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Gold offers two-way hedge

My view still remains the same – with too much uncertainties, gold offers the best investment opportunity, a two-way hedge against both deflation (second dip or crisis), and inflation (government deficits, printing money and sovereign debt).

From investor's point of view, huge liquidity remains in the market (almost zero funding cost for banks), but with too few investment opportunities. This creates the substitution effect in the market, and leads to money flow into hard assets such as gold.

WSJ has an interesting piece echoing the same view:

Markets seem to want it both ways. The yield on 10-year Treasurys pushed below 3% Tuesday. At the same time, gold rose to $1,242 and remains near record highs.

That seems schizophrenic. The traditional view is gold represents a hedge against inflation, while locking dollars up for 10 years at such low rates only makes sense if there isn't inflation on the horizon. Why the disconnect? The two have basically become a bet against stability, amid uncertainty from Europe's sovereign-debt crisis, doubts on Asian growth and fears of a double-dip U.S. recession.

But investors may be overplaying the safety offered by Treasurys compared with gold.


Treasury investors will do well if deflation is imminent, as some fear. Gold investors, however, could feasibly benefit from either the prospect of deflation or heavy inflation. And the Federal Reserve likely wouldn't allow deflation without a fight. It would probably step back in with quantitative easing, even as the federal government embraced more stimulus spending. That could likely trigger a steep dollar fall, if not against other paper currencies, then against gold. It also would raise the chance the central bank prints too much new money, causing inflation.

If, however, deflation did take hold, gold could yet prove itself as a crisis hedge against more upheaval in the global-banking system. The enemy of both trades is some form of "Goldilocks" economic recovery, with reasonable growth and contained inflation.

But if the immediate future is more instability, gold, despite the fact it generates no yield, should keep giving Treasurys a run for their money.

Corporate America’s record cash building

In my previous post, I explained why I think the current economic recovery all counts on Corporate America. But the following report from WSJ revealed the record cash piling by US companies.  It's a sign that there are still too much uncertainties in investment. If this were to continue, the US economic recovery may be crippled.  On the upside, for investors, investing in blue-chip US mulitinational firms with healthy cash-flow will offer the best opportunity.

U.S. companies are holding more cash in the bank than at any point on record, underscoring persistent worries about financial markets and about the sustainability of the economic recovery.

The Federal Reserve reported Thursday that nonfinancial companies had socked away $1.84 trillion in cash and other liquid assets as of the end of March, up 26% from a year earlier and the largest-ever increase in records going back to 1952. Cash made up about 7% of all company assets, including factories and financial investments, the highest level since 1963.

While renewed confidence in corporate-bond markets has allowed big companies to raise a record amount of money, many are still hesitant to spend the cash on hiring or expansion amid doubts about the strength of the recovery. They are also anxious to keep cash on hand in case Europe's debt troubles lead to a new market freeze.

"Cash is still king," said Jeff Hand, chief operating officer at Ross Controls, a Troy, Mich., maker of pneumatic valves and other products that is holding more cash as it struggles to recover from a sharp drop in business last year. "We're coming out of that, but the uncertainty is still there."

The rising corporate cash balances could represent a longer-term behavioral shift in the wake of the deepest financial crisis in decades. In the darkest days of late 2008, even large companies faced the threat that they wouldn't be able to do the everyday, short-term borrowing needed to make payrolls and purchase inventory.

"We just went through this liquidity crunch that's made them realize the value of a dollar in hand," said John Graham, an economist at the Duke Fuqua School of Business.

Even now, banks continue to pull back on lending. The Fed reported Thursday that net lending by the financial sector—including banks, credit unions and other lenders—was down 5.4% in March from a year earlier.

The comfort of having cash on hand, though, comes at a high price companies may not be willing to pay for much longer. They are earning almost no interest on their holdings of cash, making it more difficult for them to achieve the returns shareholders typically expect from them. That will put pressure on companies to pare down the cash holdings eventually.


