The European Debt Crisis Keeps Expanding
by Monty Guild & Tony Danaher
Guild Investment Management, Inc.
April 30, 2010
THEEUROPEAN DEBT CRISIS KEEPS EXPANDING
Greek debt has been rated as junk quality. Spanish and Portuguese debt have undergone downgrades and there are rumors circulating of a possible Italian debt downgrade.
This reminds us of the so-called Asian Contagion of late 1990’s during which bank and government debt contagion sent Asian markets down dramatically and caused the value of several regional currencies to fall. At that time, the U.S. and European markets, which were not part of the crisis, corrected by over 10 percent, then quickly recouped and were followed by market rallies. If the current European debt contagion follows the same pattern as the Asian debt contagion of the late 1990s, which we believe it will, we expect a possible 10-12 percent correction in U.S. and Asian stocks followed by continued rallies in both regions. We do not know when the corrections will take place, but we expect them to create buying opportunities.
U.S. FEDERAL RESERVE---PROPOSED ADDITIONS WILL ADD DOVISH MEMBERS TO THE BOARD
President Obama has proposed three new Governors to fill current vacancies on the Federal Reserve Board. Janet Yellen, the choice for Vice Chairperson, has been a long-time monetary dove. The two other proposed members, Robert Diamond, a professor at MIT, and Sarah Bloom Raskin, the Maryland commissioner of Financial Regulation, are both unknown quantities. We expect them to vote in support of the currently dovish Chairman Ben Bernanke until they become more experienced as monetary policy experts.
A dovish Federal Reserve argues for rising gold prices. Why? Because in our opinion, a dovish Fed will fail to keep inflation at bay by raising interest rates rapidly when inflation reasserts itself in late 2010 and 2011. The result will be more inflation in 2011 and subsequent years.
We were gratified and surprised to see this week that CNBC published a link calling gold the only real currency. This has long been our opinion and we believe that many times over the centuries gold has worked in this role. We were shocked to see a mainstream media outlet announce the same, as it is often difficult for politicians to agree with this view.
Gold is often seen as a report card on the quality of governance that the political class provides for any country. The demand for gold from Europeans during this time of crisis has led to a rise in the price of the metal, which we expect to continue as for the duration of the crisis. We anticipate that this crisis will continue in stronger and weaker waves or phases for many months and perhaps years as the bonds of Spain, Italy, and Portugal continue to be downgraded by the rating agencies.
Eventually, the crisis will end, as many predict, with a bailout of this debt by European taxpayers through the intervention of specific European governments. History has witnessed similar events many times. As currencies become debased, the public moves into gold to protect assets and hedge against the inflation which profligate government spending has created. We expect this pattern of history to repeat itself with only small variations.
MARKET SOPHISTICATION AN ILLUSION?
Although it appears on the surface that markets are becoming more sophisticated with the advent of mathematically calculated trading and instantaneous, computer-driven execution, the opposite is actually the case. Markets are becoming more reactive to daily events, and less sophisticated in analyzing and discounting future events. This is caused in part by the fact that algorithm writers often rely on patterns that can be gleaned from historical trading tendencies rather than in-depth economic analysis.
Let us consider the hypothetical case of semiconductor stocks that generally follow a trend of slower earnings growth during the second calendar quarter as compared to the first calendar quarter of that same year. As a result of this trend, the algorithm writers will recommend selling semiconductor stocks in April after first quarter earnings are announced. Now, let us say this trend is consistent for 2003-2008. During this time, algorithms will do a good job of predicting market behavior.
However, a more sophisticated analysis, which algorithm writers would miss because they are mathematicians and not market players, is that in 2010, semiconductor manufacturers have a unique opportunity to reverse that historical trend due to the fact that last year the world economy was rapidly contracting in early 2009 and demand was low. Conversely, in the period of April through June of 2010 semiconductor orders and deliveries will reflect inventory restocking and a growth of basic demand due to stronger global business trends. In the second quarter of 2010, any type of analysis of business facts will confirm that demand and prices are rising and earnings should be strong for the semiconductor group, yet algorithm based trading programs will often miss these obvious facts.
The current European government debt crisis will continue to wax and wane but stay with us until European governments take much stronger actions to reign in excessive spending of all types including social and military. The Euro and British Pound will continue to fall in value versus the U.S. dollar and other better-managed currencies such as the Australian, Canadian and Singapore Dollars, the Chinese Yuan and the Brazilian Real.
Short sellers may want to consider selling the Euro, European bonds, and European consumer stocks. European exporters and commodity producers may be exempt from the problems.
The U.S. dollar will continue to maintain some strength as the U.S. provides the largest and most liquid markets for currencies, bonds and stocks which will attract those fleeing the collapse of their home currencies.
Longer term, the U.S. will be faced with problems similar to those Europe faces today, although in the short term, the European problem will act as a windfall for the U.S. and allow Americans to delay their day of reckoning.
Gold will be the primary beneficiary of the flight from the European currencies and we believe that the current leveling off of real estate prices in China will shift some Chinese demand from real estate to gold bullion and Chinese stocks.
Stock markets outside of Europe will continue to attract European money. We remain bullish on the strong currencies mentioned above, oil, gold, several Asian markets, and exporting companies around the globe.Thanks for listening.
© 2010 Monty Guild & Tony Danaher