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The Global Investor Newsletter - Winter 2014

Welcome to the Winter 2014 edition of Euro Pacific Capital's The Global Investor Newsletter. Our investment consultants are standing by to answer any questions you have.  Call (800) 727-7922 today!

The Deflation Menace
By: Peter Schiff, CEO and Chief Global Strategist

The Year Ahead for Gold
By: Adrian Day, Manager of the Euro Pacific Gold Fund

Over-Stimulated, Over-Priced
By: Neeraj Chaudhary, Investment Consultant, Los Angeles

Austerity Boys
By: Andrew Schiff, Director of Communications and Marketing

Brazil's Infrastructure Disaster
By: Andrew Schiff, Director of Communications and Marketing

The Mexican Moment
By: David Echeverria, Investment Consultant, Los Angeles

The Global Investor Newsletter - Winter 2014


The Deflation Menace

By: Peter Schiff, CEO and Chief Global Strategist


Dedicated readers of The Wall Street Journal have recently been offered many dire warnings about a clear and present danger that is stalking the global economy. They are not referring to a possible looming stock or real estate bubble (the paper sees few threats there). Nor are they talking about other usual suspects such as global warming, peak oil, the Arab Spring, sovereign defaults, the breakup of the euro, Miley Cyrus, a nuclear Iran, or Obamacare. Instead they are warning about the horror that could result from falling prices, otherwise known as deflation. Get the kids into the basement Mom...they just marked down Cheerios!

In order to justify our current monetary and fiscal policies, in which governments refuse to reign in runaway deficits while central banks furiously expand the money supply, economists must convince us that inflation, which results in rising prices, is vital for economic growth.

Simultaneously they make the case that falling prices are bad. This is a difficult proposition to make because most people have long suspected that inflation is a sign of economic distress and that high prices qualify as a problem not a solution. But the absurdity of the position has not stopped our top economists, and their acolytes in the media, from making the case.

A January 5th article in The Wall Street Journal described the economic situation in Europe by saying "Anxieties are rising in the euro zone that deflation-the phenomenon of persistent falling prices across the economy that blighted the lives of millions in the 1930s-may be starting to take root as it did in Japan in the mid-1990s." Really, blighted the lives of millions? When was the last time you were "blighted" by a store's mark down? If you own a business, are you "blighted" when your suppliers drop their prices? 

The Journal is advancing a classic "wet sidewalks cause rain" argument, confusing and inverting cause and effect. It suggests that falling prices caused the Great Depression and in turn the widespread consumer suffering that went along with it. But this puts the cart way in front of the horse.  The Great Depression was triggered by the bursting of a speculative bubble (resulted from too much easy money in the latter half of the 1920s). The resulting economic contraction, prolonged unnecessarily by the anti-market policies of Hoover and Roosevelt, was part of a necessary re-balancing. A bad economy encourages people to reduce current consumption and save for the future. The resulting drop in demand brings down prices.

But lower prices function as a counterweight to a contracting economy by cushioning the blow of the downturn. I would argue that those who lived through the Great Depression were grateful that they were able to buy more with what little money they had. Imagine how much worse it would have been if they had to contend with rising consumer prices as well. Consumers always want to buy, but sometimes they forego or defer purchases because they can't afford a desired good or service. Higher prices will only compound the problem. It may surprise many Nobel Prize-winning economists, but discounts often motivate consumers to buy - try the experiment yourself the next time you walk past the sale rack.

Economists will argue that expectations for future prices are a much bigger motivation than current prices themselves. But those economists concerned with deflation expect there to be, at most, a one or two percent decrease in prices. Can consumers be expected not to buy something today because they expect it to be one percent cheaper in a year?  Bear in mind that something that a consumer can buy and use today is more valuable to the purchaser than the same item that is not bought until next year. The costs of going without a desired purchase are overlooked by those warning about the danger of deflation.

In another article two days later, the Journal hit readers with the same message: "Annual euro-zone inflation weakened further below the European Central Bank's target in December, rekindling fears that too little inflation or outright consumer-price declines may threaten the currency area's fragile economy." In this case, the paper adds "too little inflation" to the list of woes that needs to be avoided. Apparently, if prices don't rise briskly enough, the wheels of an economy stop turning.

Neither article mentions some very important historical context. For the first 120 years of the existence of the United States (before the establishment of the Federal Reserve), general prices trended downward. According to the Department of Commerce's Statistical Abstract of the United States, the "General Price Index" declined by 19% from 1801 to 1900. This stands in contrast to the 2,280% increase of the CPI between 1913 and 2013.

While the 19th century had plenty of well-documented ups and downs, people tend to forget that the country experienced tremendous economic growth during that time. Living standards for the average American at the end of the century were leaps and bounds higher than they were at the beginning. The 19th Century turned a formerly inconsequential agricultural nation into the richest, most productive, and economically dynamic nation on Earth. Immigrants could not come here fast enough. But all this happened against a backdrop of consistently falling prices.

