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The Global Investor Newsletter - Fall 2014

Welcome to the Fall 2014 edition of Euro Pacific Capital's The Global Investor Newsletter. Our investment consultants are standing by to answer any questions you have.  Call (800) 727-7922 today!

What Happens When the Surf Is Down - Contemplating Stocks without QE
By: Peter Schiff, CEO and Chief Global Strategist

Ignored Markets Outpoint U.S. on Basic Valuation Projections
By: Jim Nelson, Portfolio Manager, Euro Pacific Asset Management

Abenomics Death Watch: More of the Same, Only Worse
By: Andrew Schiff, Director of Communications and Marketing

Then and Now: The Fed's U-Turn on Low Inflation
By: Peter Schiff, CEO and Chief Global Strategist

Colombia Gets Its Act Together
By: David Echeverria, Investment Consultant, Los Angeles

Buybacks are Corporate Version of Quantitative Easing
By: Andrew Schiff, Director of Communications and Marketing

The Global Investor Newsletter - Fall 2014



What Happens When the Surf Is Down - Contemplating Stocks without QE

By: Peter Schiff, CEO and Chief Global Strategist


Some influences on the stock market are casual, subtle or open to interpretation, but the catalyst behind the current stock market rally really shouldn't be controversial. As far as stocks go, we have lived by QE. The only question now is, whether we will die without it.
 
Since the financial crisis of 2008 stock prices have only risen when the Fed is either expanding its balance sheet, hinting that it will soon do so, or actively recycling assets to hold down long term interest rates. Absent any of these aggressive moves, stocks have shown a clear tendency to fall. Curiously, while most investors now believe that QE is in the past, and that the Fed will not even be hinting at a restart, few would argue that the current bull market is in danger. But a quick look at how much influence the Fed's operations have had on market performance should send a chill down Wall Street. The Chart below should speak for itself: 
 
 
Created by EPC using data from the Federal Reserve and Bloomberg
 
In August 2007, the Federal Open Market Committee's (FOMC) target for the federal funds rate was 5.25%. Sixteen months later, with the financial crisis in full swing, the FOMC had lowered the target for the federal funds rate to nearly zero, thereby entering the unfamiliar territory of having to conduct monetary policy without the ability to cut rates further. Six years later, rates are still at zero. This has left the Fed's capacity to buy assets on the open market (now known as Quantitative Easing - QE) as their principle policy tool.
 
In order to stop the markets from crashing further in the Fall of 2008, the Fed announced a plan to purchase $600 billion in mortgage-backed securities (MBS) and agency debt. When first announced, the plan faced some political resistance even though most thought it would be a one shot deal. But when the opening salvo wasn't enough to push stocks back up, on March 18, 2009, the Fed announced a major expansion of the program with additional purchases of $750 billion of agency MBS and $300 billion in Treasuries. That got the market's attention.
 
Between March 6, 2009, when the S&P put in its low watermark, and March 2010, when this program (which would become known as QE1) came to an end, the Fed had expanded its balance sheet by $1.43trillion, or 247%. Over that time, the S&P 500 put in a rally of 71%, rising from a low of 683 to 1169 at the end of March 2010.
 
But when the dust settled, bad things started happening. From April to November 2010, QE was on hiatus, and the Fed's balance sheet expanded by just 1.5%. In this environment, stocks fared quite poorly. From the end of QE1 to August 2010, stocks declined by about 11%, the first correction since the market began rallying in 2009. As the markets panicked, the Fed came to the rescue. On August 27 2010, at an eagerly anticipated speech at the Fed's annual Jackson Hole Wyoming retreat, Fed Chairman Ben Bernanke strongly hinted that he was ready to launch another round of QE.
 
As it turns out, just a little tease was enough. The markets immediately started rallying, notching an approximate 18% gain in the final five months of 2010. The formal launch of QE2 occurred on November 3, 2010 when the Fed laid out a plan to purchase another $600 billion of mostly long-dated Treasury bonds. Like the first QE program, it was born with an expiration date (June 2011). By the time the program ran its course, the Fed' balance sheet had swelled by 29.4% to $2.64 trillion, and the S&P 500 had rallied about 25% from its August 2010 lows. Fairly neat correlation.
 
But then the entire movie started again. When QE2 became a thing of the past in July 2011, markets turned south. With no QE wind at the back of Wall Street's sails, and no hints that it would return soon, the S&P 500 put in a wicked 16% sell-off between July and August 19. A decent September rally soon petered out and by the end of September stocks were once again approaching their August lows.
 
Cut to Ben Bernanke charging on his cavalry horse, bugle firmly in hand. However, the Fed had become wary of falling into a predictable pattern of launching a fresh round of QE every time the market stumbled. So, on September 21, 2011, he announced the implementation of "Operation Twist," which authorized the Fed to purchase $400 billion of Treasury bonds with maturities from 6 to 30 years and to sell bonds with maturities less than 3 years, thereby extending the average maturity of the Fed's portfolio. By buying "on the long end of the curve" the plan hoped to push down long-term interest rates, thereby more directly stimulating mortgage origination and consumer and business lending. It was hoped that Twist would offer the benefits of QE without actually expanding the Fed's balance sheet. A rose by another name could perhaps smell as sweet. And like the earlier QE plans, Twist was announced as a finite program with an expiration date.
 
