Please, click here to read this article in pdf format: january-17-2011

After almost a month, the most part of which we spent traveling in Argentina, we resume our publication with the first letter of 2011. A few weeks into the year and we don’t see but the continuation of themes we singled out at the end of 2010.

More than a month ago, on December 14th,  we wrote that: “…given the latest increase in yields, as of last week, we have in our personal portfolio moved a bit away from commodities, in favour of US stocks. Do we think that the rally in commodities is overdone? No, we simply think that (and specially in the case of gold) the macro situation, which includes the unstable inflation picture out of China, points towards a bit of caution in owning gold, which may underperform relative to US stocks. However, as the fiscal view in the US deteriorates in 2011, we believe that the rise in yields that began post QE2 announcement will crystallize into a more clearer run against the sovereign and its currency. That will be the time when we will add to gold aggressively. But that time lies in the future…”. In hindsight, we were right to shift away from gold into US stocks (long 2x Nasdaq, more specifically) and in early January, we decided to further reduce our position in gold (do less of that which doesn’t work, to do more of that which does!).

To the risk of sounding like a broken record, we will repeat the 2010 themes that we think will further develop this year:

-Further consolidation of the European Union:
In 2010, we were the first to openly say that the EU’s problem was of an institutional nature (see: “An institutional perspective on the Euro”, February 10th, 2010). While everyone discussed Greece’s weakness in terms of solvency, we challenged the mainstream view with our perspective. Nowadays, everyone on the street is discussing the federalization of Europe.

On this point too, on November 24th, we changed our view. Until then, we had thought that Germany’s leadership would not be able to stand fully behind the EU. But on the 23rd, we had happened to read a Bloomberg report that had taken Ms. Merkel out of context. Ms. Merkel had been reported saying that the situation (i.e. of EU) was “extraordinarily serious” and the market began to sell the Euro, in full herd-like behaviour. As we happen to speak German and were surprised by the herd reaction, we went to the source (video link below) and concluded that for an unknown reason, Ms. Merkel’s speech had been fully misinterpreted. That was when we changed our view on the Euro, from bearish to neutral, for it became clear to us then, that Germany would move the EU in full force away from dissolution towards a proto-federal framework. We offer here again the speech (summarized) that changed our view: Click here

Where does this leave us? The European Central Bank has been buying and will continue to buy sovereign debt. But unlike the Fed, the ECB has not yet monetized it. Until now, that debt has been sterilized by issuing ECB debt, driving Euro liquidity rates higher than USD ones, thereby contributing to put a floor to the Euro (for an explanation of this process, see our letter of May 13th and December 2nd ) . In other words, the ECB still has a lot of firepower to save the monetary union and although they are now showing themselves as anti-inflationary, a good sell-off of sovereign or Euro-bank debt will change their minds quickly. In the meantime, the clock will be ticking for the Fed, which brings us to our next point:

-Further deterioration of US risk:
It is now very clear that after the extension of tax cuts in December, the US has not done anything yet to address its fiscal situation (see: “Europe is proving it…what about the US?”, November 29th, 2010).  The tipping point on this issue, we think will prove to be a wave of failed auctions in municipal/state debt. This is beginning to show its ugly head, as we saw last week with the debt auction of the Port Authority of New York and New Jersey. Everybody in Wall Street will tell you this is not a serious problem. Everybody will downplay it. We understand why. What we have trouble understanding is how the only ETF we know to short municipal debt is actually “down”, in the last month!!! (ticker: NYSE:SMB) If any reader understands it, please, we welcome your feedback.

Now, as we wrote on December 6th: “…We think that monetizing state or municipal debt would be counterproductive for the Fed, because the market would realize that the issuers all depend on the same purchaser, and the market would level down, following the proverbial path of least resistance. The reasoning would be this: Muni debt, just like Federal debt, depends on the Fed = Muni investors leave and those in the Treasury market trigger an arbitrage, whereby they seek higher yield for the same risk. Therefore, the yields in Treasuries and Munis would converge (i.e. higher Treasury yields), forcing the Fed to buy even more Treasuries (i.e. QE3). This would all create more inflation, hurting municipal and state revenue in the process, as the stagflation grows…”

This outlook make us think gold is still to make higher highs in 2011 in spite of the temporary pullback we’re seeing now. Would this be consistent with higher stock prices? Yes, as long as a true sovereign crisis does not unfold. Such crisis is not our base case.

-Further price controls in China:
We think that China will continue to sustain its peg to the USD by enforcing even stricter price/quantity controls. This is a key assumption, for it means that the US Treasury market, particularly if the US shows at least a weak recovery, will keep a buyer. Will reserve requirements keep increasing? They will. Will credit controls pop out of nowhere? They will. Will the Chinese people seek to invest in gold or any other asset that serves them as an escape valve? They will. Please, note that we do not say this situation is sustainable. We just say it can remain another year without being solved.

What does this all mean?

If the three key assumptions play out, in 2011 we should see high volatility but higher stock prices worldwide, the Euro not making lower lows (i.e. not falling below 1.18USD), higher commodity prices and higher CAD/AUD/NZD dollars, higher interest rates, slow growth and steady unemployment.

Martin Sibileau