Scorched Earth Economy

Even a casual glance at the devastation now being wrought on the very building blocks of the economy confirms that the term “Scorched Earth Economy” may be the most accurate description one can give about the current state of things. David Galland explains…

Here at Casey Research we have been on the record as bearish on the outlook for the economy for some years now. Lest you think that is loose boasting, I can offer proof in Doug Casey’s August 2005 article, the dramatically titled “Profiting from the End of Western Civilization”.

In that article, he looked ahead and saw the inflation that the government’s loose money policies made inevitable. A quote…

“Of particular importance is that the U.S. dollar has been used as a gold substitute for decades by other countries. This has been very convenient for the U.S. – we can create almost infinite numbers of greenbacks and give them to people in other countries in exchange for real wealth. Idiotically, central banks abroad have been holding those dollars as backing for their own currencies.

“The amounts involved have grown so immense, and the eventual grim fate of the dollar has grown so obvious, that foreign central bankers are now looking at each other, trying to figure out who will head for the exits first. Many are ‘diversifying’ from dollars into other currencies – which are themselves backed mainly by other paper money, mostly dollars. At some point there’s going to be a panic out of U.S. dollars that’s going to dwarf any financial event in history.”

And in that same article he also predicted the current collapse in the housing bubble that the loose money had made possible. Another quote…

“What’s going on now in the residential real estate market is much like the tech bubble, but potentially much, much more serious than what went on in stocks a few years ago.”

Jumping ahead 3 years, to today, the unhappy scenario Doug then foresaw is now unfolding. Right on schedule the economy and markets are heading inexorably toward what might be termed the Scorched Earth Phase.

Even a casual glance at the devastation now being wrought on the very building blocks of the economy confirms the appropriateness of that term.

For instance, consider the U.S. financial firms, the single largest component sector of the S&P 500. So far, the losses to those firms are approaching half a trillion dollars. And the odds are high that there’s much more to come. With the exception of Bear Sterns, the big name financials have been able to cobble together the billions of dollars in additional capital needed to shore up their balance sheets…but they are quickly running out of rope. That becomes apparent when you consider that many of their major revenue centers are now either severely wounded or in the morgue. Last quarter alone Morgan Stanley saw its investment banking fees fall by half and toxic paper sales (ah err, I mean “fixed income”) sales and trading revenue collapse by over 85%. And this at a time when these same firms are being forced by regulators to repatriate their off-balance sheet assets…to wit, the aforementioned toxic paper.

Sovereign Wealth Funds (SWF) to the rescue? Not anymore. Those that initially rushed in were seriously burned and many are now on record as staying on the sidelines. But any that might wish to take a second roll of the dice, will only do so if they get much better terms, which is dilutive to existing shareholders.

Meanwhile, the housing meltdown persists and will continue for at least another year or two. Unless, of course, the government gets serious about “doing something”…in which case the downturn could last 5 or 10 years.

Why do I say that? What the market needs most of all right now is for house prices to fall, as quickly as possible, to a market-clearing price. The problem, of course, is that thanks to the self-serving exuberance shown by many appraisers during the real estate bubble-mania, at this point nobody actually knows where the bottom is. Another 10%? 20%? 30%?

There really is only one way to find out…let the brush fire burn, as painful as that will be. But as I don’t need to tell you, “doing nothing” is not a concept that politicians in an election year are very comfortable with. And so, like trained seals leaping after vote-fish, the politicians will jump though any number of hoops to keep people in their homes even though many can’t afford the carrying costs, let alone the mortgages. That only prolongs the pain and increases the government deficits that are at the core of the current crisis.

So, we have a tumbling collapse in the largest component of the stock market, coinciding with a tumbling collapse in the largest component of people’s net worth, their homes.

And we aren’t even warming up yet.

For a more complete accounting, you also have to add into the mix the intractable problems unfolding in energy patch, including the near-certainty that Mexico, the 3rd largest source of imported oil for the U.S., will stop exporting said oil within 4 to 6 years…max.

Rather than rushing ahead with emergency initiatives to open up new energy sources, the U.S. Congress just passed emergency legislation to prevent so much as exploring for uranium anywhere near that big hole in the ground, the Grand Canyon. It is this perfect world mentality that assures that the cost of what energy is available, will only get more, not less, expensive. Of course, as energy is required in the production of, well…everything, so the cost of everything will go up.

