Week 49/2011: Will Mario Ask Santa for a Printing Press this Christmas?

Summary:

Investors will be glad to see the back of 2011, an incredibly difficult year for both equities and bonds. Many institutional investors will be praying that Mario Draghi, our ECB President, gets a new printing press from Santa this Christmas. With three weeks of the year left to go, the majority of stock markets remain in the red. Bonds are barely positive. Could the cyclical bull market that began in March 2009 be rolling over? We should find out in a couple of months.

The model portfolio returned 0.0% last week. Equities gained +0.4%, bonds rose +0.6% and gold in euro terms declined -2.0%. There is no change to the 60% equities / 20% bonds / 20% gold split.

In November, the model portfolio returned +0.9% compared to -0.3% for the Managed Fund Index. Equities gained +0.9%, bonds declined -3.5% and gold in euro terms rallied +5.0%. YTD through end-November, the model portfolio has returned +1.6% compared to -5.3% for the Managed Fund Index. Equities returned -5.7%, bonds declined -1.3%% and gold in euro terms gained +22.3%.

DJIA	12,184	Dollar Index	$78.65	CRB Index	306.45
DJTA	4,957	CAD/EUR	1.3615	Gold	$1,712
DJUA	447	USD/EUR	1.3385	Silver	$32.20
NDX	2,647	JPY/EUR	103.90	Copper	$3.55
S&P 500	1,255	JPY/USD	77.65	Oil WTI	$99.60
ISEQ	2,741	USD/GBP	1.5670	Natural Gas	$3.32
FTSE	5,529	10 Yr. Tsy.	129.85	Soybeans	$11.15
Nikkei	8,654	30 Yr. Tsy.	141.15	Corn	$6.00

Equities:

Central bankers and politicians, when faced with difficult choices, always choose the path with the least short-term pain. When push comes to shove, the ECB will be forced to print. The announcement two weeks ago that the Bank of Canada, Bank of England, Bank of Japan, European Central Bank, Federal Reserve, and Swiss National Bank would act in unison to provide liquidity support to the global financial system was a clear signal of the outcome we should expect. In this instance, central banks agreed to cut interest rates on USD liquidity swap lines by 50 basis points, the new rate being the USD overnight index swap (OIS) rate plus 50 basis points. The Fed also indicated that, should US banks get into difficulty again, continued financial support will be provided. The Fed will not allow overleveraged, badly run banks to fail. Capitalism in the good times; socialism in the bad times.

The co-ordinated nature of the intervention, signalling a willingness by all of the large central banks around the world to work together, rather than the interest rate cut itself, sparked the large move up in stock and bond markets. Stocks rallied because they recognised that global central bankers are prepared to co-ordinate their efforts and resort to the printing press rather than allow defaults to happen. Stock markets consolidated those gains last week following the conclusion of yet another Eurozone crisis meeting.

Markets were heavily oversold, bearish sentiment was high and we are in the seasonally strong part of the year historically for equities. The odds favoured a rally, which is exactly what we got. I expect it to continue through yearend. Short term gain, long term pain. You can't print your way to prosperity. I think our central bankers genuinely believe they are doing the world a favour by printing money. Markets may levitate for a while, but this is certainly no long term solution.

Next, I want to talk history for a few moments, courtesy of a recent Bloomberg article, which discussed the last failed money printing experiment in Germany in the 1930's. This is why the Germans are dead set against the monetisation of the euro, an idea gaining increasing popularity in Europe as the months go by…..

Quoting directly from that article: "It's worth revisiting why the memory of hyperinflation has seared itself into the minds of many Germans, and how it's shaping their thinking and the future of the euro itself. Imagine yourself among the wealthiest people in the world in 1914, holding 4.2 billion marks (then about $1 billion) in safe government bonds. Those bonds would have been nearly worthless nine years later, easily payable with, say, a 50 billion-mark banknote signed by Reichsbank President Rudolf Havenstein. Of course, you would need 45.8 billion marks in change, which illustrates one of the great ironies of hyperinflation: Everyone was always short of cash in the midst of a blizzard of paper. Havenstein justified the continuous purchasing of government debt on the grounds that there was little choice given the national emergency. Havenstein thought the real sources of inflation were the legislature’s inability to balance its budget and the burden of reparations placed on Germany by the Allies at the end of World War I.

Despite millions starving, the demobilization of millions of soldiers, and a near civil war in the Ruhr, inflation creeped until 1919, then “galloped” until mid-1922. Then, in late 1922, it spiralled into hyperinflation as Germany refused to continue payments on the 132 billion gold marks levied on it at the London Ultimatum of May 1921. Because Germany halted reparation payments, France decided to confiscate goods in kind and occupied the Ruhr, the centre of German coal and steel might, in January 1923. In response, the Germans began a campaign of "passive resistance" that all but destroyed the mark. Havenstein felt that he had no choice but to continue printing money to support the Reich.

