March 2013
Welcome to the March 2013 edition of Euro Pacific Capital's The Global Investor Newsletter. Our investment consultants are standing by to answer any questions you have. Call (800) 727-7922 today!
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The Stimulus Trap
By: Peter Schiff, CEO and Chief Global Strategist
Flying High on Borrowed Wings
By: Peter Schiff, CEO and Chief Global Strategist
Japan's Dangerous Game
By: Andrew Schiff, Director of Communications & Marketing
Iceland: Back from the Dead
By: Andrew Schiff, Director of Communications & Marketing
Digging for Options in Precious Metal Mining
The Convertible Option
By: Hemant Kathuria, Managing Director, Los Angeles, and Neeraj Chaudhary, Investment Consultant, Los Angeles
Mining Without a Shovel
By: David Echeverria, Investment Consultant, Los Angeles
The Global Investor Newsletter - March 2013
March 1, 2013
The Stimulus Trap
By: Peter Schiff, CEO and Chief Global Strategist
For years we have been warned by Keynesian economists to fear the so-called “liquidity trap,” an economic cul-de-sac that can suck down an economy like a tar pit swallowing a mastodon. They argue that economies grow because banks lend and consumers spend. But a “liquidity trap” convinces consumers not to consume and businesses not to borrow. The resulting combination of slack demand and falling prices creates a pernicious cycle that cannot be overcome by the ordinary forces that create growth, like savings or investment. They argue that a liquidity trap can even resist the extraordinary force of monetary stimulus by rendering cash injections into useless “string pushing.” Some of these economists suggest that its power can only be countered by massive fiscal stimulus (in the form of a world war or other fortunately timed event) that leads to otherwise unattainable levels of government spending.
Putting aside the dubious proposition that the human desire to strive and succeed can be permanently short-circuited by an economic contraction, and that modest price declines can make penny pinchers of us all, the Keynesians have overlooked a much more dangerous and demonstrable pitfall of their own creation: something that I call “The Stimulus Trap.” This condition occurs when an economy becomes addicted to the monetary stimulus provided by a central bank, and as a result fails to restructure itself in a manner that will allow for robust, and sustainable, growth. The trap redirects capital into non-productive sectors and starves those areas of the economy that could lead an economic rebirth. The condition is characterized by anemic growth (masked by the delivery of perpetual stimulus) and deteriorating underlying economic fundamentals.
Japan has been caught in such a stimulus trap for more than a decade. Following a stock and housing market boom of unsustainable proportions in the 1980s, the Japanese economy spectacularly imploded in 1991. The crash initiated a “lost decade” of de-leveraging and contraction. But beginning in 2001, the Bank of Japan unveiled a series of unconventional policies that it describes as “quantitative easing,” which involved pushing interest rates to zero, flooding commercial banks with excess liquidity, and buying unprecedented quantities of government bonds, asset-backed securities, and corporate debt. Although Japan has been technically in recovery ever since, its performance is but a shadow of the roaring growth that typified the 40 years prior to 1991. Recently, conditions in Japan have deteriorated further and the underlying imbalances have gotten progressively worse. Yet despite this, the new government is set to double down on the failed policies of the last decade.
I believe that the United States is now following Japan into the mire. After the crash of 2008, we implemented nearly the same set of policies as did Japan in 2001. In the past two years, despite the surging stock market and apparently declining unemployment rate, the size and scope of these efforts have increased. But as is the case in Japan, we can clearly witness how the stimulus has perpetuated stagnation.
In 2008, one of the country’s biggest problems was that we had over-leveraged too many non-productive sectors of the economy. For instance, we irresponsibly lent far too much money to people to buy over-priced real estate. Since then, the problem has gotten worse. Currently the process of writing, securitizing, and buying home mortgages has been essentially nationalized. Fannie Mae and Freddie Mac (which are now officially government agencies) write and package the vast majority of new home mortgages, which are then guaranteed (almost exclusively) through the Federal Housing Administration, and then sold to the Federal Reserve. According to a tally by ProPublica, these government entities bought or insured more than nine out of 10 home mortgages originated last year, a $1.3 trillion business. Compare this to 2006, when the government share was only three in 10. As a result of this, our lending is far more irresponsible than it has ever been.
In the fourth quarter of 2012, 44% of all FHA borrowers either had no credit score or a score of 679 or lower. In addition, the overwhelming majority of FHA guaranteed loans are being made at 95% or greater loan-to-value. This means down payments are an afterthought. Under the FHA’s Home Affordable Refinance Program (HARP), loans are now even extended to underwater borrowers whose mortgages may be worth far more than their homes. As a result, the FHA could be exposed to enormous losses in the event of future housing market downturns. Such an outcome would be likely if mortgage interest rates were ever to rise even modestly from their current low levels.
