On one hand of the spectrum, the bears believe that China is a train-wreck and that its economic growth is unsustainable. These skeptics love to highlight the property bubble in China and they never miss the opportunity to mention the fact that fixed asset investment accounts for a disproportionately large chunk of the Chinese economy. According to the bearish camp, China’s economy is not real; rather, its breakneck economic growth is centrally planned by Beijing. Furthermore, the bears argue that China’s vast foreign exchange reserves are meaningless and that they will be used up in dealing with the aftermath of the Chinese real estate bust.

On the other side of the equation, the optimists believe that China is the next great nation in the world and its super power status is all but assured. These bulls point to China’s foreign exchange reserves, low debt levels, high savings rate, strong work ethic and growing domestic consumption. According to these folk, China’s economy is amongst the strongest in the world and Beijing is in total control.

So, given such conflicting views, it is hardly surprising that investors are confused about China. Furthermore, it goes without saying that over the past few months, we have spent a lot of time thinking about China’s prospects. Therefore, we will now outline our views about the Chinese economy and its financial markets.

First and foremost, we want to make it clear that we are not bearish about the long-term prospects of the Chinese economy. After all, the country has amassed the largest foreign exchange reserves in the world (US$2.85 trillion), it boasts a very high savings rate (37%), its household debt to GDP ratio is very low and its per-capita income is rising rapidly. Therefore, at first glance, the Chinese economy appears to be in good health.

Unfortunately, China’s economy also has a soft underbelly; it’s out of control property market. After reviewing heaps of data, it is clear to us that real-estate prices along the coastal cities in China are grossly over inflated and due for an abrupt adjustment. When measured in terms of affordability (median home price to median household income), it is blatantly obvious that Chinese property is in a gigantic asset bubble. Moreover, various other data points also confirm overvaluation and excesses in China’s property market.

According to some reports, billions of square feet of commercial real-estate is unoccupied in China. Furthermore, we have also heard accounts from reliable sources that there is rampant speculation in China’s residential real-estate. For example, the Chinese have been snapping up bare-shell apartments (no internal walls or fittings), for the sole purpose of flipping these properties for a quick profit. It is interesting to note that these buyers are not the least bit interested in a rental yield, their only intention is to sell these properties to a ‘greater fool’.

Needless to say, China’s banks have been doing their part to fuel this speculative orgy. For instance, the South China Morning Post recently reported that in 2010, China’s banks originated CNY8 trillion in new ‘official’ loans and this amount exceeded Beijing’s loan target. However, the buck did not stop here and allegedly the Chinese banks loaned out an additional CNY3 trillion via ‘off the balance-sheet’ arrangements orchestrated through various Trust entities.

The chart below captures the sharp increase in China’s Yuan-denominated loans. According to China Daily, outstanding Yuan-denominated loans stood at CNY47 trillion at the end of October, which is an astronomical sum when you consider that China’s economy is worth only CNY37 trillion. Unfortunately, this rampant credit growth is not slowing down and apparently, Chinese banks have already created new loans worth CNY1.5 trillion in 2011!

So, there you have it. All the conditions are now in place for a property bust – extreme overvaluation, abundant credit and massive oversupply. The trillion dollar question though is whether the unavoidable bust in housing will impact China’s broader economy or will the damage be confined amongst the property speculators and developers?

Unfortunately, this is a very difficult question to answer but given the relatively low household debt in China, we are inclined to believe that the pain will be limited to the property developers, leveraged speculators and banks. We have no doubt in our mind that China’s non-performing loans will escalate in the future, therefore we believe that an investment in Chinese banks is risky.

Furthermore, when the Chinese property boom turns sour, various asset markets and economies will be impacted. First and foremost, the prices of base metals may fall from their lofty levels and this will affect the earnings of the major mining companies. Remember, China is the major importer of base metals and any slowdown in its real-estate construction will diminish demand for industrial raw materials. Accordingly, we have recently liquidated our investment positions in the base metals mining companies.

Moreover, any fallout from the Chinese real-estate bust will surely impact the economies of the commodity-producing nations such as Australia and Brazil. Thus, investors should remain vigilant and perhaps reassess the risk/reward of their cyclical investments in these resource-rich nations.

Now, this may sound strange but despite our near-term concern about China’s housing bubble and our bearish stance towards certain sectors, we remain optimistic about the nation’s long-term economic prospects.

In terms of the broader Chinese economy, we believe that a housing bust in China will cause some hiccups in its breakneck growth. However, we suspect that this slowdown will be temporary because most Chinese households are not leveraged to their eyeballs (China’s household debt to GDP ratio is below 20%).

Furthermore, it is notable that currently, China’s private domestic consumption accounts for only 34% of GDP (Figure 2) and in our view, this percentage will increase in the future. Remember, in its latest five year plan, Beijing has made it clear that it wants to increase private consumption and reduce China’s dependence on low-margin manufacturing and exports.

It is our contention that China’s policymakers are serious about this issue and they have the necessary tools to encourage domestic consumption. For instance, if Beijing allowed its currency to appreciate, such a move will undoubtedly increase the purchasing power of the Chinese, thereby increasing private consumption.

Despite the looming property bust, it is our contention that China’s stock market has already discounted the housing problem and this is why the Shanghai Composite Index is trading approximately 55% below its all-time high. As far as valuations are concerned, it is notable that the index is trading at 17 times reported earnings, which is remarkably cheap when you consider the 12-year average price earnings ratio of 34. Last but not least, if you factor in this year’s corporate earnings growth, the index is valued at just 13.1 times projected after-tax earnings.

In summary, given our long-term optimism towards the Chinese economy and the historically low valuations, we are maintaining our investment exposure to our preferred companies in China. While we continue to avoid the property developers and banks, we have allocated capital to terrific Chinese companies which should benefit from an increase in China’s domestic demand.

If our assessment is correct, the ongoing weakness in Chinese stock prices is a good buying opportunity for the patient investor.

Regards,

Puru Saxena
for The Daily Reckoning

China – Risks and Opportunities originally appeared in the Daily Reckoning. The Daily Reckoning, published by Agora Financial provides over 400,000 global readers economic news, market analysis, and contrarian investment ideas. Recently Agora Financial released a video titled "What Causes Gas Price to Increase?".

The truth is that the world’s output of conventional crude oil peaked in 2005 and global oil exports are also past their prime. Furthermore, the unconventional sources (tar sands, heavy sour crude, ethanol, natural gas liquids, bio-fuels and shale) are struggling to keep up with the ongoing depletion in the world’s largest oil fields. Therefore, it is probable that the world’s current production of total liquids is at or near maximum capacity.

Veteran clients and subscribers will recall that we have been extremely concerned about ‘Peak Oil’. However, for many years, ours was one of the lone voices in the dark. It is interesting to observe that up until 2007, various government sponsored energy agencies were extremely optimistic about their oil production forecasts. In fact, before it commissioned its first field by field analysis in 2008, the IEA used to claim that the world could easily produce over 110 million barrels of total liquids per day! Ironically, other agencies such as CERA and the EIA were even more liberal with their oil production projections and ‘Peak Oil’ was dismissed as a lunacy.

