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EURO RISK AND GOLD/OIL
RATIO STRATEGY Strategy Objectives: *Cover USD and EUR inflation risk Trade or Investment Period: June- November/December 2008 Analysis and Rationale 1. The Euro is not an Inflation Shield US and international investors are perhaps surprised to see how little effect the strong, in fact critically and unsustainably over-valued Euro delivers in the way of ‘shield against inflation’ in the Eurozone. Recent (May 08) statements and information from the ECB-European Central Bank, and data from Eurostat and EU27 national economic agencies all tend towards one conclusion. Inflation is high in most Eurozone countries (around 6%pa in Spain), and is extreme in some ‘peripheral’ non-Euro countries of the EU. Including the fast-growing Baltic Republics, annual CPI-Consumer Price Inflation data excluding energy and food indicates strong double-digit inflation in these ‘Euro-linked’ countries, sometimes edging into the fantastic range of more than 15%pa. In the UK, where the GB pound has plunged towards 1.15 Euro and now tracks the Euro, food and energy price inflation is at record highs. These numbers can be contrasted with ‘official inflation’ data from the ECB, which continues its claims that the base inflation rate in the Eurozone, outside food and energy, is around 3.6%pa. Even the core Eurozone economies of Germany, France and Italy are exposed to real CPI rates well above the claimed “4% maximum comfort zone”, despite a miraculous GDP growth surge for Germany at about 6% annual in Q1 2008. For Germany ‘rearview mirror’ data on the economy still looks good, but leading indicators tell a different story. Germany is now exposed to exactly the same rising ‘core inflation’, and sagging GDP growth which sap performance in the two other pillars of the Eurozone, France and Italy Nothing needs to be said about Italy’s economic woes, but in France the rose-tinted period following Sarkozy’s arrival as Bling-Bling President is now fading fast, as prices mount inexorably and GDP growth hovers at around 1.8% to 2%pa. Daily or weekly strikes, refinery blockages, and demands for cheap diesel fuel from a growing range of energy-intensive professions tell a different story, going forward. International holders of the Euro as an inflation shield relative to the USD will soon get this message. Earlybirds have begun slimming these low-performance and unsure holdings. This starts the process which erodes the USD/EUR ratio, revealing the key pivot point of 1.50 USD for one Euro. This strategy however awaits clear signals from the USA – both economic and political – to attain the tipping point and to move further forward, in accelerated fashion. From a pivot at 1.50 USD, this Summer, the fiat money Euro can easily behave like any other fiat money, dating back far into economic history. By definition a fiat money has virtually no ceiling and no floor against other and ‘real’ moneys, or certain key ‘stores of value’, in this case Oil and Gold. Due to a host of factors in the real world and real economy, the EUR is headed for the floor after flying over the ceiling-cuckoo nest. By late Summer little prevents the Euro eroding fast, perhaps to near-parity with the USD, in the region 1.15 USD/1 EUR. 2; Oil is Undervalued Compared with the above USD/EUR analysis, the argument that Oil is still under-valued may not appear convincing at first sight. In the snow of arguments and counter-arguments on whether we are at Peak Oil or not, with Peak Oil gaining converts very fast, the actual energy economics of the fossil fuels, and costs of delivered energy from fossil and non-fossil sources, get obscured or forgotten. The bottom line is simple: oil is still cheap by many criteria and yardsticks, for example relative to the food-based biofuels, wind electricity or solar PV electricity. Current oil prices only underline the fire sale price of natural gas until late 2007, coal into Q1 2008, lignite for technical and geological reasons, and electricity from almost any fossil energy source. Rather than oil falling, we are witnessing an inexorable ‘major correction’ upward for these alternate sources of Cheap Fossil Energy, providing higher platforms for oil prices to rise further. At the global economy level, despite occasional brave talk on ‘rising signs of price elasticity slowing world oil demand growth’, and occasional inventory recoveries in a general trend of low and falling stocks, global demand growth is implacable. Oil demand growth estimates from almost any agency or source, also including OPEC, can spin a different story – but they are unrealistically and dramatically low. As in 2006 and 2007, these irrational estimates will inevitably be confronted by reality; and revised up later in the year, immediately bolstering prices. Probable demand growth in calendar year 2008 is likely above 1.6 mln barrels/day. This demand growth is in fact possible from only current expansion trends in the world’s car, 2-wheeler, truck, marine, air transport and off-road transport industries, including mining and agriculture. Demand compression outside the transport sector, for example in the oil and energy intensive world construction industry is at the least episodic and erratic, due to vintage growth of activity. This makes the actual outturn for world oil demand growth a permanent ‘surprise’ for price elastic theorists and Cheap Oil hopefuls. The big bulge in annual demand comes along in June-August when the north hemisphere goes on holiday - and the Emerging Economies keep growing their industries, as well as their middle classes eager to make long vacation voyages and acquire the oil-intensive consumption habits of ‘postindustrial’ OECD countries. This year, all the signals on likely supply/demand balances through this period are red, as the OECD’s IEA increasingly admits. Prices up to 150 USD/bbl, and above that in the event of real geopolitical stress, must be included in our forecast. 