Please, click here to read this article in pdf format: february-22-2011

During the last two weeks, we think that three self-evident macro-themes began to develop. We can even venture to add that these themes may stay with us longer than at this is imaginable. Let us explain…

Theme 1: Capital leaves the Middle East
Since the upheaval in Tunisia and the fall of Mubarak in Egypt, political uncertainty defines the Middle East. It is difficult at this time to speculate on how this will impact the price of oil in the long term but one thing we are sure of: Capital is and will continue to leave the region. We can simply post what seems to us a self-evident axiom: Capital that was funding energy exploration and production in the region will be looking for a safer place, likely in the energy sector in North America. Part of the capital that was in the form of liquid savings will likely be invested in gold. We have been trading this theme profitably since the start of February. On February 7th, we said that :

“…With regards to the political situation out of Egypt, we know as much as anyone else: Nothing! But here’s what we think, and which we understand may not be shared by many: A shift towards democracy in Egypt and the rest of the Middle East is bearish for oil. Regardless of who inherits power in the area, the new political class will need revenue to appease public employees and the people in general. Without the ability to coerce, the new leaders will need to buy peace and will not care a whit about the origin of their much needed funding. This means that the OPEC will slowly become irrelevant, as member countries need to place their produce with urgency, at any price. Along this same rationale, we should not worry about the Suez Canal. Every ruling party in Egypt needs it open to profit from the toll.
So far, we are at the very early stages of a more general transition in the Middle East. On this basis, we preferred not to trade last week’s increase in the price of oil. Instead, we chose to be net long of Canadian energy stocks, with the belief that capital within the energy sector will leave the Middle East, looking for safer jurisdictions…”

Theme 2: Capital inflows are discouraged by Emerging Markets
At the same time, the monetary experiment of the Fed is causing enormous pain in emerging markets (EMs) where the ruling lobby groups in the export industries had managed to keep the USD pegged. The mandate to keep a stable USD has pushed central banks to expand the money supply in their respective local currencies, triggering inflation.  From now on, to avoid a spiraling situation, these markets will seek to discourage capital inflows. They will tax the inflows, cut the credit expansion via higher reserve requirements or simply force exporters to clear their transactions offshore, as is the case in China, favouring Hong Kong. At “A View from the Trenches” we had anticipated this more than a year ago, when on January 21st, 2010, we wrote:

“…We would quickly see that there would be segmentation in the credit market, where exporters borrow offshore and internal consumption is financed onshore…(…)…. No central bank can simultaneously sustain a fixed exchange rate regime and control the local rate of interest…”

Therefore, the self-evident theme here is that capital should start flowing back to the developed world. Flows that went to EM stocks should now be redirected to stocks in developed markets. Flows that went to corporate EM bonds/loans, should now be redirected to corporate bonds/loans in developed markets. This, together with the QE2 bid, should provide a strong support, in our view, to the recent rallies we saw in stocks in North America, particularly in the energy sector. A disclosure here: “A View from the Trenches” does not count with the data to back these assumptions. But as we say, they seem self-evident to us.

Theme 3: Inflation can no longer be denied
The last theme is our usual theme: Inflation. On our first letter, on April 14th, 2009 (almost two years ago), we put a chart that very visually explained an inflationary process. We said it was myopic to only believe inflation could be managed tracking a CPI (consumer price index) print. We reproduce the graph below:

Only now, politicians are admitting levels of 3-5% in CPI. This means that real inflation, as they should be measuring is at least 8-10%. This is for sure what we personally witness. This fact and the ongoing disagreements within the G-20 are very supportive of gold and commodities. Patience will be well rewarded.

Martin Sibileau