V-Shaped Recovery, Where Art Thou?
This week was largely spent watching the recovery fall apart. Not a dramatic collapse. No market crash yet, for example. But the important indicators are giving way.
On top of the bad news from housing and employment over the past few weeks, Richard Russell’s famous PTI indicator finally dipped into negative territory – signaling a bear market. And the Baltic Dry Index – a measure of world trade – continued to fall.
No new buyers are coming into the housing market. No new jobs are being created. Consumers are still de-leveraging. Banks are still reluctant to lend. And businesses are still loathe to expand in the face of an economy-wide de-leveraging.
Automakers say they see no sign of recovery. Investors are spooked by the thought of a double-dip recession. And 10-year US Treasury notes are selling at the lowest yields in 14 months.
To make matters even more unsettling, the world’s governments have pledged to reduce their countercyclical spending. They won’t get an argument from us on that score. They are doing the right thing. But if they follow through, it will result in the private sector and the public sector de-leveraging at the same time. This is highly deflationary.
Countercyclical spending cannot stop a correction. But pro-cyclical tightening may be able to trigger a depression (as Treasury secretary Andrew Mellon’s drive to balance the budget did from 1921-1930).
Let me put that another way. Governments can’t make bad debt go away. So they can’t prevent a correction and a de-leveraging; they can only delay it. One way or another excess debt needs to be reckoned with. But when the authorities begin to tighten at the same time that the private sector is tightening, the effect will push the world into a sharper, deeper correction…even into a depression.
This is a dangerous situation. This period of price deflation and debt destruction could be more dramatic than we expected. Seen through this lens, cash and gold seem preferable to stocks. The goal is not to lose money while waiting for the next great opportunity.
Gold is the ultimate money. It is only useful as a store of value – and then only when other forms of money are defective. In a healthy monetary system, investors scarcely need gold. It functions best as a reserve currency and a reserve monetary asset. Your bank should have gold. You shouldn’t need it.
But the special conditions of our time make gold: (1) a necessity and (2) a good speculation. It is a necessity because the banking system lacks real reserves. One bank holds IOUs from other banks in place of reserves. The others do the same thing. If one fails, they all may fail.
Central banks are no better. They hold the IOUs of their governments. But the governments are nearly all close to insolvency. Depending on how you look at their balance sheets, most governments in the developed world are already broke. And they are all adding more debt. At the recent G20 meeting in Canada, the world’s richest nations pledged to gradually reduce their deficits. If all goes well, deficits will decline. And sovereign debt will plateau at about 100% to 150% of GDP.
Governments that are reducing their deficits are headed in the right direction. There are two big questions: How far will they go? And what will happen along the way?
The private sector is de-leveraging. Even $12 trillion worth of bailouts and boondoggles has not been enough to stop it. Imagine what will happen when government begins de-leveraging too!
Much more could be said about this. A research report written by our friend Dylan Grice at Societe Generale revealed that it is unlikely governments can actually stay the austerity course. The only successful examples, he points out, occurred under much different circumstances – that is, when the private sector credit cycle was still in full expansion.
We doubt that governments will have the stomach for deep spending cuts. It is easy to talk about austerity; it is difficult to implement it. And it is especially difficult when the economy is de-leveraging.
In fact, the move towards tighter government budgets could produce a terrible outcome. It may not be enough to reduce sovereign debt levels…but still be enough to tip several national economies into depression (thus reducing GDP growth and keep debt-to-GDP ratios dangerously high).
We could see greater losses to equities, bigger write-downs at banks and more bankruptcies than expected. This would clear away debt fast. And allow a speedier recovery.
Gold is an insurance policy against monetary mistakes. We think we see an error coming. The Fed has nearly tripled its balance sheet since 2007. The Bank of England expanded its balance sheet fivefold.
If the private sector were still expanding its use of credit, these moves would be horribly inflationary. Instead, credit is shrinking in the private sector. The inflationary policies of central banks are not being transmitted to the economy. There is no sign of consumer price inflation so far.
Does that mean we’re going to see much give in the gold price?
