What Else if not Gold and Silver?

March 23rd, 2011

TahirN

These are indeed extraordinary times that we live in today. Having recently witnessed a massive earthquake in Christchurch, New Zealand which damaged a substantial part of the quaint, South Island town, we are now hit with the horror of a super tsunami in northeastern Japan. While the quake in New Zealand caused some manageable monetary damage and some 200 lives were lost, this latest tragedy in Japan had wiped out towns and villages on the coast, with estimated loss of lives likely to exceed 10,000 people. The cost of this destruction, direct and indirect has yet to be tallied up. The Japanese government, which is already heavily in debt, a result of its anemic economy for the past 15 years, and being in a deflationary cycle pledged a rescue package of 15 trillion Yen to stabilize its financial system. Japanese PM Naoto Kan has called this his country’s worst national disaster since the end of World War 2, and is in the midst of battling how to help its affected citizens, while trying to contain a possible meltdown from its nuclear reactors damaged by the earthquake. In reaction to the potential economic slowdown and huge costs needed to rebuild the world’s third wealthiest nation, the benchmark Nikkei 225 index was down 6.0% to 9632.10 points on Monday. Following comments by the PM on Tuesday that radiation levels at a stricken nuclear plant had become high, the market took another hit – the index plunged a further 7%. (The earthquake had damaged several reactors in the nuclear powered plants run by Tokyo Electric Power - TEPCO, just 200kms north of Tokyo).

In the last issue of Auruma Express, we have also warned of the increased geopolitical risks around the world - from Libya, to North Korea. The situation in Libya is still unresolved as President Muammar Gadaffi continues to defy international pressures to step down; his military offensive to re-take oil towns controlled by the opposition forces had sent jitters through the western world; crude oil prices remain stubbornly high at US$100/ barrel as the supply pipeline from this oil rich country remains under threat.

Where to put your money?
This is a big question that is on most investors’ mind as they struggle to come to grips with what’s happening around them. Let’s take a look at some of the options available.

Bonds
One popular asset for investors are bonds – which are basically i.o.u issued by companies and governments to raise funds. The bonds usually pay a fixed coupon rate plus the repayment of the capital at maturity. Hence, the prevailing interest rate would affect its pricing in addition to the risk of the bond as assessed by rating agencies like Standard & Poor’s and Moody’s. All things being equal, as interest rates rise, the price of a bond would decline. Any changes in the risk of the bond for example, a downgrade would also negatively impact its price.

As such, with the current unresolved European debt crisis – where the PIIGS (countries Portugal, Italy, Ireland, Greece and Spain) are still facing problems with their finances, the EU continue to debate about how to strengthen their bailout funds. Earlier this week, Moody's Investors Service cut Spain's sovereign debt rating one notch to Aa2 and warned of further downgrades, estimating the capital shortfall at the country's banks at 40-50 billion euros, or as much as 110-120 billion euros under a more severe stress scenario.

The overall scenario in the U.S and UK are not much brighter when it comes to sovereign bonds. Both countries continue to run high budget deficits as a result of trying to pull their respective economies out of the doldrums post the 2008 financial crisis; the latest lackluster economic data suggest that the economies are not growing as well as expected hence putting a higher risk premium to its debt. This will only serve to reduce the longer term yield on its debt papers.

Further the prospects of higher inflation brought on by increasing commodity prices, and also effects of their QE, will likely to push inflationary expectations even higher – the result is again, generally lower yields which makes bond returns less attractive.

