It’s going to be difficult for the Euro to strengthen under these circumstances and that in turn will make it harder for precious metals prices to advance.  That is tempered by the fact the US trade deficit is growing again, the Current Account deficit is at a three year high and that gold continues to be a “risk on” trade for many.
 
There is still some chance that Europe can exceed traders’ very low expectations.  Consumer and business confidence numbers in Germany have been fairly good.  Europe’s largest economy is also the most likely to be able to reverse its slump.  The peripheral countries won’t be any help but they represent only a tiny fraction of the EU economy.  If Germany can generate a bit of growth there may be some new life breathed into the Euro and, by extension, precious metal prices.
 
Things are more complex for base metals and materials.   In addition the impact of a strengthening dollar and Euro fears these markets have to contend with fears of a slowing Chinese economy. 
 
Beijing announced it was lowering its annual economic growth target for the current 5 year plan from 8.5% to 8%.  So far, Beijing has done a better job of managing its economy that most.  The 8% figure is a target and, if the last 20 years are anything to go by, it’s a target likely to be exceeded in practice.
 
Inflation appears to finally be moderating in China.  This leaves more room for stimulus if needed. Whether Beijing is ready to open the taps remains to be seen. Recent comments by Chinese leaders make it clear they are still very concerned about high real estate prices and unwilling to ease the pressure on that market.
 
China is moving to increase the amount of economic activity represented by consumer spending.  This has to happen if the economy is going to mature and support higher incomes.
 
Redirecting the economy this way might mean less intensity of metal use, but that change will happen over many years, if not decades.  There is still a lot of infrastructure build required in China, especially in the interior and eastern provinces. 
 
Even if pressure to cool private real estate markets succeeds the construction boom isn’t likely to end.  Beijing has promised millions of units of subsidized housing.  That is a promise that has to be delivered on to maintain social stability.  There will be plenty of metal buying out of China for some years to come.
 
LME copper inventories are now below their 2010 low.  It still looks like most of the drawdown is going straight to Shanghai warehouses and no further.  The continued increase in optimism will support copper prices but we don’t expect big lift from current levels until we see sustained decreases in both the London and Shanghai warehouse inventories.
 
By and large, most regions reported better than expected economic readings.  Optimism has been improving and we think this will support moderate growth.   Most large bourses are close to 52 week highs and some, notably the S&P and NASDAQ, have seen new post-crash highs.
 
It’s been a tougher road for resource equities so far but we still think 2012 will be a good year on a full year basis.  Precious metals have to stabilize after their recent fall but there will be room for gains once that happens.  China will have to put up numbers that dispel the hard landing scenario for its economy.  If that happens base metals should see some lift again.

Once it starts, the climb will be slow and probably concentrated in gold and silver explorers at least at first.  Even there, a small subset of well-funded and managed companies will have to lead the way.  Better growth numbers should ultimately help base metals which could broaden and strengthen a resource stock rally.
 
There might be a little more post PDAC selling but an overdue and well deserved rally after that looks like the path of least resistance. 
 
Ω
 
DAVID COFFIN:  1955—2012
 
I’m sure that most of you appreciate how surreal the current situation is for me.   Never in my worst nightmares did I think I would be doing back to back obituaries and that one of them would be for my brother David.
 
As many of you know, David and I were very, very close.  Not just brothers but best friends too.   We weren’t twins and certainly didn’t agree on everything but we didn’t let that get in the way of our affection for each other. We did agree on most big picture subjects however so you needn’t fear that HRA will suddenly start looking very different.   HRA was a true collaboration and both of us looked at both sides of all the companies we followed.   I’m better versed on geology that some of you may suspect and I have access to plenty of technical resources if I think I need them in a given case.
 
You will find me using the royal “we” for some time to come.   Partially that is just habit, but its also because I can still hear David’s voice and know his opinions.  I intend to keep speaking for both of us.
 
Rather than an obituary, what follows is David’s eulogy which I wrote for his funeral.  It may give you more insight into David the man. 
 
People tend to say nice things in eulogies of course.  It’s sort of bad form not to.   Don’t assume that you are just hearing the nice stuff though.   David really was a caring and gentle man as his many, many friends can attest. 
 
As we noted with our father’s obituary we don’t generally go in for overly personalizing the newsletter.   That’s not because we are aloof or unfriendly, but because we always aimed for objectivity.  We never wanted to be cheerleaders and preferred to avoid the cult of personality that some newsletter editors seem to strive for.  It would be massive understatement to say this month is a special case. I trust you will indulge me in this.

David’s Eulogy

How does one sum up a life?  In a word – inadequately.  No brief verbal sketch can encompass a life as varied and nuanced as David’s.   Those who know David, know him.   Those who didn’t get the chance to while he lived are the poorer for it.  The word Eulogy means “good words” in the original Greek so we will hold to that and say a few good words to give you a sense of the man David was.
 
David was born on the Gaspe Peninsula in Murdochville, a town that came into being because of a copper mine.   Dave was probably too young to realize that when he moved with his family to the outskirts of Toronto at the age of three.  Then again, maybe he did sense the presence of a nearby lode even then. He always seemed born to seek out value in all things and to know ore from waste.
 
Dave had a fairly standard suburban upbringing though he managed to add a few unique twists to the experience.  He loved Scouting and took it upon himself to earn badge after badge, ultimately pressing the Scout leaders to start a Venturers troop to accommodate his enthusiasm. 
 
Scouting represented a way for David to pursue his love of learning new things and of passing that knowledge unto others, themes that would be repeated over and over in his life.  David’s enthusiasm did not go unrewarded.  He was selected as a Canadian representative to the World Jamboree in Osaka Japan.  At the age of sixteen David boarded his first intercontinental flight on his own.  He told our mother on his return that he planned to visit as many countries as he could when he got older. He never looked back.
 
Even back then, David was always intensely interested in politics and economics and the big questions of the day.  He took it as a duty to pass on his well thought out opinions, even when they were not exactly solicited, and he loved to argue his position.  Those of you who know David well may have noticed that his nose was not perfectly straight. The bump in the middle was a trophy from a high school discussion that ended abruptly.  He was always a little vague on the details.
 
Mom always told us that David seriously considered becoming a priest or a monk when he was quite young.   While we can’t quite square that idea with Dave’s wine collection it’s not hard to picture him taking pleasure in long bouts of quiet contemplation. 
 
Of course, Dave didn’t move to a monastery but soon started spending time in what many would consider a reasonable facsimile; exploration bush camps.  Dave started working in the bush during summers in high school and quickly caught the bug.   He loved to explore, to crest the next hill to see what lay beyond and to unravel the meager clues Mother Nature left to guard her buried treasures.  David had found a vocation and lifelong love.   He attended the Haileybury School of Mines in Ontario then spent two decades exploring throughout North and Central America.
 
Later, David would entice his unsuspecting younger brother to join him at a local consulting group so that he could “clean up the books”. Eric had largely succeeded in dodging the family business up to that point but was finally drawn in.  It was the beginning of a 25 year partnership that ultimately evolved into a family of resource investment publications that most people know David by.
 
Working in a business that saw some of its nastiest cyclical downturns during his tenure gave David a keen appreciation of life’s difficulties and the need to persevere when the odds seem long.  Those were lessons he never forgot.  Even when he became successful he always appreciated the difficulties of those starting out.   In a very competitive business that can breed large egos, David was never arrogant.   He always had time for everyone and was always patient in listening to people’s stories.  He offered good advice and encouragement whenever he was asked.   In short, David was a kind person.
 
David was also a thinker.  A real thinker in the way that very few are.    He loved to consider problems from every angle and work his way through long chains of reasoning.  He read history, politics and economics widely and had a full appreciation of the ways societies change over time.  Never a follower, he talked about some of today’s most important issues and changes in the world long before most others had even thought of them.
 
David was not all about work however.   He always loved art and appreciated those that create it.  In his early twenties, David started collecting original pieces, sometimes spending a large chunk of his summer earnings on a new painting.   He continued collecting through his adult life.  He wasn’t a trend follower here either.   He liked to find artists early in their careers and bought what he liked, never what was trendy. 
 
He often returned from overseas trips with pieces of art to go with the pieces of rock.  His home is full of interesting small sculptures and eclectic objects d’art and much of his furniture is one of a kind creations by local artisans. 
 
David never married but had a wide circle of friends.   While he liked a bit of time alone to contemplate he was nonetheless very convivial.    He knew a good restaurant when he saw one and frequented many of them, entertaining friends and colleagues alike.  
 
Dave always tried to be objective in his writing, so many who know him only from that might be surprised to learn that something his many friends valued most was his sense of humour.   David loved to joke and tells stories and never minded when the tables were turned.   He didn’t take himself too seriously and didn’t expect others to.  He had more than a bit of a gift for sarcasm and his friends recognized the mischievous glint in his eye when he was about to deliver it.  
 
He was generous with friends and strangers alike.  If he spotted a bottle of wine or special item he thought his guests would like he would always order it.  It was just something he did.  He certainly didn’t expect others to underwrite his taste which is one reason he was always quick to grab the bill at the end of a meal.
 
David was just as generous with his time and advice.  Many, many times a meeting intended to sell David and Eric on a company or project evolved into David making suggestions on exploration or changing presentations or giving pointers on how best to sell their ideas.
 
Like anyone in his line of work David always had many demands on his time but was always willing to listen to other people’s stories and ideas.   Dave always worked long hours, partially because he gave his time so freely in this manner.  Most people knew that so his phone rarely stopped ringing.  He didn’t really mind though since he loved his job and loved a good conversation.
 
David didn’t have children but he had nieces and nephews he adored.   He always had time for them too and loved to take them places and show them new things.   He was always happy to step in and help brag about them on their parent’s behalf.  His brothers always tried to counsel their children to go easy on the gift suggestions to Uncle Dave.   He was the softest touch around and even the most outrageous requests would be happily delivered on. 
 
By this point you must be thinking David was a saint who must now be growing wings.   He was a good man in the truest sense that few men are, but he’d be rolling his eyes at all this praise.   Lest you think he was perfect it should be noted that David did have some issues with, well, punctuality.   
 

His brothers would fondly – well, sort of fondly –refer to it as “Dave Standard Time”.   David lived by the clock; it just wasn’t the same clock as the rest of us.
 
When he and Eric had a lot of meetings to cover, Eric was known to quote earlier (false) times to Dave in the hope he would arrive at something approximating the actual meeting times.   David’s many colleagues knew they could linger over lunch before heading to a meeting with him without fear that he’d be waiting at their office door tapping his foot. 
 
Dave’s family always viewed with wonder his million plus aeroplan miles total.  Not because they didn’t know he travelled constantly but because that total implied he must have actually arrived on time for hundreds of flights.  Eric often commented that David was sure to be late to his own funeral.   Of all the predictions he’s made over the years that is the one Eric most bitterly regrets being wrong about.
 
David loved life and he lived it fully and well.  Everyone wants to be missed when they are gone and know they were and are loved.  Even so, he wouldn’t want us to dwell on the negatives and would rather be remembered holding a glass and wearing a smile.  Anyone who chooses to explore as a vocation has to be an optimist above all.  Dave was and he’d want us to take what good we can from this and keep moving forward. 

David loved widely and was loved in return.   He got to see virtually every part of the world and enjoyed many good friendships and work that always engaged and interested him.  The rest, Dave would say, was just details.  
Those of you who knew David well will know that the comments about his lack of punctuality were no exaggeration.  He was really, really bad at showing up on time.  With that in mind I’ll pass on a short story about David’s funeral.
After the church service, the immediate family went to the cemetery while his friends headed to a reception in his honor.  We had to make a stop on the way.  When we headed back to the highway we noted to our horror that the hearse that led the procession was making a wrong turn.  We had no choice but to go the correct way and hope the driver of the hearse would know a back way to the cemetery.

Twenty minutes later my brothers and I (David and I have two older brothers, Terry and Ian) found ourselves waiting at the cemetery with our mother and families but without David.   Fifteen minutes later the hearse rolled in.  My brothers and I looked at each other then started laughing hysterically.   David, god bless him, actually HAD managed to arrive late for his own funeral!

I’ll admit to not being a particularly religious person but sometimes things happen that just make you go “hmmmm”.   Knowing the person David was I know that if there is a better place to go to he’s on his way there.    And if there is, I’m equally sure our father, one of the most punctual people in history, is already standing by the gate muttering “where the hell has that kid gotten to this time?!”
Eric Coffin

Dear Subscribers:

The attached PDF file contains the announcement that appears in the Vancouver Sun today concerning David’s funeral.   His service will be held on Saturday February 25^th at 10 AM.   The name and address of the church is included.  Please feel free to attend if you are in the area and have the desire to.   I know that David would be pleased to know you were there.

Please note also the two charities that were selected as memorials for David.   If you go to the hraadvisory.com  website you’ll find live links to both of them on the homepage.  David was a very generous man and I know his family would appreciate anything you wanted to give either cause in his name.

I also want to thank all of you that have sent condolences and thoughtful notes to me in the past few days.   I may not get around to answering all of them but know that they have been a comfort to me and that I plan to collect them all and present them to our mother.

Knowing he was loved by so many will help ease her pain.

Fond regards to you all;

We are extremely comfortable that our prognosticating for 2012 may or may not work out.  Which puts us in the same camp as most others.  That said, a contrarian turn ahead of possible normalizing of the debt issues still with us that we suggested in December does seem to be gaining ground in the market.  With that should come a greater focus on basic technical indicators like metal stockpile changes.  We note small copper stocks on page 4, but will point out here these are focused by direction over weeks.  Don’t get hung up on day to day changes.  Both bull and bear issues in this market are really year to year, which means looking for value and for sustainability.

This month we review a gold juniors merger in the making.  It involves two Canadian focused explorers we have mentioned in the past, and which we put in the same room for reasons outlined in the review.  We are in an environment of high metal pricing, by historic standards, but weak risk appetite.  Combinations like this that pool talent in a busy sector plus complimentary assets may become more common.  They can lower risk in even early phase stories.             

