June 25, 2011
Before we look forward to where we may be going, let's back up and look at where we have been. Here is an excerpt from My Take published December 23, 2008 at the tail end of the recession:
...for the record, my views on the economy have been the same for some time. They are as follows: I believe economic recovery will come in the second half of 2009. The reason is not the government stimulus plan, but the healing of the credit markets. The majority of government spending has not even begun yet. The vast amount of new stimulus dollars will be spent between October 2009 and September 2010. Because much of the money will be borrowed from abroad, which represents new money entering the economy, I think that the economy will show positive growth well into 2010. Unlike the fed's injection of funds which shored up bank's balance sheets, the new money being borrowed and spent by government will go directly into consumption and make-work projects. The results, however, will be short lived.
I think we will see prices rise to the 2 to 4% range. This amount of inflation is no small matter in today's context. We have come off a year of deflation where prices fell 1.5%. Our money has bought more home for the buck, more car, more electronic devices, more apparel, more telecommunications, etc. Soon, we will be looking at a reduction in purchasing power as prices once again rise.
I believe the recovery will be cut short as the artificial government stimulation ends, which could only be temporary at best by any economic theory. The economy will fall once more, and no serious amount of money will be available to prop it up this time. I have for some time envisioned a double dip in both the stock market and the economy where both turn up, then turn down again and then simply level off.
At best we should be left with an L shaped recovery for as far as the eye can see. Whether we have a double dip recession, or an L shaped economy, there is no getting around the fact that we are about to hit a mountain of debt accumulation that will serve as a wall against any return to the robust growth of the last 25 years. That era is over.
I expect gold to move gradually higher over the years as the economy stagnates, inflation increases (albeit at "low" levels) and foreign governments continue to diversify into gold and other strategic commodities at an attempt at monetary prudence and independence. I would not be surprised to see gold fall near term when the realization sets in that the nature of our future is not runaway inflation, or robust world growth, or the dumping of dollars, but a more stagnant future of unfunded liabilities, higher taxes, greater borrowing, and greater control and regulation over the economy.
A year ago I saw no reason to change my 2009 outlook and added:
I think the GDP will initially do very well in 2010 but eventually fall back to trend between zero and a positive 2% growth for years. 2010 will be a year of transition. As the artificial stimulus comes to an end so will the artificial spurt of growth. To expect the government to come up with another stimulus package of any consequence, try as they may, would be wishful thinking. The government would have to increase spending more than the last spending program to get a new economic boost and that's not going to happen. The government is out of money.
However, three things occurred last year that did change things a bit. First came the birth of the Tea Party Movement which successfully blocked higher tax rates from being imposed at the beginning of 2011. That and the Tea Parties role in reducing payroll taxes gave the economy a much needed boost. I believe this alone took a double dip recession off the table. This is one reason I moved my GDP projection for 2011 up to 2.75%. The second catalyst was QE2, an anti-deflationary policy intended to fight deflation and increase inflation; which it has. The third and final factor was that while interest rates went up as expected from about 2.75 to over 4%, they came back down very quickly and are under 3% today. I believe this was due to the reassertion of the recessionary/deflationary bias together with the Euro crisis.
In my Looking Forward article the first of this year I quipped about my being willing to make a very large bet with Ben Bernanke that the GDP this year would be closer to 2% than his prediction of around 4%. The Fed took their GDP estimate down from 3.9 in January, to 3.3 in April, to 2.8 today. My estimate for the year is 2.75%.
It looks like we will avoid a double dip--but housing must stabilize soon. I’m actually looking for a better second half. But there are still great dangers out there and aside from housing is the European debt crisis. This will be a drag on world growth for years to come. Here is my view of that developing crisis.
The Death of the Euro
While most have been predicting the death of the dollar, I have been predicting the possible death of the Euro. It is too early to know exactly how the Euro crisis will play out, but the odds are high that the Euro will not survive in its present form.
The most likely scenario for Europe, I think, could look something like this:
Over the next few years, Greece will be forced to break from the Euro Zone and return to the Drachma as its national currency. It will then allow its currency to float and seek its true market level, which would result in a major devaluation and a de facto default on creditors.
All those with loans outstanding to Greece will be forced to write down these loans, and the losses could be huge. French, banks hold a lot of Greek debt and would come under heavy attack from speculators. The fall in French bank stocks would then create a liquidity squeeze, much like what happened with Lehman Bros. The world financial community would try to rally around the banking system in an effort to save it; but at a tremendous cost. (This week European bank stocks are falling dramatically. The Bank of Scotland, one of the world’s largest banks fell 11%. The European stock markets are down eight weeks in a row, and Italy’s debt has reached 100% of GDP.)
