Distrust with a slump...

The steady rise in the value of gold to a large extent reflects the eroding trust in the monetary authorities of the world, most notably those of the U.S. and Europe. Commodity prices have been following the same pattern until very recently. The price of oil, for example, has been surging on the back of speculation related to a potential constraint on the supply side, reflecting the ongoing conflicts in the Middle East. This speculation has also appeared on the demand side, reflecting the anticipation of more demand from emerging markets and, at a more distant future, greater demand from developed markets as their respective economies recover.

More recently, the price of oil has seen a sharp drop in value reflecting the economic turmoil that is brewing across Europe and the U.S. In the speculators mind, two things have changed on the demand side of the equation. Emerging markets, battling a surge in inflation are applying the monetary brakes more aggressively whilst the economic conundrum in Europe and the U.S. that seems to be showing signs of worsening is likely to postpone any sustainable recovery to a more distant future.

In summary, what these two indicators are telling us at this point in time is that the distrust in monetary authorities continues but that the global recovery is in peril.

Gold, the pseudo commodity...

Asset managers and investors typically classify gold as a commodity. After all it shares characteristics of commodities such as the fact that it is tangible, can be traded and is used in the production of goods.

Gold also has certain characteristics that is highly specific to it that really put it in a class of its own. The price of gold, for example, is not impacted by changes in demand and supply, unlike commodities. This is because annual demand and supply are only a fraction of the outstanding gold in circulation. This characteristic makes it curiously similar to paper money or stocks, with the big difference that gold does not produce any revenue or cash flow streams and therefore does not have an intrinsic value. The price of commodities, on the other hand, are very much impacted by current and expected demand and supply dynamics. Almost all of the supply of a commodity will be consumed in one form or another, only a small portion is stored indefinitely. In the case of food, this is pretty obvious whilst in the case of hard metals, it is converted to become part of something else in a production chain somewhere around the globe.

So what is it that influences the value of gold? There are several factors that have an impact on the price of gold. Amongst the most important is sentiment, more specifically how much confidence an investor has on monetary authorities. If confidence is being eroded, the price of gold is likely to go up as it serves as a refuge investment in the event of uncertainty in the financial system. This is also the reason why the price of gold rises when there is "money inflation", which is exactly what is happening in the U.S. today.

Gold is not only a surrogate for money, it is a powerful diversifier that softens the blow when monetary authorities get it so very wrong. This makes it a rather unique investment which is why any sound portfolio should contain some.

Paving the way for QE3?

Things are not looking good on the housing front in the U.S. The latest figures show that prices slumped yet again in March, dragging the closely watched Case-Shiller index to its lowest point since the start of the downturn (see graph above).
Sure, there is still some distance to go before the housing bubble is completely burst, but any further drop in prices will be a drag on the economy as it widens the already dire "negative" equity situation for a large number of households.
Quantitative easing is a critical tool in maintaining a floor on housing prices because of its influence on the 10 year maturity yield. A large number of market participants including mortgages, pension funds and the good old dividend discount model (DDM) use it as a benchmark to set their rates. In other words, the latest housing price figures are likely to put additional pressure on the Fed to do something post QE2 which will end very soon.

Embracing for a restructuring?

Somewhere along the line, Greece and probably Ireland and Portugal are going to have to restructure their debt. It is almost inevitable because all other options that would effectively help avoid restructuring don't seem to work. Those "options" would be:

• A sharp rise in taxes, which will probably only lead to a further paralysis of the economy, especially given the chronic level of tax evasion in a number of the peripheral countries involved.
• A devaluation of the currency which unfortunately is no longer an option for the countries of the Euro-zone given that they no longer have this tool at their disposal.
• An internal form of devaluation which is effectively a sharp and sustained cut in wages across the board. As with a hike in taxes, such a move would be so deeply unpopular that it would provoke more riots that would plunge the respective economies into further turmoil.
• A sharp cut in fiscal expenditures or the infamous austerity measures. This is yet another "dead in the water" option as it is unlikely to resolve the debt problem on its own and would also contribute to weakening the other options such as tax income further.