Thomas Edison once said that his goal was to make electricity so cheap that only the rich would burn candles. He was fortunate to have no Nobel economists on his marketing team.They certainly would have advised him to raise prices to increase sales. But Edison's strategy of driving sales volume through lower prices is clearly visible today in industries all over the world.By lowering prices, companies not only grow their customer base, but they tend to increase profits as well. Most visibly, consumer electronics has seen chronic deflation for years without crimping demand or hurting profits. According to the Wall Street Journal, this should be impossible.

The truth is the media is merely helping the government to spread propaganda.It is highly indebted governments that need inflation, not consumers. But before government can lead a self-serving crusade to create inflation, they must first convince the public that higher prices is a goal worth pursuing. Since inflation also helps sustain asset bubbles and prop up banks, in this instance The Wall Street Journal and the Government seem to be perfectly aligned.

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The Year Ahead for Gold

By: Adrian Day, Manager of the Euro Pacific Gold Fund


One headline that you will likely not encounter in the first weeks of 2014 is "Gold Ends 2013 At a Dramatic Discount." Instead all you will likely encounter are obituaries. The mainstream has taken gold's 2013 sell off (its first annual decline in the last 13 years) to be a clear sign that its historic bull run is at an end. Some have even questioned the sanity, and moral character, of those who continue to advocate for it. In a December interview, CNBC host Simon Hobbs abrasively asked gold advocate Frank Holms if he "had no compassion" for investors who had followed his advice. Rarely does any asset class encounter such overt hostility. The inclination to kick gold while it's down stands in stark contrast to the cheerleading equities would likely have encountered had they seen similar declines.

I have been actively involved in the gold market for more than 30 years and I know from experience that gold stocks can rally briskly off lows.Given that continually easy monetary policy and economic optimism are likely to persist throughout the year, any sell off in the broad market may be only temporary. Considering the steep decline from the highs, spot prices nearing rising production costs, and loose monetary policies, we are cautiously optimistic that gold stocks could deliver a strong rally from current levels.

In a year that saw strong gains in just about every asset class, the 2013 declines in gold were a surprise. Commodities fell generally and precious metals were no exception: platinum down over 13%, gold down 27% (its biggest loss in 30 years) and silver down a staggering 36%. As would be expected, gold stocks exaggerated the decline of gold itself. The benchmark XAU index of senior gold and silver stocks was down a stunning 49% from January 3 through January 2, 2014.

Given that most analysts assumed that the end of QE would be bearish for gold, expectations about the timing and pace of Fed tapering had kept the gold market in a knot all year. But now that the initial step in cutting back on the Fed's monthly bond purchases has occurred, the markets apparently have more certainty on that front. As a result, I believe the heavy selling pressure will abate and that the roughest sledding may be behind us. The expectations of the taper may be more damaging to gold than the taper itself.  In fact, gold has rallied slightly from the mid-December meeting when the Fed first announced its forward guidance on QE.

But looking beyond QE, which we do not believe will be wound down fully in 2014, there are many potential positives for gold which could lift it from current low levels.Gold has ample precedent for recovery from a vicious downturn. In 2008, gold fell about 28% from March to October. However, it rose by more than 157% over the ensuing three years. But this turnaround pales in comparison to the mid-1970 reversal. Gold dropped by 48% from 1974 to 1976, before turning around to run up more than 700% by 1980. This does not guarantee that its future performance will be the same.

But more important than the technical history are the fundamentals for gold,  which I see as very positive. Monetary policy around the globe remains very accommodative and debt levels in major economies-the U.S., Europe, and Japan-remain extremely high. Until just a few years ago, gold tracked these debt levels fairly closely. But the correlation diverged in 2011 as gold began to drift downward from its all-time nominal high. Although there are no certainties, I believe this correlation will reestablish itself.

 

On the micro level, there are also positives. The major selling from ETFs, the proximate cause of gold's decline earlier in 2013, has slowed recently. Physical demand from China, almost a mirror image of the ETF selling, remains very strong. India's currency has been recovering (along with the current account balance), which is helping to restore buying power to what has become the world's largest market for physical gold. (Many assumed that sagging physical demand from India helped push the market lower in 2013).

I also take the overwhelmingly bearish sentiment on gold to be ironically bullish. As Warren Buffet is wont to remind investors, the contrarian who buys what no one else wants stands to benefit the most if the market turns. I believe that mainstream sentiment on gold has never been lower. This may present opportunities for those with courage who refuse to join the herd, if the market turns.

You should consider the funds' investment objectives, risks, charges and expenses carefully before investing. For a prospectus or summary prospectus, each of which contains this and other information about the funds, call 1-888-558-5851 or visit www.europacificfunds.com. The Fund can also be bought through a brokerage account at Euro Pacific Capital, www.europac.net. Other broker-dealers may also sell shares of the fund through their own programs. Please read the prospectus or summary prospectus carefully before investing or sending money. 

