Please, click here to read this article in pdf format: January 8 2013

This is my first letter of 2013. I was not able to write earlier as I was travelling in Argentina. The situation there is complex and fluid. It would seem easy to compare it to that of Venezuela, but that would be a dangerous reductionism. Three things really caught my attention and are related to what we are going through in the developed world:

a) Argentines, just like everyone else in this world, struggle to find acceptable assets to allocate their capital. This is striking because they have no capital markets and it would seem that real estate or the US dollar should be the no-brainer, natural alternatives. Yet, unlike in the past, they are not. However, the reasons for this go beyond the scope of today’s letter.

b) In spite of explicit acknowledgment by the Argentine government that the monetary base will grow at no less than a 40% per year (this is even embedded in the government budget projections), the government still manages to issue its currency. The country is still far from hyperinflation, although with high inflation. There are no definitive metrics given the media repression, but private estimates gauge it at no less than 25%.

c) Just like some analysts today see a bubble in the price of gold, there are analysts in Argentina who see a bubble in the price of the US dollar vs. that of the peso. This is a country that has gone through two hyperinflations and decades of high inflation within a single generation. I was astonished to see how easily the memory of all this was lost. This is so impressive that even Roberto Cachanosky, a leading Austrian voice in the country and who regularly writes at La Nación, had to devote one of his weekly columns to “explain” that the US dollar was not in a bubble.

Why do I bring this up? Because I still can’t find what the difference is between Ben Bernanke, who is telling me that he’s going to monetize US sovereign debt as long as the unemployment rate (as measured by the government) is not below 6.5%, and Mercedes Marcó del Pont who openly says that monetizing debt does not lead to inflation (as measured by the government) and that the Banco Central will monetize all the sovereign debt necessary to boost economic growth. As much as I hate acknowledging this, I am convinced Cristina Fernandez de Kirchner is right when she says that the developed world lacks the moral authority to criticize her policies.

Real estate under high inflation: Context and assumptions

Let’s return now to the topic of the day, namely real estate as an inflation hedge. Today, I want to offer my family’s experience in the case of Argentina’s hyperinflation and their choice of real estate as the hedge against it. The context in which this story takes place is one of high inflation, in which the market knew two things: a) It was a point of no return, and b) It was going to get worse before it would get better.

I think it is clear that none of these points are visible today in the developed world. For instance, gold was sold last week simply because the FOMC minutes suggested that the same Fed that has to buy approx. 90% of the Treasury’s long-term debt issuance to keep rates from rising (without much success one must add), may end the purchases by the end of this year.

The context of the story was also one of increasing financial repression. As I suggested earlier, inflation and financial repression are only two different sides of the same coin. And as inflation spikes, so do interest rates, for the trust in the system collapses. Only with higher rates can central banks sustain a target level of deposits, so that the coerced banking system sources the funds needed  to buy sovereign debt. High nominal interest rates and inflation then, go hand in hand.

In such a context, there is no return and the market knows it will get worse. The fear of confiscation sets in. Confiscation can and did take place in two ways: a) Between private citizens/corporations, in which case, we are in the face of explicit wealth transfer from creditors to debtors or landlords to tenants, and b) from private citizens/corporations in favour of the state.

A true story

In 1973, Argentina decided to nationalize bank deposits and to impose a 100% reserve requirement. This measure however was not to last long and by 1976, the banking sector was again allowed to leverage on its deposits. To fight the increasing exodus from the system by depositors, the central bank decided to encourage deposits by paying interest on savings accounts deposits and charging a fine on current account deposits. By 1980, 90% of all deposits were in savings accounts under 90 days and the average lending rate was 35%. This brought about a spiralling quasi-fiscal deficit (i.e. a deficit at the central bank) that led to the hyperinflations of 1985 and 1989 (Read more about this –in Spanish- here)

It was in the context described above that my father first lost his first apartment and later bought a ranch as a hedge against the increasing inflation. The apartment in Buenos Aires was lost to a tenant, in the early 1970s, who took advantage of a new bill favouring tenants over landlords. That apartment was my parents’ first home and they had only vacated it because they were working outside Buenos Aires at the time. It was not their investment property. My father ended up negotiating a ridiculous discount to at least get something back, but he basically lost it all. There is really not much more to say in defense of the investment-in-condos thesis as a hedge against inflation (Remember that if rental contracts at one point, given high inflation, become denominated in a foreign currency or gold, the government will very likely fix the price of these assets (i.e. fx, gold) at an official rate, below the proper market prices. Landlords will receive that official rate and will not be able to challenge it in court).