Thereafter, in November 2008, the IEA released its World Energy Outlook 2010 report, which contained a thorough analysis of the world’s 800 largest oil fields. In this study, the IEA admitted (for the first time) that most of the world’s largest oil fields are depleting at a rapid clip and serious capital spending is essential to avoid an energy crunch in 2020. Although this report was a step in the right direction, in our view, the IEA was still painting an unrealistic picture.

Fortunately, it has taken the IEA only two years to realise its mistake and its latest World Energy Outlook 2010 report presents a far more realistic scenario. According to its latest study, the IEA now expects global total liquids production to increase to just 96 million barrels per day by 2035! Bearing in mind the fact that the world currently produces 88 million barrels of total liquids per day, the IEA is now essentially implying that output will only increase by 9% over the next 25 years!

It is notable that in 2009, the IEA stressed the importance of oil for economic growth and concluded that 106 million barrels per day will be required by 2030; representing an increase of approximately 18 million barrels per day above current output. Interestingly, in last year’s report, the IEA predicted that global production will peak at only 96 million barrels per day in 2035! So, within the course of a single year, the energy watchdog for the developed world lowered its production estimate by 10 million barrels per day!

To complicate matters further, the IEA’s latest forecast of 96 million barrels per day of peak production depends on the assumption of finding an extra 900 billion barrels of oil over the next 25 years! However, given the fact that over the recent past, we have managed to discover only 10 billion barrels of oil each year, we cannot help but take the IEA’s rosy forecast with a pinch of salt. Call us skeptics, but at the current rate of discovery, it will take us 90 years to discover 900 billion barrels of oil. Yet, the IEA somehow believes that this task can be accomplished by 2035!

The chart below is taken from the IEA’s World Energy Outlook 2010 report and it does a good job of capturing the sorry state of affairs. As you can see, the IEA now expects the output from the currently producing fields (dark blue area on the chart) to drop from approximately 70 million barrels per day to only 16 million barrels per day by 2035. Furthermore, the IEA also believes that 60% of oil production in 2035 will come from oil fields not yet found (light blue area on the chart) or developed (grey area on the chart)! Once again, call us skeptics, but we do not believe that oil fields yet to be found or developed will somehow succeed in offsetting the ongoing depletion.

It is our contention that the world will struggle to produce more than 91-92 million barrels of total liquids per day and global demand will collide with available supply. Of course, we do not know the exact timing of this event but if global consumption continues to grow by 1.5% per annum, we will get there within the next 2-3 years.

Needless to say, when aggregate demand hits available supply, the price of oil will rise sharply. More importantly, if demand continues to increase in the developed world, there will be a permanent shortage of crude and governments will probably end up rationing petroleum. Furthermore, it is our firm belief that ultimately, oil will only be used for its highest uses (agriculture and aviation).

If history is any guide, the price of oil will not rise in a straight line and the secular uptrend will be punctuated by severe economic recessions. After all, the cure for a high oil price is a high oil price! At some point during the course of this business cycle, as the price of oil continues to rise, it will (once again) cause economic pain for the overstretched citizens of the developed world. When that happens, consumption will slow down and we will experience demand destruction in some parts of the world.

In our view, the next economic recession will be caused by yet another spike in the price of oil and during the next business slowdown, crude will get whacked again. This is the reason why we will liquidate all our energy related investments prior to the onset of the next economic recession.

Turning to the current situation, the price of oil is trading around US$90 per barrel and during the course of this business cycle, we expect it to surpass its previous record of US$147 per barrel.

In addition to crude oil, we are also optimistic about the prospects of uranium. As you may know, various nations are scrambling to build new nuclear reactors and this is good news for uranium (raw material used for a nuclear reaction).

As the world approaches ‘Peak Oil’ and crude is conserved, demand for electricity will surge. Either that or the world will go back to horse drawn carriages, which we seriously doubt! Furthermore, given the environmental damage associated with burning poor quality coal, the world will turn to nuclear energy to meets its energy needs. Therefore, worldwide consumption of uranium will appreciate over the following years and this will exert enormous pressure on mined supply.

At the time of writing, the price of uranium has climbed to US$61.5 per pound and it is probable that it will at least double from this level. In the previous cycle, the price of uranium peaked around US$140 per pound and we will not be surprised to see that level exceeded within the next 2-3 years. Such a bullish scenario for uranium is great news for the unhedged uranium mining companies and a modest exposure to these stocks seems like a reasonable bet.

In summary, given the reality of ‘Peak Oil’ and our bullish bias, we have allocated approximately 30% of our clients’ capital to those assets which will benefit from the looming energy crunch. At present, we have exposure to upstream oil companies, integrated energy giants, oil services firms, renewable energy stocks, uranium and electric car/rechargeable battery manufacturers. It is our contention that these businesses will prosper over the following years, thereby rewarding our investors.

Regards,

Puru Saxena
for The Daily Reckoning

Welcome, ‘Peak Oil’ originally appeared in the Daily Reckoning. The Daily Reckoning, published by Agora Financial provides over 400,000 global readers economic news, market analysis, and contrarian investment ideas. Recently Agora Financial released a video titled "What Causes Gas Price to Increase?".

Look. The ‘Great Recession’ in the developed world was brought about by excessive debt and consumption. In the boom years, millions of Americans borrowed copious amounts of money to buy real-estate; they used their homes as a source of funding (home equity withdrawals) and spent way beyond their means. In those heady days, everyone was convinced that real-estate prices could not decline on a country wide basis. Unsurprisingly, the bankers gladly supported this misconception by providing cheap fuel to the raging speculative fire. The end result was that unworthy debtors were able to purchase several properties and real-estate prices appreciated considerably.

Unfortunately, when interest-rates went up and credit became scarce, the house of cards collapsed. When boom turned to bust, millions of American homeowners were left with negative equity (see chart below) and the entire banking system came to its knees. When that happened, the American policymakers embarked on a fear-mongering campaign and they misled the public into believing that it was essential to save the banks. During the depth of the financial crisis, we were repeatedly told that the ‘too big to fail’ banks had to be saved, or else the consequences would be dire.

After the establishment succeeded in its scare tactics, it unleashed its ‘stimulus’ and used tax payers’ money to bail out the insolvent financial institutions. In the name of national interest, the Federal Reserve created trillions of dollars out of thin air and it purchased toxic mortgage-backed-securities from the commercial banks. Furthermore, instead of marking down the value of these securities, the American central bank bought the dubious assets at face value! Thus, the American taxpayers bailed out the banks and the risk was transferred from the private-sector to the state.