In fact, losses on low-quality mortgages have already left the FHA with $16 billion in losses. To close the gap, it has had to raise the insurance premiums it charges to borrowers. With those premiums expected to rise again next month, many fear that marginal borrowers could be priced out of the market. But rather than learning from its mistakes, the government just announced that Fannie Mae would pick up the slack, lowering its lending standards to match the ones that had led to losses at the FHA. In other words, we haven’t solved the problem of bad lending – we have simply made it bigger and nationalized it.
The overall financial sector is equally addicted to cheap money. Banks have seen strong earnings and rising share prices in recent years. But their businesses have largely focused on the simple process of capturing the spread between the zero percent cost of Fed capital and the 3% yield of long term Treasury debt and government insured mortgage backed securities. As a result, banks are not making productive private sector loans to businesses. Instead, the capital is being used to pump up the already bloated housing and government sectors.
Corporate profits are indeed high at the moment, but much of that success comes from the extremely low borrowing costs and extremely high leverage. Investors chasing any kind of yield they can find are pouring money into companies with dubious prospects. This January, yields on junk rated debt fell below 6% for the first time. Currently they are approaching 5.5%. Consumers are using cheap money to buy on credit. Savings rates are now hitting post-recession lows.
Lastly (but certainly not least), the Federal government is now totally dependent on the Fed's largess. Without the Fed buying the bulk of Treasury debt, interest rates would likely rise, thereby increasing the cost of servicing the massive national debt. While Congress and the media have focused on the $85 billion in annual cuts earmarked in the “Sequester,” an increase of Treasury yields to 5% (3% higher than current levels) on the $16 trillion in outstanding government debt would translate to $480 billion per year of increased interest payments. Such an increase would force a tough choice between raising taxes, cutting domestic spending or reducing interest payments sent abroad for debt service. If foreign creditors begin to doubt that America has the resolve to make the hard choices, they may refuse to roll-over maturing obligations, forcing the government to actually repay principal. With trillions maturing each year, actual repayment is mathematically impossible.
But for now most people feel that the transition is underway to a healthy economy. The prevailing debate is when and how the Fed will let the economy fly on its own. Many of the top market analysts have great faith that Ben Bernanke can pull the monetary tablecloth off the table without disturbing the dishes. Those who hold this view fail to understand that the United States is caught in a stimulus trap from which there is no easy exit. How can the Fed wean the economy from stimulus when stimulus IS the economy? In truth, the trick Bernanke must actually perform is to pull the table out from beneath the cloth, leaving both the cloth and the dishes suspended in air.
What would happen to the Treasury market if the Federal Reserve, by far the biggest buyer and largest holder of Treasury bonds, became a net seller? Who will be there to keep the sell off from becoming an interest rate spiking rout? It may sound absurd to those of us who remember the economy before the crash, but our new economy can’t tolerate “sky high” rates of four or five percent. What would happen to the housing market and the stock market if interest rates were to return to those traditional levels? The red ink would flow in rivers. With yields rising and asset prices falling, how long would it take before the Fed reverses course and serves up another round of stimulus? Not long at all.
That means any talk of an exit strategy is just that, talk. Not only can the Fed not exit, but it will have to delve further into the stimulus abyss. While doing so, the Fed will continuously insist that the exit lies just behind an ever moving horizon. It will repeat this mantra until a currency crisis finally forces a painful exit.
Unfortunately, the longer the Fed waits to exit, the more painful the exit will be. But trading long-term pain for short-term gain is the Fed's specialty. In the meantime, Wall Street watches in uncomprehending stupor as the economy settles deeper and deeper into the stimulus trap.
Back to Top >>Flying High on Borrowed Wings
By: Peter Schiff, CEO and Chief Global Strategist
After selling off an astounding 56% between October of 2007 and March 2009, the S&P 500 has staged a rally for the ages, surging 120% and recovering all of its lost ground too. This stunning turnaround certainly qualifies as one of the more memorable, and unusual, stock market rallies in history. The problem is that the rally has been underwritten by the Federal Reserve’s unconventional monetary policies. But for some reason, this belief has not weakened the celebration.
Although the Fed has been tinkering with interest rates and liquidity for a century, nothing in its history could prepare the markets for its activities over the last four years. And while most market analysts give credit to Ben Bernanke for saving the economy and sparking the rally, they have not fully grasped that market performance is now almost completely correlated to Fed activism. A detailed look at stock market movements over the past four years reveals a clear pattern: upward movements are directly tied to the delivery of fresh stimulants from the Fed. Downward movements occur when markets perceive that the deliveries will stop. In other words, the rally is really just a bender. The rest is commentary.
Since 2008, the Fed has injected fresh cash into the economy with four distinct shots of quantitative easing and has added two kickers of Operation Twist. In recent months, the Fed has dispensed with the pretense of designing, announcing, and serving new rounds of stimulus and is now continuously monetizing over $85 billion per month of Treasury and mortgage-backed debt. The new cash needs a place to go, and stocks, which now often provide higher yields than long term Treasury bonds, and which offer much better protections against inflation, provide the best outlet.
