China: Paper Tiger

This post China: Paper Tiger appeared first on Daily Reckoning.

China’s shock currency devaluation last week begs the following questions: Is China a rising giant of the twenty-first century poised to overtake the United States in wealth and military prowess? Or is it a house of cards preparing to implode?

Conventional wisdom espouses the former. Yet, hard evidence suggests the latter.

IMG 1

Your correspondent in the world famous Long Bar on the Bund in Shanghai, China. The Long Bar (about 50-yards long) was originally built in 1911 during the heyday of foreign imperialism in China just before the formation of the Republic of China (1912-1949). Bar regulars were divided into “tai-pans” (bosses who sat near the window), “Shanghailanders” (who sat in the middle), and “griffins” (newcomers who sat at the far end).

I made my first visits to Hong Kong and Taiwan in 1981 and my first visit to Communist China in 1991. I have made many visits to the mainland over the past twenty years and have been careful to move beyond Beijing (the political capital) and Shanghai (the financial capital) on these trips. My visits have included Chongqing, Wuhan, Xian, Nanjing, new construction sites to visit “ghost cities,” and trips to the agrarian countryside.

I spent five days cruising on the Yangtze River before the Three Gorges Dam was finished so I could appreciate the majesty and history of the gorges before the water level was lifted by the dam. I have visited numerous museums and tombs both excavated and unexcavated.

My trips included meetings with government and Communist Party officials and numerous conversations with everyday Chinese people, some of who just wanted to practice their English language skills on a foreign visitor.

In short, my experience with China goes well beyond media outlets and talking heads. In my extensive trips around the world, I have consistently found that first-hand visits and conversations provide insights that no amount of expert analysis can supply.

These trips have been supplemented by reading an extensive number of books on the history, culture and politics of China from 3,000 BC to the present. This background gives me a much broader perspective on current developments in China and a more acute analytical frame for interpretation.

An objective analysis of China must begin with its enormous strengths. China has the largest population in the world, about 1.4 billion people (although soon to be overtaken by India). China has the third largest territory in the world, 3.7 million square miles, that’s just slightly larger than the United States (3.6 million square miles), and only slightly behind Canada (3.8 million square miles).

China also has the fifth largest nuclear arsenal in the world with 280 nuclear warheads, about the same as the UK and France, but well behind Russia (6,490) and the U.S. (6,450). China is the largest gold producer in the world at about 500 metric tonnes per year.

China has the second largest economy in the world at $15.5 trillion in GDP, behind the U.S. with $21.4 trillion, and well ahead of number three Japan with $5.4 trillion. China’s foreign exchange reserves (including gold) are the largest in the world at $3.2 trillion (Hong Kong separately has $425 billion in additional reserves).

By way of contrast, the number two reserve holder, Japan, has only $1.3 trillion in reserves. By these diverse measures of population, territory, military strength and economic output, China is clearly a global super-power and the dominant presence in East Asia.

Yet, these blockbuster statistics hide as much as they reveal. China’s per capita income is only $11,000 per person compared to per capita income of $65,000 in the United States. Put differently, the U.S. is only 38% richer than China on a gross basis, but it is 500% richer than China on a per capita basis.

China’s military is growing stronger and more sophisticated, but it still bears no comparison to the U.S. military when it comes to aircraft carriers, nuclear warheads, submarines, fighter aircraft and strategic bombers.

Most importantly, at $11,000 per capita GDP, China is stuck squarely in the “middle income trap” as defined by development economists. The path from low income (about $5,000 per capita) to middle-income (about $10,000 per capita) is fairly straightforward and mostly involves reduced corruption, direct foreign investment and migration from the countryside to cities to purse assembly-style jobs.

The path from middle-income to high-income (about $20,000 per capita) is much more difficult and involves creation and deployment of high-technology and manufacture of high-value-added goods.

Among developing economies (excluding oil producers), only Taiwan, Hong Kong, Singapore and South Korea have successfully made this transition since World War II. All other developing economies in Latin America, Africa, South Asia and the Middle East including giants such as Brazil and Turkey remain stuck in the middle-income ranks.

China remains reliant on assembly-style jobs and has shown no promise of breaking into the high-income ranks.

In short, and despite enormous annual growth in the past twenty years, China remains fundamentally a poor country with limited ability to improve the well-being of its citizens much beyond what has already been achieved.

With this background and a flood of daily reporting on new developments, what do we see for China in the months and years ahead?

Right now, China is confronting social, economic and geopolitical pressures that are testing the legitimacy of the Communist Party leadership and may lead to an economic crisis of the first order in the not distant future.

In contrast to the positives on China listed above, consider the following negative factors:

Trade wars with the U.S. are escalating, not diminishing as I warned from the start in early 2018.

Trump’s recent imposition of 10% tariffs on the remaining $300 billion of Chinese imports not currently tariffed (in addition to existing tariffs on $200 billion of Chinese imports) will slow the Chinese economy even further.

China retaliated with a shock devaluation of the yuan below 7.00 to one dollar, a level that had previously been defended by the People’s Bank of China. Resorting to a currency war weapon to fight a trade war shows just how badly China is losing the trade war.

But, this currency war counterattack will not be successful because it will incite more capital outflows from China. The Chinese lost $1 trillion of hard currency reserves during the last round of capital flight (2014-2016) and will lose more now, despite tighter capital controls. The spike of bitcoin to $11,000 following the China devaluation is a symptom of Chinese people using bitcoin to avoid capital controls and get their money out of China.

The unrest in Hong Kong is another symptom of the weakening grip of the Chinese Communist Party on civil society. The unrest has spread from street demonstrations to a general strike and shutdown of the transportation system, including the cancellations of hundreds of flights.

This social unrest will grow until China is forced to invade Hong Kong with 30,000 Peoples’ Liberation Army troops now massed on the border. This will be the last nail in the coffin of the academic view of China as a good global citizen. That view was always false, but now even the academics are starting to understand what’s really going on.

International business is moving quickly to move supply chains from China to Vietnam and elsewhere in South Asia. Once those supply chains move, they will not come back to China for at least ten years if ever. These are permanent losses for the Chinese economy.