Once again the markets responded, rallying about 25% from the end of September 2011 to the end of April 2012. But when Operation Twist stopped twisting, another sell-off predictably ensued. From April 27, 2012 to June 1, 2012, the S&P dropped 9%. So on June 20, 2012 the Fed extended Twist to the end of 2012, which would include an additional $267 billion of short term/long term debt swaps. From the time of the Twist extension announcement to September 14, 2012, the S&P 500 gained back more than the 10% it had lost. But towards the end of September the rally slowed and another fall threatened.
 
At this point I believe the Fed finally understood: No stimulus, no rally. And given that the surging stock market was a key element in creating the wealth effects that the Fed believed was essential to economic growth, they instituted a policy that would ensure market gains on an ongoing basis.
 
On September 13, 2012, the Fed announced a third round of QE which provided for an open-ended commitment to purchase $40 billion agency mortgage-backed securities per month. This unlimited QE eliminated the need for embarrassing re-launches every time the markets or the economy stalled. But the $40 billion monthly rate was apparently not enough to move stocks. From the time of the announcement to the end of 2012, the S&P declined about 2.3%. So then on December 12, 2012 the Fed voted to more than double the size of QE3 by authorizing monthly purchase of up to $45 billion of longer-term Treasury debt, on top of the mortgage debt they were already buying. The rest is history.
 
The past 18 months has seen lackluster economic performance, a deteriorating geo-political landscape, and, somewhat incongruously, a nearly relentless stock market rally. From the time QE3 was announced, until the program was officially wound down this month, the S&P 500 surged 36%. But the rally was expensive. During that time the Fed's balance sheet of securities held outright, expanded by an astounding 63% to $4.2 trillion.
 
On December 18, 2013 the Fed announced the "Taper," a regular reduction of QE3 at a rate of $10 billion every six weeks. On October 29, 2014, the Fed made good on its initial timeline and officially wound down the program.
 
Although the rally in stocks continued during the taper of 2014 the rate of increase slowed along with the rate of balance sheet expansion. Full throttled $85 billion per month QE persisted from September 2012 to December 2013. During that time, stocks rallied about 26%, and the Fed's balance sheet grew by 45% to $3.7 trillion. Since the taper began, however, the Fed's balance sheet has grown just 12% (through October 22, 2014), with the S&P 500 virtually matching that with a 12% increase. As the chart above clearly demonstrates, stocks have hidden the rising wave of Fed assets like a world class surfer on Hawaii's North Shore. The big question now should be what happens now that the age of QE is apparently over, and the surf is no longer up?
 
The day after the Fed announced the end of QE 3, Paul Richards, the head of FX for UBS said on CNBC that he is "so bullish on stocks that it hurts." One wonders if he had ever seen a chart like the one produced for this article. But Mr. Richards is not far off from the vast majority of U.S. stock analysts who see clear sailing ahead.
 
To reach that conclusion, one must completely ignore not only the role QE played in driving up stock prices, but discount any negative effects that a reduction of the Fed's balance sheet could create. Most economists recognize that to normalize policy the Fed must reduce the amount of securities it holds. This will be an environment that we have never encountered. Logical analysis should lead you to believe that stocks would not fare well. But logic is not welcome on Wall Street.
 
The bottom line is that stocks should be expected to fall without QE. But this does not mean I predict a crash in stocks. I simply expect, as no one else seems to, that the Fed will go back to the well as soon as the markets scream loud enough for support. At that point, it should become clear to everyone that there is no exit from the era of QE and that there is nothing normal or organic about the current rally. At that point, the asset classes that have been ignored and ridiculed should have their day in the sun.

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Ignored Markets Outpoint U.S. on Basic Valuation Projections

By: Jim Nelson, Portfolio Manager, Euro Pacific Asset Management


A few minutes reading the financial news or flipping through the financial news stations is all that is needed to perceive the nearly universal certainty that the United States is now the most promising market to invest. The arguments are relatively straightforward:
 
1.The U.S. economy has recovered from the Great Recession and stands on the threshold of much greater growth while Europe, Asia, and the emerging markets are poised to fall back into recession.
 
2.The U.S. dollar will rise due to the tightening campaign that the Fed stands ready to launch while Europe is about to follow Japan into an open-ended campaign of quantitative easing.
 
3.The U.S. corporate sector has world-leading fundamentals, and market technicals are strong, suggesting a continuation of the bull-run that began in 2009.
 
We believe that all these premises are false, and we find far more compelling reasons to suggest that the U.S. markets do not stack up well against many foreign markets.
 
While we often base our market projections on important macro-economic issues, we decided to conduct an analysis based on what we believe are three basic drivers of expected market performance: Price to earnings ratios, dividend yield, and expected earnings growth. Ultimately, people buy stocks for financial, rather than political or philosophical reasons. When buying a car, you look at the engine and kick the tires. When buying a stock, professional investors try to make a rational determination as to what the long-term return from a particular stock may be. We feel these three drivers are key in making those decisions.
 
