17 August 2011

he month of August, still only 16 days old, has already resembled something of a Theatre of the Absurd. It opened with the farcical debate about the raising of the US debt ceiling an act that was never in question for many reasons, chief amongst them that a nation possessing the magical combination of the worlds reserve currency, a set of technologically advanced printing presses and a Central Bank committed to providing easy credit conditions for an extended period was always going to support and defend the coupon payments of the United States to all debtors, foreign and domestic. What was clear, however, as the wrangling and politicking proceeded to deteriorate into an unseemly playground squabble, was that outside Capitol Hill, other sets of eyes were watching events unfold through far more prosaic lenses.

ferred in large part from private sector balance sheets to those of the Fed and the ECB. Consequently, we find ourselves in the bizarre situation of sovereign credit being priced as more risky than that of many corporates and yet, with the flight to perceived safety gathering pace, yields at the short end of the US Treasury curve (as well as those of Japan and the UK to name but two others) are at all-time lows - well below the nadir of 2008 (Table 1). The 10s and 30s, while not approaching those kinds of levels, hardly represent the real risk of lending money for an extended period of time to a creditor with $14 trillion in liabilities on its balance sheet and no concrete plan to address those issues.
Average Yield 2000-2011 Current Debt/GDP Yield Ratio
0.19% 0.65% 0.15% 2.17% 3.73% 2.07% 100% 80% 200%

Sovereign Rating (outlook)

AA+ (neg) AAA (stable) AA- (neg)

US 2-Yr Treasury Yield UK 2-yr Gilt Yield Japan 2-yr JGB Yield S&P500 Dividend Yield FTSE100 Dividend Yield Nikkei 225 Dividend Yield

2.89% 3.88% 0.33% 1.86% 3.36% 1.17%

Source: Bloomberg Agreement was finally reached Table. 1 US/UK/Japan 2-yr bond yields vs equity dividend yield in the nick of time, although the headline cuts hardly embraced the new global trend It was this lack of political cohesion in tackling the istowards the austere. In fact, the cuts actually target sue of the debt ceiling, along with the lack of any real Congress future spending levels levels which are bite in the eventual compromise and the chaos that based on assumptions of, amongst other things, 4% surrounded the entire process that led to that bastion annual growth in the US economy, a possibility look- of fiscal propriety, Standard & Poors, downgrading ing more remote with each successive downgrade by the United States credit rating from AAA to AA+ for investment banks and will realize a massive $21 bil- the first time in its history, an act that brought stinglion in savings in 2012 coincidentally an election ing criticism from both the US government and the year. Investor-in-Chief, Warren Buffett.

Despite President Obama signing the new debt ceiling into law on August 2nd, stocks slid heavily later in the week as focus turned to the eye of the storm the European sovereign debt crisis. After three years of aggressive stimulus in the US and Europe, the problem assets of 2008 have been trans-

The downgrade, for practical purposes, was little more than a shot across the bow for the US and, borrowing a chart from CLSAs Chris Wood, a look at Japans yield curve through similar downgrades highlights the lack of any meaningful negative impact on the JGB market (fig 2, next page).

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17 August 2011

banks on the brink of insolvency (fig 3, below), while the ECB has upwards of E80 billion of Greek sovereign debt pledged as collateral by European banks who, like their American counterparts, faced the threat of extinction without state intervention. The EFSF, Europes answer to the TARP, is still to be ratified (and, indeed, MUST be by all 17 members of the EU), and yet the size of the contributions required of Source: Bloomberg its participants increases daily. Not only that, but the list of endangered sovereigns, who presumably will be looking to be net recipients of EFSF funds widens seemingly by the hour and threatens to engulf even the largest of Europes economies. Europe was last week forced into action by the reemergence of the bond vigilantes who had Italy and Greece firmly in their sights. The fact that France was dragged into the ring by investors last week was, perhaps at first glance surprising to many, but, with a debt-to-GDP ratio that is rising at a far steeper trajectory than Italy, $2.4 trillion in refunding requirements due in the next 4 years (over half of which is due in the next 16 months) and an average monthly refinancing need of $64billion for the next four months (more than double that of the Italians), it shouldnt be any surprise that the contagion