In 1978, however, my father did purchase a ranch for investment purposes, in beautiful Patagonia. Today, I want to share this experience, vis-à-vis the thesis held by Jim Rogers because my father back then thought like Mr. Rogers today.

The Jim Rogers thesis

Briefly, Jim Roger’s thesis is old and simple: The monetization of sovereign debt means higher commodity prices and owning a farm is a means to both profit from these higher commodity prices and protect one’s capital, invested in land. In Jim’s words, farmers will drive Lamborghinis.

Well, it may be true in the early stages of a hyperinflationary process. But as inflation arrives to stay and the money printing becomes structural, the financial repression that follows challenges the thesis. As well, just like in the first world today newer taxes or higher tax rates are being imposed on those lucky enough to be able to save and invest, back then politicians engaged in demagogy and established new laws to favour debtors and tenants over creditors and landlords. In my experience, under high inflation, the price of agricultural commodities rises in local currency terms because of shortages in production. There are shortages because producing is not profitable. Rising nominal prices therefore are not a signal to encourage production, but precisely the opposite; the reflection of supply shortages because producing is unprofitable. The unprofitability, of course, is caused by the government’s intervention via price controls (wages, foreign exchange), higher taxes, trade restrictions and outright confiscations. To expect that farmers will be able to receive international market prices for their produce under high inflation is naive at best. I know of no nation under high inflation, where its government would have not controlled exports (or their prices) of necessary goods (i.e. food), or forbidden imports of luxury goods.

The case of “Los Maitenes”

My father bought Los Maitenes (the name of the ranch) in 1978 with the simple idea of protecting his capital. He was not a rancher, although he knew the business well from my grandfather (who had managed an estancia for Mr. Bunge in the 1920s). Indeed, it was not a farming property in the sense Jim Rogers means: It is in the mountains and is for the purpose of raising cattle. Growing grains there is not efficient. However, whenever the price of grains rises (in US dollars) and the agricultural frontier shifts to the West, land formerly used for cattle in the Pampas needs to find a replacement and ranches in Patagonia get bid.

To my father’s disappointment, rates and the appreciation of the US dollar continued to outperform ranching. Under high inflation, soon everyone wanted to own (“stock up” would be a better word) products, but not producers. Nobody was interested in producing anything and it was not due to some behavioural problem, as Keynes and its followers always point to. Simply, the distortion in relative prices and the disappearance of credit for working capital (i.e. nobody in the business of “making stuff” could any longer reasonably calculate whether they did so at a profit or at a loss) was too high to bear. My father then became a forced long-term real estate investor. Nobody was interested in buying him out of the ranch. It was far better to keep playing the dangerous game of earning absurd returns in savings accounts deposits, subsidized by the central bank, or to keep your capital in foreign currency, fully liquid. It was a game that would last until 1989, when deposits in savings accounts were confiscated and paid back in bonds. In my view, we can see this same phenomenon playing out further down the road of this ongoing inflationary process, whereby gold would play the role the US dollar played in Argentina.

In the meantime, my family had managed to survive from other income sources until 1981. In that year, their most important source, a concession on a beach resort in Mar del Plata, was finally expropriated under the regime of General Galtieri. The thesis that owning a ranch was the final hedge against inflation and general chaos suddenly became a reality and in January 1982, my father set off to Patagonia. It was a three-day long trip with a trailer (see picture below). In this trailer, we would live the first three months.

Picture 1: A stop on the way to Los Maitenes, January 1982 (I am on the right, next to my mother and sister).