But the four year rally has been punctuated by several sharp and brief drops. It is no coincidence that these episodes occurred during periods in which the delivery of fresh stimulus was in doubt. If the Fed were ever to follow through on its promise to exit the bond market, we believe the current rally would come to an immediate halt. This provides yet another reason to believe that stimulus is now permanent.
A close look at the performance of the S&P 500 over the past four years tells the story.
Source: Yahoo! Finance, Euro Pacific Capital. Past performance is no guarantee of future results. (Click to enlarge)
In May 2007, with the "Goldilocks" economy of 2005 and 2006 still in control, the S&P finally eclipsedthe March 2000 high of the dotcom era. It ultimately hit an all-time high of 1565 in October 2007. But later in the year, things began to unravel when bankruptcies of premier subprime lenders signaled real trouble. A blood bath, though, did not materialize. As late as August 2008, the S&P was trading at nearly 1300, down a less-than-tragic 16% from its high. But when Lehman Brothers, Fannie Mae and Freddie Mac, and AIG imploded almost simultaneously in September 2008, the markets panicked. Hundreds of billions of dollars of potentially worthless debt now sat on the books of the nation's financial system. No one knew where the next bomb would explode. A stampede thus ensued.
Less than a month later the index fell below 900, a fall of more than 30%. By November 21, the S&P had lost another 100 points. Four days later, the Fed introduced the first round of what would come to be commonly known as "quantitative easing". This consisted of purchasing $600 billion of government-sponsored enterprises debt and mortgage-backed securities. By the day of the announcement (even though nothing had yet been done), the S&P rallied almost 50 points to 851. Still encouraged by the Fed, the S&P was at 931 on January 6, 2009, significantly higher than in late November.
Despite the first round of asset purchases, the market was still in chaos and had not yet stabilized. By early March, the S&P had lost an additional 25%, bringing total "peak-to-trough" losses at more than 50%. On March 18, 2009, the Fed announced that it was going to expand the size of its stimulus program. This time it really got the stock market's attention. The new guidelines called for a total purchase of $1.25 trillion of MBS and $300 billion of Treasury debt. On the day of the announcement, the S&P opened at 776 and by the time the asset purchases were complete a year later, in March 2010, the S&P was trading at 1171, an increase of 50%.
When the spigots of quantitative easing shut down in the second quarter of 2010 the S&P turned south, declining to a low of 1022 in July (a 13% decline from March). In late August, just before Bernanke delivered his 2010 Jackson Hole speech, in which he would hint at the next round of stimulus (to be later dubbed "QE2"), the S&P was still hovering a full 10% below its post QE1 high. But the expectation of another shot was enough to ignite a rally. When the formal announcement of QE2 came in November, the index had already advanced to 1193. When the program expired at the end of the 2nd quarter of 2011, the S&P stood at 1307, a 25% increase from before Bernanke jawboned the markets at Jackson Hole.
The market response to QE2 was in many ways similar, if less spectacular, than its prior response to QE1. And like the first go-round, the rally ended with the withdrawal of stimulus. In addition, after the cessation of QE2, the markets had to contend with the farce of the U.S. debt ceiling drama. As a result, the S&P declined from a high of 1343 on July 22 to 1123 by August 19, a drop of 16%. This is also the same time period when the U.S. received its downgrade by Standard and Poor's. Ironically, the U.S. eventually got a temporary reprieve from the spotlight when its problems became overshadowed by funding tensions in Greece and Southern Europe, causing the market to once again flock to the so-called "safe haven" of U.S. assets.
The cover from Europe could only go so far. Pressure soon began to build on the Fed to deliver once again. It acted in September 2011 with its "Operation Twist", a program that consisted of buying longer-term treasuries while selling an equal amount of shorter dated paper. Although Twist was advertised as being balance sheet neutral, the short-term sales the Fed made were somewhat offset by the extension of credit lines to Europe and an extended commitment to the 0% interest rate policy that at the time called for an end date of mid-2013. The day the Fed announced Operation Twist, the S&P opened at 1203. By the following April it had reached 1400, a return of 16%.
But once again the stimulus began to fade. In the second quarter of 2012, a sell off took hold, and by June 5, the S&P traded as low as 1277, a decline of 9% since April. Cue the Fed! On June 20, the Fed announced the extension of Operation Twist, sparking a new rally which has continued into 2013. This buoyancy has been maintained, in part, by the announcement of QE3 on September 13, 2012, which also included another extension of the zero interest rate policy until at least mid-2015. By October, Fed governors were already mentioning inflation targets and when QE4 was launched on December 12, they clarified that zero interest rate policies would be in place until unemployment fell below 6.5%. The current leg of the rally has been somewhat non-linear as the election, the Fiscal Cliff, and the endless empty headlines out of Europe have continued to put pressure on the markets. Despite these obstacles, the S&P has rallied past 1500 and on March 5, 2013, it closed at 1538, within shouting distance of its all-time high of 1576 on October 11, 2007.