In the chart below, we compared the above criteria to calculate hypothetical five-year returns for eight of the major global investment markets. The projections below are hypothetical in nature and do not represent trading in actual investment accounts, are not guarantees of future results, and are intended for illustrative purposes only. This illustration is not indicative of the performance of any investment product or strategy. Please review the full disclosure regarding hypothetical performance at the conclusion of this article.
 
Hypothetical Illustration of 8 Major Global Investment Markets:

 

Source: EPAM, November 2014**

Here are the mathematical principles we used to create the above chart:
 
Price/earnings Component - The ratio between a company's earnings and its share price has always been one of the most determinative pieces of information. When ratios are high, stocks are said to be "expensive," when they are low, they are said to be "cheap." Oftentimes stocks trade at high valuations for extended periods, before selling off to lower valuations. However, most analysts expect that over time they will "revert to the mean" or the median price to earnings ratio. Over the seven-year period from 2006-2013 the MSCI USA Index traded, on average, at 14.9x earnings (Bloomberg, November 2014). However, thus far in 2014 the number has averaged 17.7x earnings. In order to revert to this "mean" over five years, U.S. stocks would have to decline 3.3% per year. As a result, the U.S. receives a P/E component of -3.3%.
 
Dividend Component - Dividends are fairly straightforward; they are the percentage of an investment returned per year to investors. However, averaged over the last seven years, U.S. stocks have only yielded 2.1% in dividends, which are some of the lowest yields anywhere around the world (only narrowly outpointing Japan at 2.0%) (Bloomberg, November 2014). In contrast, stocks in Norway and Australia have yielded more than 4% over that time (Bloomberg, November 2014). To get our five-year projection, we simply extended current yields forward.
 
Growth Component - One of the best features offered by stocks is that they can respond dynamically to market conditions, and grow with the overall economy. Generally speaking with stocks, analysts like to talk about expected earnings per share (EPS) growth as a benchmark. But given that corporate earnings have been distorted by low interest rates and the wave of share buybacks, some analysts assume that overall GDP may be a more reliable growth indicator than EPS. Over the past seven years the U.S. has seen average nominal GDP growth (not stripping out inflation) of 3.1% (Bloomberg, November 2014). We project that ahead for five years. This of course assumes that the U.S. fails to fall into recession as Fed stimulus is removed as most people assume it will be.
 
To arrive then at our projected five-year annual returns, we simply add these three numbers together. For example, the U.S: -3.3% (P/E) + 2.1% (dividend) + 3.1% (growth) = 1.9%. This hypothetical data leads us to question whether the US will remain the investment Juggernaut that many assume it will be.
 
Despite the strong performance of the US equity markets relative to the rest of the world over the past couple years, we continue to find pockets of strength in emerging markets. For example, India, the Philippines, Indonesia, Vietnam and Thailand all have stronger returns than the S&P 500 year-to-date.* While we feel the period of US outperformance may likely continue for some time longer, we believe remaining disciplined and diversified may reap benefits for those with a longer term view.      
 
With US stock market valuations near all-time highs, we believe now may be an opportune time for US investors to potentially add to their foreign markets allocations. While we believe the US is overvalued, investors must be selective in foreign markets as well. Euro Pacific offers a number of managed account and mutual fund strategies that invest in the countries that we believe exhibit solid fundamentals, and potential for long-term returns. Call 800-727-7922  to speak with an investment advisor about how EPC might help you navigate foreign markets.
 
*Sensex Index up 34% - India
PSEI Index up 25% - Phillipines
Jakarta Comp Index up 20% - Indonesia
SET Thai Index up 25% - Vietnam
Ho Chi Minh Index up 24% - Thailand
S&P 500 Up only 12% - USA
[Source: Bloomberg 11/11/2014]
 
**The hypothetical chart does not consider the selection of individual securities. The results do not constitute an actual offer to buy, sell or recommend a particular investment or product. All investments are inherently risky. The asset classes and return rates used in the plan are broad in nature. The illustration is not indicative of the future performance of actual investments, which will fluctuate over time and may lose value. Investing in foreign securities involves risks, such as currency fluctuation, political risk, economic changes, and market risks. Precious metals and commodities in general are volatile, speculative, and high-risk investments. As with all investments, an investor should carefully consider his investment objectives and risk tolerance as well as any fees and/or expenses associated with such an investment before investing. International investing may not be suitable for all investors. Dividend yields change as stock prices change, and companies may change or cancel dividend payments in the future. The fluctuation of foreign currency exchange rates will impact your investment returns. No representation or warranty is made that any returns indicated will be achieved. Certain assumptions may have been made in this analysis which have resulted in any returns detailed herein. Changes to the assumptions may have a material impact on any returns detailed. Potential investors should be aware that certain legal, accounting and tax restrictions, and other transaction costs and changes to the assumptions set forth herein may significantly affect the economic consequences of the transactions discussed herein. Past performance does not guarantee future returns, investments may increase or decrease in value and you may lose money.
 
