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Nesbitt Burns Institutional Client Conference Call forApril 7, 2005
Don Coxe
Toronto
“The US Dollar Gets Help From An UnlikelySource,France”
Charts: The Euro
Thank you all for tuning in to the call which comes to you today fromToronto. The chart that we faxed out was the chart of the Euro, and the comment was “The US Dollar Gets Help From An Unlikely Source, France”. So I want to begin by talking about the situation of the Dollar and the special factors that I believe have lead to this rally in the Dollar. And then I’ve got some other themes because lot’s been happening in this week.
So, we’ll lead right off with what was in my mind when I was preparing that conference call notice. The Euro was looking to break through the 1.35 level, which would have been very significant and would have attracted a lot of attention. The move up in gold that we had had was anticipating a breakout on the upside for the Euro. Instead the Euro retraced from the 1.3460 range and fell all the way down to 1.28. It’s 1.29 and change today. That broke gold. The other currencies weakened against the Dollar, because you’ve got to understand, when you are taking bets on the Dollar and the currency market, about 80% of the trades that are done are in Euros, these days, Yen is also a big factor in this, but the Yen, because there’s almost no interest rate return on it is a lesser speculative feature, particularly for the hedge funds.
The breakdown in the Euro was very significant for the Dollar and for gold and I’m putting one country foremost on this because although it’s still nearly two months, well it’s a month and a half away, the vote on May 29th in France, to ratify the European constitution is looming larger and larger in the markets. Remember that this new constitution was put together by Valerie Giscard d’Estaing, a former President of France and one of the great statesmen ofEurope, elder statesman, yes, but highly respected on all sides. This constitution, although it’s hotly opposed by the Euro-skeptics, is one that is deemed to be a compromise beween the people that want even more power handed over toBrusselsand those who want more decisions to be made at the national and local levels.
The other thing about this constitution was it would stabilize the whole set of relationships. So, people were referring to this as being the equivalent of 1789 in thisUnited Statesas they were then, when they came up with the constitution. And you will remember the drama of getting the number of states to ratify that. They didn’t need unanimity but they had to get just enough in line to impose it. People have been making that comparison, since, after all, the creation of the Euro at the Maastricht Treaty was designed to create an economic zone that would compete with theUSand then the Lisbon Declaration of 2000 said that the goal was in five years to be more competitive than theUnited States.
So, this is a big deal.
Now why is this one so big? Well, becauseFrancehas always been the driving force in centralizing control inEurope. And the idea that the French could vote against the constitution was considered at the time we were coming up to these ratifications, thatFrancewas going to be a layup, that they would of course support more centralization. The amazing thing is that the polls show a vote against it.
And that…the first one was regarded as a rogue poll. And there lots of stuff in the international press saying “Oh well that was just a fluke, it will not be confirmed”. But the polls since then have confirmed this. The anodyne assurances that we were getting that all ignored the polls, the French will grumble about it but they know that the greater “gloire” ofFranceconsists of having the Eurozone having this kind of strength, so they’re not going to vote against it.
Well, what’s happened is that the Far Left inFrance, which is always very strong, says this is too liberal a constitution and therefore they want to vote against it. Now that’s…a lot of people are just astounded that they could allege it’s just too liberal, but, the fact remains that they’re also of course, right now, Chirac is much less popular than he was, so people could be voting against it for a variety of reasons not all of which are good in relation to the provisions of it. In any case, the idea that any significant number of the voters have read the hundreds of provisions of this constitution is somewhat remote.
What is worrying people, then, is if a vote that close, if France votes against it, then they don’t know how they even go back to the drawing board, because they wouldn’t be sure of what was significant in this and if they tried to make something that would gratify the French Left, there isn’t a chance it would be ratified by Britain or for that matter some other countries within the Eurozone itself.
So that was a big enough shock, but then, at the European meetings, France lead the group of three, the big three heavyweights within the Eurozone itself who announced that the growth and stability pact didn’t apply to them. SoFrance,GermanyandItaly said “Yeah, it’s alright for you Baltic states andAustria, we expect you to live up to the growth and stability pact, but we’re not bound by it”. Well, they drafted it. And so, one of the reasons for the strength of the Euro, has been that the growth and stability pact would reassure the European Central Bank that it could keep easy monetary policies because what we did not have was big government deficits that needed to be funded.
