Casey Files:
Scorched Earth Economy
David Galland
Managing Editor
The
Casey Report
Jul 4, 2008
Here at Casey Research we have
been on the record as bearish on the outlook for the economy
for some years now. Lest you think that is loose boasting, I
can offer proof in Doug Casey's August 2005 article, the dramatically
titled "Profiting from the End of Western Civilization."
In that article, he looked
ahead and saw the inflation that the government's loose money
policies made inevitable. A quote:-
"Of particular importance
is that the U.S. dollar has been used as a gold substitute for
decades by other countries. This has been very convenient for
the U.S.-we can create almost infinite numbers of greenbacks
and give them to people in other countries in exchange for real
wealth. Idiotically, central banks abroad have been holding those
dollars as backing for their own currencies.
"The amounts involved
have grown so immense, and the eventual grim fate of the dollar
has grown so obvious, that foreign central bankers are now looking
at each other, trying to figure out who will head for the exits
first. Many are "diversifying" from dollars into other
currencies-which are themselves backed mainly by other paper
money, mostly dollars. At some point there's going to be a panic
out of U.S. dollars that's going to dwarf any financial event
in history."
And in that same article he
also predicted the current collapse in the housing bubble that
the loose money had made possible. Another quote:-
"What's going on now in
the residential real estate market is much like the tech bubble,
but potentially much, much more serious than what went on in
stocks a few years ago."
Jumping ahead 3 years, to today,
the unhappy scenario Doug then foresaw is now unfolding. Right
on schedule the economy and markets are heading inexorably toward
what might be termed the Scorched Earth Phase.
Even a casual glance at devastation
now being wrought on the very building blocks of the economy
confirms he appropriateness of that term.
For instance, consider the
U.S. financial firms, the single largest component sector of
the S&P 500. So far, the losses to those firms are approaching
half a trillion dollars. And the odds are high that there's much
more to come. With the exception of Bear Sterns, the big name
financials have been able to cobble together the billions of
dollars in additional capital needed to shore up their balance
sheets... but they are quickly running out of rope. That becomes
apparent when you consider that many of their major revenue centers
are now either severely wounded or in the morgue. Last quarter
alone Morgan Stanley saw its investment banking fees fall by
half and toxic paper sales (ah err, I mean "fixed income")
sales and trading revenue collapse by over 85%. And this at a
time when these same firms are being forced by regulators to
repatriate their off-balance sheet assets... to wit, the aforementioned
toxic paper.
Sovereign Wealth Funds (SWF)
to the rescue? Not anymore. Those that initially rushed in were
seriously burned and many are now on record as staying on the
sidelines. But any that might wish to take a second roll of the
dice, will only do so if they get much better terms, which is
dilutive to existing shareholders.
Meanwhile, the housing meltdown
persists and will continue for at least another year or two.
Unless, if course, the government gets serious about "doing
something," in which case the downturn could last 5 or 10
years.
Why do I say that? What the
market needs most of all right now is for house prices to fall,
as quickly as possible, to a market clearing price. The problem,
of course, is that thanks to the self-serving exuberance shown
by many appraisers during the real estate bubble-mania, at this
point nobody actually knows where the bottom is. Another 10%?
20%? 30%?
There really is only one way
to find out... let the brush fire burn, as painful as that will
be. But as I don't need to tell you, "doing nothing"
is not a concept that politicians in an election year are very
comfortable with. And so, like trained seals leaping after vote-fish,
the politicians will jump though any number of hoops to keep
people in their homes even though many can't afford the carrying
costs, let alone the mortgages. That only prolongs the pain and
increases the government deficits that are at the core of the
current crisis.
So, we have a tumbling collapse
in the largest component of the stock market, coinciding with
a tumbling collapse in the largest component of people's net
worth, their homes.
And we aren't even warming
up yet.
For a more complete accounting,
you also have to add into the mix the intractable problems unfolding
in energy patch, including the near-certainty that Mexico, the
3rd largest source of imported oil for the U.S., will stop exporting
said oil within 4 to 6 years... max.
Rather than rushing ahead with
emergency initiatives to open up new energy sources, the U.S.
Congress just emergency legislation to prevent so much as exploring
for uranium anywhere near that big hole in the ground, the Grand
Canyon. It is this perfect world mentality that assures that
the cost of what energy is available, will only get more, not
less, expensive. Of course, as energy is required in the production
of, well... everything, so the cost of everything will
go up.