Of course, lurking behind all of this is the coming debt crisis in China. About 25% of China’s reported growth the past ten years has come from wasted infrastructure investment (think “ghost cities”) funded with unpayable debt. China’s economy is a Ponzi scheme like the Madoff Plan and that debt pyramid is set to collapse.

This cascade of negative news is taking its toll on Chinese stocks. This weakness began in late June 2019 when the summit meeting between U.S. President Trump and President Xi of China at the G20 Leaders meeting in Osaka, Japan failed to produce substantive progress on trade disputes.

Since then, the trade wars have gone from bad to worse and China’s economy has suffered accordingly. My expectation is that a trade war resolution in nowhere in sight and the trade war issues have been subsumed into a larger list of issues involving military and national security policy.

The new “Cold War” is here. Get used to it.

Regards,

Jim Rickards
for The Daily Reckoning

The post China: Paper Tiger appeared first on Daily Reckoning.

Why China’s a Paper Tiger

This post Why China’s a Paper Tiger appeared first on Daily Reckoning.

Markets are still digesting last week’s Chinese devaluation that sent the Dow crashing over 700 points last Monday.

And as everyone knows by now, the Trump administration labelled China a currency manipulator.

The ironic part of it is that China has been manipulating its currency to strengthen it against the dollar.

Here’s the dynamic you need to understand…

The Chinese yuan is softly pegged to the dollar. To maintain the soft peg, the People’s Bank of China (PBoC) sells dollars and buys yuan.

That props up the yuan. It’s basic supply and demand economics.

One of the primary reasons China tries to strengthen the yuan is to prevent capital flight out of the country. If the yuan depreciates too rapidly, massive amounts of Chinese money would look to flee abroad where it can get much higher returns.

After all, would you want to hold a rapidly deteriorating asset that constantly loses value? Or if you were a Chinese investor, would you try to convert your money into a currency that holds its value?

That’s the question Chinese investors have been facing.

A capital drain could devastate the Chinese economy, which badly needs the capital to remain in China to support its massive Ponzi schemes, ghost cities and overinvestment.

That’s why the PBoC has been trying to support the yuan, even though a cheaper yuan helps Chinese exports.

That’s the conundrum China faces. It wants a cheap yuan — but not too cheap.

I wouldn’t call last Monday’s devaluation  the sort of “max devaluation” I’ve warned my readers about before. That would have been a devaluation of 5% or more in a single day, and that’s not what happened last week. I would classify it as a “red line” devaluation.

The yuan temporarily broke through the 7.00:1 “red line” dollar peg. It has since returned to normalized levels.

It’s actually ironic that China is being labelled a currency manipulator, if manipulating your currency means cheapening it.

That’s because China was manipulating its currency to strengthen it against the dollar. And when the yuan/dollar exchange rate crossed the 7.00:1 “red line,” that meant China temporarily stopped manipulating its currency higher.

If China didn’t manipulate the yuan higher, it would depreciate even more against the dollar. And the exchange rate stabilized last week when China resumed the manipulation. In other words, when China strengthened the yuan.

Welcome to the currency wars! They take on a logic all their own. In many ways it’s a race to the bottom.

I explained it all years ago in my 2011 book Currency Wars.

As soon as one country devalues, its trading partners devalue in retaliation and nothing is gained. China’s case is complicated by its desires for both a strengthened and weakened yuan.

But the ultimate reality is that currency wars produce no winners, just continual devaluation until they are followed by trade wars. That’s exactly what has happened in the global economy over the past 10 years.

Currency wars and trade wars go hand in hand. Often they lead to actual shooting wars, as I have repeatedly pointed out.

Let’s hope the currency wars and trade wars don’t turn into shooting wars as they have in the past.

But below, I show you why China is more of a paper tiger than an actual one. Why do I say that? Read on.

Regards,

Jim Rickards
for The Daily Reckoning

The post Why China’s a Paper Tiger appeared first on Daily Reckoning.

The Swiss Battle to Cheapen the Franc

This post The Swiss Battle to Cheapen the Franc appeared first on Daily Reckoning.

One of the crucial insights in currency trading that many investors fail to grasp is that currencies don’t go to zero, and they don’t go through the roof. That’s a generalization, but an important one. Here are the qualifications:

This observation applies to major currencies only — not to currencies of corrupt or incompetent countries like Venezuela or Zimbabwe. Those currencies do go to zero through hyperinflation.

The observation also applies only in the short-to-intermediate run. In the long run, all fiat currencies also go to zero.

Yet over a multiyear horizon, major currencies such as the dollar (USD), euro (EUR), yen (JPY), sterling (GBP) and the Swiss franc (CHF) retain value and do not go to extremes. Instead, they trade in ranges against each other. That’s the key to successful foreign exchange trading. Trading profits are the result of catching the turning points.

Jim Rickards

Your correspondent in Zurich, Switzerland, during a recent visit. In analyzing the complex dynamics of foreign exchange markets, it is essential to visit the countries whose currencies are being studied. Foreign visits offer the opportunity to meet with government officials, bankers, business executives and everyday citizens of the affected countries to gain insights that are not available through digital and media sources.

Stocks can go to zero when a company goes bankrupt. Enron, WorldCom and a host of dot-com stocks in the early 2000s are all good examples. Bonds can go to zero when a borrower defaults. That happened to Lehman Bros. and Bear Stearns.

But major currencies do not go to zero. They move back and forth against each other like two kids on a seesaw moving up and down and not going anywhere in relation to the seesaw.

The EUR/USD cross-rate is a good example. In the past 20 years, the value of the euro has been as low as $0.80 and as high as $1.60. There have been seven separate instances of moves of 20% or more in EUR/USD in that time period. But EUR/USD never goes to zero or to $100. The exchange rate stays in the range.

Turning points in foreign exchange rates are driven by a combination of central bank interventions, interest rate policies and capital flows. The old theories about “purchasing power parity” and trade deficits are obsolete.

Foreign exchange trading today is all about capital flows driven by policy intervention, sentiment and interest rate differentials.

Another good example is the Swiss franc (CHF). If you look at its exchange rate with the dollar, an exchange rate of 0.80 francs per dollar indicates a strong franc. An exchange rate of 1.05 francs per dollar indicates a weak franc. Right now the exchange rate is 0.97, which leans towards a weak franc relative to the dollar.