And of course, lots of people are chuckling about this because the Germans were the ones who absolutely insisted on that provision atMaastricht, because they were giving up their prized Deutschemark. And they were doing it, but they extracted this promise that the only time they’d have deificts about 3½% of GDP is when you are in recession.
Although when you get down to 1% and ½% economic growth, the question of recession and growth is like the E & OE at the bottom of financial statements, which is that, a small error one way or the other takes it from one category to the other completely. Still, it was clear-cut that the kind of deficits thatFrance,GermanyandItalyare running should be restrained by the growth and stability pact.
So those two developments, I believe, have been crucial in taking the Euro down and then we’ve had a distinct weakening of the Yen, but that’s a very recent development. You remember my earlier call, last week, I talked about the Yen’s behavior in all of this, that there’s a lot of manipulation done up to the March 31st fiscal year end in Japan. Well, since then, the Yen has done nothing but fall. Which means it rises, relative to the Dollar, and what that does is another thing that has helped drive the Dollar index in to higher zones. And in the case of Japan, what’s happening there is that all of a sudden, and it really is all of a sudden, Japan’s new “Asianization” policy which got them in the stage of having more trade with China then with the United States and that they were having a huge growth in trade with Korea, this is starting to unravel for a variety of reasons, but the most recent ones – and you’ll look back on this and say “Gee, how could they have done this” – they’ve announced a revision of their textbooks and their textbooks cut the number of Chinese that they are alleged to have killed in World War II and they assert absolutely, Japanese title to all these disputed islands and so forth. And so they’re putting this right into what they’re putting in to their school textbooks and this after Koizumi made another visit to the Shrine of the Dead, which include those that were deemed to be war criminals.
So, the old hatreds ofJapanfrom the mainland country are re-asserting themselves and apparently this is having an effect on Japanese companies operations inAsia. And then we get the statistic that they just announced this week, their monthly trade statistics and exports are up 1.7% and imports are up, year over year, 11% and of course that’s primarily commodities and that’s primarily oil.
So, what we’re getting is a feedback loop effect here from what’s going, particularly in oil into Japanese numbers and of course Japan is now either just out of the zero growth rate and otherwise they’re just below it or just above it. SoJapanis looking more and more likeGermanyandItaly, so when people are looking at the Dollar, then, they’re saying, well, theUSeconomy looks really good by comparison with these other alternatives. So this has given us some strength to the Dollar notwithstanding the continuation of the 6% bleed on the Current Account Deficit. But, we got an offset on that this week, this was yesterday, with this remarkable statement from the World Bank, warning, the quote “poorer nations”, that they have too much in Dollar reserves and they could be devastated and the term that they used, the actual expression, the gravest risk for emerging economies is their putting of so much reserves in the Dollar and if there’s a sudden breakdown in the Dollar this would be devastating for their situations and their economies apart from huge losses in their Forex reserves. So, you may say well why are we putting any credence in a declaration of the World Bank? I’m not so concerned as to whether they’re right or wrong in this, what surprised me was the extremely strong language they used, because ordinarily, when you’ve got international bankers they speak in sort of Delphic tones about this, that there’s a matter of concern. But this was a much stronger document. And it illustrates the support that the Dollar has been getting from the “emerging economies” has truly been gigantic. According to their statistic, $292 billion in foreign exchange reserves by these third world economies in 2003, but up to $378 billion last year withAsiaaccounting for much of this. But they mention that 101 out of 132 developing economies had increased their reserves last year.
So, what the World Bank is saying, is in effect, that regardless of short term things like this, where the situation of the Dollar is something of true global concern and this thing could get out of hand.
I think this accounts for the fact that we’ve had this slight uptick in gold, that plus some denials of any chance of the IMF gold being sold. Now as you know, I didn’t assign any credibility to that, because it was going to have to be approved by the US Congress and although it’s always dangerous to predict what Congress will do, I find it hard, almost impossible, to believe that a Republican Congress would approve something like that. Because the Republicans were the ones who forced the freeing up of gold in the first place. And this is one area in which, interestingly enough, the Republicans are pretty much united. Which is, they want to see a free market in gold and they wouldn’t want to see the IMF destroying that market by suddenly unloading its gold.
