Inflation by Deflation

Inflation by Deflation

It was July of 2008 and oil prices soared to a $147 per barrel. At that time grain prices were going by the roof, the Chinese economy was overheating, the general population of the undeveloped emerging economies were on the verge of revolt, US consumers were angry about having to pay $4.50 per gallon of gasoline, stocks were heading lower every time oil prices were making new highs, and to top it off inflation was the main concern for just about every economic policy maker. My my my, how quickly things have changed. Who’d a thunk it? Oil would drop down to as low as $32 a barrel, the DOW down to the 6000’s, copper at less than $1.50 a pound; it appeared that the complete capital market structure was on the verge of collapsing. What a scary time it was not just for investors, but for anyone who had a bank account. I remember having conversations with my friends and family, wondering if their nest eggs would be safe in their 401 K’s, IRA’s, equity holdings and already in their savings accounts. Panic and fear ruled the world there for a few months.

Then with a few actions from the Federal save, US treasury, revisions in the mark to market accounting rules, and a enormous $850 Billion stimulus bill, VIOLA, Confidence was “restored”. edges balance sheets improved, toxic assets held by the edges suddenly disappeared (by accounting magic of mark to market), and artificial stimulus was provided by the America Recovery and Investment Act. unheard of global government spending was running rampant, 0% interest rates were provided for the edges, and furthermore $1.4 Trillion worth of Quantitative Easing by the buy of mortgage bonds and US treasuries from the Federal save was enacted. The Dow climbed from the 6443 to as high as 11,205. The CNBC stock cheerleaders were proclaiming a firm “recovery” was in place and that we could expect a V shaped recovery.

It never made sense to me. I told my clients that there wouldn’t be a V shaped recovery and that I strongly advised them to not get fooled by the hype. Take everything that was said with a grain of salt and just remember who they are and what their roles are in their specialized lives. I told my clients that the reason there wouldn’t be anything resembling a V shaped recovery in any shape or form was that we had way too many structural headwinds for this to occur.

1. In the housing market the amount of foreclosures are continuing to climb while the Federal foreclosure plan enacted by the president so far has been a huge failure, according to Special inspector general for the financial bailouts, Neil Barofsky, who said the program has not “put an appreciable dent in foreclosure filings”. Meanwhile Elizabeth Warren, who chairs a separate Congressional Oversight Panel on the bailouts, has said that Treasury’s failure to act more quickly could certainly be hurting the recovery. A problem that once was just for subprime mortgages has recently morphed into the ALT A and chief mortgages, causing an already deeper difficult situation. Now that the $8000. tax credit program has expired in April, we have had the worst home sales numbers in the last two back to back home reports. Without a recovery in the housing market, people don’t feel confident as they see in many situations the highest value asset they own deteriorating, consequently curtailing their normal spending habits. Former U.S. Federal save chairman, Alan Greenspan, recently warned that a fall in house prices could derail the U.S. recovery and cause a double-dip recession.

2. Credit, which is the life line for many businesses, is nowhere to be found. I’ve argued that it isn’t so much a problem of without of liquidity as much as it is a problem of without of credit worthy borrowers and aggregate need for domestic goods and sets, and if you associate that with all the toxic debt that edges are nevertheless holding on their balance sheets coming to a standstill, this is what you get; a harsh without of issuance of credit. Until the labor market markedly improves and commercial and residential similarities are on safer ground, edges simply won’t lend, period.

3. A structurally damaged labor market. Many of the jobs that were lost during this downturn were in the construction and manufacturing base and many of those jobs won’t be coming back for a very long time. The overhang in residential and commercial similarities is enormous; the need for goods was crushed, which in turn devastated manufacturing jobs. already now, with prospects of the manufacturers slightly improving (mainly due to growth from emerging economies), jobs nevertheless aren’t being offered, and a big reason for that has to do with technology and spending on equipment and software. As John Ryding, the chief economist at RDQ Economics stated, “You can understand that businesses don’t have to pay health care on equipment and software, and these get better tax treatment than you get for hiring people. If you can get away with upgrading capital spending and deferring hiring for a while, that makes economic sense, especially in this uncertain policy ecosystem.” The growth from our economy simply isn’t growing fast enough to meaningfully enhance the unemployment rate, as already the chairwoman of the president’s Council of Economic Advisers, Christina Romer said, “We need 2.5 percent growth just to keep the unemployment rate where it is. If you want to get it down quickly, you need significantly stronger growth than that. That’s what I’ve been saying for the last several quarters, and that’s why I’ve been hoping that we’ll please pass the jobs measures just sitting on the floor of Congress.”