In a recent survey of company chief financial officers that Duke's Mr. Graham conducted with CFO Magazine, he found that companies expect capital spending to increase by 9% over the next year, compared with 1.5% when he asked the question in December. They expect employment to grow by 0.7%, compared with the 1.4% drop they expected six months ago.

Companies' willingness to use their cash will play a major role in the strength of the recovery at a time when consumers need jobs to support their spending and many people are still trying to repair their finances.

The Federal Reserve data showed households making some progress in paring down their debt, which fell at a 2.5% annual rate in the first quarter as credit remained tight and more homeowners defaulted on their mortgages.

Household net worth—the value of houses, stocks and other investments, minus debts—rose for a fourth straight quarter as markets continued to rebound. At $54.6 trillion, though, it was still $11.3 trillion below its 2007 peak of $65.9 trillion.


Beijing resumed Yuan’s appreciation

Just a couple of days after Beijing announced its decision to make Yuan more flexible, Yuan against US dollar started to appreciate, rising from 6.83 to 6.79. This has been the first move of Chinese currency since 2008, when the world economy fell into recession. 

Looks like China is betting on using exchange rate to control for its overheated domestic economy. Higher exchange rate of RMB also makes imports cheaper, exports more expensive, both are in line with China's gradual shift into more-consumption based economy.

Here is a piece from WSJ commenting on China's recent move. According to the Journal, the recent move is a "chess-master move".

In the never-ending game over China's currency, Beijing has made what chess commentators might term a sharp move.

By unexpectedly announcing it will allow greater exchange-rate flexibility, without specifics on how far or fast the yuan might rise against the U.S. dollar, Beijing has achieved some positive ends for itself.

The move should soften criticism of its exchange-rate policy at the meeting of Group of 20 developing and industrialized nations June 26-27, which had been shaping up as a China-bashing forum.

Yet, by returning the yuan to a managed float against a basket of currencies, Beijing won't have to cede too much in the near term when it comes to the bilateral dollar/yuan rate. The euro's weakness—the yuan is up 14% against the euro this year—should mitigate the speed of any yuan appreciation against the dollar.

Allowing some rise in the yuan's value against the greenback will help the central bank battle inflation, which tipped over the government's target rate for 2010 in May. In the longer term, China's gradual move to a market-based currency regime will help the country pursue more independent monetary policy.

There are downsides for China, of course. By telegraphing revaluation plans, it risks encouraging speculative inflows into the country, complicating efforts to control money supply.

The return to a managed float could also be seen internally as China caving to international pressure. In recent weeks, Brazil and India have joined U.S. calls for China to move on its currency. And Asia's exporters will be relieved to see the yuan rise.

Overall, though, this move scores Beijing some points without causing it too many sacrifices. The game's next developments will depend on the patience of the U.S. if the yuan's resumed rise proves all-too gradual.

The rise of Chinese labor

WSJ looks at the recent fast rise of China's cheap labor.  The piece mentioned many reasons that are sensible.  In my view, the key to understand the phenomenon is to analyze the dynamics of labor supply. In this regard, Lewis' two-sector migration model is the most capable theory.

To explain the labor shortage of Chinese labor, one factor (not mentioned in the article) that is less obvious is closely related to the housing bubble in China.  Real estate developers and local governments buy up farmer's land at fast pace, and farmers (source of migrant workers) receive quite a large compensation at once, often exceeding more than five years of annual income that could be earned in coastal factories.  With the 'capital', farmers can also start their own business. such as opening a grocery store.  The rise of income of farmers in interior provinces reduces the supply of cheap labor, contributing to the shortage of labor in east coast.

What I am seeing is a gradual shift of China out of low-value manufacturing, a development experience shared by Japan, South Korea and other Asian Tigers.

The recent strikes at Honda factories in southern China represent another data point in an emerging trend: Cheap labor won't be the source of the Chinese economy's competitive advantage much longer.