Foreign investments present additional risk due to currency fluctuations, which means the value of securities can change significantly when foreign currencies strengthen or weaken relative to the U.S. dollar, economic and political factors, government regulations, differences in accounting standards and other factors. Investments in emerging markets involve even greater risks. Precious metals and natural resources securities are at times volatile and there may be sharp fluctuations in prices, even during periods of rising prices.

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Over-Stimulated, Over-Priced

By: Neeraj Chaudhary, Investment Consultant, Los Angeles


Some of the recent forecasts from America's leading financial institutions describe a market of almost limitless prospects:

"[This is] a sweet spot for equities: low but rising rates, low inflation, and a pickup in economic growth" - 12/10/2013 Bank of America Merrill Lynch strategist Savita Subramanian, whose year-end 2014 forecast for the S&P 500 is 2,000, or a 9% gain from current levels . The Tell, Marketwatch.com

"This is a classic bull market, and the 6th year is typically strong" - 12/14/2013, JP Morgan Chase chief U.S. equity strategist Tom Lee, who sees the S&P 500 rising 13% to 2,075. Business Insider

Wall Street's best and brightest appear to be convinced that the Fed has finally hit on the perfect combination of policies that will keep stocks strong in any economic environment. In an interview with CNBC on Dec. 31 of last year, even finance professor Jeremy Siegel thinks the Dow could reach 21,000, a gain of 27% this year. But with the Dow and the S&P 500 having made new highs seemingly every day in 2013 (on average once a week), the debate by less ideologically committed investors has intensified. As we move into 2014, have the markets become overvalued, reasonably valued, or even undervalued?

Based on my fairly healthy degree of skepticism regarding the health of our economy, I considered eight very diverse indicators to get a reasonable sense of where we are. Seven of them suggest that U.S. stocks are now highly valued, even overvalued. However, one remaining indicator has taken on an oversize importance in the minds of investors. Heaven help us if that turns negative as well.

U.S. STOCK PRICES VS. LONG-TERM EARNINGS: THE SHILLER S&P 500 PE RATIO

Currently market bulls will tell you that current price to earnings ratios are well within their historic range. What P/E ratios are based on are expected earnings for the coming year. But those earnings won't be known in full until well into 2015. And like many forward-looking forecasts, they may be overly optimistic. More sophisticated investors tend to rely on the Shiller S&P 500 P/E Ratio which compares U.S. stock prices to average inflation-adjusted earnings actually delivered over the past 10 years. This takes a lot of the guess work out of the equation and compares current U.S. stock prices to the historical long-term earnings power. Today the Shiller S&P 500 PE Ratio is at 26.4. But going back 100+ years, the historic mean of the index is 16.5. This means the current ratio is 61% higher than its long term average.

Shiller (1/2/2014)

Past performance does not guarantee future results.

There are only four occasions in the past 100+ years in which the Shiller S&P 500 PE Ratio was higher than it is now: 1929, 1999, 2002, and 2007. In 3 of these 4 instances, U.S. stock prices saw major declines over the ensuing two years.

U.S. STOCK PRICES VS. SHORT-TERM EARNINGS: THE S&P 500 PE RATIO (based on the most recent year of earnings)

But even if we were to agree with the bullish pundits who argue that permanently low interest rates have created a new plateau of valuations, (and therefore can't be compared  fairly to generations-old metrics) today's short term P/E ratio is still high. Based on the most recent year's trailing 12-month earnings, the S&P 500 PE Ratio is at 20.14.

Multpl.com (1/2/2014)

Past performance does not guarantee future results.

At first glance, this does not appear to be extremely high. However, there is an important caveat. Currently, corporate profits as a percentage of GDP are the highest they have ever been since the World War II era. 

(1/2/2014)

Currently profits are coming in at 11% of GDP, a level that is around 60% higher than the average of around 6% that has been seen since 1952. (It is even significantly higher than the average of the past 10 years - a period during which low interest rates pushed up financial ratios past their traditional levels). To return to a more normalized ratio either GDP would have to expand rapidly or profits would have to diminish. Given our view of the current economic prospects, we believe the latter outcome is more likely.

U.S. STOCK PRICES VS. CORPORATE ASSETS: TOBIN'S Q RATIO

But maybe earnings just aren't as important as they used to be. In order to try to justify current prices, I looked at U.S. stock prices vs. corporate assets. Tobin's Q Ratio is a popular measure that compares the market value of a company (which is a function of share price) to the amount it would cost to replace the company's assets.

So if a company owned a factory, and the market capitalization of the company was $1 million, but the factory would cost $2 million to build today, Tobin's Q Ratio would be 0.5. The lower the ratio, the less the investor is theoretically paying for the company's assets.

Past performance does not guarantee future results.

At greater than 1, Tobin's Q Ratio implies that stocks are overvalued. From the chart above, you can see that the Tobin's Q Ratio for the U.S corporate sector is at 1.05, which is approaching the level associated with past market declines. The historic mean over more than 100 years for the ratio is just .68 and there are only a few occasions over that time when the ratio passed 1.0. When it did, declines typically followed. The late 1990's was the only instance in which the ratio passed 1.1. At that time it shot up to 1.63, before eventually plunging. But should we really hold up the dotcom mania as a benchmark for sound valuations?