4. State and local budgets are looking horrendous, without federal aid over 500,000 jobs are going to be deleted by 2011. In this political climate, the will to continue to use and bail out state and local governments, much less anyone else just isn’t there. It looks as if they will be going by their own very painful deleveraging course of action.

5. Uncertainty for corporations and small businesses due to tax hikes and burdensome regulations from the health care law and Wall Street Reform. There is a reason why corporations are sitting on $1.8 Trillion and why small businesses aren’t hiring and if it wasn’t already difficult enough for these entities to hire people as it is, government policies and their incessant need to demonize corporations and their profits are making it that much tougher for them to do so. The crew from PIMCO, who are the largest bonds dealers in the world, and home of the brightest economic minds, nailed it when they coined the term THE NEW NORMAL in 2009, which is defined as slower growth worldwide (more so in the G-3 than in emerging markets), higher unemployment, more de-leveraging, more regulation, and a weaker U.S. dollar over the next 3-5 years. I remember it was just last year when the president’s top economic advisor Larry Summers disagreed with PIMCO’s assessment of our economy entering into the “New Normal” period. It looks now as if Mr. Summers was dead wrong! El Erian, the man who coined the New Normal, compared Summers’ view of the U.S. economy to a three-stage rocket ship attempting to escape the pull of Earth’s gravity. The first stage is government spending, followed by inventory reductions and consumer need.

Summers “has this concept of escape velocity,” El-Erian said Oct. 9 2009 at a meeting of financial-market professionals in Toronto. “We don’t have enough to unprotected to escape velocity.”

6. The 800 pound gorilla in the room is our National Debt risk. Look what happened when little old Greece had their problems; then it looked as if the complete European Union was going to come crashing down. People were talking about the Euro money not surviving, and may I remind everyone that already though it appears that things are back in control again, that situation is far from over. It will re appear again as all they did was buy some time and all these countries are now just beginning a very painful deleveraging course of action by austerity measures by cutting budgets, pensions, jobs and benefits that will certainly weigh on the complete Euro zone’s growth prospects which method their ability to pay back their own debt will diminish. Considering that 30% of all of our exports go to Europe, and their economies will undoubtedly slow down markedly, this will have a direct impact on our exports.

One day, just the same way the bond vigilantes (bond holders) held these southern European economies accountable for their reckless spending binges; they will undoubtedly turn their ire towards us if we don’t act in a timely manner. And who here has confidence that Congress or our president can do what it takes to get our fiscal house in order? Not me. I truly believe that many of our elected leaders, or for that matter many of the rest of us, know the consequences of this risk. Let’s put it this way; it basically would be like a run on a bank, except it is a run on the United States. Rates would soar, it would punish consumers, corporations, small businesses, the dollar would plummet, global confidence would fall apart, and there would be a whole new round of systemic risk that would shut the capital markets out which would affect every single securitized investment on the planet. One of the few investments that would gain value would be gold, and it would most likely soar 3, 4, and 5 times its value in a comparatively short period of time.

The point of the preceding really hasn’t been to highlight the risks of sovereign default or the fear of one happening, but more so to give you an idea of where our economy stands and the challenges we confront moving forward. The latest GDP growth figures for the second quarter shows that our economy has been slowing down for three consecutive quarters.

