Today we ask whether we’ve got it all wrong. We pause to examine whether or not our prediction of impending inflation is consistent with what’s actually going on in the markets. It’s one thing to keep saying it. But do the facts support it?
More on that in a moment. First, Warren Buffett once paraphrased Ben Graham, saying that in the short-run the stock market is a voting machine but in the long-run it’s a weighing machine. These days, the stock market is a humbling machine.
Last week we discovered that one of the small-cap tips we’ve been keen on for over a year lost millions of dollars in mortgage backed securities. The resulting loss on its financial investments is a blow to working capital and another blow to shareholders. It’s an especially depressing turn of events since the company is engaged in building fuel-cells, a business as different from asset-backed securities as you can imagine.
Just how badly is the real economy infected by asset-backed and mortgage backed securities? If our fuel-cell tip is facing losses on its impaired assets, who else out there is exposed to the wealth destruction? And how is it the banks aren’t losing money in their investments in asset-backed securities too?
You expect risk in small cap companies. But it’s usually what you’d call ‘entrepreneurial risk,’ namely the risk that the business itself-the product or the idea-will fail. Most do, in fact. But the winners are usually very big, which is the whole appeal of speculating in the small caps to begin with.
We’re sending out updated analysis, along with Kris Sayce, in the October issue of the Aussie Small Cap Investigator, available on-line later today. It’s a humbling experience to have your single best investment idea gutted because it was investing in the kind of securities you’ve also been warning people about for years. The idea behind the tip is as compelling as ever. But that is not always enough.
In the spirit of humility, let’s take a moment to examine whether we’re simply wrong about our main investment thesis: that extraordinary measures adopted by central bankers and government officials will result in tremendous inflation, and thus boost commodities and resource shares.
The first strike against the theory is the global recession. It now looks like the global economy will grow a lot less fast in 2009, if it grows at all. Investors are busy repricing commodity stocks for a world where resource demand drops along with consumption in the developed economies.
But a cyclical recession in resource stocks is a manageable event. The bigger challenge to the inflation argument is, well, deflation. The argument here is that there was simply much more leverage in the system than even we expected. As that leverage disappears-hedge funds selling assets to meet redemptions, for example-all assets fall in value.
So far, it looks like the deleveraging of the global financial system is destroying wealth faster than central banks can create new credit to replace it. Europe organised US$1.7 trillion in guarantees on bank loans last week. And in the States, it won’t be long before every institution and every debt is guaranteed by the full faith and credit of the American government. This should lead to the first trillion dollar fiscal deficit in American history. Heck, it might even be two trillion.
South Korea guaranteed $100 billion in bank debt this weekend, and provided banks $30 billion in loans. The Dutch government “injected” $19.6 billion into ING this weekend. Yet as large as these government guarantees and capital injections are, they might not be large enough.
These amounts are small compared to the amount of value already destroyed in the residential real estate market and in the share market. $20 trillion has already been wiped off global shares. Real estate markets in the U.K. and the U.S. are imploding.
What we may have underestimated is how quickly this deleveraging and value destruction would spread to the commodity markets, which we thought would provide relative safety with the backing of tangible value. Resource stocks did not hold up for long at all. Why not?
On the one hand, it now looks like a lot of investors were long commodities with borrowed money. Those investments have been sold to raise cash and pay back loans. Secondly, when it’s a bear market in stocks, there aren’t too many stocks that do well, full stop.
But isn’t inflation in tangible assets just a matter of time as the global money supply grows to re-flate credit markets? And what about all the new government loan guarantees and capital injections? Don’t they have to be inflationary?
Well, if governments borrow to finance these various programs, they’ll issue new bonds. Bonds soak up the available pool of global savings. To that extent, the borrowing crowds out other ventures, which might put the savings to a productive use. But financing the scheme with bonds is not, at least, right away, inflationary.
However, if governments can’t find takers for the bonds they issue to finance the scheme, they will have to either raise taxes (not likely in a recession), or simply print the money. And here’s a hint. That’s what they always do, from Argentina to Zimbabwe. That is why we maintain the preferred response to huge debt levels is outright money-printing.
Besides, simply making credit more available by lowering interest rates stops working after awhile (like when you can’t lower rates any further…zero bound.) How do get available credit out of bank computers and into consumer wallets? It’s not easy. Bankers are suddenly quite shy where they were once promiscuous.
Then you have to get people to spend the money instead of stuffing in mattresses. The banks have been stuffing their money in mattresses (overnight accounts with Central Banks). So now, governments are simply taking over the banks. Let the new loans begin!
This government nationalisation of the banks solves another problem with run-of-the-mill credit creation. You can make the credit flow, but you can’t always determine where it goes. But in these unusual times, the government is in the position of deciding where it wants the money to go. Right now, it’s simply shoring up bank balance sheets with more capital.
But to really “get things going again” and “fight the recession” the money will have to get back into the real economy. This is where see the inflation coming. Not in asset prices for houses or shares. But in real goods. Why? If the government engages in massive public works projects as a way of stimulating demand in the economy and keeping up growth, it’s going to be resource intensive.
In a way, this is just another kind of phony boom, but with the free-market varnish stripped off to reveal it as an uber-lending program by some kind of pan-governmental agreement. We already had one simultaneous global credit bubble. Now we’re getting the mother of all government debt bubbles. Only this one will not simply be a collection of various national bubbles.
Instead, it looks like we’re going to get a kind of Global New Deal. Leaders from world’s nations are already suggesting a system where the world’s top thirty banks will operate under the supervision of a government panel of some sort. You’ll see more “super banks” and greater control of the levers of global banking and a concerted program to flood the world with new fiat.
How this prevents future bubbles or leads people away from their addiction to debt, we’re not sure. But we’re pretty sure it’s not a promising development on either score. And inflation? It’s coming…
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