Financial Refuge From Mutually Assured Destruction

Uh-oh. “The moment of explosion is approaching fast,” says an official from the North Korean military. The formal statement from a spokesman for the General Staff of the Korean People’s Army read as follows:

“We formally inform the White House and Pentagon that the ever-escalating U.S. hostile policy toward the DPRK [North Korea] and its reckless nuclear threat will be smashed by the strong will of all the united service personnel and people and cutting-edge smaller, lighter and diversified nuclear strike means of the DPRK and that the merciless operation of its revolutionary armed forces in this regard has been finally examined and ratified.”

That sure sounds like a threat. Chuck Hagel, the U.S. defense secretary, says North Korea represents “a real and clear danger and threat.” Hagel also announced that the Pentagon would send an $800 million land-based missile system (the Terminal High Altitude Area Defense system, or THAAD) to the island of Guam, where the U.S. has military assets.

There hasn’t been a real military crisis to take financial markets to the boiling point in some time. In fact, since the collapse of the American real estate bubble in 2007, stock markets have been driven more by monetary policy than anything else. The “Arab Spring” was big news. But markets largely ignored it. Will they ignore the possibility of a war on the Korean peninsula?

Probably. The longer something you expect to happen doesn’t happen, the less expectant you get. It doesn’t mean the expected event is less likely to happen. It means you become less vigilant over time. You lower your guard. You become complacent. That’s when it usually happens.

Still, you’d think that no one who has anything at stake in the Korean peninsula wants a conflict. The adults in the room — China, the U.S., Japan, South Korea and Russia — have no interest in an actual shooting war. But stranger things have happened.

The action on Wall Street suggests investors are paying more attention to the Federal Reserve and economic growth than Kim Jong Un. The S&P 500 fell by 1.1% last week. But it was metals and energy stocks, led by the underlying commodities, that got hammered the most. The S&P GSCI index of 24 commodities fell by 2% last Wednesday. That was the largest one-day drop since November.

For more, let’s look at David Stockman’s article on American decline from The New York Times:

“The future is bleak. The greatest construction boom in recorded history — China’s money dump on infrastructure over the last 15 years — is slowing. Brazil, India, Russia, Turkey, South Africa and all the other growing middle-income nations cannot make up for the shortfall in demand. The American machinery of monetary and fiscal stimulus has reached its limits. Japan is sinking into old-age bankruptcy and Europe into welfare-state senescence. The new rulers enthroned in Beijing last year know that after two decades of wild lending, speculation and building, even they will face a day of reckoning, too.

Emphasis added there is ours. Stockman’s logic is easy to follow. China’s 15-year urbanization and fixed asset boom corresponds with an era of “irrational exuberance” in global credit markets. Alan Greenspan coined that famous phrase in 1996. When it spooked markets, Greenspan backed off and then got in the habit of lowering interest rates anytime stock prices fell.

The phenomena — lower U.S. interest rates and higher Chinese fixed asset investment — are inseparable in two ways. First, lower U.S. rates led to America’s housing boom and consumer credit/spending boom. This increase in consumption created demand for goods from China. China made things and Americans bought them and the world basked in the glow of a two-piston engine of growth.

The second way low U.S. rates and Chinese investment are inseparable is China’s currency peg to the U.S. dollar. This requires China to inflate when the U.S. inflates. And the trouble with inflation is that it never goes where you want it to. In the U.S., the Fed’s policies have led to a new all-time high on the major stock indexes.

In China, the corresponding credit boom from low rates led to a building and real estate boom. But now there’s turbulence.

Martin Wolf of the Financial Times has even gone so far as to pen an article titled, “Why China’s Economy Might Topple.” Wolf generally speaks on behalf of conventional and institutional thinking. A contrarian would be tempted to view his bearish comments on China quite bullishly. But his main point is that after 35 years of double-digit GDP growth, China will grow more like the advanced economies of Japan in the 1970s and South Korea in the 1990s, at about 6.5% a year.

Officials at China’s Development Research Centre of the State Council (DRC) have written a paper called Ten-year Outlook: Decline of Potential Growth Rate and Start of New Phase of Growth. The clunkily titled paper lays out five reasons why China may experience a sharp decline in growth, starting now. Wolf writes:

“First, the potential for infrastructure investment has ‘contracted conspicuously,’ with its share in fixed asset investment down from 30% to 20% over the past decade. Second, returns on assets have fallen and overcapacity has soared. The ‘incremental capital output ratio’ — a measure of the growth generated by a given level of investment — reached 4.6 in 2011, the highest since 1992. China is getting less growth bang for its investment buck. Third, growth of the labor supply has fallen sharply. Fourth, urbanization is still rising, but at a decelerating rate. Finally, risks are growing in the finance of local governments and real estate.”

Between Wolf’s five points and Stockman’s point about the end of the infrastructure boom, it is impossible to ignore the fact that China can’t keep spending money it doesn’t have on infrastructure and development projects that generate no real return on capital.

The laws of economics, to the extent that they exist, apply across all borders and all oceans. Money borrowed must be put to productive use. If it’s not, assets have to be written down in value or losses have to be taken. The whole of the last five years have been a central bank exercise in making sure the losses don’t destroy the world’s banking system.

Is there any refuge? Well, for years we’ve advocated physical gold and silver as a way to extract wealth from the financial system and store it in tangible form. After the confiscation of bank deposits in Cyprus, this seems more prudent than ever.

But what’s this? Gold is getting absolutely pounded too. Sentiment is bearish. Is it time to sell your gold?

If you were a trader, the time to sell gold would have been when it reached $1,900. But if you’re not a trader, if you’re a wealth accumulator, then you’ll relish the chance to buy gold at these prices. You should also be prepared for it to go lower still. Have a look at the chart below.

Gold-Berkshire Chart

The chart shows how many Berkshire Hathaway “B” shares it takes to buy an ounce of gold. It’s a 15-year chart with weekly prices. Berkshire is a basket of productive enterprises that trades as a stock. You can view it as a proxy for the Fed’s efforts to reflate financial asset prices. Gold is gold.

As we’ve written before, if the ratio goes back to 14 (it’s currently at 14.95), it will represent a bottom in gold and a top in stocks. You’d have to assume this would coincide with a big shift in market sentiment. Investors would be back to “risk off.” You’d see heavy selling of stocks in the second quarter. And after a merciless liquidation of the gold bulls, a bottom in the gold price.

It’s all proceeding as planned. The fall in the gold price, and the carnage in gold stocks, will no doubt make many investors and speculators nervous. But that’s exactly what has to happen for the bull market to resume its long-term upward trend. If it were a certain trade, everyone would be in it on the same side. The time to hold your nose and buy is approaching.


Dan Denning
for The Daily Reckoning