In addition to nationalising the bank’s losses, the Federal Reserve dropped the short term interest rate to near-zero and it started buying US Treasury securities. Supposedly, these Band-Aid solutions were necessary to prevent an economic depression and somehow they would revive the world’s largest economy.

By dropping the Fed Funds Rate to almost zero, the American central bank hoped to achieve the following benefits:

a. Reduce the borrowing cost of the banks (so they paid next to nothing for deposits)
b. Stimulate private-sector credit growth

In hindsight, the Federal Reserve succeeded in lowering the banks’ borrowing cost but it failed in reviving private-sector credit growth. After all, American households were already leveraged to the hilt and they refused to go even deeper in debt.

In our view, these drastic policy measures were unnecessary and they failed to get to the root of the problem – too much debt. Instead of nationalising the banks’ losses by using tax payers’ money, the American government should have restructured debt in an orderly manner. Insolvent institutions should have been allowed to fail, bondholders should have received a hair cut on their bad loans, and the total outstanding debt should have been reduced. If anything, in order to help the masses, the American establishment should have guaranteed all the bank deposits and taken steps to assist the distressed homeowners.

Instead, the American policymakers focused on helping the banks, and in the process, they increased the public’s debt burden! Furthermore, by transferring private sector risk on to the public’s balance-sheet, the American establishment has seriously undermined the quality of the nation’s balance-sheet.

It is noteworthy that over the past decade, America’s federal debt has more than doubled! Today, it stands at US$13.64 trillion and has morphed to 93.5% of GDP! The fact that this surge in debt has produced pathetic economic growth and done very little to bring down unemployment, is proof that Keynesianism does not work.

Unfortunately, the American establishment has not learnt from past mistakes and it continues to follow disastrous economic policies.

By now, it should be clear to everyone that the first round of quantitative easing failed to stimulate the world’s largest economy. So, if the initial ‘stimulus’ did not work, what are the odds that additional quantitative easing will do the trick?

The truth is that quantitative easing has never worked and this time around, the end result will be no different. In fact, we are prepared to bet our bottom dollar that quantitative easing will fail miserably in reviving economic growth in America. To make matters worse, if the Federal Reserve continues to create money like there is no tomorrow, the stage will be set for an inflationary inferno.

As an investor, it is crucial for you to understand that although monetary inflation causes asset prices to rise in nominal terms, it does not impact them uniformly. For instance, when inflationary expectations are low and confidence in the government is high, monetary inflation benefits financial assets (stocks and bonds). Conversely, when inflationary fears are elevated and investors have lost faith in the government, monetary inflation tends to benefit hard assets (precious metals, energy and soft commodities).

The nearby chart captures this inverse correlation between financial assets and gold. As you can see, between 1980 and 2000, monetary inflation benefited the Dow Jones Industrial Average (Dow) and during that period, gold performed poorly. However, since the turn of the millennium, monetary inflation has benefited hard assets and American stocks have underperformed relative to gold. At present, the Dow to gold ratio is at 8.4 and if history is any guide, over the following years, gold should continue to appreciate more than American stocks.

In our view, the ongoing bull market in hard assets will carry on for as long as the Federal Reserve and its counterparts continue to engage in quantitative easing. Now, it is conceivable that over the following months, several central banks in the developed world will announce further stimulus and this should turbo charge the commodities boom.

It is our contention that as long as the bond vigilantes are asleep at the wheel, the ‘risk trade’ will continue to flourish. However, no boom lasts forever and at some point, when the bond vigilantes get spooked, sharply higher interest rates will end up killing the commodities bull. When that happens is anybody’s guess, but we suspect that the good times will continue for another 2-3 years.

Despite the fact that quantitative easing will not succeed in the developed nations, we remain optimistic about hard assets and continue to favour the stock markets of the developing economies in Asia.

Regards,

Puru Saxena
for The Daily Reckoning

Band-Aid Solutions originally appeared in the Daily Reckoning. The Daily Reckoning, published by Agora Financial provides over 400,000 global readers economic news, market analysis, and contrarian investment ideas. Recently Agora Financial released a video titled "What Causes Gas Price to Increase?".

Never mind sky-high deficits and a crushing debt overhang, at its most recent FOMC meeting, the Federal Reserve all but guaranteed another round of quantitative easing.

While the American central bank did not officially expand its quantitative easing program last month, it did reiterate its willingness to institute more aggressive monetary policy measures in order to combat the risks of deflation. Furthermore, Mr. Bernanke did officially downgrade the Federal Reserve’s outlook for inflation.

The truth is that the US is insolvent and its policymakers will stop at nothing in order to avoid sovereign default. So, it should come as no surprise that at its latest meeting, the Federal Reserve downplayed the risk of inflation, thereby setting the stage for another round of money creation.

Make no mistake; Mr. Bernanke has already created copious amounts of money. Granted, the Federal Reserve’s previous monetisation was highly secretive, but you can be sure that it did occur. Allow us to explain:

You will recall that during the depths of the financial crisis, the Federal Reserve expanded its own balance-sheet and bought all sorts of toxic assets from the financial institutions. By doing so, Mr. Bernanke created money out of thin air and bailed out the major banks.

Thus, the banks were able to dump their garbage assets on to the Federal Reserve and once they received the newly created cash in exchange for these securities, they loaned this money to the US government by purchasing US Treasuries. In summary, in the previous round of quantitative easing, the Federal Reserve created new money and instead of lending it directly to the US government, it used the banking cartel as its conduit. Back then, not only did the Federal Reserve create more than a trillion dollars, it also dropped its discount rate to almost zero; thereby allowing banks to borrow money cheaply! It should be noted that since the banks were able to obtain such inexpensive funding from the Federal Reserve, they had absolutely no qualms about re-investing this capital in US Treasuries.

At first glance, the Federal Reserve’s stealth monetisation plan seemed flawless. The banks offloaded their toxic assets on to the Federal Reserve, they made fortunes by investing in US Treasuries and the American government got access to a cheap source of funding. Magic!

Despite the fact that this financial wizardry was a lifeline for American policymakers and their banking cronies, let there be no doubt that it was an unmitigated disaster for the American public. Not only did the Federal Reserve nationalise the banks’ losses but more importantly, Mr. Bernanke’s money creation efforts have seriously undermined the viability of the US Dollar.

It is noteworthy that since bailing out the major banks and orchestrating the stealth monetisation, the Federal Reserve has been busy purchasing US Treasuries. Furthermore, it is now almost certain that in next month’s FOMC meeting, Mr. Bernanke will unleash yet another round of quantitative easing. In other words, in order to fund Mr. Obama’s out of control spending, Mr. Bernanke will create even more dollars out of thin air! Allegedly, this new round of money creation will drive interest-rates lower, thereby helping the US economic recovery. Or so the story goes.