A few months later, war broke with the UK over the Falkland Islands. Living in Patagonia, this meant that everything could be taken from us at any moment, if either the UK or Chile invaded. Fortunately, this scenario did not play out. However, during that first year at the ranch, my father found out that squatters were living in different parts of the property. Once again, even though he managed to negotiate a settlement with some of them, the government expropriated a few hectares from us. I am sure Mr. Rogers did not take into account this sort of inconveniences, but expropriation becomes very real when credit disappears and food shortages follow. As I wrote in my earlier letter,”…thousands of years of Diaspora are screaming to us in the face that the advantage of gold as an easy-to-transport and store asset is not to be underestimated…”

From 1983 on, inflation began to grow exponentially. Soon, it became difficult to know if one was making or losing money. Relative prices in terms of US dollars fluctuated widely and in general, over the long term, everything tended to depreciate versus this currency (just as I expect prices to continue depreciating in terms of gold, if QE remains eternal). Without liquidity and credit, farmers began to barter. The most liquid items were alfalfa hay, flour, wire rolls, gasoline and meat. Contracts could be settled in alfalfa bales, 10-kilo flour bags, fencing wire rolls (1,000 meters per roll), and litres of gasoline or kilos of meat.

Bartering, my father survived those years. He hired men to plant, irrigate and harvest the alfalfa lots in the ranch, on a partnership basis. Whatever alfalfa bales he managed to keep, he used them to further buy cattle or to pay for labour. The cattle were then bartered at the nearest general store to buy groceries. Anything outside the bartering circle became extremely expensive (clothes, fuel, electronics, etc.), as cattle or alfalfa bales had to be first exchanged for currency.

The years of high inflation were years of self-sufficiency. It took us about seven years to build our house, for we had to produce our own bricks (adobe), stucco and wood. Below is a picture worth a thousand words: In it, we see Don Onofre Grandón, carpenter, working a poplar tree just cut down at the property to produce one of the rafters for the roof frame of our house. Circled far in the back, we can see a stock of adobe bricks also produced at the ranch. This picture was taken on January 1989, during the last hyperinflation.

Picture 2: House building under hyperinflation

The picture above is comparable to a painting of the London’s Carpenter’s Company in the late Middle Ages. Any European peasant resuscitated from the Middle Ages would immediately recognize and feel familiar with this scene. This is a typical scene of a farm in times of hyperinflation. And it makes perfect sense: Under the Pax Romana, the owners of villas were rich. When hyperinflation finally destroyed the Roman Empire under Diocletian, owning a villa was a liability, as one could not trade the produce without price controls or safe transportation and was further subject to either looting by barbarians or confiscatory taxation by Rome.

The above picture shows a scene of non-monetary exchange, no access to a Home Depot, no credit, no capital markets nor commodity markets (either spot or futures). The sight of harvesting machines, highly capitalized farmers participating in commodity futures markets are completely foreign to a hyperinflationary scenario. Such a sight belongs to farming under stable relative prices and available credit. Eventually, both came back after the peso collapsed and became convertible to the US dollar, in 1991. It was only after the hyperinflationary episode, when the peso as legal tender was fully repudiated, that farming became again a productive enterprise, when the government had no choice but to become friendlier to open markets and seriously diminish any form of financial repression.

Epilogue

The story I just shared is definitely not what Jim Rogers has in mind. During those years, holding US dollars or taking the risk of financing the government with deposits at the banks far outperformed any productive project. However, at one point (in 1989), even financing the government ended up a losing proposition, and term-deposits were confiscated (see the announcement of the confiscation here)

US dollars (or any other stable foreign fiat currency), in the end, were king. When I extrapolate my personal experience to our current situation, I feel confident that holding physical gold to the end will also be the winning strategy. Hence, my disagreement with Jim Rogers: Farmers will not drive Lamborghinis if inflation spikes.

During those years, the government constantly sought to manipulate the price of the US dollar or to discourage everyone from holding foreign exchange. This too is happening with gold and I expect it will become more pronounced in the years ahead.

Martin Sibileau

Click here to read this article in pdf format: December 2 2012

The intention today was to do a revision of what I had expected in 2012, what happened and what I think will happen. However, we may have to put this aside one more time, given the feedback received on the last post, titled “Anatomy of the End Game”. I seem to have been misinterpreted and to clarify this very important topic, I present a second part to make absolutely clear that:

a)      It is misguided to believe that the end game should be blamed on the shadow banking system. Should regulators succeed in leaving regulated banks the role of funding the commodities and futures markets, the end game would not be avoided and its violence would be even greater,

b)      Fiscal austerity in theUS, if my assumptions (clearly laid out in the previous post) apply, would be irrelevant unless it produces a sizable fiscal surplus,

c)      The approach taken by policy makers addressing this logical outcome (which they mistakenly call tail risk –the tail risk is the reverse: That the game does not end-) is wrong.

