Race to the Bottom

By: Peter Schiff, President & Chief Global Strategist

Long ago, before economic models developed their current levels of sophistication, it used to be that the goal of a government’s economic policy was to bring prosperity to its citizens; in other words, to raise the general level of material comfort, while at the same time reducing the amount of toil required to attain that end.

However, due to the blather spouted by modern economists, success is no longer measured in those terms. Instead, governments simply look to pump up nominal levels of gross domestic product (GDP), while simultaneously catering to the needs of entrenched political classes. As exports feed directly into GDP, currency devaluation has been widely used as a means to boost exports and therefore achieve ‘prosperity.’ In this model, selling is an end unto itself. There is no focus whatsoever paid to the obviously negative consequences of currency debasement: diminished purchasing power and lowered living standards.

Way back in the 20th century, a nation’s currency was viewed much as a company’s stock price. The reliability, competitiveness, and growth of a national economy usually translated into a strong currency.  This system made sense.

Countries that offered the most fertile soil for investment capital or that made products other countries wanted would attract funds from abroad. Demand for the currency of these “blue chip” countries (which was needed to invest or buy locally) would inevitably push up the value of the currency. And so, much as shareholders of successful companies are rewarded by higher stock prices, citizens of successful countries were rewarded with stronger currencies – with which they could buy more goods and services both domestically and internationally, raising their living standards.

But all that has changed in recent years. With a strategy that seems to be taken from the playbook of Sam Walton, governments now look to take market share from competitors by lowering the cost of their exports. To do this, they have adopted a beggar-thyself policy of habitual currency debasement. Although such a move may benefit those who buy the products, it is a burden to the country’s own workers who, like Wal-Mart employees, have to get by on subsistence wages. While the markets like a low-cost provider, this is not a niche that everyone can, or should, fill. While some will compete only on price, more successful ventures will compete on quality and innovation. For every Kia, there is a Mercedes Benz.

Given the US dollar’s status as the world’s reserve currency, America’s oversized status as the world’s biggest consumer, and the influence of overseas export-oriented businesses on their home governments, the falling dollar is a difficult issue for many countries to ignore. And with the imminent arrival of a second round of ‘quantitative easing’ from the Fed, the big guns of dollar destruction are being locked and loaded. The move looks poised to set off a frantic race to the bottom among global currencies, which will have important ramifications for every investor. Unfortunately, this is one race the United States is poised to win.

The goal of those trying to win the race to the bottom is to promote exports and create jobs. However, people don’t work simply for their love of labor. They work so that they can earn enough to consume the things they need and want. Under normal conditions, a nation only exports its production, rather than consuming it domestically, to leverage its comparative advantages. If a country can produce one type of good especially efficiently, it can trade that good for other goods it doesn’t make as efficiently at home. As a result of this process, its citizens will be able to consume more goods than if consumption had been limited to domestically produced goods.

However, when a government debases its currency in order to gain sales overseas, the nation earns less foreign exchange for the goods that it exports. As a result, its comparative advantage is blunted, and its citizens consume less as a result. In other words, as a nation’s currency declines, its citizens are forced to work harder for less.

If a department store decided to have a sale in which all of its merchandise were marked down 50%, it will surely sell a lot more stuff. However, it would earn a lot less than if it had been able to sell its goods without marking them down. This is how currency debasement works. Similarly, one way for the unemployed to get work is to accept lower wages. Workers will sell a lot more of their labor if they accept 50% pay cuts. However, are they better off as a result? Relative to being unemployed, the answer is yes – but they would be much better off being employed at full pay.

Last week, Brazilian Finance Minister Guido Mantega made headlines when he mentioned that a worldwide currency war was brewing, with the winner being the nation with the weakest currency. Ignoring the irony of why countries would want to destroy their own currencies, Mantega reasonably warned that the conflict could get out of hand and destabilize the global economy. His comments came in the wake of overt efforts by both the Japanese and Swiss governments to intervene in the foreign exchange market to push down their respective currencies.

The politics of currency intervention are actually quite simple. Japan’s economy is dominated by large manufacturers that export lots of goods to Americans. The problem is that Americans can’t really afford to buy in the quantities that they did just a few years ago. So, instead of looking for new customers with more money to spend, Japanese manufacturers use their political clout to force a bailout of their traditional US customers. 

Essentially, in order to protect the status quo of their elite, governments are surreptitiously forcing workers to take pay cuts through inflation. Everyone works harder, but the extra effort does not raise living standards. In fact, despite the added jobs, overall consumption will fall.   