This presentation has been prepared for the intended recipient only as examples of strategies consistent with our recommendations; it is not an offer to buy or sell or a solicitation of an offer to buy or sell any security or instrument or to participate in any particular investing strategy. Dividend yields change as stock prices change. All securities involve varying amounts of risk, and their values will fluctuate, and the fluctuation of foreign currency exchange rates will also impact your investment returns. Past performance is not indicative of future results, investments may increase or decrease in value and you may lose money. International investing may not be suitable for all investors. The U.S. Dollar is the currency used to express performance. Performance is also net of transaction and custodial charges, and includes dividends. Euro Pacific Capital charges a fee based on assets under management. Transaction costs and custodial fees vary and are charged directly to the client by the custodian. Please call for more information or to receive a copy of the firm's full disclosure brochure (ADV 2) and Wrap Brochure.

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Abenomics Death Watch: More of the Same, Only Worse

By: Andrew Schiff, Director of Communications and Marketing


Regular readers of the Global Investor know that we have been watching developments in Japan with keen interest. That's because the full-throttled inflationary policies instituted nearly two years ago by Prime Minster Shinzo Abe, collectively branded as "Abenomics," have turned Japan into a nation-sized petri dish of Keynesian principles. For his efforts, the floppy-haired career politician has received unabashedly enthusiastic praise from economists the world over. He has been lauded as the rare national leader with the courage to trust the wisdom of the economic "scientists" and to do whatever is necessary to slay the dragon of global deflation. As a result, the success or failure of his program should go a long way in settling the debate as to whether unbridled stimulus can lead the world out of our current morass.

But, as we have stated it would, the Abe experiment is looking like the worst Japanese idea since Pearl Harbor (some believe that karaoke claims that title, but the Global Investor forcefully rejects this view). In many ways the economic crisis in Japan has gotten far worse since Abe and Haruhiko Kuroda (Abe's choice to head the Bank of Japan) began their radical surgery. Things have gotten to the point that Abe's ruling coalition is facing a significant political crisis as junior members have threatened to withdraw their support unless the economy sees improvement. So what's gone wrong?

From the start, the primary goal of Abenomics was to weaken the yen and create inflation. On that front the plan has been an unabashed success. The yen has fallen 23% against the dollar since Abe took office in December 2012. And core inflation, which was running slightly negative in 2012before Abe took office, has now been "successfully" pushed up to 3.1% according to the Statistics Bureau of Japan. So far, so good. But more accurately that would be "so far, so bad."

But there is no great mystery or difficulty in creating inflation or cheapening currency. Craven, incompetent, and corrupt governments have been doing that since there have been governments. All that is needed is the ability to debase coined currency, print paper money or, as is the case of our modern age, create credit electronically. In addition to the simple logistics, there is also the favorable politics. Lots of constituencies are in favor of receiving newly created money. The financial industry, exporters, recipients of government aid, all rejoice. Those whose savings are robbed of purchasing power make up a much less organized political force. As a result, creating inflation is the monetary equivalent of falling off a log. Creating a strong currency, on the other hand, requires a competitive economy, sustainable fiscal balances, hawkish central banking, a reliable court system, and political stability. These attributes are much more elusive on the global stage.

So the "successes" Abe and Kuroda have achieved on the inflation and currency fronts should not come as a great surprise. This is particularly true when considering the relative size of the QE program that they have unleashed. The Bank of Japan (BoJ) has purchased about 7 trillion yen per month of Japanese government bonds, which is the equivalent of about $65 billion U.S. [Forbes 9/24/14, Charles Sizemore] While this is smaller than the $85 billion per month that the Federal Reserve purchased during the 12-month peak of our QE program, it is much larger in relative terms.

The U.S. has roughly 2.5 times more people than Japan. Based on this multiplier, the Japanese QE program equates to $162.5 billion, or 91% larger than the Fed's program at its height. But, according to IMF estimates, the U.S. GDP is 3.3 times larger than Japan. Based on that multiplier, Japanese QE equates to $214.5 billion per month, or 152% larger. And unlike the Federal Reserve, the Bank of Japan hasn't even paid any lip service to the idea that its QE program will be scaled back any time soon, let alone wound down.

In fact, Abe's promises to do more were spectacularly realized in a surprise move on October 31 when the BoJ, claiming "a critical moment" in its fight against deflation, announced a major expansion of its stimulus campaign. (The fact that official inflation is currently north of 3% - a multi-year high, seems to not matter at all. In order to stay on message, Japanese authorities have had to switch their focus to a new inflation gauge that strips out price rises which they believe are caused by the recent sales tax increases. Somehow this opaque process gets inflation below 1%). The announcement involved a roughly 15% increase in the annual amount of government bonds they are prepared to buy, and an effort to extend maturities on those bonds from an average of seven years to an average of ten years (thereby pushing down long term interest rates).

More interestingly, the BoJ also announced its intention to roughly triple its pace of its equity and property purchases on Japan's stock market. According to Nikkei's Asian Review (9/23/14), the BoJ now holds an estimated 7 trillion yen portfolio of Japanese stock and real estate ETFs. In August, the bank bought a record 123.6 billion yen (about $1.1 billion of the securities). A separate announcement from Japan's mammoth pension fund that it will increase its equity purchases sent the Nikkei soaring 5%. Even Janet Yellen has yet to cross that Rubicon.

