Dan Denning (Whiskey & Gunpowder):

We’re going to review your 2010 asset allocation strategy in a roundabout way by exposing some of the snarky disinformation being put out by the mainstream media about gold, courtesy of Michael Pascoe at The Age.

First though, let’s just check to see that markets are still functioning normally. That is, let’s just check to see that heavy government intervention is supporting house prices (by providing guarantees to home lenders), GDP growth (by spending money on infrastructure), and disguising the true state of the labour market (by lying about how many people are out of work).

Yep. Situation normal, all fouled up. The oil price, the U.S. dollar, and bond yields were all up on bullish industrial production figures in the U.S. The “recovery” meme is taking a tenuous hold. Stocks were down. Because why would stocks rise if the economy were recovering?

Ah. Well that tells you something right there. It tells you that stocks haven’t risen in anticipation of a global recovery. They’re just enjoying the benefits of all that monetary and fiscal smack being peddled in Washington, London, Tokyo and Canberra. It’s hard to rally on fundamentals when you’re already over-valued.

Speaking of value, let us now return to the question of element number 79 on the periodic table. The snarky article we mentioned at the top is from Michael Pascoe at The Age, titled “There’s more gold where that came from.”

In the article Pascoe takes on the issue of “peak gold.” But how well has he done in accurately stating the argument for gold? And more importantly, is he right about the relationship between market prices and gold? Well, obviously we think he’s pretty wrong. But let’s see what he’s said.

“Part of the dogma of the less rational gold bugs is that the world is running out of the stuff. As an article of faith, it makes a pleasant change from the idea that fiat money is about to be exposed as huge confidence trick and we’re heading back to the caves.”

Webster’s defines “dogma” as “a religious doctrine that is proclaimed as true without proof.” Already you can see what Pascoe is up to. Gold bugs are nutters and zealots. Apparently 5,000 years of monetary history where gold has proven utility as a medium of exchange and store of value does not qualify as empirical evidence of gold’s value. There’s no pleasing some people, especially those who come to an argument with their mind already made up.

Click here for the rest of Mr. Denning’s analysis at Whiskey & Gunpowder.

Dan Denning (Whiskey & Gunpowder):

The market has metal on its mind. Shares are wandering without much conviction as we look at the flickering green screens this morning. But metals? That’s a bull market with some conviction, or at least a lot of momentum.

February gold traded above $1,218 yesterday and closed at $1213. Gold has closed higher 20 of the last 22 sessions. In that time, according to Dow Jones newswires, it’s up 15% – nearly double the return of the S&P 500.

Does this mean investors are starting to give up houses and shares and speculate on gold instead? The U.S. government has been forced to suspend sales of American Gold Eagle coins, according to Javier Blas in the Financial Times last week. It’s the second time the mint has had to suspend sales since Lehman went belly up in 2008.

There’s a bit more to the story, though. The mint has sold 1.19 million ounces of gold this year. That’s a 75% increase over last year. Hmm. But it’s also sold 26 million ounces of silver coins – the highest level of sales in 23 years.

What does this tell you? Well, the rational answer is that bullion or gold and silver coins are assets without counterparty risk. True, the value of gold and silver coins fluctuates with metals prices and liquidity. But your payment does not depend on someone else’s credit quality. Your payment is in your pocket.

That rational answer presumes that investors are now showing a preference for tangible assets that are…real. But is it more fear than reason? After all, a rational investor might prefer the leverage you get with gold stocks as the best way to profit from rising gold prices. That would be the easier investment strategy.

But that suggests to us the move to gold isn’t so much an investment strategy as it is a financial survival strategy. Investors are less and less worried about capital gains and more and more worried about the preservation of their purchasing power and capital itself. Gold is the ultimate expression of that worry – a flip side of the lack of confidence in modern monetary policy (or just modern money).

Gee. It’s soooo kooky to distrust central bankers, isn’t it?

Morgan Stanley appears to distrust UK central bankers. Morgan released a report yesterday, according to Ambrose Evans-Pritchard in the UK Telegraph, which highlights the risk that capital will flee . . . .

Click here for the rest of Mr. Dennings article on Whiskey & Gunpowder.

“China also bought 590,000 tonnes of aluminium, 159,000 tonnes of zinc, 30 tonnes of indium and 5,000 tonnes of titanium, said Yu, who works in the National Development and Reform Commission’s industry department.” Now that metals prices have rebounded, though, will the stockpiling continue, even at high prices? Or was it a case of bargain shopping at everyday low prices?

There are several components of demand. There’s real economic demand (you need the stuff to make other stuff). There is investment demand (you’re buying it in order to make a profit from what you think the price trend is. There is also pure speculation, and it’s possible that some middle-men were flat-out speculating by buying alongside China’s State Reserve Bureau (sort of like the banks and brokers in the U.S. buying Treasuries ahead of the Fed late last year to improve Q4 earnings).

But if you’re trying to figure out the ultimate direction of certain base metals prices (or commodity prices in general) you have to also consider the currency in which they’re priced. Or, as my colleague Dan Amoss writes, “You also want to consider what Ben Bernanke and Tim Geithner will do to debase the dollar in the coming years. If you’re a foreign creditor facing with this constant portfolio decision, which has higher marginal utility? Is it 1.) US$2.32 or, 2.) one pound of copper?”

Dan is referring to a pretty handy economic concept. Marginal utility is the economist’s attempt to quantify how much satisfaction or benefit you get out of each additional good or service you buy. You have probably heard the term “diminishing marginal utility” more often.

An easy way to understand this is that while one cheeseburger may satisfy your appetite (and your craving for animal fat), four cheeseburgers gobbled down in a row are neither useful nor terribly good for you. They might even be bad (although as an American, we are reluctant to concede this point).

In Dan’s scenario, U.S. dollar holders will ask themselves if each additional dollar owned is more useful. Given the fact that the U.S. monetary authorities are making so many dollars, it’s pretty clear that each additional dollar added to supply makes each existing dollar less useful. It is not very satisfying to see a methodical reduction in the purchasing power of your savings.

If Dan is right, then stockpiling real assets (even during a relatively weak economy) makes more sense that stockpiling U.S. liabilities. Or, as Dan says, “The Chinese will probably go with #2, especially because copper (and oil, and iron ore) can be stored and used in infrastructure projects to keep the population somewhat placated with infrastructure jobs,” says Dan.