The irony for the United States is that its currency debasement plan has little to do with saving export jobs. We don’t have many of those left to save. The government is debasing our currency merely to ‘pay’ its own bills, preserve bank profits and Wall Street bonuses, allow us to continue buying homes we can’t afford,  and prevent many service-sector workers from having to find more productive jobs. In return, they will perpetuate an unworkable economic model. So while the US will probably ‘win’ the currency war, we will definitely lose the far more important battle to improve our quality of life.  

Labor Learns a Lesson
By: Andrew Schiff, Director of Communications & Marketing

Australia has just come through an extremely competitive election that has left a tenuous coalition government in its wake. Given our interest in the land down under, here’s a brief recap of what has happened politically and our thoughts on how the current situation may affect the Australian investing environment.  

More so than any election in recent memory, Australia’s August 2010 contest centered on one policy: the Resource Super-Profit Tax (RSPT) that had been proposed this past spring (Australian autumn) by former Prime Minister Kevin Rudd. The proposed measure would have slapped a 40% tax on the profits of all domestic mining operations. As many shareholders of Australian stocks well recall, the proposal wreaked havoc on Aussie share prices.

Australia has long had a system of excises and royalties on miners, mostly levied at the state level, as well as a federal Petroleum Resource Rent Tax levied on offshore drilling activities. The RSPT, however, would have been the first comprehensive federal tax on all mining operations. It was intended to be the first stage of a package of Labor Party reforms called the “Future Tax System,” meant to increase and simplify revenue collection.

Despite the critical importance of the mining industry to the Australian economy, Rudd believed that the majority of rank-and-file Aussies would feel no sympathy for the big corporations making record profits by extracting the nation’s resources. At the very least, he was confident in the appeal of provisions to ‘spread the wealth’ gained from the RSPT in the form of various tax cuts and subsidies to interest groups. As it turned out, despite the populist message and incentives, Australian voters were too smart to kill the goose that lays their gold, silver, and copper eggs. Based on dwindling popular support and an explosive advertising war between the Government and Australia’s mining lobby, the RSPT ultimately cost Mr. Rudd his premiership.

As the result of an internal leadership election within the Labor Party, the reins of government were handed to former Deputy PM Julia Gillard in June. This was done, as often will be in parliamentary systems, to better position the party for an imminent general election. Since Australians don’t directly elect the Prime Minister, they may give a particular party a majority in order to see the party leader become (or remain) Prime Minister.

Gillard knew that her predecessor had backed Labor into a corner and thus worked quickly to secure a truce with the major miners. Her compromise, called the Mineral Resource Rent Tax (MRRT), limits the tax to iron ore and coal mines only. It reduces the proposed tax rate from 40% to 30%, and includes an “extraction allowance” that pushes the effective rate down to 22.5%. The MRRT only kicks in when a mine’s rate of return exceeds 12%, as opposed to the 6% threshold under Rudd’s plan. Finally, state royalties are deductible from the MRRT, and MRRT payments are deductible from a firm’s corporate income tax return. All of this amounts to a much smaller hit to the mining industry.

Don’t Forget the Kiwi

When thinking of investments in the South Pacific, it’s important not to overlook New Zealand. Euro Pacific has liked New Zealand for some time because of the island nation’s simple and strong fundamentals. Here are three points to consider:

Dividend Yield – New Zealand offers some of the highest dividend yields and most modest valuations in the developed world. The NZX50 (the broad index of New Zealand’s largest public companies) offers a current dividend yield of 4.6% (~2.5x higher than the yield offered by the S&P 500). At the same time, the NZX50 is trading at just 14.5x current earnings (as compared to 21x for the S&P 500).

Fiscal Discipline – New Zealand is successfully tackling the fiscal issues that other nations are ignoring. The Government expects the national budget to be in surplus by 2016, three years earlier than last year’s projections. The National Party under John Key, which took office in November 2008, has reversed many of the socialist-leaning policies established by prior governments. As odd as it may seem to Americans, Key has actually succeeded in reducing government spending.

Currency – Based on the country’s strong economy and prudent fiscal and monetary policies, the New Zealand dollar has rallied strongly over the last year. Although the kiwi dollar is still 11% below its high, set in early 2008, it has surged more than 50% off its 2009 lows. We continue to see the NZ dollar as a good source of long-term value. Like Australia, New Zealand offers very high interest rates, with its central bank showing a current bias towards tightening. This stance should help support the currency.

Still, the MRRT is not considered a total win for the miners. Gillard’s plan scraps the original allowance to refund a portion of project losses. Smaller mining firms are also furious that Gillard’s proposal cancels tax rebates for capital spending on exploration, which makes up a larger percentage of their business.

Whatever the outstanding complaints, the compromise was sufficient to stop the bleeding. The mining lobby called off the dogs, and Gillard was able to preserve a victory for Labor in the general election. However, the election was so close that Labor had to invite independent members of parliament (one hailing from the Green Party) into their government in order to scrape together a majority. The demands that will be ultimately made by these members are still anybody’s guess.

