Peeking Under the Troubled Assets Relief Program (TARP)

By: HRA_Advisory

[The following comments went out to subscribers prior to the US Election and Hank Paulson's latest change of tack but our comments on where we expect things to turn first haven't changed. – Eds] - Its too soon to say de-leveraging and “de-Funding” is over, and all trading desks can do is respond to calls by marking up more red on screens while it continues. However, various measures to unlock credit do seem to be creating at least the potential for trading bottoms. Credit market risk measures such as the TED spread are starting to narrow. We don't expect them to return to normal for a long time but that is not required for a rally.

A few trading days without a new disaster will accommodate that. Once (based on the polls) Barack Obama is announcing his choices for a consensus administration and his stalwarts are vying for new jobs in the houses of Congress, Hank Paulson would presumably put what ever he can of the remaining ugly details on the table. Fortunately, he does seem the sort to try and shovel the worst of it out before he hands over the keys. That won't heal the US economy, but it should hopefully indicate the extent of the surgery needed to keep it functioning.

Europe started damage control later, but has put much more on the table in a short time span. A €2 trillion figure by its governments to underpin their banking systems is being bandied about. The underlying message is that whatever is needed to support the system will be found. Not pretty in terms of spending for the next several years, but hopefully enough statement of intent to base that region in the near term. While much is made of the divisiveness of the European Union when tested, we actually see an impressive unity built into their actions. It will be in the next round of discussion about how to divvy up the bill that real divisions may appear. At this point there is no reason to assume another Iceland v British-Dutch depositors rematch. But it is still-details-to-follow in Europe as well.

A number of quite solvent regional banks have been applying for government money. That could add some balance to the situation and probably shorten the bank clean up period. Rather than skewing the system in favour of weaker players, it would mean the funding could position stronger players to deal with potential after shocks. Rewarding prudence makes sense, and we hope Europe takes a similar view. Banks that messed up spectacularly should be put out of their misery, not on life support since most of them would ultimately go down anyway and take government money with them.

There are of course huge drops in consumer sentiment and spending, and continued job losses. This is particularly true in the US , were the realization that the economy can't spend its way out of a recession is sinking in. This is a good thing if only because denial stopped working months ago. Longer term health requires saving. Europe typically saves during downturns, and presumably will again. There may be more dropping shoes in the distrustful bankers' drama, but we are nearing the end of its first act. We remind that stock markets are leading indicators - they were trashed in the past six weeks, but US indices peaked a year ago and will likely see some selective recovery much sooner than the US economy will. While there will be many fiscal fundamentalists cheering on a higher savings rate we should have no illusions about what that portends for the US; a much longer and weaker recovery than many are hoping for. Consumer spending numbers will be bad for an extended period which means this will be no “v shaped” recession.

From our perspective the players to watch for resource sector recovery are still very much BRIC (or perhaps BIC, given Russia 's robber-barons have their own leverage issues) and by extension the regions around them. The most immediate questions will be about pan-China Sea economies. Of Asia's larger economies, South Korea is arguably the least well positioned given to weather this storm given its focus on heavy industry and ship building and $US denominated borrowing and hedges. Its government did just announce a $100 billion program to assist with credit lines needed to maintain work on these long lead-time items. Like most of its neighbors, South Korea does have ample foreign reserve and that should help it along.

Laying out with any precision at this point the next six months in this region would be impossible. Worth noting is that China has just announced a 9.1% GDP growth in Q3, of which 7.9% is internally driven. Restating that, trade related growth was halved to 1.2% of the total. There are of course dire notes on China being hit by the global crisis being passed around. The reality is that China 's trade driven growth has been falling for a while, in no small measure because it is having difficulty competing with lower wage economies elsewhere in the region. Chinese consumers are expressing their concern about global economic health like every one else, but consumer spending was up in September 22% on a year-over-year basis, which is considerably higher than inflation would account for. We'd have been happier with 10% plus growth but with most of the developed world going to hell in a hand basket, handwringing about China “only” growing 9.1% seems overdone. Remember that China can at least afford to crank up the stimulus- and write a cheque to cover it- unlike the US of A.

