The past week has had financial markets focus on the impending Irish bailout. Starting in April of this year, Eurozone countries such as Greece, Ireland, Portugal, Spain, and Italy have all been under scrutiny for their heavy government debt burdens while economic growth languishes. The huge amount of sovereign debt is worrisome, as it threatens to derail the global economic recovery. However, in our view, the debt will cause even more money printing by developed economies, which will be bullish for precious metals and emerging market currencies going forward.
Markets are worried about the threat of default by these debt-ridden European countries. While this is a possible outcome, it is a highly improbable one. Throughout the history of time, governments who have faced huge debt problems inflate their way out of the debt. In such a manner, governments print money to pay down their debt, thereby reducing the nominal value of the debt. Since the debt is measured in nominal terms (i.e. $10,000) and not the value of what that debt could purchase, governments often resort to money printing in order to ease the burden of debt repayment.
This outcome has been largely accepted in the US by commodity markets, evidenced by huge advances in the price of agricultural commodities and precious metals. The Eurozone presents a different challenge, as it is an economic alliance without a single government controlling it. This means that ECB President Jean-Claude Trichet must determine what is best for the entire Eurozone simultaneously, even as countries like Germany face no real debt problem while countries such as Greece are on the precipice of default.
It is our belief that the IMF/ECB-dictated austerity measures will ultimately prove to be unsuccessful. In exchange for the bailout funds, Ireland, Greece and the other weaker European countries must agree to strict austerity measures that will raise taxes and cut jobs and expenses for the government. However, as these governments cut back their spending, their GDPs will be adversely affected, causing tax receipts to decline even more and continuing the debt contagion spiral.
Instead of relying on austerity measures to right the balance sheets of the weak Eurozone countries, the ECB will eventually succumb to pressure to enact US-style quantitative easing and monetary base expansion. Until May, the ECB had remained steadfast in protecting the Euro and not enacting potentially inflationary policies. However, Trichet gave way and started purchasing weak Eurozone countries' bonds in order to cap their yields, a move very similar to the US Fed's quantitative easing, and also a policy he had sworn he would not undertake. As Trichet and the ECB realize that traditional policies will not be enough to ensure even modest growth in the Eurozone, Trichet will further relax his stance on inflationary policies. Simply put, the weak Eurozone countries have no choice but to inflate their way out of the debt, and Trichet will realize that the only choice he has is to either allow inflation to reduce the nominal amount of the debt, or risk the dissolution of the Euro entirely.
For these reasons, precious metals and commodities remain in a structural bull market (click on chart to enlarge). While gold and silver have already logged impressive performances for the year, they are in the beginning of a multi-year bull market. As extraordinary policies such as quantitative easing and government repurchases become commonplace among the US, Japan, and eventually Europe, investors will lose confidence in developed market currencies and increasingly turn to developing market currencies and precious metals as stores of value.
As an alternative currency to the traditional majors, the Australian dollar should remain highly favored. While gold is up 21.78% on the year and silver is up 53.09%, the Australian dollar has only appreciated by 7.41% against the US dollar. When also considering that that the Australian central bank rate is 4.75% against the US rate of 0-0.25%, the Australian dollar could appreciate even further. Even after factoring in brokerage costs, a long Australian dollar against a short US dollar position should yield approximately 3.3% annually. With one of the biggest knocks on silver and gold being their lack of yield as compared to cash, the Australian dollar should appear particularly attractive (click to enlarge).
Both economic fundamentals and the yield differential support a long Australian dollar, short US dollar trade. As can be seen from the table, Australia has a higher GDP growth rate, much lower budget deficit, and almost half the unemployment of the US. Additionally, the US has $8.7 trillion of debt, whereas Australia has only $167 billion of debt. To put this in perspective, Australia has approximately the same level of debt as Portugal, but produces over 4 times the GDP.
Risks to the Australian dollar include a slowdown in China. China obtains a great deal of their natural resources from Australia, including copper, coal, and iron ore. If Chinese real estate becomes a pierced bubble, or there is any other kind of economic slowdown in China, Australia will feel severe economic effects. However, we continue to be assuaged by China's recent efforts to slow property speculation, and their vigilance in controlling price inflation appears to be genuine. For this reason, any slowdown in China appears to be one of governmental preference, and should only serve to moderate growth, not stop it altogether.
While we continue to be bullish on both silver and gold, we are also actively increasing our exposure to the Australian dollar. Friday's pullback afforded a great opportunity to buy all three, as European concerns caused investors to sell first and ask questions later. However, as outlined above, these concerns will actually create a long-term bullish fundamental for the precious metal and commodity currency market, and any knee-jerk selling should serve as a buying opportunity for long-term minded investors.
Disclosure: Long Silver, Gold, and Australian Dollar