And what has this financial shock and awe actually achieved, other than 3% inflation, a weaker yen, a stock market rally, and continued international praise for Abe? Well, unfortunately nothing but more economic misery and a growing threat of stagflation.  

The weaker yen was supposed to help Japan's trade balance by boosting exports. That didn't happen. In September, the country reported a trade deficit of 958 billion yen ($9 billion), the 27th consecutive month of trade deficits. (This from a country that ran consistent trade surpluses for generations). The deterioration occurred despite the fact that import prices rose steeply, which should have reduced imports and boosted exports. And while some large Japanese exporters credited the weak yen for easier sales overseas, small and mid-sized Japanese businesses that sell primarily to domestic consumers and businesses have had a much harder time as they struggle with rising fuel and material costs.  

But price inflation is not pushing up wages as the Keynesians would have expected. In August, Japan reported real wages (adjusted for inflation) fell 2.6% from the year earlier, the 14th straight monthly decline. This simply means that Japanese consumers can buy far less than what they could have before Abenomics. This is not a recipe for happy citizens.  

Japanese consumers must also deal with Abe's highly unpopular increase of the national consumption tax from 5% to 8% (with a planned increase to 10% next year). On top of the higher prices and falling real wages, the tax increase deals a triple whammy to consumer spending. This may help explain why MacDonald's reported its first annual loss in Japan in 11 years. (The sales tax was largely put in place to keep the government's debt from spiraling out of control as a result of all the fiscal stimulus baked into Abenomics. How about that for circular logic?)  

As you may imagine, this all adds up to a rapidly deteriorating political situation for Abe and his supporters. Even the surprise October BoJ policy announcement was reached after a split 5-4 vote of its board members, a rare show of disunity. But while no one is happy, few can propose any solutions that don't simply involve more of the same. Keiichi Ishii, the policy chief of the Komeito party, which may leave the Abe coalition, has called for more spending from the government to soften the blow of the tax increases. But the country already has a staggering public debt load of 227% of GDP, according to statistics from the Ministry of Finance Japan, the highest in the developed world. Add in Japan's shrinking and aging population, and you get a cul-de-sac of possibly epic proportions. 

Despite these bleak prospects, Abe continues to bask in the love of western economists. In an October 6 interview with the The Daily Princetonian, Paul Krugman, who has emerged as Abe's chief champion and apologist, responded to a question about the European economic crisis by saying "They [Europe] need something like Abenomics only Abenomics, I think, is falling short, so they need something really aggressive in Europe". A headline from an October 20th Reuters Breaking Views column downplayed growing concern about Japan with: "Abenomics Hits Speed Bump, Not Road Block."  If so, it is the kind of speed bump that wrecks a car's axle and sends it flying off the roadway.

One wonders how much more bad news must come out of the Japanese experiment in mega-stimulus before the Keynesians reassess their assumptions? Oh wait...I'm sorry, for a second there I thought they were susceptible to logic.

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Then and Now: The Fed's U-Turn on Low Inflation

By: Peter Schiff, CEO and Chief Global Strategist


Based on recent coverage of the Federal Reserve's efforts to resuscitate our faltering economy, one would have assumed that one of its central missions has always been to guard the country from the lurking threat of deflation, a specter that is now spreading more fear on Wall Street than Ebola. The headlines are now a daily occurrence: Official inflation figures have now remained below the Fed's 2% target for almost 2 years and analysts assure us that if this is not corrected soon, or if inflation falls even lower, the country will surely fall into a stagnant morass from which it may never escape. But it may surprise many that this view is strictly a 21st Century development. The fear (some would say paranoia) regarding sub-2% inflation was nowhere in evidence during prior periods, even when inflation was lower than it is today. 

The average headline inflation index (which includes food and energy) in the U.S. has increased about 1.5% since 2013 (this is tabulated based on the many changes in the CPI over the past 20 years that have tended to produce lower inflation statistics). In the 70 years or so since the end of the Second World War, there was only one other period in which the Fed had to deal with persistent sub-2% inflation in the broad CPI, the 7-year period between 1959 and 1965 when headline inflation averaged a skimpy 1.26%. This period of low inflation is far lower, and lasted longer, than our current episode. (The first four years of the period were even lower, averaging just 1.17% between 1959 and 1962). With inflation that far below 2%, modern economists would surely have assumed that the Fed would have sounded the alarm about disinflation and broken out the big guns to push it back up, and probably over (given how long it was under) 2%. In fact, the opposite was true.

In 1961, when inflation came in at just 1.07%, the Federal Reserve, under William McChesney Martin (who was hardly considered hawkish at the time), began a campaign of consistent rate hikes that lasted five full years, raising rates from an average of 1.96% in 1961 to 5.1% for all of 1966. He had continued the hikes even though inflation hadn't even moved above 1.5% until 1965! The biggest increase in the cycle between 1961 and 1965 came in 1962 when the Fed jacked rates by 75 basis points (during a year when inflation was below 1.2%). Incredibly, Martin and the Fed had decided to pursue such a "callous" policy at a time when unemployment (which averaged 6.15% in 1961 and 1962) was 36% higher than it had been during the prior 10 years (averaging 4.5% between 1951 and 1960). He continued tightening even though unemployment didn't fall below 5% until 1965. To use a 21st Century response, modern economists would say, "What's up with that?"