Stocks
World stocks fell to six-week lows on Monday over concerns about the economic consequences from Japan's devastating earthquake and tsunami and as officials grappled with a nuclear crisis. The U.S and European stocks took big hits over fears that what’s happening in Japan could derail a much anticipated
global recovery. In the meantime, emerging market stocks rallied on the expectations that they would benefit from massive reconstruction in Japan – the demand as a result, for resources such as timber, coal and others would increase significantly. What stocks would one invest in, in today’s market? What appears cheap may be even cheaper tomorrow; it was reported in CNBC that U.S investors hoping for a resurgence in the country's market and economy last month, poured over $1 billion into Japanese exchange-traded funds, second only to U.S energy funds and more than what they had invested in funds focused on agriculture, mid-cap U.S. stocks and large cap growth, according to Biriniyi Associates data. The iShares MSCI Japan which is one of the largest US listed funds focused on the country saw its price decline by a massive 7% on Monday as the repercussions from the disaster filtered through. Although the U.S markets were quite resilient in light of the disaster, it is by no means out of the woods yet. As one fund
manager puts it: “if you shut down Japan, you have a global recession” And no county including the U.S will be spared. If you have a strong gut for a rollercoaster ride, then stocks could be where you would find the most thrill for your buck.

Nikkei could plunge another 30% to 7,000 (Chartist, www.cnbc.com)

Currencies
What about currencies? The yen rose versus all of its major counterparts as Japan's PM Naoto Kan said the danger of further radiation leaks from a crippled nuclear power station is increasing, boosting speculation domestic investors will bring home overseas assets. The US dollar also benefited as a safe haven currency. However the gains in the yen were tempered on speculation Japanese policy makers will sell the currency to help exporters as local stocks tumbled. Yen advanced to 113.63 per euro while
the US dollar rose 0.4 percent to $1.3932 per euro yesterday.

However, what is the longer term outlook for the yen and US dollar? In respond to the disaster the Bank of Japan (BoJ) immediately injected 15 trillion yen ($186m) to stabilize the financial system and to avert widespread panic; this was then followed by another infusion of 5 trillion ($61m) yen to further calm jitters. Japan's need to raise huge amounts of money for reconstruction after the massive earthquake raises the prospect of higher U.S. costs to finance its own budget deficit and ultimately higher costs to American consumers on financing everything from houses and cars to credit card debt. Japan has long been a major purchaser of U.S. Treasury bonds, helping to keep demand for U.S. debt high and the cost of financing it low. Last year, it bought about $130 billion in Treasuries, much of it with funds accumulated from the nation's trade surplus. Already Japan is one of the world’s biggest debtor nations with a massive 200% debt to its GDP. As it begins the process of nation rebuilding it will certainly buy less of US Treasury and perhaps issue more yen. The impact can only mean that there will be more yen around, and its value likely to be lower in the longer term.

As for the US: Japan buying less of its debt could in turn push the country to pay higher rates on its securities to attract new buyers, eventually putting upward pressure on other U.S. interest rates — including what American consumers pay for credit. This is not likely to be welcomed as it seeks to put its economy back on a solid growth track. The US dollar is also prone to what’s happening in the Middle East presently: any escalation of troubles such as going to war in Libya or elsewhere could well see the
US dollar taking a hit.

So, it still comes back to gold and silver
In the wake of the disaster in Japan, both the precious metals saw heavy buying; gold prices shot by 1% on Monday prices to $1431/oz just off the high of $1444.40/oz hit when Libya tension flared about two weeks ago. The price of silver also rallied as investors seek out the precious metal as a possible safe haven. Although gold has retreated by $15.66 today as speculators scrambled to cover losses, the long term up trend still continues. As uncertainty over the global recovery looms larger with the massive losses in Japan, the shine of the yellow metal continues to be bright. The retracement in price represents an opportunity to accumulate more gold. It is possible for gold to test $1500/oz level as the
Japan losses gets tallied up, and the massive rebuilding starts to take place – prospects of a swift global recovery is looking slimmer by the day.

As for silver prices, it hit a 31-year high last week on short term supply tightness and increased physical demand ($36.745/oz). Now, ratio gold to silver (how many ounces of silver needed for one ounce of gold) is at 40 – its lowest since Feb 1998. This is cheap vs. its long term average of 60. Silver is likely to outperform gold in the short term as a hedge against increasing global uncertainty. Accumulate on any weakness.

Silver prices retraced from its high but up trend is still intact