U.S. STOCK PRICES VS. GDP

For ships and goggles, I decided to compare U.S. stock prices to GDP, which is the widest measure of domestic economic activity. On that front there was little encouragement to be found. The chart below compares the total market capitalization of all publicly traded U.S. companies with U.S. GDP.

Vectorgrader.com

Past performance does not guarantee future results.

Since 1950 the median figure of this ratio is .65, meaning that all public companies together were worth 65% of that year's GDP. Currently, the ratio is nearly double that at 1.25. The only times U.S. stocks were valued extremely higher relative to GDP were those banner years of 1999 and 2000.Sensing a pattern here? Our markets are looking more and more like they did in the days of the Pets.com Sock Puppet. This is not a cause for celebration.

U.S. STOCK PRICES VS. MARGIN DEBT

Just as it's possible to buy houses with debt (mortgages), people can buy stocks with debt (it's called margin). As stocks go higher, an increased number of investors may become tempted to tap into available margin in order to buy appreciating assets. This is particularly true when low interest rates push down the cost of borrowing. Not surprisingly, the chart below from the New York Times shows that stock margin debt as a percentage of GDP is approaching the higher end of its historic range:

New York Times (5/31/2014)

As we have seen in so many of the other metrics, the chart shows large spikes in 1999 and 2007. And while it's certainly possible that margin debt could go higher from current levels of 2.27% (it reached 2.85% in 1999), it is also possible that margin debt will decrease sharply soon thereafter. When margin equity falls below a certain percentage, many investors are forced to sell stock to repay the loans, which brings downward pressure on share prices. We have seen this movie before, and it's not a comedy.

U.S. STOCK PRICES VS. GOLD

At Euro Pacific we believe the price of gold is a very important indicator that is too frequently ignored by the mainstream.

Macrotrends.net (1/2/2014)

Past performance does not guarantee future results.

Over the past 100 years, the prices of equities have plummeted against gold on three distinct occasions:  by 90% in the early 1930's, by a staggering 95% in the 1970's, and more recently by 67% since 1999 (this includes what we believe to have been a bear market rally over the last two years. But currently the Dow trades at 13.5 ounces of gold. Of the past 100 years, stocks have only been higher than this for a sum of 27 years, in three distinct periods: one year during the stock bubble of the late 1920's, 14 years from 1958 to 1972 (a period of solid economic growth and stability), and then again for 12 years from 1996 to 2008 (a period of economic growth and asset bubbles in stocks and real estate). This might indicate stocks moving up against gold if we see either a period of strong economic growth or another episode of bubble blowing. If neither occurs (which we believe is the more likely scenario), then we might conclude the opposite.

U.S. STOCK PRICES VS. DIVIDEND YIELD

Of all the ways to measure stock valuations, dividend yield may be the most tangible. Evaluating dividends doesn't require projections or assumptions, just straight math. Dividends are what investors are paid directly to own stocks. Yields (which are calculated by dividing dividend payments by share price) give us a fairly good barometer of relative value. By that metric, U.S. stocks are looking historically expensive.

Multpl.com (1/2/2014)

As you can see in the chart above, the dividend yield on the S&P 500 is the lowest it's ever been (with the exception of the period around 1999 - there's that year again).

U.S. STOCK PRICES VS. INTEREST RATES

Ah, the Holy Grail of stock market bulls: interest rates. By definition, the present value of stocks is valued higher by investors when interest rates are anticipated to be lower in the future (Meaning that investors are willing to pay more for well-established income streams today in anticipation of lower rates making it more difficult to find yield in the future).

(1/2/2014)

As seen in the chart above, during the 30+ years from the early 1980s to 2013, yields on the 10-year Treasury bond were cut in half between 1981 and 1989, from 16%. They were halved again by 2002, and again by 2011. From there they decline another 25% before bottoming in May 2013, at 1.5%. These historic declines helped fuel an historic rally in stocks.

Low interest rates also tend to keep corporate costs down and profits up (low rates are one of the main factors in the current profit boom), and make stocks more attractive relative to bonds. They tend to be a further positive catalyst for stocks. As a result of the Fed's current commitment to keep interest rates near zero for the foreseeable future, many investors have adopted the "Don't Fight the Fed" rallying cry. (A new variant on this maxim is "As long as it's Yellen, don't think of sellin.")

But here's the problem...interest rates remain in historically low territory and have been trending upward slowly for the past year and a half. It's unreasonable to expect this trend to reverse and interest rates to fall once again into record low territory. Instead, it would be more likely that rates would rise from current levels, especially if the Fed goes through with its tapering campaign and diminishes the amount of Treasury bonds it buys on a monthly basis (purchases that have helped keep rates low).