This suggests that a new election won’t be too far off, and that aggressive policymaking will be nearly impossible. 

Fortunately, centuries of history support Thoreau’s old maxim: "the government is best which governs least." Based on that formula, the new regime in Canberra may be the cream of the crop.

There has been some speculation that because Labor triumphed in the general election, Gillard may look to ratchet up some of the provisions of the MRRT. Industry has anticipated such an eventuality and fired a few warning shots across the government’s bow – including a strong statement from mining giant BHP Billiton’s Marius Kloppers. The message: a deal has been made, and the mining industry expects the government to honor it. 

For now, at least, the investment thesis that favors Australia remains strong. Their domestic economy continues to be in the forefront among all Western economies. Government debt-to-GDP, at 17.6%, is among the lowest in the developed world. The country’s strong economy has allowed the Reserve Bank of Australia to lead the G-20 by raising interest rates six times over the last year, to 4.5%. August’s unemployment figures, just released, show a decline to an impressive 5.1% -- very close to what economists call “full employment.” But more important than the raw numbers is the strong position Australia occupies in the global economy. By supplying raw materials to the surging Asian economies, Australia’s economic future is more intimately tied to the developing world than just about any other Western country.

Based on its solid economic statistics, trading relationships, prudent central banking, and high interest rates, the Australian dollar has been one of the best performing currencies in the world this year (and the last decade, for that matter). Since June, the Aussie dollar is up nearly 16%, approaching the highs achieved back in 2008.

Japan’s recent (misguided) market interventions aimed at weakening the yen should bolster the Aussie dollar even further. That’s because many hedge funds and foreign exchange traders engage in the “carry trade,” whereby they borrow Japanese yen at a near-zero rate of interest and invest the proceeds in Australian bonds yielding 6% or more. With the Japanese government now actively trying to push the yen down, many more funds may find the “carry trade” to be irresistible.

Even without currency considerations, Australia looks strong simply because other regions look weak.  Given the fiscal gaps in the EU and US, particularly the high levels of sovereign debt, it is difficult to see central banks doing much else but printing money for some time to come. That should be a recipe for extended bull markets in gold and commodities, and a boon for the country that is a reliable and nearly pure play on these markets.

Of course, Australia has shown a particular sensitivity to global economic pullbacks. If a worldwide recession were to take hold once again, commodity prices could drop violently in the short term. If that happens, as it did in 2008, Australian equities and the Australian dollar could show oversized losses. However, given the independent strength of the Asian economies thus far and our belief that inflationary forces are a much greater threat than deflation, we see this scenario as remote.

Whatever happens with the mining tax, the Labor Party would have to really try hard to disrupt Australia’s positive momentum. This Government, being a tenuous and unpopular coalition, will likely have neither the strength nor the lifespan to put through a radical agenda. If it were to fall, the staunchly pro-mining Liberal/National coalition is waiting in the wings. Not only does Australia have bullish fundamentals, this election has shown that the population has no interest in biting the hand that feeds it. 

Australia’s Economy and Currency Rise on Fundamentals
By: Michael Pento, Senior Economist

While the political situation in Australia is in a state of flux, we don’t expect that uncertainty to make much of an impact on the country’s ongoing economic success. A quick comparison between US and Australian fundamentals reveals the current relative strengths of the Australian economy. Here’s a snapshot: 

While much of the recent growth down under has been boosted by increasing Chinese demand for Australian coal, nickel, gold, zinc, iron ore, and other natural resources, it has also been aided by the increased purchasing power of domestic consumers. Much of that is attributable to an appreciating Aussie dollar.

The currency is up 11.23% from a year ago, and is currently worth a strong 96.79 US cents. Helping to spur the ascent toward the 2-year high has been the responsible monetary management of the Royal Bank of Australia (RBA). 

RBA Governor Glenn Stevens has recently signaled that he may resume raising interest rates at the Oct. 5 policy meeting. Think of it, Australia currently offers 4.5% interest, one of the highest rates in the developed world, and they are looking to tighten, not ease!

In light of Australia’s long history of producing solid growth along with its central bank’s continued commitment to sound money, low inflation, and the encouragement of savings, global investment dollars should continue to find a home in the land down under.

Investment Opportunity 

For those investing in Australia, we continue to see value in resource companies. We have recently added a large Australian coal miner to our list of covered stocks.

The company in question has operated coal mines in Australia for more than 50 years. Although the company expanded beyond national borders in 1989, it recently sold off its non-Australian assets to focus on its core domestic holdings. The company owns 100% of an important terminal in Australia to export coal.