Generally speaking, we are a little less cautious and a little more optimistic.  At a minimum, we expect gains to be more notable gains later in the year.

2012 has started out stronger than many were predicting.  Granted, the year is only two weeks old but some bullets have already been dodged.  Some credit for this should go to new ECB head Mario Draghi.  He's been a calm hand on the tiller so far. 

The European Central Bank operates under many policy constraints. Germany's Bundesbank had heavy influence over the ECB's core mandate and it’s a Teutonic one indeed with inflation control and price stability as its sole remit.

Former ECB head Jean Claude Trichet followed the mandate closely until last year when he became more proactive.  Trichet still stuck to the script but became more creative in interpreting it.  His frustration with the Euro political class also became more evident as he neared the end of his tenure. 

Trichet was ahead of the curve in raising interest rates twice and too slow to reverse the increases but he recognized the danger of a liquidity crunch in the banking sector.  Opening the lending window when he did in 2009 gave the Eurozone banking sector some breathing room.  Unfortunately, that respite wasn’t taken advantage of to clean up balance sheets in any meaningful way.

Draghi took over the ECB on November 1 and started to make changes quickly.   The first ECB governing meeting after he started the job marked the first cut in ECB rates in two years.  The real impact of the rate cut was psychological.  The message was sent that the new head of Europe’s central bank would do as much as he could while still staying within ECB mandate.

Draghi has generally agreed with the party line when discussing things like Eurobonds which Germany still flatly refuses to consider.   He has gotten considerably more creative when it comes to dealing with bank liquidity issues however. 

In December, Draghi introduced the first three year refinancing operation for Euro area banks.   The facility allowed qualified institutions (basically any Euro area bank) to borrow from the ECB at a zero interest rate for a three year term.  Banks are required to put up collateral, normally holdings of sufficiently high grade sovereign bonds. 

The facility was expected to total about 150-200 billion Euros.  The market was shocked when the loan total came in at close to 500 billion.

Banks needed the funding.  Euro area banks hold large amounts of medium term debt that has to be rolled over before the end of 2013 and many of the larger ones are being pressured to increase reserve ratios and tier one capital.

So is this the Euro version of Quantitative Easing?  Not exactly, though it looks like it if you squint.   Quantitative Easing is the creation of money out of thin air by a central bank for asset purchases.  The ECB didn’t (and probably won’t) take that step which would directly contravene its price stability mandate.   Draghi gets around that by setting up loan facilities.   When banks pay the loans back in three years (assuming they do) the ECB balance sheet would shrink again. 

There would and should be some monetary expansion if the banks are taking these funds and re-lending them.  Traders treating the lending facilities as money printing are one reason for the Euro’s recent weakness.

A more important side effect can be seen in the charts above and below.  The chart above shows 10 year yields for the main Eurozone countries.  The scale is exaggerated because of Greece, but even at this scale you can see rates which were running higher start to peak and drop off after Draghi announced the credit facility in early December. 

The chart below is shorter term and deals only with the three year yields for Italy and Spain.   The effects of the refinancing operations are much more obvious at this scale.  By the end of November things had spun out of control.   Yields were spiking higher and jawboning by politicians across the EU was having exactly zero impact on the yield curves.

The impact of the credit facility on the other hand has been dramatic.   Its helped to thaw the interbank lending market and some of it at least seems to be going into the sovereign debt market at well.   Draghi has noted that there are drops in money on deposit with the ECB on days when member states were holding bond auctions. 

The implication is that some of these funds are being used to buy new sovereign bond issues.  These bonds can be used as collateral for the ECB credit facility.  There is little doubt this is part of what Draghi was hoping would happen though the health of the inter-bank market itself was a major concern.

Spain and Italy both sold bonds last week at roughly half the yield they had to offer to attract funds in December.  Bid to cover ratios were also significantly higher than later 2011 indicating generally stronger demand.

None of this makes the debt and deficit issues go away, but lower rates can help buy time and that is really the name of the game right now.  For most EU members and large European banks this is more a liquidity issue than a solvency issue.   Being able to roll over debt and issue new paper at half the interest rate is a huge help.

Note that we said it’s a liquidity issue for “most”.  For Greece it is very much about solvency and liquidity operations won’t be much help.  Greece needs a big debt write off. Period.  That was still being argued as this was written and there is real potential for it to end badly. 

The biggest outlier on the chart on the previous page is actually Ireland.  It too is indebted to the point that it became a solvency issue.  Ireland’s issue was a real estate bubble that wiped out its largest banks that the government felt obligated to rescue.  Its fiscal situation was dire and it will take a long time to fix.  Unlike Greece however, the government and people of Ireland have made a lot of tough decisions to cut spending and the markets are taking them seriously. 

Ireland’s yields have dropped 50% since mid-year.  While we’re leery of the short term economic impacts of hard austerity programs there are several countries that need to undertake them.  Ireland is proof the market will respond to a county’s efforts if they are serious and focused.

In the mist of these market changes S&P announced debt downgrades to a large number of EU states, notably France, as well as a rating cut for the European Financial Stability Fund.  It’s the last that was the largest concern. 

S&P had telegraphed most of the other rating cuts, including France, and the markets took the changes in stride.  All three major rating agencies have seen their market credibility diminished after the subprime crisis.   They are viewed correctly as being behind the curve most of the time.  The other two major bond raters, Moody and Fitch, haven’t said what they would do though Fitch indicated it didn’t plan on downgrading France.

Both France and the EFSF carried out bond issues right after the downgrades.  France sold bills at better yields than last month and the short term EFSF bills were little changed.  

None of the foregoing is going to change the drive for greater government austerity by northern Europeans.   That austerity will take its toll on this year’s EU growth rate.  How much of a toll will depend on how much slack gets picked up by the private sector and consumers to replace lost government expenditures. 

The combination of ECB actions and market fears should help to ease things here too.  Recent investor surveys in Germany have shown the largest one month improvement in years and confidence surveys have also improved.  Most economic stats have been better than expected in the EU, though few doubt there will be some contraction this year at least.   It may be less severe that expected though if consumers in Europe continue to cheer up.   One side benefit of the uncertainty is the large drop in the Euro.   Germany is the world’s strongest export economy next to China.  Getting a 10% discount on its currency is a good thing.

Gold, Copper

The Euro discount is helping German exporters but didn’t do the gold price any favors.   Gold has seen a nice bounce in the past two weeks aided by Iranian sabre rattling. 

The Euro could see more weakness if the economy gets worse or traders convince themselves the ECB’s ultimate aim really is printing Euros.   Draghi plans another lending facility in February and if it’s another big one that might generate Euro selling.

Notwithstanding the Euro, gold has seen heavy physical buying with strong demand from Asia and from ETF buyers.   Copper has also gotten an assist from China.   Beijing announced above consensus growth numbers for Q4.  It was sort of a Goldilocks number; strong enough to allay fears of a hard landing but weak enough to generate hope that Beijing would open its wallet and start spending heavily.  Strike activity has kept copper warehouse stocks on a downtrend.  LME stocks are sitting at the 350kt level they bottomed at in 2010.  More drawdowns should be supportive of copper prices.

Gold managed not to enter a “bear market” and has seen a good bounce.  More good news from Europe and stronger markets that generate more risk on trading can both help it.   The amount of physical and ETF demand as gold prices neared a 20% drop was impressive.  Traders are still very much “buying the dip” which is classic bull market behavior.

Stocks

Equity markets are looking less classic, but they have advanced much further than many seem to think.  The bottom for US markets followed the debt ceiling debacle and they have been climbing by fits and starts since.   Large US indices have now reached levels they last saw in July.  

Unscientific as this may sound this simply feels like a market that wants to go up.  Its felt that way to us for over a month.  Recent trading activity and economic numbers have simply strengthened that impression. It would not take a lot of good news to start the next leg up.

Things have been tougher in the junior space, but trading is constructive.  We’ve been seeing strong volume on some of the most beaten down stocks.  This may be tax loss sellers repositioning which is the first step to recovery.  More high volume days are needed but a spring rally still looks like a strong possibility to us.

Plus ça Change.....

Another month, another Euro area country in the hot seat...   Italy already had issues thanks to the buffoonery of its former Prime Minister and it’s now the target of bond vigilantes. No real surprises and no mystery about the steps the euro area countries have to take. What steps get taken and how forcefully is the issue as it has been for months.  It’s still all politics.

Unless the EU fixes everything in the space of the next two weeks plenty of tax loss selling should be expected.  Notwithstanding that, we’re finding the buying in the bulk material space and strengthening oil price encouraging.  There are clearly those that expect a resolution in Europe.

Economic numbers closer to home continue to improve, if slowly. Manufacturing has been a pleasant surprise and China is promising to be a bigger importer.  Outside of the bulk materials and oil though, it’s still gold stocks getting the most traction.   Volumes overall do continue to be light  As we move into December and tax loss selling intensifies we may start seeing the volumes required to clean up share overhangs.   If that happened in addition to some debt resolution we could still see a decent yearend/ early 2012 rally.  Stay tuned.

So who wants to play poker with Angela Merkel? Not us. Ok, it’s not just about Merkel, but the country she is Chancellor of is more than ever calling the shots in Europe.   Many, not just Germans, think that is the way it should be.  Germany has low risk bonds and high(er) growth so its ways are considered the solution for all, particularly by Germans.

There is some truth to this but Europe’s problems will not be that easy to solve.  Every country in Europe can’t suddenly become an export powerhouse unless there is a country somewhere (other than the US) conveniently running massive trade deficits. Other structural changes in EU countries internal markets need to come first.

In the past two weeks the debt crises have claimed two national political leaders.  Before the next election cycle in Europe is over it’s all but certain to claim at least a couple more.

The two latest victims were of course the leaders of the current basket cases du jour, Greece and Italy.  Of the two, we definitely have more sympathy for Papandreou, the former Premier of Greece.   He’s been vilified far and wide but he wasn’t the architect of Greece’s many problems.  He got elected after the mess was made.  If anything he was the whistleblower. 

Papandreou's surprise announcement about a referendum on the austerity package sped his demise. It may have been one of the worst timed political maneuvers of recent memory but we can understand the motivation. 

The amount of unrest in Greece shows most of its citizens are not invested in the austerity program.  Greeks are sick of being asked to make sacrifices.  Whether that is a realistic complaint or pure cynicism on their part is beside the point.  The country is a democracy. If the populace isn’t willing to support the program it won’t work.  

Papandreou obviously knew this and there was a lot of sense in the idea of forcing Greeks to make a choice they would have to stick to.  He made it clear the question would have been framed as a vote on the EU.  The idea was sensible; it was the timing that was crazy.

The high level of danger in the Eurobond markets doesn’t allow for democratic niceties right now but the underlying issue is not going to go away.   Austerity required to fix the problem will be long lasting and in many cases severe.   The fact that its required and fair as most would argue for Greece doesn’t mean it’s going to be popular.

Papandreou’s referendum call was a tactical disaster but it showed more political courage than he got credit for.  Even at this stage of the crises it’s not clear most Greeks understand how stark the choices facing them really are.  

Backing down on its austerity program would mean expulsion from the Euro and a complete loss of borrowing power.  Debt default and the currency adjustment back to the Drachma would bankrupt the entire Greek financial sector and many industrial companies as well.  

Many Greeks act like they are seeing some middle ground solution no one else is.  Greece’s new Prime Minister Papademos is looking for a three month mandate to push through austerity measures.  His predecessor had his bluff called by Chancellor Merkel and the position of most northern European countries has hardened considerably in the past two weeks.  There is open talk in the north about amending the EU treaty to make it easier for countries to exit. Everyone knows which country would be the test case. 

The market’s hatred of uncertainty will dog Greece until it passes measures that will satisfy the rest of the EU.  This looks more possible now than it did a couple of weeks ago. 

Europe is playing a dangerous game but it was right to call Greece’s bluff.  There is still a confidence vote in the Greek parliament to get past but indications are that most parties will back Papademos.     

Markets turned on Italy almost as soon as the Greek government fell.   In this case no sympathy is required.  Unlike Papandreou, Italy’s former Prime Minister Berlusconi held his position longer than anyone.  He had no one to point fingers at about the lack of progress on reform, though it didn’t stop him from trying.

Berlusconi had his bluff called too, and had to be dragged off the podium by his own coalition members. New Prime Minister Mario Monti is working to craft an interim government that will have the main task of introducing austerity measures Berlusconi dithered on.

Italy has one of the world’s largest and most liquid government bond markets.  That gives Italians minute by minute readings on the market’s opinion and it’s anything but positive.  Yields reached all-time Euro era highs as Berlusconi departed and Monti’s arrival hasn’t helped much yet.  He and his new technocrat cabinet have to be very convincing.

Italy’s situation is scary because it’s in the “too big to fail” camp.   It’s not Greece however.   At 120%, its debt to GDP ratio is far too high but that ratio has been relatively stable.  The country was running structural surpluses until the Credit Crunch struck.  The combination of revenue increases and spending cuts required in Italy should be far less severe than the other PIIGS. 

Italy needs austerity measures convincing enough to bring bond yields down.  Even working back to a structural surplus won’t solve things if bond yields get out of control.  The ECB has been buying Italian bonds but this is a stopgap and perhaps intentionally so.  Like Greece, northern Europeans are not willing to commit too much to Italy until it proves it’s serious about solving its problems.

At the end of the day, Europe is still capable of dealing with these issues if politicians are willing to be bold.  Like the US, the EU can issue debt in its own currency and the ECB can buy unlimited amounts of it.  If it’s pushed to the wall Europe can start up the printing presses.  Northern Europeans insist this will never be allowed to happen but the ability to do it is there nonetheless.  If even northern European bond yields started to explode we suspect the reticence about printing Euros would dissipate.

Unlike the US however, doing this will only solve half the problem. Most European economies have structural issues that need to be fixed so that their growth rates can increase.  Ultimately, real growth combined with spending restraint is the only way to permanently bring down debt/GDP ratios across the continent.

