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August 2012 Investment Journal 


Markets in August continued the low volume, low volatility pattern begun in July. There were no "fireworks", and stocks drifted higher, while US bonds were flattish. Oil was up on renewed Middle East tensions, and gold rose stealthily, breaking out of a yearlong sideways pattern. Here is the return summary for August:
Indices Aug 2012  
Indices Chart Aug 2012   
As our Journal is published, the European Central Bank has just released details of its new support program, "Outright Monetary Transactions" (OMT), and risk-on markets are soaring:
In a nutshell, the ECB will now stand ready to purchase unlimited quantities of 1-3 year bonds of stressed countries (Spain et al), and they'll fully sterilize the purchases by selling something else (to be determined, but selling long bonds is just going to raise the cost of refinancing for those sickly countries most in need). They'll only stand ready to help if the sick man agrees to their "conditionality", which is to hand over the keys (financial decisions) to the IMF. They'll decide when to start, stop, or suspend any or all portions of the program, and they'll get rid of the first attempt at stabilization (SMP program, which failed).
The US Fed is likely working on their own "support" announcement, which may come shortly after this Friday's US Employment report.
These actions continue efforts to mask the cause of global monetary malaise, which is too much bad debt that can/will never be repaid (try googling "debt deflation" to really get into the particulars). As we've written about many times, bailing out countries/states/provinces/cities etc. through the raiding of the public purse is the height of arrogance by governments. It has never turned out well throughout the pages of history, and this time will be no different. Investors should first and foremost be realists, realizing that markets go through periods of euphoria and despair. We may be witnessing the end of the euphoria phase with this latest EU announcement.
So, while markets snoozed and shrugged off the possibility of adverse events, a startling announcement was made in late August by two of the world's largest "clearinghouses" (these are the guys who hold collateral to insure performance on the part of traders who use them as "middlemen"). Here's the copy from Zerohedge:
"Gold's re-monetization in the international financial and monetary system continues. LCH.Clearnet, the world's leading independent clearing house, said yesterday that it will accept gold as collateral for margin cover purposes starting in just one week - next Tuesday August 28th.
LCH.Clearnet is a clearing house for major international exchanges and platforms, as well as a range of OTC markets. As recently as 9 months ago, figures showed that they clear approximately 50% of the $348 trillion global interest rate swap market and are the second largest clearer of bonds and repos in the world. In addition, they clear a broad range of asset classes including commodities, securities, exchange traded derivatives, CDS, energy and freight.
The development follows the same significant policy change from CME Clearing Europe, the London-based clearinghouse of CME Group Inc. (CME), which announced last Friday that it planned to accept gold bullion as collateral for margin requirements on over-the-counter commodities derivatives.
It is interesting that both CME and now LCH.Clearnet Group have both decided to allow use of gold as collateral next Tuesday - August 28th. It suggests that there were high level discussions between the world's leading clearing houses and they both decided to enact the measures next Tuesday. It is likely that they are concerned about 'event' risk, systemic and monetary risk and about a Lehman Brothers style crisis enveloping the massive, opaque and unregulated shadow banking system."
It is hard to overstate the importance of this new policy, especially when we also know that governments and central banks around the world have re-instituted gold accumulation policies-i.e. it is an asset class that serves as a "store of value", and not just a "medium of exchange". In other words, gold is money, despite Bernanke's pleas to the contrary. To us, this is another sure sign that currencies and sovereign bonds are going to be at the epicenter when volatility returns.
Another little noticed event also occurred in August, when the US Treasury auctioned a new TIPS issue:
"...the US Treasury sold a whopping $14 billion in TIPS. The yield?  A record low -1.286%, courtesy of TIPS being the only US debt instrument allowed to price at a negative yield (but not for long: JPM's new head of the London CIO divison Matt Zames who is also head of the TBAC is working hard at getting negative yields legalized across the board). The first time the Treasury sold TIPS at a negative rate was back in 2010, when it priced $11 billion at -0.55%."
This is known as NIRP, or Negative Interest Rate Policy, wherein investors PAY GOVERNMENTS for the privilege of buying their paper (Switzerland is the global leader, with all yields out to 6 years being negative). This may not seem rational at first glance, but with some assets going to ZERO (google "debt deflation" and read again), it is perhaps a thoughtful strategy for the mega-size funds that rule government bond markets.
Also, on August 31, Bernanke spoke at the Fed's annual shindig for central bankers in Jackson Hole, Wyoming. Markets were poised to move on his every word. The entire speech can be read here:
In the end, no major policy changes were announced, disappointing investors who have the "risk on" trade primed and wanted more money printing/QE to goose the markets. It was just more of the same (unemployment is too high, we're watching everything and are prepared to act).