Looking back at the data, one can only imagine what Ben Bernanke or Janet Yellen would have done in 1962.  During the two-year period of 1961 and 1962, the unemployment rate average was about what it is today, but the Fed Funds rate was about 120 basis points above the persistently low inflation rate (today it is more than 140 basis points below the rate of inflation). Could anyone doubt that based on the policies over the past decade that Bernanke or Yellen would have immediately dropped rates to zero and unleashed quantitative easing? To use another modern rejoinder, it would have been a "no brainer."

But McChesney Martin (who somehow avoided a Scrooge McDuck reputation despite his apparent tightness) went in the exact opposite direction. The Paul Krugmans of the world would have predicted that raising rates in the face of persistent disinflation and high unemployment would have driven the economy into recession. But guess what? That's exactly what didn't happen.

1962 GDP came in at 6.1% over the full year, more than 3 full percentage points above the 1961 rate. And real GDP growth in the five-year period from 1962 to 1966 (when the Fed raised rates every year) averaged 5.9% (and never fell below a yearly increase of 4.4%), which is perhaps one of the best streaks in modern memory. In 1965 and 1966, Fed Funds averaged 230 basis points above the rate of inflation, and still real GDP came in at an average of 6.5%. The difference between the economy then and now could not be any more dramatic. These are not just numbers from another era, they are numbers from another planet. What explains the difference?

Back in the 20th Century the Fed did not consider inflation below 2% to be a problem, because it wasn't. The truth is that when it comes to inflation, the lower the better, no matter how low that rate is. Back in the early 60s the Fed was worried that if it did not act preemptively to contain inflation, that it would accelerate, maybe even rise above 2%, which would be a real threat to economic growth. That was because at the time the economy was strong, the stock market was booming. Today most economists believe the economy is also strong, and the stock market gains over the last five years have been far larger than those that concerned McCheney Martin back in the early 60s. But he wanted to take the punch bowl away before the party got too rowdy. Yellen seems never to want anyone to sober up.

So if low inflation was not a problem for the economy in the early 1960s, why does it represent such an existential threat today? The answer is that it doesn't. Low inflation, or even deflation, is not a threat to the economy, but to the asset bubbles that the Fed has inflated in order to create the illusion of economic health and to allow the government to sustain its massive liabilities. Without the Fed creating inflation, the bubbles burst and the government will be forced to deal with its insolvency.

Given that Wall Street economists have a vested interest in downplaying concerns about asset bubbles, it is understandable that the big financial firms have failed to point out the Fed's historic response to low inflation. It is somewhat more troubling to see how the media has completely ignored the past in passing judgment on how the Fed should act today.

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Colombia Gets Its Act Together

By: David Echeverria, Investment Consultant, Los Angeles


Although communism never fully gained traction in Latin America (with the exception of Cuba) like it had in 20th Century Europe and Asia, socialist ideas continue to be extremely influential throughout the region. Just this month in Brazil, Dilma Rousseff of the leftist Workers' Party (PT) won a second term as president, turning back the challenge of pro-business candidate Aecio Neves. Rousseff's victory came despite a disastrous first term which saw economic stagnation and rampant inflation. The Workers' Party has held power for 12 consecutive years and will now have another four to promote its socialist agenda. Meanwhile, the Brazilian stock market, which had been rallying throughout the year, was down a staggering 5% following the election results[i].

Unfortunately, the turn towards socialism in Brazil is part of a larger trend in the region. Ecuador, Argentina, Venezuela, Bolivia, and Nicaragua have all elected socialist leaders in recent years. In spite of historically high oil prices, Venezuela, which also boasts the world's largest oil reserves, is expected to contract at an annualized rate of 2-3%, while inflation soars at an astounding 63% (although some believe it's actually twice that high)[ii].

In spite of the recent wave of socialist advances, there have been a few bright spots in Latin America, most notably in Colombia. A nation once known primarily for its illicit exports, Colombia has been in the midst of what some have termed an economic miracle[iii]. Under the stewardship of President Juan Manuel Santos, the government has worked hard to both secure political stability and promote an agenda of economic freedom. The results should be sending a clear beacon to Latin America and the rest of the world, especially when considered against the leftist failings of neighboring Venezuela. But sadly they aren't.
 
Beginning in the 2000s, Colombia's military forces began a renewed effort to finish a five-decade long conflict with FARC (Revolutionary Armed Forces of Colombia), a paramilitary group funded largely by drug trafficking. This effort involved an aggressive campaign to cut FARC off from its coca fields, and to use spies to undermine FARC's leadership structure from the inside out. The mission was a resounding success and in early 2012, President Santos was able to bring leaders of the FARC to the negotiating table in Havana, Cuba. But unlike previous attempts at peace, Santos has refused to declare a ceasefire with negotiations underway. But the strategy appears to be working. Two years into the talks, experts say that a final settlement is within reach.
 