3. Gold is Undervalued There are two strands to this persistent under-valuation, which is easy to compare, by its divorce from real economic fundamentals, with the Euro’s massive over-valuation and potential for sharp adjustment. Firstly we focus the the Gold/Oil ratio, and secondly the likely impact of a ‘sea change’ in FX parities, featuring a big shift in the EUR/USD relationship, favoring the USD. In both cases Gold gains. The Gold/Oil ratio (SEE CHARTS) clearly shows we currently have abnormal low ratios, well below 7.15 : 1 that is 7.15 times the barrel price in dollars for 1 Troy ounce of gold. The floor ratio is historically above or around 7, and the long-term 20-year average is above 15 meaning that current gold prices below 900 USD/oz, in an oil price environment above 125 USD/bbl for WTI are unsustainably and unrealistically low. Recovery of the USD against the Euro and Yen (and only against these two de facto reserve currencies) will, to be sure, firstly generate weakness for Gold and Oil. But this will correct in a short period as FX traders, and later Gold and Oil traders understand they confused a fast-falling Euro with a rising US dollar, when the real world-real economy witnessed only an overdue adjustment of the Euro. The amplitude of cross-rate changes driven by the Euro’s over-valuation against the USD by 20%, or more, does not hide the Euro’s over-valuation against other moneys, notably the Yuan and Ruble by as much as 35%. Nothing in theory excludes the potential for USD weakness to also continue against these key nonOECD moneys, and possibly some ‘niche currencies’ among the resource exporter countries. Gold will in fact likely gain more, and faster from this context than Oil. Mid-year oil prices can surely head for exotic all-time highs, but this will be a choppy ride. We will be witnessing FX parities adjusting and correcting in royal fashion, making gold more desirable than ever as a ‘troubled waters’ holding or secure store of value. Gold price growth from late Summer 2008 can be exceptional, attaining well beyond 1100 USD/Troy ounce. 4. The US dollar is Undervalued As many commentators say, the worst enemy of the US dollar is the G W Bush administration, with its de facto “slay the dollar” policies and spending habits. The last few months of the second and last G W Bush administration sets the stage for what comes next. This includes the sure potential of Obama taking power, and moving towards getting US troops out of Iraq. As the Stiglitz & Bilmes book shows, this massive geopolitical error was also a fantastic money drain. Bringing home the troops implies a very sharp drop in US Federal deficits and an immediate gain for the US dollar from early 2009. To be sure, nobody know what an Obama administration would do in power, but the potential for a large ‘windfall cut’ in US federal borrowing needs will be the meat of a rising chorus of commentaries, later this year, delivering added strength to the USD at the moment we witness real EUR weakness, due to its own, accumulated faults. Traditional ‘exuberant excess’ of FX traders can do the rest, making the USD overshoot up, while the EUR overshoots down. We note again that forecast USD gains are strictly against the EUR and to a certain small extent against the JPY and SFR, but are not part of a general lever-up of the US dollar’s world value, which however has a surprise ally in the shape of record oil prices.. An ignored backstop to USD weakness resides in high oil prices due to US dollar purchase needs for settlements of around 65% of world traded oil. As oil prices evolve into the stratosphere, so does world demand for the USD as still by far the dominant oil settlement currency Another key backstop is the economic growth driver for ‘surprisingly buoyant’ US domestic crude and oil products demand, despite a swath of declining indicators such as US car sales. These ignore the other 90% of the iceberg, that is existing stock, in this case the USA’s estimated 200-million-plus car fleet, plenty of which will be operated, at least for vacation travel. Real economy growth, or shallowness of the recession curve, will become clearer this Summer, as the US real economy detaches and separates from the financial subprime and CDO rout, surely with a bulge of inflation. This in turn will keep pushing oil prices up, and collaterally bolster the US dollar. As noted above, by or before end-year 2008 we can expect a USD/EUR cross rate as low as 1.15 to 1.20 USD for 1 EUR. TRADE or INVESTMENT STRATEGY The main elements feature EUR weakness, recovery of the USD against the EUR, strong Oil prices and major potential for Gold price growth, through a period of less than 7 months from start of June 2008. For EUR or GBP holders, who want to maximize their gains in these two moneys, the simplest strategy would feature a EUR/GBP denominated Gold ETF. For USD holders different strategies can be suggested. Timing and programming of the trade can be finessed, to further cur risk and deliver a better stream of value, relative to a simple buy-and-hold strategy.
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