So, what this tells me is that the sell-off in gold that we’ve had may well have exhausted itself. Now that’s not what we’re hearing and seeing a lot of, people are talking of $400 gold and that kind of thing. Maybe so. But I think that we may have seen the bottom here. Not that I’m predicting a big rally in gold, for that to happen we have to have the Euro and the Yen reversing their downward moves. But in the near term, at least, those of you and certainly in my visits with institutional investors this week, this has come up. Part of that is because the kind of investors who are overweight the oils and the metals also tend to have significant exposure to the golds and they’re feeling frustrated because although they’re doing extremely well on the oils and the metals, they are puzzled why it is they can’t seem to make money on the golds or they’re losing money on the golds.
Quite frankly, I believe that we’re at a stage where there’s pretty much inverse correlation here. The metals and oil prices can only keep rising if we have a strong global economy. And gold is in there, if things break down. Could have been helped in gold somewhat by the continuing unfolding of bad news about the US financial system and I’m going to get to that in a couple of minutes.
Anyway, as you know I haven’t been saying much about gold lately, so I wanted to update this, that I still believe that you need to be overweight gold mining stocks in your portfolio but don’t think that there’s positive correlation between oil and gold or between copper and gold. There isn’t. The fact that they rose together when we had that commodity rally was because the triple waterfall crash which ultimately engulfed them all but actually preceded from somewhat premises was over and so we were entitled to a relief rally, a good one, off that. But, copper at a dollar fifty one is not a gigantic bet on inflation, it’s simply a bet that the growth inAsiais going to continue and we’re not going to have a recession in theUnited States.
Gold is not any kind of bet on the Chinese and Indian economies or for that matter much of a bet on theUSeconomy. It’s a bet that the Dollar is going to go down. And the Dollar will go down if we have a revaluation of the Chinese and Japanese currencies or if there’s a perception that the US is sliding into recession, in which case the reason for being in a weak currency country with a gigantic current account deficit is taken away on the basis that it’s still the best country to invest in.
So, the gold story is, I would argue, has to be judged on its own rather than just as a “commodity story”.
Okay, so going from the gold story and the currency story, lots happened this week on oil, so I just want to update that story and my thanks to Sherry Cooper for sending along Greenspan’s speech, very interesting speech, with lots and lots of interesting detail. He was speaking to the chemical industry and so it was a remarkably technical speech in terms of the data he covered. But as worthwhile as so much of it was, he left out, there was no reference to what I believe is the single biggest part of the oil story, which is Hubbert’s Peak. No reference to that whatever. And so, my criticism of it is my criticism of the establishment generally on this, which is, that when they look at oil supply and demand, they use the economist’s static state situation, which is that they just look about new oil that;s going to be released by Saudi Arabia and countries like that and they look at demand figures and they assume that the current production, will just continue.
Well that’s just not the case.
As the current Basic Points points out, we’ve got Ghawar and Chantarelle, the two biggest oil fields in the world have no w entered Hubbert’s Peak declines. Well, holy cats, what you’ve got to have is some big, big new discoveries being brought onstream to offset it when those granddaddies are showing signs of senility.
The reason why I am, you know, pounding this story for so long and why it is that I, you know, don’t get worried about the API numbers each week, as to inventories and everything, which I regard as a very short-term number, is the fundamentals, which is that we need to keep bringing on new great quantities of oil to offset the decline from existing fields.
And so, I’m sorry that Mr. Greenspan didn’t address this as even a credible hypothesist. But by leaving that out, so much of the rest of it where what he did was emphasize that what the price mechanism will bring on alternative supplies of energy. Well, that’s absolutely true, but what that leaves out is that the adjustment process takes years. I had two clients that said well this has got to be good for companies like Ballard Power and the alternative energy developers and there was talk of hydrogen energy and so forth, these kinds of things. Well, we’re going to need all that stuff going forward over the next couple of decades because we just are running out of cheap oil.
But, to argue that that’s in the near-term going to be any help to the global economy is delusionary. Because now we’ve got the International Energy Agency coming up with a really shocking number for what oil demand is going to be this year. Now you may say, why would I be citing the IEA, because I’ve been ridiculing them for years for their numbers, but notwithstanding that I refer to them in Basic Points as Botching Boulevardier, it seems they’ve gotten their act together and they’re really looking at Chinese demand now and they’re plugging the numbers in, I guess they’re scared for their jobs. If you can believe their number we’re going to have 86.1 million barrels of demand a day in the fourth quarter this year. Well, that just completely wipes out all these Saudi announcements we got this week of excess production, Kuwaiti announcements and what it means is that we’re going to have a squeeze on oil through the end of the year and that helps to explain the contango in oil that we have now as opposed to the backwardation nearly forever.