The much improved security situation and the prospect of a lasting peace are unlocking Colombia's economic potential. This year, the country's economy is projected to grow at nearly five percent, the fastest in Latin America. The country's finance minister, Mauricio Cardenas, believes that a successful conclusion to the Havana talks would yield an additional hundred basis points to GDP[iv] over 4 years. During the conflict, FARC has been responsible for various attacks on the country's infrastructure, and had diverted farmland towards the production of cocaine. With the FARC in the rear view mirror, Colombia could experience a dramatic rise in both legal agricultural and energy output.
 
On other fronts, the Santos administration has implemented a number of domestic economic reforms to boost growth. Egregious payroll taxes have been reduced, resulting in formal-sector job growth of eight percent while simultaneously reducing black market job growth[v]. That means more money for the government via tax revenue, which is already being slated for infrastructure projects, in particular on roads and railways needed to transport the country's abundant natural resources. Mr. Cardenas believes that upgrading the country's infrastructure could boost the GDP growth rate by seventy basis points inside of four years[vi]. The country has also seen an increase in foreign investment.
 
Thus far in 2014, according to statistics from the Heritage Foundation Index of Economic Freedom, foreign direct investment was measured at $15.8 billion, an improvement that was no doubt influenced by the improved security situation. But equally important are the smart, pro-business fiscal, regulatory, and monetary policies. The top corporate tax rate was reduced to 25% and government spending held to 29% of GDP. As a result, the public federal debt remains at only 33% of GDP and inflation kept to prior year lows of, between 2-4%.
 
More importantly, regulations on businesses have been reduced dramatically. There are now fewer than 10 procedural hoops to jump through when starting a business and no minimum start-up capital required. Colombia now ranks 34th in the world, above Belgium and 3rd in the Central / South American region. Its 2014 score is the highest ever achieved since the Index was created 20 years ago.
 
In 2012, Colombia signed a Free Trade Agreement with the United States along with a dozen other important trading partners. These agreements should increase the long-term global competitiveness of the country's largest industries and further attract foreign investment, creating thousands of new jobs.
 
Colombia's strong democratic tradition and leadership, diverse natural resources, and improved security profile should propel the country to be among the fastest growing countries over the next decade. However, the positive outlook has yet to be manifested in Colombian stock prices. The broadest measure of the Colombian market is still down nearly 16% since January 1, 2011. For investors who can see beyond the stereotypes, Colombia may be one country to watch in Latin America.
 

 
[i] http://www.bbc.com/news/world-latin-america-29782073
[ii] http://online.wsj.com/articles/venezuelas-currency-hits-new-low-1412031953
[iii] http://www.spcorrespondents.com/sp-pulses/french-newspaper-calls-colombia-an-economic-miracle
[iv] http://www.economist.com/news/finance-and-economics/21610305-colombia-overtakes-peru-become-regions-fastest-growing-big-economy-passing
[v] http://www.economist.com/news/finance-and-economics/21610305-colombia-overtakes-peru-become-regions-fastest-growing-big-economy-passing
[vi] http://www.economist.com/news/finance-and-economics/21610305-colombia-overtakes-peru-become-regions-fastest-growing-big-economy-passing

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Buybacks are Corporate Version of Quantitative Easing

By: Andrew Schiff, Director of Communications and Marketing


Most people now recognize that the Fed's quantitative easing policies have goosed economic performance over the last few years. Some wiser people even recognize that these moves have created the possibility for a nasty hangover in the years ahead when the policy is finally wound down. But few have noticed how a parallel policy has been pursued on a slightly smaller level in the corporate sector in the form of a massive share buyback campaign. In both cases the dynamic is the same: We bring forward future growth to the present, and set ourselves up for pain down the road.

Bloomberg recently reported, on October 6, that S&P 500 companies will spend $565 billion on share buybacks in 2014. This is a big number, but by itself means very little. In order to be given context, it must be compared with total corporate profits. Based on estimates by Standard & Poor's analyst Howard Silverblatt, profits for the S&P 500 are expected to reach $964 billion in 2014. If that is the case, this means those companies will spend nearly 59% of all profits on corporate share buy backs (the vast majority of remaining profits to go towards dividend payments). While these purchases certainly have provided much of the momentum that has pushed up share prices this year, the size and significance of the buyback program has eluded most of the market cheerleaders who set the tone on Wall Street. Right below the surface the picture can get very ugly, very fast.