When the Fed made the first round of asset purchases in November of 2008, the market was still in a state of flux. However, since the system stabilized in mid 2009, there has been a reliable correlation between the timing of the programs and the performance of the markets. This intention was stated explicitly in Ben Bernanke's November 4,2010, Washington Times Op-ed in which he provided the rationale for QE2:
"This approach eased financial conditions in the past and, so far, looks to be effective again. Stock prices rose and long-term interest rates fell when investors began to anticipate the most recent action. Easier financial conditions will promote economic growth. For example, lower mortgage rates will make housing more affordable and allow more homeowners to refinance. Lower corporate bond rates will encourage investment. And higher stock prices will boost consumer wealth and help increase confidence, which can also spur spending."
With the Fed on pace to expand its balance sheet by over $1 trillion in 2013, there can be little doubt that much of that money is headed straight into the stock market. Treasury bonds are still offering negative real yields and so there is less incentive than ever to own government paper.
Recently, the New York Post's Jonathan Trugman pointed out that Citigroup could be considered the poster child of the dubious rally. Since the crisis began, he reports that the Bank has received $45 billion in TARP funding, an additional $45 billion line of credit from the Treasury, and a government guarantee of $300 billion for its own troubled assets. At the same time, its cost of capital (the money it borrows from the Fed) is near zero, while it earns 3% to 5% on mortgages and 12% to 18% on credit cards. But from an operational standpoint, those gifts have failed to create a flourishing, self-sustaining, business. The company had shed almost 100,000 employees from its period of peak employment a few years ago (down to 260,000 employees) and it announced three months ago that an additional 11,000 cuts are to come. But Citi's share price has risen more than 85 percent since June of 2012, despite scant evidence that the company has turned itself around.
But look what all the Fed intervention has wrought. Each time they have intervened the resulting rally has diminished in intensity, and a sell-off has always ensued when the drug wore off. Through the years, the cycle of stimulus administration has quickened pace and has now arrived at a stage where it is continuous. Currently, the Fed is talking about a potential exit strategy, but as we have argued in the past, and as the chart above surely indicates, any withdrawal of stimulus could likely have dire implications for stocks which will not be tolerated by Washington.
Japan has been unsuccessfully trying to inflate its way out of these problems for the past 20 years (see article). Now many of the indebted nations of the developed world seem intent to follow that example. But the monetary experiment of unending stimulus has, up to now, never been tried on a global scale. No one knows when or how it will end, but I believe it will end badly.
Investing in stocks is supposed to be a way to harness real economic growth, not a way to front run stimulus. Our advice for stock investors is to recognize that and to get as far away from artificially induced highs as possible. More fundamentally sound markets exist. We just have to find them.
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Japan's Dangerous Game
By: Andrew Schiff, Director of Communications & Marketing
In the years following the global financial crisis, economists and investors have gotten very comfortable with very high, and seemingly persistent, government debt. Underlying this is the vague assumption that governments know what they are doing and that a real crisis can't occur with so much international cooperation among central bankers. However, Shinzo Abe, the newly elected Prime Minister of Japan, is now threatening to bring such a radical approach to debt accumulation that this complacency may be finally put to the test. After a few years of "Abenomics," investors, both inside and outside of Japan, may conclude that Japanese government debt is simply not worth holding under any circumstances.
Japan has been providing valuable lessons to the rest of the world that have largely gone unappreciated. For the better part of 20 years, Japanese governments and central bankers have been trying, unsuccessfully, to use quantitative easing strategies to pump up a deflated asset bubble. These policies have taken a toll. Total Japanese government debt is now approximately $12 trillion, representing more than 200% of GDP (the IMF calculates that this year it will reach 245%). Japan already spends approximately 25% of its tax revenue on interest payments (as compared to 13% in the U.S.).But that staggering figure takes on epic aspects when considered in the context of today's low interest rates. Japanese ten-year bond yields recently fell below 0.7%, while five-year Japanese debt now yields only 0.12%. This provides the Japanese government with extremely low borrowing costs. Any marginal increase in rates would hit Japanese citizens with the force of 10 Godzillas. But somehow Japan has failed to prepare.
Many economists look to downplay the danger by pointing out that only 9% of Japanese public debt is held by foreigners. But while this might mean that Japan is not as reliant on the foreign markets to roll over its debt, it hardly eliminates the problem. Japan has an aging demographic and as more time goes by the pool of potential bond buyers continues to shrink. Sub 1% yields on long term bonds offered at a time when the Prime Minister is loudly implementing a 2% inflation target is not an investment profile that most rational savers will find attractive. Unlike the United States, where individual savers are mostly irrelevant in the debt discussion, Japanese investors have largely set the market for bonds in their own country. Already there is mounting evidence that many of these buyers are beginning to get cold feet.
This is actually Abe's second term as prime minister. He was elected in 2006 and served for one year before resigning amid a slew of scandals, gaffes, and health concerns. He garnered a reputation as a "hawkish nationalist" that included an emphasis on additional military spending and a general policy of nationalism. In a 2006 appointment speech, he also spoke of ideals like creating "a society in which there is no stratification into winners and losers" and a desire to "expand the application of social insurance coverage to part-time workers." In other words, he is a politician who sees no limits to state power.
