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Nesbitt Burns Institutional Client Conference Call for December 16, 2005
Don Coxe
Chicago
[The webcast of the call cut off the beginning, so Don starts below in mid-sentence.]
…call was suggesting that maybe The Great Symbiosis was threatened because of the fall in the Yen. And the fall in the Yen was the key. Once people saw that it seemed to be breaking out of its trading range relative to the Dollar and the Renminbi indicating that maybe all the open spats between Japan and China, signaled by the fact that at this meeting that was held in Asia this week that Hu Jintao refused to speak to Koizumi, indicated that maybe this situation which had underlain the whole global monetary system since 1998 was going to give way.
And that of course was a crucial thing for judging everything else, because the deal that began in October 1998 after the collapse of Long Term Capital, where the Japanese revised upwards sharply the value of the Yen, undoing the stealth devaluation they had done, was a key to all sorts of things in the world, most particularly to generating the purchase of about 1.3 trillion in Treasuries and the foreign exchange reserves of China and Japan which was the thing that allowed the US consumer boom to progress the way it did.
Because despite the Fed funds rate going from 1% past 4, that long-term interest rates did not go up. As shown by the fact, for example, this year, the T-Bond futures - which is sort of one way to measure the long end of the US bond market - are up modestly, up .4%. So when you put in the running yield on the T-Bonds what you have is returns on the T-Bonds this year, which are higher than the returns on NASDAQ. And not many people would have predicted that knowing that the Fed was going to be tightening at every single meeting.
So, The Great Symbiosis has been so important to our overall asset calls, that the thought that this was going to unravel was something we wanted to alert people to. And the fact that this was driving this thirty-five dollar move in gold so suddenly, where gold was going up at a time that the Dollar was going up, because of course the Yen is so important in the Dollar index, was something that was stunning to a lot of people. We were getting arguments such as “Well, the gold market senses that all the inflation statisitics are fraudulent, we’re going to have gigantic global inflation. You got to get in to gold now.” None of that was true.
This week, of course, the CPI was negative in the US because we didn’t have another rise in the price of energy, it actually went down for the month. And we’re still of the position that ex-energy, not only the US CPI but world CPI is in very, very modest levels, around the 2% range, despite the fact we’re nearly four years into an economic recovery.
So, the reversal that’s occurred this week is truly dramatic. And we’ve taken the Yen down from…it was cruising along at around the 121 level and as we alerted you last week, 122 was to us, a line in the sand that Japan [he probably meant to say China] had drawn back then. They told the syndicate of three hundred bankers bailing out Indonesia that the Yen had to go up from at least the 145 range that it was then, to 122. That was their minimum target.
So it’s fascinating to see the trading action of the Yen in recent weeks, just how that trading range held up. That it went to 121, it did not touch 122, and it reversed. And we’ve had this sharp rally in the value of the Yen, taking it from the 121 and change all the way to 115.80. And that of course has brought gold back down to the 500 range.
And so the big story is that we aren’t going in to year-end facing some kind of global financial crisis, which allows us to look at everything else. Our approach has always been that we talk in terms of long-term investment themes. We try to use five-year themes in what we talk to you about. But we keep a weather eye out there for sudden storms.
And to us, the big thing to us that would signal that the game had changed and that you had to start moving in to shore would be a move in the Yen, which would trigger a breakdown of The Great Symbiosis. And then we wouldn’t know what safety net there was under the Dollar. And without having a safety net under the Dollar, then some pretty ugly things could happen. Now, it would be good if you owned gold, but it wouldn’t be good if you owned much else.
And so, this evidence that once again, that Japan is once again, however unhappily, not let the Yen get devalued below that level that China warned them about is a sign that as much as these countries may resent each other, that they’re still run by rational people. And so we have, I think, the chance is for a Merry Christmas and a Happy New Year instead of a major global financial crisis.
And that’s of course, unalloyed good news. But it means that we’re going to have to watch the value of the Yen as being one of the most important indicators going forward. Because there’s nothing else out there which gives us this direct correlation into a gigantic policy arrangement, which is this new currency environment.
As you know, we’ve taken the position that there have been three global currency environments. The first was the Bretton Woods, 1944, the second was the Plaza and its successors beginning in 1985 and now we are in the Beijing-Tokyo axis.