The auto maker has caved and given workers a 24% pay increase to restart one assembly line. Foxconn, the electronics producer that has experienced a string of worker suicides, has also announced big raises. This is all part of the virtuous cycle of development: Productivity increases, which drive wages higher, forcing businesses to adjust, leading to more productivity growth.

The supply of Chinese migrant workers from the countryside, once thought to be endless, is running dry, and that is giving workers leverage to demand bigger pay packets. The brief drop-off in orders brought on by the global financial crisis provided a respite, as did a recent drought in southwest China that spurred extra migration to the coastal factory zones. But shoe manufacturers are the canary in the coal mine. An American industry association recently polled its members and found that 88% saw a labor shortage in China, and almost as many had experienced late deliveries as a result.

While higher wage costs could mean more expensive sneakers for consumers and squeezed profit margins for the big brands, it has some silver linings. For instance, tamping down protectionism.

New York Senator Charles Schumer is again threatening to impose punitive tariffs on Chinese goods unless there is progress toward revaluing the yuan. The Senator says that currency manipulation holds down the cost of Chinese labor, at the expense of "millions" of American jobs. If wages rise in southern China regardless of the fixed exchange rate to the dollar, it undercuts the protectionist claims.

Jobs are hardly going to flood back to the U.S. merely because final assembly costs in China rise by 20%—just as they didn't after the yuan appreciated by 21.2% from 2005-08. More likely, some labor-intensive operations will shift to the likes of Vietnam or Bangladesh.

However, rising wages would hasten the long-awaited "rebalancing" of the Chinese economy toward greater consumption. The high savings rate has been a function of profits being reinvested by both private and state-owned companies, not the savings decisions of households, whose income has lagged behind the stunning GDP figures. Government spending and bank lending have been geared toward investment, which remains the main driver of growth. Greater spending power for individual Chinese would make for more sustainable growth and also encourage imports, lessening the trade surpluses that cause tension with the U.S.

Some investors may question to what extent Beijing is encouraging workers to be more assertive in demanding higher wages from foreign companies to favor local producers, as competition for the domestic market heats up. However, the trends that are making labor more costly will ultimately force all employers to adjust, including less efficient state-owned enterprises.

No doubt the government would prefer that foreign firms go first, which is reflected in the fact that state-owned media have been allowed some freedom to report on the Honda strikes. But as China leaves behind the era of cheap labor, the quality of management will become ever more critical to success in the marketplace. That should favor foreign companies honed by global competition, and drive China's next round of state-owned-enterprise reform.

deflation remains main worry, but inflation will strike, eventually

Don't count on central banks to get the timing right, reports WSJ:

With 30-year Treasury yields hovering around 4%, a central question for investors is if and when inflation will strike.

The near-term risk looks negligible, but central banks' extraordinary laxity during the crisis and $1,200-an-ounce gold warn of trouble down the road.

One defense of the Federal Reserve's current policy is its observation that "substantial resource slack" means inflation will remain subdued. Despite some improvement since early 2009, industrial-capacity utilization stood at a miserable 73% in the first quarter. The average since 1967 has been 81%. With that much idle capacity, why worry about inflation?

Like any single measure, it is wrong to put too much faith in this one in isolation. Capacity utilization has a spotty track record in predicting inflation. Big increases in utilization in the 1970s prefigured spikes in core inflation, but oil-price shocks are the likelier culprits. Meanwhile, inflation slumped in the 1990s even as utilization rose.

In a 2005 paper, Philadelphia Fed officials Mike Dotsey and Tom Stark found capacity utilization proved moderately useful in explaining inflation trends until the mid-1980s, but its predictive capacity waned sharply after that.

The timing suggests a range of possible rationales for this change, from globalization shifting the source of inflationary pressure from U.S. factories to Chinese ones, to rapid technological progress, which might distort the data themselves.

When gauging inflation risks, therefore, it is important not to focus on one indicator like capacity utilization. Price expectations can change rapidly, especially under such an extraordinary monetary policy. In particular, it is hard to count on the Federal Reserve scaling back reflationary efforts at the right time, given its record of blowing bubbles.