The End Game in a world without shadow banking

There are continuous attempts at further regulating money market funds and central counterparties (i.e. clearinghouses), based on the belief that their operations entail risk of a systemic nature. But the systemic nature of the risk is simply due to the leverage built upon the collateral that these players use to provide funding. There is nothing particularly intrinsic to either the players, the markets that use that collateral or the collateral (i.e. sovereign debt, mortgages, etc.) itself, to make them “systemic”. To coerce these players to increase their capitalization or to prevent them from freely disposing of their liquidity as risk varies only increases costs and volatility.

Let’s assume the extreme case where the “shadow banking” sector disappears and banks become the sole providers of funding in the repo market. The figure below describes the situation. In stage 1, we can see the consolidated balance sheets of the financial institutions, traders, and non-financial institutions (private sector). Traders have US Treasuries as assets, which in stage 2, they sell to source cash. This cash is expressed as deposits (in stage 2), which are liability of the financial institutions. Deposits then, are backed by US Treasuries. When these are repudiated (our main assumption) the sustainability of the financial institutions is challenged, precisely at the same time that traders may be suffering a short squeeze on short commodities positions and margins are called. This short squeeze would also affect the commodities and futures markets’ clearinghouses (not shown in the figure). From stage 3, it is easy to see that depositors (non-financial institutions) who are not part of the aggregate “traders” class are the ones who are most at risk. The faith in the US dollar system is lost and a run on the banks is triggered.

We must clarify that the US dollar zone/system is not bound by geographical or jurisdictional borders. A Hong Kong or Brazil based bank that relied on US dollar funding to generate relevant net interest income would be equally affected by the liquidity squeeze, as so many European banks learned in 2008 and 2011.

Under this scenario, and unlike the case where the shadow banking system funds the repo market, the Fed would not have the luxury of choosing whether or not to intervene. It would simply be their duty to do so, and they may believe that they have the option to purchase the US Treasuries from the banks with or without sterilization. But in the end, it would not matter…sadly. Let’s go through the process:

a)      The Fed purchases US treasuries without sterilization

This is the easiest option to understand. As the figure shows below, the Fed purchases US Treasuries from the financial institutions and their reserves grow. As the whole context in which this would occur is not positive for economic growth, to say the least, and the private sector delevers: Loans outstanding, on a net basis, decrease. Deposits decrease and the non-financial private sector increases cash on hand. The equity of the financial sector, naturally, suffers. This cash on hand will keep rising as long as the US debt remains repudiated and US Treasuries need to be monetized by the Fed. Eventually, in the absence of alternative investments (as in the current context, with zero to negative interest rates), the cash is simply spent on consumption. In an environment of financial repression, where companies use whatever liquidity preferably to distribute back to owners via share buybacks or dividends (as we expected back in March), the higher consumption facing lower production ends up driving prices higher.

b)      The Fed purchases US treasuries with sterilization

If the Fed decided to sterilize the purchase of US Treasuries being repudiated, the market would immediately begin to discriminate between those banks who get the benefit of carrying Fed debt and those who don’t. This is similar to what we see in the Eurozone: Deposits flee banks which are seen at risk of being caught on the wrong side of the tracks, should a break up of the Euro zone occur, to banks in the core of the Euro zone (i.e. banks with continuous access to liquidity lines of the European Central Bank). This arbitrage (why carry cash, which pays no interest, rather than Fed debt?) would drive all banks to buy distressed US Treasuries to make a difference exchanging them for Fed debt. This would be a very perverse process, because banks would drive deposit rates higher to maximize the sourcing of US Treasuries.

At this point, I am aware you may be confused: It doesn’t seem to make sense to first assume that Treasuries are being repudiated and later say that banks seek to raise deposits to purchase them. But this makes perfect sense, when we realize that in this context, the market for US Treasuries would be simply broken, segmented. Only banks with the privilege of access to the Fed’s window would be interested in US Treasuries, because only they would have access to the interest-paying debt of the Fed. The US Treasuries, effectively, would be marked to model by the Fed and as the private sector gets crowded out and deposits drop, the need for liquidity and profitability of the financial institutions would demand that higher interest be paid by the Fed on its debt.

