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420: Underlying Causes of Stagflation - Opportunities For Investors

04-13-2012 team 

Blaming Outcomes: Too often the blame for economic misfortunes is pointed at particular events or outcomes rather than exploring the underlying causes. For property investors, it is critical to consider the underlying causes rather than the symptoms. Only by fully considering these can one invest cash and savings in the right place at the right time. One needs to consider the underlying trends – and “go with the flow” – like a swimmer catching the tide in an estuary.

“Euro Debt Crisis” Example: We’ll give you a good example. At the moment the mainstream media is fixated on the so called “European debt crisis”. This seems to be the biggest threat to markets at present – and the key uncertainty. Every time the financial markets get wind of some positive news on this issue, stock prices rise – so called “risk on”. When there is some negative news on this issue, they decline – so called “risk off”.  Let’s explore the issue just for a while.  On the face of it, it’s just that these countries have too much government and private sector debt – if it goes down, then things will get back to normal. But this is an extremely simplistic view. A smokescreen to the wider issues and causes. A closer analysis show the following:

Underlying Cause: European Union expansion took in peripheral European countries like Greece, Spain, Portugal and Ireland many years ago – part of the expanding “European Project” – in large part a political project to bring countries together after WWII to create peace and aiming for overall integrated prosperity. But economically, the perfipheral EU countries have about half or less competitive strength compared to Germany at it's core. Over time, as Germany increased its efficiency, Greece and other peripheral countries stood still – or even decreased their efficiency with large public sector projects paid by cheap European money (at low interest rates). The difference between the efficiency these countries and German/French/Dutch/Danish became more marked.  EU money subsidized Greece and rural parts of Spain, Portugal and Ireland with new infra-structure projects and EU Directive funding. This expanded regional governments, employment, decreased efficiency and made these countries increasingly reliant on European project money. This started to dry up in 2008 after the first financial crash. The ultra-cheap money from low interest rates kept Germany and France from deflation around 2002 - this cheap money was used in Ireland “the Celtic Tiger” and PIGSs countries to fuel a massive housing bubble. These valuable Euros at very low rates made most citizens asset rich for a while – and caused a two speed housing market – Germany was stable-flat, whilst peripheral countries with far weaker economies had housing bubbles and construction booms from this cheap plentiful money.

Oil Prices: The early phase of European integration took place during a period of incredibly low oil prices – of $8-$20/bbl between 1986 and 2000. This meant large oil, gas and commodities imports cost very little at that time and people bought large cars, used energy inefficiently and created very little GDP units per bbl of oil imported. They drove a lot but created little. A feel good factor with low cost tourism, a housing boom from cheap Euro money and very low interest rates and easy money boosted the economies in peripheral European countries. This was augmented by tourists buying second homes with airlines offering £10 flights to rural southern European destinations.

Cheap Money: Anyone that wanted a loan for a new house could get one. Public sector jobs growth accelerated and the private sector paid low taxes and fed off the public sector projects and tourism.  Cheap imports with the high value Euros made everyone feel wealthy. Things looked good. To keep things rolling forward, governments started to get into annual deficits well before the financial crash of 2008.

Tipping Point: The tipping point came when oil prices skyrocketed from $75/bbl to $147/bbl by July 2008 and inflation took off then interest rates increased – banks started to suffer large losses as the private sector and individuals could not pay for the high oil/commodities import costs and delinquencies started in the housing and construction sectors. Tax receipts dropped. Unemployment rates rose, social costs rose, inflation started to increase. All of a sudden, everyone felt worse off. The housing market crashed, building stopped and no-one could get loans from banks as the banks started to suffer large losses. The European Union efforts to bail out banks and government kept things from imploding, but the printing of money started to accelerate the inflation.

2012 Debt Issue:  The size of the debt that requires refunding is 2012 is colossal in countries like Italy, Spain, Greece, Ireland and Portugal. So the questions are – 1) will it get worse before it gets better, 2) what will happen, and 2) how can an investor make money in such an environment.

2013 Crash:  We think things will get markedly worse – not so much in 2012 – but in 2013. Europe will stumble from one crisis to the next this year, but the real action will be in 2013 when inflation will take off because money printing has been too extreme everywhere in the world and the US problems catch up with Europe (not the other way around).

Credit Is Due: To Europeans credit:

·         They know they have a severe problem

·         They are trying to refrain from printing money willy nilly

·         Germany and France are putting severe pressure on governments in peripheral countries to reduce their deficits with austerity measures

·         Cost cutting and spending reduction plans are pervasive along with tax increases and more efficient tax collection

·         Longer term, things might improve because these countries are trying to cut their deficits – also being pressured by financial markets to do so – all good discipline

Oil Prices Worsen - Already A Bad Situation: The thorn in the side of European countries (apart from Norway) is high oil prices. Whilst the oil prices continue to rise, this will affect EU nation deficits and they will require even deeper cuts and higher unemployment because of it. The oil prices will also fuel inflation and this will make everyone feel worse off. So please don’t expect any quick fix in these countries – instead expect years of stagflation – and the bottom has not yet been reached.

Don’t Buy Yet: So if you think you should buy some low cost house in southern Spain or Greece at this time – our advise is – don’t. Two key reasons are:

·         House prices are likely to drop further as the European economy sinks in recession by end 2012

·         The threat of many countries leaving the Euro is real – if this happened – the new currency would be worth about half the Euro value – so a flat in Greece worth say Euro 150,000 would then be worth Euro 75,000. If the country left the Euro, about six months after, this would be the time to buy a house in that country. In summary, there is at least a significant risk you could lose half your asset value. If you put down 50% deposit, you could therefore loose the whole amount of equity. Not wise.