And there will be a successor to this and it’s not going to last forever, but in the meantime, what it does is allow the bond markets of the world at long-term interest rates to all or to remain at low levels, which is the gigantic underpinning of global economic growth. It’s not…when the US Treasury bonds don’t break down then you get remarkably low yields around the world. And we’ve got all these bond markets of the world where the long 10-year bonds are trading with a three handle, despite an economic recovery and despite the huge move in oil and natural gas and in the industrial metals.
That gives us a chance then to look at what else is out there from an investment concept going through year-end. Now there’s no doubt that part of what’s happened here is that the US hedge funds who’ve been short the Yen and long the 10-Year note have been having to unwind their position and put on currency hedges, but what they clearly have not done is heavily sold the 10-year note. Because we’re looking at 4.43 on the 10-Year note today.
So it looks as if the hedge community has concentrated on Euro funding, which we always thought was the most important aspect of how the carry trade was being done. And that still remains a good pick-up, but no as glorious a pick-up as there was in the past and certainly not the pick up you get if you’re borrowing in Yen and long in the 10-Year note.
So, the world is undoubtedly short the Yen, which is one of the reasons why, of course, the Yen could never have been the global store of value. And to have a currency as the global store of value with zero interest rate is an oxymoronic thought.
And what this illustrates though, is that the Yen plus the Renminbi are the new global store of value and that the Dollar is very much at risk for the decisions that we made and the transactions that will occur going forward among most currencies. And that it’s part of the concept that this is Asia’s century and it underlies our view that we’ve got to remind everybody that this is the first economic recovery in two centuries where the incremental unit of demand comes out of China and India, not out of the United States and not out of the OECD. And that is so important in evaluating what investments will outperform.
Now, on a year-to-date basis it’s been no contest as to which sections of the market have done well. Those that are tied in to China and India, which is the energy and the base metal stocks, they’ve had tremendous returns. If we use, as our proxy, for the base metals, we use the TSX Capped Mining Index, it’s up 42 ½% this year. And the XOI, which is the US oil stocks, it’s up 40%. The XAU, which is gold, is up 23%, as against a 5% move for the S&P, a 1% move for the Dow and a 3.8% move for NASDAQ.
So, the theme of the upcoming issue of Basic Points, which will come out early next week, is the fundamental mispricing in the US market and to a lesser extent, global markets. Which is, that there’s a pretty efficient market operating in the non-commodity sectors of the stock market, because you have thousands of economists, strategists and analysts who are following each tick of economic numbers within the OECD and the analysts covering the large-cap stocks, which have really done very little in this millennium. So there’s very efficient pricing there.
But within the mining and oil sectors of the market, we have very few analysts covering them. And it relates to our basic line…our Obesity Index. Which is, that obesity is dangerous to your financial health if you invest in an equity group where the weight of analysts on Wall Street is heavy in relation to the group’s weight in the index, you’re going to lose.
What you want are the Anorexic Index, a few scared, skinny analysts who are too frightened to issue a bullish forecast. That helps to explain why it is that for four years now the Wall Street consensus on oil prices and on the earnings of the oil companies has been that they’re going down. And in the base metal stocks, why it is that such low price assumptions are used for the base metals going forward.
For a while, this was vindicated by the forward curve for the base metals because there was such a deep backwardation. And even though the backwardation remains, it’s not as intense as it was and now we have a situation where even looking further out on the copper futures, which are the ones that are the most easily obtained, what we see is that they’ve been moving up. And so, next year’s copper, that is, a year from this date, it’s 1.79 now. And that’s so far above the kinds of numbers that are used by analysts - Wall Street analysts at least – in their earnings forecasts, that we see that there’s still mispricing there.
Now, as you know, the second mispricing that we’ve talked about and discussed in this Basic Points is the mispricing of the commodity stocks within their own group, based entirely on earnings or cash flow. And that is, as if they were just stocks like the rest of the stock market. But since what makes them commodity stocks is commodities, what you really have to do is say “Well what distinguishes them is the value of their reserves.” And it’s got to be reserves in the ground in politically secure areas of the world.