Unfortunately, as any serious student of economic history knows, there is no such thing as a free lunch. By adding trillions of additional dollars to the monetary stock, Mr. Bernanke may succeed in bailing out his friends in high places but he is seriously jeopardising the US Dollar. In fact, bearing in mind the recent developments, it has become clear to us that the Federal Reserve wants to debase its currency. In our humble opinion, the US Dollar is a doomed currency and there is a real risk of an abrupt plunge in its value.

If our assessment turns out to be correct and Mr. Bernanke unleashes the second phase of quantitative easing, you can be sure that the US Dollar will slide against most un-manipulated currencies (which are few and far between) and hard assets. In fact, monetary inflation is the prime reason why we believe that the ongoing bull-market in stocks and commodities will continue for several more months.

Look. The US economy is swimming in debt and the total obligations (including social security, Medicare and Medicaid) now come in at around 800% of GDP! Furthermore, this year alone, Mr. Obama’s administration plans to spend another US$3.5 trillion, meanwhile the US Treasury will raise roughly US$2.2 trillion from issuing new government debt! Clearly, these numbers are unsustainable and you can bet your bottom dollar that the Federal Reserve will end up buying a large proportion of the newly issued US Treasury securities. As the American central bank funds more and more of Mr. Obama’s spending by creating new money, it will trash the value of its currency. In fact, given the growing imbalance between the government’s spending and tax receipts, very high inflation is inevitable and even hyperinflation cannot be ruled out.

For the sake of their financial well being, it is crucial that investors understand that inflation or even hyperinflation is a monetary phenomenon and a strong economy is not a pre-requisite for the debasement of a national currency. Whatever the reason, if a central bank decides to significantly increase the quantity of money in the system, that currency’s purchasing power will always diminish. This is how fiat-money regimes have operated since the beginning of time and this era is no different.

It is interesting to note that throughout recorded history, the worst excesses of inflation occurred only in the 20th century. Undoubtedly, this was a direct consequence of the adoption of fiat-money.

The following chart highlights all the hyperinflationary episodes in recorded history and as you can see, with the exception of the French Revolution (1789-1796), all of the other disasters occurred in the last century. In fact, it is an ominous sign that 29 out of the 30 recorded hyperinflations in human history occurred during the 20th century!

Let there be no doubt, a paper money system usually ends in the reckless destruction of money and it is no coincidence that all hyperinflations in history have occurred in the presence of discretionary paper money regimes. Furthermore, it is important to understand that a political system based on democracy is inherently inflationary and political leaders have been responsible for all major inflations in the past. Conversely, history has shown that monetary systems binding the hands of political leaders are essential for keeping inflation in check. If history is any guide, metallic monetary systems have shown the largest resistance to inflation and this is due to the fact that currencies anchored by a tangible asset cannot be inflated ad infinitum.

It is our conjecture that the current monetary system is absolutely pathetic; a system designed to enslave society. Unfortunately, the vast majority of humans do not understand the endless inflation agenda and this is why the perpetrators get away with this crime. Furthermore, let it be known that the Federal Reserve is largely responsible for the incredible inflation we have experienced over the past century.

The chart below plots the cost of living in Britain, France, Switzerland and the US. As you will note, the cost of living in these nations was relatively stable for over 160 years (1750-1913) but once the Federal Reserve came to power in 1913, everything changed. Suddenly, the cost of living exploded in these nations, so it should be clear that the Federal Reserve’s covert policy of currency inflation and debasement is solely responsible for this mind numbing inflation.

Unfortunately, the Federal Reserve and its allies have not finished inflating and over the following years, they will create even more confetti money. Under this scenario, cash will continue to lose purchasing power and the asset poor middle-class will get even more impoverished. If our assessment is correct, cash will prove to be a disastrous ‘asset’ over the next decade and once the Federal Reserve’s manipulation ends, fixed income securities will also depreciate in value.

Bearing in mind our grave concern about high inflation and the very real possibility of hyperinflation, we continue to favour hard assets such as precious metals and energy. At present, we have allocated roughly half of our clients’ capital to these sectors and it is our belief that this should be an adequate inflation hedge.

Regards,

Puru Saxena
For The Daily Reckoning

The US Dollar is Doomed originally appeared in the Daily Reckoning. The Daily Reckoning, published by Agora Financial provides over 400,000 global readers economic news, market analysis, and contrarian investment ideas. Recently Agora Financial released a video titled "What Causes Gas Price to Increase?".

Today, many prominent economists (Nouriel Roubini, David Rosenberg and Paul Krugman) and fund managers (Bill Gross and Jeremy Grantham) are forecasting deflation and according to these folks, a deflationary contraction is now ‘baked in the cake’. In fact, these deflationists are extremely worried about the ongoing private-sector debt-deleveraging in the developed world and they are also concerned about the lack of aggregate demand in the industrialised nations. Bearing in mind these two factors, these prominent people believe that deflation is now almost guaranteed and inflation is out of the question.

On the other end of the spectrum, and in stark contrast to the deflationist camp, many prominent market participants (Paul Tudor Jones, John Paulson, Jim Rogers, Marc Faber and Peter Schiff) are now warning about high inflation or even hyperinflation. According to these people, the large fiscal deficits and massive debt overhang almost guarantee runaway inflation.

It goes without saying that such conflicting views are extremely strange when you consider that all these highly experienced and successful people are reviewing the same economic data! Well, everyone is entitled to their opinion, but as far as we are concerned, deflation is an urban myth and the global economy will have to contend with very high inflation.

It is our conjecture that inflation is always a monetary phenomenon and willing policymakers have the ability to create inflation. Now, before we delve any further, we want to make it clear that inflation is an increase in the supply of money and debt. Conversely, deflation is a decrease in the supply of money and debt. Furthermore, it is critical to understand that an increase in the general price level is a consequence of inflation and a decrease in the general price level is a consequence of deflation. Most importantly, despite what you may hear elsewhere, you should keep in mind that a booming economy (operating at maximum capacity) is not a pre-requisite for inflation.

Now, if you reside in the deflation camp and believe that inflation cannot occur in a weak economic environment, you need to visit Zimbabwe and meet Mr. Mugabe who will explain how you can create hyper-inflation at a time when a nation is facing an economic depression! Whether you like it or not, Zimbabwe’s hyper-inflationary saga clearly shows that despite a huge output gap, surging unemployment and a bankrupt economy, reckless policymakers can succeed in creating massive inflation.

Look. We do acknowledge the fact that the economies of the developed world are struggling and they will probably remain weak for several years. We also accept the fact that the aggregate demand in these troubled economies will stay well below the available capacity (output gap). However, contrary to the deflation camp, we totally respect the money-creation abilities of the central banks. Accordingly, we firmly believe that in order to avoid sovereign defaults in the near-term, the Federal Reserve and the European Central Bank will create unprecedented inflation.