CHF has traded in a range of 0.87–1.03 for the past six years. One move that stands out is the spike on Jan. 15, 2015, when CHF surged from 1.02 to 0.86, a nearly 20% move in a matter of hours. CHF then backed off that high of 0.86 and declined to its more recent trading range of 0.91–1.03.

The spike on Jan. 15, 2015, was caused entirely by the decision of the Swiss National Bank (SNB) to remove a cap on the Swiss franc relative to the euro intended to protect Swiss exports.

The Swiss economy is heavily dependent on exports of precision equipment, luxury goods such as Swiss watches and food including cheeses and chocolates. The Swiss economy also depends on tourism, which is akin to a service export sold to foreigners. All of these exports suffer when the Swiss franc is too strong.

The SNB has been enforcing the cap by printing francs and buying euros to put downward pressure on the franc. The problem with this policy is that the world wants francs as a safe haven.

That was especially true during the European sovereign debt crisis of 2010–2015. The SNB balance sheet was becoming top-heavy with European debt purchased with printed francs at a time when the European debt itself was in distress.

Eventually, SNB threw in the towel and allowed market forces to determine the value of CHF. This produced an immediate spike in CHF against the euro and the dollar, which has since moderated into a trading range.

But the franc is currently at the 1.09 level versus the euro, on expectations of monetary easing in both the euro zone and the United States have set in.

So the SNB has been buying euros in an attempt to get out ahead of the curve. It’s trying to cheapen the franc to keep its exports and tourism industry competitive. You see evidence for this in its so-called sight accounts. Sight account can be transferred to another account or converted into cash without restriction.

There has been a recent surge in these accounts lately, which indicates the SNB has been actively intervening in the currency markets.

With rising market uncertainty and hot money in search of safe havens, what does the future hold for the Swiss franc?

The single most important factor in the analysis is that hot-money safe-harbor inflows are clashing with the SNB’s cheaper franc policy.

The demand for Swiss francs will be driven by the lack of palatable alternatives. Investors are increasingly concerned about sterling because of conditions imposed by the EU, Ireland and others in the Brexit process. Brexit is irreversible, but satisfying all of the demands of interested parties to achieve Brexit will weaken the U.K. economy and sterling.

Likewise, the dollar and yen are both the cause of investor concern because of out-of-control debts. The Japanese debt-to-GDP ratio is over 250% and the U.S. debt-to-GDP ratio will soon be 110%. Any ratio higher than 90% is considered a danger zone by economists.

Almost all Japanese government debt is owned by the Japanese people, so there’s a higher threshold for panic in Japan than in the U.S. The U.S. debt is about 17% owned by foreign investors who could choose to dump it at any moment. Still, both Japan and the U.S. are on unsustainable paths and have shown no willingness to tackle their debt problems or reduce their debt-to-GDP ratios.

The euro offers better debt-to-GDP ratios than Japan or the U.S. in the aggregate. However, the European Central Bank is getting ready to pursue more quantitative easing and near-negative interest rate policies. The euro is also plagued by lingering doubts about the individual debt situations in Greece and Italy, a legacy of the 2010–2015 European debt crisis.

Meanwhile, the Swiss debt-to-GDP ratio is about 30%. In fact, Keynesians complain that its debt levels are far too low!

Russian rubles and Chinese yuan are unattractive for major global capital allocators because their markets lack liquidity and they do not have satisfactory rule-of-law regimes behind their currencies.

With dollars, yen, sterling, the euro and emerging-market currencies all unattractive for different reasons, the primary safe havens for global investors are Swiss francs, gold, silver and some of the smaller currencies such as Australian or Canadian dollars.

Many investors won’t allocate to gold because of investment restrictions or simple bias. This leaves the Swiss franc first in line to absorb huge global capital flows looking for a home.

The SNB may keep trying to knock down the Swiss franc by buying stocks, bonds, euros and anything else that’s not nailed down, but in the end it won’t be enough. Global capital will continue buying francs for lack of a better alternative.

Eventually the SNB will once again throw in the towel as they did in 2015 and allow the franc to appreciate sharply.

Having a strong currency is desirable. But in today’s world outside of a gold standard, having too strong a currency can actually be a curse.

Regards,

Jim Rickards
for The Daily Reckoning

The post The Swiss Battle to Cheapen the Franc appeared first on Daily Reckoning.

Free-Riding Investors Set up Markets for a Major Collapse

This post Free-Riding Investors Set up Markets for a Major Collapse appeared first on Daily Reckoning.

Free riding is one of the oldest problems in economics and in society in general. Simply put, free riding describes a situation where one party takes the benefits of an economic condition without contributing anything to sustain that condition.

The best example is a parasite on an elephant. The parasite sucks the elephant’s blood to survive but contributes nothing to the elephant’s well-being.

A few parasites on an elephant are a harmless annoyance. But sooner or later the word spreads and more parasites arrive. After a while, the parasites begin to weaken the host elephant’s stamina, but the elephant carries on.

Eventually a tipping point arrives when there are so many parasites that the elephant dies. At that point, the parasites die too. It’s a question of short-run benefit versus long-run sustainability. Parasites only think about the short run.

A driver who uses a highway without paying tolls or taxes is a free rider. An investor who snaps up brokerage research without opening an account or paying advisory fees is another example.

Actually, free-riding problems appear in almost every form of human endeavor. The trick is to keep the free riders to a minimum so they do not overwhelm the service being provided and ruin that service for those paying their fair share.

The biggest free riders in the financial system are bank executives such as Jamie Dimon, the CEO of J.P. Morgan. Bank liabilities are guaranteed by the FDIC up to $250,000 per account.

Liabilities in excess of that are implicitly guaranteed by the “too big to fail” policy of the Federal Reserve. The big banks can engage in swap and other derivative contracts “off the books” without providing adequate capital for the market risk involved.

Interest rates were held near zero for years by the Fed to help the banks earn profits by not passing the benefits of low rates along to their borrowers.

Put all of this (and more) together and it’s a recipe for billions of dollars in bank profits and huge paychecks and bonuses for the top executives like Dimon. What is the executives’ contribution to the system?

Nothing. They just sit there like parasites and collect the benefits while offering nothing in return.