This is as much a generational issue as anything.   Europe has extremely restrictive labour laws designed to protect long term workers.  That is coupled with monopolistic practices that cover virtually every occupation. These are designed to protect existing workers and make it all but impossible for new entrants.   In Italy’s case, making changes to these practices has been more contentious than deficit cutting.

Politicians have spent decades buying off interest groups to cement coalitions and stay in power.  The web of protections and regulations this created is a huge drag on growth.  Solutions will have to wait for the passing of the more immediate debt crisis but Europe’s job is not done until they deal with this.

The European debt crisis has reached a new level.  Greece has a new government that must prove it deserves EU money and Italy has one that must prove it doesn’t really need it.  At best, that will take a couple of months.  The markets have moved to a higher level than August-September but are going sideways again.  This should continue until it looks like some Euro resolution is at hand.  Italy’s bond yields, currently 7%, should be a good proxy to track.

Gold will continue to be supported by uncertainty.  Base metals appear to have stopped falling.  China is promising more imports but its strikes that are the big support for copper.   Strikes or not, copper inventories are dropping which bodes well if the world can avoid a recession. 

Of equal interest is strength in bulk material stocks and oil.  These markets are trading like they expect stronger growth.  Pundits have predicted weaker economic stats for months but they have yet to appear.  That doesn’t mean it won’t happen but it hasn’t yet.

Economic stats continue to be better than expected. If Greece and Italy can get their act together there is room for a year-end rally after tax loss selling is done

The market refrain this month could be summed up with the phrase “just do something!” Growth continues to be slow and the spectre of debt default in Europe has cast a pall over the markets for the past three months.   Unfortunately, the EU bureaucracy is not built for speed so the torture is likely to continue for a while yet.

Notwithstanding all the drama and lack of action it looks like the EU will do what it takes to avoid default and, ironically, markets are cheering that the thought that China might lend them some money.  What a difference a couple of decades make.

Whatever the outcome, it will be combined with continued austerity so it’s not likely we’ll see pre-2008 growth rates any time soon.  That will put a damper on industrial metal price gains though there will be room for gains on discovery when things stabilize.

In the short term gold prices will depend on traders opinion of which group of politicians looks stupider on a given day.  Not an easy call, that.  Eurodrama will cap the $US gold price and weak US statistics will improve it.  That should leave gold in a broad channel until there is closure on Europe. In that environment we’re comfortable with good gold explorers but will be keeping the shopping to weak days for gold prices.

As we moved through the end of August politics again reared its head in the debt crisis.  The market hasn’t liked the latest version of brinkmanship any more than the previous one despite moving the venue to Europe.

A number of state elections were held in Germany the first weekend of September and Chancellor Merkel’s party didn’t fare well.  The Social Democrats, the national opposition party, won the state election by a 12% margin. Pollsters are blaming the loss and others earlier in the year on Merkel’s attempts to hold the Euro zone together with the help of German chequebooks.   Social Democrat candidates were calling for Greece to be expelled from the EU.  That was a vote getter.  This wasn’t lost on bond traders who lifted Greek sovereign bond yields back above the 50% mark.

Northern Europeans are getting tired of underwriting their southern brethren.  This is making the bond vigilantes restless again since no one has any illusions about who has to foot the bill.   Ironically, it might have been easier to deal with this situation in early 2009 when the markets had already priced world ending scenarios in. 

On the basis of maintaining some moral hazard the EU should have expelled Greece when it announced back then it was fudging the budget numbers.  Three years of dithering means it will be difficult to extricate the EU from this impasse without serious consequences.

If one or more of the PIGS are forced out, their sovereign debt could be all but worthless.  Everyone in EU leadership knows this already of course.  Fear of systemic failure in Europe’s financial sector due to sovereign debt write downs has been a main driver of the bailout process. 

The latest pullback accelerated when rumors started circulating that Germany was putting together plans to shore up its banking system in the event of a Greek default.  We’d be shocked if core EU countries weren’t drawing up contingencies.  That doesn’t make a default inevitable but does mean it’s getting serious consideration by core area politicians. 

The level of fear was exacerbated by the announcement that Juergen Stark, German member of the ECB’s executive committee, was quitting in protest of the central bank’s recent bond buying.  This buying is what capped bond yields on Italian and Spanish debt last month.  In the wake of Stark’s announcement yields have risen again, with the Italian 10 year bond now yielding only a few basis points less than it did before the ECB buying campaign.

There have been several studies on costs to economies of leaving the Euro zone.  Although Greece would get the benefit of a depreciable currency, it would endure all but complete debt default and the loss of most of its banking sector.  Even trade would not get as much of a boost as hoped, since few traders would want to get paid in the currency of a bankrupt country. Overall, the loss to the Greek economy would be a catastrophic GDP decline of 50%.

Significantly, a pullout by Germany itself would be no picnic either.   A very strong currency and loss of automatic access to so many markets would be a major blow.  The cost of simply paying off Greek debt is actually a small fraction of the cost for pulling out of the EU for the average German.  There are no free choices and the decision is now political. It’s quite conceivable the German populace will choose to stop underwriting Greece even if it’s a more expensive option.

The Chart below tracks the spread between 3-month LIBOR, the overnight lending rate between European banks and the Overnight Indexed Swap rate, considered a “risk free”  rate.  The LIBOR-OIS spread is a measure of bank’s willingness to lend to each other and the perception of financial sector risk.  As you can see, it started rising sharply after EU officials left Athens.  The spread is now about 3 times its long term average.  That’s not good news, but it’s important to keep some perspective. The rate is still a small fraction of the 3-4% levels reached in 2008.

The markets are sending a pretty clear message that a decision on Greece and other peripheral EU nations is required.  As days pass the markets are getting closer to pricing in the worst case scenario.   Credit default swaps on Greek debt now imply a 98% probability of default.   A default would be a huge shock to the financial system but the markets won’t be appeased by talk much longer.  It’s time for a decision—any decision.

Metal Markets

Various market scares led to gold hitting yet another all-time high, briefly breaching the $1900 per ounce level.  Uncertainty will be the byword for some time to come.  That will be advantageous for precious metals, though recent events have complicated the market. 

Traders’ frustration about EU inaction is getting taken out on the Euro. The weekly chart to the right shows how large this month’s downward move on the Euro was.  This has helped the $US, as has the flood of safe haven capital into Treasuries.  It has hit the gold price in recent sessions even when markets were down.  Fear buying, has pulled gold back above $1800 though some of that will dissipate if things ever calm down.  The same is true for the Dollar so those two markets could work against each other and keep gold in a broad trading range until we see a European resolution.

ough markets hit base metals harder as they usually do.  Copper continues to hold up well though it’s near the bottom of its recent trading range. We still think it’s vulnerable to a further drop.  We note that recent trading stats show China buying more in August than it has since early this year.  The same is true for iron ore, but that’s not helping explorers much.

The US has started its latest round of brinkmanship after Obama’s job speech.  It’s too soon to tell how that will pan out though it sounds like at least some of the package will be passed.  Most August economic numbers were better than expected and still portend slow growth rather than a double dip.

That is good news but it’s Europe that will dominate the agenda.  Either some concrete solutions are put forward or the market will simply find a level that discounts a default by Greece and perhaps others. 

Eurozone politicians vowed not to bend to the markets last month.  High sounding language doesn’t mean much when the same governments have to resume borrowing days later.  The markets need closure, not rhetoric. 

If this drags on without resolution is may simply start getting ignored but traders bored with the issue.  That, ironically, leaves rooms for gains but it’s not an issue you can ignore. Stay nimble and at least partially liquid. 

Things turned hard in the markets since the last issue, and not in a good way.   A lot of bad news has been priced into the market.  At this point only time will tell whether that has impacted people hard enough to tip the slow growing developed countries into recession.  Whichever way things go, it’s going to be close.

Gold and, for once, senior gold stocks have been the place to be.  Even if markets stabilize, gold has proven itself to more new owners that ever before.  It would dip on stronger equity markets but its reached another new plateau.  Gold explorers make up the bulk of the updates and we have added a 2011 Yukon Watch list.   Northern gold explorers continue to trade very well given the horrible market backdrop.  We are still waiting for definitive results on this year’s crop but it seems clear a winner in the region will trade better than the markets.

Traders are giving up on politicians and counting on central bankers.  We may see better trading ahead of the US Fed’s Jackson Hole summit this weekend, the site of last year’s QE2 announcement.  We’re not convinced yet there will be a QE3, so we could see more turbulence afterwards.  Gold is the standout and will help companies that find it and mine it but the markets will not before the faint of heart for the next while.

Brinkmanship on one side, bumbling on the other and markets caught in the middle.   It’s been a terrible month for markets and an even worse one on the political leadership front.   Markets have suffered the worst dive since 2008. The markets direction going forward is very much dependent on traders believing politicians can get ahead of the curve and “deal with” debts issues in the US but especially in Europe.  

Major indices in North America flirted with “bear market” drops of 20% and several large exchanges in Europe and elsewhere have already seen drops of that much and more.  Traditional indicators of fear across the markets including Treasury yields, volatility readings and, of course, the gold price have been pushed to extremes.  

While many of the debt troubles can be traced back to the 2008 debt crisis, its politics that have become the heart of current market issues. So far, politicians have proven to be inadequate to the task at hand.  This does not bode well for the markets or the economy unless there is a sudden outbreak of stiff backbones and cooperativeness in the halls of power.

Leaders across the G7 (the ones not at their cottages at least) have insisted they were prepared to do whatever necessary to stop debt contagion.  A nice sentiment but, like many similar pronouncements in recent weeks, it included no concrete plans. Lack of direction or a roadmap out of the current crisis is keeping markets on edge.  Rumors of weakness at various large financial institutions are easily peddled, widely believed and traded viciously.

So far, the soothing has been left to central bankers.  The ECB has been the most forthright and active.  The European Central Bank has been buying up Italian and Spanish government debt to push those yield curves down.  That was a brave move on the part of Jean Claude Trichet. It’s no secret several members of the ECB board were screaming foul about that trade.

So far it’s also a move that has worked.   Yields on 10 year Italian and Spanish bonds have dropped 1.5% in the past two weeks. Two year notes issued by the Italian government on August 10th bore a 2.96% yield, 71 basis points below the yield on a similar auction a month ago.

In the US , it was left to Ben Bernanke to do something definitive, if not dramatic.   At this month’s Fed meeting, Bernanke put a timeline on the “extended period” of low rates, promising to keep the current rate in place until the middle of 2013.  

This made markets happy for a couple of hours though it too drew catcalls from some.  The move does take away a lot of flexibility from its actions.  We’re not sure how good a thing that is.  The Fed already has constraints with such a dysfunctional bunch of politicians in Washington.  The Fed board could still increase its balance sheet but many of the stronger actions it might contemplate would need political cover that isn’t likely to be forthcoming.

There are several inflation hawks on the Fed board to satisfy.  They won’t be happy about the latest 0.5% CPI increase.  We think some moderate inflation is the best thing that could happen to a debtor country issuing chits in its own currency.  Inflation is the most painless way to debase the debt, even if it’s a genie that’s hard to control once it’s out of the bottle.

In the US, down-to-the-wire debt ceiling negotiations combined with a cynical and ineffectual last minute agreement weakened the markets considerably.  The big losers on both sides of the Atlantic have been the banking sector, though selling is broad based. 

European politicians fared no better. EU members agreed to an expanded stability fund that most observers think should be three or four times the agreed size.  This is based on the assumption fund would take over the job of sovereign bond buying from the ECB.  Just getting the scaled down fund final approval will take a vote by 17 separate member country legislatures. The EU is not built for the speed that decision making during a financial crisis requires. The markets are making it clear they want to see concrete action, not just press conferences.

The US deficit deal led to the loss of S&P’s AAA rating.  The announcement rocked markets worldwide but should not have been a surprise. The credit rater drew a line in the sand months earlier, insisting a plan to cut $4 billion from US federal deficits over 10 years was the minimum requirement for keeping AAA.  

The Washington agreement promises $2.4 billion in cuts and most of that must be determined by a committee certain to be as fractious as this month’s political farce.

Debt uncertainty, worries about recession, downgrades, runs on Italian debt and rumors of bank troubles in Europe created a perfect storm of selling.  In the past few sessions markets clawed back some losses though daily swings have been huge and the markets are only one bad day away from lower lows. The question now is whether the combination of shocks has been powerful enough to create a recession.

Consumer spending and employment numbers in the US were ok, if not great, for July.  Weekly unemployment claim numbers have fallen back slightly though these can’t be correlated to the monthly employment report with any real confidence.  Corporate profits have remained strong and balance sheets are in the best shape they have been in for years.  All these factors point to continued, albeit modest, growth.

On the downside, consumer sentiment numbers have been terrible.  We’ve never found small moves in this reading to be predictive when of near term consumer spending but you can’t ignore the worst reading in 30 years.   The average person is clearly spooked right now. This could be enough to tip the US into a recession.

The market massacre itself will reinforce negative sentiment.  That impact will be blunted if the indices can gain a few more percent near term but something needs to spark a gain.

Recession or not is the crux of the matter now. If the US and core EU countries avoid falling into recession then the markets are fairly valued at worst, and probably undervalued after the recent drop when compared to historically low treasury yields.  If things continue to worsen and a number of countries fall into recession the market could still go lower.  It’s really that simple.

At this point it’s, pun intended, a confidence game.  The baseline numbers are not recessionary yet, but are getting closer all the time. Recession could come fast unless people believe the problems we all know about are being dealt with.

Few doubt that the US can get past its debt and deficit issues if they want to. Interest rates at all-time lows and the ability to issue debt in its home currency gives the US huge flexibility. For all the moaning, there is plenty of scope to increase revenues too. The real question is whether there is the political will to make the hard decisions.  It doesn’t look that way at the moment. 

