QB
ASSET MANAGEMENT
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See Important Disclosures at the end of this report.
February 2013Locked & Loaded
February marks QBAMCO’s sixth anniversary and we are grateful for the interest our views havegenerated. In the coming months we will be assessing the platform on which we offer investmentservices and our policy of distributing our views externally. Your thoughts are welcomed. This pieceaddresses the following issues:
Currency War – Theory & Practice:
We argue one should not necessarily mistake rotating currencydevaluations presently for the threat of a belligerent global currency war. Monetary authorities arelikely to continue managing the timing and magnitude of discrete, coordinated relative currencyweakness so that the appearance of a stable global monetary system remains intact.
Cause for Concern:
While we do not expect a breakdown in global monetary oversight, we do expectfiat currency debasement to continue to mask the driver of real economic malaise and contraction –global bank de-levering; and we do expect this process to lead to a popular loss of confidence in today’smajor currencies as savings instruments – perhaps beginning in the global capital markets in 2013.
Lambs to Slaughter:
We do not expect an overt crash in global stock, bond and real estate markets, orone that would last very long. They are already crashing in
real terms
and there is a well-structuredmechanism in place to support
nominal pricing
. Any future flight of public sponsorship would be metwith central bank credit support working through bank intermediaries. For those not part of the supportmechanism, however, the monetary
market put
does not necessarily argue in favor of investing broadlyin implicitly levered financial markets.
The 1998 Committee to Save the World & Centralize Global Economic Control (and their LegacyBeards):
We think the smart play is to bet with these guys and the power of their institutions.
Reasonable Contrarianism:
The pain of holding an inflationary bias over the last six years has beenintense, and the pain has only increased exponentially over the last two years. The good news is that webelieve for the first time there are important macroeconomic events signaling a fundamental shift in theglobal monetary system is finally approaching.
We expect discussion of Fed, ECB and BOE inflationand/or nominal GDP targeting to become louder and more frequent in 2013, and we expect markets tobegin adjusting asset prices accordingly
.
The Pain Trade:
All the Sturm and Drang in the financial press about a revival of the US housing marketis bologna. We provide a short idea.
Bad Science:
On February 1, a large multinational bank published a report that called the end of the bullmarket in gold, claiming; “the 2011 high will prove to have been the peak for the USD gold price in thiscycle.” While no one knows the future and the dollar price of gold may rise or fall, we are quite certaingold’s future path will have nothing to do with the arguments included in this report. Sadly, it was a casestudy in false identities leading to wayward causations and, in our view, a diametrically wrongconclusion.
The True Lesson of JMK:
The most important takeaway from John Maynard Keynes many views is thatsometimes change for change’s sake is necessary to jumpstart popular confidence.
QB
ASSET MANAGEMENT
www.qbamco.com
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See Important Disclosures at the end of this report.
The Play:
We think that what will eventually (or soon) occur will be the rare occasion when return-on-savings trounces return-on-investment, implying precious metals will outperform the great majority of financial assets (except for shares in precious metals miners and natural resource producers).
*The big macro questions: Will global central banks raise rates, withdraw bank reserves or tighten creditpolicies in any way before the global economy experiences significant price inflation? No. Will theycontinue threatening to tighten? Probably. Will they continue to de-lever bank balance sheets via bankreserve creation? Absolutely. Will global central banks continue to be significant net purchasers of physical gold in 2013 and beyond? Bank on it. Will big global wealth holders convert increasing amountsof fiat currency into physical precious metals, resources and other beneficiaries of global price inflation?Highly likely. Will Western financial asset allocators figure out what all this implies for stocks and bondsin 2013? We think so, probably after a significantly higher-than-expected CPI print.Higher global goods and service inflation is a tail event currently unforeseen by the great majority of investors and unexpressed, or expressed improperly, in the great majority of investment portfolios. Andyet we see it as a lock, perhaps asserting itself in 2013.
Currency War – Theory & Practice
All seem to agree now that global monetary authorities are fully engaged in trying to protect theircurrencies from relative appreciation. The fundamental question remains: is there a growing likelihoodof a messy sovereign “currency war” in which monetary authorities compete to beggar their neighborsor are treasury ministries (in fact, central banks) collaborating with one another to devalue theirrespective currencies in a sequentially, but orderly fashion? By identifying the answer we should gaininsight into the nature and timing of significant changes in economic output and market valuations.