Given the above, it becomes clearer that the only viable option would be some form of restructuring. But then again, there are different shades of restructuring to choose from and the outcome can be materially different depending on which one is selected. At one end of the spectrum is the more painful approach of applying a "haircut" which is effectively paying back a fraction of the original value of the debt. This would force the various banks to take losses by writing off a large amount of debt in their books. At the other end is a softer technique known as "reprofiling" which is effectively to extend the maturity of the bonds and by doing so, buy precious time for the troubled governments. This option, which seems to be the one favored by the core European countries, begs the question as to how exactly buying additional time would resolve the problem. Considering that the various alternative options are likely to be ineffective, the only effect of buying time will be to postpone the inevitable to a future date.

This brief analysis clearly suggests that restructuring is the only viable option at the table. The question to be asked is what form of restructuring will be applied and when will it take place.

How to tackle spiraling debt...

There are a couple of ways that a government can tackle a mounting debt problem.
If the debt itself is reasonable, and the economic conditions are stable, the method with the least repercussions is through growth. If the economy is expanding rapidly enough, the debt of the country should be very manageable. Austerity measures or cutting spending is another solution although, once again, it assumes that the debt is reasonable to start with.
But what happens when the debt is out of proportion relative to the gross domestic product of a country? The quick and dirty way of getting out of it is to simply default. The main problem with this solution is that the consequences are bound to be extremely damaging. Think Lehman's and multiply the effect a thousand times! A softer version of this is to restructure the debt by means of applying a haircut or just simply extending the maturity. That is, for example, what the markets are anticipating for Greece.
Another method is for a country to try to inflate itself out of the debt spiral. The idea is that by stimulating the economy, prices will begin to rise high enough to depreciate the value of the outstanding debt. The real value of that debt has actually changed since the lender is getting paid less in real terms than what was lent in the first place. The major drawback with this approach is that the impact of inflation goes beyond debt and is therefore bound to be politically unpopular.
A related method is the devaluation of the currency, a tool that is unfortunately unavailable to the peripheral nations in Europe who need it most. By devaluing the currency, foreign lenders get paid less in real terms, so technically it becomes cheaper for the borrow to service the debt. This is a very attractive proposition for the U.S. where the large bulk of debt is in the hands of foreign owners. It would explain why the Fed is in no hurry to tighten rates like the rest of the world is doing. Depreciation has its drawbacks too. It could trigger inflation by boosting demand for exports and spiking the price of imports.
Although the examples show that there are several ways a country can tackle its debt problems, it doesn't mean that they have access to all these methods. Eurozone countries are a case in point: By joining the Euro they gave up the very monetary tools that would have provided them with greater flexibility. Without these tools, they can't inflate themselves out of the debt and nor can they depreciate the currency. This leaves them with two possible solutions: hard core austerity (which doesn't seem to be working) and restructuring. It looks increasingly likely that some form of restructuring will eventually have to take place.

A surge in the price of Gold...

Just as the dollar has been steadily losing value, the price of gold has surged passed $1500 to the ounce. This is once again a reflection of the dire conditions that monetary authorities around the globe find themselves in.

The U.S. is facing challenges from various fronts, starting out with a growing interest rate decoupling with the rest of the world. As central banks across the globe begin tightening rates, the federal reserve is sticking to its stimulative plans. The situation is further exacerbated by the fact that the second $600 billion quantitive easing program will end by next June and there are no plans to introduce an additional round which means that we can expect a sharper slope between the short end and the rest of the yield curve.

Last but not least, there are growing signs that China's appetite for dollars may be dwindling. This can be seen with the steady appreciation of the Yuan against the dollar, which means that Chinese authorities may be shifting its policy on exchange rates. Other countries in the region are likely to follow suit.

