Old Rules No Longer Apply

Over the past 30 years, globalization has made the world a much smaller place. Supported by advances in technology and communications, corporations have sought markets outside their domestic borders. As a middle class takes root in emerging economies, those markets become increasingly important to the bottom line of global companies. The result is greater profitability and enhanced balanced sheets.

Globalization and the attendant removal of trade barriers has, for the most part, been a positive experience. It spawned a new class of consumers, sparked unprecedented global growth and created efficiencies that allowed for rapid expansion without inflation.

But all that may be changing. Since the financial crisis of 2008, there has been a marked decline in the value of international settlements, which has caused some companies to shift their emphasis away from international commerce onto localized markets, in which revenue is more dependent on domestic consumption.

David Francis, writing in the Fiscal Times (www.fiscaltimes.com) cites a recent McKinsey Global Institute report that measures how much money was removed from the global financial system in the wake of the financial crisis and the worldwide economic slowdown. In 2007, US $11.8 trillion in capital in the form of investments and loans moved internationally, representing 335% of global economic production. By 2012 that number had declined to US $5 trillion, representing 312% of global output. For perspective, that brings the level back to where it was in 2000.

That data is disconcerting, but it is not clear what’s behind the numbers. It may be the result of global government stimulus programs supported by liquidity infusions from the worlds’ central banks. There is no doubt that central banks are adding liquidity, and there is little evidence to suggest that consumers are spending. That is clear from the divergence in global money supply which is at record highs versus the velocity of money at record lows. The velocity of money is a gauge of how quickly money changes hands, providing a macro snapshot as to the spending patterns of consumers.

In keeping with those themes, we find ourselves working with a playbook where old rules no longer apply.It appears that global growth – anemic as it is – is being propped up by government stimulus that focuses on domestic economies. Out of necessity, that may be an appropriate strategy, but it is artificial and longer term, and will negatively impact global growth and probably delay any potential recovery.

The desire to artificially stimulate global economies also sets off a series of unintended consequences that wreak havoc on the normal interaction between investment assets. To make that point, follow the bouncing ball; central banks add liquidity through the purchase of government debt. Governments take that capital and use it to stimulate economic activity through various initiatives. Excess liquidity leads to domestic inflation. To remain competitive the country’s currency is devalued. But within the Eurozone devaluation is not an option, which leads to bailouts and ultimately economic chaos.

When all the major central banks are adding liquidity at the same time it should debase all currencies. For countries that cannot arbitrarily devalue, there is economic fallout; Cyprus being the tip of that iceberg.

All of this should lead to a spike in the value of hard assets like gold and silver which theoretically act as a currency substitute. And it worked for a while as gold reached record levels. But lately hard assets like gold, silver, oil and copper have become casualties of unexpected consequences.

We know that the Cyprus economy was artificial – based on ultra-low tax rates – and rested on a foundation of quicksand. Despite that, if it were standing alone its economy may have survived. But as a member of the Eurozone it had to seek assistance from other members, which resulted in currency controls that forced the government to sell hard assets – i.e. its gold reserves – to pay for social programs. That strategy was never factored into the pricing metrics of gold when analysts promoted its role as a store of value and “crisis insurance.”

Still, this should not come as a surprise to investors. We have long questioned the value of gold as crisis insurance believing that the ultimate store of value is the US dollar. In a crisis, people will flock to the US dollar as the last haven of security. In fact we have seen that recently as the US dollar has risen ever so slightly against all major currencies

The good news is that a strong US dollar lowers the price of commodities. Most of that fallout felt in base metals, oil and agricultural products that negatively impact countries like Canada but is a positive for US and Eurozone consumers.

Lower commodity prices, combined with ultra-low interest rates, may be enough to kick start US consumers. That could spark some much needed growth in the third and fourth quarter, which will appear on the bottom line of consumer discretionary and industrial companies.

Investment Strategy

Gold closed on Friday at US $1,407 an ounce, down 5.9% on the week. Even before last week, gold was vulnerable as it had not been able to break through its 50 day moving average. Cyprus was simply the lynchpin that caused gold to sell-off to levels that are now well below its 50 day and 200 day moving average. And most analysts do not expect it to recover anytime soon. That’s because gold typically follows its primary trend – which is clearly bearish – for long periods… sometimes years.Assuming of course that there are some old rules that still apply!

The real concern for gold and the Eurozone is that Cyrus is not the only Member State with serious problems. We suspect that further bailouts will follow the same model that was applied to Cyprus; i.e. any country requesting a bailout will have to agree to major structural reforms. That will be difficult in the current political climate which means that the Eurozone will continue to be a black cloud hanging over the financial markets.

In light of so much uncertainty, we continue to believe that our best defense is to invest in solid dividend paying blue chip stocks that have and continue to generate the bulk of their revenue domestically. It is simply the best alternative in a bad environment. But even with that thesis we recognize that investors will likely seek shelter over the next few months, which is why the “invest ‘til May then go away ‘til labor day” remains our mantra.

To that end, I remain convinced that investors should maintain an overweight position in cash and high quality preferred shares. The former for security, the latter for yield! Further, any exposure to dividend paying stocks will provide cash flow that will help stabilize portfolios during a black period.

The straddle hedgethat I discussed in the March 4^th, 2013 blog will also provide some insurance because I am under no illusion that Cyprus is the end game. Unfortunately the equity markets are susceptible to Eurozone shocks and it is impossible to predict which country will come onto center stage with its own set of problems. At least with the straddle hedge, you have some downside protection and with the over-weighted cash position, the wherewithal to take advantage of opportunities.