In the first weeks of 2014, yields on 10-year Treasuries flirted with three percent for the first time since July 2011, a time in which the Dow Jones Industrial Average was about 23% below current levels. We could argue that the recent increase in yields, and the likelihood that it continues, has yet to be factored into stock prices. Instead, investors appear to be expecting permanently low rates.

IN CONCLUSION

While our analysis is in no way exhaustive, I believe that the above metrics make a fairly solid case that U.S. stocks are likely overvalued. I believe that the current optimism is based solely on confidence in monetary policy and the belief that the U.S. has embarked on a period of sustained expansion. However, as Peter Schiff has explained many times, the economy now shows many of the over-leveraged and delusional characteristics that existed before the recessions of 2000 and 2008. Perhaps that helps to explain why today's markets so closely resemble those periods.

Could the U.S. stock market go up from here? Of course it can. Irrational increases often go on longer than level-headed people expect. But the longer it goes on, the more worrisome it becomes.

But while the mainstream media on Wall Street continues to paint pretty pictures, other facets of the financial establishment are following a different script. According to a recent report from a Bank of America Merrill Lynch analyst,  while private buying of stocks has increased briskly in the past year, institutional players (the so-called "smart money") have accelerated their sales1 2.

Business Insider Dec. 2013

Based on all of the above, it may be time to assess whether portions of your wealth should look to areas of the global market  that have not moved into the kind of bubble territory that we see in domestic markets.

1.   http://www.irishtimes.com/business/personal-finance/stocktake-us-equities-are-a-hard-sell-1.1622192

2.   http://www.businessinsider.com/institutions-are-dumping-stocks-2013-12

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Austerity Boys

By: Andrew Schiff, Director of Communications and Marketing


With the Standard & Poor's 500 Index having posted a 30% gain, it's easy to assume that U.S. stocks easily led the world in 2013. As it turns out, the stimulus-loving U.S. markets had plenty of company. Surprisingly, this includes countries supposedly saddled by the scourge of austerity.

The Irish Stock Exchange Quotient (ISEQ), the index for the Dublin market, gained 33.6% in 2013. Close behind were the 21% rally in Spain's IBEX 35 Index (IBEX)and the 28% jump in the Athens General Share Index. Factoring in the 4% rise of the euro over the calendar year, and these returns look even better from American eyes. Europe was supposed to be the economic dregs in 2013 and these three charter members of the so-called PIIGS (Portugal, Ireland, Italy, Greece and Spain) were supposed to be the worst of the worst. Yet, they saw big rallies on their stock markets. Despite all we have heard about how callously imposed austerity had threatened to knock these fragile economies back into the Stone Age, the policy has not been as toxic as advertised. In fact, we would argue that it has helped these deathbed economies get partially back on track.

The Luck of the Irish

Despite little fanfare on both sides of the Atlantic, in December Ireland became the first troubled euro zone state to exit its rescue program completely. Three years ago, amid the collapse of the country's property market bubble and large losses in the banking sector, Ireland received a 67.5 billion euro loan from a lending troika consisting of the International Monetary Fund, the European Commission and the European Central Bank. In exchange, Ireland was required to impose a series of spending cuts, tax increases, asset sales, and banking reforms. Although these measures made the Paul Krugmans of the world shudder, they appear to have worked.

A turning point came in March when, for the first time since November 2010, Ireland successfully floated sovereign debt on the international market. Demand for its 10-year bond was so strong in March 2013 that Ireland increased the size of the offer to 5 billion euros from the original 3 billion euros. Then in the new year 2014, things got even better when Ireland was able to raise another 3.75 billion euros at an even lower rate (3.54%) than in March. Ireland appeared out of the financial doghouse. In late 2012, Fitch Ratings had taken Ireland off a "negative outlook," leaving its BBB+ credit rating in place. In December 2013, ratings firm Standard & Poor's affirmed its long-term credit rating of BBB+ and said the outlook remained positive. With cash balances at the end of 2013 estimated at 20 billion euros according to Ireland's Prime Minister Enda Kenny, the country now feels it has protections against internal and external risks.

In its most recent Quarterly Bulletin, the Central Bank of Ireland expects to see gross domestic product (GDP) rise 0.5% in 2013. The bank said this reflects "a broadly stable outlook for domestic demand and a modest positive contribution from net exports." In 2014, the central bank projects GDP to grow to about 2.0%, while the European Commission forecasts a rise to 1.7%.

In another positive sign, Ireland's housing market appeared to have turned around after having fallen about 50% during the crisis. In June of last year, "national residential prices recorded their first year-on-year increase (of 1.2%) since January 2008," said the Central Statistics Office. Additionally, October saw prices rise 6.1% year-over-year. Finally, the unemployment rate had fallen again in December for the 18th consecutive month, registering the lowest rate since May 2009. In the third quarter of 2013, the seasonally-adjusted rate fell to 12.8% from 13.6%, and more than two percentage points below its early 2012 peak.

The falling unemployment rate has been helped by American technology companies expanding their Irish operations. In 2012, Apple announced it would build new offices at its Cork headquarters and would hire 500 people. Then in December, Microsoft invested170 million euros to expand its Dublin center.