Already, short-term interest-rates in the US and in Europe are at extremely low levels and real short-term interest-rates are negative. If such a loose monetary policy fails to create inflation, you can bet your bottom dollar that these central-banks will unleash even more rounds of ‘Quantitative Easing’. Needless to say, such reckless monetary-inflation will dilute the existing money-stock even further and reduce the purchasing power of money. Okay, enough about the inflationary bias of the public-sector, let us now move on to the private-sector.

As far as the private-sector is concerned, you may recall that after the credit-bubble burst two years ago, commercial-bank credit in the US started to contract. After all, this debt repayment by the private-sector was a logical response to the crisis and for 17 months, commercial-bank credit declined by roughly US$700 billion. In fact, it was this private-sector debt contraction, which prompted many economists and investor to enter the deflation camp.

Whilst it is true that the private-sector in the US did experience deflation (contraction in debt) for a brief period of time, it is notable that this ‘austerity’ did not last very long! Figure 1 shows that US commercial-bank credit bottomed out earlier this year and since then, it has risen by roughly US$400 billion. So, it should be clear to all observers that the private-sector in the US is no longer de-leveraging and this is inflationary.

Furthermore, we would like to point out that even though commercial-bank credit in the US contracted between October 2008 and March 2010, during that period, America’s federal debt went through the roof! Ironically, during the time-frame when American households and corporations were tightening their belts, the US-Treasury borrowed almost US$2 trillion; thereby stopping deflation in its track. The truth is that at no point during the recession did total debt (private-sector plus federal) in the US contract, so deflation did not occur. Now, it is conceivable that the private-sector in the US may abruptly start repaying its debt again. However, if such a debt-contraction occurs, Mr. Bernanke will create money like there is no tomorrow.

Today, America’s total liabilities (including social security, Medicare and Medicaid) are around 800% of GDP and federal debt has climbed above 90% of GDP (Figure 2). Given the fact that deflation will increase the real value of this debt, you do not have to be a brain surgeon to figure out that before the US government declares bankruptcy, it will desperately try and inflate its way out of trouble. By unleashing another ‘stimulus’, Mr. Obama’s administration will try and maintain nominal GDP growth, so that nominal incomes and tax receipts are sufficient to service the outstanding debt.

It is interesting to observe that in order to fund its spending binge, so far the US administration has succeeded in borrowing huge amounts of money at low interest-rates. It is notable that up until now, demand for US-Treasuries has been strong and the US administration has not had much trouble raising money. Perversely, in today’s volatile economic environment, US government debt is still viewed as a safe haven. However, every good thing comes to an end and investors’ perception could change at short-notice. When that happens and the bond market starts to focus on America’s ballooning deficits, demand for government-debt will dive. At that point, the Federal Reserve will have no option but to create new money so that it can lend it to the US Treasury. In fact, the Federal Reserve has already announced that it will use the proceeds from the sale of its mortgage-backed securities to buy US Treasuries. In our view, this is only the beginning and outright asset-monetisation will intensify over the following years.

Throughout history, periods of massive money-creation have always been inflationary and this time should be no different. Over the following months, if the economies of the developed world take a turn for the worse, you can be sure that the respective policymakers will respond by creating copious amounts of paper money.

If you still believe that deflation will prevail, perhaps you should review the table below, which highlights the inflation rates in various countries. It is noteworthy that the inflation rate depicted here for each nation is in fact the Consumer Price Index (CPI), which significantly understates the price increases within an economy. Let there be no doubt that the majority of government agencies make seasonal and hedonistic adjustments to bring down the level of the CPI. Regardless, you can see that despite such ‘feel good’ adjustments to bring down the reported ‘inflation’ rate, every nation (except Japan) is currently experiencing ‘inflation.’

Bearing in mind this compelling data, we are left wondering how anybody can get hoodwinked by the deflation hype!? Perhaps, the deflationists know something the rest of us do not, but at this point, hard data does not support the deflation thesis.

Given the inflationary environment we find ourselves in, we do not like cash or fixed-income securities. In our view, both cash and bonds will lose considerable real value over the following years and the ongoing strength in the government bond-market may turn out to be an exceptional selling opportunity. Conversely, we maintain our view that precious metals, energy and the stock markets of the fast growing developing markets in Asia will provide stellar returns in this inflationary environment.

Regards,

Puru Saxena
for The Daily Reckoning

Deflation: Reality or Urban Myth? originally appeared in the Daily Reckoning. The Daily Reckoning, published by Agora Financial provides over 400,000 global readers economic news, market analysis, and contrarian investment ideas. Recently Agora Financial released a video titled "What Causes Gas Price to Increase?".

Look. We know that the developed economies are in trouble and they are unlikely to improve anytime soon. For instance, unemployment remains stubbornly high, deficits are spiraling out of control and debt levels are unprecedented. At first glance, things do look dire but we still believe that nominal stock prices will continue to rise.

If our assessment is correct, stock markets in the developed world will continue to drift higher over the following months as corporate earnings play catch up and compress valuations. So, even though it may take years before the major American and European indices decisively break out above their record-highs, equity investors should be able to outperform both cash and government bonds over the next decade.

More importantly, we suspect that the stock markets of the developing world (led by Asia) will outperform their counterparts in the developed world over the following years. This is due to the fact that unlike the industrialized nations, the developing countries are growing at a healthy pace and we expect their stock market valuations to expand.

As we have stated previously, we continue to believe that the nominal low of the entire secular bear-market was registered in March 2009 when the S&P500 Index bottomed out at the devilish number of 666. It is our conjecture that 6th March 2009 will go down in the history books as the ultimate nominal low of the entire secular bear-market. Put simply, given the ultra-loose monetary policy and the central bank’s ability to unleash “stimulus”, we do not expect the stock markets to break below last spring’s lows.

Now, we are aware that many smart people continue to believe that we are still in a secular bear-market and that it is only a matter of time before stock prices plunge again. According to the bearish camp, global stock prices are currently in a “dead cat bounce” and they are ultimately headed much lower. As much as we sympathize with such dire predictions, such pessimistic forecasts do not stand the test of time. Allow us to explain:

The purpose of bear-markets is to compress valuations. In other words, during the course of any secular bear-market, valuations gradually decline to the point where businesses become incredibly cheap. Remember, the purpose of secular bear-markets is not to plunge stock prices in nominal terms. Sometimes, the nominal low can be years in advance of the low point in valuations (end of the bear-market).

For example, the previous secular bear-market in the US lasted between 1966 and 1982. During that 16-year period, American stock prices oscillated within a wide trading range and frustrated most market participants. In terms of valuations, even though the bear-market continued until 1982, the ultimate nominal low was recorded 8 years earlier in 1974 (Figure 1).

It is interesting to observe that despite the fact that stocks were not cheap in September 1974, that low turned out to be the best long-term buying opportunity. Unfortunately, during the 1974 stock market plunge, purists kept waiting for lower valuations and they ultimately ended up paying much more because nominal stock prices never fell below the levels seen in 1974. Ironically, when valuations bottomed out in 1982, the Dow Jones was significantly higher than the low recorded in 1974. Essentially, what happened between 1974 and 1982 is that nominal stock prices gently drifted higher as corporate earnings skyrocketed; thereby compressing valuations and ending the bear-market.