So, the near-term outlook for oil at the very least, as long as the global economy doesn’t roll over, is for tight supplies and don’t expect cheap oil.
Now the move to the contango, is a big development in itself. Now, yeah, admittedly this happened a few weeks ago and I didn’t comment on it because I wasn’t sure if this was durable. But it clearly is durable because now what you’ve got is years ahead, oil prices higher than spot. So when you move from backwardation, where spot is always higher than every month, including the next month and certainly far higher than out years, and you move to contango, that is an historic change. And there’s various ways you can look at it. My view of that is the best way to explain it is that the backwardation was created largely because the oil industry was still dominated by people who had come through the triple waterfall and didn’t believe in high prices. And because Wall Street’s investment bankers kept telling them you’ve got to lock in these ridiculously high prices for oil by selling forward…coming back to my dictum that the first jobs that should have been outsourced toAsiawere Wall Street’s oil price forecasters. So the oil industry eagerly sold forward. They went short in a way that would make Barry Gold look like pikers. And they seem to have decided that Ashanti Gold was a perfect model for their practices.
Big Oil made a hundred billion dollars last year, notwithstanding the losses that they had by their forward sales. The US E&P industry, according to Barron’s, had shorted at year-end, 42 to 46% of its production this year in oil and gas at prices of $35 a barrel and less.
Now, what happened though was that we didn’t have enough consumers buying ahead, because they also fell for the same lousy research and the hedge funds weren’t going along on oil back then. We know that only because during the first nine months last year the commodity hedge funds managed to lose money, which meant they were also shorting oil.
So, oil rose purely because of demand running ahead of supply and to the extent that there was speculation in the market, what we have is the speculators collectively on the same side, which was shorting oil. That appears to have changed. I can only assume that when the finance people of the oil companies looked at their numbers at year end they said “Why are we still doing this?”, that they started reining in their forward sales and that the hedgies said “Gee it’s time to start going long” and so what we’ve done then, in the derivatives part of it which is the forward market, we’ve had this huge swing.
Now that is to me somewhat reassuring in the sense that it means we’re closer to the top for oil. One of the reasons why I was concerned that oil prices really could get out of hand was the backwardation. Because I was convinced that the speculation was on the short side. In other words, I was totally against this stuff that we’re getting in the press that speculators were responsible for a $7 to $10 of the overpricing in oil. That was just not possible, given the statistics of forward sales from the companies and the performance of the commodity hedge funds.
So, now, what you can say is that the oil companies are actually sticking to the business of producing and selling oil and that the speculators and consumers are moving out the curve and bidding up the price of the derivatives.
And so that gives us some hope that we aren’t going to go running through sixty dollars or sixty-five dollars. That plus the most reassuring thing of all was Goldman’s talk of $100 oil, which got all this publicity and that does suggest that we’re much closer to a peak. Now, that peak though is not a peak that makes me want to sell oil stocks. Because it’s not as important as Hubbert’s Peak. Hubbert’s Peak is reality. These kinds of things are near-term volatility. And if the oil stocks were selling at 18 times earnings or something and if the Wall Street consensus was for $60 oil then we would be at a peak. But that’s not the case.
So I continue to believe that the oil stocks remain as a high value area of the market, but I reiterate that you buy these stocks not on the basis of their current earnings but you buy them on the basis of their reserves in the ground in secure areas. One of the reasons you don’t buy them based on current earnings, is their current earnings have been hurt because their Treasurers succumbed to the bad research from Wall Street and were selling forward too much. So that hurt their earnings last year. Imagine that, they made $100 billion despite having done everything wrong in terms of their forward market. If they’d gotten that right their profits would have been truly incredible.
So, haven’t changed in my view on this. It is a salutary experience to spend a few days inCanadaand see the amount of coverage of commodities in the press up here. And one of the reasons then why, the Canadian investors I talk to are getting nervous that commodities have reached a peak and it’s time to take money off the table. But the only commodity that gets any real discussion in theUnited Statesis oil and that’s because it’s a bad news commodity. Not because of the investment merits thereof, so in theUSmarket, we have this negative ratio that 10% of the value of the S&P is the oils and the mines and the other 90% of the S&P is companies that either aren’t effected by this or are negatively effected by strong commodity prices.
