The Sovereign Society's  Instablog

Gold is rising because the post-Breton Woods exchange rate system doesn’t work.

More than ever, governments are loading up on debt as a result of bailing-out their respective banking systems. And there’s a price to pay for this profligate spending. Gold sniffs trouble.

Gold has traditionally been viewed as the best inflation hedge since the creation of fiat coins under the Roman Empire. When deficits became too large – namely to fund foreign conquests – the Romans simply chipped-off parts of the coin…de facto inflation.

Now inflation leads to the debasement of our purchasing power and ultimately reduces our long-term standard of living. No other monetary phenomenon has plagued central bankers more than inflation – except for deflation – the worst of two evils…

And deflation – not inflation – has gripped the world economy since the asset “bubble” pricked in July 2008. Stocks, bonds, commodities, real estate and even fine art and the most expensive French red wine vintages have all declined sharply over the last 20 months. Despite a massive recovery since March for most of these risk assets, investors are still sitting on double-digit losses since January 2008.

If gold prices are tied to inflation then why has spot gold risen a cumulative 300% this decade compared to just 25% for U.S. CPI? Something doesn’t give. True, gold should exceed inflation but that rate of excess performance belies a different story behind this rally.

It’s a big mistake to assume that bank balance-sheets across Europe have already seen the worst as the global economic recovery enters its sixth month.

Credit default swaps, contracting bank lending, tepid consumer spending and regional woes in Central Europe all pose ongoing threats to a sustainable recovery in Europe.

To be sure, the risk of a systemic bank collapse has receded since governments across the euro-zone announced blanket guarantees on deposits last October. Many of the weakest institutions have been de facto bailed-out by local governments, and stock prices have surged off their multi-decade lows.

Yet it’s important to point out that despite all efforts to expand the money-supply and grow inflation since last fall, euro-zone M3 (the broadest measure of bank credit growth) is still contracting.

Loan growth is also contracting.

And consumer prices across the euro-zone remain in the deflation zone, yet another challenge for central banks hoping to boost inflation, which remains in short supply since oil prices and asset bubbles collapsed starting in July 2008.

Storm clouds still loom on the horizon for European financial institutions – especially in the banking and insurance sectors. More losses are coming our way in 2010.

Back in late August, the European Central Bank (ECB) voiced concerns about financial derivatives or credit default swaps (CDS). These instruments are used for insurance-like purposes to hedge credit risk if a sovereign or corporate issuer defaults; the ECB continues to warn about CDS counter-party risk.

The top ten counter-parties of the leading European banks accounted for 60% of CDS exposure, according to the ECB.

Governments in the West are still in the process of regulating a global platform to settle or clear outstanding credit default swaps, which according to some estimates tops approximately $30-$60 trillion dollars in notional value.

Nobody really knows what the total value of these derivatives is or how to even settle most counter-party trades. The entire sector remains a massive house of cards. Both Warren Buffet and George Soros continue to warn of impending trouble if a global platform is not launched to identify counter-parties; Soros proposes banning credit default swaps altogether.

If global markets were in a freefall from October 2007 through March 2009 – reacting negatively to the deluge of bad economic news – then the opposite is true today. Risky assets have continued to appreciate since March 9 in the biggest rally since 1932 measured in percentage terms.

Good news about the global economy and its continued recovery has pushed stock prices through the roof while even the occasional dose of bad news hasn’t affected prices. These include record U.S. insider stock sales in August, a gaping hole still widespread in financial sector intermediation, contracting loan growth among banks, declining consumer and wholesale prices and rising job losses.

The markets continue to feed only on good news. Just how long this mirage will last is hard to forecast. But at some point reality will check-in. My guess is that will happen in 2010.

Sincerely,

Eric Roseman
Investment Director

There's nothing more beautiful than Vienna in the summer. There's also nothing better than waking up to Viennese coffee…

The best coffee in the world, in my opinion, is in Vienna. The Austrians borrowed from the Turks during the 17th century amid two Ottoman invasions and walked away with their own version of coffee – now popularly served in Viennese coffee houses worldwide. Basically, the Austrians took Turkish coffee and added sugar and milk to the mix.

And though ardent coffee drinkers like their Joe black, I still prefer the Viennese version.

I usually have one or two cups of coffee per day. But this morning, I had five. The coffee on-board Austrian Airlines from Toronto to Vienna was tops – and coffee on airplanes usually tastes like battery acid. For the record, the food on Austrian Airlines is the closest thing to edible I've found on numerous carriers to Europe.

