A View from the Trenches, February 6th, 2012: "Walking the fine line"
Please, click here to read this article in pdf format: February 6 2012
When we last wrote two weeks ago, we took the time to lay out an analytical framework that would act as our guide. We invest following the approach of the Austrian School, which is deductive, logical, consistent and aprioristic. We reproduce below the chart we posted then.
During the last half of 2011, the world saw a run for USD liquidity that caused a general sell-off. This sell-off lasted until the Fed first reinstated and then lowered the cost of USD swaps and the European Central Bank offered refinancing operations for a term of 3 years and lowered the requirements for the corresponding collateral. This triggered the rally we witnessed in January. But now, we can see clearly that the time has come, when markets realize that the results of austerity, intervention and higher taxes are not working and that the social unrest they bring could, once again, derail the efforts of the European Monetary Union.
In particular, the role of the European Central Bank in the negotiations on Greece’s debt, in our opinion, has been horrible. We can mince no words here. The world needs leadership and what does it get in instead?…
The authorities of the central bank are going to wait and see what results from the negotiations between the Greek government and private debt holders. They are not going to come first and show they are willing to take a haircut. If they did so, they would:
1.-Show their willingness to solve this problem, with an unequivocal devaluation (because the value of the assets backing their liabilities, the Euro, would fall), as well as
2.-Provide the capital markets with a clear signal of what the floor value of sovereign debt is. Most likely, if they did so, markets would embrace the news with a minimal correction in the value of the rest of the sovereign spectrum and the “orbiting” bank capital sucked into it.
However, it appears we will not get good news. Since our last letter, we have seen the opposite: A European Union trying to flagrantly and openly seeking to eliminate the sovereignty of Greece and to manage their public finances! Have these people lost their minds? Can they not see that they are adding insult to injury? Don’t they realize what a fine line they are walking?
Our chart is very clear: If social unrest gets out of control in Europe, the whole status quo in Europe will decouple from that of the rest of the world. The markets sense this and, consequently, gold sold off on Friday, as wise money sold on the strong employment data print and looked for cover before the party is over. As we said at the end of December, in our “Recap of 2011 and thoughts for 2012 ”: “…We think 2012 will see a rebellion of the people. On the economic front, they will likely repudiate the financial status quo, with an increasing run on deposits, perhaps even at a worldwide scale. On the political front, we will see a fight to retake democracy…”
The leaders of the European Union still have time to ensure Greece and its debt holders reach a reasonable agreement. Somehow, we are optimistic on this point and want to believe that the can will be kicked down the road, once again. Therefore, we have bought and will continue to buy weakness in gold. But we may be wrong here…
We think everyone is also very aware of the future consequences of the policies of the Fed and the ECB. The latest rally is not only delaying the necessary corrections but also, by distorting the price of capital, it is guaranteeing that when these corrections inevitably appear, they will be many, many times more painful. Personally, we have no doubts that the global financial system is set on a course to collapse and we fear that the strength behind gold is very much related to this view. This is the reason why in this rally, we have preferred not to chase stocks. The long-term trend, in our view, is negative for those who produce and innovate: the entrepreneurs. Here, we disagree, for instance, with Marc Faber, who has been advising to be long equities (and also gold). Long term, we see gold and real estate as the only places to store value. We lived in Argentina under high inflation and cannot recall how inflation can either yield employment or allow entrepreneurs to conserve the value of their capital.
Lastly, when we wrote two weeks ago, we had concluded that, in extremis, the velocity of circulation of the Euro would spiral, a common feature of high inflation. However, in the short-term, the demand for Euros does not wane, because sovereign debt is denominated in that currency and the refinancing operations of the European Central Bank facilitate the purchase of that debt. This suggests to us that shorting the Euro will be a painful trade, with very high volatility.
Martin Sibileau
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