Turning to the most recent secular bear-market, there can be no doubt that valuations in the developed world were not incredibly cheap in March 2009. However, similar to 1974, it is probable that last spring’s panic-fuelled prices represented the nominal low of this secular bear-market. If history repeats itself, stock markets in the developed world will continue to drift higher over the coming several months and corporate earnings will play catch up, thereby compressing valuations.

In any event, we continue to believe that over the course of the next decade, the investment return from high quality companies (consistent revenue and earnings growth, low debt level, free cash flow and predictable earnings) will be higher than the yield from government bonds or cash. Accordingly, we are patiently holding on to our outstanding collection of varied businesses and we are pleased to report that the recent operating results of our companies have been very satisfactory. Like always, we do not know when Mr. Market will recognize the inherent value of our companies but we do know that we have allocated our clients’ capital to world-class corporations. Last but not least, as and when the market climate improves, Mr. Market should revalue our stream of growing earnings and cash flows.

Look. Although “end of the world” deflation fears are still fashionable, we do not expect a deflationary depression. Whilst it is true that bank credit is still contracting (Figure 2), in our view, this does not mean that deflation is imminent. As Figure 2 reveals, this is not the first time total commercial and industrial loans in the US have fallen sharply. After all, bank lending in the US also contracted in the aftermath of the previous two recessions, yet the world’s largest economy did not have to deal with deflation. This time around, we are betting on a similar outcome and our investment strategy is positioned for a slow-growth, high inflation environment.

If our world-view is on the mark, over the following years, the developed world will produce sluggish but positive economic growth and in a perverse manner, this is bullish for global stock markets. In a nutshell, as long as the industrialized economies remain relatively weak, interest-rates will stay low and this will help prolong the bull-market in “risky” assets.

At some point in the future, when the global economy starts to overheat, interest-rates will rise again and a defensive investment position will be warranted. When such conditions express themselves, we will defend capital and switch to “capital preservation” mode. However, for the next several months at least, we intend to enjoy the benefits of “stimulus” and cheap money.

Puru Saxena
for The Daily Reckoning

The Stock Market Has Hit Its Low!…Sort of originally appeared in the Daily Reckoning. The Daily Reckoning, published by Agora Financial provides over 400,000 global readers economic news, market analysis, and contrarian investment ideas. Recently Agora Financial released a video titled "What Causes Gas Price to Increase?".

You will recall that during the bottom of the previous bear-market, most of the pundits were shunning ‘risky assets’ (stocks and commodities) and they were advocating a heavy exposure to cash and fixed income assets. Back then, the vast majority of strategists and their devotees were erroneously fretting about deflation. According to these folks, deflation was a done deal due to the following reasons:

a. Contraction in private-sector debt – When the credit crisis arrived in the summer of 2008 and asset prices collapsed later that year, over-leveraged consumers and businesses started paying off their debt. After all, this act of deleveraging was a logical reaction to the devastation caused by the most vicious bear-market since the 1930s. So, when private-sector debt began to shrink, the proponents of deflation (deflationists) announced the death of inflation. “How could the global economy inflate when the private-sector was tightening its belt?” was their battle cry.

Although the deflationists had a point, their assessment was flawed because they totally ignored the borrowing capabilities of the governments. While it is true that from peak to trough, private-sector debt in the US contracted by roughly US$800 billion, this debt reduction was overwhelmed by the US government’s debt accumulation efforts.

As the chart below shows, over the past two years US federal debt has surged by a whopping US$3 trillion, thereby more than offsetting the deflationary impact of private-sector deleveraging. If you have any doubts whatsoever, you will want to note that total debt in the US is now at a record high!

b. Excess capacity – The lack of aggregate demand and the excess capacity prevalent within the economy is another factor often cited by the deflationists. Let us explain:

You will recall that in the aftermath of the Lehman Brothers bust, the credit markets froze and the global economy came to a screeching halt. Suddenly, worldwide consumption contracted and the world was left with idle factories, empty buildings and unwanted inventories. Thus, the deflationists argued that with such a lack of aggregate demand and so much spare capacity, we could never experience inflation.

Once again, the deflationists failed to understand that over-capacity has been a constant feature in our economic landscape and price increases (which they erroneously describe as inflation) have very little to do with capacity utilization.

It is interesting to observe that over the past 42 years, the US economy has never operated at full capacity. Moreover, it is notable that even during the highly inflationary 1970s and the most recent inflationary boom (2003-2007), the US economy operated well below maximum capacity. In case you are wondering, the same holds true for the global economy. Therefore, the idea that inflation cannot occur in the face of excess capacity is ill-conceived and absurd.

All the popular deflation myths aside, the reality is that inflation is an increase in the supply of money and debt within an economy. Furthermore, the price increases often described as inflation are simply consequences of monetary inflation – a euphemism for the dilution of the money stock.

Look. Whenever any central bank creates new money and whenever any entity (individual, business or government) takes on more debt, the outcome is inflation. As Milton Friedman once said, “Inflation is always and everywhere a monetary phenomenon.”

Today, under our fiat-money system, governments are willing borrowers and central banks are more than eager lenders (money creators). Under these circumstances, a contraction in the supply of money and debt (deflation) is out of the question. Conversely, given the short-sightedness of the politicians and their perpetual urge to “kick the can down the road,” the real risk facing the economy is extreme inflation or even hyperinflation.

Given our grim outlook on inflation, we continue to favor hard assets and the fast-growing developing economies in Asia. If our assessment is correct, our preferred sectors (energy, precious metals and industrials) and our favorite stock markets (China, India and Vietnam) are likely to generate superior long-term returns.

Regards,

Puru Saxena
for The Daily Reckoning

Debunking Deflation originally appeared in the Daily Reckoning. The Daily Reckoning, published by Agora Financial provides over 400,000 global readers economic news, market analysis, and contrarian investment ideas. Recently Agora Financial released a video titled "What Causes Gas Price to Increase?".

Let there be no doubt, both the technology and real estate bubbles were spawned by cheap credit and it is now clear that the central banks have learned nothing from those two episodes. Despite the fact that near-zero interest-rates caused the previous mishaps, the central banks are (once again) pursuing a suicidal monetary policy. By keeping interest-rates well below the rate of inflation, the officials are encouraging speculation, thereby sowing the seeds of yet another asset bubble.

At present, the yield curve is steep in most nations and the cost of borrowing is low, so is it any surprise that asset markets are rallying? All over the world, asset prices are inflating again and dangerous excesses are around the corner. Only this time around, the public sector in the West is already over-leveraged and when the next asset bubble bursts, governments will not be able to come to the rescue.