On Monday, I met with several local banks, including Valartis Bank Austria, formerly Anglo Irish Bank Austria. Valartis, which is a Sovereign Society Convenient Account member bank, is one of the few banks among the privacy domain still accepting American clients.

The Swiss, of course, have largely abandoned U.S. business since UBS opened the bank secrecy window this summer under fierce pressure from the United States (though we keep in close contact with a few reputable Swiss banks that will still accept your business).

Still, even the Austrians have recently relented on bank secrecy. It seems the world is heading in this direction as the infamous numbered account eventually goes the way of the dinosaur.

To be sure, Austria hasn’t been spared from the global financial crisis since 2008. The banking system has indeed survived, but with the crucial assistance of government deposit guarantees – not unlike the rest of the euro-zone.

And, like other countries (including even mighty Germany) Austria has also struggled to raise government debt financing as some auctions have been reduced or cancelled since last fall. Germany, by far one of the most liquid government bond markets in the world, saw four auctions either scrapped or reduced in late 2008.

Smaller Austrian local banks have recovered nicely in 2009 as earnings rebound, including Valartis Bank Austria. But larger banks with loans tied to Eastern and Central Europe are still struggling.

These include Bank Austria Creditanstalt AG and Erste Bank AG. Both banks, the largest in the country, have big loans outstanding to their Eastern neighbors; capital markets in nearby Eastern Europe have calmed down since the March lows but a sense of nervousness still plagues the banking sector in this country. Most believe this is a lull and not a market bottom.

Still, despite the regional headwinds facing Austria, I remain bullish.

This is a stable democracy, rich in culture and dedicated to market stability. It's still a largely conservative country. At some point in the future I expect leveraged markets in the region to finally bottom and that should set the tone for another round of prosperity for Austrian banks and industrial companies. But in no way have we seen the bottom in late 2009.

I'm often asked where I would live if I had to leave Montreal. And my answer for years has always been the same: Switzerland.

The world's most famous Alpine country offers a high quality of life, clean air, great views from virtually every corner of its borders and a first-rate transportation system.

My favorite city in Switzerland is Zurich, but other visitors prefer Montreux, Geneva, Basel or Lugano – depending on what appeals to you most. Basically, you can't pick a corner of this country without being overwhelmed by its raw natural beauty.

Unfortunately, Switzerland's image has been badly tarnished by the UBS, or Union Bank of Switzerland, fiasco over the last 24 months. If there's one institution that has served to hurt the Swiss brand amid this financial crisis it's undoubtedly UBS.

UBS was probably one of the worst managed banks in the world before the credit crisis ripped apart its balance sheet. Management has been a disaster with wave after wave of bad news and write-downs plaguing this once venerable Swiss financial icon. Today, UBS ranks on par with some of the worst managed banks in the world. Its glory days are gone for good.

But let's keep things in perspective.

What's bad for UBS has been great for its rival across the Paradeplatz on the Bahnhoffstrasse – Credit Suisse. The latter has been a major beneficiary of UBS's woes and has largely escaped the credit crisis with shrewd management of its loan book and investment banking unit.

Though UBS has been an utter disaster for Switzerland, other banks, especially smaller institutions have remained true to their clients and continue to attract capital.

But, on a sad note, Americans have largely been shown the door as the Swiss rid themselves of U.S. depositor liability since the beginning of the year.

Some Swiss banks still accept American business (and we can get you in touch); but the primary trend is obviously on the way out as U.S. investors find it increasingly hard to establish an asset base in Switzerland following the UBS tax scandal.

Despite the fallout over UBS and its unruly co-operation with the IRS, Switzerland is still home to an estimated one-third of global offshore deposits. On the other hand, the end of tax dodging for many depositors in this country might also reduce that proud capital base.

Finally, after spending time with some of my friends and colleagues in Zurich last night, you'd never believe the Swiss were victims in this historical financial crisis. Apart from UBS, the financial sector has been hurt but not devastated like the City of London.

Unemployment remains below 5%, real estate office vacancy rates are still low and residential real estate prices remain very expensive. The cost of living here is also still expensive. If there was a correction in Swiss-based assets it was felt only in the Swiss SMI Index, or the stock market – and nothing else.

I'm still very bullish on Switzerland. I always have been. And I eat my own cooking. My largest individual holding in my retirement plan in Canada remains Néstle SA.

Switzerland is still a compelling destination for your assets. In a world gone almost mad over the last decade, this nation still exudes financial responsibility, safety, conservatism and remains a bastion for asset protection purposes.

Sincerely,

Eric Roseman
Investment Director