And that includes, food…which, as I don’t need to tell you, has been on a tear of late.

Sure, opportunistic new plantings will help, over time, to moderate the higher food prices…but not overnight. Meanwhile, the cost of filling the old tractor and shipping food to market will keep going up.

So, to the list of serious problems for the economy, we have to add persistent high energy and food prices.

But even those fall short of the KING KONG of the set piece…the collapsing fiat monetary system that helped create the recent series of bubbles in the first place.

In a fiat monetary system the only tangible barriers to money creation are provided by a loss in stakeholder confidence. While the average American is, sad to say, almost completely ignorant of what a fiat monetary system is, let alone the consequences of same, the same cannot be said of the foreign holders of an unprecedented $6 to $7 trillion dollars.

To be a touch more specific, by unprecedented I mean as in “never happened before”. While, under other circumstances this fact might evoke a raised eyebrow or a concerned comment over cocktails…going into the jaws of a vicious economic/dollar crisis those foreign dollar holdings become akin to playing toss with a lit stick of dynamite. He who holds the dollars when the fuse meets the powder is in for a very, very bad day.

As a result, the foreign holders are watching the moves of the Fed very closely. Trying to avoid that scrutiny the Fed, like a curbside Three Card Monty dealer, has come up with some clever sleights of hand, including lending directly to investment banks and swapping Treasury bills for toxic paper. But that has accomplished little more than buying some time; it does nothing to resolve the “rock and a hard place” dilemma.

Which remains as thus: if the Fed raises rates to prevent a sell off in dollars, they’ll crush the highly indebted and already struggling populace and, in so doing, unleash a serious economic crisis. But if the Fed keeps rates where they are, or even lowers them, they’ll trigger a dollar sell-off and unleash a serious economic crisis.

Either way, the story ends the same: a serious economic crisis.

At this point, our bet remains that the Feds will go to default mode which means cranking up the printing presses into the red zone, letting the dollar move ever closer to its intrinsic value: zero. That they’ll follow this route is suggested by two inputs. First, a depreciating dollar means a reduction in the trillions of dollars in obligations now owed by the U.S. government. And, secondly, foreign holders don’t vote.

So, we are calibrating our investments toward a serious economic slowdown, but with high inflation. Some people would call that Stagflation. But given the severity of both sides of that formula, the situation may be better described in terms of Scorched Earth. Or, because people seem to find concepts ending in “flation” handy, Stag-flagration.

Businesses and personal net worth will be devastated at the same time that costs run out of control.

How to Play It?

Our strongest recommendation is to position your portfolio in anticipation of higher inflation and, in time, a turnaround in interest rates. The latter is because interest rates, which are still near a 50-year low, can only go up as the inflation rises to the point of banner headlines (at which point, the government is hoping, the economic downturn will have moderated).

In fact, we think the move towards higher interest rates is a trend that will surprise many, but, once it gets going in earnest (and corporate bond yields are already on the rise) last for at least the next several years.

In terms of other investments, it’s worth noting that in the last major bull market for tangibles, back in the 1970s, oil was the best performing investment, followed by gold, U.S. coins, silver and stamps.

Today the range of investment vehicles you can use to make the trend your friend is greatly expanded a wide variety of specialized ETFs (though an added layer of analysis is required to sort the strong, well structured, high volume variety from the thinly traded variety of suspect parentage). And while they continue to require patience, the highest quality junior Canadian gold exploration stocks remain one of the most prospective investments you can make. A number of these companies are now sitting on proven big discoveries, but thanks to the stop-start markets, are significantly undervalued. They won’t stay that way long.

Whatever you do, don’t be complacent at this point. If we are right, then the economic crisis will soon head into its next and most dangerous stage. Certainly, we should feel the heat, and maybe worse, by the end of the year. Therefore, at the very least, you’ll want to take measures now to protect yourself. For our own portfolios, we believe that the best defense is a good offense, and so are positioning ourselves in the sectors that will profit, and profit big, as the stag-flagration sweeps across the global economy.

Then it’s just a matter of sitting tight and being right.

Regards,

David Galland
for The Daily Reckoning
July 10, 2008

David Galland is Managing Director of Casey Research, LLC., publishers of the Casey Energy Speculator, a monthly advisory that identifies undervalued investments in companies that profit by helping to solve global energy challenges.