Seven years later, with the Japanese economy continuing to limp along, Abe decided to recast himself as a monetary radical. His recent electoral platform was primarily based on a mandate to overwhelm the Japanese market with new cash. Call it the monetary version of "Shock and Awe." Abe is now asserting that Japan's previous experiences with quantitative easing were simply never taken far enough. Apparently influenced by economists like Paul Krugman, Abe is essentially doubling down on a failed policy. Like Krugman and other Keynesians, he is taking the position that inflation is the cure to all economic ills. Exactly why higher prices are a benefit to citizens, many of whom are living on a fixed income, is left largely unexamined.
Similar to other nations with "independent" central banks, the bank of Japan is not allowed to directly purchase government debt. The impediment is designed to prevent an indebted government from simply selling debt to itself. Although modern governments (including the United States) have gotten around this obstacle by simply setting up favored private banks as intermediaries, the process does impose limitations. This past November, Abe openly began a campaign to essentially eliminate this independence. As politicians always do, he cast the change as a way to protect society's most vulnerable citizens:
"To protect people's lives and keep our children safe, we must implement public works spending and do so proudly. If possible, I'd like to see the Bank of Japan purchase all of the construction bonds that we need to issue to cover the cost. That would also forcefully circulate money in the market. That would be positive for the economy, too."
After his election he made it quite clear that his campaign rhetoric was no set of empty promises.
"With the strength of my entire cabinet, I will implement bold monetary policy, flexible fiscal policy and a growth strategy that encourages private investment, and with these three policy pillars, achieve results."
So far this is exactly what he has done and the markets have reacted strongly. Between May and November of 2012, the Nikkei traded within a range of 8500-9000, before ascending to almost 12,000 as Abe's eventual victory began to be priced in. The chart of the Yen versus the dollar has taken the opposite trajectory. Since October, the yen has fallen approximately 20% against the U.S. dollar. The sudden steep drop, which is unusual in the foreign exchange markets, has become a global issue that threatens to destabilize an already weak financial system.
Recently, the falling yen issue sparked a full-fledged headline war. On February 16th, participating members of the G20 issued a statement warning against competitive devaluations and currency wars. A day later, Japan's Finance Minister Taro Aso seemed to contradict that statement by telling CNBC that the G20 was not suggesting Japan was attempting to manipulate its currency. However, any chance of the markets believing that idea was quickly eliminated. A week after the G20 statement, Abe threatened to force the issue by warning the BOJ that, unless they fell into line with his desire to print money until his 2% inflation mandate was met, he would revoke their charter.
"It would be necessary to proceed with revising the BOJ law if the central bank cannot produce results under its own mandate. There are views calling for foreign-bond purchases. I hope the BOJ will take effective policy steps that would contribute to overcoming deflation."
The Japanese are essentially taking the position that it is possible to print money to create inflation without creating downward pressure on the currency. This is absurd on its face.
On February 24th, Abe continued to make sure that matters were not left to chance. He set about assembling a support team of the most dovish set of central bankers in modern history. The most important of these is the nomination of former finance-ministry official Haruhiko Kuroda as the next governor of the Bank of Japan.
Kuroda formerly ran the finance ministry's currency policy in the early 2000s, where he oversaw an extended campaign to devalue the Yen. He has already stated in interviews that he supports a continuation and escalation of these policies. He even said that there was so much room for additional monetary accommodation that it is possible that the central bank could even begin purchasing stocks as well. The possibility that the Bank of Japan may one day be buying common Japanese stocks has likely played a large role in sparking the Nikkei's current rally.
The parade of doves continued with the more recent nomination of Kikuo Iwata for deputy governor of the BOJ. During his confirmation hearings, Iwata explicitly called for revising laws so that the BOJ would be required to achieve an inflation target set by the government. So much for central bank independence! He also said that monetary policy should aim to "maintain the yen's weakness against other major currencies and to support rallies in Tokyo stocks." Surprisingly, the G20 did not respond to that statement.
In addition to his plans for inflationary monetary policy, Abe is also attempting to wage war from the fiscal side as well. His Liberal Democratic Party has called for over $2.4 trillion worth of public works stimulus over the next 10 years. This spending represents approximately 40% of Japan's current GDP, and adjusted for population would be the equivalent of nearly $600 billion annually in the United States. These robust spending plans are being proposed by a government that already has a debt load of over 200% of GDP (more than twice the official estimate of the U.S.).
If Abe is successful in pressuring the Bank of Japan and implementing his fiscal policy, we believe that the results will be catastrophic. Japan will quickly find itself in a position where even its legendary savers will be incapable of, or unwilling to, bail out its government. Unlike the U.S., which has the luxury of printing the world's reserve currency, the Japanese yen could be much more expendable from the global stage. This means that Abe risks sparking an uncontrollable decline of the yen and a much steeper acceleration of inflation. Already, luxury retailers like Louis Vuitton and Harry Winston Diamond Corp (that rely on imports) have already raised prices in response to the weakening currency. Soon these price increases will show up in more modest sectors. Higher stock prices on the Nikkei could be cold comfort when Japan's ramen shops raise their prices.