The company produces coal for the international and domestic thermal coal markets. It exports in excess of 50% of its coal production to Asia-Pacific markets with the remainder being consumed domestically.

In recent months, Australian coal mines have been acquisition targets. Yanzhou Coal of China bought Australian-based Felix Resources for ~US$2.9 billion back in August 2009. In December 2009, Macarthur Coal of Australia announced a takeover bid for Gloucester Coal of Australia. Then, in April of 2010, Peabody Energy (USA) announced a takeover of Macarthur.  Before the month was out, Nobel Group (Singapore) announced a takeover of Gloucester Coal.   

The takeover of Macarthur was dropped, Macarthur dropped its takeover of Gloucester, and the Nobel-Gloucester deal is underway.  In any event, it is not illogical to conclude that the appetite for takeovers has not subsided. This undercurrent should continue to exert upward pressure on multiples in the sector.

Based on its history, strong balance sheet, and export capacity, and its potential as a takeover target, we look favorably upon the prospects of this company.

Of course, the company could see oversize declines in the event of an economic pullback in Asia, a fall in the price of coal, any interruption in regional trade, or onerous new taxes and regulations from the Australian government. 

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 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.

Basel III: Return of the Fed Lie
By: John Browne, Senior Market Strategist

On September 12th, meeting in Basel, Switzerland, twenty-seven of the world’s most powerful central bankers agreed on a new framework for banking regulations. The keystone of the accord was a requirement that banks raise the amount of capital they hold in reserve. As it turns out, the highly anticipated new standards, termed Basel III, were not as demanding as had been previously rumored. As a result, international bank shares rose swiftly in the wake of the announcement. But more noteworthy is that the Fed signed on at all, because it is actively working against the spirit of the agreement.

In calling for higher reserve requirements, the bankers generally acknowledged that these troubled economic times demand that more money be set aside to deal with another potential credit crisis. Of course there was much dispute about how much capital would be sufficient and the proper time frame under which the new rules should take effect.

However, the critical split emerged when a block of bankers, led by the United States, seemed to accept currency debasement as a necessary means to continue to “stimulate” the global economy. Higher reserve requirements and a deflationary environment could bankrupt many of them, after all. This group favored lower capital ratios and a longer introductory period.

They were opposed by the majority, led principally by the Germans, who felt it best to accept a degree of austerity as means to right the global economy. It is common knowledge that a great many banks still hold many hundreds of trillions of dollars worth of derivatives, some of them linked directly to toxic assets such as dubious home mortgage debt or obligations from bankrupt governments. If a repeat of the 2008 crisis is in the cards, adequate reserves will be vital to avoid another systemic collapse. Thus, the latter group urged more stringent rules, imposed more quickly.

However, the more capital a bank must retain, the more its lending power declines. In Europe, this is seen as an acceptable consequence of this policy. Not so in America. The Fed and the Obama Administration take the view that lack of credit is the principal cause of the present economic contraction. Anything that inhibits more lending is viewed as contrary to current policy. To them, banks must lend now, and the long-term consequences can be dealt with later. The Europeans rightly see this policy as merely postponing and worsening the economic crisis.

Yet, despite a public in revolt, massive debts, and no clear exit strategy, the United States is still the world’s only superpower. More importantly, the US dollar is still the reserve currency upon which the international monetary system is built. Therefore, although heavily outnumbered in Basel, the Fed was able to impose its will on the final agreement. The results were necessarily complicated.

For example, the capital ratios of internationally important banks are made up of the sum of such exotic components as their Tier 1 capital ratio, capital conservation buffer, countercyclical capital buffer, and capital for systemically important banks. Basel III phases-in various ratio hikes over a period stretching from 2010 to 2019!

Nevertheless, for all the attention they have attracted, the new Basel III requirements are likely to have little impact on the security of the world’s banks, hence the rally in bank stocks following the announcement. More significant are the changes now taking place in the US and EU regarding accounting rules and securities laws. These reforms will likely make or break the Western banking sector.

But Basel III is still significant in the sheer irony created by the US signature. As evidenced by the latest FOMC statement, the Fed believes that it is currently failing to expand credit fast enough to meet its mandate of price stability and full employment! Clearly an agreement with foreign counterparts to require banks to hoard more cash is working against the Fed’s own goals.

Politics is seldom black-and-white, and often hypocrisy is the order of the day. With US power waning, the Fed surely felt pressure to reach some compromise with the other delegations. The danger moving forward is that the United States finds itself increasingly isolated in its stimulative approach to economic policy. Our traditional negotiating chips – foreign aid, military muscle, and access to our markets – are looking increasingly tenuous. At some point, the US may be invited to conduct its inflationary experiments in the privacy of its own economy.