He adds that you should look for the Chinese to stockpile resources on the dips in commodity prices, while selling/divesting of U.S. Treasuries into the rallies that come with ’safe-haven’ buying. That sounds right to us. But the only catch to the plan is if Treasuries fail to rally on safe haven buying.

On that score, the Treasury market seemed to survive last week’s big auction without a huge spike in yields. If the economic news remains neither bullish nor exceptionally bearish, then we reckon Treasuries could rally (prices up, yields down), providing a discrete exit opportunity for certain large investors.

Incidentally, we still haven’t seen much in the Australian press about the long-term consequences of government deficits. That’s probably because most people are accepting the government’s case that Australia’s borrowing (and its deficits) will be temporary. We’re not as sure. And besides, there are some serious questions about how structural deficits affect a country’s currency, its credit markets, and its interest rates.

Those are just some of the questions we hope to take up at our upcoming debt symposium/summit, which will precede the first Australian screening of I.O.U.S.A. We’ve even picked a date, booked a venue, and secured a cracking panel of experts to train their eye on Australia’s very own addiction to debt. Stay tuned for your official invitation!

Meanwhile, did you see that China has astonishingly and rather conveniently discovered some 3 billion metric tonnes of hematite and magnetite iron ore? It’s apparently true, and probably comes in pretty handy during the current stagnated annual price contract discussions with Aussie iron ore producers BHP Billiton (NYSE:BHP) and Rio Tinto (NYSE:RTP).

As you know, China is the world’s largest steel maker and thus the largest importer of iron ore. Chinese geologists claim they have found Asia’s largest iron ore deposit ever in Benxi city, which is in the northwest province of Liaoning. The good news is that the deposit is said to be about 2.5 miles long and 1.8 miles wide and could, officials say, have a mine life of 50 years-if a mine is built.

The bad news is that the resource (not a reserve because it’s not know if it can be produced economically) is buried around a mile underground. That’s a long way down, or a long way to lift iron up, if you prefer, and if you’re strong (which China is).

Contrast that with the Pilbara, where the stuff seems to lying around waiting to be found in the hundreds of millions of tonnes by any Tom, Dick, or Kerry. That’s right. Iron Ore Holdings, owned by Kerry Stokes, told the ASX yesterday it was increasing by 50% its estimate of its mineral resource at Iron Valley in Western Australia.

This deposit is only 97 metres below ground. It’s surrounded by big projects by BHP, Rio, and Fortescue (ASX:FMG). And the company says it reckons its sitting on a 132 million tonne resource-which is up from the 88 million tonnes it believed it had just three months ago.

Proving up a resource into a reserve-and seeing your share price benefit because of it-is the name of the game for the iron ore juniors. Despite the big Chinese find, we reckon the Iron Valley story is where the Big Picture meets the Little Juniors (or where the rubber meets the road, if you prefer).

At the right prices, stockpiling commodities makes sense to people who will need them later anyway and already have too many U.S. dollars. And if prices aren’t right…if..in fact…commodity prices decline (either because of slow economic growth or a halt in stockpiling) then commodity stocks probably fall a bit too…which makes those very stocks-especially the smaller ones that need capital and JV partners-the next logical candidates for acquisition or accumulation.

Dan Denning
Source: China Has Stopped Stockpiling Metals

When a large holder of U.S. dollars declares that the dollar is in “great shape,” should we believe him? My answer is, “Probably not.”

Russia’s Finance Minister Alexei Kudrin told journalists this week that the U.S. dollar is in “good shape.” He added that, “It’s too early to speak of an alternative [to the U.S. dollar].” These remarks came after Chinese and Russian officials have quite publicly suggested that the world’s financial system would benefit from using a currency that wasn’t being run by a bunch of inflationistas in America.

But the dilemma for the large dollar-holders of the world – Japan, Russia, and China to name a few – is how candidly they should verbalize in public about what everyone knows in private. By blowing the whistle on the Fed’s inflationary monetary policy, dollar-holders penalize themselves. The lesson? There’s a price to pay for rightly pointing out that a huge supply of Treasury bonds threatens the credit rating of the U.S. That price is paid by owners of dollar-denominated assets.

The dollar-supportive remarks by Kudrin, then, should be seen for what they are: a white lie, designed to halt the dollar’s slide…at least temporarily. In the meantime, however, you can bet that these same dollar-holders are working behind the scenes to find alternatives to the greenback and, of course, to diversify their currency reserves into other currencies or tangible assets. It’s just that you don’t want to precipitate a crisis until you’re good and ready to profit from it with a well-planned trade. Goldman Sachs would never make that kind of mistake!

There may be a few escape avenues from the dollar. It comes down to figuring out what-if anything-will go up when the U.S. dollar resumes going down. In fact, the question on everyone’s minds is what U.S. creditors will do with their money if they aren’t lending it to Barack Obama to spend.

“Over time,” says Nouriel Roubini, professor of economics at the Stern School of Business at NYU, “the willingness of the U.S. creditors to finance U.S. spending and buy dollar reserves is going to be reduced. People are getting nervous rightly about us devaluing or inflating our way out of the debt problem and causing real losses on the holdings of those assets.”

If you’re losing money on an asset, naturally you’re going to either sell of it, or at the very least, accumulate less of it. But then what? Where does your money go after that? We’d suggest the investment needs of the emerging market nations are the natural replacement for throwing away money in the U.S. Treasury market. Granted, there’s risk in emerging markets. But it’s now clear there’s risk in the sovereign bond market too. Take your pick.

Speaking of those emerging markets, four of them spoke with one voice in Russia this week. The leaders of Brazil, Russia, India, and China gathered to figure out how to solve their dollar dilemma. Criticize it too much, you lose value on your current dollar-denominated holdings. Do nothing, you lose value on your dollar-denominated holdings as Obama and his Congress spend America into poverty and servitude…and then inflate like mad men.

“There is a strong need for a stable, predictable and more diversified international monetary system,” the final statement from the BRIC nations read. Russia’s Dmitry Medvedev added his own “two roubles,” saying that existing reserve currencies, “have not managed to perform their functions.”