The US agreement should force cuts if a plan isn’t agreed to before year end.  This may be as good as it gets.  Even those cuts will be a drag on an economy with a weak growth rate.  There is some logic to waiting on large cuts but we sympathize with those who don’t want to.  It’s taken over a decade for Americans to even acknowledge the problem.  If there is momentum to fix it no one wants to squander it at this point.

The debt issue is far more serious in Europe, but the confidence issue is the same.  Aside from the PIGS, most European countries have debt/GDP ratios that are manageable, though not low.  Most are lower than the US for that matter.  The real task in the short run is to convince markets that issues will be dealt with and not glossed over.

Credit markets are spooked bur not yet disarrayed like 2008.  Yield spreads used to measure risk temperament like the TED spread, LIBOR and Treasury-OIS have risen but by amounts that are still small compared to 2008. 

Concerns about some large French banks are disturbing, but at least they are French.  Gallic pride will probably demand they be bailed out and a “Lehman scenario” doesn’t seem likely under Paris’ watch.

The only cure for this kind of situation is time and enough action by the political class to decrease uncertainty.  If the large economies are still growing, it will show up in the numbers, with US employment and consumer spending being the most heavily watched.  Only time will tell when confidence lost during the past weeks of political farce will return.  

On a positive note, market weakness has affected energy prices substantially. A $40/bbl drop in oil prices is a good tailwind, particularly for the US, if prices stay down. Also good are strong growth numbers out of China and India.  Beijing is (finally!) letting the Yuan rise.  If that continues, the increased purchasing power would do a lot of good. With China’s current inflation rate a new bout of government spending like late 2008 is very unlikely.

One thing different (so far) about this market drop is that resource stocks, especially juniors have not been harder hit.  The percentage drop in the Venture index since late July is less than the S&P.  If you’ve been through a few cycles like we have you know this is very unusual.

Gold prices are the main reason for this of course.   Unlike 2008, many have taken refuge in the gold market this time, running the price past $1800/ounce.  

A lot of it is fear buying.  If the markets manage to calm themselves the pullback in gold prices is a reasonable expectation. We don’t expect a massive drop.  There is plenty of “disgust” buying along with the fear purchases. Its impressive how poorly the US$ fared given the massive flows into the Treasury market.  Some of that distrust will remain and support gold if it eases back to recent highs in the $16-1700 range.

Silver’s industrial side kept it from matching gold’s gains this month and the same is true for Platinum and Palladium.  It’s not as countercyclical as gold.  If the markets calm it  may outperform gold in the next while.

Things were anything but rosy for the red metal.  Copper gets pounded hard right along with equity markets.  We’ve expected a pullback even before major markets crashed.  The speed of the downside move was impressive and it looks like a lot of longs have exited the market.  The copper price is getting closer to reasonable but if markets fall harder copper will fall with them.  We see no point in getting brave about copper equities until the markets sort themselves.  The same holds for other base metals.

So far at least, bulk minerals like Potash and Iron Ore have been almost unscathed by the crisis.  Both moved up in price but that won’t help producers and explorers in the bulk mineral space.  The pro cyclical nature of these stocks is so ingrained that they will recover with and only with the larger indices.

We’d love to give you a definitive target for the major indices but to do that we would need to literally be mind readers.   At a big picture level, a lot of the bad news is out there unless we encounter a “Lehman moment”.  From here forward growth, or lack thereof in the major economies will determine the direction of markets.

A return of confidence depends on citizens believing things won’t get worse.  That requires a greater sense of stability and purpose than politicians on either side of the Atlantic have delivered. If everyone acts on the assumption crises cannot be controlled then we will have a recession sooner rather than later.   It’s no more complicated than that. 

Gold and discovery can help cushion things if some stability returns. There are not many bolt holes if it doesn’t though gold and gold stocks would be the best of the worst.  The market will be a very dangerous place for the next few months, even in the best case. 

Europeans came up with a Band-Aid for the Greek crisis, and the markets applauded.  Markets were buoyed by the fact the facilities set up for Greece were clearly designed to be used for some of the other Euro area basket cases if need be.  Core country leadership reiterated their unwillingness to force default or push peripheral countries out of the Eurozone.  This is admirable perhaps, but it does narrow the options for future arm twisting quite a bit. 

The new plan does imply a haircut for private lenders in the order of about 21%.  This seems more than fair since the odds of these bondholders seeing 100% directly from Athens are slim and none and everyone knows it.  Of course, this decision led to another ratings cut on Greek debt from “junk” all the way down to “what the heck is that smell?”  The rating cut is simply more after the fact behind covering and no surprise to anyone, though it may roil the bond markets in Italy again.

There are an increasing number of calls for the ECB to issue some sort of umbrella EUbond backed by all member countries to replace high yielding paper of the peripheral countries.  If this sounds suspiciously like the US Fed printing money that was passed off to the states to cover state and municipal shortfalls in the past couple of years that’s because it is.  This solution would create another political dogfight between the spendthrift south and fiscally responsible north in Europe.   It would also be kicking the can much further down the road and would work for a while at least.  

Like the US Dollar, the Euro has hardly been punished in the past few months given how serious the fiscal situation is.  Bond rates of the core countries have barely budged even though it’s obvious to all who will have to foot the bill at least in the short and medium term.  That is because the market recognizes that, viewed as a single economy; the debts of the PIGS (sans Italy) are quite surmountable for the EU block.   The real question is the willingness of core countries to take the proverbial bullet on this one.   If they do, it will be for the same reason Washington took the bullet in 2009; fear of a systemic breakdown.

A EUbond plan would require a basic change in the philosophy behind the European Central Bank. The ECB would morph from guardian of price stability to being guardian of financial system stability.  This would not be a comfortable change and would be fought hard in most of northern Europe. The ECB buying up high yield debt to replace it with some new EU bond would be money printing, but would also have the advantage of creating another deep and hopefully liquid market to rival the US Treasury and Japanese government bond markets.  

This would be a good thing longer term even if creation of the bonds themselves isn’t.  The world’s number one and three economies manage to maintain fairly stable interest rates in the face of huge public debts in Japan and political one-upmanship in the US.  There is a lot of money in bonds and it gravitates to the most liquid markets in times of stress, even when they are the cause of the stress.  A pan Europe bond would finish the third leg to the currency stool the Euro alone didn’t quite do.  

The EUbond is a long way from being reality, but we won’t be surprised to see this idea gain traction.  We don’t like the moral hazard implicit in this concept but it may yet be necessary.  There is no reason a plan like this couldn’t entail losses for current bondholders the way the latest Greek rescue is supposed to.  It should.  These rescues have always been about protecting EU financial institutions as much as anything.  Less dithering and a more final solution would be best but it could and should mean real pain and maybe bankruptcy for the most incompetent institutions. As long as the market viewed it as punishment fitting the crime and there was an umbrella guarantee that precluded a domino effect it should work. 

This is not dissimilar from TARP.  For all the moaning and wailing and gnashing of teeth over that program it looks like it should wrap up turning Washington a small profit.  The same thing should be possible in the EU if banks were forced to give up equity stakes as part of the bond buyouts.  Whether the ultimate creditors (citizens of the PIGS countries) should get off is the real and thorniest political question but one that can be argued after the system is stabilized.

As the Europeans were pouring oil upon the waters politicians in Washington were busy adding gasoline to the flames of their own conflagration. The situation in Washington is really less serious by any objective measure but you wouldn’t know it by listening to the increasingly shrill debate.

Politicians on both sides of the House are acting like increasing the debt limit is drama never before seen.  If only.  The debt limit has been raised seventy times (that’s no typo) in the past fifty years and ten times in the last ten.  It’s an annual display of cynicism by politicians of both parties that have already voted spending bills that will breach the existing limit. And don’t think those spending bills all originate on one side of the house.   Europe may have the PIGS but Washington has no shortage of pork in all political stripes.  This year is different only in the level of intransigence being displayed.

As this is written we’re a week away from the US having to shut down programs.  This is not a once in a lifetime event either.  It happened in 1995 when Bill Clinton and Newt Gingrich sparred over the deficit and the debt ceiling.   There was no “default” but government services and entitlement payments came to a halt.   The situation will be similar a week from now if politicians continue to choose melodrama over common sense.  

What is different this time is that rating agencies (yes, them again) are threatening to cut ratings on US debt if an agreement isn’t reached before August 2nd. A change in rating could be long term, but probably not permanent if reasonable deficit cutting plans get agreed to and are actually stuck to. This too is not the end of the world, but it would be a shock to markets and would raise US government borrowing rates across the board. A ratings cut of 2-3 notches might add half a percent to borrowing costs.  Not chickenfeed on $14 trillion in debt but not Greece either.

If August 2nd passes without an agreement the Treasury would have to match expenditures to revenues since additional debt could not be issued (existing debt could be rolled over, but the total could not get larger).  Given the large mismatch between revenues and expenditures in Washington this year the cuts would be large and painful until a new agreement was in place.

Expect more and perhaps larger swings as each side of the debt debate ratchets up the rhetoric in coming days. It may already be too late to forestall some interruptions in benefits but we’re pretty sure the sun will still come up on August 3rd even if there is no deal yet.  We note again that if one looks to the debt markets there is no sign of panic.  US 10 year yields are barely above 3% and two year yields are sitting near 0.5%.  Credit default swaps on US government debt are priced at 0.6% which tells you that even at this point bond traders see default, as they define it, as a very low probability event. 

Maybe the traders are just being overoptimistic but the bond market has a pretty good track record for sniffing out problems before the equity markets figure them out. It’s all politics now and bond traders seem to be going out of their way to ignore it unless they are already largely and publicly short the Treasury market. 

All this drama is not making any markets but the ones for gold and Swiss Francs happy, and we doubt the Swiss are pleased about how high their currency is trading.  Gold continues to make new highs, but traders are cautious about gold producer stocks.   There is worry, justified we think, that this is a fear buying spike that would at least partially dissipate as soon as the two sides in Washington reach an agreement.  We wouldn’t expect to see gold producers respond strongly to higher gold prices until there is a debt agreement and traders are comfortable short term money parked in the gold market has left. 

That’s not to say the gold price would see a long term top at that point, nor that gold producers as a group would continue to languish.  A currency alternative without squabbling politicians attached to it has taken root as a concept and gold is part of that.  

Juniors are faring better, and companies delivering good results are getting traction, particularly in the precious metal space. The Yukon continues to gain traction though there have not been many news releases recently. We would stick to those companies with the caveat that a resolution to the US debt issue will probably mean at least a temporary pullback in gold prices. 

More economically sensitive issues (think iron ore, potash and base metals) could be good for stink bids but we would wait to see if Washington actually grinds to a halt before placing those.  The ultimate impact on the world’s economy shouldn’t be anywhere near as dire as politicians are making it sound so the most pro-cyclical names could be the best buys if the markets do freak out next week but you may as well wait to see if it happens at this point.  

We’ll preface those comments in turn by stressing the debt crisis in Europe is very fluid.  This is a crisis of confidence as much as anything else.  Markets will be highly volatile and subject to reversals on every bit of news, rumor or innuendo until traders decide to take a time out.  We’re about to find out how good Europe’s political class really is at calming a crowd. Their track record hasn’t been great but if nothing else the latest market dives should add some immediacy and focus to the political tussles.  That’s a good thing, even coming at the expense of a market drop.

The Bond Vigilantes are making the rounds again in Europe. You could almost hear them saying “you’re next” to Italy as they continued to trash other PIIGS sovereign debt issues.  The chart below depicts the percentage change in bond yields for the hardest hit EU members over the last three years.  Italy’s bonds look stable by comparison but that is misleading;

Italian bond yields have risen about 50% in the past week.  As this issue was being completed Italy sold one year bills at a yield of 3.67%.  This compares to a yield of 2.15% at the last auction a month ago.  The fact that both the Euro and the Milan stock exchange moved up smartly after this auction tells you how much fear there is in the markets.

Yields on 10 year Italian bonds ran up through the 6% level that is considered unsustainable prior to the auction, though it has fallen back since.  The Euro has continued to rally, as have other markets and gold after Italy’s leadership promised to get serious (again) about austerity measures.

Yields on Greek and Irish debt indicate traders expect both of these countries to default, period.  That outcome would not surprise us.  We expected, and saw, a deal in Greece but no one other than a handful of core EU political leaders and Eurocrats view this as more than extend and pretend.  

Italy is a much bigger potential problem, having far larger debt balances, but it’s really not in quite the dire straits that Greece and Ireland are.  Italy has larger domestic ownership of its debt load and higher savings rates that could allow it to take over more of the outstanding debt.  That said, it also has low growth and productivity and a political class that is a running farce more adept at providing titillation than leadership.  Italy is in a better position to convince the markets that its Mediterranean neighbors, if its stops dodging and dawdling and gets on with it.  Italy’s finance minister, who seems the most capable guy in the room by far, pledged to pass austerity measure by the end of the week rather than the end of the summer. 

We lay these issues out first because they are going to dominate trading and, in the final analysis they are all about politics.  We could do reams of number crunching and prognostication but it would be meaningless without seeing how the politics get settled.

Italians have to decide if they will get serious about fixing their finances.  Northern and central Europeans have to decide whether they suck it up and just pay allowance to Greece, and Ireland and whomever.  They can afford to do it. The real question hinges on whether they are willing to do it. The debt numbers involved with those two countries are not large in relation to the EU economy but an actual decision needs to be made and stuck to.

It comes down to whether the populace in the better managed countries is willing to pay to keep the EU as presently constituted together.  If not, they should cut loose the fiscal basket cases and let them devalue their way back to mediocrity and be done with it.  Until we see how that question is decided no one really knows what the ultimate fallout is. Lest anyone have any illusions, a similar set of decisions faces Americans and there too the situation is completely politicized.  With our rant du jour out of the way, we’ll move on to the specific of the sectors we’re dealing with.

The best reason to pick up juniors on the cheap during the summer months is that market issues are behind them.  We still wouldn't say that the market should be comfortable about either western debt or eastern inflation fighting.  However, the second reason for summertime bargain hunting is share prices so badly beaten down they are too cheap to ignore even if you are thinking medium term.  Lately, quite a few traders seem to have come to that conclusion, though they are making the judgment about specific companies, not the sector as a whole.

