If any longish marriage is an exercise in irritation management, so is listening to the hype by media commentators about the soundness and superiority of the US economy and about how well US stocks are performing. I suppose that if Larry Kudlow were living in Zimbabwe, where the economy has been contracting for eight straight years and has shrunk by 50% since 1999, and where hunger is spreading and life expectancy is down to 35 years, he would also be enthusiastic about the prospects of Zimbabwe’s stock market, which is currently soaring as inflation is likely to reach 5,000% this year. (Michael Lewitt of Harch Capital Management recently commented on the Zimbabwe stock market and noted that on March 20, the Zimbabwe stock exchange rose in that one single day by as much as in the previous 40 years to December 2006 combined.)
As in the case of the US, but in a more extreme way, while stocks are soaring in Zimbabwe, the currency is collapsing. (In fact, it is an exact replica of what happened during the Weimar hyperinflation of 1919-1923, in local currency terms, the stock market index soared into the trillions but collapsed in gold terms.) John Paul Koning, an analyst at Pollitt & Co in Toronto and writing for the Mises Institute, has made the following pertinent observation about the Zimbabwe Stock Exchange:
“The ZSE is growing some three times faster than consumer prices. This relative outperformance versus general prices is a result of stocks being a chief entry point for the flood of newly created money. Keep Zimbabwean dollars in your pocket, and they’ve already lost a chunk of their value by the next day. Putting money in the bank, where rates are pithy, is not much better. Investing in government bonds is the equivalent of financial suicide.
“Converting wealth into foreign currency is difficult; hard currency is scarce, and strict rules limit exchangeability. As for capital improvements, there is little incentive on the part of companies to invest in their already-losing enterprises since economic prospects look so bleak. Very few havens exist for people to hide their wealth from the evils created by Mugabe’s policies. Like compressed air looking for an exit, money is pouring into shares of ZSE-listed firms like banker Old Mutual, hotel group Meikles Africa, and mobile phone firm Econet Wireless. It is the only place to go. Thus the 12,000% year over year increase in the Zimbabwe Industrials.
“Our Zimbabwe example, though extreme, demonstrates how changes in stock prices can be driven by monetary conditions, and not changes in GDP. New money gets spent or invested. In Zimbabwe’s case, because there are no alternatives, it is stocks that are benefiting. This sort of thinking can be applied to the stock markets in the Western world too. Though western central banks have not been printing nearly as fast as their Zimbabwe counterpart, they do have a long history of increasing the money supply. It forces one to ask how much of the growth in Western stock markets over the preceding twenty-five years has been created by a vastly increasing money supply, and how much is due to actual wealth creation.
“Perhaps stock prices have increased faster than goods prices for the last twenty-five years because, as in Zimbabwe, Western stock markets have become one of the principal entry points for newly printed currency.”
Now, I don’t anticipate that a Zimbabwe-like scenario will unfold in the United States soon, but the phenomenon of investors realizing that cash deposits don’t give them adequate protection from the loss of their paper money’s purchasing power and therefore rushing into any kind of asset is the same everywhere in the world. Also similar is the increase in asset prices in local currency in Zimbabwe and the United States, and the collapse of the Zimbabwe dollar and, to a far lesser extent, the decline in value of the US dollar.
Still, for now, there is some hope for the US dollar. As explained in last month’s report, it is not the Fed that has tightened monetary conditions, but the marketplace through the collapse of the sub prime lending industry. Since the housing market is more likely to deteriorate further than to recover, credit problems could get much worse. In any event, Robert Toll, CEO of Toll Brothers (NYSE: TOL), just sold another US$8.3 million worth of shares. Since his company’s shares are down from almost US$60 in 2005 to US$27, his selling would indicate that he doesn’t see any immediate turnaround in the housing industry.
Moreover, there are several reasons why the Fed is unlikely to cut interest rates in the near future. Food and energy prices as well as import prices are rising, which could further increase inflationary pressures. The dollar is also in a very precarious position, and bond yields have so far failed to decline despite evidence of an economic slowdown.