Hyperinflation wreaked havoc on Germans. People on fixed incomes suffered terribly. One poor elderly woman, whose life savings in Deutsche Bank were wiped out, later discovered that the bank didn't inform her because the stamp would have cost too much. The propertied middle class lost their savings after suffering deprivation throughout the war. Many sold possessions to raise cash for increasingly expensive "real goods" such as bread or meat. Housewives stood outside factories to collect their husband’s pay and spend it as quickly as possible. Businesses needed sacks of cash to pay workers. Famous photographs show money being carted in wheelbarrows.

Eventually, industrialists gave up paying in marks, sometimes creating their own substitute scrip or paying workers in “three breads.” Cities and organizations also created their own monies. Retailers had to continually adjust prices, which gave considerable room for misunderstandings. The response was sometimes violent. In November 1923, mobs attacked Jewish shops around Alexanderplatz in Berlin. Similar attacks occurred across the country. Speculators, bankers, and black-market dealers came in for particular criticism. One small savings bank organized a swap meet for buyers and sellers to eliminate the dishonest profiteers.

The hyperinflation also fomented a new and dangerous activism in German politics. The prime minister of Bavaria declared martial law. In October 1923, federal troops marched into Saxony and Thuringen to depose radical communists from government. Then, in November, Adolf Hitler and General Erich Ludendorff attempted a Mussolini-like march on Berlin, in what's now known as the Beer Hall Putsch. The putsch failed miserably, but Hitler continued to seize on the prevalent economic despair. He was briefly sent to prison where he wrote "Mein Kampf". Although he didn't gain power until January 1933, the link between reparations, financial crisis and the destruction of the mark proved ready rhetorical fodder.

Hyperinflation didn't lead to the rise of Hitler, but it undermined the legitimacy of the democratic Weimar Republic. Millions of disaffected middle-class voters soon drifted to various splinter parties on the right. The centre hollowed out, and subsequent coalition governments ruled on a tolerated-minority basis. German politics never really regained its balance in the mid-1920s, a time of relative economic stabilization; and then came the Great Depression, government austerity packages and, ultimately, the rise of the Nazis. Never again, the thinking goes today. And rightly so. But the fate of the Euro Zone depends on which historical lesson one draws from this episode. Are there circumstances in which monetizing government debt is appropriate, or not?"

We are a long way from a hyperinflationary outcome, and the chances are, this is a low probability outcome. However, printing money to meet your debts does have consequences, of which everyone should be aware. It is not a simple solution and if inflation seeps into the mindset of society, it is quite difficult to bring back under control.

Finally, moving back to Ireland, I have updated my forecast/guesstimate of our fiscal position through 2015E. There are some positives. We are slowly but surely tackling our budget deficit but we desperately need GDP growth. If we only get 1% growth in GDP and 2% growth in tax revenues per annum, we will end up with a 5% budget deficit and 130% debt/GDP ratio in four years time. That's a lot of debt. The good news is that if we manage 2% GDP growth each year, we will have a balanced budget by 2015, albeit with an unsustainably large debt balance in excess of €200 billion. If we can somehow manage 2% GDP growth over the next handful of years and can also negotiate a partial debt writedown, I can see a glimmer of light at the end of a long tunnel.

	2009	2010	2011E	2012E	2013E	2014E	2015E	2016E
Current Income	33,881	34,225	36,870	38,345	39,879	41,474	43,547	45,725
		1%	7.7%	4.0%	4.0%	4.0%	5.0%	5.0%
Capital Income	1,463	1,790	2,140	1,635	1,800	1,830	1,850	1,870
Total Income	35,344	36,015	39,010	39,980	41,679	43,304	45,397	47,595
Current Spending	-45,248	-47,345	-48,400	-47,916	-46,958	-46,019	-45,098	-44,196
Capital Spending	-14,737	-7,425	-8,280	-7,949	-7,631	-7,326	-7,033	-6,751
Total Spending	-59,985	-54,770	-56,680	-55,865	-54,589	-53,344	-52,131	-50,947
Deficit	-24,641	-18,755	-17,670	-15,885	-12,910	-10,040	-6,733	-3,353
Debt (MM)	100,000	149,255	166,925	182,810	195,720	205,760	212,494	215,846
GDP	157,300	157,300	161,200	164,424	167,712	171,067	176,199	181,485
		0.00%	2.48%	2.00%	2.00%	2.00%	3.00%	3.00%
Deficit/GDP	-15.7%	-11.9%	-11.0%	-9.7%	-7.7%	-5.9%	-3.8%	-1.8%
Debt/GDP	63.6%	94.9%	103.6%	111.2%	116.7%	120.3%	120.6%	118.9%

The government is targeting an 8.6% deficit in 2012, achievable only if we get over 2% GDP growth next year.
The technical setup for stocks continues to be positive in the short-term, though we need to see a turnaround in equity markets in the next few days. From a technical perspective, we broke long-term support in August but regained the rising trend in early September. The primary trend continues to support a bullish outlook for stocks.
BONDS:
The current term structure of interest rates for the German, US and UK government bond markets are summarised in the following table.