Just because the Japanese government has hitched itself to a suicidal economic policy does not mean that global investors need to go down with the ship. Portfolio allocations need to account for this rapidly escalating situation and it is therefore wise to assess exposure to the Yen and Japanese government bonds.
On the bright side, Abe and his allies are poised to provide the rest of the world with a stark lesson on the limitations of inflation as a panacea to economic ills. Let's hope we will be in a position to utilize the wisdom before we follow them down the rabbit hole.
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Precious metals are volatile, speculative, and high-risk investments. Physical ownership will not yield income. As with all investments, an investor should carefully consider his investment objectives and risk tolerance as well as any fees and/or expenses associated with such an investment before investing. The value of the investment will fall and rise. Investing in precious metals may not be suitable for all investors.
Iceland: Back from the Dead
Andrew Schiff, Director of Communications & Marketing
When global credit markets began to collapse in 2007, one of the nations hit hardest by the financial panic was the tiny Nordic island of Iceland…that’s right, Iceland. Although known to Americans as the land of volcanoes, glaciers and all-night raves, Iceland also provides an interesting economic parable for these confusing times.
During the mid-years of the last decade, the three largest Icelandic banks saw a massive increase in leverage and lending. The relatively high interest rates offered by these banks, combined with the relative lack of financial regulation, attracted capital from around the world. At one point, the banks’ combined debt exceeded the nation's gross domestic product by six times. Given the size of their debts relative to the Icelandic economy, the banks would fit anyone’s definition of “too big to fail.” But when international investors began to rapidly, and unexpectedly, pull money from Icelandic banks to cover losses at home, the banks quickly found themselves to be completely insolvent. The Icelandic government then did something unthinkable in the world of contemporary economic policy: it let all three default.
Most governments around the world have operated under the idea that it would be suicidal to allow major banks to fail. Most have therefore followed the bailout model set by the United States and the Federal Reserve. However, tiny Iceland, with a population of just 320,000, bucked the trend. It has dealt with the crisis with the old fashioned measures of default, liquidation, contraction, and devaluation. There is no question that the recipe delivered a few very hard years for the average Icelander. Not only did per capita GDP (measured in dollars) fall by more than a third between 2007 and 2010, but at one point the Icelandic stock market plunged 90%. In addition, inflation rose to nearly 20%, the Icelandic Krona declined significantly, unemployment skyrocketed, and emigration became a major issue. At the same time, the Icelandic government reduced spending, raised interest rates, and raised taxes. Essentially they delivered a mix of policies that would qualify as Paul Krugman’s worst nightmare.
The immediate result was 10 consecutive quarters of shrinking GDP and a 50% devaluation of the currency, the Icelandic Krona. However, since then, Iceland has seen 7 out of 8 quarters of positive growth while their unemployment rate now sits at 5.5%.
While undeniably painful, the sharp recession did deliver some gain. Iceland has begun to experience a real recovery while the United States, Europe, and Japan, all remain dependent on the next round of stimulus to keep their economies afloat. Iceland has repaid IMF rescue loans ahead of schedule. Growth in 2012 came in at around 2.5 percent, better than most developed economies. In 2009, the Icelandic government deficit accounted for 13.5% of GDP. But in 2010 and 2011, Iceland tackled this problem head on with austerity measures. In February 2012, Fitch Ratings restored the country’s investment-grade status. The IMF estimated that Iceland was in surplus by the end of 2012.
While the country’s per capita income is still far below the bubble-induced highs that occurred before the crash, Iceland is also no longer dependent upon a fragile and leveraged banking system. In contrast, the nations that did bail out their banks are still living on borrowed money and have only increased the interdependency between the banks and the government.
In Iceland, those banks and investors who made bad decisions have paid for their actions. A consequence of the losses has been a reallocation of capital and labor away from the financial sector and into the resource and export markets. Before the crash, much of the country’s top skilled labor was attracted into the financial sector by the lure of big paychecks. However many Icelandic exporters have now reported that they have been able to recruit the top talent once again. There are plenty of anecdotal stories of fishermen who became bankers, who then became fishermen once again.
Certainly the Icelandic government has not done everything perfectly. They instituted strict capital controls that still hobble businesses and banks, and they have implemented approximately 100 new taxes in an attempt to prevent capital from fleeing the country. These measures have slowed the market’s ability to clear. They have done enough right, however, to allow progress and, despite these setbacks, positive momentum is unmistakable.
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Digging for Options in Precious Metal Mining
The past few months have been trying times for investors in gold and silver mining stocks. Factoring in the vicious sell-off over the past six months, the GDX gold mining index (which is a reasonable proxy for the entire sector) is now down almost 30% over the past five years. This will strike many as odd. Over the same time frame, the price of gold is up nearly 60% and silver is up more than 40%. The divergence may be explained by rising mining costs and other risks in the sector. According to a recent report from Bloomberg, cash costs for gold miners rose 17% during the first nine months of 2012.In essence, investors have paid for the inflation that they bought gold miners to help protect themselves from.