Finally, I suppose Mr. Bernanke understands very well the difficult position he finds himself in as the chairman of the Fed. Should inflation under his chairmanship at the Fed become a problem, he knows that he will be blamed for it. Conversely, he is also well aware that if some sort of recession occurred due to a currently somewhat more hawkish monetary stance, financial observers will be quick to blame Mr. Greenspan for it, since the former Fed chairman addressed any financial crisis or any potential problem (Y2K, for example) by printing money and can thus be considered directly responsible for the housing bubble.
So, from a career and reputation risk point of view, Mr. Bernanke will likely move very slowly in cutting rates and rather take the risk of some mild form of recession occurring. He could then blame a recession, which would have come from the housing sector, on Mr. Greenspan. After that, he could take some “extraordinary monetary measures” in order to engineer an economic recovery for which he would take credit. And should at that time inflationary pressures have failed to abate or have even increased – as I would expect them to do – he could always argue that the Fed’s policy priorities have temporary shifted to emphasize “economic growth” over “targeting inflation”, and that the Fed will deal with inflation once the economy has fully recovered. The stance of emphasizing “economic growth” over “inflation targeting” would by then also be perfectly acceptable politically and thus would be welcomed by the “establishment”, which would have taken advantage of a bear market in housing and hardship among sub-prime borrowers to acquire some assets at bargain prices…
I am mentioning this because as my friend Bill King, author of The King Report reported, Ben Bernanke recently gave a speech at Stanford in which he said that “increased trade with China has reduced U.S. inflation, now running at about 2%, by only about 0.1 percentage point”. He also noted that while emerging economies have added to the global supply of manufactured goods, they are also adding to the demand for oil and other commodities. And according to Mr. Bernanke, “There seems to be little basis for concluding that globalization overall has significantly reduced inflation in the U.S. in recent years; indeed, the opposite may be true.”
And this is where I think the Goldilocks prophets with tunnel vision, who argue for continuous economic growth amid low inflation, will be as wrong as they have been for the past few years. The super-bulls on the US have simply overlooked the fact that if economic growth in China, India, Vietnam, and other emerging regions of the world remains strong and the US economy continues to expand, this synchronised global boom will be supportive of commodity prices whose price gains have significantly outstripped the performance of US financial asset prices since 2001. So, in the event, as the entire Goldilocks sect argues, that the global economy remains strong, inflationary pressures should increase. Commodity prices, especially for agricultural products, are in real terms still extremely depressed and, contrary to expectations, could rise far more than many would think possible.
However, illiquidity among the US household sector, along with the reluctance of the Fed to cut rates right away, combined with the requirements for enormous capital investments for infrastructure in emerging and developed economies, could lead to some tightening of liquidity around the world.
Therefore, I expect a more meaningful setback in asset prices and would certainly defer the purchase of financial assets. In particular, I am concerned by the inability of financial stocks to rally convincingly from their March 2007 lows, since financials are usually leading the market up and down. In my opinion, there is an ongoing deterioration in the US stock market. In the summer of 2005, the homebuilders peaked out. Last year, it was the turn of the sub-prime lenders to top out. And early this year, financial shares, including brokers, made their highs. The economy is likely to follow this slow stock market erosion and gradually deteriorate, with disappointing corporate profits to follow.
Investors who must own US shares may find some relative outperformance among pharmaceutical companies, and oil and coal stocks. For the reasons outlined above (a relative tightening of liquidity in the world), I don’t expect the US dollar to collapse immediately. However, it should be clear that in the long run the purchasing power of the US dollar will continue to decline against sound currencies such as precious metals. Therefore, I continue recommending the accumulation of gold and silver.
But it is increasingly likely that something will give soon: either asset prices will decline in a tighter liquidity environment, or the US dollar will fall sharply if the Fed continues to pursue expansionary monetary policies. For the US financial market, this means either weak equities and a strong dollar or strong equities and a weak dollar.
Not a particularly appealing scenario!
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