That works if sellers finished offing before pulling out beach towels.  The macroeconomic realities actually made this more likely as sellers don't want to wait for September when thinking about the mess outlined above.  That does imply higher market risk this coming autumn, but looking at valuations and forward to eastern growth we think selective bargain hunting can begin.  If the past week is any gauge, at least the algorithms that increasingly trade even small companies are willing to take the risk.      

With Portugal joining Greece on the Euro bail out 2 (BOII) list we don't think the recent run in the copper price has a lot to do with recovery, per se.  There are however unusually heavy snow in Chile and strikes in Indonesia that  are slowing supply of mine product to smelters, and until Japan sorts out its power situation smelting capacity is below the glut level miners were enjoying before the tsunami took down generators.   

Market listed stocks of the red metal in Shanghai moved up 10K to 90K tonnes in the past week while the light decline of LME listed stocks begun a month ago has become a trend line.  Barring a large shift in the macro picture, the copper price has found a range above $4/pound pending news of how demand will be impacted by eastern inflation fighters. 

China hasn't yet seen a peak number on the inflation front and we expect at least some further tightening there. Harmony (or ’peace’ according to Premier Wen’s recent comments in London, which may be more to the point) will demand costs for lower wage Chinese drive policy. 

If it were simply a matter slowing domestic demand China’s growth could decline measurably enough to dampen inflation with little impact on metal prices. However, in the context of global trade and western uncertainties some over compensating is more possible. 

One area where governments’ policy has maintained good order is, so far, on keeping trade liberal.  So long as beggar thy neighbor doesn't rear its ugly head in trade rules any inflation-related slowing in China and other growth economies should be short lived.  If trade was to become a political football the copper support from supply/demand balance plus a new role as a paper money hedge would slip.  That would mean hunkering down, but traders would look for lower support levels rather than a cascade as they did in late ’08-early ‘09.   

We think gold has similarly found a trading base from the $1500 level, pending in this case whether the Euro or the Dollar gest more distain going forward. We’d be more comfortable if the prices gains were less about fear buying, but that has always been part of the gold market. The rerating of senior gold producers also appears to have reached a bottoming point.  There has been some tearing of cloth over the fact that gold producers haven't kept up with gold for price gains.  We think that seeming anomaly should now be done.

Barrick and Newmont are up about 350% from both 10 years ago and Credit Crunch bottoms, while growth oriented Goldcorp has gained more like 450% over those periods.  The metal is up 600% over 10 years and 100% from Crunch lows.  Comparing these to the copper space is uninspiring, but there were no copper bugs to support weak bottom lines during the bear market.  Base metal companies were badly hit during the “commodities are dead” Tech Bubble, and typically recovered first when this secular bull started.

As we have said before weak gold equities is a case of ’be-careful-what-you-wish-for’.  Gold companies are becoming a normal part of portfolio planning, which means they are also being priced to normal valuation levels — you can’t anticipate higher gold prices after they have arrived.  The Credit Crunch rebased everything, but it came before gold producers had finished rebalancing output to more realistic cost assumptions.

Yes, we did go through this not so long ago.  However, we thought it worth repeating since the notion of retying national currencies to gold is getting a bigger listen these days in some quarters.   We aren't convinced that is good for gold over the longer run.  Gold, copper, oil and other commodities are already effectively part of the monetary system.  Trying to fix a part of the system that isn't broken we can do without.  The notion may be good for gold companies near term though and is worth keeping an eye on. 

As far as more local major markets go, traders will have to depend on earnings season to keep interest up.  Job numbers in the US have been awful.  We can only hope that situation improves but no one will believe until it happens at this point.

While the market hasn’t priced in European calamity, it’s set up for positive earnings surprises.  The chart above from Bespoke Investment Group shows the weeks with either positive or negative earnings revisions by analysts going back three years.  We’re currently in the longest successive streak of negative earnings revisions in the whole period. With all the scary stuff out there analysts have been cutting earnings estimates constantly since the last earnings season.   This is actually positive news.  Its evidence that market sentiment is gloomy and substantially increases the odds that earnings surprises will be positive rather than negative.  Odds are the earnings season we are entering will help support broader markets in the current range, assuming the world’s political class doesn’t screw things up yet again.

The many “typical” issues with downside potential that markets have been dealing are still some ways away from sufficient resolution to calm markets.  One that has slipped off the economic pages, but is still causing much chatter on the political front, is the ongoing movement in the Arab world for changes of government.  Though not as up front with the market crowd as when it began, it is still having its impact on markets. 

Few observers doubt the potential good this movement in the Arab Street portends.  About the same number would suggest they can see just what it will have brought in a year’s time.  It’s that added layer of opaque on a global economy already being rapidly repositioned that is causing an itch.  The editorial this month attempts to put the Arab street movement in some historic context. We understand the concern about uncertainty, but see a lot of potential as well.

Since markets continue to focus on potential downside issues, we continue to focus on updates in this issue.  We are tracking a growing list of spec stories and expect to lay a few of them out during the summer doldrums.  For the time being it is still best to look for opportunity and then wait for the markets to indicate it’s time to act on it.

David Coffin & Eric Coffin

US equity markets had continued to benefit from export driven bottom line growth, but are now sagging on hesitancy about the US domestic economy ahead of QEII buoyancy drying up in June.  The Dollar decline that allowed export strength has also boosted US import costs. This could mean a modest US summer driving season unless recent declines in oil prices continue. 

China’s inflation concern has taken up more of its policy.  The tighter Yuan policy isn't showing up in the inflation rate but it will have some impact and mean that growth engine downshifts.  On top of that the vagaries of nature and street crowds continue to add uncertainty.

We began the year with an “expect the unexpected” stance.  May began with the death of bin Laden, which caused only the barest ripple of market applause.  We stir entrails this time of year on whether to look for bargains early in the northern summer, or not — a tough call this year. 

The sector we focus on has been consolidating after doing very well.  This downward move accelerated recently, which could hasten the start of a buying period.  The recovery of the broader equity market after March events seems to be stalling after new highs again in the past couple of weeks.  It’s not looking comfortable though, and volumes are low.  Are the market’s about to repeat last summer’s pause?

“Events” have been hard on the algorithmic.  The muddle of just-in-time manufacturing waylaid by tsunami wasn't expected, but adjustments can be made for it.  It’s possible to program varied responses to currency and bond or inflation related policy shifts.  However, aging powers having to choose between the old buddy system or newly emboldened Arabic Street is quite variable rich. 

Despite these weakening events, inflationary pressure would be the most likely cause for a pause.  It’s not the G7 economies that are the big concern for us.  The real pressure is in the growth economies that the high income economies still need for export support.  This pressure comes from resource price gains and most worryingly from high food prices and simple demand growth across many local markets.  This again is event related.

Weather events have been getting a lot of ink lately, the most recent being the unusually heavy and deadly North American storm season.  Our sympathy goes out to the victims of the southern US tornado onslaught, but it is slower motion events that concern markets.  Weak crops and high food inflation are becoming a plague.  Those still looking for a second market collapse and double dip recession will remind us the ‘30s dust bowl deepened the Depression.  Markets run on perception so analogies like this can have an impact.

Perception aside, the problem is a real and serious one.  The chart above, courtesy of the Food and Agriculture Organization of the UN, shows their food price index hitting new all-time highs, in both nominal and real terms.  The price measure is already well above the levels reached in 2008.  The one cause for optimism is that the commodity rout going on the past few sessions is driving speculative money out of grain and other “soft” markets too.  This helps, but speculators aren’t the main Within the pile of issues hitting this market, the one with the oddest feel is what some are calling the “Arab Spring”. 

Although there have been few protests in large oil producers, oil is part of the concern. It’s unclear how broad an area this Spring may impact, and what it may mean in a region that has been a focus of foreign security concerns for a long time.  Simply put it’s a wild card, but then some wild cards are welcome.  

Arab “Spring” of course alludes to overturning totalitarian regimes of Eastern Europe as the Soviet system fell apart.  Some of the parallel themes in North Africa and southwestern Asia seem to be fairly obvious.  However the markets’ twitchiness underscores some real and important differences between that early ‘90s Spring and the Arab one of the early ‘10s.

Neither the Soviet experiment’s highly centralized, “planned” economy nor the brutality of Stalinism attached to it early on is unique to human experience.  They combined in Russia, which had been pegged as a coming power a century before the Soviet experiment got underway.  Its failing’s aside, the Soviet system did generate both high science and high art with Russian accents.

Even the global competition between Russia and the USA that became the Cold War was probably over well before it got underway.  Few would have predicted Marxist musings coming into play (Marx would probably have thought Russia unripe for a “workers utopia”).  The Soviet dictatorship of the proletariat lasting as long as it did testifies to Russia’s strengths going in.

Those strengths kept the system going despite the hollowing out caused by centralized planning.  It was too late for the system by the time its rot was finally accepted at the top.  By then digging out the rot simply weakened the system further and it crumbled in a spectacular whoosh that opened the way for the eastern European “Springs”.          

How well Soviet satellites have done since then has reflected what they were before being taken over by the Soviet expansion.  Areas of Eastern Europe that democratized during earlier springs have made real the trappings of democracy built into the system.  Areas with no such history have fared less well.  

Coming out of a short lived and globe spanning empire also helped the cause in Eastern Europe.  Much has had to be undone and we certainly don't mean to suggest its been easy.  Still, pre Soviet days were a living memory and establishing ties to the kindred west has been relatively straight forward. The east European Spring has been a renewal. 

Contrast this with the Arab world that was established and flowered centuries before Russia began taking root on the western steppes.  In fact both the zenith of the Arab empire and the start of Russian unification began with the westward push of the Mongols.  In the Arab core that is a recent event.     

The “mid-East” was our first region of cultivation and city building.  Egypt has been the center of North Africa for many millennia.  Street protests have been part of the region’s politics throughout that history.  The question for the market isn't so much why has the Arab Street risen, but rather why now?

Facebook and Twitter may deserve some organizational credit, but are hardly the cause.  Certainly there are large groups of young, educated and underemployed people through the region, but that isn't new.  A better clue is the Syrian placards written in Chinese seeking aid from the outside world. 

In both China and India new deals between elites and broader populations are bringing prosperity.  If the same doesn't happen in the Arab world, and other areas for that matter, the broader population may get left out of the new deals to be cut with these rising economic powers.  China’s first aircraft carrier is in the works, a sign its concern for ‘security’ will equal that of the West.

Security + Arab has equaled crude oil for over a century now, but that is more external to the region than local.  Clearly the more important message is that people want a greater say in choosing their own futures.  Neither the rants of Al Qaida-like groups nor the promise of some eventual payday from western investment is at play here.  Real choice is.

It is true that countries with real ties and outlines of western style democracies have so far had an easier time of generating change.  As with Eastern Europe, having the mechanisms of choice in place has been useful.  The hard parts are however just underway.

No one, including the protest leaders, can outline what this movement will bring in terms of policy shifts.  The protesters have been clear that whatever comes it needs to come from within.  An understandable stance given that “uncertainty” has been the main bugaboo for ignoring bad leadership that was friendly with western democracies.  This time, you take what you get. 

Markets really do hate uncertainty so the ill ease they are demonstrating simply makes sense, at that level.  That doesn't mean a bad outcome should be expected.  In fact, this Arab Spring looks as likely to be a tonic for uncertainty in the medium term.

The concern isn't about the desire to democratize, but about the lack of much experience with western norms for democracy.  Some are also concerned that Islam isn't built for the concept.  Western democratic norms actually developed to overcome the ridged centralization of the Christian world through the Vatican.  Islam has its own theological divisions, but not a centralizing institution vaguely like the Vatican once was.

Talking shops the Arab world and Islam do have.  The real change so far has been that their voices have become more effective, and that is the real wellspring of democracy.  We can’t pretend to know the details of what comes from this movement or that we will like all of them as they arrive.  However, we don't know the details of what comes from the market focused democratizing going on in China, or other regions, either.  So far those have meant more balance and more prosperity.

The less Pollyanna view of uncertainty in the Arab world is potential oil supply disruption.  Concern about “peak oil” is matched by concern about unfriendly Arab regimes coming to power.  We have said before that peak oil, like peak copper or iron ore, is really about needing higher prices to bring new “lower grade” sources to the table.  These are found in the oil rich Middle East as much as anywhere else.

A “Comment” article in this weekend’s Toronto based National Post speaks to that potential in Israel where a well-funded company is setting up to test oil reserves in shale.  The article speaks in terms of security concerns and the politics of oil hampering development of this resource in the past.  That may be true, and the lead Canada’s oil sands have been able to get amongst high cost sources, because it is in a secure area, speaks to that.  But the cost issue is part of the deal.

The mid-East and North Africa as a whole could be generating more oil if risk premiums were to come down.  The crowds in the street, who mostly just want to speak their minds and eat better, are protesting their own leadership with little focus on which foreign powers have been backing them.  A muddle of other issues can certainly come into play, but the crowds aren't likely to oppose investment if they think it will help put food on the table.  The system now in place, fed in part by keeping tension high, hasn't been doing that well enough. 

Mideast political risk premiums won’t be coming down before this Arab Spring has solidified around some guiding principles.  Those will differ in different parts of the region, and only if those principles encourage investment will they generate reduced premiums.  It will take a while for this process to work through and for direction to be recognized.  Markets will be edgy while the process continues. 

However, no one has put an alternative route to lower risk premiums on the table.  We doubt there is one.   

The Arab Spring is just one more uncertainty in a market full of them.  The more “western” issues like debts, deficits and stimulus will play out through the summer. If there is to be resolution to those issues (or really well handled extend and pretend) it’s likely to come in the next ninety days.  Until at least a couple of those uncertainties are dealt with things will be soft.  Going with the flow and waiting for a turn, hopefully in the dog days of summer, makes more sense for now than fighting the tape.