The Drain in Spain

Spain agreed to its rescue package in July 2012, about 19 months after Ireland, but it expects to exit its bailout program in less time (the country expects to transition in early 2014). While the euro zone partners authorized a rescue package of 100 billion euros, Spain only took 41 billion.

Like Ireland, Spain was forced by the lenders to make budget cuts and structural reforms in the financial system, and while the measures have bitten, they have led to improvements. In the third quarter, the Spanish economy emerged from a two-year recession and posted growth of 0.1%. While this is below the euro zone average, it is not the catastrophe that some had predicted. In November, Standard & Poor's raised its outlook on Spanish debt to stable from negative, and kept its debt rating at BBB-, one notch above junk-bond status. By year end 2013, Spain's government bond market stabilized with yields on 10-year bonds falling to 3.9% from 6.4% in July 2012.

In its November report on the European economy, the European Commission said Spain's domestic consumption and equipment investment began to stabilize in the second quarter of 2013 and that it expected these trends to continue, with the composition of growth becoming more balanced as domestic demand strengthens.

For all of 2013, the Commission expects the Spanish economy to contract 1.3%. But it expects to see growth of 0.5% in 2014, and 1.7% in 2015. And while unemployment fell from its first-quarter peak of 27.2%, it remains extremely high at 26%. While these jobless numbers seem unimaginable to Americans, it must be remembered that Spain's highly restrictive labor laws have driven a large portion of the nation's jobs into the opaque world of the under the table economy.

There can be no doubt, however, that Spain is still in the thick of it. Based on its historic housing boom of the last decade, the country's real estate market has yet to show signs of a true bottom, and will probably continue to contract in 2014. Still, the European Commission said, "overall, the adjustment process is progressing, but challenges and vulnerabilities remain significant." Apparently that was enough for investors.

Greek Trajectory

The situation in Greece remains much riskier for investors than either Ireland or Spain. The country is nowhere near exiting its bailout. Actually, it's expected to receive another 1 billion euros as part of its bailout program before the end of December 2013. The country is currently in the sixth year of a recession, and since 2010 has received 240 billion euros from the lending troika. (That's more than 21,000 euros per resident). But its fiscal picture is improving.

In December, the Greek parliament approved the 2014 budget in which it expects its first surplus in a decade, 812 million euros, double the previous estimate. Although the surplus excludes debt payments, it may be likely the country will meet next year's fiscal targets. Meanwhile, Greek bond yields have plunged to 8.28% from 25% in August.

While the European Commission expects Greece's GDP to contract by 4.0% in 2013, this is still an improvement over the 7.1% decline in 2011 and last year's 6.4% contraction. Going forward, the Commission expects Greece's GDP to grow 0.6% in 2014 and increase to 2.9% the following year. Last summer, the tourism industry staged a strong revival as it proves to be a much cheaper destination compared to other vacation spots. 

However, the austerity measures have required the government to eliminate many public-sector jobs from Greece's famously bloated bureaucracy. This transition to a sustainable model is causing much current dislocation. The unemployment rate jumped to 27% in 2013 and with the lending troika demanding more austerity from the government, it doesn't look like this problem will get better in the very near term. But investors may be looking past these numbers.

In its autumn European Economic Forecast Report on the Greek economy, the Commission said, "Led by exports and investment, real GDP is expected to expand in 2014... In contrast, private consumption is expected to still decline, in line with aggregate disposable income. In 2015, the recovery is forecast to gain strength, as investment becomes the main engine of the recovery. ... With consumption no longer being a drag, real GDP growth is projected..." Given how woefully awful the Greek economy was widely understood to be, this forecast is actually a fairly acceptable prospect.

While economists such as Paul Krugman have been at the forefront of the chorus that says austerity doesn't work, these extreme measures have not stopped these countries from improving their fiscal positions while setting a sustainable course. Although unemployment remains high in Greece and Spain, the falling unemployment rate in Ireland shows that restored faith in government responsibility leads to investment.

The improvements in these "basket case" economies remind us of the emerging market economies that came out of the Asian debt crisis with a new lease on life. For those who can tolerate the risks and volatility, it may be a good time to look deeper.

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Brazil's Infrastructure Disaster

By: Andrew Schiff, Director of Communications and Marketing


It wasn't supposed to be this way. After spending most of the last decade as one of the fastest growing economies in the world, Brazil's winning of the 2014 World Cup and the 2016 Summer Olympics was going to show that South America's largest country was no longer an up-and-comer, but had finally arrived.  Instead, preparations for these major world sporting events have exposed how far the world's sixth-largest economy still has to go.

As Brazil prepares for its debut on the world stage, many of the massive transportation and infrastructure projects necessary for the games, which had been promised as one of the benefits, have been delayed or canceled. Instead, the massive public investment has exposed rampant government corruption which has only exacerbated the country's extreme income inequality.