And that includes, food, which,
as I don't need to tell you, has been on a tear of late.
Sure, opportunistic new plantings
will help, over time, to moderate the higher food prices... but
not overnight. Meanwhile, the cost of filling the old tractor
and shipping food to market will keep going up.
So, to the list of serious
problems for the economy, we have to add persistent high energy
and food prices.
But even those fall short of
the KING KONG of the set piece... the collapsing fiat monetary
system that helped created the recent series of bubbles in the
first place.
In a fiat monetary system the
only tangible barriers to money creation are provided by a loss
in stakeholder confidence. While the average American is, sad
to say, almost completely ignorant of what a fiat monetary system
is, let alone the consequences of same, the same cannot be said
of the foreign holders of an unprecedented $6 to $7 trillion
dollars.
To be a touch more specific,
by unprecedented I mean as in "never happened before".
While, under other circumstances this fact might evoke a raised
eyebrow or a concerned comment over cocktails... going into the
jaws of a vicious economic/dollar crisis those foreign dollar
holdings become akin to playing toss with a lit stick of dynamite.
He who holds the dollars when the fuse meets the powder are in
for a very, very bad day.
As a result, the foreign holders
are watching the moves of the Fed very closely. Trying to avoid
that scrutiny the Fed, like a curbside three card Monty dealer,
has come up with some clever sleights of hand, including lending
directly to investment banks and swapping Treasury bills for
toxic paper. But that has accomplished little more than buying
some time; it does nothing to resolve the "rock and a hard
place" dilemma.
Which remains as thus: if the
Fed raises rates to prevent a sell off in dollars, they'll crush
the highly indebted and already struggling populace and, in so
doing, unleash a serious economic crisis. But if the Fed keeps
rates where they are, or even lowers them, they'll trigger a
dollar sell-off and unleash a serious economic crisis.
Either way, the story ends
the same: a serious economic crisis.
At this point, our bet remains
that the Feds will go to default mode which means cranking up
the printing presses into the red zone, letting the dollar move
ever closer to its intrinsic value: zero. That they'll follow
this route is suggested by two inputs. First, a depreciating
dollar means a reduction in the trillions of dollars in obligations
now owed by the U.S. government. And, secondly, foreign holders
don't vote.
So, we are calibrating our
investments toward a serious economic slowdown, but with high
inflation. Some people would call that Stagflation. But given
the severity of both sides of that formula, the situation may
be better described in terms of Scorched Earth. Or, because people
seem to find concepts ending in "flation" handy, Stag-flagration.
Businesses and personal net
worth will be devastated at the same time that costs run out
of control.
How to Play It?
Our strongest recommendation
is to position your portfolio in anticipation of higher inflation
and, in time, a turnaround in interest rates. The latter
is because interest rates, which are still near a 50 year low,
can only go up as the inflation rises to the point of banner
headlines (at which point, the government is hoping, the economic
downturn will have moderated).
In fact, we think the move
towards higher interest rates is a trend that will surprise many,
but, once it gets going in earnest (and corporate bond yields
are already on the rise) last for at least the next several years.
In terms of other investments, it's worth noting that in the
last major bull market for tangibles, back in the 1970s, oil
was the best performing investment, followed by gold, U.S. coins,
silver and stamps.
Today the range of investment
vehicles you can use to make the trend your friend is greatly
expanded a wide variety of specialized ETFs (though an added
layer of analysis is required to sort the strong, well structured,
high volume variety from the thinly traded variety of suspect
parentage). And while they continue to require patience, the
highest quality junior Canadian gold exploration stocks remain
one of the most prospective investments you can make. A number
of these companies are now sitting on proven big discoveries,
but thanks to the stop-start markets, are significantly undervalued.
They won't stay that way long.
Whatever you do, don't be complacent
at this point. If we are right, then the economic crisis will
soon head into its next and most dangerous stage. Certainly,
we should feel the heat, and maybe worse, by the end of the year.
Therefore, at the very least, you'll want to take measures now
to protect yourself. For our own portfolios, we believe that
the best defense is a good offense, and so are positioning ourselves
in the sectors that will profit, and profit big, as the stag-flagration
sweeps across the global economy.
Then it's just a matter of
sitting tight and being right.
David Galland is the Managing Director of Casey
Research, LLC., publishers of Doug Casey's International
Speculator which provides unbiased research and recommendations
on the highest quality junior exploration companies.
Casey Research has also recently
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and global economy, and how to profit from those trends. As a
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