You may ask why should the Fed be forced to pay higher rates, when the private sector would seem to be out of investment alternatives. First, we must remember that in this context, commodity prices would be rising and the nominal rate of return in gold would be a benchmark, just like simply holding US dollars in the ‘80s was a benchmark shaping inflation expectations in Latin America. Secondly, the Fed would be forced to pay higher rates to keep deposits from dropping in a context of decreasing trust in the solvency of the banking system. Those living today in the periphery of the Euro zone understand this. Why should deposits not drop? Because if they do, more currency will be circulating and available to buy real assets (i.e. gold) and the outstanding stocks of US Treasuries being repudiated would not be cleared from the market into the balance sheet of the Fed. Their increasing yield (as the price drops) would be a price signal to the market that the Fed would have every reason to kill.

However, if the value of the US Treasuries falls and the interest the Fed has to pay to sterilize their purchase rises, the Fed will face a net interest loss. The Fed may chose to keep accumulating these losses or may also decide to simply convert its debt in legal tender, to end the arbitrage between currency (not paying interest) and its interest-paying debt. In the first case, we end up with a plain monetization of US Treasuries, which we just analyzed above. The second case (enforcing Fed debt as legal tender) would truly mark the end of the game in terms that would make historians of the 21^st century would devote entire volumes…

Why fiscal austerity would be irrelevant without a surplus

A logical outcome, which I think is clear from the two scenarios above, is that no matter how far the spending cuts go, the only way to compensate for the monetization of EXISTING INVENTORY of US Treasuries, is to reach a fiscal SURPLUS. Being only frugal won’t cut it!

In order to avoid being dragged to double digit inflation, there will have to be a fiscal surplus to offset the quasi fiscal deficit of the Fed. However, the implementation of austerity measures (i.e. spending cuts), will necessarily lead to a decrease in activity which would only be temporary if the same are accompanied by a widespread liberalization of markets. It is possible but unlikely, for reasons beyond the scope of this post. All sorts of negative feedback mechanisms could be triggered in this situation, only enhancing the repudiation of the US sovereign debt and the resolve of the Fed to monetize it (For instance, the so called Olivera-Tanzi effect postulates that as inflation rises, access to working capital is restricted and firms delay their tax payments, to get them devalued by inflation. The government therefore receives depreciated tax revenue while its operating costs increase, facing deficits that need to be further monetized, thereby fueling even higher inflation).

In Argentina, this negative feedback was always resolved with the plain confiscation of citizens’ assets: Savings accounts in 1989, chequing accounts in 2001, pension funds in 2008, etc. (I can’t stress enough how important it is for anyone in the financial markets today to study the monetary developments in Argentina between 1972 and 1991)

Policy makers look the wrong way

The natural reaction from policy makers, so far, has not surprised me. Rather than addressing the source of the problem, they have and continue to attack the symptoms. The problem, simply, is that governments have coerced financial institutions and pension plans to hold sovereign debt at a zero risk-weight, assuming it is risk-free.

This problem truly brings western civilization back to the time of Plato, when there was nothing “…worthy to be called knowledge that could be derived from the senses…” and when “…the only real knowledge had to do with concepts…”.  In the view of policy makers,  the statement “the probability of US sovereign default is zero” is genuine knowledge, but a statement such as “The US government needs to issue about $100 billion per month to finance its fiscal deficit” is so full of ambiguity and uncertainty that it cannot find a place in their universe of truths…(Note: I am paraphrasing Bertrand Russell here. I am certainly not erudite)…and just like since the beginning of the 17^th century almost every serious intellectual advance had to begin with an attack on some Aristotelian doctrine, I fear that in the 21^st century, we too will have to begin attacking anything supporting the belief that the issuer of the world’s reserve currency cannot default, if we are ever to free ourselves from this sad state of affairs. The following paragraph, from a speech by Paul Tucker (currently Deputy Governor at the Bank of England) says it all:

“…Two strategies come to mind which I am airing for debate. The first would be ‘recapitalizing’ the CCP (i.e. central clearing counterparty) so that it can carry on.  The second would be to aim to bring off a more or less smooth unwinding of the CCP’s book of transactions…”  P. Tucker, Bank of England, “Clearing houses as system risk managers”, June 2011

Policy makers then believe in recapitalization and coercive smooth unwinds. With regards to recapitalization, I will just say that we are not facing a “stock”, but a “flow” problem. US Treasuries would be repudiated because of fiscal deficits, which are flows. No matter how capitalized a clearinghouse is, once the repudiation starts, the break-up of the repo market and the short squeeze would unfold and develop. Whether there is or not a capital buffer is irrelevant to the problem. In fact, in my view, it would be better that there wasn’t: Why would you want to add more resources to a lost cause?

