Axel Merk, April 1st 2004
This article was written by Merk Investments before the Merk Hard Currency Fund was launched.

Bush is weak; Greenspan calls for “fiscal sanity”, yet pushes consumers to extremes; gold moves up against all currencies. The markets seem to have run out of steam; we are concerned, but see opportunities.

Bush’s decision to make his fight against terror a central theme for his re-election campaign is off to a bad start. Richard Clarke, counter-terrorism advisor to George W Bush and his three predecessors, is criticizing Bush on a number of fronts – that before 9/11, he did not pay enough attention to the threat; and that he started an unnecessary and costly war in Iraq that strengthened the fundamentalist, radical Islamic terrorist movement worldwide. With every attack the Bush administration is launching against the highly reputable Clarke, Clarke seems to be getting stronger. Indeed, Clarke is in some ways telling a remarkably similar story as former Treasury Secretary Paul O’Neill did – both of them Republicans: Bush is so focused on his agenda that he is not listening to intelligent and reputable advisors. That is, except if they say what Bush wants to hear. O’Neill desperately tried to convince Bush that government spending is spiraling out of control; Clarke tried to get Bush to focus more on terrorist threats. 9/11 finally did get Bush’s attention. We commented on O’Neill in more depth a few weeks ago.

In the meantime, Greenspan is picking up where he and O’Neill previously failed. He warned Congress that “the imbalance in the federal budgetary situation, unless addressed soon, will pose serious longer-term fiscal difficulties [..] Without corrective action, this development will put substantial pressure on our ability in coming years to provide even minimal government services [..]federal budget deficits could cause difficulties even in the relatively near term.”. However, rather than forcing fiscal prudence through various tools in his arsenal, he goes to extremes to boost the economy. A few weeks ago, he told homeowners, they would have been better off with adjustable rate mortgages – we deemed his comments highly irresponsible; after publishing a criticism, we received phone calls from the Wall Street Journal leading to a quote in their foreign exchange section.

On the currency front: Japanese extreme buying of US Treasuries continued early in the year - $70 billion worth in January alone; about $90 billion this year through February. There are rumors that Japan may have reduced its purchases as concerns in Japan are increasing that this policy is causing inflationary economic distortions. Reduced purchases by Japan should mean higher US interest rates, and a lower Dollar versus the Yen. Back in Europe, sentiment is weak, and combined with the terror attacks in Spain, there is talk that the European Central Bank may lower interest rates. We were quoted by Dow Jones Newswire and Associated Press as saying “We believe it when we see it” – this short quote highlighted that on the one hand, the ECB could save face by moving now to lower interest rates; but on the other hand, there is serious concern raised by some at the ECB as it doesn’t want to be seen as joining the competitive devaluation game. Temporarily, the Euro is weakening. We are also concerned about the appointment of Germany’s designated new President, Horst Köhler, until recently head of the International Monetary Fund. While the post of President is mostly ceremonial in Germany, Köhler’s job has been to criticize government fiscal policies even (or especially) when his opinion is not invited. Köhler recently praised Japan for its “increasingly proactive approach” – meaning that he is in favor of the greatest money printing experiment there since the destruction of the German Reichsmark. We believe that, should there by a currency crisis, Köhler, who is friends of ECB head Trichet, will meddle with politics in a serious blow to the independence of the ECB.

The beneficiary of these concerns is gold. While US-based investors have enjoyed the rising gold prices, Euro-based investors have until now only benefited from gold if they took out some sort of leverage, for example by investing in gold producers. But we start to see signs that gold decouples and will rise against all paper currencies as these continue to be inflated. All commodities benefit on the one hand from weaker currencies, and on the other hand, from the economic stimulus that the world sees. China has started to pull the breaks a little bit as they see too much inflationary buildup. Still, we believe explosive growth in Asia is unstoppable over the long run, even if it may be a bumpy road.

The massive stimulus in the US and Asia has created overcapacities in the world keeping a lid on US consumer prices. However, corporations dependent on increasingly expensive materials must continue to reduce employment to stay competitive. The imbalances that have been created by Bush (extreme budget and current account deficits) and Greenspan (artificially low interest rates) cause an acceleration in the transformation of the US society. The challenge is that even service jobs are outsourced to Asia; the low interest rates also encourage even further investment into “productivity” as the cost of capital has decreased steadily, whereas the cost of US labor has increased. Many of the transformations that take place may not entirely be avoidable, but they cannot take place at the expense of fiscal prudence. The US rating agency Standard and Poors has just warned that industrialized countries face crushing debt burdens unless governments make politically painful cuts in social spending in the next few years. Governments must use the time now to prepare of the retirement of baby boomers, not to push consumers further into debt for the sake of inflating the US and world economy.

The markets in return have shown signs of topping out after the impressive rallies of 2003. Taken together with the concerns listed above, we believe the stock market could be in a similar situation as in 1973 or in 1930; in both cases, just as today, we had seen dramatic recoveries after painful declines in the stock market. But in both cases the ultimate low of the stock market was a few years later. Given that today’s valuations are not cheap, and given the breadth of the concerns raised above, we have deemed it prudent to significantly reduce the equity positions in all of our portfolios.

Industrialized countries will face an uphill battle to compete with Asia. The winners in this battle will be commodities, from precious metals to industrial metals, to energy to agricultural commodities. The Financial Times writes that China now produces more steel than the US and Japan combined; China has surpassed Japan to become the world's second largest importer of oil, after the US. Last year, China consumed 40 percent of the world's cement. Chinese exports rose 50% last year to $480bn. Of all commodities, gold is the one least exposed to swings in industrial demand, and currently our preferred investment.

Addendum April 2: The US unemployment report released Friday morning April 2 finally shows strong job growth. Long-term interest rates are soaring as a result. This may be what signals the end of the US housing market bubble. The US consumer will also be highly sensitive to higher interest rates; corporations not directly dependent on the US consumer won’t be as affected.