. REE’s are used to make lasers, magnets, batteries, superconductors, ceramics, catalysts and metal alloys, just to name a few. They are critical components for a growing list of new-energy and green technology products. For example, several kilograms of REE’s are needed to manufacture every hybrid car and a single large wind turbine uses several hundred kilograms of neodymium, the most valuable Light REE.

Economic fundamentals state that when demand outstrips supply, prices go up. This has indeed been the case recently for REE’s. But the steep trajectory has prompted some to warn that the market has crossed into bubble territory. Others say the rise has only just begun. With opinions diverging wide enough to drive a truck through, many investors are understandably confused. But any analysis of REE’s has to start with the peculiar and unique aspects of the marketplace.   

There are approximately 220 known sites around the world where REE’s are currently found in high enough concentrations to be mined. By chance the vast majority of these sites are in China which, according to the Industrial Mineral Company of Australia (IMCOA), accounts for some 95% of the world’s output. This is fortunate for the Chinese who are also the largest end user of REE’s.  It’s not so great for the rest of us.

By virtue of its geologic luck and its rock bottom production costs, China has nearly monopolized REE production. And as a result of its domestic demand, China has reduced exports of REE’s, thereby leading to substantial price increases the world over. China has signaled that its future REE production will be intended primarily for domestic use. There is even talk of China becoming a net importer. This alone should keep the pressure on prices.

Over the next five years IMCOA expects the production of REE’s to increase by 55% from 145,000 tons in 2011 to 225,000 tons in 2015. Over that time they expect the rest of the world will try to break the Chinese monopoly. IMCOA assumes that while Chinese production will increase by 35% between 2011 and 2015, the rest of the world will increase production by a whopping 230%. This will still leave the Chinese with 78% of production…but it’s a start.

This year, prices of REE’s such as lanthanum, cerium and yttrium all reached new highs in excess of $130 per kg. A year ago prices stood at $10, $8 and $45 per kg respectively. Although the spike surely has an element of froth, from our perspective it is doubtful that the increases are simply a function of mass speculation. In addition to the evidence of legitimate demand, REE's have specialized end uses that are often formulated for distinct customers. Unlike other industrial metals, they are not exchange traded commodities. As a result, it appears that the bulk of the buying is driven by users, not speculators. 

The price increases have attracted a myriad of new participants to the industry. However, while the annual growth in demand is 8% to 10%, the overall market for REE’s is still relatively small and can only accommodate a few participants, particularly among the market segment for heavy rare earth elements (HREE’s) such as yttrium.  And while the market for light rare earth elements (LREE’s) should be able to accommodate more participants, two very large companies, Molycorp Inc and Lynas Corp Ltd, currently threaten to shake out the market.

By 2015, as a result of production from Molycorp and Lynas, lanthanum and cerium should be in surplus, which could push prices down. On the other hand, neodymium, praesodymium, terbium and dysprosium currently have use rates growing well in excess of the overall market for REE’s, and are expected to be in deficit by 2015. This should benefit companies mining those minerals. These differences in outlook should keep wise investors on their toes.

Despite the promising dynamics of the market, many of the new entrants on the scene may face difficulties in the years ahead. Many of the deposits mined by rare earth start ups are in remote areas that present tremendous logistical problems. Also, the extraction and separation of each rare earth element is technically challenging. Many of the new entrants may fail to deliver the custom designed precision materials demanded by the high tech end users.

As a result, investors should favor companies that have a history of successful production and delivery. The lack of widespread manufacturing expertise could result in industry consolidation as miners look to partner with more experienced processors.

As a result of this broad diversity in outlook, REE investing is best approached on a company by company basis. Using net asset value (NAV) calculations to analyze companies at early stages of development will be very difficult.  Using in-situ valuations (estimating the dollar value of minerals in a given plot of ground) is perhaps the easiest method of comparing companies. But such comparisons are also subject to myriad variables.