The Dow resumed its downward slide yesterday. It lost 237 points as the deflation commandos continued their counterattack.

It’s war. And war is hell, as General Sherman said, before burning Atlanta to the ground.

Oil was unchanged in yesterday’s trading. Gold gained $5.

Most of yesterday’s hard fighting took place in the financial sector.

“Fed Sees Turmoil Persisting Deep Into Next Year,” saith the New York Times.

The New York press tells us that Steve & Barry’s, a clothing retailer with 200 stores, has filed for Chapter 11. And Fannie Mae (NYSE:FNM) and Freddie Mac (NYSE:FRE) got walloped again. The two Mississippi Companies [a reference to the government-chartered company in 18th century France that dominated a huge bubble, went broke and practically bankrupted the nation] desperately need to raise money. But even though the two are backed by the U.S. government and clearly “too big to fail,” investors are being a lot more grudging with their money these days. Fannie had to pay 74 basis points over the Treasury rate to get cash, much more than in the past. Freddie’s stock dropped to $10. Fannie’s hit $15. Both traded as high as $60, if we recall correctly.

IndyMac (NYSE:IMB) is in the news too. The big mortgage lender specialized in Alt-A loans – a step up from subprime, but apparently not a very big step. The shares traded at $50 in 2006. Yesterday, they were marked down to 44 cents.

Bloomberg tells us that Wall Street debt is being “downgraded by derivative traders.” They know the stuff better than anyone, of course.

What is surprising – to us, anyway – is that they aren’t downgrading government debt. We believe the credit cycle has turned. After a quarter century of falling yields, it looks to us as though yields have formed a major, triple-bottom. Which is to say, bond prices, (remember, they go up as yields go down) have hit three successive peaks, more or less at the same altitude, in 2003, 2005 and again in 2007.

But if we’re on the downward slope, so far it’s a gentle one. We looked yesterday and found the 10-year T-note yielding all of 3.88%.

We have to pause a minute and draw breath. What are bond buyers thinking? Of safety, surely. They see this latest assault of deflation – with falling stock prices all over the world…with Wall Street collapsing…the Fed nervously holding the key rate at 2%…oil slipping, possibly topping out – and they look for a hole to jump in. What better hole than U.S. Treasuries…dug deep by the full faith and credit of the U.S. government and denominated in the almighty dollar?

Well, ahem…that there is the problem. The hole may be deeper than they think.

Conventional wisdom holds that inflation will not be a lasting threat. The experience of the last quarter century is that short bursts of rising prices are soon replaced by another longish period of stable ones. But this was the period when the Chinese and Wal-Mart were lowering prices on manufactured goods…when labor rates were held down by the influx of millions of people into the modern economy…and before the cycle of commodity prices turned up. This was also the period in which interest rates were falling…and almost infinite amounts of money were available to increase consumer spending and production. That period is over.

Nevertheless, millions of investors expect it to continue. They believe that a cooling world economy will bring the forces of inflation back to their barracks and that they can go on collecting 3.88% coupons without feeling like chumps.

Who knows? Maybe they’re right. Still, we think they are morons. Even if they turn out to be right, the margin of safety on U.S. Treasuries is so razor thin they’re bound to cut a vein.

The real issue for us here at The Daily Reckoning is how the world ends. The world as we know it…Boomland…the world of constantly expanding credit and rising asset prices…is finished, we think. Does it end with a bang or a whimper? Does it end with the bang of inflation? Or the whimper of dying prices?

“Both” is still our best guess.

*** “People come to believe what they must believe when they must believe it,” we said today at breakfast.

“Where does that quote come from?” Elizabeth asked.

“It comes from me…from The Daily Reckoning. Many years from now, as historians search through the ruins of our civilization, someone will come across that line. Then, they’ll wonder what it meant. Finally, they’ll realize how profound it is…and probably misattribute it to some great thinker, like Thomas L. Friedman.”

“Oh stop picking on Tom Friedman…”

“Okay…but seriously, you can’t understand our era without understanding how intelligent people can come to believe such absurd things.”

“What do you mean?”