And, oh boy, we’ve had lots of news in the last seven days to vindicate that way of evaluating the big stocks.
This week the big oil companies operating in Venezuela had to capitulate to Chavez, giving up a significant percentage of ownership in the fields they’re currently producing a half a million barrels a day of oil on and those fields are a big constituent of the Reserve Life Index of ExxonMobil and Total.
So what we see then, is with a stroke of the pen, that reserves get deleted. And this has been a bad three weeks for ExxonMobil, because they lost the exploration leases off Angola, which Lee Raymond had indicated was something they could make up for the fact that they were not counting on Russia or Venezuela going forward. And it just illustrates that political security is a big part of the evaluation of these assets. And now we switch over to the mining side and the news has been really bad.
We’ve got an election in Bolivia this weekend and it looks really bad. And it’s a Chavez-backed person who’s likely to win that. Now Bolivia is not a big deal anymore, we’re not talking about the Patino tin mine, but it is a major natural gas producer and this is viewed as something where the natural gas thing will be nationalized.
But the victory for this radical in Bolivia suggests that the next big election, which is Peru next year, the leader in the polls there is somebody who actually makes Chavez look somewhat moderate and a Chavez ally with financial backing from Chavez. And so this is already knocking the Peruvian stock market down. And we’re talking here about the world’s fourth biggest copper producer.
This is not a trivial election. Because if these mines are nationalized, and the candidate there is talking about abolishing currencies and abolishing private property, I mean, he’s a true radical and a person who’s been prepared to actually engage in open warfare. It’s hard to put a good spin on this story.
And yes it’s true Phelps Dodge has some production there, but Phelps Dodge’s biggest reserves are Arizona and Chile. And in Chile, they’re going to have elections there although it’s a Social Democrat who’s favored to win, this is a moderate. And so, we’re taking out from the world’s secure copper reserves, a significant part. Just because of politics.
So this helps to explain why it is our enthusiasm for the big mining stocks who have operations around the world and that they have a lot of reserves in politically secure areas of the world. And therefore, I think that the market will start to make these kinds of distinctions going forward.
So far this year, although it’s true that the oil sands stocks have outperformed short reserve life stocks, the market still doesn’t really get it, in terms of how much more they’re worth. And I think that that is going to unfold next year. Apart from the fact that we’re going to have the SEC ruling, I assume at some point next year, I don’t know how much longer they can put it off. But if you look at…just using a leading US oil producer, such as Apache, which is up 39% this year, a great number indeed and just about exactly on the US XOI index, but Suncor is up 84%.
So that’s a sign of how much people are starting to realize what the value is of multi-decade reserves. And I believe that this is going to be a fundamental part of how the stock markets are going to evolve next year. That we are going to go at the two kinds of mispricing.
I believe the commodity stocks will gain weight in the indices going forward because they’ve been supplying such a gigantic percentage of the earnings gains of the indices, so they will assume a heavier weight. And that within the commodity stock groups, that analysts will start to evaluate them by what’s in the ground as opposed to what their current or near-term earnings are. So this we discuss in the upcoming issue in more detail. But, as I say we can do this with rather more calm and comfort now that we’re not worried about some kind of financial crisis, that doesn’t mean that we can’t keep a weather eye out for the Yen.
Therefore I’m quite comfortable with the notion that we don’t have to alter any of our investment asset mix recommendations. I never like to do them precipitously, but I was worried if we’d gone through that 122 Yen level that this would mean that some caution, extreme caution, would suddenly be in order.
So, those of who say “Well you alarmed us last week and everything’s gone fine, now why did you do that?” Well, I’m fundamentally risk-averse and so if a basic part of the thesis that I’ve been using for years for evaluating financial assets is threatened, you can bet that I’m going to say, yes I still have a long-term view of the value of these stocks but something could happen in the near-term which could be quite devastating for the financial markets. That’s no longer the case, so relax and enjoy the upcoming season and that’s it and let’s have questions.
[no questions]
Okay well if there’s no questions at this time then we will talk to you next week. And given what’s going to be happening next week with vacations, the call will come to you on the 22nd, Thursday the 22nd. So have a good weekend.
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 the University of Toronto and a law degree from Osgoode Hall Law School. Don joined Harris in September, 1993.
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