US equity markets had continued to benefit from export driven bottom line growth, but are now sagging on hesitancy about the US domestic economy ahead of QEII buoyancy drying up in June.  The Dollar decline that allowed export strength has also boosted US import costs. This could mean a modest US summer driving season unless recent declines in oil prices continue. 

China’s inflation concern has taken up more of its policy.  The tighter Yuan policy isn't showing up in the inflation rate but it will have some impact and mean that growth engine downshifts.  On top of that the vagaries of nature and street crowds continue to add uncertainty.

We began the year with an “expect the unexpected” stance.  May began with the death of bin Laden, which caused only the barest ripple of market applause.  We stir entrails this time of year on whether to look for bargains early in the northern summer, or not — a tough call this year. 

The sector we focus on has been consolidating after doing very well.  This downward move accelerated recently, which could hasten the start of a buying period.  The recovery of the broader equity market after March events seems to be stalling after new highs again in the past couple of weeks.  Its not looking comfortable though, and volumes are low.  Are the market’s about to repeat last summer’s pause?

“Events” have been hard on the algorithmic.   The muddle of just-in-time manufacturing waylaid by tsunami wasn't expected, but adjustments can be made for it.  It’s possible to program varied responses to currency and bond or inflation related policy shifts.  However, aging powers having to choose between the old buddy system or newly emboldened Arabic Street is quite variable rich. 

Despite these weakening events, inflationary pressure would be the most likely cause for a pause.  Its not the G7 economies that are the big concern for us.  The real pressure is in the growth economies that the high income economies still need for export support.  This pressure comes from resource price gains, and most worryingly from high food prices and simple demand growth across many local markets.  This again is event related.

Weather events have been getting a lot of ink lately, the most recent being the unusually heavy and deadly North American storm season.  Our sympathy goes out to the victims of the southern US tornado onslaught, but it is slower motion events that concern markets.  Weak crops and high food inflation are becoming a plague.  Those still looking for a second market collapse and double dip recession will remind us the ‘30s dust bowl deepened the Depression.  Markets run on perception so analogies like this can have an impact.

Perception aside, the problem is a real and serious one.  The chart above, courtesy of the Food and Agriculture Organization of the UN, shows their food price index hitting new all-time highs, in both nominal and real terms.  The price measure is already well above the levels reached in 2008.  The one cause for optimism is that the commodity rout going on the past few sessions is driving speculative money out of grain and other “soft” markets too.  This helps, but speculators aren’t the main cause of price run ups.  Its supply and demand, and there is no obvious easy fix.

Brazil has temporarily halted rice exports.  Drought in China’s wheat region may have the country importing grain for the first time this century.  There is also news that China wants to import more sugar due to declining domestic supply and because imported sugar is cheaper.  The need to import food may finally be pushing aside the weak Yuan policy.  Not the best reason admittedly, but still better for overall balance in the exchange rate system. 

A stronger Yuan won’t stave off rural unrest in China by itself.  It would however help with broader inflation and increase purchasing power for imported goods which could ease the transition for the poorer regions of China.

Talk about a stronger Yuan  comes on top of a concerted tightening policy that is finally impacting oil and metal prices.  The most recent statistics out of China include weaker Purchasing Manager Indices and inflation numbers that appear to be peaking.  The move out of commodities based on these is now fully underway.

Weakening metals and energy prices are a necessary consolidation that we have been looking for, which offers some relief for weak economies.  It doesn't help other, poorer economies deal with their food issues though.  These keep piling up.  Whatever the direct political causes might be, the rash of street protests in the world have an underlying concern about soaring food costs. 

Certainly there are some dire predictions for this year’s weather, but we won’t wade in on them.  Rather, we will point out that changing crop conditions have had as much impact on history as kings or bishops.  Early signals over the next few months of crop potential in the north may have a larger than usual impact on equity markets.  We add that watch to the waiting game on QEII’s end.    

Rising food costs could (and should) hasten a reduction in the global farm subsidy system.  This may be wishful thinking politically, but higher market prices and demand suggest the time is ripe to try.  The subsidy system in wealthy economies has hurt capital input elsewhere and closed some markets to developing world farmers.  Now that shortage is on the table and prices are high across the board this will be a talking point.  It should be kept track of.

The currency mix will also be important to this.  Liquidity created to hold the Yen down for 20 years was combined with protected high-cost food producers.  Japan could take advantage of Yen strength that liquidity and low external debt now bring to rethink that food subsidy system.  Tokyo certainly has better places to spend the money after the tsunami.   

The EU has always had a transfers system around agriculture.  It’s a smaller fraction of the budget than it used to be and is being reformed, but is still there.   The will to push reform further as part of a global realignment may be in place.  It would need to recognize the debt realities of EU members, but the ECB focus on inflation positions the Eurozone to refocus trade. 

The US situation is similar but arguably tougher to deal with right now.  Reducing direct subsidies would be small change against the Federal deficit.  Like most industrialized democracies the rural vote has a large impact.  The Fed’s loose money policy is making US export of all commodities more viable, and sensible.  It should be taking this export gain, but it shouldn't need to subsidize to do that.  

The subsidy system has been such that other big, wealthy exporters like Canada and Australia compete, but not  too heavily.  In the low income world subsidy tends to be for inputs like power and soil additives, which have also moved up in price.  The problem with that has been a skewing of capital allocation to farming.  Sound familiar?

Some blame global warming for shortage, while others say the Malthusian equation is simply setting in.  We think it’s another case of a century of technological based cost reductions working through to their end.  Food has rejoined metals and energy in reverting to a larger slice of a global economy that has been prosperous enough to add hugely to the population base. 

Investment from the Mid-East and East Asia in Africa is changing that.  How well that feeds locals is now the issue.  There will be more unrest in more places if some solutions don’t get found.  Food is not an issue that can be put off.

 Another issue shared by the US and China is income disparity.  In the US this is taking a back seat to debt.  China has been trying to work through that by creating non-rural payrolls, with great success so far.  But now urban workers are demanding higher wages to better inflation and that is eating up the country’s competitive advantage. 

China is one country where higher food prices (if they are allowed) could be an added boon for a very large rural population hoping for better living standards.  The export of low wage manufacturing from China means the next Wal-Mart will do its shopping in places like Viet Nam, Indonesia, Pakistan and Nigeria.  How does the US compete with that?    

Strictly speaking, it can’t.  There is no point trying to outdo developing countries on low wage manufacturing.  Quality, innovation and productivity are the only realistic competitive advantage for a country like the US.   This worked for Germany after all, and no one would classify it as a low wage country.

That means the US accepts that it needs to resume the hard goods export model it had before it became a global investor.   That has been happening, with last month’s exports reaching an all-time high.  It’s one more reason why strong dollar talk in Washington is just that.  Export sectors have been the real wealth and job creators lately and no one in Washington will mess with that.

That notwithstanding, last month we laid out what may eventually turn the US$ back up as a cautionary tale on when precious metal prices could top.  At the same time we have been reordering the list a bit to reduce exposure in silver relative to gold. 

Silver continued its strong price run until the end of April and came just shy of making a new notional high. It was a very short lived spike and the metal has been falling since.  Silver has now given back all the move that began in March.  Margin requirements for futures traders were raised several times during the move up which silver bugs are pointing to as the cause of the fall.  Futures markets attract speculators that use maximum leverage and may have sold rather than put up more margin.  Similar steep down moves were seen in the oil market when margin requirements were upped there in recent sessions.

However, the margin changes mainly reflected increased contract size as prices rose.  Traders with sufficient conviction could have put up more margin.  The fact they chose to sell rather than do that indicated there was plenty of short term money in these markets.  Momentum traders that had taken over the tape in some trades cut and ran when the trend changed.

Similar moves have been seen across the commodity space during the past couple of weeks.   We want to be clear here.  We are not saying that internal market issues like margin requirements are the reason for the price pull backs.  They might have hastened the moves in a couple of the most overdone markets, but only because traders had already decided it was time to take profits.  

We don't think the US$ bear has left the woods yet, nor do we think the longer term commodity bull cycle has suddenly evaporated.  We do think that growth economy central bankers are starting to succeed in slowing their economies.  That success, plus ongoing concerns like QEII, European debt squabbles and US debt ceiling smack downs has traders blowing the froth off metal and other commodity markets. It’s what they do.

Copper has finally made the move back below the $4 mark we have been expecting for months.  Copper’s move can be more directly attributed to signs of slowing in China, though it too had a speculative component that needed to be dented.  Now that the spell has been broken there may be a bit more downside left before the red metal is again ready to base and provide another sustained up leg in price again.

We are still focused on market warehouse stocks to time the red metal, and so far they are not suggesting it’s time to go long.  The Shanghai total is down some, so we may be approaching the “right” price soon.

Similar moves have been seen across the base metal space.  For the most part, the scale of the current pull backs has been in direct relationship to earlier upward price moves.   In short, the larger the late 2010-early 2011 price increase in a particular metal the bigger the resulting correction.   This is what would be expected in a market where prices were being reset to match lowered expectations or greater concerns.

Gold has been an exception so far.   In percentage terms the pullback has been small.  This reflects gold’s status as a quasi-currency and its insurance value.   We expect that to continue and gold to be one of the stronger metals as the markets settle.

During silver’s 1980 run many wondered where the buying came from and lined up with grandma’s silverware to cash in.  No such line ups are seen this time even though the recent run up looked pretty bubbly by the time it peaked.  Again, this points to the current price moves in commodities being corrective, not a “sky is falling” scenario.

Now that traders are lightening commodity positions and markets are easing, the question is when and where to we find a bottom.   At a macro level, the big risks are growth economies slowing too much, QEII ending with a bang not a whimper and politicians in Europe and the US letting gridlock keep them from negotiating debt deals.

China has proven adept at managing growth so far.  Likewise, for all the handwringing about QEII the bond markets are acting a lot less worried than people who talk about bond markets.  Both of these situations may end well, but it will be at least a couple of months before that is known.  That points to a bottoming during mid-summer and charts that may yet look a lot like last year’s.  We plan to position accordingly.

World events continue to signal support for hard assets, but caution is still advised.  News in the copper space is as much about consolidation of the players as the metal itself right now.  The $7 bid by China Minmetals for Equinox Minerals (EQN-T, ASX) has offered some support for other mid tier copper assets.  The Minmetals bid requires EQN to drop its own bid for Lundin Mining (LUN-T, LUNMF-Q) that had already squelched the planned merger of LUN with Inmet Mining (INM-T, IEMMF-Q).   EQN had already merged with an Australian junior to acquire its Saudi copper mine development that is to begin out put late this year.  To this has just been added a take-over bid by Capstone Mining (CS-T, CSFFF-Q) for Far West (FWM-T, FWMLF-Q) and its copper-iron project in Chile, with an assist from state owned Korea Resources Corp.  Small and mid tier copper producers are focused on securing growth assets of the right scale as Asia gets more aggressive in ensuring supplies for its markets.   

That’s enough to and fro for even the most ardent resource sector bears to give the sector another look.   The interest in copper equities has contrasted with weakness for the metal’s fundamentals.  The three-market (LME, SHFE, COMEX) inventory levels for the red metal are back up to levels similar to those at the copper price low in March ‘09.  The biggest build up through that period has been in Shanghai where stocks actually went negative in early ‘09.  (Of note is that the SHFE now breaks out “bonded” metal which has been delivered to a Chinese port but hasn't had duties paid for entry.)  This extra stockpile will work through the system in time, but it is large enough to have broadened the call for near term weakness in copper’s price.  The looming structural deficient in copper supply still has producers looking for near term additions to their output.  That should continue to support copper assets with well defined cash flow potential.  Near term weakness for the red metal can still be viewed as an aid to picking up asset rich deals.

Base metals and globally priced commodities more generally also continue to see support from US dollar weakness.  Dollar weakness and inflation are somewhat perversely linked.  At the start of the year many expected strength in the Dollar based on higher growth forecasts for the US.  The rise of the Arab Street and $110+ oil prices changed the picture.  If a ceasefire in Libya calmed that region the oil price at least may be less of an issue.  That’s still a big if.  High oil prices definitely hurt in 2008 but much of the following recession was baked in the cake by the real estate bubble.  Mayhem in the Arabic could generate a real time experiment on the breaking point from rising oil prices this go around. 

News that tightening moves in China don’t seem to be biting yet has added to concern on the oil, but in balance we think China will continue this tightening until they do.  However, near term Euro strength may ironically have the most influence Dollar pricing.

The ongoing debt crisis in Euroland is one reason many expected the Greenback to keep strengthening, but Portugal finally succumbing to its debt reality caused barely a ripple in the markets.  The amounts involved are small enough that the larger Euro economies should not have much trouble absorbing those costs.  That is not yet the end of the story. It’s widely assumed the next domino to fall could be Spain.  The cost of a Spanish bailout would be an order of magnitude higher than Portugal, and the market would be much less sanguine about it.  Spain continues to insist a bailout is unnecessary, as did Greece, Ireland and Portugal until right before they threw in the towel.  Given this backdrop the strength in the Euro would be surprising except for one thing — the European Central Bank.  

The ECB has credibility as an inflation fighter.  It raised interest rates again this month by 25 basis points and made it clear it would continue to if it sees evidence inflation continues to accelerate.  This sort of credibility is the reason the Euro has been strengthening.  The US Dollar Index has now reached new 52 week lows, largely due to Euro strength.

Inflation is also rising in the US, but messages out of the Fed and Washington politicos are as mixed and contradictory as ever.   While it seems unlikely there is the political will or necessity to institute “QE3”, it’s equally unlikely the US will follow Europe’s lead with interest rate increases anytime soon.  The US Fed tracks GDP price deflators and core inflation numbers that are still steady since they exclude food and energy.  The “QE3” issue revolves around the lack of demand for US Treasuries.  The Fed has been the buyer of last resort in the treasury market for some time now.  PIMCO, the world’s largest bond fund has sold what had been the biggest private holder of US treasury bonds, and gone short Treasuries. 

