4 December 2008

The Value of Money


The global financial storm that we have entered is causing much worry and concern throughout the world. I too have stayed awake many a night reviewing this tempest so that I can decide on our best course of action. So far, I have only been surprised by the speed by which it has unraveled — never in my wildest assumptions did I think the system was this weak. Through recent careful study of the situation, I believe I can see how this financial mess may unravel and what course of action the rational investor might take.

Inflation or deflation? — that is the question as to how the mess will unravel. It is extremely important that we understand this debate as its outcome will have serious implications for your financial wellbeing. My observations and conclusions are that the outcome of this mess will lead to inflation. I believe "the deflationists" are wrong. The main arguments for the deflationists are based upon two premises: first, the fact that deflation was the outcome of the Great Depression of the 1930s and of Japan in the 1990s; second the argument that the levels of debt are so big that the Central Banks could never print as much to offset the deflationary effect of unwinding the debt. A historical study of these arguments reveals that deflation is a rarity. Furthermore, we have the experience of all other financial storms over the past century (apart from The Great Depression and Japan in the 90s) creating inflation. Inflation has been the historical norm. It is important to understand why so that one can make rational investments decisions.
Mervyn King, Deputy Governor of the Bank of England, wrote a very good paper on the subject in 2001. In this paper, King traces the effect of money and inflation all the way back to 1885. His main conclusion is that the ability of Central Banks to create money always leads to inflation. This was not the case during the Great Depression as the US Fed was unable to print money because the currency was pegged to the gold standard; thus it was impossible to inflate the money supply. This is the topic of Ben Bernanke's thesis: if the Fed had had the ability to print money in the 30's, they would have been able to inflate and avoid the deflationary pain. In the words of the Maestro himself, Ben Bernanke;

"Suppose that, despite all precautions, deflation were to take hold in the US-economy and moreover, that the Fed's policy instrument, the federal funds rate, were to fall to zero. What then? Well, the US government has a technology, called a printing press, or today, its electronic equivalent, that allows it to produce as many US-dollars as it wishes at essentially no cost."
It is important to understand that deflation is the Central Banks' greatest fear as it is the one thing they cannot control. Furthermore, one must also understand that the Central Banks' sole aim right now is inflation through their monetary control — an outcome that is easier to control down the road. In this context the Central Banks will continue to increase the money supply and inflate.
As I wrote earlier, I was surprised by the rapidity of the unwinding yet now realize that all that has happened is a fast forwarding to a point we all will have reached anyway. To explain, if Lehman Brothers had been bailed out like the other financial institutions, the world would never have witnessed the massive liquidation of assets that has taken place over the last two months. In this alternative scenario the Fed would have been able to slowly control the process through money creation in order to fund the bailouts needed to slow the unraveling of its financial system, all the while with inflation rising. However the Fed took a detour and institutions have been forced to liquidate their holdings so that they can pay back their obligations, resulting in some great assets being thrown out with the dirty bath water. What many have mistaken for deflation has only been a forced liquidation by hedge funds and financial institutions trying to meet their financial obligations. The question we must ask is why this was allowed. Oddly enough, everything that is required to best deal with this mess is happening.
If there was a central banker manual the best solution to this mess would require an extension of these bad debts as long as possible, 10 to 30 years is preferable. Next it would be great if this could be facilitated with as low a rate as possible in order to reduce the already enormous cost to the taxpayer. And finally, if the currency was to decline as much as possible the problem would be inflated away. And wouldn’t you know it, thirty year bonds at 3.19%, wow! What are the chances that the dollar goes next? However, this route will result in inflation like we have never seen before, and the rational investor must prepare in order to benefit.