Given all of these federal subsidies to the banks, a trained pet could be CEO of J.P. Morgan and the profits would be the same. This is the essence of parasitic behavior.

Yet there’s another parasite problem affecting markets that is harder to see and may be even more dangerous that the bank CEO free riders. This is the problem of “active” versus “passive” investors.

An active investor is one who does original research and due diligence on her investments or who relies on an investment adviser or mutual fund that does its own research. The active investor makes bets, takes risks and is the lifeblood of price discovery in securities markets.

The active investor may make money or lose money (usually it’s a bit of both) but in all cases earns her money by thoughtful investment. The active investor contributes to markets while trying to make money in them.

A passive investor is a parasite. The passive investor simply buys an index fund, sits back and enjoys the show. Since markets mostly go up, the passive investor mostly makes money but contributes nothing to price discovery.

The benefits of passive investing have been trumpeted by the late Jack Bogle of the Vanguard Group. Bogle insisted that passive investing is superior to active investing because of lower fees and because active managers can’t “beat the market.” Bogle urged investors to buy and hold passive funds and ignore market ups and downs.

The problem with Bogle’s advice is that it’s a parasitic strategy. It works until it doesn’t.

In a world in which most mutual funds and wealth managers are active investors, the passive investor can do just fine. Passive investors pay lower fees while they get to enjoy the price discovery, liquidity and directional impetus provided by the active investors.

Passive investors are free riding on the hard work of active investors the same way a parasite lives off the strength of the elephant.

What happens when the passive investors outnumber the active investors? The elephant starts to die.

Since 2009, over $2.5 trillion of equity investment has been added to passive-strategy funds, while over $2.0 trillion has been withdrawn from active-strategy funds.

The active investors who do their homework and add to market liquidity and price discovery are shrinking in number. The passive investors who free ride on the system and add nothing to price discovery are expanding rapidly. The parasites are starting to overwhelm the elephant.

There’s much more to this analysis than mere opinion or observation. The danger of this situation lies in the fact that active investors are the ones who prop up the market when it’s under stress. If markets are declining rapidly, the active investors see value and may step up to buy.

If markets are soaring in a bubble fashion, active investors may take profits and step to the sidelines. Either way, it’s the active investors who act as a brake on runaway behavior to the upside or downside.

Active investors perform a role akin to the old New York Stock Exchange specialist who was expected to sell when the crowd wanted to buy and to buy when the crowd wanted to sell in order to maintain a balanced order book and keep markets on an even keel.

Passive investors may be enjoying the free ride for now but they’re in for a shock the next time the market breaks, as it did in 2008, 2000, 1998, 1994 and 1987.

When the market goes down, passive fund managers will be forced to sell stocks in order to track the index. This selling will force the market down further and force more selling by the passive managers. This dynamic will feed on itself and accelerate the market crash.

Passive investors will be looking for active investors to “step up” and buy. The problem is there won’t be any active investors left or at least not enough to make a difference. The market crash will be like a runaway train with no brakes.

The elephant will die.

Regards,

Jim Rickards
for The Daily Reckoning

The post Free-Riding Investors Set up Markets for a Major Collapse appeared first on Daily Reckoning.

Robot Trading Will End in Disaster

This post Robot Trading Will End in Disaster appeared first on Daily Reckoning.

Today, stock markets and other markets such as bonds and currencies can best be described as “automated automation.” Here’s what I mean.

There are two stages in stock investing. The first is coming up with a preferred allocation among stocks, cash, bonds, etc. This stage also includes deciding how much to put in index products or exchange-traded funds (ETFs, which are a kind of mini-index) and how much active management to use.

The second stage involves the actual buy and sell decisions — when to get out, when to get in and when to go to the sidelines with safe-haven assets such as Treasury notes or gold.

What investors may not realize is the extent to which both of these decisions are now left entirely to computers. I’m not talking about automated trade matching where I’m a buyer and you’re a seller and a computer matches our orders and executes the trade. That kind of trading has been around since the 1990s.

I’m talking about computers making the portfolio allocation and buy/sell decisions in the first place, based on algorithms, with no human involvement at all. This is now the norm.

Eighty percent of stock trading is now automated in the form of either index funds (60%) or quantitative models (20%). This means that “active investing,” where you pick the allocation and the timing, is down to 20% of the market. Although even active investors receive automated execution.

In all, the amount of human “market making” in the traditional sense is down to about 5% of total trading. This trend is the result of two intellectual fallacies.

The first is the idea that “You can’t beat the market.” This drives investors to index funds that match the market. The truth is you can beat the market with good models, but it’s not easy.

The second fallacy is that the future will resemble the past over a long horizon, so “traditional” allocations of, say, 60% stocks, 30% bonds and 10% cash (with fewer stocks as you get older) will serve you well.

But Wall Street doesn’t tell you that a 50% or greater stock market crash — as happened in 1929, 2000 and 2008 — just before your retirement date will wipe you out.

But this is an even greater threat that’s rarely considered…

In a bull market, this type of passive investing amplifies the upside as indexers pile into hot stocks like, for example, Google and Apple have been. But a small sell-off can turn into a stampede as passive investors head for the exits all at once without regard to the fundamentals of a particular stock.

Index funds would stampede out of stocks. Passive investors would look for active investors to “step up” and buy. The problem is there wouldn’t be any active investors left, or at least not enough to make a difference. There would be no active investors left to risk capital by trying to catch a falling knife.

Stocks will go straight down with no bid. The market crash will be like a runaway train with no brakes.

It comes back to complexity, and the market is an example of a complex system.

One formal property of complex systems is that the size of the worst event that can happen is an exponential function of the system scale. This means that when a complex system’s scale is doubled, the systemic risk does not double; it may increase by a factor of 10 or more.

This kind of sudden, unexpected crash that seems to emerge from nowhere is entirely consistent with the predictions of complexity theory. Increasing market scale correlates with exponentially larger market collapses.

Welcome to the world of automated investing. It will end in disaster.

Regards,

Jim Rickards
for The Daily Reckoning

The post Robot Trading Will End in Disaster appeared first on Daily Reckoning.

New Multi-year Gold Rally Has Emerged

This post New Multi-year Gold Rally Has Emerged appeared first on Daily Reckoning.