And what is the function of a reserve currency? Well, it’s probably the same as the tripartite function of any money: as a store of value, a unit of account, and a medium of exchange. Countries hold baskets of currencies (yen, Euros, Swiss Francs, U.S. dollars) in order to conduct international trade and commerce.

Of course all this is relatively new. That is, when money used to be a commodity (gold and/or silver) then a country’s monetary reserves were the same as its precious metal reserves. Debtor nations that consumed more than they produced and borrowed to do so paid the price in a net outflow of commodity money. But things don’t work that way in a world where everyone uses fiat money. So what we’re seeing now is a worldwide monetary system that is, well, systemically flawed.

Make of it what you will. What we make of it is that the very foundation of the world’s commerce and the currency in which it’s conducted is shifting. The stock markets of the world have no idea what to make of all this because it is not clear yet who the winners and losers will be.

All that we know is that paper currencies and government debts are proliferating very rapidly. We also know that natural resources are not. In fact, they are depleting very steadily.

So we conclude that the prices of most natural resources will go up…a lot. That’s why lots of bears on the U.S. dollar suggest buying gold. We are sympathetic to this idea, but we’d suggest a slightly different strategy: Sell bonds. Buy energy.

Source: Sell Bonds, Buy Energy

Editors Note: Pulbished by the Rude Awakening, this article origianlly appeared in the Australian Daily Reckoning

By the way, last year at the Agora Wealth Symposium in Vancouver, one of our colleagues took the stage to point out that your editor was complete moron. In this particular case, it was for being bullish on gold.

He said that gold hadn’t done much adjusted for inflation since 1980. What’s more, he said, its worth less, adjusted for inflation that it was twenty years ago. How, he speculated, could anyone take the advice to buy gold seriously when it had performed so abysmally?

Well here are the facts. The gold price bottomed in October of 2000 at $263.80. At that time, the S&P 500 traded at 1,379. Since then, the S&P 500 has fallen by 31% (closing yesterday at 942.43) while the gold price is up 262% to $956.

We’ve asked Kris Sayce to bring this small fact to the attention of our colleague when he attends this year’s Vancouver show next month. The theme of this year’s show is “Ten Years of Reckoning,” celebrating the tenth anniversary of the Daily Reckoning. Kris will be spearheading the Australian delegation. More details on that later this month.

In any event, it seems pretty obvious, that for the last ten years anyway, selling stocks and buying gold would have been a good trade/strategy. Stocks ended an 18-year bull market in 2000 and gold ended a 20-year bear market. One asset class was at a cyclical low. The other was at a cyclical high. In fact, you might even say that one was at a generational low and the other was at a generational high.

Gold is no longer as low as it once was. But it’s still not as high as we expect it to go before it starts to look foolish. Meanwhile, today’s government bond market looks an awful lot like the stock market circa 2000. You’re seeing a generational high in bonds. It’s another version of the “high-low” strategy.

This time around, though, we would add energy stocks to the mix, along with gold. Crude oil climbed to an eight-month high over $70 yesterday. Bloomberg says the weakness in the U.S. dollar is, “bolstering the appeal of energy as an alternative investment.” Sell bonds, buy energy. Pretty simple.

There is probably some truth to the fact that oil’s latest move is driven by investment demand more than, say, demand growth in the real economy. But investors ARE looking for ways to profit from U.S. dollar weakness. Oil is liquid and popular. In the long-run, it’s the smaller-than-expected oil supply growth that will drive the market.

By the way, some Diggers and Drillers subscribers have wondered exactly which of our energy recommendations come from our “Long Aftershock” scenario. We’ll make sure to specify which oil and energy stocks we had in mind in tomorrow’s weekly e-mail update (for subscribers only).

One thing Kris will probably be making clear to U.S. dollar-based investors is just how relatively attractive Australia’s position is in the developed world. “Even as Australia’s challenges increase, it will still be the envy of the developed world,” writes William Pesek at Bloomberg. “Even in its worst moments… Australia is among the least unsightly economies anywhere,” he adds rather optimistically. We’ll see about that.

Finally, we meant to write a bit about other possibilities in China today. That is, we were going to explore collapse scenarios (financial, political, and societal). But we did not realise it would be ambitious to try that in a few hundred words. So look for something more considered later this week in the essay spot.

Dan Denning

Source: Last Decade: Buy Gold, This Decade: Buy Energy

If we’re using numbers instead of metaphors, we’d say the CRB Reuters/Jeffries Index had its biggest monthly rally in 34 years. It was up 14% on the month. That was the best performance since July of 1974.

A monthly performance like that can only mean one thing. We’re just not sure what one thing it is. It could mean commodities have rebounded from being oversold, as they were in late 2008. It could mean that markets are less pessimistic about the global economy than your editor at the Old Hat Factory (though we doubt that).

It could also mean that investors increasingly prefer tangible assets as a long-term growth strategy over financial assets. Even after $1.465 trillion in realised losses by global banks and financial institutions, there are trillions more to come. Commercial real estate…the option-ARM recast period in the U.S. housing market…European banks…any or all of these things could conspire to lead to more losses and more capital raisings in the financial sector.

Perhaps that is what explains crude oil’s biggest monthly gain in a decade. July crude futures traded at $66.52 in Friday’s New York action. The U.S. dollar price of gold powered to $981.20, before sliding back a bit $975.

The Aussie gold price is fighting its way up despite the fact that the Aussie dollar keeps gaining on the greenback. While the Aussie gold price is up just $1.71 in the last 30 days (0.14%), the U.S. gold price is up nearly nine percent. We reckon the Aussie gold price will begin moving up closer to $1,500 again on a combination of events (weakness against the greenback for one.)

There are also two data releases this week that will affect the Aussie dollar. The RBA meets tomorrow to decide the price of money in Australia (set interest rates). And then Wednesday, the March quarter GDP figures come out. This will tell us how bad the recession is, although not how bad it may become.

It’s no use predicting these things. But for what it’s worth, our view is that we’re in a bit of a plateau between down moves. The “down moves” will come again in financial stocks, although they may not be as “down” as before, and employment. Mostly, the indices are going to have to price in very slow GDP growth for the remainder of the year and more job losses.

The wildcard for Australia is trade. Its proximity to Asia means that a rebound in that part of the world provides some cushion to resource companies. But then, we thought the resource stocks would be pretty well insulated from the first round of deleveraging too, and we were wrong about that. And the second time around?