Fig. 2 Japan 10-year JGB yield vs S&P downgrades

I continue to believe that the risks of 2008 have been transferred to the public balance sheet and that the dangers facing markets spring largely from both political reaction and inaction towards the twin problems of the endemic indebtedness of Central banks and governments and the catastrophic levels of entitlements that have been promised but cannot possibly be paid. Added to this, the serial attempts to rig the outcome of various events by changing the rules midgame by the relevant authorities have created an environment where traditional investing dynamics no longer work. Since the Greenspan Fed attempted to abolish the business cycle by repealing the bust component with perpetually low rates as an answer to any downturn, government involvement in the markets has become more and more pervasive. Presently, I see a strong flight to government debt based purely on what has become an outdated investment rationale that assumes pristine sovereign balance sheets provide safe haven and a true risk-free rate. Perversely, they are anything but, as the Fed has become the worlds largest holder of its own debt in a matter of months and amassed a collection of toxic mortgage loans pledged as collateral by

Fig. 3 US Federal Reserve balance sheet

Source: Federal Reserve/Crossing Wall St.

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17 August 2011

has reached Paris. Contrast this to the state of the private sector and the difference is all too clear as companies sit on record hordes of cash, have reduced their outstanding debt and pared back their costs to find themselves in good financial shape on the increasingly big assumption that the economy finds a way to somehow translate stagnation into growth. The quest for that elusive growth allied with the brutal correction in equity markets this past week leads us to believe that QE3 and QEU will be applied in concert by the Fed and the ECB and this should be enough to give a shot of adrenalin to stock, bond and commodity markets alike but, with the duration of the effect these shots have on risk assets diminishing with each application, there is an increasing danger that one shot may actually end up killing the patient. I remain extremely alert to this possibility. At Vulpes, we have built a substantial position in gold, silver and precious metal mining stocks (most significantly in the Testudo Fund) as we believe that the weakness being shown by all fiat currencies (with the notable exception of the Swiss Franc a traditional safe haven in times of distress) has rendered gold a de facto currency one that is appreciating and making new highs against every major form of paper tender on the planet (with the notable exception of the Swiss franc). The performance of the mining stocks has significantly lagged the metals themselves as they have been caught in the pervading equity weakness, but with the HUI Index not only underperforming spot gold by 30%, but, more alarmingly, losing almost half its value in gold ounces in the past year, they have found valuation levels that make them extremely compelling investments particularly with their main input cost, oil, falling in price. In the longer-term, however, we believe the oil price may be destined for far higher ground as diminishing reserves, continued unrest in the Middle East and the now-confirmed Fed policy of zero interest rates at least until 2013 could combine to push crude prices (along with other commodities) significantly higher. We are positioned accordingly. Whilst this will doubtless increase the cost of producing gold, potentially

hurting our gold mining positions, we feel that the concomitant increase in the gold price will more than mitigate the rise in oil. In conclusion, during bouts of market weakness (of which there seem to be many) we continue to see investors flee what they perceive to be the burning building of equities only to leap without pause onto the sinking ship of government debt. The memories of 2008 are still fresh in many minds but, with constrained credit conditions leading to a lack of leverage in markets and the afore-mentioned transfer of problematic assets to the public balance sheet weakening the hand of those institutions being relied upon to once again act as the saviours of the market, opportunities are being created to position our book for the return of sanity and the realization that the term riskfree can no longer be applied to government debt. Covert devaluation of the dollar continues through inflation and this tactic looks soon to be extended to the Euro as Brussels tries to hold together a rapidlysplintering Union - the continuation of which (at least in its present form) looks to only be possible through a fiscal union. We see these paths being bullish for commodities and, with valuations retreating to what we consider to be cheap on both a relative and an absolute basis, equities alike though the potential for further sharp, fear-induced corrections is something we remain alert towards.

Grant Williams
Vulpes Investment Management

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