In early January, Sepp Blatter, the president of FIFA, the international governing body of soccer, ripped into the Brazilian government for its slow preparations. Despite having more time than any other World Cup host country has received, Brazil failed to complete building the 12 required stadiums by the December 31 deadline. With the games only six months away, only half the stadiums have been completed.

 "No country has been so far behind in preparations since I have been at FIFA even though it is the only host nation which has had so much time - seven years - in which to prepare," said Blatter in the Irish Independent.

The current estimates for the cost of the World Cup land around $13.3 billion. Spending on the stadiums alone, originally estimated at $1 billion, has jumped to more than $3 billion. Another $14.4 billion is expected to be spent on preparations for the Olympics.Despite the government's promises that most of the costs would be privately funded, it's turning into a public-spending debacle.

The rude joke on all countries hosting such events is that the revenue brought in by these games never matches the cost outlays. According to Americas Quarterly, "the World Cup generates approximately $3.5 billion in revenue, (with most going to FIFA) and the Summer Olympics generate around $5 billion, with most going to the International Olympic Committee."

As the costs for building the infrastructure to host the games increase, the infrastructure that was supposed to be the permanent legacy of the games, such as new rail systems, have been put on the back burner.  Many of the upgrades to Brazil's airports, needed to accommodate the mass of international soccer fans, won't be ready in time for the games. Meanwhile, a number of studies have shown that many of the host cities and countries of previous Olympics and World Cups received few long-term benefits .

"As a path to riches and long-term economic development, most Olympic hosts have been sorely disappointed," wrote Victor Matheson, associate professor of economics at the College of the Holy Cross in Worcester, Mass., in The New York Times. "Evidence of any direct economic impact from these types of 'mega-events' is lacking... If a city is using an expectation of a financial windfall as justification for hosting the Olympics, past experience suggests that the host will be in for a rude awakening."

Between the two events, Brazil has projected to spend nearly $28 billion dollars. As the U.S. economy is 7.2 times larger than that of Brazil, according to the CIA's The World Factbook, such outlays would equate to more than $201 billion here. This level of spending is exactly the quantity of infrastructure spending that Keynesian economists like Paul Krugman have argued would be beneficial for America. Recall that Krugman has even said that the precise purpose of the spending is less important than the spending itself. But Brazil has reaped scant benefit thus far for its efforts besides a stalling economy,rising interest rate, and nearly six percent inflation for 2012 and 2013. 

As more and more Brazilians have come to understand the poor return on their  investment, tempers have flared. In October they took to the streets to protest an increase in the Sao Paolo bus fares. But, this was merely an outlet to protest the government's spending huge amounts on stadiums that a vast majority of the population will never use or enjoy. 

With Brazil's government debt more than 60% of its gross domestic product, as published in Moody's recent annual report, and more spending expected as the national election approaches, ratings agencies Standard & Poor's and Moody's have indicated they are considering a downgrade of the country's credit rating.

So perhaps infrastructure spending is not the panacea that its proponents like to believe?

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The Mexican Moment

By: David Echeverria, Investment Consultant, Los Angeles


It is increasingly felt by many Americans that the Federal government has been stifling economic growth with a host of counter-productive regulatory policies. From taxation to immigration, employment, and energy policy, the government seems to be gumming up the economic works, often standing in the way of business expansion and new job creation. But even if Americans could agree on a needed course of action, few are under any illusions that Washington could conjure the political will to actually do anything meaningful.  2013 offered a case study in political paralysis in Washington, in which both Republicans and Democrats punted on the most important budgetary crisis of our nation's history and instead crafted what may be the most meaningless budget agreement in memory.

But while Americans complained about the lack of action in Washington, many may not have been aware of the meaningful changes that were being passed just south of the border in Mexico.  The Mexican legislature, under the direction of the newly installed Institutional Revolutionary Party (PRI)led by President Enrique Pena Nieto, has just concluded an historically productive legislative session that produced a series of social, political and economic reforms which many policy analysts agree are the most sweeping and important changes since the passing of NAFTA in 1994.

While Mexico certainly faces a host of challenges that will not go away with the passage of a few new ordinances, taken together we believe that the moves will help the country continue with the momentum it has picked up over the past few years. In fact, according to Jim O'Neill, an economist who tracked economic reform initiatives over his lengthy Wall Street career, Mexico was one of the standout success stories in Latin America in 2013. Below is a summary of some of the reforms passed in 2013 and some reasons we believe that they should make a positive impact on the Mexican economy.

Oil / Energy Reforms

Pena Nieto's cornerstone legislation was passed just this past December which, after months of tense negotiations, has yielded a legislative framework to open the nation's stagnant energy market to foreign investment. For much of the past few generations, energy development in Mexico has been the sole purview of Pemex, the state-run energy company. But in recent years the government has used the company as a cash cow to pay for the massive state bureaucracy. The drain has starved the company of the funds it needs for technological development and investment. In addition, Pemex has seen average daily production decrease by 25% since 2006. (Bloomberg, 12/13/13)

The energy reforms seek to reverse these declines as the largest foreign energy companies and other domestic firms will now be able to enter into joint production partnerships with Pemex to develop vast swaths of untapped oil and natural gas reserves. Moreover, foreign corporations will be able to log reserves as assets on their balance sheets, which will provide them with a basis for securing capital needed for project development.