Source: Yahoo! Finance, Euro Pacific Capital.
Given this low valuations of many miners, it is understandable that investors may be looking to now move into the potentially oversold sector. However, investors should be aware of the range of options that exist. Directly purchasing a shares in mining stocks could potentially offer high rewards, however, choosing the right mining stock can be difficult. In order to mitigate risks in the sector, Euro Pacific Capital suggests that suitable investors may consider the following two strategies:
The Convertible Option
By: Hemant Kathuria, Managing Director, Los Angeles, and Neeraj Chaudhary, Investment Consultant, Los Angeles
Sophisticated investors who wish to maintain their exposure to precious metals in these uncertain times - and who meet suitability requirements - may consider convertible bonds of gold and silver mining companies. These securities pay a fixed rate of interest and can be converted into a predetermined amount of common stock at a pre-determined set price.
At the present time, many of the largest and most recognized mining companies offer fixed interest rates on their convertible bond issues that exceed 5% annually. Due to the perceived risks, bond yields from mining companies tend to be higher than similarly rated corporations from other sectors. Like all bonds, these instruments provide some degree of protection against declines in the stock market. At the end of a bond's term, which is typically five or ten years, the bond is redeemed at par by the issuing company. Provided the company does not file for bankruptcy protection, principal and interest payments are due and payable as promised by the issuer. Even if the company enters bankruptcy before the bond matures, convertible bondholders have a higher claim on the company's assets than all equity holders. However interests of convertible bond holders are generally subordinate to secured bond holders. In other words, while bonds are not risk free, they provide much lower risk than equities of the same companies.
But it is the conversion feature that is perhaps most attractive to those interested in the precious metals sector. Convertible bonds can be exchanged for a fixed number of shares of common stock of the issuing company at a predetermined conversion price. In a situation where the underlying mining shares are moving higher, the conversion feature provides bondholders the ability to participate in the upside of rising share prices. Bondholders have broad discretion as to when and if they exercise this option. If the stock price never exceeds the conversion price, bondholders are unlikely to convert. In this case they will likely hold the bond to maturity, collecting interest along the way. If share prices do rise higher than the conversion price, holders do not have to convert right away. They can convert at the conversion price at any time during the life of the bond, no matter how high the share price moves. In this manner, bondholders may choose to hold and collect interest while waiting for an appropriate time to convert. Once converted into shares, investors become equity holders in the company. In this way, convertible bondholders get income and principal protection in a down market, and the potential for upside in a rising market.
Of course, bonds involve their own set of risks. In the event of rising interest rates and inflation, bond prices will generally fall in the secondary market. Bondholders selling at such times may suffer losses if they can't hold to maturity. In addition, the fixed yields could become negative in an environment of very high inflation. Since high inflation could exert upward pressure on mining firms' share prices, the convertibility feature may provide potential protection on this front. As with other bonds, convertible bonds may be called by the issuer prior to maturity and/or at a lower price than the purchase price.
For those looking to diversify a portion of their portfolios within the volatile world of precious metals investing, convertible bonds may be worth consideration. Diligent research to select bonds issued from well-managed, highly rated companies that have prudent debt levels and a long term track record of bond retirement is essential. Investors may wish to contact their Euro Pacific representative to determine whether convertible bonds are suitable for their portfolios.
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Mining Without a Shovel
By: David Echeverria, Investment Consultant, Los Angeles
Mining gold or silver is a very risky business. Operations must contend with infrastructure and logistical challenges, rising input costs, labor issues, hedging strategies, political risk, and various production challenges associated with complex geology. Nothing is certain when it comes to mining.
A mine may have a million ounces of proven gold reserves, but a structural collapse could render it useless. Another mine could have wide margins one day, only to report lower ore grades the next, impacting profitability.
Sir Francis Drake, the legendary 16th Century English sea captain, recognized the tremendous risks endured by the Spanish Empire during its campaign to extract gold and silver from the New World. He developed a clever strategy to participate in the bounty without muddying his impressive boots. He let the Spanish build the infrastructure and risk lives and capital during extraction. But when the Spanish attempted to move the treasure back to the motherland, he descended upon the galleons and plundered them.
I raise this anecdote not to condone piracy, but rather to demonstrate that there are ways to participate in precious metals mining while letting others do the digging. Such modern-day Sir Francis Drakes may want to consider precious metals royalty companies as a source for exposure. These companies, many of which trade publically on American and Canadian exchanges, engage in the following three basic strategies (some are active in all three):
Royalty companies make early-stage investments in start-up mining companies, effectively operating as venture capitalists by providing capital in exchange for a percentage of production. Typically these deals involve a fixed price for the metal over the life of the mine. This feature provides the royalty company with protection from rising operational costs, while ensuring that the royalty company maintains exposure to exploration and production upside.