More data is needed on how India is faring, but there more than anywhere else the discussion around the potential to gain from problems in the higher wage economies. Evidence of slowing had already knocked down India 's markets, but as we have pointed out already that evidence actually indicated a strong growth, and quite sufficient for domestic consumption to make up for reduced trade. Unlike China , India had maintained trade barriers until recently in order to stimulate its economy through internally driven gains. It is only this century that it has been loosening those trade restrictions. Much has been made of outsourcing tech related services to English speaking India as a job stealer in the US . In fact much of that was in lieu of importing Indian talent to high-cost Californian jobs, and more evidence that that India was dealing with a brain drain. Whether India continues the trade liberalization policies underway, and whether that would have an immediate impact in the current environment is more of an issue for India than any immediate economic decline from the debt crisis.

Brazil has seen the Real, like most “commodity currencies”, get hammered in the past several weeks. The country had in fact been getting worried about the strength of its currency, so at an operating costs level the decline is actually useful. It does however move capitalization costs higher, at least were foreign borrowing is a factor (or when it becomes a factor, perhaps). Again it is wait and see, but Brazil is in much better shape to weather this storm than it has been in the past. The counter-commodity trade in the greenback will aid with this, as it will in other Latin American countries that are in similar boats. More critical in this region will be how its currencies react to a weakening Dollar, when conditions bring that into play.

We think that copper , having taken a big swoon through over the past few weeks, may be on its way to forming a price bottom. It will remain the metal to watch in terms of perceptions about a broader recovery. Copper has been moving to surplus, partially thanks to the economic slowdown, but continues to have supply side issues as well. The recent announcement of lower production targets for the RTZ/BHP Escondida mine would wipe out basically the entire 2008 estimated surplus, for instance. Copper's biggest issue is the knowledge that it is still priced above the average production costs, in contrast to other base metals. While there has not been a lot of inventory buildup relative to previous economic downturns that fact alone can generate selling or shorting in a market that is selling everything. In the meantime, we will wait out the market see how much production gets shaken out by sub $2.00 copper prices.

Gold has confirmed its status as a safe haven buy, but not seen new price gain because of course those who already owned were making use of their hedge. Many who cheered gold being bought as insurance forgot that insurance policies get cashed in. As we have noted before about gold, it is also subject to the same downside as any other asset class in a meltdown, namely redemption and margin selling. Margin calls have been very much in evidence and those may continue to provide occasional downdrafts. It would likely be the strongest gainer on greenback weakness, and we continue to consider it a focus area.

There are a lot of oversold gold juniors, and it is simplest at this point to focus on our past comments in trying to sort them out. Having the cash to move forward with, and management that will continue working, frugally, to increase value are the main considerations right now. However this market plays out, it will be several months at least before it will be possible to raise money on livable terms. This will make for some tough decisions for management and shareholders. While we like to see news flow, we also recognize that there isn't much sense in generating it for a market that won't care anyway. Odds are, many cashed up juniors will be hanging onto their funds at least until the smoke clears.

Our basic thesis about resource companies being able to build value as quick as any has not changed, but the market will need to have the fear factor decrease before a tide that can lift a few boats starts coming in again. It will come in however and companies with true and growing discoveries should see their current discounts shrinking as soon as a bit of greed returns to the market.

Lest you think we are being overly rosy in the outlook we want to be clear. As a global business resource discovery and extraction will get some tail winds from the areas that have been its main booster though this decade. We think a tradable rally may be close to starting, not because we think things are “fixed” but because the 50% haircut most markets have received discounts a lot of bad news. We think earnings going forward in most sectors, especially in the US , will be lousy for an extended period. Financials, which were the lead dog for many indices and certainly for Wall St , will probably never return to the levels of profitability they enjoyed the past couple of years. All of that makes a quick return to former glory for equities difficult. The markets will have to accept new realities and price them in, so the roller coaster ride is not over, but there should be some room for new gains soon on nimble trades.

David Coffin and Eric Coffin
http://www.hraadvisory.com

David Coffin and Eric Coffin are the editors of the HRA Journal, HRA Dispatch and HRA Special Delivery; a family of publications that are focused on metals exploration, development and production companies. Combined mining industry and market experience of over 50 years has made them among the most trusted independent analysts in the sector since they began publication of The Hard Rock Analyst in 1995. They were among the first to draw attention to the current commodities super cycle and the disastrous effects of massive forward gold hedging backed up by low grade mining in the 1990's. They have generated one of the best track records in the business thanks to decades of experience and contacts throughout the industry that help them get the story to their readers first. Please visit their website at www.hraadvisory.com for more information.

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