With its QE program, the Fed buys Treasury or Mortgage-backed bonds, thereby pushing down interest rates and providing liquidity to the financial markets. This not only encourages the creation of credit throughout the corporate world, but it creates the illusion of a strong economy. But the downside of these benefits is a swelling balance sheet of assets that has accumulated on the Fed's balance sheet. Since the QE program began in 2008, the Fed's inventory of these bonds has expanded from just $500 billion to more than $4 trillion. But these bonds are not a benign presence as most analysts would have us believe. They are like bowling balls stored on high shelves; temporarily quiet but full of potential energy that could exert extreme downward force. Eventually the Fed will need to "normalize policy", which means it must shrink the size of its balance sheet by either actively selling bonds or allowing them to mature without replacing them with new bond purchases. But these moves can inflict damage to the economy by withdrawing liquidity, pushing up interest rates. It will simply be impossible for the Fed to make a meaningful drawdown of its holdings without causing rates to rise substantially. After all, for years the Fed has been the biggest buyer of these assets. If it were to sell even a small portion of its inventory, or even just stop buying, the prices of the bonds would fall, which would push up rates across the economy. As interest rates rise, the value of the low-yielding bonds sold by the Fed would fall further, exposing the bank, and ultimately taxpayers, to losses. Higher rates also slow down economic growth.

On the corporate level, share buybacks function in much the same way. Rather than using its cash for more productive investments, corporations buy their own shares on the open market. This creates demand for those shares and pushes up share prices. Once purchased, the shares are taken off the market, held as "treasury shares," existing in a sort of financial limbo. With these shares off the market, the earnings and dividends per share go up. This creates the illusion of revenue growth, which makes investors very happy and often qualifies corporate management for bigger bonuses.

But this immediate gratification can come at the expense of long-term growth. The money used for buybacks is not available to fund future projects, hire workers, or acquire other businesses. In addition, the growing balance sheet of treasury shares could become a danger to future share prices. In a rising rate environment, the option to sell these shares back into the market to raise cash becomes an attractive one. This, of course, would push down share prices and dilute earnings per share. Given today's record high share prices, future share issuance could set up corporations for losses if they sell for less than they have bought. In other words, today's profits may be tomorrow's losses.

Iconic American corporation IBM is emerging as the poster child for the perils of the habitual buyback. Rather than making profits selling mainframe computers (the company has seen 10 straight quarters of negative revenue growth), IBM is now more known for issuing debt to buy back shares. According to David Stockman's Contra Corner article of October 6, The Canary in Big Blue's Mainframe, the buying has removed roughly one third (half a billion) of IBM shares from the marketplace since 2006. Over that time, the company has reported net income of $107 billion, but bought back $111 billion in shares (and paid $23 billion in dividends). Despite the questionable financial engineering, investors have pushed up IBM's share price almost twofold since 2008.

But recently the wheels have started coming off IBM's buyback program. After repurchasing an average of $6 billion in shares during each of the prior three quarters, activity dropped to just $1.7 billion in Q3. Apparently it could no longer maintain the blistering pace. But IBM's consumption of its seed corn is now starting to bite. Also according to Stockman's calculations, over the period that IBM was spending $134 billion on buybacks and dividends, it only spent $33 billion on CapEx (capital expenditure). This lack of investment may have something to do with its competitive troubles in the marketplace. Recently the company announced a $4.7 billion write down in its microchip business and a large 12% miss in Q3 earnings.

It's now becoming clear to a greater number of investors that Big Blue is really just a shell of its former self, a once mighty behemoth that has been coasting on its size, reputation, and a large dose of financial engineering. The same can be said for the United States as a whole. By borrowing to buy assets, QE has helped inflate bubbles in stocks, bonds and real estate.

Much like the way IBM's buybacks have benefited current shareholders by sacrificing the prospects of future shareholders, the Fed's actions have benefited today's owners of financial and real estate assets by sacrificing the future health of the nation. The low rates encourage companies to issue debt. Money is made not by organic growth and investment but through financial engineering. The lower interest rates have pushed up prices on Wall Street but have starved savers of yield and discouraged businesses from investing in plant, equipment and hiring. This is why the rich have gotten richer under the Bernanke/Yellen economy while the middle and lower classes have been stuck or spiraling downward. The real pain won't start until the Fed could be forced to rapidly pare down its balance sheet in the face of growing inflation. That's when the chickens will really come home to roost.   

The dots are easy to connect for any who care to notice. But until IBM started to post big misses on earnings, no one seemed to care about its use of smoke and mirrors. The same will likely be true for the nation as a whole.

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Investing in foreign securities involves additional risks specific to international investing, such as currency fluctuation and political risks. Risks include an economic slowdown, or worse, which would adversely impact economic growth, profits, and investment flows; a terrorist attack; any developments impeding globalization (protectionism); and currency volatility/weakness. While every effort has been made to assure that the accuracy of the material contained in this report is correct, Euro Pacific cannot be held liable for errors, omissions or inaccuracies. This material is for private use of the subscriber; it may not be reprinted without permission. The opinions provided in these articles are not intended as individual investment advice.

This document has been prepared for the intended recipient only as an example of strategy consistent with our recommendations; it is not an offer to buy or sell or a solicitation of an offer to buy or sell any security or instrument or to participate in any particular investing strategy.  Dividend yields change as stock prices change, and companies may change or cancel dividend payments in the future.  All securities involve varying amounts of risk, and their values will fluctuate, and the fluctuation of foreign currency exchange rates will also impact your investment returns if measured in U.S. Dollars.  Past performance does not guarantee future returns, investments may increase or decrease in value and you may lose money.

Opinions expressed are those of the writer and may or may not reflect those held by Euro Pacific Capital, or its CEO, Peter Schiff.

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