The dollar price of gold has been on a roller-coaster ride for the past six years. But the past six weeks have been a turbocharged version of that. Investors should expect more of the same for reasons explained below.

The six-year story is the more important for investors and also the more frustrating. Gold staged an historic bull market rally from 1999 to 2011, going from about $250 per ounce to $1,900 per ounce, a 650% gain.

Then, gold nose-dived into a bear market from 2011 to 2015, falling to $1,050 per ounce in December 2015, a 45% crash from the peak and a 51% retracement of the 1999-2011 bull market. (Renowned investor Jim Rogers once told me that no commodity goes from a base price to the stratosphere without a 50% retracement along the way. Mission accomplished!)

During that precipitous decline after 2011, gold hit a level of $1,417 per ounce in August 2013. It was the last time gold would see a $1,400 per ounce handle until last month when gold briefly hit $1,440 per ounce on an intra-day basis. At last, the six-year trading range was broken. Better yet, gold hit $1,400 on the way up, not on the way down.

The range-bound trading from 2013 to 2019 was long and tiring for long-term gold investors. Gold had rallied to $1,380 per ounce in May 2014, $1,300 per ounce in January 2015, and $1,363 per ounce in July 2016 (a post-Brexit bounce).

But, for every rally there was a trough. Gold fell to $1,087 per ounce in August 2015 and $1,050 per ounce in December 2015. The bigger picture was that gold was trading in a range. The range was approximately $1,365 per ounce at the top and $1,050 per ounce at the bottom, with lots of ups and downs in between. Yet, nothing seemed capable of breaking gold out of that range.

The good news is that gold has now broken out to the upside. The $1,440 per ounce level is well within reach and the $1,400 per ounce level seems like a solid floor, despite occasional dips into $1,390 per ounce territory. Gold’s trading at $1,416 today.

More importantly, a new multi-year bull market has now emerged. Turning points from bear to bull markets (and vice versa) are not always recognized in real time because investors and analysts are too wedded to the old story to see that the new story has already started.

But, looking back it’s clear that the bear market ended in December 2015 at the $1,050 per ounce level and a new bull market, now in its fourth year, is solidly intact. The recent break-out to the $1,440 per ounce level is a strong 37% gain for the new bull market. This price break-out has far to run. (The 1971 – 1980 bull market gained over 2,100%, and the 1999 – 2011 bull market gained over 650%).

The price action over the past six weeks has been even wilder than the price action over the past six years. As late as May 29, 2019, gold was languishing at $1,280 per ounce. Then it took off like a rocket to $1,420 per ounce by June 25, 2019, an 11% gain in just four weeks.

Gold just as quickly backed-down to $1,382 per ounce on July 1, rallied back to $1,418 per ounce on July 3, and fell again to $1,398 per ounce on July 5. These daily price swings of 1.5% are the new normal in gold. Again, the good news is that the $1,400 per ounce floor seems intact.

What’s driving the new gold bull market?

From both a long-term and short-term perspective, there are three principal drivers: geopolitics, supply and demand, and Fed interest rate policy; (the dollar price of gold is just the inverse of dollar strength. A strong dollar = a lower dollar price of gold, and a weak dollar = a higher dollar price of gold. Fed rate policy determines if the dollar is strong or weak).

The first two factors have been driving the price of gold higher since 2015 and will continue to do so. Geopolitical hot spots (Korea, Crimea, Iran, Venezuela, China and Syria) remain unresolved and most are getting worse. Each flare-up drives a flight-to-safety that boosts gold along with Treasury notes.

The supply/demand situation remains favorable with Russia and China buying over 50 tons per month to build up their reserves while global mining output has been flat for five years.

The third factor, Fed policy, is the hardest to forecast and the most powerful on a day-to-day basis. The Fed has a policy rate-setting meeting on July 31. There is almost no chance the Fed will raise rates. The issue is whether they will cut rates or stand pat.

The case for cutting rates is strong. U.S. growth slowed in the second-quarter to 1.3% (according to the most recent estimate) from an annualized 3.1% in the first-quarter of 2019. Inflation continues to miss the Fed’s target of 2.0% year-over-year and has been declining recently. Trade war fears are adding to a global growth slowdown.

On the other hand, the June employment report showed strong job creation, continued wage gains, and increase labor force participation. All of those indicators correspond to higher future inflation under Fed models. The G20 summit between President Trump and President Xi of China led to a truce in the U.S.-China trade war and the prospect of continued talks to end the trade war.

In short, there’s plenty of data to support rate cuts or no cuts in July. The Fed is biding its time. Meanwhile, the market is highly uncertain. A good headline on trade results in a stronger dollar and weaker gold. The next day, a bad headline on growth results in a weaker dollar and stronger gold.

This dynamic explains the erratic up-and-down price movements of the past week. The dynamic is likely to continue right up until the July 31 Fed meeting in two weeks.

With so much uncertainty and volatility in the dollar price of gold lately, what is the prospect for a rally in precious metals prices and stocks that track them?

Right now, my models are telling us that the gold rally will continue regardless of the Fed’s action on July 31.

Expectations today are that the Fed will cut rates at the next FOMC meeting, but the probabilities are far from a sure thing. If the Fed cuts rates, the market will simply move its expectations of further rate cuts to the next FOMC meeting (September 18). The weak dollar/strong gold rally will continue.

If the Fed does not cut rates, gold may suffer a short-term drawdown, but markets will assume the Fed made a mistake. Expectations for a 50bp (0.5%) rate cut in September will start to build.

That new forward expectation will power gold higher just as surely as the missed July rate cut. That covers gold. But what about silver?

Many investors assume there is a baseline silver/gold price ratio of 16:1. They look at the actual silver/gold price ratio of 100:1 and assume that silver is poised for a 600% rally to restore the 16:1 ratio. These same investors tend to blame “manipulation” for silver’s underperformance.

That analysis is almost entirely nonsense. There is no baseline silver/gold ratio. (The “16:1 ratio” is an historical legacy from silver mining lobbying in the late 19th century, a time of deflation, when farmers and miners were trying to ease the money supply by inflating the price of silver with a legislative link to gold.