The U.S. monetary authorities are not the only one's experiencing trouble. The Euro is also under pressure despite the ECB's 25 basis point rise in its target rate. Serious trouble seems to be brewing in the peripheral countries, most notably Greece, where there is growing anticipation that some sort of restructuring is in the works. Most pundits would agree that this is the only viable option considering the country is stuck in a perpetual cycle of weak growth. Restructuring could include "reprofiling" its debt which is basically extending its maturity whilst keeping the rest of the conditions intact. It could also include a haircut which would hurt the banks that hold Greek paper.

Finally, we have Japan that is reeling from the disaster that ravaged a large chunk of the country. Reconstruction will take place, but this will occur over the longer term and its impact on growth wont be felt for a while to come. The disaster will also give Japanese industries an excuse to relocate their remaining factories to mainland China. Add to this a weak government and it becomes difficult to see how the country is going to pull itself out of the mess.

No wonder then that gold is surging.

A bottomless pit?

The dollar has been on a long term downward spiral ever since reaching a peak in 2001. The most recent plunge has been caused by a growing disconnect between the U.S. and the rest of the world. This disconnect is a result of the following factors:

• A surge in commodity prices and signs of overheating of the economy in emerging markets is prompting a growing chorus of central banks to tighten rates. The ECB was the latest to raise rates last week in response to a commodities fueled steady rise in headline inflation.


• The second round of quantitative easing still has a couple of months to go and there is talk of a possible third round if things dont improve.


• A U.S. government shutdown may have been narrowly averted but the upcoming confrontation on raising the debt ceiling would have far greater consequences in the event that an agreement is not reached by around May 16 in which case the government would no longer be able to honor its debt obligations.

In summary, the dollar is weakening because other currencies, especially those of "commodity rich" countries provide an attractive hedge against inflation and because the unique "dual mandate" status of the Fed effectively forces it, in the context of the current environment, to be less proactive on the inflation front. Although the Fed will eventually have to tighten rates, there will be a lag in timing relative to the 18 other countries (mainly emerging) that have already embarked on hikes.

correlations from different angles

Correlation measures are meant to provide an idea of the relationship between two variables. It answers the question as to how one variable relates to another. Do they tend to move in the same direction? Do they move in the opposite direction or are they actually unrelated to one another? Correlation figures can also be misleading because they tend to change over time. A negative correlation between say two variables could suddenly turn highly positive or vice versa. So correlations can be useful in devising a portfolio but one needs to be aware of this major caveat.

There are also other, more subtle factors that should be considered when studying correlations. Take "Cat Bonds" as an example, which are insurance linked bonds that basically pay out in the event of a specific natural disaster such as the earthquake/tsunami that recently ravaged Japan. Looking at the correlation between this particular sub asset class and the stock and general bond markets, even over long periods, one gets the impression that they are not related (see graph). In fact, their very nature should ensure that for most events there should be no positive correlation, but like for any investment, this rule can break down when "extraordinary" events occur. The Japanese quake was extraordinary in the sense that it was not only the largest experienced in Japan but also amongst the top five largest in the world for more than one hundred years. This should therefore be considered as an "outlier" event, something of extremely rare occurrence but which can provoke the sort of correlations that one is trying to avoid in the first place.

Here is an outline of the sequence of events that would help explain the sudden sharp rise in correlations between Cat bonds and the equity markets: The Japanese earthquake/tsunami devastated a large part of the north of the country, causing an estimated $25 billion in damages to be covered by insurers. This is on the back of a series of other natural disasters (albeit at a smaller scale) since the beginning of the year, which have depleting the reserves that insurance companies had set aside for such events. On the stock market front, the Japanese disaster comes on the back a number of other events that have the potential of derailing the global economic recovery. These include the ongoing European sovereign debt crisis that seem to be worsening, turmoil in the Middle East that show no signs of ebbing and commodity prices that continue to rise. In the context of such a backdrop it is no surprise that markets would respond with a correction following the damage caused to the third largest economy in the world. Still, these are extraordinary events, never before observed in such a configuration and are unlikely to repeat themselves. Nevertheless, it is important to note that no matter how rare an event may be, it still has the potential of occuring and by not accounting for it is understimating the risks involved.