End of an Era?

Lets face it, the era of easy money and cheap oil has come to an end. And if Puru Saxena’s assessment is correct, this transformation will have a significant impact on the global economy.

There is no doubt in my mind that since the early 1970’s the global economic boom has been largely financed by an ever-expanding quantity of money and credit. Once gold was removed from the monetary system in 1971, central banks were free to create as much paper currencies as they wanted. This reckless monetary inflation and credit growth has caused the value of "money" to diminish significantly over the past three decades and created a gigantic boom in global asset prices. Each time an asset "bubble" has burst in the past 35 years, central banks have responded by reducing interest-rates, thereby encouraging even more credit growth, which has spawned further speculative manias down the road. This time around, in the aftermath of the Anglo-Saxon housing bust, Mr. Bernanke and his comrades are desperately trying to do the same and the trillion dollar question is whether they will succeed.

In the current circumstances, I suspect it will be extremely difficult for the central banks to further expand credit growth, thereby inflating their way out of trouble. Below I present the reasons why I am doubtful about the continuation of the credit bubble:

First and foremost, in the current credit crisis, the entire banking system is being brought to its knees. This is very different to the previous crises when perhaps a handful of financial institutions or hedge funds got into trouble. Unfortunately, the financial alchemy (creation of structured products, over the counter derivatives, collateralized debt obligations, credit default swaps etc.) over the past few years has been so severe that the entire banking system is now on the verge of a total collapse. So, even if the central banks tried to further inflate the credit bubble by keeping interest-rates low for an extended period of time, I doubt if the commercial banks are in any position to expand their balance sheets. With billions of dollars of write-downs in the past year and humungous "Level 3" liabilities still undisclosed, the commercial banks have no other option but to try and repair the damage to their balance sheets by tightening credit standards. So, I doubt very much if they (for the foreseeable future) will participate in the central banks’ sponsored credit and inflation agenda.

Secondly, I also happen to think that as a result of so many ridiculous tax-payer sponsored bail-outs of Wall Street banks, the U.S. government and regulators will tighten their grip over the ministry of inflation (the banking industry). Therefore, tighter regulation in the months ahead will also prevent the commercial banks from inflating the credit bubble further.

Another reason why I believe we have reached the inflection point in this credit cycle is the state of the U.S. dollar. With the U.S. dollar trading at record-lows against major world currencies and soaring energy and food costs, I doubt very much if the Federal Reserve is in a position to lower interest-rates further. In fact, I would argue that the situation is totally out of the Federal Reserve’s control and the entire global economy now depends on the mercy of the owners of U.S. Treasuries. I have to admit that so far, given the amount of bail-outs and the state of the U.S. dollar, holders of U.S. government bonds have been rather well behaved. However, it may only be a matter of time before foreign holders of U.S. Treasuries start liquidating their holdings. When that occurs, long-term interest-rates in the United States would rise rapidly and the Federal Reserve would have no other option but to raise its Fed Funds rate.

Finally, given the level of indebtedness of the U.S. consumer and falling asset prices, I wonder how the average American household would be able to take on even more debt. Once the technology bubble burst at the turn of the millennium and the Federal Reserve lowered interest-rates, Americans were quick to borrow and speculate in real-estate. However, this time around in the aftermath of the housing bust, even though the cost of borrowing has been reduced, Americans are not going deeper into debt. U.S. bank credit peaked earlier this year and is now in a decline. So, if American households are really tightening their belts and repaying their outstanding debt, there is no way the credit bubble would continue to inflate.

It is my observation that we have now entered a new era of credit contraction and deleveraging. The abrupt bursting of the credit bubble is likely to have a profound impact on asset prices in the West. If my view is correct, we are likely to see a period of poor economic growth and deflating asset prices in the developed world. The U.S. economy is clearly struggling, Europe faces its own problems and Japan cannot seem to turn things around. So, I would not advise you to invest your capital in stock markets or real-estate in the industrialized nations.

There can be no disputing the fact that U.S. financial assets have provided disappointing returns since the beginning of this decade. It is worth noting that even though the Dow Jones index is flat in nominal terms since 2000, it has lost more than half of its value against gold over the same period. At the turn of the millennium, the level of the Dow Jones could buy over 40 ounces of gold. Eight years later, the level of the Dow Jones can only buy roughly 12 ounces of gold! Clearly, gold has been a much better investment than U.S. stocks over the past eight years. In the years ahead, I expect to see further underperformance of financial assets and maintain my position that hard, tangible assets will continue to provide superior returns.


