Financial system is a farce: Sprott

(October 2007) Few investment managers can fill a room like Eric Sprott. His annual roadshow blends economic doom and gloom, humour and investor optimism. Those who packed the ballroom in Toronto were not disappointed.

“When I think about leveraged finance, and what central banks do, and the banks’ stocks are all going up, I actually think that the whole financial system is a farce,” says Sprott, CEO of Sprott Asset Management and portfolio manager of the Sprott Canadian Equity Fund.

Recent events in the U.S. sub-prime mortgage market, spilling over into the global market for asset-backed commercial paper, have only reinforced Sprott’s distrust of central banks.

“You get totally out of control — you have a system that’s unwinding, and what do you do? Throw more money at it,” he said. “We’re basically throwing gasoline on the fire.”

Investors would be better off, he asserts, if they ignored the moves of central banks altogether. They might want to rethink holding shares of commercial banks as well.

“I’ve always been a believer that the financial system is grossly over-levered,” he says. “The system is so fragile because of leverage. People borrow short and lend long.”

He questions why anyone would invest in a bank that is levered 20:1, in an environment where volatility can suddenly explode onto any market: currencies, stock markets, bond markets, and most recently the mortgage market.

“There are three ways to value things. There’s mark to market, mark to model and mark to myth,” he says. “These are allowed valuation methods. It’s almost like your best guess. Don’t think that banks don’t do this.”

He says this ability to estimate the value of investments is what allows banks to post such consistently strong earnings.

“We still have $400 trillion in derivatives out there. It doesn’t matter what you derive; it’s still volatile,” he says. “One percent of $400 trillion is $4 trillion. The world has never made $4 trillion, ever. Some people will say it’s all off-setting. Somebody has to be taking some risk, but you rarely see the results of that.”

He points out that the markets seized up in mid-August on concerns over asset-backed commercial paper, and yet stocks have continued since then as if nothing happened.

With the Western financial system a farce, Sprott says investors should be keeping an eye on emerging markets, especially the giants like China, India and Russia. The Chinese market alone, he says, is more significant than that of the U.S.

“Asia’s open at 7 o’clock at night, but you’d never know it by the TV coverage,” he says. “You get Jimmy Cramer yelling and screaming at you for two hours … bunch of idiots still talking about U.S. stocks. Meanwhile the real world is happening out there, where things are really made, in China and India and the other developing countries.”

These manufacturing centres are ideal trade partners for Canadian resource companies, which supply the raw industrial materials, but there is also an opportunity after the products have been shipped. Both India and China still hold very traditional views toward gold, a commodity which Sprott’s fund is notorious for holding in its physical form.

As these countries conduct trade with America, they receive U.S. dollars in exchange. China and India have both been moving to mitigate their growing exposure to the U.S. dollar by exchanging greenbacks for bullion. India alone buys 1,000 tonnes of gold a year, at a time when global production hovers around 2,500 tonnes a year.

John Embry, chief investment strategist at Sprott Asset Management and manager of the Sprott Gold and Precious Metals Fund, predicts that gold will only continue to rise. He’s calling for bullion to reach $850 US an ounce early next year, and hit $1,000 US before the end of 2008.

Gold will eventually climb even higher, to multiples of today’s price, according to Embry. This call is not on a 10-year time horizon — he believes it will happen within the next couple of years.

While this shift from dollars to bullion has driven gold higher, the U.S. dollar has sagged — a fact Canadians are well aware of.

“I am of the view that the U.S. dollar is in peril,” Sprott says. “It is the Achilles heel of America that they have to import 20 million barrels of oil a day. They are still a militaristic country, and the costs are incredible — it’s devastating for them.

“The dollar and the yen are having this competition to see which is the crappiest piece of paper out there. They’re both awful,” he says, predicting that the Canadian dollar will continue to appreciate.

Jean-François Tardif, manager of Sprott Opportunities Hedge LP, has been predicting that the loonie would reach parity with the U.S. dollar for so long that he cannot resist predicting parity with the British pound — double the value of the greenback — within 10 years, although he emphasizes that this is his personal view and not that of the company.

There is another downside to the growth in developing economies, though. Both India and China are becoming greater consumers of oil, increasing the pressure on already-strained global production.

Global consumption is already four times higher than the replacement rate. China currently consumes just two barrels per capita daily, while India consumes only 0.8 barrels. With their stunning economic growth rates, it is not hard to imagine that they could soon match Mexico’s per capita consumption rate of seven barrels per day. That would require an additional 36 million barrels per day in new supply on the global market.

Meanwhile, the world’s largest oil fields, Cantarell in Mexico and Ghawar in Saudi Arabia, are both believed to have already peaked. Saudi Arabia is notoriously secretive about the health of its oil fields, but increased drilling has not led to an increase in production. In Mexico, Cantarell could be tapped out within three years.

“Russia has been the saviour to the world in the past 10 years because they’ve gone from 6 million barrels to about 9.8 million,” says Sprott. But this increase was not due to new reserves being found but simply the importation of more efficient Western-style methods of extraction. “These are really just improvements of known reservoirs. Petro-physicists think that Russia is about to peak out.”

The growth rate of new production has already slowed, with just 200,000 new barrels coming onto the market this year — a mere drop in Russia’s 9 million barrel bucket.

Filed by Steven Lamb, Advisor.ca, steven.lamb@advisor.rogers.com

(10/04/07)