“Well, for instance, there’s a report in today’s news. The SEC did a study of the rating industry – you know, the people who decide how creditworthy various investments are. Institutional investors rely on them in placing money for pension funds and insurance and so forth. Well, they found that the rating industries engaged in what they called ‘flawed practices,’ meaning that instead of telling investors that subprime debt was trash, for example, they gave it Triple A ratings. Any dope could see that when you lend money to people who can’t pay it back you’re going to have trouble. But the rating agencies made a lot of money by rating the subprime debt. If they said it was trash, they wouldn’t get the business.

“That’s just a relatively small example. More broadly, history…and life itself…follows certain inevitable patterns. When you’re a teenager you have to think like a teenager, in other words. When you’re an old man, you have to think like an old man. If you live in Switzerland you have to think like a Swiss person. If you live in America in 2008…for good or for evil, I don’t know…but you have to think like a card-carrying member of the reigning imperial elite…that it’s your duty to police the world. If you live in an economy that is really growing and booming, you save your money and invest, in order to profit from it. But if you live in an economy that is peaking out or in decline, you just make the most of it, spending and borrowing as much as you can…and then, you gradually adjust your thinking to the new reality.”

“Yes, but how do you know thought follows action…rather than the other way around? If Americans had saved and invested…rather than borrowed and spent…wouldn’t the economy be growing, rather than declining?”

“Well, Americans would be in much better shape, financially, of course. But relative to the rest of the world, the United States would still be in decline. An old man can’t become a young man just by acting like one. All he can do is accept old age with grace and dignity.”

“You may be reaching too far with this idea…it’s a very fatalistic view of things. But why do you bring this up?”

“Oh…because I just read in the paper about poor Obama.”

“Poor Obama? I thought he was way ahead…”

“He is. But according to the report, he’s worried that he can’t attract the old Hilary stalwarts…the white, lower-middle class democrats. So, he’s modifying his views on things like Iraq, abortion and child rape. He’s coming to think what he needs to think to win the election. And what he needs to think is what appeals to the yahoo voters – the mob of electors in a late imperial period. They want to kick butt all over the world…and they want to worry about abortion and child rape, rather than bother to think about the real challenges the country faces – bankruptcy and declining living standards, for example.”

“Well, child rape and abortion are important moral issues.”

“Yes, exactly, they’re moral issues. They are the sort of thing that get a man sent to Hell. But they’re not important for the state. Whether a child rapist gets life in jail or the scaffold doesn’t matter to the health of the empire. We don’t even know which punishment is worse for the offender. But rather than bother to think about how the feds are going to close their $57 trillion dollar financing gap, or how to bring the Pentagon back under control, Obama is talking about frying child rapists. Don’t get me wrong. As far as I’m concerned the electric chair is too good for them. But these issues are like terrorism…they’re distractions, they’re bugaboos; they’re not serious challenges to a great nation. But the mob wants bread and circuses. They want Medicare, victory in Iraq…and public hangings. Obama – like every other candidate except Ron Paul – is ready to give them what they want.”

*** We have come back to Ouzilly for the summer. You editor will still be at work. He will travel to Spain, Canada, and America in the next few weeks. But he will return to rural France each time – to spend a few days of holiday.

We arrived on Tuesday night…dragging a horse van behind us. It was 10:30 at night.

“Hi, I’m Jean,” said a pleasant woman with a Midwest accent, bright red cheeks and yellow hair.

“I’m going to cook for you this summer.”

You don’t need much to be happy. But a good cook is indispensable.

Elizabeth had placed an ad on the Internet – on Craig’s List. With so many people coming and going, we need household help in the summer. Jean, from Oregon, by way of Iowa, responded. She was already in the kitchen when we arrived and had prepared a dinner for us.

“Everything is from the garden or the farm,” she announced. “The salad, the green beans, the peas, the onions, the eggs…well, not the noodles.

“It’s so nice to have a garden to work with. And Damien (the gardener) is so nice. But I think he overdoes it…”

On the floor were huge buckets overflowing with green beans, peas, onions and other vegetables we couldn’t recognize.

“I’m going to can it…or freeze it. But there’s no more room in the freezer. He overdoes it, but it’s so nice to have fresh food directly from your own garden.”

And here’s a report from USA Today: “Americans are planting gardens to cope with high food prices.”

Yes, dear reader, it doesn’t take much to be happy…or to beat rising food prices. Just begin with a good gardener …and hire a good cook.

Until tomorrow,

Bill Bonner
The Daily Reckoning