Today, most of the developed world is drowning in debt and various industrialised nations face severe deficits. Moreover, these over-indebted economies are struggling to grow, therefore it is highly unlikely that their stock markets will provide leadership.

Now, given the fact that the developing world is growing much more rapidly, it is highly probable that the emerging market equities will benefit the most from asset inflation.

Apart from sporting superior growth rates, it is worth noting that the developing nations have relatively low debt levels. It is our contention that this combination of strong economic growth and compressed leverage will be sure to catch investors’ attention.

The next chart highlights the huge discrepancy between the fiscal health of the industrialised and developing nations. As you can see, public debt relative to the economy is already very high and likely to surge in the developed world, whereas this ratio is expected to decline in the developing world. Therefore, over the next decade, we can expect more and more investors to shift their capital from the debt plagued developed nations to the healthy developing economies.

Historically, the developing markets have traded at a valuation discount when compared the developed markets. However, over the coming years, we suspect that the ‘risky’ developing markets will command a valuation premium relative to the industrialised world. Put simply, when you factor future earnings growth and an expansion in valuations, the developing markets are prime candidates for the next asset bubble.

Since the turn of the millennium, we have favoured the developing countries in Asia and we continue to like China, India and Vietnam. In our view, these economies will prosper for different reasons and their stock markets will reward long-term investors. Now, there can be no doubt that both China and Vietnam have been disappointing over the past few months, but we view the ongoing consolidation as a fabulous buying opportunity.

In addition to the developing nations in Asia, we believe the energy sector is also a worthy candidate for the next asset bubble. In fact, when the realities of ‘Peak Oil’ dawn in investors’ minds, we could witness an outright mania in conventional and alternative energy stocks.

Although we recognise that the developed world faces some serious economic problems, we are positive about asset prices for the next 2-3 years. In our view, monetary policy determines the fate of every asset-class and as long as interest-rates are low, the ongoing bull-market should continue. In fact, history has clearly shown that each bear-market in the past was preceded by a period of significant monetary tightening. In every previous bull-market, rising interest-rates was the straw which broke the camel’s back.

Finally, the last chart shows the Fed Funds Rate since 1998 and plots the two most recent US recessions (pink shaded areas on the chart). As you can see, prior to the 2001 recession, the Fed Funds Rate peaked in mid-2000 and it is this monetary tightening which caused the NASDAQ-bust and the 2000-2003 bear-market. Furthermore, prior to the most recent recession, the Fed Funds Rate peaked in mid-2007 and this monetary tightening was responsible for the credit-bust and the 2007-2009 bear-market.

At present, the Fed Funds Rate is extremely low and if the economic recovery remains intact, then over the following months, interest-rates will rise. In our opinion, the next bear-market will only occur when the Federal Reserve is done raising its benchmark rate for this cycle. Now, given the precarious state of the US economy, we suspect that the Federal Reserve will increase interest-rates in baby-steps and the next monetary tightening cycle should last for at least 2-3 years. If our guesstimate turns out to be correct, the next significant correction in asset prices will occur around 2012-2013 and until then, we intend to enjoy the benefits of cheap money.

Now, before you get excited, we want to caution you that the next bear-market has the potential to be as equally traumatising as the previous one. Remember, when the bear returns in 2-3 years time, governments in the West will be unable to provide more ‘stimulus’. By then, their balance-sheets will be in a terrible state and during the next bear-market, sovereign default risk will be the Achilles Heel. So, in the next bear-market, instead of financial institutions going bust, entire nations are likely to default.

Given the ominous scenario outlined above, we want to re-iterate that we have no intention of suffering during the next bear-market. Accordingly, we will endeavour to re-position our clients’ capital towards the end of this bull-market, so that we are able to preserve our gains over the full business cycle.

If our assessment is correct, towards the end of this bull-market, we are likely to see the following red flags:

• Rising interest-rates
• Surging inflationary-expectations
• Deterioration in the market’s breadth
• Diminishing new highs and expanding new lows
• Increasing credit spreads
• Credit concerns
• Spike in the price of crude oil
• Inverted yield-curve
• Extreme investor optimism

When the above warning lights start to flash in tandem, the next recession/bear-market will be around the corner and we will switch from ‘capital growth’ to ‘capital preservation’ mode. However, as we have explained above, this bull-market should continue for the next 2-3 years and as long as the primary trend is up, we will remain fully invested in our preferred growth-producing assets.

Puru Saxena
for The Daily Reckoning

Blowing Bubbles originally appeared in the Daily Reckoning. The Daily Reckoning, published by Agora Financial provides over 400,000 global readers economic news, market analysis, and contrarian investment ideas. Recently Agora Financial released a video titled "What Causes Gas Price to Increase?".

After years of excesses, the developed world is slowly beginning to realize that you cannot continue to live beyond your means and spend your way to prosperity.

Today, US national debt stands just north of $12 trillion. Its fiscal deficit for this year alone should come in around $1.6 trillion and the nation faces mind-boggling deficits for as far as the eye can see. Furthermore, demand for US government debt has begun to wane and this implies that the Federal Reserve will have to resort to creating even more money over the following years.

Make no mistake; the US cannot afford higher interest rates and in order to keep a lid on the government bond yields, we are convinced that the Federal Reserve will resort to debt monetization. In other words, the central bank will create new dollars in order to fund the deficits. Needless to say, this money-creation will be extremely dilutive and end up undermining the viability of the world’s reserve currency.

If our assessment is correct, within the course of this decade, the interest payments on the existing government debt will become so large that the US Treasury will need to issue new debt just so that it can keep paying interest on its outstanding debt. When that happens, you can be sure that foreigners will not be eager buyers of US government debt. Therefore, the Federal Reserve will have to create additional money, just to keep the Ponzi scheme going. And when all else fails, the US will simply debase its currency, thereby repaying its creditors in significantly depreciated dollars.

Although our prognosis may sound far-fetched, we want to remind you that throughout history, currency debasement has been the norm rather than the exception. Let us put it simply, the US is now left with three options:

• Sovereign default (unimaginable)
• Severe economic contraction (unlikely)
• Currency debasement (most probable)

Due to the risk of being thrown out of power, the policymakers will certainly not admit to an outright sovereign default. For such an event would cause a revolution within the US and shock-waves throughout the economy. So, this drastic measure can be ruled out.

Next, we are also sure that policymakers in the US will not swallow the bitter pill and pursue sound monetary policies. So this option is also out of the question.

Finally, it is obvious to us that policymakers in the US will have no hesitation in opting for the inflation solution. By diluting the supply of money and eventually debasing their currency, policymakers in the US will create the illusion of prosperity via rising nominal asset prices.

Unfortunately, severe monetary inflation and currency debasement is likely to occur in many Western nations, not just the US. Remember, a host of nations such as Ireland, Italy, Spain, Greece, Portugal and the UK are also swimming in an ocean of debt. Moreover, their populations are ageing and this trend will put further pressure on these countries’ finances.