We do not think current whack-a-mole currency devaluations imply a belligerent currency war, now or inthe future
. Let’s follow incentives. Who does a cheap currency ultimately benefit? It theoretically helpsindebted governments fund themselves with foreign investment from entities with stronger currencies,and it benefits cheap currency-based exporters deliver cheaper goods and services than exporters thatreport earnings in domiciles with stronger currencies. On the first score, most indebted sovereigns havecome to rely predominantly on their central banks for funding (i.e., QE), rather than foreign funding.Regarding global exporters, most have set up foreign manufacturing capabilities where their productsare consumed, better matching costs with revenues. Further, swap markets and trade receivables allowexporters to adequately manage their currency exposures. Everyone knows the enormity of the swapsmarket and it has recently come to light that trade receivables have become the largest credit market inthe world (see graphic on following page). At $17 trillion, it is larger than the mortgage and corporatemarkets. That exporters must report earnings in their native currency by converting all margins back is adirect problem for corporate treasurers and their shareholders, not domestic employees (at leastdirectly), which means strong currencies are not directly a problem for politicians.For these markets to break down, the banking system would have to break down, which leads us to ourfinal point about the potential for a global currency war. Modern currencies are created by banks andtheir central banks – not by governments or by domestic exporters that would benefit from cheapercurrencies. This suggests a trade war is not a decision for politicians or exporters to make. Ultimately,SIFI banks control the game.
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See Important Disclosures at the end of this report.
When push comes to shove, the primarymission of central banks is to keep theirbanking systems solvent in times of stress. (Should this effort be claimed tosupport economic objectives like pricestability or full employment, all thebetter.)A monetary food fight would risk thedemise of a major currency, which, withtoday’s cross-levered, cross-funded bankbalance sheets, would further suggestmutually-assured global bank systemdestruction. As bank deposits are nowhighly concentrated within very large SIFIbanks, one major global bank failureanywhere in the world arising from oneeconomy “winning” a currency race tothe bottom would impact all globalbanks and, by extension, the broadperception of bank failures.SIFI banks are the controlling shareholders of the most influential central banks. Central bankerscontrolling over 75% of global GDP, in turn, gather every two months at the BIS in Basel, Switzerland todiscuss and coordinate policies. We think this implies a continuation of managed, discrete currencytakedowns. Beggar-thy-neighbor attitudes and rhetoric among sovereign politicos may spring up fromtime to time but we do not expect such attitudes in the global banking system, where it counts.Share prices of the world’s largest banks are lagging the general market even though their revenues andearnings are soaring. Some argue the market fears that one day central banks will reverse their loosemonetary conditions, in turn decreasing bank net interest margins. We do not think narrowing loanmargins is a valid reason to be concerned. The cash flows of most large banks are almost certainlyhedged against higher market rates, if not with each other than with their central banks. The realproblem, as we see it, would be the value of their loan books, which would decline materially were ratesto rise coincident with a decreasing appetite for new bank assets (loans). This fear, in itself, provides thefundamental reason not to be concerned that central banks will withdraw from the markets, lettinginterest rates rise, before adequately reserving SIFI banks. We expect no interest rate surprises.So by our way of thinking there is very little risk of a belligerent global currency war. This is not to say wethink central banks will stop methodically cheapening their currencies. They must continue to satisfytheir principal aim of de-levering bank balance sheets to maintain bank loan book valuations. Consistentwith domestic optics central banks will continue to destroy their currencies in a coordinated fashion thatavoids “a global currency event.”From a trading perspective, we speculate it is wise to play reversals at extremes of cross-rate FX ranges.The risk of major currencies breaching well-established ranges seems remote as long as major centralbanks work together to preserve their currency oligopoly. In light of this theory, consider the significantbounce of the EURUSD since July 2012, from 1.21 to 1.35, against almost universal sentiment believing itwould see parity to the USD. Should FX traders now apply this theory to the universally accepted demiseof JPYUSD?
Source: The Receivables Exchange
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