Well, even if the long-term underlying demand for Aussie resources is real and growing, it still takes real money to make new projects happen. The financing of resource projects will continue to be a key issue in your stock selection. The other issue, obviously, is the direction of commodity prices.

Take LNG, for example. Last year the Australian Petroleum Production and Exploration Association said it wanted to triple Australia’s LNG output to sixty million tonnes per year. Meeting this weekend in Darwin, the group says 50 million is a more realistic target, given both the slump in energy prices and tight credit markets.

If LNG prices track oil prices-as they did in the big run up to $150 per barrel for crude-the economics of big Aussie projects get a lot better. Our view is that energy prices are going structurally higher anyway. Global recession aside, the big plunge in energy capital spending virtually guarantees a supply shortage in the coming years anyway.

Besides, you have to wonder why big international energy firms would be investing in conventional and unconventional Australian LNG projects if they weren’t convinced that a) oil prices were going higher, or b) more carbon-friendly fuels like gas would gain as coal gets politically demonised and punished with cap-and-trade or emissions-trading-schemes.

Obviously, if global trade continues to contract and a second round of losses in the global banking industry triggers another financial crisis, demand for energy is going to fall. And while we’re at it, stocks would probably test the 2003 lows too. We enter a new stage of grimness.

In the meantime, energy and precious metals stocks are riding higher commodity prices. And there’s a distinctly 2007 mind-set in the air. It’s vogue to be long-commodities and indifferent to risks in the financial system. It’s enough to make an investor with a short memory nervous. More on that tomorrow.

Dan Denning

Commodities Tell Us the World Wont Stop Turning in a Financial Crisis

But how about those powerful idealists on U.S. markets? Both the S&P 500 and the Dow were up nearly three percent. If you can believe it, they were led by financial stocks and retailers. Bank of America (NYSE:BAC) finished up 9.9% after Goldman Sachs (NYSE:GS) put it on its “conviction buy” list. Home hardware retailer Lowes was up 8.1% after a survey of U.S. homebuilder confidence surged.

By the way, what the hell is a “conviction buy” list? Does that mean you can only recommend stocks in which the executives have been convicted of a crime? And if it means a share you can buy with conviction, is there a “non conviction buy?”

Can you see yourself calling your broker to say, “Hey Bob. I don’t much like stock XYZ. Earnings suck. It’s got heaps of debt. Management is incompetent. But stocks are rallying…so yeah…let’s do this baby. Buy. Just… you know…don’t do it with any conviction.”

Does anyone still take broker recommendations seriously?

Still, the rally in U.S shares-based on whatever it is based-is giving some investors the impression that demand for commodities will increase if the U.S. and world economies begin to grow again later this year. We think this is the dying convulsions of the “green shoots” theory/sucker’s rally. You know, the one that ignores another $1.5 to $3 trillion bank losses from residential and commercial real estate.

But if you’re a market neutral trader, why complain? Crude oil prices surged 4.8% in New York. Part of that rise stems from a shooting war between Nigeria’s government and rebels who operate in the Niger delta. It’s another reason to be bullish on oil. Not only has capital investment in new supply crashed, existing supply comes from national oil companies who are likely to use oil as a strategic and political weapon. Or it comes from countries like Mexico, Nigeria, and Venezuela that have fiscal stability issues.

Incidentally, Nigeria supplies 2.1% of the world’s oil each day, or about 1.76mbpd. It would be more if about 500,000 barrels of capacity weren’t idled because of the ongoing guerrilla conflict. The slack in global oil demand from the worldwide recession has made people forget about how slim the margin in is between daily global supply and daily global demand. Any combination of even more reduced supply (inevitable with the cap ex collapse of 2008) and increased demand will put oil right back into the red zone.

What about metals? Copper was up too. It closed up 2.7% in New York trading. And hey, what’s this? In late April we reported that China’s State Reserves Bureau was stock-piling metals at low prices. Bloomberg reports today that, “China is stockpiling commodities such as copper and iron ore as part of a reallocation of its sovereign wealth amid concern that the value of its dollar assets may decline.”

The report cites a Royal Bank of Canada report on China’s strategy to hedge its risk of owning US$796 billion worth of U.S. government bonds and notes. “Increased spending on commodities represents a reallocation of China’s sovereign wealth away from the accumulation of financial assets,” said Royal Bank analyst Brian Jackson.

China, by the way, increased crude oil imports by 14% in May and imported a record 57 million tonnes of iron ore. In fact, the China Iron and Steel Association (CSIA) is trying to blame the import surge on speculators who are front-running what they think will be an increase in demand, according to an article in today’s Australian.

Remember, the annual iron ore negotiations are part of this public hemming and hawing. Chinese buyers of Aussie ore want to talk down demand growth, which would suggest a lower contract price. The CSIA says six of the top ten Chinese ore importers in the first quarter were traders, not steel-makers. But www.steelguru.com is reporting that Chinese steel-maker Baosteel said earlier this week that, “orders from auto sector hit a new monthly record of 937,000 tonnes in May up 317,000 tonnes or 50% over April.”

Hmm. China has a current steel-making capacity of 650 million tonnes per annum (mtpa) according to Boatel chairman Xu Lejiang. That sounds like too much.

Meanwhile, we can’t go into it in great detail, but could the great U.S. dollar exodus be happening right under our noses? China has been busy setting up bi-later currency swaps with its trading partners. The purpose is to settle cross-border transactions in currencies that are not the U.S. dollar.

Today’s Financial Times reports that, “Brazil and China will work towards using their own currencies in trade transactions rather than the US dollar, according to Brazil’s central bank and aides to Luiz Inácio Lula da Silva, Brazil’s president. The move follows recent Chinese challenges to the status of the dollar as the world’s leading international currency.”

China’s government has set up currency swaps with Hong Kong, South Korea, Indonesia, Malaysia, Argentina, and now Brazil. The purpose of the swaps varies from county to country. But the main benefit is that China can conduct more of its trade using its own currency and not the U.S. dollar. It also is a kind of vendor financing deal in which China supplies currency to countries from which it buys a huge amount of commodities (Argentina and Brazil, not yet Australia.)