Puru Saxena
for The Daily Reckoning
August 12, 2008

Puru Saxena publishes Money Matters, a monthly economic report, which highlights extraordinary investment opportunities in all major markets. In addition to the monthly report, subscribers also receive "Weekly Updates" covering the recent market action.

Puru Saxena is the founder of Puru Saxena Limited, his Hong Kong based firm that manages investment portfolios for individuals and corporate clients. He is a highly showcased investment manager and a regular guest on CNN, BBC World, CNBC, Bloomberg, NDTV and various radio programs.

What happened to stagflation?

Big news yesterday: gold dropped $36.50 – to $828.

Oh la la…and our "Trade of the Decade" – long gold, short stocks – still has a year and a half to go. Looks like we should have ended this trade a few months ago, when gold was pushing up to $1,000.

What’s going on?

Well, it appears that the feds are losing the battle. We have the ‘stag’…but no ‘flation.’ All over the world, in almost every sector of the economy, prices are falling. Inflation is on the run – or so it appears today.

Housing prices are on the decline in America, Britain, Australia, Ireland, and Spain. We don’t know about other markets. They are said to be still rising in Brazil and other emerging markets. But we wouldn’t bet on it.

Commodity prices have been going down for about two months. After hitting a high of $147, oil has slipped all the way down to $114.

Stock markets are down all over the world. Most indices are off 15% to 20% for the year, except for China, which has been cut in half.

Even the dollar is showing signs of deflation – it’s going up! Not only are the things it buys becoming cheaper, it is also gaining ground against its archenemy, the euro. Yesterday, the euro fell below $1.50.

"The inflation rate is going to come down," said an economist at Lehman Bros. Most economists agree. And so do investors. TIPS are U.S. Treasury notes that are adjusted to inflation. Investors pay a premium for them in order to get the protection of the feds’ inflation adjustment. Thus, the yield spread between these notes and regular 10-year Treasuries is a good measure of how much inflation investors expect. And currently, the yield has dropped to its lowest point in nearly five years.

What is the reason for this stunning defeat of inflation? How come the central banks and financial authorities aren’t better at what they do best? The latest numbers we have show them trying hard. Money supplies worldwide are increasing at about 20% per year – five times faster than the rate of economic growth. According to theory, if the supply of money increases faster than supplies of goods and services inflation will result. Is the theory wrong? Or is something else is going on?

Yes, something else is going on. The world economy is cooling off. After running so hot for so long, a chill wind is blowing. It began almost exactly a year ago – on August 9, 2007 – when the subprime story broke. First, the homeowners got in trouble. And then, the builders. And then the lenders. And then the investors who lent to the lenders. The problem mounted up the financial ladder like a crusader scaling the walls of Constantinople.

For a long time, it looked as though the go-go economies of the Far East…and the commodity producers…would be able to hold them off. The world economy had "decoupled," it was said – with the emerging economies continuing to grow while the old economies of Europe and North America were in a slump. With this huge new demand in front of them, commodities markets continued to move higher…even as stock markets and housing sank.

But now, it looks as though nothing will be spared. Everything is going down. Gold, stocks, property, copper, inflation, GDP growth rates, consumer spending, car sales, student financing, employment, house sales, housing prices – everything.

And against all this…the dollar is going up.

But what does it mean? Well, no one knows…(still, we offer a "what if" below…)

Expansions are typically inflationary. Contractions are typically deflationary. But we knew that. What we didn’t know was whether there would be enough juice in the emerging markets to keep the world economy growing…

…and whether the feds could effectively re-inflate – with their bailouts, handouts, and monetary cop-outs. The answer to those questions seems to be ‘no.’ But the matter is far from settled. No economist has ever seen a world money system such as the one we have now. No one knows how it will react to the stress of a major contraction. So, we’ll hold onto our gold a bit longer…and wait to see what happens next.

*** Greenspan’s "Age of Froth" is over, sayeth the columnists. The Bubble King is no longer at the Fed. And the bubbles seem to have come to an end. Now the headlines are depressing; the losses are mounting; and the lawyers are circling.

