Economics: French Schadenfreude, Jim Callaghan, A Large Vault In Hong Kong, The Credit Crunch And Why Gold Looks So Shiny! By Gareth Milliams

I hear so many reports of unemployment being a lagging indicator. This historically is true. However those who were rendered unemployed in previous recessions tended to be unskilled or semi skilled workers. This recession is different. It has affected every strata of society. It does not discriminate.

This recession was built upon our collective avarice and debt. Sure, the banks are guilty of bundling up mortgages and slicing and dicing and reselling them over and over again. But blaming the banks is like blaming a drug pusher for our addiction.

We live in a society which allows excess without taking responsibility. We can get fat on MacDonalds and sue them for our obesity. We can get drunk on cheap alcohol and take the brewer to court. If our lives are not happy, we blame our parents. We have become a society of grasping needy children wanting whatever shiny thing it is that takes our eye without considering the consequences.

We want fame without having talent, beauty without having the looks. We wanted homes without the wherewithal to buy them and the lifestyle without the hard work or means to finance it. Now that it has all gone wrong, we are looking to apportion blame. We take no responsibility. Yet "The truth", as the poet Browning said, "lies within us".

In Asia, people look askance at Europe and the US, wondering how these massive economies could have created such chaos. How entire nations could have allowed their economies to crash head first into the hardened concrete of financial reality. It almost became a right to own a million dollar home or to have a brand new car every year and take holidays in exotic climes. As aforementioned, we are grasping, needy children who have no regard for the consequences of our actions.

This recession is different. This one matters. This is not about overvalued stocks. It is about our financial values.

A good model of a sensible western economy is France. France was comparatively unaffected by the downturn and is now officially out of recession. In France, very few people own a credit card and proportionately less own their home. Lending criteria is much tighter than in the UK or US and therefore personal debt levels are markedly lower. Additionally, the state plays a massive role, in what is a Keynesian economy. This is not to say that France (or Germany) won't go back into recession, but it does highlight how a society more sensitive to personal debt can weather the credit crunch better.

From The Economist of May 7th 2009:

The French are great savers and most have not taken out unaffordable mortgages or spent heavily on credit. Household debt as a share of GDP is less than half that in Britain or America. The prospect of nationalising banks may give Americans nightmares about turning French. In fact the French government has not yet had to rescue any big French bank from collapse, let alone nationalise one. Though there is outrage at bonus payments in firms laying off workers, bosses’ pay in France is not that extravagant, and the income gap between the top 10% and the bottom 10% is far smaller than in Britain or America.

Please excuse the awful pun, but I think for the smirking Germans and French, schadenfreude has now become de riguer.

Surely the prerogative of government is to regulate. I cannot walk down the street shooting people because it is dangerous. We legislate and create severe penalties to stop me from doing that. I understand the letter of the law and the morality behind its spirit and so I choose not to kill. However, should a group of people decide to risk the financial security of others and enrich themselves doing it, then that is OK. Should they do so and bankrupt entire nations in the act, then they may do so with impunity. It seems that sheer greed has its own moral code.

So where are we now and where are going?

What worries many in the UK and US is the level of individual debt built up by people even on minimal wages. Many lower income workers have a large mortgage on their home and substantial debt via credit cards. It is the always the unskilled and semi skilled workers who are more likely to be laid off.

Once unemployed they are more likely to be unable to pay their mortgages thus could lose their homes increasing inventory reducing the value of all property. Even those that keep their houses and their jobs are likely to be underwater and so cannot move to an area with better employment prospects. Workforce mobility is key to long term economic growth.

Below is a graph highlighting state by state as to when US properties are likely to reach their previous highs. It is from an excellent article by Barry Ritholtz of The Big Picture (click provided links accordingly).

If you are wondering what CSI stands for; it is the Case-Shiller Index which calculates data based on repeat sales of single homes.

The findings are quite shocking with some states having to wait more than 14 years to regain peak value.

The devastating effects of this crisis are multifarious. For example, those who are younger may find themselves frozen out of jobs as senior staff are forced to take later retirement because of the decimation of their pensions. Employment is a trickle down system where older workers retire creating room upstairs for the next generation of senior staff. This continues down to the very lowest trainee levels.

Thus we have high unemployment with no relief from worker retirement and less worker mobility due to mortgage indebtedness. More dangerously, we may also have a generation of unemployed youngsters with nothing to do and no prospects.