We don’t know. No one does.
Gold went up 13% so far this year. Stocks worldwide are down 10%. Gold is clearly not responding to inflationary pressures. It is responding to uncertainty, and the increasing risk that the monetary system will fall apart.
During the 1930s the price of gold doubled in sterling terms. Of course, we could be facing something more dramatic this time. In the 1930s the developed nations did not face such huge debts and deficits. They had no institutional or structural bent towards currency debasement. They were merely in a de-leveraging period and trying to get out of it. This from John Hussman:
One of the greatest risks to investors here is the temptation to form investment expectations based on the behavior of the U.S. stock market and economy over the past three or four decades. The credit strains and de-leveraging risks we currently observe are, from that context, wildly “out of sample.” To form valid expectations of how the economic and financial situation is likely to resolve, it’s necessary to consider data sets that share similar characteristics. Fortunately, the U.S. has not observed a systemic banking crisis of the recent magnitude since the Great Depression. Unfortunately, that also means that we have to broaden our data set in ways that investors currently don’t seem to be contemplating.
Hussman makes an important point: it is very difficult to forecast what will happen in the markets except through the lens of our own experience.
Most investors have only seen bull market/credit expansion conditions. Those conditions (although punctuated by setbacks) have dominated housing, stocks and bond markets since the early 1980s. It is therefore very difficult now to imagine how bad things could get. In 1932 for example, the S&P 500 sold for just 2.8 times the peak earnings of the pre-depression period.
And this was a time when the US was still overwhelmingly the world’s most dynamic, richest, fastest-growing economy – one with relatively little regulation, low taxes and great prospects for future growth.
By contrast, today we seem to be approaching endgame. The neo-Keynesian plan for stimulating the economy, for example, has pretty much played itself out – except in America. So has the dollar-based monetary system. Meanwhile, the system of open-ended, debt-based financing of social welfare spending is also running out of room to maneuver.
Even in the best of circumstances, it would be difficult to make the adjustments that even one of these challenges calls for. Trying to do them all at once – against the backdrop of a huge private sector debt destruction – could be disastrous. From Hussman again:
Having squandered trillions in an empty confidence-building exercise, it will be nearly impossible for those same policies to build confidence again in the increasingly likely event that the economy turns lower and defaults pick up again. The best approach will still be to allow bad debt to go bad, let the bondholders lose, and defend the customers by taking whole-bank receivership (as the FDIC does seamlessly nearly every week with failing institutions). Almost undoubtedly, however, our policy makers will choose to defend bondholders again, pushing our government debt to a level that is so untenably high that little recourse will remain but to suppress the real obligation through long-term inflation (though…the near-term effects of credit crises are almost invariably deflationary at first).
This is our view, too: deflation now, inflation later. Which is why we favor gold as insurance AND as a speculation.
As insurance, it is the oldest, simplest and surest place for your money. It may or may not be overpriced at any moment. But it will never be 100% overpriced. It represents real wealth. Always will.
As a speculation, it is a bet that the financial authorities really are as maladroit as they appear to be. So far, they’ve given no indication that they grasp what is really going on. If they did, they would immediately give up their project of trying to stop the market from correcting. They would look to their own precarious situation, immediately cut spending and immediately try to beef up their own balance sheets.
(In any event, no one asked our advice…)
Most likely, as Hussman argues, the feds will not abandon their neo-Keynesian stimulus. And when they realize this stimulus doesn’t work they will turn to debt monetization – they will create money to buy their own bonds. This will work. It will cause inflation – possibly hyperinflation – which will wipe out much of the debt (along with much of America’s counterfeit economy).
Gold has been going up ever since I first recommended it to readers more than 10 years ago. The cracks in the world’s monetary system are widening. But they remain just cracks. My guess is that the bull market in gold will pause during the coming deflation and then resume, probably turning into a speculative frenzy when the deflation turns into consumer price inflation.
At that point – which could be 5 or 10 years ahead – we hope to trade our gold for stocks, buying the best companies at the best prices in a quarter century.