At least, that’s the word on the street.

"Economic Slump in US to Worsen as Consumers Get Squeezed," says a headline at Bloomberg.

They’re probably right about that. The longest-running increase in consumer spending, which began in 1992, is coming to an end. And the unemployment rate is expected to reach 6% before the end of the year. Consumers – with lower income, less credit, and falling house prices – must feel like they’ve been caught in a vise. They’ll wiggle and complain; but what can they do but cut back? And a cut back in consumer spending marks the end of the booming consumer-driven, credit spiked economy of the last 16 years.

But does it also mark the end of the bubbles? Of the sturm and drang in the financial markets? Is the dollar now as good as gold – or better – now that the froth is gone?

Our intuition tells us that it ain’t quite so. The feds are still inflating – or trying to. Speculators are still speculating. People still believe in the dollar…and in the dollar-based monetary system – even though it’s the very same system that has created so many problems for so many people. And even now, after 10 years of negative real returns, most investors still believe in "stocks for the long run."

We anticipate a major change in consumer/investor attitudes – but it hasn’t come yet. Consumers – especially baby boomers – must stop spending and begin saving. And since they are so far behind, they must begin saving as if their retirements depended on it – which they do.

And investors need to change their way of looking at things too. You can’t have another great bull market in stocks until investors have given up on them. Speaking more broadly, you’re not likely to have another big run of profit from investments until investors stop looking for them…

These changes of attitude don’t come easily…or painlessly.

Another sign of the times: "prime" borrowers are defaulting on their home loans at increasingly high rates. Last month, reports CNN.com, JP Morgan Chase CEO "called prime mortgages ‘terrible’ and suggested that losses connected to prime may triple. For the second quarter, the bank reported net charges of $104 million for prime rate delinquencies, more than double the $50 million recorded three months earlier."

WaMu reports similarly disturbing losses and it is clear that this latest trend is doing nothing to help the already struggling housing sector on the road to recovery.

*** But let us imagine that the bubbles are over…what would the world economy and the world’s markets look like?

A few years ago, along with Addison, we wrote a book called Financial Reckoning Day. Our guess was that the United States would follow Japan into a long, slow, soft slump. Prices would fall. Consumers would stop consuming. Families would begin saving again. Investors would be wary of the stock market. And speculators would go broke.

We were wrong. Instead, the Greenspan Fed set its key borrowing rate at 1% and left it there for over a year. Anyone who wanted to borrow money could get it – on the easiest terms ever. No credit? No problem! This money giveaway set the world on the most reckless period of borrowing and speculation the planet had ever seen.

But we are at the end – or near the end – of that period now. And what if the great slump that we saw coming in 2001-2002…came six years late? And what if it weren’t limited to the United States, but gripped the whole, globalized world economy? What if prices fell across the board? What if consumers in the West stopped consuming…putting workers in the East out of jobs? And what if the world didn’t really need so much oil, or so much copper, or so much other ‘stuff’ after all?

What if the whole world entered a long, slow, soft Japan-like slump?

It’s just a possibility, dear reader…just a possibility. We tend to prepare for the worst…because if the worst doesn’t occur, at least you’ve made some money in the process. Our friend and colleague Chris Mayer has recently discovered a three-step strategy that will allow you to tap in to a relatively unknown cash pool.

*** "Grandma wants me to print out the baby photos," said Jules.

"What baby?" Henry replied.

"I don’t know…one of our new cousins."

The two boys tried to find the website where photos of the newborn baby were posted.

A few minutes later they were ‘oohing’ and ‘aahing’ over the photos…and Grandma was crossing the room for a look.

"Wait, Grandma," said Henry, "we were just looking at a porno site…where did you say those baby pictures were?"

When they finally found the site, they typed in the name and photos of a black baby appeared.

"I don’t think that’s the right one," said Grandma.

"What’s the matter, Grandma, are you prejudiced?" Henry teased. "Times have changed. We’re even going to have a black president. That’s just progress. Get with the times, Grandma."

"Oh Henry, don’t be silly. I even like Obama…he seems like a very nice colored man. So, you see, I am with the times, as you put it."

"Uh, Grandma – maybe not completely."

Until tomorrow,

Bill Bonner
The Daily Reckoning