A Deflationary Double-Dip?

Bring Out Your Dead

Last week, the price of gold again broke below its new base at $1,200, and the U.S. stock market was again under strong pressure, due to a confluence of fears, most of which point to a deflationary double-dip. The fears were fanned by disappointment in the just-released early quarterly results, by the latest CPI reports that show inflation continuing to moderate, and by yet another poll revealing faltering consumer confidence.

The market is also spooked, no doubt, by notes from the latest Fed Beige Book that make it clear that the Fed is (finally) beginning to understand the entrenched and endemic nature of this crisis. While the notes are written in shamanic double-speak, the point is unambiguous – members of the Fed don’t expect the economy to get back on track until 2015 or 2016. 

“Participants generally anticipated that, in light of the severity of the economic downturn, it would take some time for the economy to converge fully to its longer-run path as characterized by sustainable rates of output growth, unemployment, and inflation consistent with participants’ interpretation of the Federal Reserve’s dual objectives; most expected the convergence process to take no more than five to six years.”

The simple reality the Fed is waking up to is that the structural underpinnings of the economy are damaged beyond any quick or easy fix.

That’s because until the debt is wrung out of the system, either through default or raging inflation – there’s no chance of it actually being paid in anything remotely resembling current dollars – the equivalent of an economic Black Death is going to plague the land.

Each new government initiative, the latest being financial reform, that doesn’t decisively address the debt, but rather tightens the dead hands of politicians around GDP, only serves to spread the wasting disease like so many flea-infested rats running through the economy.

And so, each new day will find the carts freshly laden with failed homeowners, businesses, and banks that have succumbed.

Pundits are fond of saying that things are never really “different this time around”… yet there is something truly unusual now going on. See if you can spot the disconnect in the following descriptions of the current economy.

• Record total debt.
• Record government deficits.
• Record trade deficits.
• Massive additional government debt financing required to keep the doors open and avoid reneging on social contracts directly affecting the quality of lives of millions of people around the globe – the U.S., Japan, and Europe especially.
• Near record-low interest rates.

Anything strike you as out of place?

The current setup with massive debts and low, low interest rates is like making an uncollateralized loan to an acquaintance at a very friendly, low interest rate. Then he comes back again for more, and more, and more. Because you live in a small town, you know he’s putting the touch on a bunch of other people too. And because you know his loose-lipped accountant, you also know what his income is, and even what his total debts are – and it is blatantly obvious that he won’t be able to repay his debts in a dozen lifetimes.

So would you keep lending him money? And, if you did, would you do it at the same friendly interest rates?

Not hardly. And therein lies the almost Twilight Zone caliber disconnect in the world as we know it.

In a conversation yesterday, my dear partner and friend of several decades, Doug Casey, made just that point – that the situation today should only exist if the fundamental laws of economics had been suspended. Interest rates should be going up, but they aren’t – rather, they are bumping along at the very bottom of the possible range.

In my view, this is testimony to the truly extraordinary lengths – involving trillions of dollars – that the U.S. Treasury and the Fed have gone to in recent years. But they can only suspend reality for so long before the fundamentals again rule – and when that happens, the entire system could literally collapse. Not to sound dramatic, but it could happen almost overnight.

As frustrating as it may be to all of us, the world is still locked firmly in the jaws of a powerful bear market. While the bear may loosen its bite now and again, it’s really only temporary – to get a better grip.

That being the case, it’s worth remembering the single most important thing about bear market investing – it’s hard. Or, put another way, it’s hard to make a decent return without taking extraordinary risk.

As Doug points out, in the current environment, everything – including commodities – is overvalued. And they are going to remain that way until they aren’t. Maybe the Fed actually has it right this time, and the bottom won’t be reached until 2015 or 2016? I wouldn’t discount it at this point.

But what of the inflation we see as inevitable? And gold, in the interim?

Let me quickly tackle the second question first.

In any debt crisis, the foremost concern of creditors is to get paid back. Compared to that, returns on investment come in a weak second. In a sovereign debt crisis, the question of repayment is complicated by the fact that the debtors control the creation of the currency units that will ultimately be used for payments.

Individual and institutional holders of U.S. Treasuries, along with other assets amounting to trillions of U.S. currency units, can see with their own eyes what’s going on. To continue holding such large quantities of instruments denominated in these unbacked currency units – or those labeled “euros” or “yen” – is to risk being left with a lot of worthless paper as the governments try to repay debtors by creating the stuff, literally, out of thin air.