While the current rising tide of REE prices should generally lift all shares, the two heavyweights of the industry, Molycorp and Lynas (which together account for the majority of the sector’s market capitalization), seem to be more adequately priced relative to their values. Certainly both companies are in a position to take advantage of the present shortage of rare earths. But the very act of coming on stream could be their undoing as their own production should be sufficient to satisfy the world’s demand for LREE's at least for the next couple of years. We also expect the prices for heavy rare earths to rise faster than light elements, and heavy elements are not a big portion of the production mix at either Molycorp or Lynas.  The shortage of HREE’s could be with us for somewhat longer, possibly 5 years or more. As a result investors should favor companies that will benefit from the shortage of both HREE’s and LREE’s, and have a proven capacity to deliver product. Such companies do exist. Investors just need to do their homework.

The market for rare earth elements is probably in its adolescence. As a result, investors should expect growing pains. One thing seems certain however, demand is likely to remain. On the supply side, China, at present, has the market locked up tight and is unlikely to loosen its control. These are major factors that should give long term speculative investors reason for confidence.  

Tony Hayes is a Metals and Mining Analyst at Euro Pacific Canada. Opinions expressed are those of the writer. 

Euro Pacific Canada is 20% owned by Euro Pacific Bank Ltd which is wholly owned by Peter Schiff. Peter Schiff is CEO of Euro Pacific Capital, Inc.

Euro Pacific Capital does not guarantee the accuracy and completeness of third-party authored content. In addition, any opinions expressed are solely those of the third party and may or may not reflect those held by Euro Pacific, or its CEO, Peter Schiff.

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International Trade with Asia Benefits Canadian Transportation Segment

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Considering the continued rise in global trade, Canadian transportation companies have benefited materially from the rise in the demand for dry bulk commodities (i.e. coal and fertilizers) and containerized goods (i.e. intermodal) from Asia.

As exhibited in the table below, one can clearly see the benefit of this trend by examining total ocean imports/exports at the port of Vancouver. In April, total volumes grew 10.3% year over year, accelerated from +6.8% growth in February/March (combined to normalize for the timing of Chinese New Year). For 2010, combined volumes grew by 12.5% y/y, materially improved from -10.3% in 2009, with imports outpacing exports by 20.7pp. Most of this traffic stemmed from trade flows with Asia, with China being the largest driver of growth.   

Port of Vancouver Import and Export Year-over-Year Container Volume Growth

 

Source: Port of Metro Vancouver; Euro Pacific Capital. – The data gathered in this chart is believed to be from reliable sources. Please consult the Port of Metro Vancouver source for complete data.

Also, by examining container trends since 2008, one clearly sees that volumes are now modestly above pre-recessionary 2008 volume levels. On a three-year stacked basis, for example, overall April Vancouver volumes are 1% above 2008 levels, which is materially better than the 8% three-year stacked decline from the combined February/March period. In contrast to Canadian-based west coast seaports, container volumes at the two largest west coast ports in U.S.(i.e. Los Angeles and Long Beach) have yet to reach traffic levels achieved three years ago, before the international freight recession. On a three-year stacked basis, for example, April volumes from the ports of Los Angeles and Long Beach were 3% below 2008 levels.  

Within the Canadian transportation group, we believe one sector is best poised to benefit from the secular international trade growth story with Asia. Container traffic, for example, has grown from 16% of sector revenue in 1990 to 23% in 2010, with the international business being the highest growth driver. Previously announced terminal expansion projects in the west coast of Canada (outside of the port of Vancouver) are also expected to benefit this sector materially over the next five years.

It is also our view that this sector seems well poised to grow Earnings Per Share even in a flattish-to-potentially slowing global economic environment. Overall, it has had a consistent recent history of being able to grow EPS double digits during periods of flat to slightly declining mid-single digit volumes as they did successfully in 1991, 2001, 2006, 2007 and 2008 when volumes were flat to -4%. 

Past performance is no guarantee of future results.

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