The US Treasury yield did drop in March as the safety trade took hold, but that reversed fairly quickly as the markets started to normalize later in the month.  During this period the Dollar itself barely benefited from the safety trade.  There was some uptick as rates moved up but this soon dissipated and reversed.  Despite worry about bonds selling off, Treasuries are still a parking spot for funds.  That might change with another interest rate gain in Europe.  If that happens PIMCO would have lots of company on the short side of US Treasuries. 

Meanwhile, China still refuses to let its currency appreciate.  And, recent economic stats increase the likelihood of more rate increases there.   China’s Q1 trade statistics were headlined with a trade deficit, the first in years, but the numbers for March indicate strong gains for both imports and exports and a small trade surplus for the month.  Numbers like these indicate China is still the world’s widget maker. 

Like the ECB, Beijing is serious about tackling inflation so more interest and reserve ratio increases seem certain. The Yuan should be gaining while this tightening continues, but Beijing still seems to be more concerned about losing sales than allowing a stronger currency to knock down import costs and help cool inflation.  With China trade so important these days, that eats into everyone else’s wiggle room.

Assumptions that the US Fed will avoid raising rates to fight inflation are none the less still quite rational.  Moderate inflation debases US debt, and it’s simply not that easy to argue with the world’s biggest debtor.  The US will try to maintain a negative real interest rate policy for at least the rest of this year.  As long as the market is letting them get away with not spiking Treasury yields it makes no sense for the Fed to change tack — unless forced to.  

More hawkish central banks trying to stay ahead of the inflation curve will continue to attract bond holders.  This will maintain a benign environment for metals and other commodities, even if it does not push them to higher prices.  However, as rates outside the US move higher it will become more difficult for Washington to roll over its debt without following suite.  The S&P downgrade of US debt recognized that simple truth.   We aren't yet at that point of concern and may not be soon, but it has potential to be turning point when it takes place.

Gold and silver have continued barreling higher thanks to insurance buying, inflation expectations, and the currency picture.  Given the underlying chaos in global affairs there is room for gold and silver to continue their gains, in US Dollar terms at least, as long as negative real rates persist in the US.  Around that upward bias will be traders moving in and out of the safety trade and other short term sentiments.  Expect volatility. 

Gold’s advance has been fairly measured, with plenty of consolidation along the way.  Pullbacks have been few lately in the silver market.  Silver looks technically stronger, but it will be prone to sharp pull backs given the large one way move it has already had.  Silver’s strength has shifted a number of companies we follow from being gold dominant to silver dominant just as they are reaching cash-flow waypoints.  These are safer ways to play silver after its strong gain, so they have been getting some emphasis in our updates to subscribers.  We are looking at a few exploration stories that may offer better silver leverage, but we do so cautiously.  Market shifts can impact smaller metal markets swiftly, and unpredictably.  

Cloth-dying and soap-making have employed residue from boiled plant material since ancient times.  The plants are reduced to brine and that evaporated until only the useful “potash” remains.  In the 19th century the active ingredient in this precipitate was fit into the periodic table as “potassium” with the symbol “K”.  Potash has stuck for potassium bearing salts mined in modern times.  The salts are processed into fertilizer, now 95% of the K market, which returns potassium to the plant world to increase agricultural yields.  Potassium is irreplaceable in this application, so growth of its supply is considered critical to expand global food output.  Potash salts are extracted in about a dozen areas, but only a few have large scale.  As with other bulk minerals, the boom in potash exploration is keyed to both greater supply diversity and more capacity.     

The most important potash basin in Saskatchewan supplies about 1/3 of the market and contains half of the current reserves.  Potash Corp of Saskatchewan (POT-T, N) is the region’s and world’s biggest potash miner, with Mosaic Co (MOS-N) and Agrium Inc (AGU-T, N) making up the balance.  All of these producers market through a single agency.  BHP Billiton (BHP-LSE, N.ADR) indicates it will move ahead on its Janson Lake deposit, acquired by take-over of Anglo Potash in 2008, despite a rebuff of a bid to takeover POT last year; Germany’s K+S KALI is also active there (see below); and a number of other Canadian juniors own projects in the basin.  These thick, rich 400 million year old deposits lie below 1000 metres (3000 ft) of cover.  Most are mined from high-capital underground operations, though several use wells to circulate solutions that absorb salts.

The second largest active basin is Upper Kama in western Russia whose largest producers, Silvinit (SLV-RTS) and Uralkali (URKA-RTS), are attempting a merger.  Fertilizer giant PhosAgro has also expressed an interest in Silvinit.  PhosAgro had gained Russian government approval to counter the bid by BHP for POT last year before Canadian governments nixed a take-over.  The next most important potash source is the Starobin basin in Belarus being mined by a state owned firm.  Russia and Belarus have joint marketing arrangements and together represent another 1/3 of potash output. 

Other significant producers include:  K+S KALI GmbH (K+S Group; SDF-XETRA) operating a series of German mines and which recently took over Canadian junior Potash One;  Intrepid Potash (IPI-N) mining in Utah and New Mexico;  Vale SA (VALE3-BOVESPA, VALE-N.ADR) from expanding mines in Brazil;  ICL Fertilizers (ICL-Tel Aviv)from mines in the UK and Spain as well as solar evaporate operations in Israel; and Arab Potash (APOT-Amman) with solar evaporate operations in Jordan.  These are significant producers with some room for expansion, but none approaches the scale potential of Saskatchewan or Russia/Belarus.   

The Israel and Jordon operations extract potassium from Dead Sea brine.  The Dead Sea is a present-day equivalent of the now dry Danakil Depression seabed on the Ethiopia-Eretria border where potash deposits were laid down less than two million years ago.  Danakil is generating a lot of interest.  Shallow potash deposits have been located along 10s of km of the 200 km (120 mile) long Depression, suggesting potential for both low entry costs and significant scale.

In Ethiopia the Indian miner Sainik Coal Mining is considering a move forward with a $1 billion potash development, and BHP Billiton is at an earlier stage of assessing holdings.  Smaller companies with established resources include Toronto based juniors Alanna Potash (AAA-TSX.V) and recently listed Ethiopian Potash (FED.TSX.V), both testing deposits first discovered in the 1960s.  Chinese funding has begun an upgrade and expansion of Ethiopia’s rail system that could move product to port facilities in Djibouti.  On the Eritrean side of the boarder Australian explorer South Boulder Mines (STB-ASX) is in the early stages of outlining a resource, Vancouver’s NGEx Resources (NGQ-TSX.V) from the Lundin group added potash ground to other in-country holdings, and others are showing interest.  The basin is close to Eritrean port facilities on the Red Sea.  Danakil means “salt lake” and it has supplied the common salt trade for millennia.  It may now become important to diversifying the modern potassium salts market. 

Potash Deposits and Products

Salts form as evaporation of trapped water increases its brine density.  The first of the “evaporites” to drop out are halite (NaCl), the table or common salt used in spicing and preserving food, and gypsum used in construction.  To generate potash salts a higher density brine is required.  Small deposits are found in a number of regions, but only a few basins have had the right conditions to both form and preserve large potash deposits. 

Sylvite, KCl, is the purest potash salt with a 52.5% K content.  This is one of the last salts to precipitate out of brine, so it is relatively scarce.  Potassium in fertilizer is usually expressed as potassium-oxide, K2O, which is 82% K by weight; sylvite equates to 63.2% K2O.  The high sylvite layer in an evaporite sequence, if it exists, is usually a mix of sylvite and halite.  The more common carnallite has a K content of 14%, or 17% K2O, but carnallite ore can contain other salts that upgrade its potassium content. 

The most common potash product is “muirate of potash”, or MOP (muria is Latin for brine,) which is potassium-chloride and therefore chemically equivalent to sylvite.  This is usually what a producer output will reference.  Another typical product is potassium-sulfate, K2SO4, or SOP that contains about 52% K2O but gains value as a sulfur source.  Salts such as kainite containing sulfur and can be preferentially upgraded to SOP. 

The USGS estimate of a global 2010 mine output at about 33 million tons (30 MM tonnes) is K2O equivalent.  Most general comments on pricing will be based on this higher grade form used to denote fertilizer content.  Potash pricing went from a stable US $150-200/tonne prior to 2007 to over $800/t in 2008 as the biofuel craze gripped markets. Post Credit Crunch pricing slumped to $300 but has recovered to near $400.

Fertilizer pricing is dependent on product form plus the content of other nutrients that may go into various retail sales products.  Potash deposits are valued on potassium content net of the costs to get that on to a loading dock in a useable form.  In comparing deposits or districts it’s important to note whether reporting uses K2O or KCl equivalent, or some other local notation.  As with most bulk mineral commodities valuation is based on contract pricing which can be tracked through news from marketing agencies Canpotex and Belarussian Potash Co who account for over 60% of sales.  Spot pricing, which is an important gauge of market sentiment, tends to trade in line with grain prices.  Flooding in Australia and low precipitation in China’s grain belt have been underpinning recent gains for both grains and potash.  

With Libyans having joined the movement to overturn aging autocracies the Arab street action has moved into a geopolitically more difficult territory.  Concern over Libya’s oil exports are showing up as higher crude pricing.  Libya’s 1.6 M barrels/day of crude output may well undergo disruptions, but the Saudis could replace that if prices move high enough to cause concern.  As troubling is the unpredictability of Muammar Gaddafi and those around him.  They seem more likely to go down fighting than the western leaning autocrats have been, and that is more likely to cause splintering of the country and concern similar shifts elsewhere in the region.  Markets are reflecting this heightened uncertainty with continued gains for precious metals and US$ as well as oil.  We expect the US$ and oil to peak before gold and its cousins do.         

Base metals have been trending lower as would be expected during Dollar strength, but broader considerations are also part of this.  Traders managed to push copper through $10,000/t ($4.56/pound), but that 5-figure copper pricing has acted as a ceiling.  More analysis is now focused on the growth of on-market stockpiles and the unknown size of off-market stocks, plus increased efforts to cool emerging market growth.  Traders have begun listening to those concerns as much as to Arab street rallies.  The share prices of First Quantum (FM-T, FQM–L), Capstone (CS-T), Lundin (LUN-T, LNUMF-Q) and most other copper miners began declining ahead of the metal’s peak.  Since Dr Market tends to trump Dr Copper, this more cautious mood around the red metal is likely to last.  Waiting for weakness in the subsector should pay off.

Gold’s early year price decline reversed during Egypt’s street action. The new uptrend continues and has steepened as the movement spreads over North Africa and southwest Asia (see chart next page).   This comes as gold’s 60% price gains of the past two years finally shows up in the bottom lines of yellow metal producers.  For some miners the earnings gain has been in the 100s of percent over last year. These include number one producer Barrick Gold (ABX-T, N) and intermediate producer Agnico-Eagle (AEM-T, N).  Like most miners the gold producers pulled back in early year profits taking after strong run ups at the end of 2010.  This combination may have set up the answer to a valuation question of ours. 

Gold producers have long garnered high P/E ratios, unlike base metal miners that traditionally sported fairly low ratios.  High gold company ratios have been justified on the basis in-ground gold reserves, which must have left base metal players felling like chopped liver.  We have said before that this secular bull market for metals, or super cycle if you prefer, could close that gap.  For the past few years gold producer prices have not kept up with the metal’s gain. This has partly been an issue of miners paying down past expenditure while dealing with rising costs such as for steel and energy.  A number of gold miners seem to have put those issues behind them for now. 

When Barrick’s 2010 results came out they showed a trailing P/E at half the +30 multiple it had seen in some past years despite a strong share price recovery through last year.  The Agnico-Eagle P/E was similarly priced at half the extraordinary +60 P/E of some past years when its stellar 2010 results came out.  In the several days since Barrick gained nearly 4%, helped by gold’s own price gain, to sit at a trailing ratio of 15.7.  Agnico however has slipped almost 8% over those several days to sit at a still impressive trailing P/E of 35.7.  While Barrick is obviously likely to continue its gains in this market, reaction to 2010 results for these and other established gold miners will stabilize a sector gaining a broader, balanced audience as an insurance holding.  As the market settles on what it will pay for producers they will be more likely to seek new resources amongst junior players.      

Silver is making this year’s second set of new 30 year highs, and we expect that to continue.  The moon metal is always more volatile than its yellow cousin.  In the current environment its smaller market could get pushed that much more than usual.  We would also point out that a gauge of P/E standards for silver is even tougher than for gold.  Even after silver tripled and quadrupled many small producers struggled to generate any E but still managed share price gains along with the metal.  The silver sector could undergo a re-ranking similar to that gold seems to be in, but not while the current run continues. 

Thoughts on the base metals side of the earnings equation can await more numbers from them, but the buying up of copper juniors speaks to a group that is happier with its market.  Though share prices would slide in the space along with metal prices, it would take a much larger dips than we expect to put any actual deal making off side.  For the time being patience on the buy side is most likely to be rewarded longer term. 

Ω

It’s a secular bull market for metals and resources. We’ve been saying that for ten years. And we’ve been right. HRA initiated coverage on 19 companies since early 2009 – the average gain to January 12, 2011 is 309%! We’re constantly reviewing companies for potential addition to the HRA list so there are sure to be more winners going forward. Of course, you won’t know about them unless you’re a subscriber! 

Another thing we’ve been right about is the growing importance of the Yukon as an exploration destination and, more recently, Area Play. HRA was there early and continues to follow several of the biggest winners in the play. To watch Eric Coffin’s latest Yukon Area Play Crescendo video (Feb 2011), please click here now to access it for free for a limited time!

Events in Arabia have been sending flutters through the market.  Egypt, by far the largest Arab state, has shifted into a virtuous economic growth cycle confirming it as an important emerging market regional centre.  That said, it continues to have a high population growth and economic expansion has to be high to maintain current wealth levels.  As street demonstrations go, these haven't been all that chaotic given they lack a pro rallying point.  It is hard to say just what a growing Arab middle class will want beyond a say in its own governance.  It was that middle class that first called for political change, but the poor who are trying to cope with rising food costs have also joined in.  Both deserve some consideration.