Does it mean the remnimbi is the next world reserve currency? Nope. But it does mean that the Chinese are not looking to accumulate large financial reserves held in U.S. dollars any longer. They believe it’s better, judging by these actions, to accumulate real assets that will be needed in the future by Chinese industry and Chinese consumers.

And what about all those dollars? Well, most of China’s dollar reserves are held via U.S. Treasuries. And it’s possible China has been performing a kind of financial alchemy, turning financial reserve assets into tangible commodity stockpiles. As this article points out, you’d think it’d be easy enough for Chinese holders of USTs to loan them to U.S. banks (who just love that sort of collateral at the moment) in exchange for cash which can be used to stockpile real stuff. It would be a clever trade.

Australia, of course, would stand to benefit from that trade. As Glenn Stevens pointed out in his speech to the Canadian Australian Chamber of Commerce, Australia’s exports are biased towards commodities rather than manufactured goods. He says this has cushioned Australia from the world-wide slump, without damaging the huge improvement in terms of trade.

Why have Australia’s export volumes not weakened. Stevens says that, “One reason is that the slump in global trade was initially concentrated heavily in manufactures, which is a smaller share of exports for Australia than others. Another is the stronger linkage of key commodity exports to China, which appears to have seen a pick up in growth this year.”

“Chinese industrial output fell for four months between July and November, but has since recovered all those losses. A similar pattern has been seen in Korea, where industrial output suffered a sharp decline around year end but apparently made up about half of that over February and March.

Getting More and Paying Less: The Terms of Trade Improve and Correct

“Looking ahead, with commodity prices at present levels, Canada’s terms of trade look like they are still somewhat above the average for the preceding couple of decades. Australian resource producers have accepted lower prices for the year ahead, and this is likely to contribute to a decline in the terms of trade by the end of 2009 of about 25 per cent from the peak, as shown in the chart [above] Yet even with that, at this stage Australia’s terms of trade over the coming year look like they will still be around 40 per cent above the two decade average up to 2000.”

Hmm. Well, Stevens is right that the terms of trade are still well above the two-decade average. And when you are paying less for your imports but receiving more for your exports, that is not a bad position to be in. But where will they go from here? Would Australia benefit or suffer from a bi-lateral currency swap with China? More on this subject later.

Finally, we feel compelled to point out that Housing Industry Association Chris Lamont has said, “There has never been a better time to enter into home ownership,” in Australia. Someday he’s going to regret saying that.

Dan Denning

Source: China Performs a Kind of Financial Alchemy

Mind you, this is if you want to be in the equity market at all. There is a very good case to be made for NOT being in the equity market this year, or only being in those asset classes and single stocks you think will appreciate (or grow earnings) faster than the rate of inflation.

But let’s be more direct and say that this is still a bear market. The bear market began in 2000 with the popping of the tech bubble. The Fed fought back in 2003, setting a low-interest rate policy the rest of the dollar-pegged world followed. This kicked of leveraged booms in residential housing, credit derivatives, and stocks, bonds and commodities.

All those bubbles are popping. You do not wipe out twenty five years of credit and leverage excess in a mere eighteen months. We are barely halfway through the liquidation/loss realisation phase. The essential question is which assets are going to perform the best as governments inflate and create a new bubble in government debt? And by the way, it’s going to be very large bubble.

Forget the $1.8 trillion deficit the Obama White House admitted to today. Forget the A$60-$70 billion deficit Wayne Swan is going to shove down your face tonight. The true scope of government borrowing is breathtaking, and rather sickening. More importantly, you have to wonder where the money is going to come from, and what will happen when it’s not forthcoming from private investors.

Consider the chart below, courtesy of Niels Jensen, writing in John Mauldin’s “Outside the Box” e-letter. Niels shows that according to IMF estimates, twelve governments around the world (the ‘Dirty Dozen’) will have to issue $10.2 trillion in bonds to cover future banking losses and funding requirements in the credit markets as a result of the ongoing financial crisis.

The ‘Dirty Dozen’ and $10.2 Trillion in New Bonds

Ten trillion is a huge number. But there’s every chance the number is, in fact, a conservative estimate of government borrowing requirements. It is based on smaller than expected losses in the banking sector (the bogus scenarios modeled in the U.S. Treasury’s ’stress tests’) and a lower-than-average increase in public borrowing to deal with a financial crisis.

The IMF estimate is that public sector borrowing will grow to an average of 27% of GDP in Western or industrialised countries. But according to a study by economists Carmen Reinhart and Kenneth Rogoff published last year, governments almost always underestimate the amount of public borrowing that takes place in the wake of a banking crisis.

They do because-as the government here in Australia has done-they underestimate the blow to tax takings that comes from lower bank lending and lower economic growth. Tax takings fall while spending generally increases, especially borrowing to subsidise lending in key sectors like say, high-risk mortgage lending and property development. Think of the AOFM’s role in buying securitised residential mortgage backed securities and Ruddbank.

So how big could government bond borrowing needs get? Under the ‘best case’ scenario (lower loan losses, quicker economic recovery) Rogoff and Reinhart say public sector debt would grow to an average of 40% of GDP, leading to global borrowing needs of $15 trillion-50% higher than the IMF’s estimate. But that’s just the best case scenario.

Using the chart below, Reinhart and Rogoff suggest that in previous banking crises, government borrowing as a percentage of GDP has risen to an average of 86%. Under that scenario, now you’re talking $33 trillion in global government bond issuance in the coming five years to deal with the rest of the losses in the banking system.

The Mother of All Bubbles in Government Debt

You can see why we think all this talk of recovery and rally is a bunch of hokum. Maybe it won’t be quite 86%. Or maybe it will be more. But we know for a fact that global governmetns are going to flood with world with bonds in the coming years. But will investors buy them? If they don’t, you can expect much higher bond yields and much more money printing. That means inflation.

If you think this is just an American problem, think again. Professor Paul Kerin of the Melbourne Business School says Australia’s government has already over-responded to the crisis with its policy response. Writing in yesterday’s Australian, he says, “I estimate the 2008-09 and 2009-10 deficits announced tomorrow [tonight] will exceed $32 billion and $55 billion respectively, and that net debt will exceed $250 billion by mid-2013.”