Overall, it was his explanation of unconventional policies - i.e. Quantitative Easing - that had the most import in our view. Here are a few choice snippets from his speech: "Monetary policy cannot achieve by itself what a broader and more balanced set of economic policies might achieve; in particular, it cannot neutralize the fiscal and financial risks that the country faces. It certainly cannot fine-tune economic outcomes....A second potential cost of additional securities purchases is that substantial further expansions of the balance sheet could reduce public confidence in the Fed's ability to exit smoothly from its accommodative policies at the appropriate time. Even if unjustified, such a reduction in confidence might increase the risk of a costly un-anchoring of inflation expectations, leading in turn to financial and economic instability."  That is a stark admission that inflation could really ramp up, and that there is no guarantee of stability when the Fed decides to let up on the monetary gas pedal. 
As we've written before, the Fed is mostly out of "monetary bullets", and this is also his warning to the US Congress to act. If things do not improve, it is a near certainty that rates will decline even further in longer maturities as that is all that is left in the Fed's quiver (buying/swapping longer term bonds). Anybody ready for 2% long bonds?
Notably missing from the proceedings was ECB head Mario Draghi, who was busy in Frankfurt trying to jawbone the Germans into submission. His Op-Ed piece (The Future of the Euro: Stability Through Change) in the German language weekly Die Zeit was published the day before Bernanke's speech and can be read here:
The crux of his argument is that "it is neither sustainable nor legitimate for countries to pursue national policies that can cause economic harm for others...countries have to live within their means." His solution is to impose "true oversight over national budgets", i.e. ceding fiscal sovereignty to the EU masters in Brussels (as in now happening in Greece). And the real zinger: "Where necessary, sovereignty in selected economic policy fields can and should be pooled and democratic legitimation deepened."
We might be wrong, but most thinking Germans probably blew a gasket when they read that last line. There is just no way the ordinary German is going to give up their fiscal sovereignty to bureaucrats in Belgium (although the irony here is delicious: Belgium was the first country over-run and absorbed by Germany in World War I; now the Germans are being asked to submit to Belgians without firing a shot.)
But there are greater forces at work than just the man on the street in Berlin, and our hunch is that the US Fed and ECB are closely coordinating actions to be unveiled soon. The next few months are critical if central banks are to succeed. Popular elections are increasingly sending victories to austerity-rejecting "homeland first" type of candidates, and the status quo, including Angela Merkel's CDU, may find themselves out of a job by next spring unless things turn around.
Meantime, markets wax and wane but are mostly range bound, in spite of real economy signals that spell nascent or deepening recessions in Europe, China and the US. In the USA, for example, the all- important ISM Manufacturing Index contracted for the third straight month in August. Europe is in a deep funk, with the OECD just releasing reduced growth expectations for the entire euro-zone. The story from the FT lays out the case:
"The world economy has slowed alarmingly since the start of the year and will continue to struggle unless significant progress is made in solving the euro-zone crisis, the OECD said on Thursday.
In an interim update to its twice-yearly forecasts, the Paris-based international organization for developed economies, said the euro-zone slide into recession was "having an impact worldwide".
In a significant downgrade of its short-term forecasts, it said the euro-zone recession would deepen in the third and fourth quarters of this year, while other G7 countries - the US, Japan, the UK and Canada - would struggle to post anything like their normal growth rates.
Pier Carlo Padoan, the OECD's chief economist, said: "The slowdown will persist if leaders fail to address the main cause of this deterioration, which is the continuing crisis in the euro area."
"A number of downside risks threaten the outlook, including the potential for further increases to already high oil prices, excessive fiscal contraction, notably in the United States in 2013, and further declines in consumer confidence linked to persistent unemployment," he added.
The OECD revised down its forecasts for German growth this year to 0.8 per cent from 1.2 per cent and cut France's outlook to 0.1 per cent from 0.6 per cent. It slashed Italy's forecast to a 2.4 per cent contraction, from minus 1.7 per cent.
The OECD forecast showed how world trade had stopped growing, a sign in the past of an impending global recession, and that unemployment was rising across most of Europe.
Weakness in the euro-zone, in particular, was even beginning to hit exports from China, with growth slowing to a crawl.
The OECD recommended that the euro-zone had to recognize that creditor countries needed policies to expand rapidly, while debtors should speed up structural reforms and impose wage restraint. It urged the European Central Bank to go ahead with aggressive action in bond markets to help the transition to more balanced euro-zone economies and stronger banks.
The OECD did not suggest European fiscal policy should be loosened, however, despite the deeper recession it now expects in the area."
Many market observers are commenting on this divergence between markets and reality. All of the developed world is in a slowdown/recession, the venerable Dow Theory has given an emphatic "sell", yet the S&P 500 is at a four year high. Do fundamentals really matter any more?
As we head into the fall season, new rounds of coordinated "QE" are being deployed, and risk markets are responding favorably. Once the latest injection of monetary morphine wears off, the patient will still be in a lot of pain, and so we are skeptical of the longevity of this "rally". It is especially important now for investors to be very broadly diversified, with a good helping of low volatility assets. Fear and complacency are noticeably quiescent as we head into September, and that's normally a good time to get your Buy Lists refreshed. Will the markets fall in fall? We'll report back in early October.
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