Please, click here to read this article in pdf format: july-06-2010

The summer doldrums are here and investors (including ourselves, of course) are trying to understand the latest “structural” foundations driving the markets. One can think of these drivers in terms of different markets, currency areas or asset classes. However, there seems to be one in common, when we take a global perspective. Namely, the realization that going forward, economic growth will be lower than previously expected, muted, whatever that final number is.

Growth is in our view one of the most difficult economic concepts to grasp. Without getting theoretical here, we just want to say that personally, we prefer to treat “growth” just like biologists treat the concept of life. Biologists do not try to describe life itself, but as a set of characteristics proper to organisms (i.e. homeostasis, metabolism, reproduction, etc.). Along the same line, growth to us is all about “improving the ability to improve” what we collectively call our living standard.
Given that all of us have different ideas about “living standards”, it is critical first that we can freely trade to reach them, at minimal transaction costs. And secondly, in order to trade, we need “clean” prices. However, we are always limited by present resources, so that at an aggregate level, inevitably, we end up having to reduce present consumption (i.e. saving) in favor of future consumption. The price of that inter-temporal exchange is what we call an “interest rate” and therefore, in order to correctly assess that trade-off between present and future, it is imperative that interest rates be as “clean” as possible. When free trade is reduced and interest rates are manipulated, growth is seriously damaged and with it, our aspirations.

Since 2009, governments, in the name of temporal solutions, have affected the value of our indirect medium of exchange (i.e. money) and consequently our liberty to trade. Compared to December 2009 (only 7 months ago) it is, for instance, approximately 22% cheaper to buy products from the Euro-zone, if you earn your income in US dollars. Somebody pays for this (i.e. the German taxpayer) though. Governments have also been affecting our liberty to channel resources from the least productive to the most productive enterprises, by regulating our financial systems without compromising their own ability to keep printing money. The damage is so extensive that citizens of the world, in search of an escape valve, are affecting the relative prices of economic jurisdictions. This is an ongoing process with no end in sight, as the charts below show (source: Bloomberg).  As you can see, savings within currency zones are shifting between member jurisdictions. In the case of the Euro zone, capital is leaving Spain , Greece or France and goes to Germany (i.e. sovereign spreads of these countries vs. Germany’s widen, as the charts below show) . In the case of the US , capital is fleeing “provincial” risk, in favor of federal risk (also shown in charts below). The ongoing nature of this process suggests that given the institutional weakness of the European Union, its currency will be more affected than that of the USA . But in the end, everybody loses, which is why we are bullish of gold.

This process has multiple stages. The current perceived confusion, we think, is simply driven by technicals resulting from the growth underperformance. On the demand side of investments, money has been printed since March 2009 in excess and is still out there (unsterilized). On the supply side, private investment opportunities are being crowded out by sovereign ones, leaving a relative “spread-tightening” force in corporate credit, while markets sell off equities, in anticipation of slower growth, or as we like to say, the diminished ability to improve our living standards. Overshadowing this, we are coincidentally faced with a technological revolution that allows us to live longer, impairing all previous actuarial calculations done by pension funds and flooring unemployment rates in the developed world. This should be another reason to deregulate savings and allow individuals to save at the rates of their choosing (Yet, in Canada , for instance, the government is contemplating the expansion of the Canada Pension Plan). In the meantime, some analysts still dream of a decoupled world, where emerging markets, which now carry out a meaningful trade among themselves, can be resilient and sustain a weak recovery on their shoulders.

The Canadian dollar is debating itself in this macroeconomic backdrop. As long as relative differences between jurisdictions exist, there will be a “reserve currency bid” for the CAD. But in absolute terms, as long as the global misery increases and commodity prices fall, the Canadian dollar will suffer. Will we have a story of relative contrasts that finally lead us to some consolidation followed by growth, or will we have a story of fading relative contrasts that leaves us with a picture of unanimous poverty? The correlation between gold and the CAD is vanishing (-0.7479 at the start of the year, vs. -0.0453 yesterday, source: Bloomberg), which indicates that the story of global misery is winning the bet.

Martin Sibileau