“In the past half-century, the cash deficit has never exceeded 4.1 per cent of GDP — that was in 1993-94, when unemployment was running in double digits. Net debt has never exceeded 18.5 per cent of GDP — that was in 1995-96, the sixth straight year of deficits run to fight high unemployment…Yet the 2009-10 deficit will exceed 4.5 per cent of GDP — topping our 1993-94 record. And net debt will exceed 17.4 per cent of GDP by mid-2013, beating the 1995-96 record.”

As you can see from the chart below, the government’s deficit spending and borrowing ambitions have already steepened the Aussie yield curve. This makes long-term debt more expensive for ALL borrowers in Australia and will probably push up mortgage rates too, gagging the rebound in the housing bubble and jeopardising the one sector that’s held up the economy through the early stages of this so-far mild recession.

Australia’s Yield Curve Steepens

One last note on this before we move on to the investment strategy. A lot of readers ask how hyperinflation can happen in Australia if the U.S. dollar is weakening against the Aussie dollar. Further, you might wonder how the expanding American deficit has any bearing on the fiscal stability of the Australian economy. They are great questions.

There are four factors that we believe will lead to an even weaker fiscal position in Australia and lead to more borrowing and a weaker Aussie dollar-despite the circumstances that are undermining the U.S. dollar. Or to be plainer, U.S. dollar weakness is not going to be enough to keep Australia’s currency sound.

So what are the four factors? First, government tax takings are going to fall more than expected. This is already the case. Lower commodity prices are going to compound the problem in the second half of the year. Barring a full recovery in the job market, the government is factoring in revenues that will not be there, while increasing spending.

But the big increase in Aussie government borrowing will come elsewhere. If indeed there is a “second half” to the capital crisis in American and European banks, it means financing needs for the Australian economy are going to have be backstopped by government guarantees or direct loans (Fed style, a la the TALF).

Sectors that the Australian government may have to borrow on behalf of or loan to include the commercial property market, the residential property market, and the corporate bond market. Right now the Australian Office of Financial Management reckons it won’t have any trouble selling $1.4 billion per day to finance growing government deficits. But how much larger will Australia’s borrowing needs become if the government must become the lender of last resort to all these other credit markets?

And if Aussie government-competing with all those other countries for global savings-can’t sell its debt abroad-how do you think it will pay for it? The Reserve Bank will do what the Fed, the ECB, the Bank of Japan, and the Bank of England are doing. It will print money to buy government bonds. It will monetise the debt. Quantitative easing will begin in Australia and inflation will have arrived.

Does that seem impossible to you? Is it just Doom and Gloom pornography? We’re certain a lot of people will find this scenario absolutely unbelievable. But in a worldwide credit depression where government borrowing needs amount to nearly one third of all global savings, you have to wonder how Australia is going to raise money against the likes of the U.K., Japan, and the U.S. If it can’t do it, it’ll have to print.

So back to the question. What does an investor do? Well it’s worth noting that Microsoft (NASDAQ:MSFT) appears to be preparing for massive inflation by borrowing. The company is selling $3.75 billion in debt in order to buy back some of its own shares. Obviously Microsoft reckons the real value of the debt will diminish with inflation while the current purchasing power of the borrowed money allows it to buy back its own shares.

It’s a nifty trade and provides the example of buying equity in world-class businesses at cheap prices. There have to be a lot of investors in the world out there who see the end-game of this explosion in government debt and would much rather buy equity. That alone means the “weight of money” argument for equities could send shares higher.

We have to admit we are extremely dubious of this strategy because it says nothing about how these businesses will perform in a world saddled with so much debt. But we suppose if you are a truly a long-term investors and have decades to wait, buying equities at these lows is, a) a much better idea than buying government bonds, and b) about the only sensible investment strategy if you’re going to stay in the equity markets.

Incidentally, Swarm Trader Gabriel Andre has been thinking along these lines himself lately. He’s applied his Swarm system to the ASX/200, looking for entry and exit points on Australia’s largest stocks. His aim is to find which Aussie blue chips present long-term buying opportunities and which are looking mighty over-bought.

Mind you, Gabriel is a technician. He doesn’t look at fundamentals at all. Still, we’ve been reviewing the early results of testing the Swarm on blue chips for the purpose of issuing buy, sell, and hold recommendations. And we have to say, it’s looking pretty intriguing.

But let’s say you don’t want to buy-and-hold blue chip stocks. And let’s say you want to be in the market and not just in gold, vodka, bullets, and canned goods (although if you are preparing in that way, you should check this out). If you’re a “financial survivalist” what else can you do?

Try uranium and lithium (as investments, not meals). In late November, we tipped an Aussie-listed uranium producer in Diggers and Drillers. The stock is up 90% since then. And this was a relatively “safe” stock because it’s already producing from mines in Africa, with plans for a joint venture in the Northern Territories. It also owns some excellent ore bodies in Queensland, if the government there ever decides that it would like a uranium mining industry.

We reckon the government WILL decide that because energy is an industry that’s going to survive the credit crisis. In a recent Diggers and Drillers weekly update, we reported that China is building twenty one-gigawatt nuclear reactors at the moment. China will not be able to supply its own uranium needs. Australia, with over 30% of the worlds proven uranium reserves, is in position to capitalise, should it so choose.

According to Scotia Capital Inc. China strategist Na Liu, China’s nuclear industry will consume 15,700 tonnes of uranium per year by 2020. “At this rate,” she writes, “China’s currently known uranium resources can only last for five to 10 years. Clearly, in our opinion, it is imperative for China to secure long-term supply through imports or investment.”

That “other investment” is why we’ve drilled down further into the roster of junior explorers in the coming issue of D&D. The explorers and prospect generators are starting to look interesting. We’re also going to have another look at lithium.

Back in May of 2008 we profiled the rare earths industry, including Australia’s two best rare earth stocks (both of which became recommendations, both of which got slaughtered in the market correction, and both of which have doubled from the lows after partnering up with Chinese investors).

In that report prepared for subscribers, we also looked at lithium. Enhanced battery life and power is becoming a key issue for a world filled with mobile telecommunications devices. It’s also critical for hybrid-electric cars that can store an electric charge. One of the stocks we profiled in that report has just signed a letter of intent to build a lithium carbonate processing plant…in China.