But nearly everybody is negatively effected by a determined Fed. Our economics department has raised its estimate of the Feds fund rate by year end to 4%. So what we have then is a double whammy for theUSstock market. Rising short term interest rates at a time long term interest rates aren’t going up. And rising oil prices and rising prices for steel and metals.
And that’s not good. And since the US economy is once again, the one that’s holding up the world on it shoulders, I have to regard this as a situation where you want to reduce your exposure to those sectors of the US market which have the most to lose from rising short rates without long rates following through or rising commodity prices which they may or may not be able to pass along. But it’s Catch-22.
If they pass the price increases along then we will get enough inflation so the Fed is even more determined to raise rates and if they don’t, there’s going to be a profit squeeze. So that’s why we get so much coverage down here now of oil. It’s because it’s such a negative for the sectors of the market the drum-beaters are trying to promote you into buying.
The next observation that I’d like to make just before the question period, is another speech of Mr. Greenspan’s and one that I thought was more important is his all-out call for doing something about Fanny and Freddy and the mortgage-backed sector of the market. I’ll reiterate my view that you’ve heard before. When I’m asked by clients, what is there that wakes you up at night, I can tell you that it has always been my fear of something going wrong in the mortgage-backed sector of theUSbond market, which is 36 or 37% of the Lehmann Aggregate Index. And when that sector of the market exists primarily because of the fact that Fanny and Freddy are deemed to be in effect the US Government guaranteeing the mortgages, and when you’ve got Greenspan talking of potential disasters, I mean he was really using strong language in this, in 1994, I’ll reiterate, we had the worst Treasury bond market since 1927 and the reason was the real breakdown in the mortgage-backed sector of the market, leaving the bankruptcy of the mortgage backed experts such as David Askin but most importantly the bankruptcy of Kidder, Peabody even though it was owned by GE Capital’s they were able to borrow at Triple A rates, so Greenspan is right to be highlighting this, but I’m surprised that this isn’t getting more concern in the market, it isn’t producing wider spread developing in the bond market
So, I put this all together and I’m more convinced than ever of my call in the recent Basic Points to reduce equity weightings while keeping big overweights in the commodities sector. Because the values there are clear and yes, if we have a global recession as a result of a breakdown in theUSeconomy at the time we got softenings inEuropeandJapan, commodity prices are going to retreat. But what you’ve got there is assets that are going to be viewed by strategic buyers very favorably in any pullbacks. And this time the strategic buyers are awash in cash. And this includes the mining industry now. The mining industry has lots of cash. So when you look at a 7 P/E on Phelps Dodge and a 10 P/E on Inco – and I’m not recommending these specific stocks, that’s not my job, I’m citing evidences that we do not have any bubble in the mining group, I’ve already told you that we don’t have a bubble in the oil group so I’m simply saying that’s the value.
So I’m recommending that you be cautious about other sectors of theUSmarket, most particularly the financials. MBI got added this week to the list and it’s extremely bad news because MBI is a huge factor in the entire tax exempt bond market in theUnited States. And if MBI proves to be in financial difficulties, we’re going to have disorderly markets in the tax-exempt sector and that would just superate through theUSbond market.
So we look at the debt arket in theUS, it’s a problem area and so all of this is reasons why you can see the financials underperforming and when you’ve got the financials underperforming you’re not going to have a soaring S&P.
So that’s it. A combination of bullish and bearish comments, but just reiterating the adjustments to the assets that I made in my most recent issue of Basic Points. That’s the story, any questions?
[Question on Canadian financial stocks]
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Don Coxe Profile from the BMO websites:
Donald G. M. Coxe is Chairman and Chief Strategist of Harris Investment Management, and Chairman of Jones Heward Investments. Mr. Coxe has 27 years experience in institutional investing, including a decade as CEO of a Canadian investment counseling firm and six years on Wall Street as a 'sell-side' portfolio strategist advising institutional investors. In addition, Mr. Coxe has experience with pension fund planning, including liability analysis, and tactical asset allocation. His educational background includes an undergraduate degree from theUniversityofTorontoand a law degree fromOsgoodeHallLawSchool. Don joined Harris in September, 1993.
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