Wednesday, June 06, 2007

Energy, Gold and BRICs

Here is more fodder for consideration:

Energy, as a percentage of the S&P500, peaked at over 20% in 1980. It then declined to near 6% in 2000. Now it is back at 10%. So, the price of energy stocks could double versus the rest of the market before they were historically overvalued / near a top.

Gold is a similar story. Gold relative to oil also peaked in 1980 at $800 versus oil at $40 per barrel. Normalized for inflation the past 20 years, the comparable price of oil would be $100, which means the comparable price of peak gold would be $2000. If the dollar continues to decline, then dollar inflation relative to 1980 (as a baseline) will increase this equation and $150 oil and $3000 gold at the next peak. If the pattern from the 70s repeats and we are at about 1972 right now (using the Bretton Woods II thesis), then we would see this scenario play out by 2015.

The above scenario is given a fixed world market for oil and gold. But it can be argued that the global supply of both gold and oil is tighter in 2007 and the demand is greater with the development of the BRIC economies (Brazil, Russia, India and China). So, lots of upside.

Bretton Woods 2: Wither American currency?

I had to share this article with you. It is a reminder that relative global interest rates and their effects on currency exchange rates are what really matter in investing. All the rest is just noise.

China and the ROW have been financing America for a long time, at least since 9/11, by buying up our Treasuries in exchange for the dollars they get from exporting to our consumers. This has allowed our interest rates to remain artificially low and has encouraged consumption and spending, including the housing bubble. It has kept our financial markets (and financial stocks like banks and brokers) strong and supported full employment (by financing production of consumer products and services).

So what happens when this trend reverses? Interest rates go up, financial assets including housing prices go down and inflation erupts. Eventually, unemployment increases and we get a recession. Through all of this, the only safe place to be, relatively, is in hard assets like oil and gold. The real value of hard assets remains constant through time, which means they increase in value relative to a declining currency like the dollar. Here is the article by economist Randall Forsyth in today's Barrons:


Bretton Woods II: About to Follow the Original?
IS BRETTON WOODS II heading for the same fate as its predecessor?

Bretton Woods is shorthand for the postwar international monetary system, named for the New Hampshire resort town where its blueprints were laid out by the Allies in the latter days of World War II. The rules called for currencies' exchange rates to be fixed against the dollar, whose value in gold was set at $35 an ounce.

In reality, however, foreign central banks would buy dollars to keep their currencies from rising in violation of the Bretton Woods rules. That would require the central banks to expand the supply of deutschemarks, yen or francs, to purchase the excess dollars, which was inflationary. Finally, when they started demanding gold for their dollars, then-President Richard Nixon closed the gold window on Aug. 15, 1971. About a year and a half later, the dollar would float along with the currencies of the other major industrialized nations.

The improvised, more-or-less floating exchange-rate system has prevailed since 1973, about as long as the designated-hitter rule in baseball, and equally unsatisfactory to purists.

Bretton Woods II arose not from some formal treaty but as an ad hoc response to the Asian financial crisis that began 10 years ago next month. Then, the currencies of most of East Asia were informally pegged to the dollar. The Thai baht came under attack, and the pegs of much of the rest of the region's currencies were threatened in turn.

The domino theory, so feared in the Vietnam era, came to fruition in the financial markets as hot money fled the region even faster than it entered. The culmination came a year later, following the Russian ruble collapse, which triggered the Long-Term Capital Management near-meltdown.

That's prologue to the present situation. In contrast to a decade ago, emerging economies around the globe, from Asia to Latin America to Europe, generally run substantial trade surpluses and are accumulating vast foreign-exchange reserves. The main reason: to forestall a rise in their own currency's exchange rate, which would harm their economies' export competitiveness.

As under the original Bretton Woods system, the signal aspect of Bretton Woods II is the willingness on the part of foreigners to hold U.S. dollars. In the current regime, that's meant recycling their mounting surpluses mainly into U.S. Treasury and agency securities, providing cheap financing for the budget deficit, American homeowners and the capital markets.

But, as in the early 1970s, the rest of the world is balking at continuing to accumulate dollars at the same pace as before. Bridgewater Associates' Bob Prince and Jason Rotenberg write in the money manager's Daily Observations letter that private-sector accumulation of dollars abroad overseas has been essentially nil.

Central banks have been forced to step into the breach, buying the dollars needed to fund the U.S. current-account deficit, which is equal to about 7% of gross domestic product. In other words, America spends $1.07 for every dollar it earns. Foreign central banks lend us the difference, a form of vendor financing for all those goods produced abroad, especially oil.

In the process, China has accumulated $1.2 trillion of foreign-exchange reserves. Rather than keep piling up Treasuries ad infinitum, China will invest $3 billion of that in Blackstone, which sounds like a lot but equals 0.25% of its reserves.

Less well-publicized is that central banks are just saying "No" to piling up greenbacks. Not selling, mind you, as the disaster-movie scenario envisions; just accumulating at a slower rate.

There are signs that's beginning to happen, as the Bridgewater duo detail. In just the latest, this week Syria became the second Middle Eastern nation to abandon its currency's peg to the dollar, which followed a similar move by Kuwait last month. Meanwhile, a parade of countries has directed an increasing portion of their reserves away from dollars and euros. Among them, the United Arab Emirates, Switzerland, plus America's good friends, Venezuela and Russia. And China announced this week said it, too, will increase the euro's share of its currency cache -- not reducing dollars, but not adding to them as much.

Syria? United Arab Emirates? When the dollar was being attacked in the early 'Seventies, the dollar was losing value against the Italian lira, long considered a joke among currencies. Informed of this, Nixon was famously captured on the Watergate tapes as saying, "I don't give a f--- about the lira." Later, the dollar would plunge, sending the price of everything, notably oil, soaring. (Question: which was more traumatic back then, Watergate or gas lines and soaring unemployment?)

Conversely, in recent years, if there's ever been a free lunch, the dollar has come closest for America. Because the rest of the world wants greenbacks for transactions or as a store of wealth, the U.S. can print dollars to cover the gap between what the nation spends and what it earns.

But as foreign central banks have become less ardent accumulators of dollars of late, U.S. Treasury security yields have been marching higher. Sure, the bond market has gotten over the notion that the Federal Reserve will cut rates any time soon. More particularly, as bonds have retreated, the dollar's recent recovery has stalled. Could there be a connection?

Bretton Woods II essentially translates into foreigners' absorbing a nearly infinite supply of dollars, which they recycle into the credit markets, funding everything from subprime mortgages to private-equity LBOs to the budget deficit.

They'll do that as long as it serves their purpose, mainly to keep their currencies in check to keep their exports strong. Once it no longer suits them, they'll withdraw from Bretton Woods II just as they did with the original. And U.S. bonds and stocks won't like it.