So you see, for the resource speculator, an inflationary boom can be the best of times. It is a high-risk exercise. But junior resource stocks are one of the asset classes the CAN go up faster than the rate of inflation. And if, as we believe, the explosion in government bond issuance is going to lead to an inflationary rally in stocks, then dabbling the junior resource stocks and small caps is like hitching a front seat on a rocket.

Remember, this is pure speculation. You only hope your rocket is like Richard Branson’s new Virgin Galactic space plane, and note the nuclear missile Slim Pickens rides in Dr. Strangelove.

And what about red wine? The bottle shop across the street from the Old Hat Factory is closed for renovations. In its clearance sale, we were able to pick up a few bargain bottles of Penfolds Bin 389 Cabernet Shiraz. That is wealth you can either drink or store. We’ve done a little of both.

But you can also sell it! There appears to be a roaring trade in Penfolds wines on e-Bay. There are certainly worse things you could spend depreciating paper money on. We’re also hearing that the 2004 vintage of the Penfolds Grange is the best ever. Can’t wait to find out.

Dan Denning

Source: Very Large Bubble of Government Debt

Treasurer Wayne Swan surprised everyone and rejected China Minmetals’ bid for OZ Minerals in its current form. Nothing like a little Friday afternoon bombshell.

The Treasurer said that Prominent Hill-OZ’s major copper and gold asset in South Australia-is too close to the Department of Defence’s Woomera Testing Facility. It’s about 160km away. Swan said, “The Woomera Prohibited Area weapons testing range makes a unique and sensitive contribution to Australia’s national defence,” and that, “It is not unusual for governments to restrict access to sensitive areas on national security grounds.”

That means you China. Stay away, sort of. That is, Swan did not rule out an alternative bid for OZ that does not, presumably include Prominent Hill.

This is no laughing matter for OZ or its shareholders. The company has $1.3 billion in debt it must refinance by Tuesday. The $2.6 billion bid from Minmetals would have solved that problem. But now the question is whether OZ’s bankers will give it more time, or pull the plug.

Part of this problem is of the company’s own creation. As of August last year, it classified the $1.3 billion in debt as a “non-current liability,” assuming, we presume, that it would be able to refinance that debt easily enough. That was obviously not the case. And now the clock is ticking.

But would the Treasurer make a decision on Friday night that would put the company in receivership by Tuesday? Is the government convinced that OZ is being run by the gang that couldn’t shoot straight and is better off being cut up into parts and sold rather than delivered into Chinese hands whole?

Maybe we’ll never know what the Treasurer is thinking. But it may not matter. The Australian Financial Review reports this morning that Minmetals revised its offer over the weekend. The offer excludes Prominent Hill but includes the Sepon gold mine in Laos and the high-cost but massive Century zinc mine in Queensland. More on this story tomorrow. OZ is currently in a trading halt.

The big G-20 meeting gets going later this week. Stocks in New York were down Friday but have enjoyed a pretty good month so far. Here in Australia, stocks are up 16.75% since the ASX/200 closed at 3,145 on March 6th. Does this rally have legs?

If the market is channeling the market from the Great Depression, then yes, the rally could last months and recoup as much as 50% of the losses since it peaked at 6,828 in November of 2007. It’s hard to say what kind of economic news might come down the pipe to cheer investors that much.

Investors are currently a pretty gloomy bunch. But perhaps the aggressive monetisation of debt by the Fed will drive institutions out of bonds and into stocks. There is a lot of cash in money market funds that could get back into the market and send stocks up quickly.

Or perhaps not to all of that. The Economist Intelligence Unit has just released a report that predicts a 40% chance of global depression. The report is called “Manning the Barricades: Who’s at risk as deepening economic distress foments social unrest.”

To be fair, it also says there is a 60% chance the various stimulus efforts in the developing world successfully stabilise the global economy and share markets. But it says there’s a 30% chance of global depression and a 10% chance of global depression with massive social upheaval.

Magazine cover contrarians know that any time a big claim is safe enough to put on the cover of a mainstream publication, the trend behind it is probably over. If this is the case, the Economist article is a massive buy signal. But it’s also possible the Economist has gone as far as it can without terrifying its readers and more importantly, its advertisers.

In other words, it’s possible that things are a lot worse than the Economist is willing to say, which is not exactly a comforting thought. More on this tomorrow as well.

Amidst all these dire forecasts comes another prediction of higher oil prices. In a Wall Street Journal article on Friday, Richard Jones, the deputy director of the International Energy Agency, said the oil crash of 2008 may prevent around 8 million barrels of oil per day from ever reaching the market.

The oil price crash has caused so many projects to be deferred or cancelled that Jones says, “Unless sufficient companies have the will and financial ability to invest through the downcycle, there is a real risk that supply growth may lag the eventual rebound of demand, leading to substantial price increases — possibly as early as this year.”

We sent a longer letter out this weekend about the oil markets. Please note, if you’re already a Diggers and Drillers reader, you have already read our full reports on the stocks mentioned in “The Coming Oil Supply Crunch.” If you’re not a D&D reader, this report contains our analysis of the oil market and three of our favourite Aussie energy recommendations.

Source: Swan Rejects China Minmetals’ Bid

Obama as Prime Mover will have to turn the chaos in America’s housing and mortgage market into harmonious order. Then He has to single-handedly leap a tall legacy of toxic assets in a single bound, freeing up banks to lend by buying all of their dodgy assets.

It’s a big ask. But if anyone can do it, He can. Especially when He’s got America’s credit rating to abuse!

Reordering the financial universe is not cheap. It takes a lot of energy and a lot of matter in the form of new U.S. dollars. Reuters reports that, “Goldman Sachs estimated that it would take on the order of $4 trillion to buy troubled mortgage and consumer debt. That number could shrink if the program were limited to only certain loans or banks, but it could also grow if other asset classes such as commercial real estate loans were included.”

How much is $4 trillion? “At $4 trillion, that would be the equivalent of nearly 1/3 of U.S. gross domestic product. If the government had to fund that amount by issuing additional debt, it would intensify investor concerns about massive supply scaring off demand.”