Royalty companies provide capital to well established miners that are looking to acquire new operations. Due to the high capital costs involved in mining, even the larger and more successful companies don't usually carry large pools of acquisition capital over and above their operating budget. But miners can be great candidates for mergers and acquisitions. Oftentimes particular mines are hamstrung by mismanagement, poor mining techniques, and inexperienced geologists. The unlocked potential of such operations provides takeover opportunities for other operators, particularly those in close geographic proximity, who may have the expertise to take over but who lack the funds to pull the trigger. Royalty companies provide the funding to make these deals happen and specialize in matching management teams who have established track records with failing mines in need of rejuvenation. As with direct investments in start-ups, royalty companies typically take a fixed percentage of production at a fixed price from the acquired properties. Thus, the royalty company is protected from rising costs while maintaining upside to potential increased production.
A significant amount of gold and silver is actually produced residually by companies digging for something else. Royalty companies also help miners of base metals like zinc, copper and lead to monetize the precious metals produced as by-products of their dominant operations. In order to maintain focus on their prime businesses, base metal miners often take upfront payments from royalty companies in exchange for a fixed percentage of their gold/silver production. It's an equitable solution for both parties. The miner gets an immediate infusion of cash and seasoned help in monetizing a non-core asset, while the royalty company locks in gold or silver at a fixed price for a predetermined period of time. As is the case with the previous two examples, the streaming agreement leaves the royalty company with virtually no exposure to mining costs while preserving potential production upside.
Royalty companies also help mitigate risk through due diligence and diversification. Royalties employ world-class geologists and mining experts that can objectively evaluate prospective royalty partners. They perform a tremendous amount of analysis before entering into a royalty agreement with mining partners.
Moreover, because royalty companies make agreements with multiple partners, they create a diversified portfolio of income streams. This has proven to be crucial over the past decade, as we have seen numerous production declines and delays among the big mining names even as global output of precious metals has increased. In 2012, many of the world's largest mining firms experienced delays and downward revisions in production. South African miners, on the other hand, were hampered severely by disruptive labor strikes.
But this risk reduction through diversification has not necessarily translated to lower upside potential. Although past performance is no guarantee of future results, some of the largest and most well-known royalty businesses have significantly outperformed their traditional mining peers in the past year. They have risen more in the bull markets and have fallen less during bear markets.
Factoring in the vicious sell-off over the past six months, the GDX gold mining index is now down almost 30% over the past five years. At the same time, the price of gold is up nearly 60% and silver is up more than 40%. Given this, it is understandable that investors may be looking to now move into the potentially oversold sector. Directly purchasing a mining stock, however, adds a significant degree of risk in excess of commodity risk. According to a recent report from Bloomberg, cash costs for gold miners rose 17% during the first nine months of 2012.
In essence, investors have paid for the inflation that they bought gold miners to help protect themselves from. By locking in the price of the metals and outsourcing the costs to the miners, royalty companies have been able to help insulate investors against this margin compression.
However, royalty companies themselves are not immune from sector and market risk. They will be negatively impacted if metal prices were to fall and they may fall with downward movement of the broader markets.
For investors seeking exposure to precious metal mining, but who hope to contain the considerable risks, royalties may be worth considering. Euro Pacific brokers would be happy to discuss specific options suitable to clients based on their investment objectives and risk tolerance.
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INTERNATIONAL INVESTING MAY NOT BE SUITABLE FOR ALL INVESTORS. TO SEE IF IT IS SUITABLE FOR YOUR INVESTMENT OBJECTIVES AND RISK TOLERANCE, CLICK HERE TO RECEIVE MORE INFORMATION OR CALL 1-800-727-7922 TO SPEAK TO AN INVESTMENT CONSULTANT.
Investing in foreign securities involves additional risks specific to international investing, such as currency fluctuation and political risks. Risks include an economic slowdown, or worse, which would adversely impact economic growth, profits, and investment flows; a terrorist attack; any developments impeding globalization (protectionism); and currency volatility/weakness. While every effort has been made to assure that the accuracy of the material contained in this report is correct, Euro Pacific cannot be held liable for errors, omissions or inaccuracies. This material is for private use of the subscriber; it may not be reprinted without permission. The opinions provided in these articles are not intended as individual investment advice.
This document has been prepared for the intended recipient only as an example of strategy consistent with our recommendations; it is not an offer to buy or sell or a solicitation of an offer to buy or sell any security or instrument or to participate in any particular investing strategy. Dividend yields change as stock prices change, and companies may change or cancel dividend payments in the future. All securities involve varying amounts of risk, and their values will fluctuate, and the fluctuation of foreign currency exchange rates will also impact your investment returns if measured in U.S. Dollars. Past performance does not guarantee future returns, investments may increase or decrease in value and you may lose money.
Opinions expressed are those of the writer and may or may not reflect those held by Euro Pacific Capital, or its CEO, Peter Schiff.
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