Current Yields	German Bunds		U.S. Treasuries		U.K. Gilts
3-Month	0.18%		0.00%		0.39%
2-Year	0.29%		0.22%		0.37%
5-Year	0.97%		0.86%		1.05%
10-Year	2.06%		2.03%		2.11%
30-Year	2.58%		3.06%		3.18%

The Aon Hewitt Asset Allocation Team currently maintains the following fair value yield estimates for 5, 10 and 30 year government bonds for the French, US and UK fixed income markets:

Fair Value Yields	German Bonds		U.S. Treasuries		U.K. Gilts
5-Year	4.30%		4.40%		5.30%
10-Year	4.40%		4.50%		5.30%
30-Year	4.40%		4.50%		5.30%

The above government bond yields remain significantly below the fair value estimates of the Asset Allocation Team, particularly for 5 and 10-year government bonds, hence the continued bearish view on this particular asset class. Now, let's take a closer look at the trend in 10-year yields for Germany and the peripheral Eurozone debt markets.

German 10-Yr Yield at 2.15% DOWN from 2.26% last week

French 10-Yr Yield at 3.26% DOWN from 3.69% last week

Irish 9-Yr Yield at 8.72% DOWN from 9.67% last week

Italian 10-Yr Yield at 6.36% DOWN from 7.26% last week

Greek 10-Yr Yield at 35.05% UP from 29.87% last week

Spanish 10-Yr Yield at 5.75% DOWN from 6.70% last week

Portuguese 10-Yr Yield at 13.00% UP from 12.64% last week

Commodities:
Gold closed on Friday at $1,712/oz, a fall of -2.0% in US dollar terms over the past week. The euro was unchanged versus the USD over the same period, closing the week at $1.3390, so gold in euros also fell -2.0% for the week. Year-to-date, gold has gained +20.5% in euro terms.
Model Portfolio:

The model portfolio returned 0.0% last week. Equities gained +0.4%, bonds rose +0.6% and gold in euro terms declined -2.0%. There is no change to the 60% equities / 20% bonds / 20% gold split.

In November, the model portfolio returned +0.9% compared to -0.3% for the Managed Fund Index. Equities gained +0.9%, bonds declined -3.5% and gold in euro terms rallied +5.0%. YTD through end-November, the model portfolio has returned +1.6% compared to -5.3% for the Managed Fund Index. Equities returned -5.7%, bonds declined -1.3%% and gold in euro terms gained +22.3%.

TOP TEN INVESTMENT IDEAS FOR 2011:

	Top 10 For 2011	28/01/2011	Comment
1	Long Gold	$1,337	Conservative inflation hedge
2	Long CEF.A	$18.95	ETF backed by 50% gold, 50% silver
3	Long NEM	$55.00	Miner leveraged to rising gold prices
4	Long EGD	$4.20	Mining services company that sells equipment to the sector without taking the exploration risk.
5	Long GDXJ	$34.60	Junior miners ETF – when gold hits bubble territory, GDXJ will best capture the mania that follows.
6	Short 30 Yr Treas.	$121.45*	28 year bond bull market over, with US 10-year yields troughing at 2.4%.
7	Long MSFT	$27.75	The cash machine of the technology sector; single-digit P/E with double-digit EPS growth.
8	Long CAD/ Short JPY	JPY 82.00	JPY must decline so Japan can regain competitiveness and reduce its massive debt burden (200% of GDP).
9	Long Sugar	$0.34/lb	Commodity play with strong supply/demand imbalance
10	Long Soybeans	$14.05/ bushel	Commodity play with strong supply/demand imbalance

YTD PERFORMANCE OF 2011 BEST IDEAS:

		28 January 2011	09 December 2011	2011 Return YTD
1	Long Gold	$1,337	$1,712	28.0%
2	Long CEF.A	CAD 18.95	CAD 22.37	18.0%
3	Long NEM	$55.00	$66.94	21.7%
4	Long EGD	$4.20	$4.89	16.4%
5	Long GDXJ	$34.60	$28.99	-16.2%
6	Short 30-Year Treas.	$121.45	$141.15	-16.2%
7	Long MSFT	$27.75	$25.70	-7.4%
8	Long CAD/Short JPY	JPY 82.00	JPY 76.00	-7.3%
9	Long Sugar	$0.34	$0.24	-29.4%
10	Long Soybeans	$14.05	$11.15	-20.6%
2011 Top 10 Ideas				-1.3%
Managed Fund Index				-4.2%
FTSE World Equity				-4.8%

PERFORMANCE OF 2010 BEST IDEAS:

		01 January 2010	31 December 2010	2010 Return
1	Long Gold	$1,097	$1,421	29.5%
2	Long Silver	$16.88	$30.91	83.1%
3	Short 30-Year Treas.	$115.38	$122.10	-5.8%
4	Long NEM	$47.31	$61.43	29.8%
5	Long PAAS	$23.81	$41.20	73.0%
6	Long DVN	$73.50	$78.51	6.8%
7	Long CAD/EUR	CAD 1.5100	CAD 1.3356	11.5%
8	Long Nikkei	10,546	10,229	-3.0%
9	Long Sugar	$0.27/lb	$0.321/lb	18.9%
10	Long Soybeans	$10.54/bsl	$14.09/bsl	33.7%
2010 Top 10 Ideas				27.8%
Managed Fund Index				12.0%
FTSE World Equity				20.1%