So, in this ‘new era’, whereby most of the ‘advanced’ economies are on the edge of bankruptcy, various paper currencies will come under pressure. The more nations that move to debase their currencies, the more that the paper monies of the world will depreciate against hard assets such as gold.

Although currency debasement and inflation are good enough reasons to hold on to some gold, the biggest bullish factor is that real (inflation-adjusted) interest-rates are now negative in most nations. Thanks to the central banks’ reflationary efforts, short-term interest rates today are way below the official inflation rate. Therefore, holding cash is now a loss-making proposition and thus, forward-looking investors are turning to gold.

On the supply side of the equation, it is worth noting that central-banks have now become net buyers of gold. After years of selling bullion, the public sector has done an about-face and this is very positive for the yellow metal. Currently, the creditor nations in Asia are sitting on mountains of foreign exchange reserves and in an effort to diversify out of paper, they will surely add to their gold holdings. Recently, we have seen China and India buy huge amounts of gold and you can bet your bottom dollar that they will continue to add to their tiny positions.

Gold is in a secular bull-market and every investor should own some bullion as an insurance policy. At present, gold mining stocks are undervalued relative to gold bullion, so those seeking extra leverage should consider investing in dominant gold producers. Finally, in our view, the high-cost South African gold producers, who do not hedge their production, offer the maximum leverage to gold. And at current prices, these companies are being given away.

Regards,

Puru Saxena
for The Daily Reckoning

A Rock and a Hard Place: Understanding the US Debt Crisis originally appeared in the Daily Reckoning. The Daily Reckoning, published by Agora Financial provides over 400,000 global readers economic news, market analysis, and contrarian investment ideas. Recently Agora Financial released a video titled "What Causes Gas Price to Increase?".

It is our contention that similar to Mr. Madoff’s hedge fund, the sovereign debt markets in the West have now become gigantic scams. Only this time around, the players have changed and the sums involved are significantly larger.

Figure 1 highlights the incredible expansion in America’s national debt. It is noteworthy that at the turn of the millennium, America’s national debt was less than half of its current value. Put simply, American policymakers have taken on more debt over the past decade than they have over the last one hundred years!

What is more astonishing is the fact that America is funding a large portion of its newly issued debt by direct purchases from the Federal Reserve. In other words, as private-sector demand for US Treasuries wanes, Mr. Bernanke is creating new money so that Mr. Obama’s government can bail out insolvent financial institutions. Strangely, the American establishment is quite content to pledge the economic fate of its future generations in order to protect the bondholders of dubious ‘too big to fail’ corporations. Hmm, talk about change…

Apart from the world’s largest economy, various other nations in the ‘developed’ world are also following such misguided policies. For instance, UK’s national debt is exploding and is forecast to reach GBP1.1 trillion by 2011. At present, its national debt is worth GBP891 billion and this equates to GBP14,304 for every man, woman and child in the United Kingdom!

Elsewhere in Europe, the situation is equally dire in nations such as Ireland, Spain, Greece and Italy. Furthermore, various countries in Eastern Europe are on the verge of economic doom.

Given the precarious state of so many economies in the West, we are amazed that the respective government bond markets have not fallen apart at the seams. Perhaps, they are all heading down Japan’s route, where national debt is now above 170% of GDP, yet the yield on Japanese government debt is pathetic. But then again, perhaps they are not…

In our view, in the not too distant future, the interest payments on the outstanding national debts in the overstretched ‘developed’ nations will become so large that their central banks will need to create money just to keep the Ponzi schemes going. When that happens, the game will be up and we will probably experience a total breakdown of the fiat-money experiment. At this stage, we do not know when the day of reckoning will arrive but we do know that all Ponzi schemes ultimately collapse under their own weight and this one will be no different.

Given the shocking debt overhang in the West and the threat of surging inflation later this decade, we cannot understand why anybody would want to lend money to bankrupt governments!? In the worst case scenario, these naïve bondholders risk losing their entire capital and the best outcome involves a significant loss of purchasing power due to inflation. Accordingly, we are not investing in sovereign debt and we suggest that you refrain from lending money to dubious governments.

Finally, although we are pessimistic about the long-term prospects of government debt, we are aware of the possibility of a near-term rally; especially if there is another round of risk aversion in the financial markets. So, if we do get another deflationary scare and bond prices rally, holders of government debt are best advised to liquidate their positions.

Furthermore, if our world-view is correct, extremely high inflation is now inevitable. As long as the monetary velocity in the US is weak, inflationary expectations will remain subdued, but once the economic activity picks up, the world will experience spiraling inflation. When that occurs, hard assets will protect the purchasing power of your savings. Accordingly, we have allocated a large portion of our clients’ capital to energy (upstream companies, oil services plays and alternative energy plays), precious metals miners and diversified base metals miners.

At the time of writing, precious metals are at a critical juncture and the price of gold is trading above an important support level.

Figure 2 shows that the price of gold peaked at US$1,075 in October 2009 and that level is now acting as important support. Now, if the bull-market’s trend consistency is intact, then the price of gold must rally immediately and challenge its December high. At the very least, the price of gold must hold above US$1,075 per ounce. So, will gold manage to stay above this critical support level?

Before we attempt to answer this question, we must confess that short-term forecasting is extremely difficult and we really do not know what will happen over the following days. However, what we do know is that the macro-economic environment has never been better for the yellow metal. After all, mined supply is in decline, investment demand is rising, the public sector has become a net buyer of gold and hatred towards paper currencies is on the rise. Under these circumstances, we expect gold to perform very well. However, you must remember that the American currency is in rally mode and this is exerting downward pressure on all metals.

Now, if we were forced to take a stand at gunpoint, we would say that the odds of a rally in gold are 65/35. Accordingly, we are holding on to our positions in precious metals mining stocks and may consider lightening up during spring (which is when precious metals usually make an intermediate-term peak).

Now, if gold does the unexpected and breaks below US$1,075 per ounce, then we envisage a deeper correction to the US$1,000 per ounce level. Even if that happens, we will continue to hold on to our positions in gold mining companies, which have already depreciated in the ongoing stock-market correction.

Short-term setbacks notwithstanding, we continue to believe that hard assets are in a secular bull-market, which will probably end in a gigantic mania. According to our guesstimate, the bull-market will end in the latter half of this decade; at a time, when inflationary expectations are spiraling out of control.

Make no mistake, the policy actions of the past 18 months are extremely inflationary and once the American economy stabilises, we will experience a significant increase in the general price level. And before this is all over, government bonds will (once again) be recognised as ‘certificates of confiscation’.

Regards,

Puru Saxena
for The Daily Reckoning

Government Bond Market Just a Ponzi Scheme originally appeared in the Daily Reckoning. The Daily Reckoning, published by Agora Financial provides over 400,000 global readers economic news, market analysis, and contrarian investment ideas. Recently Agora Financial released a video titled "What Causes Gas Price to Increase?".