Concern about a radical emergence from this call for change is valid insofar as it’s difficult to predict what would come out of disparate voices having their say.  But there is little in Egypt’s past, or the voices of its middle class or its military, suggesting radicalism.  Even though the process of change is still being formed in Egypt, and in Tunisia, it is the broader region’s politics that will now most likely to concern markets.  Baring an unlikely spread of this street action to Saudi Arabia, the protests in Yemen and Jordan are the next greatest areas of ‘contagion concern’.  Both also have western leaning governments and groups agitating for change in a neighboring state. 

A big concern is upheaval in an oil kingdom or cross-border hostilities emerging that toss a lit match into oil markets.   That much is obvious.  Idle urban youth have been the region’s main problem for generations.  This round of agitation is a reminder that this demographic problem isn't going away any too quickly.  So the bigger question now is: where does a youthful population transition to as it pushes away from rule by a heavily centralized wealth base?  To support these calls for democracy in Egypt and Tunisia means accepting the outcome of ballot boxes and that the process can generate unexpected results in its early going.  Markets don’t like surprises, but stability is usually the fruit of vox populi when it flowers in its own soil.                      

In January we cautioned that upheaval might scuttle the market during this period of shifting geopolitical balance for which a new handbook about dealing with the unexpected still needs to be written.  That was said in the context of US-Sino relations, at least in its primary sense.  Markets have certainly been riled by these unexpected events in Egypt.  Does this fit our concern?

It does insofar as Egypt’s stability has been important to the mid East balance.  Fear of chaos there is shared by just about everyone and this should include China.  Of course China’s leadership also fears agitation for democratic change.  Direct involvement by China in Mid East doings is likely to be limited, but this sea change could speed along writing some of that new geopolitical handbook.  And, how the US deals with allies in transition may influence how China deals with events closer to home. 

What comes next from the Arab contagion is still an open question, but it’s important to note that Algerians have been joined by Yemenis and Jordanians in a focus on rising food costs.  Food, more than any other commodity, can almost instantly morph into an issue that topples government.  Rising metal prices that are our stock in trade can often be passed on since they are only a small part of many end-use costs.   It’s tougher to avoid passing on food cost gains.  The impact of higher food prices is hurting poorer classes across the developing world.  And, unlike the grain price spikes in 2008 the current shortages aren’t about a bio fuel craze.  Weak harvests and more meat consumption are creating real shortage.

Because it’s a large part of the cost basket, food is also driving inflation rates higher in the growth economies.   Demand push is driving up costs across many sectors in these economies, but food is increasingly the main culprit.  Central banks in a number of growth regions have started to raise interest rates again.   BRIIC countries have all done so, and there is little sign that trend will end soon.   The most recent rate increase by China did cause a hiccup in the copper and other base metal markets, though so far just that.  Inflation rates are climbing in enough areas that even a rate increase by China did not spook the gold market this time.   Buyers seemed more worried about inflation than a potential direct impact on currencies. 

More rate increases in short order would be tougher on base metals.   Base metals are economic growth barometers.  Metal prices may pause on further sign that the governments of the economies doing all the buying in the metals space are serious about cooling their economies.   We don’t expect anything too dramatic in terms of pull backs, but base metals are priced for perfection right now so a slow down won’t be shocking.  Precious metals will be supported by inflation concerns as well as concerns about the Arab and other restive Streets.

Unfortunately, its unlikely rate increases will have much impact on food prices.  The good news is that higher prices for farmers spread incremental wealth gains pretty broadly.  It’s no coincidence that one of the best growth regions in the next few years will be Africa.  That is a direct result of higher commodity prices. 

Higher food costs because more people can afford them are obviously a good thing.  Alas, agriculture has supply constraints just like the mining sector does, even before random weather events are factored in.  Like the metals market, it’s a pricing issue that may wax and wane but won’t go away for a long time.  It’s an issue that bears watching.  The poorer classes in many developing countries can to put off buying a fridge, but can’t put off buying the stuff that would go into it. 

Like most other gains, higher food prices are a good news/bad news story that will take nimble markets, and politicians, to manage.  Those that lack flexibility may find themselves swept away.  Adjustment will eventually get made to the new cost regime.  In the mean time there will be opportunity for those in agribusiness sector who focus on improving yields.  Bigger names in the fertilizer business such as Potash Corp of Saskatchewan (POT-TSX, NYSE) and Agrium Inc (AGU-TSX, NYSE) should be in for continued steady growth, and there are increasing numbers of junior companies on our radar screen that may do very well by focusing on resource building for this increasingly important market space. In fact, the growth in the bulk minerals demand is generating the best market for start up opportunities the space has ever seen. 

It’s certainly true that Arab politics has been reminding us that we live in interesting times, but unlike some we don’t believe that such times need to be viewed as a curse.  A broadening of governance in the Arab world will generate the same benefits that it has elsewhere.  That will in the longer run is also the best route to dealing with the rising food costs since it is part and parcel of open markets thinking.  

Preface Comments:

As usual, most of the first Journal issue of the year is given over to that annual exercise in masochism known as predictions for the year. We note several potential problems but, overall, we think the markets should be ok, and the sector we deal with will be more than ok.

There has been a small pullback to start the year as those who waiting for the next tax year to book profits have been putting stock in the market.  We won’t be surprised if the pullback gets deeper before it’s over but we are not concerned about it. 

We’re used to being contrarians. That might explain why we would be more comfortable if there was some correction in Venture companies and some of the base metals. Given we were about the only people around recommending both of those near the start of 2009 we think we’ve earned the right to be cautious. 

Cautious is as far as it goes however.  The exploration sector is as well funded as it’s ever been.  After several thin years, a number of new discoveries arrived last year.  All of those and anything near them will be getting lots of spending this year.   News flow should be even heavier than 2010. There should be lots to trade once a bit of start of the year portfolio management has been gone through. We’re looking forward to it.

We said at the start of 2010 that it would not be a literal repeat of 2009.  We expected gains, but ones that were less dramatic than 2009.  That largely came to pass in the markets, though there has been a recent shift in leadership.  Metals performed far better than most thought they would.  We were among the most optimistic but still found the scale of some of the gains a surprise.  There are a lot of different areas we want to make New Year comments on so we’ll get right to it.

Major Economies:

As expected, developing economies accounted for most of the marginal growth in the world economy last year.  We think that could be repeated again this year, though the difference in debtor/developing country growth rates could narrow. 

The debtor economies (US, Euroland and Japan) muddled through another year as we thought they would.  They didn’t put in a stellar performance but progress was steady, if slow.  That is a victory of sorts given the widespread belief early in 2010 there would be a double dip recession. Few observers expect one in 2011.

Plenty of risks remain. There is much to be done before debtor economies are back to anything like pre-crisis normality.  Growth rates should shift to a slightly higher level in 2011, while deleveraging continues.

The threat of sovereign default continues to hang over Euroland.  This concern might ease but is not going away any time soon.   The economic dislocations in many of the peripheral countries in Europe are too large, and there is still too much resistance to change for the picture to improve quickly. 

That said, in most cases we think the fear of small country defaults is overblown.  Not because they can’t happen, but because the cost is manageable, in most cases.  That said, Portugal is the latest concern and its bond yields are climbing again. 

This time the EU is trying to engineer a bailout before the market forces everyone’s hand.  Portugal’s government is insisting the bailout is unnecessary, but that’s what governments always say before they agree to one.  There would be market fallout from another bailout, but one at the scale of Portugal is not an end of the world scenario.

Weaker EU economies will continue to weigh the costs and benefits of leaving the Euro.  The productivity gap between the PIIGS and the larger EU members is far larger than should exist within a currency union.  It will be difficult Europe’s poorer countries to regain competitiveness without the ability to devalue their currency.

We’re not convinced any of them will leave.  Richer Euro members will buy them off with continued assistance. Nonetheless, potential for exits and/or bailouts could weigh on the Euro through 2011. This may become an added source of “strength” for the US Dollar.  That said Europe’s larger markets have been strengthening.  Germany continues to excel at high value manufacturing and France has recently seen better PMI numbers. 

US stats are also improving steadily.  Sales through November and early December were stronger than anticipated.  Purchasing Manager Indices (both Manufacturing and Service) and capital spending have greatly exceeded expectations.  Recent US optimism is tied to bi-partisan agreement to extend Bush era tax cuts and cut payroll taxes. The stimulus effect of those cuts has many raising their growth targets for the US this year.   We think the acceleration is real enough.  The real question is sustainability after this initial flush of positive sentiment. 

Jobs are the indicator that means the most and the key to a higher growth track. The market was disappointed by a lower than expected December jobs number in the US.  However, the October and November numbers were revised upwards substantially.  Continual upward revision in these sorts of statistics is common when an economy is shifting to a higher gear. 

The numbers are still not strong.  There is little danger the US Fed will either raise rates or back off on QEII any time soon.  That should contain over enthusiasm about the US Dollar. 

China’s leaders are starting to worry about inflation, though not enough to let the Yuan rise, which is the simplest solution.  Inflation has only risen to the 5-6% level so far, and much of that are food prices.  Since Beijing’s mercantilist leaders seem unwilling to use currency appreciation to stem inflation traders worry they will overdo a tightening round.

Several increases in bank reserve ratios did little to cool the economy. There have now been two interest rate increases in quick succession and more are expected if those don’t work quickly.  Beijing has proven more adept at adjusting its growth rate than most, but do seem to be tapping the brakes too lightly right now.  Markets everywhere react to events in China now.  Signs of continued overheating in China can be expected to hit markets and commodities.

India and Brazil both had moderation in their growth rates, though they were still strong.  Indonesia, the “other I” in BRIIC, came through the Great Recession in good shape.  It’s not growing at the rate of the other Developing country leaders yet but the growth rate is accelerating.  Indonesia still relatively poor, but its large population means it will matter more to the world economy soon.  It’s already starting to attract the levels of inbound investment that helped China and India take off (see table above).  

Equities & Inflation 

The table above shows the main index changes in a number of the world’s important bourses through 2010 and 2009.  Several of these also appear on the relative performance chart on the next page.  Developing country bourses that massively outperformed developed country exchanges in 2009 lagged some in 2010.  Some of this was simple mean revision after a great year.  But, the lower returns also reflect concern these economies will increasingly struggle to contain inflation. 

The flood of liquidity that the US Fed and ECB have been generating hasn’t done much to boost inflation at home but it’s causing headaches elsewhere.  Large capital inflows combined with soft commodity (i.e. food) price inflation has been raising inflation rates across most of the developing world.  This has created a tough problem for their central bankers since inflation has been accompanied by strengthening home currencies in most cases. 

The classic inflation solution of fiscal tightening and higher interest rates further boost these rising currencies.  Nonetheless, Brazil, India, Indonesia and China have all raised rates recently to tackle inflation.  More increases are expected this year.  Real (inflation adjusted) interest rates are still low, but the markets are not reacting well to the potential for a string of rate increases.

Most of these countries can be expected to press Beijing to let the Yuan rise to help reduce some of the world’s fiscal imbalances.  Other Asian countries that are approaching lift off as low wage manufacturing shifts from China to them will add their voices.  This pressing may however be gentle as China is becoming as important to Asian exporters as it has been to western importers for over a decade. 

Foreign currency reserves in China recently surpassed $2.85 trillion. This will add to the pressure on Beijing. A stronger Yuan would make some lawmakers in Washington happy, until they start getting the same message about the Dollar.

Concerns about fiscal tightening led to a year over year loss on Shanghai, and a flat market in Brazil.  India fared better, but overall the average developing country gain was lower, while developed country bourses caught up.  Some of the weakness in developing country indices was driven by greater optimism in developed markets after QEII became official and the US tax compromise was reached.  Increased money flow into developed markets was partially at the expense of “emerging markets.”

After months of worries about double dips and European defaults the developed markets rose through the last third of the year.  Loose fiscal policy was a big driver, but many multinationals that dominate first world stock indices had good years. Some of this was cost cutting that will be tough to repeat, but not all of it.  Many large companies managed to generate good top line growth. 

It won’t be easy to replicate those gains unless the higher growth rate for the G7 sticks through the whole year.  Earnings should be decent, but much of that is priced in.  We expect gains in the single digits for most developed country exchanges, with room for significant turbulence if there are bailouts in Europe.   

One thing that could improve returns would be a rollover in the bond markets, if it’s due to greater optimism.  Notwithstanding high levels of investor bullishness, there are still vast amounts of money in bond funds.  

A sentiment swing that moved an appreciable amount of that money back to equities could lead to another P/E ratio expansion.  It’s not something we’d bet on but it’s not outside the realm of possibility.  For our purposes, a market stable enough to allow for gains from the sector we focus on is good enough.

Resource Stocks:

Now that was a rally!  The chart of the TSXV Index on the next page suggests just how remarkable the move has been these past few months.  Bottom to top, the Venture index climbed 72% in the space of six months, one of the most impressive rallies you’re likely to see.  The rally was all the more impressive given the strong trading volume that accompanied it.

Resource companies took full advantage of the move. Juniors raised billions of dollars, with the largest funding coming toward the end of the year.  Much of this stock will come off escrow over the next 2-3 months.  Since most of this placement stock it well in the money profits taking is to be expected.  

This could lead to a period of consolidation that would be healthy after a long one way streak.   We’re not assuming a large drop, unless metal prices really came off.   Volumes continue to be high and sellers have had little trouble finding bids.

A lot of last year’s gain was driven by discoveries, which make for sustainable rallies.  Companies with strong management and targets are mostly cashed up.   Even if larger markets are flat the ingredients to generate news flow in the resource sector are already in place. 

After a potentially rocky start, resources will continue to be a favored market sector through 2011.  As long as there are companies generating new discoveries and expanding resources the Venture exchange should have room for a spring rally.  This is still a secular bull market that continues to broaden its audience.