Yes. You can imagine the world’s main owners of dollar-denominated reserve assets (China, Japan, the Petro states) would be intensely concerned about a $4 trillion increase in dollar denominated debt. But wait a tick…

It’s one thing to say you might need to float as much as $4 trillion in debt to fund your bad bank. It’s another thing to sell that debt? Who will buy it? Even these days, $4 trillion is a lot of capital to loan. Maybe that number has been floated to make a smaller number, say $2 trillion, look small by comparison.

Good news everyone! The Bad Bank is going to cost us half as much as we thought!

If the ‘big bang’ goes off this week, what will it mean for Planet U.S. Dollar? Or Planet Gold? Well, as our friend Steve Belmont in Chicago reported on Friday, gold is moving toward a day of reckoning after trading in a range for the last ten months. It will either break out much higher, Steve says, or buckle. We’ll be watching.

Did you notice the obnoxious change in political rhetoric this weekend? You knew Barrack Obama was going to give it to Wall Street, calling executives “shameful” for getting bonuses while their firms received TARP money. Remember, by the way, the TARP money was forced on some firms in an effort to boost confidence in the overall plan.

We normally try to keep a reserved, ironic, and sceptical air when reading the statements of politicians. Most of them are not worth taking seriously. But every once in a while, you get the scent of something so noxious and dangerous that you have to put aside humour and call it what is. Today is one of those days.

Now, the populist shame game is to be expected. That’s not a big deal. What’s more alarming is the bilge and claptrap spilling from Kevin Rudd’s gob and what it may mean for your ability to preserve and create wealth in the coming years.

In The Monthly, Rudd plants a Neo-Marxist flag in the ground of the current debate with the kind of jargon-laden elitist preening that makes academic critics of the free market (who’ve never spent a day in the business world creating value) so nauseating.

Specifically, Rudd writes that, “The time has come, off the back of the current crisis, to proclaim that the great neo-liberal experiment of the past 30 years has failed, that the emperor has no clothes. Neo-liberalism, and the free-market fundamentalism it has produced, has been revealed as little more than personal greed dressed up as an economic philosophy.”

Why not proclaim, since he is apparently in the position to make such proclamations, that the experiment in paper money and the deliberate policy of inflation it implies is theft? It is bureaucratic lust for power and authority disguised as monetary policy? It’s also, at its heart, the belief that one or a few people in government know better than you how you should lead your life.

Leave it to Rudd and the resurgent global Left to use the present crisis as an occasion to expand their political ideology of government power and wealth confiscation. Despite the fall of the Berlin Wall in 1989, Marxism never really went away. It ensconced itself in Western universities and colleges, and in the careerism of the political class, which believes it is entitled to govern by virtue of its intellectual superiority and the moral justness of its anti-market position.

Their strategy, as always, is to control the rhetorical high ground by framing the discussion in populist terms and making an enemy of “greedy capitalists.” Don’t get us wrong. There are plenty of greedy capitalists to go around, or to go to jail. In fact, many more of them would be going out of business if the government would quit propping them up with taxpayer money. This generation of corporate executives shares plenty of blame for playing fast and loose with the corporations they were supposed to be stewards of. They over-levered, over-speculated, and over-paid themselves.

But Rudd is an ignoramus of the lowest order to say that current events somehow negate the last thirty years of globalisation, or three hundred years of economic growth and the division of labour. Tens of millions have been lifted out of poverty. Hundreds of millions have more economic and political freedom than ever before.

These results can only be the product of a system in which risk taking entrepreneurs have access to capital and savings, allocated through competitive markets where firms that deliver real value to consumers thrive and those that don’t fail. That system has worked for 300 years of Western history to create wealth, choice, and opportunity.

Shame on Kevin Rudd for calling that “market fundamentalism”, as if belief in the institutions that create wealth and liberty is akin to the same kind of religious fundamentalism that permits suicide bombing. If there is a more offensive use of rhetoric to equate two vastly different things, we haven’t seen it.

But the Neo-Marxists are back on the march. And they are probably coming for your wages and pension sometime soon. Make no mistake about it. 2009 is the year the Neo-Marxists have been waiting for.

It is their chance to undo all the perceived evils of Thatcher and Reagan. There would be plenty of those to undo, of course, not least the idea that deficit spending is morally permissible. But the real push by the Neo-Marxists is to use the present occasion to expand the scope and reach of government power into your private life, so they can tell you what to do, what to watch, what to eat, what car to drive, and ultimately, what to think or say.

This will be disguised as better more “parental” regulation to achieve more equality and social justice. But behind the false populist outrage and the elevated language of idealism, it’s just another push for government elites to expand their ability to compel you to live the life they think you should lead.

The simple regulatory response to all this is to reduce the amount of leverage available to financial players. Reduce margin lending in shares. Let bankers get back to making prudent loans in the housing market based on what a buyer can actually repay, rather than letting the government subsidise subprime lending because it’s politically desirable.

There are other sensible regulatory responses to the mess. But they will be discarded in favour of grandiose and over-reaching plans to redesign the entire world in some utopian image. A “big bang”? Really. Does that mean they’re going to blow things up and call it a “fix?”

What we’re getting at is that it’s going to be a tremendous challenge to withstand this push in the next few years, mostly because it will have so much popular support from people with no brains who believe in fine sounding speeches and appreciate getting tax rebates/credits/handouts from the government. The first battle in the war on wealth creation is wealth redistribution, whether you like it or not.

It would be more honest if the Left just came out and said something like, “The last ten years have been a huge wealth transfer from the middle class to Wall Street and from the developing world to the developed world. We’re going to try and reverse all that now because we know it’s our best shot in the last thirty years to get some back. So here we come! Open your wallet and shut your mouth!”

Neo-liberalism isn’t the culprit in all this. What does that word even mean? Isn’t Rudd using it because it sounds like Neo-Conservatism? And everyone knows that Neo-conservatism is evil, therefore Neo-Liberalism must be evil too!

The real evil of the last thirty years is the vast expansion of credit in the world that changed personal and corporate incentives. The plunge in the cost of capital-encouraged by governments and Central Banks-set of an orgy of bad risk taking, quietly condoned by regulators and politicians who all benefitted in some way from housing/commodity/trade booms.

But now the credit cycle has turned. The Credit Depression is upon us. And Comrades Rudd and Obama will try and use it for the next great push in the Neo-Marxist dream, one world government with one world currency. More on that tomorrow!

Source: Marxism Marches On