Greece would no longer be able to borrow after defaulting, and the country would be forced to live on tax receipts alone. The result would be the same kind of austerity measures they’ve been trying to avoid--only two to three times worse. Meanwhile creditors would be licking their wounds after having taken a beating on Greek bonds. Money would again become tight in Europe as creditors pulled in their risk lending and an inevitable economic contraction set in.
As governments and creditors assessed the damage, the market would likely turn to the next weakest link, and begin to attack its banking system causing fast and furious selling off of financial stocks there. That country would also be forced to part from the Euro and reestablish their own currency at substantially devalued levels. The next potential candidates to be run are Ireland, Portugal, and even perhaps Italy and Spain.
If this is the outcome, after the smoke cleared, the Euro would be represented by only the strongest, most solvent nations. Europe would be split in two, divided into a group of strong nations (the haves), and a recession torn group of financially weak nations who would then make up Europe’s have nots.
America, I believe, would only be affected indirectly by this deconstruction. The turmoil of this experience would obviously lead to a contraction in world growth, a reduced appetite for risk, and stagnation in many areas of the world. But I would not expect to see the dollar decline in this period. In fact it should rise, except possibly against the eventual new Euro. And I do not think this kind of process would lead to a major decline in growth here in America, although we could experience a technical recession. But once the readjustment process ran its course, growth would pick up once again.
The biggest change for everyone in the world, including the US, would be in the way we live. All of us would have to rely a lot less on credit and a lot more on savings; something many today know nothing about. Higher bank capital requirements will be the order of the day world-wide for years to come. This would lead us back to bank reserves more consistent with a gold standard’s reserve requirements.
It would be in this environment that the world would want a currency it could trust; one that wouldn’t be easily devalued or inflated away. In a setting like the one I am describing, gold together with silver and other metals would have the best chance of evolving as the new currency of choice by people and businesses all over the world.
This is just one of many possible chain of events rattling around in my brain lately. The worst case scenario would be if in the middle of one of these currency and debt crises, people threw up their hands and rejected all paper money. If that happened, the entire international fiat system would quickly collapse. Which leads us to this week’s...
Returning to reality and away from the speculative world of theory, we will most probably see a GDP growth rate of around 2% for, as Ben Bernanke likes to say, “an extended period of time”. Unfortunately that means that the stock and commodity boom, caused by a short burst in world growth, is over. The momentum play has ended. I think inflation has peaked, the dollar will firm, and unemployment will remain high. Most likely China will continue to slow, Europe will remain mired in crisis, and the US will continue to languish.
While commodities fall and level off at lower levels, gold will fare better than most, as governments keep a constant bid under it. Their appetite to diversify is insatiable, and the mega-trend away from fiat money toward hard money is still intact. I think we all should consider doing the same. At the very least, gold and silver coins in small denominations should be a part of any portfolio.
For the rest of the year, and into the foreseeable future, I see an L shaped world where the GDP remains low, inflation is receding, and unemployment remains high. The stock market has finally caught onto the fact that world growth is slowing, and has responded by retreating to a more defensive level. PE ratios are being adjusted downward. Gold bugs don't like to admit this, but how the stock market at large behaves often determines how resource stocks behave. This time has been no different.
I think the market is probably going lower, so I am backing into resource stocks slowly by buying some of my favorites as they fall due to investor fear and panic. Preferably, I would like to see one more large washout on high volume. At that point I would enter the market and pick up a few more stocks. But patience is the order of the day. Patience and caution.
In my article Our Nagging Deflationary Problem, posted here in May, I said:
We will see the effects of de-leveraging; debt defaults, a search for safety, very conservative spending by individuals and governments everywhere, and less leveraged investments. As this occurs we should see lower interest rates, slowing growth, a rising dollar, and falling stocks. Commodities should fall back to lower levels and stabilize. Just as everyone begins to focus on the last couple of months of higher inflation rates, which are lagging indicators, the disinflationary/recessionary bias has already set in. I seriously doubt most people are ready for this. It isn't a terrible scenario, but it is a confusing one.
It is because of confusion over present policy, plus the realization of the world economic slowdown, that all markets are falling. We have indeed entered a world of L. Profits will be much harder to come by in the future.
Although I recognize that all markets are likely to fall further, I can't help picking up some stocks that are down over 40%. But with all my buys, I still stand at 70% cash and cash equivalents, including gold and silver. The 30% invested in resource stocks now includes five newly purchased stocks and represents about half of my shopping list.
As I look at my portfolio, all new buys are in the green in spite of a 50 dollar drop in gold this week. This means that resource stocks have already substantially discounted the coming drop in metals. While I can envision a drop in gold of a hundred or two hundred dollars, I doubt that the stocks have more than about another 20% downside risk.
And if we fall further I will continue to step into and buy what may be very scary drops. Anyway, this is the way I see the world halfway through 2011. It has been a very profitable year so far, and we will see what the future will bring.