The result was “bimetallism,” an early form of QE. The ratio had nothing to do with supply/demand, geology, or any other fundamental factor. Bimetallism failed and was replaced with a strict gold standard in 1900).

This does not mean there is no correlation between gold and silver prices. As Chart 1 below reveals, there is a moderately strong correlation between the two. The coefficient of determination (expressed as r2) is 0.9.

This means that over 80% of the movement in the price of silver can be explained by movements in the price of gold. The remaining silver price factors involve industrial demand unrelated to gold prices.

Chart 1

Read more here.

Recently, a huge gap has opened up between the rally in gold prices (shown in blue on Chart 1 with a right-hand scale) compared to silver prices (shown in orange on Chart 1 with a left-hand scale).

Given the historically high correlation between gold and silver price movements, and the recent lag in the silver rally, the analysis suggests that either gold will fall sharply or silver will rally sharply.

Since I have articulated the case for continued strength in gold prices, my expectation is that gold will continue to outpace silver.

Either way, both metals are heading higher.

Regards,

Jim Rickards
for The Daily Reckoning

The post New Multi-year Gold Rally Has Emerged appeared first on Daily Reckoning.

Trump Declares War

This post Trump Declares War appeared first on Daily Reckoning.

Trump has had it!

He is apparently declaring a currency war on the rest of the world. Trump resents China and Europe cheapening the yuan and the euro against the dollar in order to help their exports and hurt ours.

He says it’s time for the U.S. to cheapen the dollar also. Trump has a point. If you put a 25% tariff on many Chinese exports to the U.S. (as Trump has done) or a 25% tariff on German cars exported to the U.S. (as Trump has threatened to do), it can be a powerful way to reduce the U.S. trade deficit and generate revenue for the U.S. Treasury.

But a trading partner can undo the effect of the tariff just by cheapening its currency.

Let’s say a Chinese-made cellphone costs $500 in the U.S. If you slap a 25% tariff on the imported phone, the immediate effect is to raise the price by $125.

A simple solution to tariffs is to devalue your currency by 20% against the dollar. Local currency costs do not change, but the cellphone now costs $400 when the local currency price is converted to U.S. dollars.

A 25% tariff on $400 results in a total cost of $500 — exactly the same as before the tariffs were imposed. Tariff costs have been converted into lower production costs through currency manipulation.

There’s only one problem with Trump’s currency war plan. There’s nothing new about it. The currency wars started in 2010 as described in my 2011 book, Currency Wars. 

As soon as one country devalues, its trading partners devalue in retaliation and nothing is gained. It’s been described as a “race to the bottom.” Currency wars produce no winners, just continual devaluation until they are followed by trade wars.

That’s exactly what has happened in the global economy over the past 10 years. But the final step in the sequence is often shooting wars. That’s what happened leading up to WWII. Let’s hope the currency wars and trade wars don’t turn into shooting wars as they did in the 1930s.

Meanwhile, the Fed is a critical player in the currency war because it has a major influence on the dollar.

The world is waiting to see what it does at its policy meeting on July 31. There is almost no chance the Fed will raise rates. The choices are to cut rates or keep rates unchanged. The market is betting heavily on a rate cut, for what it’s worth.

If the Fed cuts rates, we’ll have to see how other central banks react. But the Fed has many factors to consider when it meets later this month…

For the past 10 years, Fed policy changes have been relatively straightforward to forecast, based on a simple model. The model said the Fed would raise rates consistently in 0.25% increments until rates are normalized around 4% (the amount needed to cut in case of recession).

The exceptions (where the Fed would “pause” on rate hikes) would occur when job creation is low or negative, markets are disorderly or strong disinflation threatens to turn to deflation. Markets certainly became disordered late last year, when the U.S. stock market nearly entered a bear market. And so the Fed paused.

None of those conditions apply today. Job creation is strong, markets are at all-time highs and disinflation is mild. But a new factor has entered the model, which is the fear of causing a recession.

Estimated growth for the second quarter of 2019 is 1.3% annualized, compared with 3.1% in the first quarter. Using the Fed’s own models (which are different from mine), the Fed is concerned that if they don’t cut rates, a market correction and recession may occur.

But if they do cut rates, inflation may result due to tight labor markets and higher costs due to tariffs.

This Fed decision will likely come down to the wire. Second-quarter GDP will be reported on July 26, and personal income and outlays will be reported on July 30. Both data points (and underlying inflation data) will be available right before the July 31 decision date.

Markets will cheer a rate cut and probably sell off if the Fed does not cut rates. But both the markets and the Fed itself will have to wait until the last possible minute before this conundrum is resolved.

And the world will be watching very closely.

Below, I show you how Fed policy is one of three factors driving a new multiyear rally in gold. What are the other two? Read on.

Regards,

Jim Rickards
for The Daily Reckoning

The post Trump Declares War appeared first on Daily Reckoning.

The Perfect Storm

This post The Perfect Storm appeared first on Daily Reckoning.

What are the three elements of the perfect political and market storm I see coming together this fall?

The first is an effort by the Democratic House of Representatives to impeach President Trump. The second is the socialist-progressive tilt in the 2020 presidential election field. The third is the fallout from the Mueller report and the Russia collusion hoax — what I and others called “Spygate.”

These components are independent of each other but are at high risk of convergence in the coming months.  Let’s look more closely at the individual elements of impeachment, electoral chaos and Spygate that comprise this new storm with no name.

The first storm is impeachment. Impeachment of a president by the House of Representatives is just the first step in removing a president from office. The second step is a trial in the Senate requiring a two-thirds majority (67 votes) to remove the president. Two presidents have been impeached, but neither was removed. Nixon resigned before he could be impeached.

If the House impeaches Trump, the outcome will be the same. The Senate is firmly under Republican control (53 votes) and there’s no way Democrats can get 20 Republicans to defect to get the needed 67 votes needed. So House impeachment proceedings are just for show.

But it can be a very damaging show and create huge uncertainty for markets. There are powerful progressive forces in Congress and among top Democratic donors who are fanatical about impeaching Trump and will not be satisfied with anything less. One poll shows that 75% of Democratic voters favor impeachment (including almost 100% of the activist progressive base).