The recent boom in shale gas production from Eagle Ford Shale in Texas has American firms chomping at the bit to extract 460 trillion cubic feet of gas, as estimated by Pemex, just across the border. Foreign investment is expected across the supply chain to include pipeline and refinery development. In the end, these reforms could entice as much as $20 billion in foreign investment each year and are estimated by the Mexican government to add a full point to GDP within five years.

Banking Reforms

According to some prominent Mexican economists, the recently passed reforms in the banking industry will probably have the most immediate impact on Mexico's economy. Primarily the changes will impact banks' ability to recover collateral pledged for loans. Under previous law, banks would often have to spend 3-10 years to recover collateral on a defaulted loan. Consequently, most banks have been hesitant to lend to small and medium enterprises and low credit individuals which, generally speaking, are the most in need of capital. The result is that commercial credit to the non-financial sector in Mexico is only 17 percent of GDP, based on the latest Financial Access Survey of the IMF,well below its Latin American peers. Most economists would suggest that a higher ratio would be more conducive to economic health. The new reforms create specialized judges and courts to handle collateral recovery claims and also allow development banks to register losses, freeing up additional capital to lend out. Long-term estimates by the Mexican Central Bank are that the reforms could add 50 basis points to GDP.

Telecommunications / Media Reforms

Landmark legislation created a new regulatory agency with the power to implement asymmetric changes to dominant players in the country's telecommunications and media markets. The country's telecom industry is currently dominated by Carlos Slim's America Movil, which has 70% of all wireless subscribers, and its subsidiary Telmex, which controls 70% of fixed telephone lines. The broadcast television market, on the other hand, is dominated by Grupo Televisa and Azteca TV, with about 70% and 30% market share, respectively. (WSJ, 6/10/13) As a result of limited competition , it should come as no surprise that there has been a decided lack of investment in these sectors. This has meant that consumer prices have remained increasingly high and availability stubbornly scarce. In fact, according to a 2012 Mexican government survey, only 26% of Mexican households had access to internet, while only 32% had computers at home. The new regulatory regime will seek to address the lack of competitive market forces by potentially compelling asset sales, ending product exclusivity contracts, limiting ability to overcharge for calls to other networks, and limiting what Telmex can charge competitors for use of its network. These efforts should allow smaller companies to gain market share and increase competitiveness, thereby driving down prices and increasing quality for millions of Mexican consumers.

Education Reforms    

Among all the Organization for Economic Co-operation and Development (OECD) countries, Mexico spends the highest percentage of its budget on education and has the least to show for it, both in terms of school attendance and outcomes. Much of this is directly attributable to Mexico's powerful teachers union, the SNTE. Throughout much of the country, the Union has monopoly over what is taught and who is hired, and promoted. This process has become blatantly political and laced with corruption.

The SNTE was originally given carte blanche over half a century ago by the PRI in exchange for assistance at the ballot box. Since then teaching jobs, which are amongst the best paid in Mexico, have been put up for sale.But in recent years the SNTE has raised the ante and has attempted to become a de facto political party and governing body. Recent SNTE "strikes" have shut down Mexican schools for months. These excesses may have finally convinced the PRI to try to reign in its creation. The reforms just passed are intended to make teachers more accountable and weaken the hand of SNTE by requiring teacher candidates to take standardized testing to determine competency, although the unions did gain a delay for two years. The government will also put into place standards for promoting teachers, further weakening the SNTE's hand.

While these reforms may take time to effect, the very fact that they have been passed, in the face of determined opposition, has brought a good deal of hope.

Political Reforms

In the United States the concept of "term limits" has often been held up as a sure fire means to achieve political purity by preventing politicians from establishing lifetime positions. In Mexico, many critics have complained that term limits have simply resulted in a more rapid corruption when politicians race to deliver political favors when they have time.  Newly passed reforms now allow many federal, state, and local politicians, who had been previously limited to one term, to serve up to 12 years in office. Reforms also allow independent candidates to run for office, thereby breaking the stranglehold that political parties had on elective office. This legislation also effectively loosens the grip of political parties on incumbents, who can exercise more independence.  These reforms will help cut down on traditional patronage linkages and corruption.

The Bottom Line

Taken together, Mexico's bold reforms of 2013 seek to implement competition in all arenas of society and may present investors with a number of opportunities.  In the near term, look for reforms to the banking and energy sectors to have an impact on GDP, possibly from 50-100 basis points. The injection of foreign capital and increased lending should trickle down to broader parts of the economy as well. In the medium term, look for reforms in telecommunications and media to help increase consumption as well as market share for secondary players.  In the long term, both political and educational reforms should contribute to a more efficient and productive allocation of resources and human capital.

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