PIMCO’s chief, Bill Gross (another one of my favorite economists by the way) said deficit spending by governments that seek to continue artificial levels of consumption “can be compared to flushing money down an economic toilet.” He went on to say, “Deficit spending will be unsuccessful because under the “new normal” scenario, deleveraging, re-regulation and de- globalization produces structural headwinds that rule to slower growth and lower-than-average investment returns.” As I’ve noted, our problems with the labor market are structural, and the idea of spending to fill the gap just isn’t working. I want you to think of the Stimulus Strategy as a bridge. On one side of the bridge is pre-recession on the other side is the recovery. The bridge is the stimulus and the idea was to build that bridge long enough to rule us to recovery. The problem is that the distance between the two is much further than most economists, and more importantly, the White house, had woefully expected, AND that we don’t have the resources ($$) to build a bridge long enough to get us from one side to the other. Now that stimulus funds are dissipating and wearing off, and state and local government jobs will be laying off thousands of workers, there is a very good chance that over the next 2 quarters our GDP growth will be around the 1% -1.5% area which most likely method the real unemployment rate will go higher. So what will this administration or the Federal save do to try to get this economy going in the right direction in a meaningful manner?

Congress and the White House have virtually spent all of their political capital and don’t have the will to push by another stimulus bill, and if they do it will be very limited, and I am certain that it would be destined to fail simply because they just don’t understand that there is no quick fix solution and their attempts of staving off this downturn are ill-conceived. So that leaves the Federal save. The Federal save has already stepped up in an enormous way by lowering the Fed funds rate to 0%-.25%, with $1.4 Trillion of Quantitative easing by the buy of Mortgage bonds and US treasuries; essentially printing money to buy our own debt with the purpose of providing more liquidity to the capital markets and lower mortgage rates. In regards to its effectiveness, that can be debated, for both sides. It has brought down rates and it has provided liquidity, but it hasn’t increased lending in an appreciable manner, and that folks, is what it’s all about.

Here’s what I believe what the Federal save will do, and I believe it will happen sometime in the second half of the year. The options are:

1. Buy more assets. The Fed could buy more mortgage-backed securities, or since its holdings of MBS are so large, it could buy more long-term Treasury securities. already James Bullard, a voting Federal save board member and perennial inflation hawk, recently wrote a piece backing this idea if conditions continue to worsen.

2. Deepen its commitment to keep up rates low for a long time. The Fed could rephrase that potential to provide additional guarantees or rock-bottom rates already when the recovery begins to take off.

3. Stop paying interest on excess reserves. The Fed could try to spark more lending by cutting the interest rate it pays edges on reserves they keep up at the central bank from the current.25%.

4. Open a new lending facility. The Fed could open or keep open a lending facility to increase credit availability for any sector of the economy it wants to help out such things as commercial real estate.

5. Stop shrinking its huge balance sheet. It would be a more subtle approach as opposed to continuing more asset purchases.

6. The Fed could change its inflation target from 2% to 4%.

All these strategies carry heavy inflationary risks, but the fear of deflation is greater than that of inflation. When the Federal save made their announcement of the $1.4 Trillion mortgage and Treasury purchases, the value of the dollar dropped 11% and the price of gold increased by 25% and silver 55% in a six month time period. Considering that we are now entering into the strongest time of the year for precious metals and we anticipate the dollar to get hammered because of these actions, we strongly advise our clients to increase their precious metal holdings.

I honestly don’t see how these actions will help stimulus bank lending; as noted earlier the problem isn’t liquidity or rates, it is confidence from the banking sector to lend. The risks of expanding the Fed’s balance sheet are tremendous. The size of the Fed’s balance sheet has exploded; it’s never ever been as close to as large as it is today. Every time there has been a large expansion of the money supply from central edges, inflation has always followed. Now the whisper on the street is that it Federal save could expand its balance sheet by another trillion dollars.

The money supply that was produced can sit there for quite some time, with latent price inflation. If edges don’t lend money, then it doesn’t matter how much money was produced, there will be very little inflation. In order for inflation to come about, the money that was printed has to circulate into the real economy. However, the more money that is out there being held by the edges, the more possible inflationary implications and risks exist. Psychology from consumers and edges can suddenly change, and the “velocity” of that money can release its way into the economy at an upsetting rate, catching policy makers off guard, allowing inflation to take keep up.

To make things worse, we see this scenario unfolding within the next few years, WITH a high unemployment rate, most likely around 7-8%, with GDP growth in the 1-2% area. This would be a very bad development for the economy known as stagflation, which can be defined as low growth with high inflation. There wouldn’t be too many investments that would thrive in this scenario other than precious metals. Investors should protect themselves by diversifying, and precious metals should be a part of your investment strategy. Once again, I thank you for the time you have taken to read this newsletter; I hope it helps.

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