Speaker of the House Nancy Pelosi and House Majority Leader Steny Hoyer have both poured cold water on impeachment talk. They feel it’s a distraction from Democratic efforts to enact their legislative agenda. But some of the party’s biggest private money donors, including Tom Steyer, are also demanding impeachment.

If Steyer does not get an impeachment process, he looks to support primary challenges to sitting Democrats who don’t join the impeachment effort. This could jeopardize Pelosi’s speakership in a new Congress. So Pelosi could come under heavy pressure to go along with impeachment.

The final outcome is irrelevant; what matters is the process itself. Impeachment fever is not likely to last long into 2020, because at that point the election will not be far away. Voters will turn their backs on impeachment and insist that disputes about Donald Trump be settled at the ballot box. That’s why you can expect impeachment fever to come to a head by the fall of 2019. And that will create a lot of uncertainty for markets.

The second storm is the 2020 election.

Trump is on track to win reelection in 2020. My models estimate his chance of victory is 63% today and it will get higher as Election Day approaches. The only occurrence that will derail Trump is a recession.

The odds of a recession before the 2020 election are below 40% in my view and will get smaller with time. Meanwhile, Trump will keep up the pressure on the Fed not to raise interest rates and will ensure that the U.S.-China trade war comes in for a soft landing.

This may sound like a rosy scenario for the economy. But it’s not so rosy for the Democrats. Every piece of good economic news will cause Democrats to dial up their political hit jobs on Trump. Each one will try to outdo the next.

There are now 24 declared candidates for the 2020 Democratic presidential nomination. That’s more than the Democrats have ever had before. Currently Joe Biden and Bernie Sanders are out in front. Biden is considered the most moderate of the candidates.

But I don’t expect Joe Biden to stay in front for long, and I don’t believe he’ll win the nomination. But the only way for a Democrat to stay in the race is to stake out the most extreme progressive positions. This applies to reparations for slavery, free health care, free child care, free tuition, higher taxes, more regulation and the Green New Deal.

If Biden does fall away, then the choices are back to Sanders, Elizabeth Warren or maybe Kamala Harris. But one is more radical than the next. So, you could have a shock effect where all of a sudden it looks like the Democratic nominee is going to be a real socialist. And that would rattle markets.

This toxic combination of infighting among candidates and bitter partisanship aimed at Trump will be another source of market uncertainty and volatility until Election Day in 2020 and perhaps beyond.

But the third storm is the most dangerous and unpredictable storm of all: Spygate. It involves accountability for those involved in an attempted coup d’état aimed at President Trump.

The Mueller report lays to rest any allegations of collusion, conspiracy or obstruction of justice involving Trump and the Russians. There is simply no evidence to support the collusion and conspiracy theories and insufficient evidence to support an obstruction theory. The case against Trump is closed.

Now Trump moves from defense to offense, and the real investigation begins.

Who authorized a counterintelligence investigation of the Trump campaign to begin with? Did surveillance of the Trump campaign by the U.S. intelligence community (CIA, NSA and FBI) begin before search warrants were obtained? On what basis? Was this surveillance legal or illegal?

These are just a few of the many questions that will be investigated and answered in the coming months.

These criminal referrals will be taken seriously by Attorney General William Barr along with other criminal referrals coming from Congress. Barr will take a hard look at possible criminal acts by John Brennan (CIA director), James Comey (FBI director) and James Clapper (director of national intelligence) among many others.

At the same time Lindsey Graham, Republican senator from South Carolina, will hold hearings in the Senate Judiciary Committee about the origins of spying on the Trump campaign and lies to the FISA court. These may be the most important hearings of their kind since Watergate.

Trump will be running for reelection against this backdrop of revelations of wrongdoing by his political opponents in the last election. Actual indictments and arrests of former FBI or CIA officials will cause immense political turmoil. Such charges may be fully justified (and needed to restore credibility). They will certainly energize the Trump base.

But they are just as likely to infuriate the Democratic base. Cries of “revenge” and “witch hunt” will be coming from the Democrats this time instead of Republicans. Markets will be caught in the crossfire.

How do these three storms — impeachment, the 2020 election and Spygate — converge to create the perfect storm?

By November 2019, the impeachment process should be well underway in the form of targeted House hearings. The 2020 Democratic debates (starting in June 2019) will be red-hot. Trump’s counterattacks on the FBI and CIA should be reaching a fever pitch based on real revelations and actual indictments.

The impeachment process and Trump’s revenge represent diametrically opposing views of what happened in 2016. The Democrats will continue to call Trump “unfit for office.” Trump will continue to complain that the Obama administration and the deep state conspired to derail and delegitimize him.

The 2020 candidates will have to take a stand (even though they may prefer to discuss policy issues). There will be nowhere to hide. The bitterness, rancor and leaking will be out of control.

Any one of these storms would create enough uncertainty for investors to sell stocks, raise cash and move to the sidelines. The combination of all three will make them run for the hills. That’s my warning to investors.

The next six months will present unprecedented challenges for investors. Markets will have to wrestle with fights over impeachment, election attacks and Spygate. Trump will be trying to improve his odds with Fed appointments and an end to the trade wars. Democrats will be trying to derail Trump with investigations, accusations and leaks.

Some of this will be normal political crossfire, but some of it will be deadly serious, including arrests of former senior government officials and revelations of an attempted coup aimed at the president.

A perfect storm with no name is coming. The only safe harbors will be gold, cash and Treasury notes. And make sure you have a life preserver handy.

Regards,

Jim Rickards
for The Daily Reckoning

The post The Perfect Storm appeared first on Daily Reckoning.

Rickards: “Perfect Storm” Is Coming

This post Rickards: “Perfect Storm” Is Coming appeared first on Daily Reckoning.

People often refer to the “perfect storm.” A perfect storm is generally understood as two or more events that are independent but converge to produce an outcome much worse than either event alone.

The term is an overused cliché, and as a writer I avoid clichés whenever possible. But though rare, perfect storms do exist. The most common example is the devastating 1991 storm popularized by the book and movie of the same name, although it was initially known as the “Halloween storm.”

In that case, three separate weather dynamics all converged in one place on one day to produce a perfect storm. The odds of all three coming together at once were less than one in 100,000. That’s less than once in 270 years. That’s a perfect storm.

Do metaphorical perfect storms happen in politics and capital markets?