With regards to smooth unwinds, I think it is obvious by now that the unwind of a levered position cannot be  anything but violent, like any other lie that is exposed by truth. Establishing restrictions to delay the unmasking would only make the unwinds even more violent and self-fulfilling. But these considerations, again, are foreign to the metaphysics of policy making in the 21^st century.

  Martin Sibileau

Click here to read this article in pdf format: June 4 2012

The loyal reader knows by now that we have been, perhaps since the start of our publication, expecting a dynamic like the one seen last Friday, namely, lower stock prices and a higher gold price. The last time we insisted on such a forecast was on April 9^th, under the title “We’re getting closer”. But no, we are not like the oracle of Delphos, supplying pagans with loose predictions. We have been very precise in laying out what the drivers for the upcoming collapse are. At the beginning, in 2009, we were alone (read, for instance, our letter from May 19^th, 2009) . Today, we are only one of many to side with this view.

We want to throw a word of caution. Last Friday also, Treasuries ended higher (i.e. yields lower), which means that the status quo, although challenged, is still the status quo. There are now many, including Peter Schiff or George Soros, who assume that from now on and incarnated by the reversal in gold, we start a new phase. This phase would lead us to a crash, followed by unseen amounts of money printing and ending in hyperinflation.

This is a simplistic, 10,000 ft above ground perspective, we think. Undoubtedly, and as per our last two letters, liquidity seems not to be an issue and the intervention of central banks will do little to prevent what we think will be a crash. This crash will be nothing else than the repudiation of the uncertainty provoked by and the misleading nature of zero interest rates, as well as of the increasing financial repression. But exactly for this reason, the status quo will not leave without a fight that will involve more capital controls, price controls, unilateral currency devaluations and a diversity of other interventions.

On this basis, we think it will be wise to be cautious taking a trading view. We will not only have to protect our savings, our assets “nominally”, but physically as well. Coming from Argentina, we have the dubious benefit of knowing a thing or two about this, but it may not be all that handy. After all, the developed world has its own methods and (going by the experience in the manipulation of the price of gold) one of them is the manipulation of prices via the futures markets.

In the futures market, prices can be affected on an unfunded basis, that is…without actually having to own an asset or all the cash to own it. As long as futures markets exist and regulators impose a risk weight on the assets that serve as collateral, the defenders of the status quo will have a tool to inflict pain on those who want to seek refuge in real assets. Therefore, it is valid to ask what could bring the collapse of the futures markets. High inflation would be one of the factors, but in our view, it is a longer term one. A simple answer to the question is this: Futures markets will collapse when an asset that was supposed to be delivered, cannot be delivered in the quantities and at the time it was going to be delivered. Most likely, due to the failure of a big counterparty, followed by that of the corresponding clearinghouse. This event, if it takes place and we think there is an increasing likelihood that it will, will really boost the flight from nominal to real capital.

Why do we think there might be an increasing likelihood of it happening? Because it would be the unintended consequence of the same manipulative actions governments are taking to affect spot prices. As these manipulations increase, their unintended consequence is more likely to occur, just like it did happen to the derivatives position of a well-known, global bank.

With these words of caution, we can only add that the future weeks, months, will be horribly volatile and that one will have to sit tight, and on the margin, move nominal capital to real capital at each opportunity. Policy makers believe they are still in control, but they are not. And by the time they find out, it will be too late for us to take any protective measures. The European periphery, for all practical purposes, is already out of the Euro zone. The US, for all practical purposes, is insolvent. The creditor countries of the world, for all practical purposes, are heading towards deception, as they find out that their mercantilist view of reserves management has destroyed wealth and misallocated capital. The Middle East, for all practical purposes, is heading towards complete anarchy and the commodity countries likeCanadaorAustralia, have left their fate in the hands of hope, unable to steer a course on their own, at the mercy of global capital flows…and hope is seldom a good strategy.

Martin Sibileau