In November the International Energy Agency issued its November report on the status of the global energy complex. This was a very important report as the IEA finally did a study of the long term supply of world energy, and the conclusions are not good. What I find amazing is how the Wall Street pundits and the media completely neglected to mention 99% of the 400 page report and only concentrated on the fact that the IEA now expects global oil demand to grow by only 120,000 b/d in 2008, to 86.2m b/d, the lowest annual increase for 23 years. Of greater importance to me were the warnings in the remainder of the report of a coming perfect storm in the energy sector. The report is sounding the alarm that our ability to supply the world with the needed energy to meet global demand is in dire straits due to three factors: 1. ongoing and accelerating reservoir depletion, 2. lack of capital investment, and 3. continued global demand for energy.
In this environment Canada looks very bright as, net of new discoveries, we are the only producing oil country that can actually increase oil production, and with no political risk. Yet our oil companies are trading as though oil is going to $35 and with tax free yields above 11%. I love the irrational decisions people make due to fear. My convictions of investments in the Canadian oil sector were once more confirmed at a recent meeting with John Priestmam, Manager of the Guardian Monthly High Income Fund. In his opinion the current pricing of Canadian energy income trust is presenting a great opportunity for the rational investor, from a valuation and income perspective. It is my conviction that all evidence points to the fact that this is the last time we will see these low prices and yet irrational short term sighted investors are giving these assets away at liquidation prices.
Another sector with similar characteristics as energy is agriculture. One need only look at a company like Agrium to understand the current irrationality of investors. Agrium is currently trading at a ridiculous 3.5 P/E, yet its sales increased from $900 million Q3 2007 to $3,200 million Q3 2008, and management is telling us that they have very good visibility of earnings for the next two years. I urge you to listen to the latest quarterly Webcast for both Agrium and Potash. The rational investor will very quickly realize why they should consider investments in this sector.
The current financial mess has not resolved the fact that we are currently using 98% of the planet's arable land to feed the world, and that global food stocks are still at all time lows and not increasing. In addition, as the energy issues progress, our ability to grow food will also be affected for two reasons: 1. diversion of food stocks to ethanol production, and 2. increases in the price of natural gas to meet energy needs will lead to higher fertilizer costs. For some reason we have forgotten that the Green Revolution was due to the discovery of hydrocarbons and that as these decline our ability to feed the world will decline. As matter of historical fact, in the late 1800's Chile fought Peru and Bolivia over control of the nitrate fields in what is today northern Chile. Today I believe Potash and Agrium are investments with great outlooks on earnings for many years to come due to the need to feed a growing world, and yet they are currently priced as though the world is on a diet.
Having been an institutional bond trader, it is absolutely unbelievable to me that the 30-year US bond is trading at a yield of 3.19%. In light of the current liabilities facing the US government (discussed below) and the fact of the coming Baby Boomer cohort's retirement, I can't help but conclude that the final credit bubble to burst is the US long bond. Yields will greatly increase sooner than later as all these liabilities are assumed by the US tax payers.
From an investment perspective this represents another great long term opportunity for the rational investor as today we have the ability to participate on the increase in yields of US debt. The strategy is simple as we are witnessing a change in the direction of declining interest rates for the last 20 years, and are about to embark on a steady climb for many years. Stated in a more fundamental way, the US debt is the last remaining credit bubble and rates have to climb from now on. This is one more good reason for increasing inflation as the US knows that the only way to deal with this tsunami of debt is to inflate the debts away at the expense of their creditors. This is normal Central Bank procedure, especially when one understands that the only thing that Central Banks can control is inflation. It was done in Russia, Argentina and all other over indebted countries. The simplest way to reduce debt owned by foreigners is to devalue the currency, either overnight or over a longer span of time. Which leads one to conclude that the recent rise of the $US is unsustainable and will reverse sooner than later. As a side note, understand that this sudden rise is the $US is the last thing the US needs at this time, and the US Fed will do what it needs to do to lower its currency.
I have often observed that one of the problems with today's society is that we have lost the ability to assess the value of things, especially the value of money. If you really think about it, the financial mess we find ourselves in is about empty financial promises made over things that were in the end not worth anything. As a matter of fact the world would not find itself in this mess if currencies were pegged to gold, as we would never have been able to create debt of such levels without acquiring the necessary gold to back the obligations. Gold allows us to peg the value of money to a constant, so that the financial system does not get into this kind of situation.
I have never been a "Gold Bug," I just have a great understanding of human history and know that today we are at a crossroad. To a large extent this last summer will mark a very important change in the way the global system works. We are witnessing the beginning of a new transitional period that will require us to re-evaluate the value of things. In a world where we have endless amounts of money we will have to re-evaluate what things are really worth. I noticed this first hand in Chile as the things that were necessary to maintain your Quality of Life became very dear. Likewise, today, we are witnessing the rapid rise of new economies at the expense of the old ones. Throughout history this process has never been a smooth one as it usually requires a cleansing of the financial system. I see the same changes starting to take place and from a financial perspective gold will increase as we re-define the value of money.
From a fundamental perspective wealthy individuals around the world have been buying gold and today we find ourselves with global shortages for the physical metal. The US mint has announced that they will not be selling gold and silver coins until the spring of 2009, South African gold producers do not have any to meet the demand for Krugerrands, and most dealers are about 16 weeks behind in meeting orders. Bank lease rates have greatly increased as financial institutions start to husband their gold, and more importantly for December delivery the COMEX has registered sales for 15 million ounces against inventory of only 8.5 million. Once again gold is signaling a very different picture than deflation.


Going forward we will see the global banking system normalize. The banking system will solve the illiquidity issues through global money creation. Central Banks now know what deflation means and will do whatever they can to prevent it: they will inflate. And who better at the helm than the inflation expert himself Chairman Bernanke? The US dollar will resume its decline and within the next three to nine months we will see prices rising and inflation returning to the headlines—this inevitable as the US needs a lower dollar. Supply destruction of the things we need will have worked itself into the system, further supporting rising prices. Deflation, which always appears prior to an inflationary wave, will be a thing of the past and those who position themselves appropriately will be very well rewarded. In this new reality Canada will be one of the best performing economies, not only because we have very little US debt, but also because we have what the world needs.

Jaime E. Carrasco CFP

excellent work

© 2008 Jaime E. Carrasco CFP

Contact Information
Jaime E. Carrasco CFP
Investment Advisor, Blackmont Capital in Toronto.
181 Bay Street, Suite 3200 BCE Place, P.O.Box 779 Toronto, ON M5J 2T3

1 comment:

Anonymous said...

Excellent article. Especially the historical perspective on deflation moving into inflation. With an inflationary environment a few months away, i agree with the investment strategy he lays out, oil, gold, and agriculture.