The answer is yes, provided the conditions of the perfect storm definition are satisfied. The multiple events that make up the true perfect storm must be independent and rare and come to converge in an almost impossible way.

Unfortunately, a political and market perfect storm is now on the way and may strike as early as Halloween 2019, marking a new “Halloween storm.” Get ready.

Today I’ll be discussing the components making up this perfect storm, and how I see them all coming together at the same time.

In my 40-plus years in banking and capital markets, I have lived through a number of financial fiascos that arguably qualify as perfect storms. Here’s a partial list:

  • 1970: Penn Central bankruptcy, the largest in history at that time
  • 1973–74: Arab oil embargo
  • 1977–80: U.S. hyperinflation
  • 1982–85: Latin American debt crisis
  • 1987: One-day 22% stock market crash
  • 1988–92: Savings and loan (S&L) crisis
  • 1994: Mexican tequila crisis
  • 1997: Asian financial crisis
  • 1998: Russia/Long Term Capital Management (LTCM) crisis
  • 2000:Dot-com crash
  • 2007: Mortgage market collapse
  • 2008: Lehman Bros./AIG financial panic.

I was not just a bystander at these events. From 1977–85, I worked at Citibank and dealt with inflation, currencies and Latin America from a front-row seat.

From 1985–93 I worked for a major government bond dealer that financed S&Ls and traded their mortgages.

From 1994–99, I was at LTCM and dealt in all the major international markets. I negotiated the LTCM rescue by Wall Street in September 1998.

In 1999–2000 I ran a tech startup, and in 2007–08 I was an investment banker and financial threat adviser to the CIA.

That’s a lot of action for one career, but it also makes the point that financial perfect storms happen more frequently than standard models expect.

Here’s what I learned: Every one of these episodes was preceded by mass complacency or euphoria.

Before the Arab oil embargo, we expected cheap oil forever. Before the Latin American debt crisis, countries like Brazil and Argentina were “the land of the future.”

No one worried about a stock market crash in 1987 because we had “portfolio insurance.” The S&Ls could not get in trouble because they had FSLIC (Federal Savings and Loan Insurance Corp.) insurance.

Mexico could not get in trouble because it had oil. Asia could not get in trouble because it had cheap labor, high growth and “fixed” exchange rates.

Russia would not go broke because it was a “nuclear power.” LTCM would not go broke because it had two Nobel Prize winners. Dot-coms would not go broke because they attracted “eyeballs.”

Mortgages were solid because we had never seen a simultaneous nationwide decline in home values. Lehman Bros. was “too big to fail.” AIG was the Rock of Gibraltar.

In short, the fiascoes I witnessed were “not supposed to happen.” They all did. The worst panics are always preceded by a sense that nothing can go wrong.

We are there again. Stocks are approaching all-time highs again. The bond bust hasn’t happened. Mortgage interest rates are near the lows of the early 1960s. Exchange rate volatility is low.

Unemployment is at 50-year lows. Real wages are rising (at least a little). There are more job openings than job seekers. ISIS is defeated. Brexit is on indefinite hold.

It’s all good. What, me worry?

I saw a recent poll asking investors when they thought a market crash might happen. Something like 80% of the respondents answered not anytime soon.

I cannot imagine a better setup for catastrophe. No one ever sees disaster coming. That’s the point.

I believe a perfect storm is coming. It’s hard to foresee the full magnitude of it, but it will likely be dramatic. It will have a major impact on markets. How it impacts you depends on how far in advance you see it coming.

What are the three specific elements of the new perfect storm I see coming for markets? Read on.

Regards,

Jim Rickards
for The Daily Reckoning

The post Rickards: “Perfect Storm” Is Coming appeared first on Daily Reckoning.

If Gold Was Just a Barbarous Relic…

This post If Gold Was Just a Barbarous Relic… appeared first on Daily Reckoning.

There’s nothing new about the Russian accumulation of gold bullion in their reserve position. It began in a material way in 2009 when Russia had about 600 metric tonnes of gold.

Today, Russia has 2,183 metric tonnes, a stunning 264% increase in less than 10 years. Russia is the sixth-largest gold power in the world after the U.S., Germany, IMF, Italy and France.

Russia’s gold hoard is over 25% of the U.S. hoard, but Russia’s economy is only 8% the size of the U.S. economy. This gives Russia a gold-to-GDP ratio over three times that of the U.S.

While these developments are well-known, the question of why Russia is accumulating so much gold has never been answered.

One reason is as a dollar hedge. Russia is the second-largest energy producer in the world. Most of that energy is sold for dollars. Russia can hedge potential dollar inflation by buying gold.

Another reason has to do with the avoidance of U.S. sanctions. Gold is nondigital and does not move through electronic payments systems, so it is impossible for the U.S. to freeze on interdict.

Yet a deeper reason is that Russia has a long-term plan to subvert the dollar’s role as the leading global reserve currency. The Russian ruble is not positioned to be a reserve currency, but a new cryptocurrency backed by gold would be a good candidate.

The Central Bank of Russia will consider a new study that suggests just such a gold-backed cryptocurrency to settle balance of payments among willing participants. This plan is in its preliminary stages and is a long way from reality at this point.

Still, the Russian endgame has now been revealed. The dollar’s days as the leading reserve currency are numbered.

Of course, Russia is not the only nation accumulating gold as a means to move away from the dollar. You can certainly add China to that list, and many others.

The latest move comes from Malaysian Prime Minister Mahathir Mohamad. He promoted the idea of a common trading currency for East Asia that would be pegged to gold. “The currency that we propose should be based on gold because gold is much more stable,” he said.

I’ve actually advised Mahathir Mohamad in the past and he’s very familiar with my writings on gold. So I’m not surprised he’s issuing this call.

The global monetary regime has collapsed three times over the past 100 years, in 1914, 1939, and 1971. They seem to happen about every 30 to 40 years on average. It’s now been over 40 years since the last collapse, so we’re due.

Got gold?

Below, I show you why gold is heading for a powerful breakout. And yes, it involves the world’s central banks. Read on.

Regards,

Jim Rickards
for The Daily Reckoning

The post If Gold Was Just a Barbarous Relic… appeared first on Daily Reckoning.