On the matter of the unemployment figure; it did drop during the summer, but now we face the prospect of winter and an official figure somewhere north of 10%. Yet all we hear from the fund managers on CNBC is talk of green shoots and confidence. It is pure propaganda. They need you to spend your hard earned savings on equities. The fact that they know that the equity indices are overbought is irrelevant. So long as you believe that the recovery is here; all is right with the world.

However, where there is a lie, truth can also be found. To create this false environment of growth and stability, trillions of dollars, pounds sterling and euros have been spent by governments around the world in order to prop up their failing economies. This 'quantative easing' (QE) is where central banks inject into the banking system massive amounts of cash to lubricate the rusting teeth of the cogs of lending. Its immediate effect is beneficial. Used well and in overwhelming tranches, it will defeat deflation. But it comes at a price. When the printing of money is out of control, a time will come when it is supported by nothing other than a politicians promise.

It used to be that money was supported by gold and that government could not spend money like a drunken sailor unless there was enough gold or taxes to support it. No longer. Federal deficits rose under Reagan, fell under Clinton and exploded under George W Bush. Unfortunately, the Republicans lacked the courage of their outspoken convictions by refusing to cut services whilst slashing taxes and fighting two major wars. Preferring to talk of freedom from big government whilst indebting themselves to China and Japan.

So here we are faced with the massive levels of personal debt that caused the credit crunch and enormous governmental debt designed to fight it. The outcome will be inflation. If a government prints more money than the value of the assets that back it, then inflation will ensue.

From the Independent 22nd July 2009:

In the UK, debt as a proportion of national income is expected to surge above the level it reached when Jim Callaghan was forced to go cap in hand to the International Monetary Fund in 1976. And as a proportion of GDP, it is shooting up to levels not seen since Britain was paying off the borrowing it incurred to fund the Second World War.

So as an investor how do you make money with a large lump sum of cash? How can your portfolio grow in 2009/10?

The interesting thing about a market like this is that your choices are so limited. Therefore you work on what you know and what is systemic. The time for imaginative portfolio management has gone for the time being. Now it is about discipline and patience.

We know that inflation is coming. We know that gold reacts well to an inflationary environment. We know that gold is up despite it presently being in a deflationary environment, an adverse condition. Therefore we can assume that if gold is up in a negative climate, that its rise will logically be greater when inflation arrives.

We also know that the Chinese government is selling the concept of buying gold to its people via TV and radio advertising. Therefore, we can ultimately expect a massive increase in the purchase of physical gold making it more scarce, thus pushing up the price. This is in conjunction with Hong Kong withdrawing its gold reserves from London to be deposited in its own vault near Chep Lap Kok airport. This weakens the London gold market and establishes Hong Kong as a regional gold hub. The Chinese government knows the value of having access to available gold reserves at a time of financial crisis.

Lets assume that the inflation comes. It will not only be gold that rises but other commodities too. These we will select according to their particular market environment at the time. However, we like CAD and AUD. These are two great commodity currencies that offer a fair amount of hedging against a falling USD.

Mining has been on a tear for the last 6 months. It (possibly more than any other sector) was traumatised by the collapse in equity prices in October/November 08. When the hedge funds began to receive record redemption requests from worried clients last year, they dissipated their positions in mining. The effect was catastrophic. Anybody who held mining stock then, experienced a massive loss.

This time may be different. Mining stock is comparatively cheap compared to a year ago. In fact year to date the gold ETF, GLD has outperformed the worlds two largest gold miners, Barrick and Freeport McMoran by 10%.

This is key because during a bull market in gold, the physical metal prices will go higher, but the gold mining shares are leveraged to the physical price. In other words, as the price of gold rises, profits from mining stocks rise more in percentage terms. Generally, over the longer term, the share prices of the major gold producers rise by a factor of two to three times more than the price of gold. Successful junior mining companies can rise by a factor of 5 to 10 times more than the price of gold. The reason for this leverage is that a rising gold price does not lead to a rising cost of production. Therefore, for companies that are already profitable, incremental revenues received from selling gold at a higher price flow straight to the bottom line. For mining companies that are not profitable, a rise in the gold price can suddenly lift them into profitability and a much higher share price.

Effectively, I am recommending a three tier approach. Tier 1 is cash and physical gold. Tier 2 is large miners and tier 3, junior miners. As aforementioned, we are also looking at other industrial metals but the worlds largest gold miners tend also to be amongst the worlds largest silver and copper miners too.

So whether by lump sum via a portfolio bond or as a fund in a savings plan the future looks very shiny for those who love gold..