And so these holders diversify their portfolios into alternative, and far more tangible, assets – gold and silver included. That is the fuel that has sent gold higher over the last ten years and that will keep it high – short-term corrections notwithstanding.

It is, however, when the inflation from all the money creation starts to appear that we’ll begin to see the shift into gold begin in earnest, and the price will really take off. When might that occur? Rather than trying to answer that question myself, I’ll refer you to the latest, excellent edition of, Conversations with Casey, in which Louis James interviews Casey Report co-editor Terry Coxon on the outlook for inflation.

 

Here’s an excerpt…

Coxon: …the operations that began in late 2008 have about doubled the monetary base. It was very roughly a trillion dollars. Nothing like that had ever happened before. Most of the new cash went to buy troubled assets from commercial banks. The first goal was to prevent the commercial banks from collapsing. If the Federal Reserve had done nothing else, the result would have been a doubling of the money supply within a few months, and we would have had South American-style price inflation.

L: So they changed the rules so they could create a huge amount of money to keep the banks open, while trying to avoid hyperinflation.

Coxon: Yes. The money supply grew by about 20%, which, I suppose, they thought would be enough. To keep it from growing any further, they started paying interest on excess reserves, effectively sequestering those excess reserves.

L: That’s a lot of sequestered cash. But the U.S. government has done more than directing or allowing the Fed to buy toxic paper. There’s Cash for Clunkers and all sorts of other insane ideas coming out of Washington, with Congress seemingly willing to spend “whatever it takes” to get Boobus americanus to imagine he’s rich enough to start spending again.

And yet, the average Joe in the street doesn’t see inflation. Life hasn’t really gotten any cheaper, but gas is still way below its previous $5 high-water mark. Joe is worried about losing his job and cutting his expenses, which is price-deflationary. Why isn’t he seeing more inflation?

Coxon: Joe isn’t seeing inflation because, so far, the Federal Reserve has not allowed the money supply to grow enough to trigger inflation. You’re mixing apples and oranges when you talk about Congress and the Federal Reserve. All of the runaway deficit spending is not, in and of itself, inflationary. The government spending borrowed money does not increase the money supply – it doesn’t change the amount of cash people have.

L: Ah. You’re saying that out-of-control government spending isn’t inflationary, but sets the stage for future inflation, when money has to be created to pay the government’s debts?

Coxon: What it does is create a political motive and economic need for inflation. These huge deficits may have slowed the recession that began in 2008, but to keep the recession from worsening, the Federal Reserve will have to prevent interest rates from rising for months or years to come. And to do that, it will have to start printing money to buy up debt instruments whenever the economy starts recovering, to keep interest rates down to levels that will not choke off the recovery.

L: So more money creation will be necessary to keep interest rates low, but at some point, the foreigners holding dollars, believing it to be a sound currency, will have to get worried about all this dilution of the dollar – and that would tend to force interest rates up, as it will take more and more to convince those people to keep buying T-bills and such.

Coxon: The world outside the U.S. has become like a giant capacitor for U.S. inflation. The charge that’s building up is the accumulation of dollars and dollar-denominated assets in the hands of foreigners. When the outside world wakes up to the threat of inflation in the U.S., they will start unloading U.S. dollars, which will suppress the dollar’s value in foreign exchange markets, which will make prices of imports (including oil) go up, and that will be a separate vector feeding price inflation in the U.S.

For now, the key is to get through this period in the best possible shape. That means watching your debt, keeping well cashed up, buying gold on dips, and, when you venture into investment markets, it’s never been more important to understand what you are investing in and why.

There’s no need to chase anything – which means you have the luxury of building your portfolio over time, on exactly the terms you want.

While it may sound contradictory, I think this is also a good time to learn more about speculating. In the simplest terms, a speculator risks just 10% of their portfolio in the hopes of receiving a 100% return. By comparison, most investors put 100% of their portfolio at risk in the hopes of getting a 10% return (actually, these days, most people would be happy with just 5%).

In the case of the speculator, 90% of their portfolio can be largely kept in cash and gold. So, who’s more at risk – the investor or the speculator?

And where are the best speculations found today? Personally, I like energy, and I very much like bottom fishing in the junior gold sector. That’s because there are some terrific micro-cap Canadian junior exploration and mining companies (which you can buy using your U.S. discount broker) sitting on large known deposits – but their share prices periodically fall back based on nothing more than investor emotion. That’s called a buying opportunity.

(For our best bets in this sector, check out a risk-free 3-month trial to the International Speculator – it’s no coincidence that every single stock Senior Editor Louis James picked in 2009 has turned out to be a winner. Details here.)