So what about the UK?  At least the current government is trying to reign in spending and reduce the deficit. It will take many years and progress has been slow, but at least the financial markets have expressed confidence in the UK government for trying to tidy up it's books after a disastrous period under Labour from 1997-2010 when the government raked up huge debts during the good times and sold most of the UK gold reserves at record real terms low prices in 2002 of $240/ounce (current price $1660/ounce, a loss to the state of £60 Billion in value). We expect base rates to stay very low, interest rates on mortgages to rise as the banks take an ever increasingly large slice of the pie from anyone with debt. The differential between the base rate of 0.5% and borrowing rate of 5% is a gigantic 4.5% - this money goes straight into the banks coffers. In 2002 this differential was more like 0.5% - the banks take has increase about ten fold or 1000%. Its a form or indirect robbery in a way. But the real losers are the people with savings who are lucky to get 0.5% on their cash, meanwhile this money is lent out at 5%. Just expect this to continue – if anything get worse. The Bank of England will continue to print money to try and keep inflation going as a proxy for growth. But real GDP growth will be non-existent. Prices will keep going up at the official rate of 4%, but the real inflation rate is more like 8%. Now everyone will be talking about a house price crash. But in the UK this won’t happen in our view - unless the government increase property tax - this would precipitate a crash. The reason is, the Bank of England has not and will not let a crash happen. A crash would however occur if the Treasurey were stupid enough to increase property taxes - and shoot themselves in the foot. Instead the BoE will print money and keep rates ultra-low to make sure house prices don’t crash. But the outcome of this policy will be higher food prices, higher oil prices, higher housing rental costs, and higher general inflation. Expect the average house prices to rise at about half the rate of inflation, with London being close to the rate of inflation. They wil decline in real terms but rise in nominal terms. A good proxy is if you add the average official inflation rate to the real inflation rate, then divide by four, you will get the house price inflation.

UK House Price Increase = (8% + 4% / 2 ) /2  = 3%

Hence house prices will lag inflation somewhat, not go down in nominal terms but will go down in real terms. The good news is, after a few years of high inflation, your debt will be severely eroded and you will feel equity rich once more. But remember the government will tax this equity increase at 28% - so they will still get their cut and more. This is the Bank of England’s longer term plan we believe. To create inflation to devalue the currency, boost exports, make imports more costly and keep the house prices from crashing and large scale private and individual default from occurring. A way to deflate away the debts. The only fly in the ointment seems to be a knee-jerk increase in property tax for buy to let investors - this would drive them out of the market, cause a house price crash and lead to a gigantic shortage of rental property and massively increasing rental prices.

Investment Strategy:  The final outcome in such low growth inflationary times is that the rich get richer and the poor get poorer. It's just that the rich know how to position themselves in such inflationary times - they understand inflation and can control their finances accordingly. What they do – and indeed – this is our guidance to make sure you don’t go bankrupt and instead make a good return - is:

·         Hold only minimal cashing savings in banks that might go bankrupt (why take the risk if you are earning an inflation adjusted  -4% per annum?) 

·         Avoid Treasuries and Government Bonds that might default

·         Avoid high-tech stocks that are probably in a bubble

·         Invest in property – with good rental incomes (high yields)

·         Buy physical gold and silver

·         Buy stocks in commodities companies – oil exploration-production and mining exploration-production

·         Buy land

·         Buy commodities like food, fertilizer, forestry, water

Inflation The Only Option: In general terms, without the ability to print money from thin air, central banks would have to declare themselves insolvent and/or bankrupt and default on their debt payments. Greece has already defaulted – they just have not called it this. The private sector investors took a haircut of 50% in the latest re-structuring. Governments now understand that their debts are so large their only way out is to inflate away the problem.

Transfer of Bad Debts from Private to Public Sector:  After the private sector financial crisis and crash of 2008, governments stepped in and picked up the bad debt and transferred it onto the public sector balance sheet – for the tax payer to pick up. Now years of higher taxes and low growth weighed by this debt burden and high oil prices will affect European economies. Every time central banks print more money, this will go into higher commodities prices as a hedge against inflation. Investors will want real physical assets – not paper money. So as the paper money comes off the printing presses (or appears on the computer screen) – the investment bankers will say “risk on” and try and achieve high returns as the commodities prices rise. They will surely bet on these prices continuing to rise. So as governments continue to prop up the economies, even though no shortage of oil exists in the markets, oil prices will keep going higher – just because they are a favoured investment vehicle. This will then lead to higher fuel prices and higher inflation and so the cycle will continue until there is another crash and recession.

Bumping Along A Peak Oil Plateau:  As the oil prices rises, more frantic drilling will take place, more oil will be bought on stream at higher finding and producing cost. This will delay the day that oil production (all liquids) starts to go into a significant decline. This is a very important investment model to consider:

·         Economy slows – oil prices drop slightly

·         Government print more money to prop up economic growth

·         Oil prices start to rise sharply whilst economic activity increases

·         Oil prices feed through to inflation and economy slows, oil prices drop back

·         Governments print more money to prop up economic growth

·         Each time the price trough of the oil price crash back gets higher and the oil price spike gets higher – further weakening the economies of all but the largest per capita oil exporters

This is what we mean by our expression "bumping along a Peak Oil production plateau". Global economic activity is being severely constrained by high energy costs and high inflation - caused by printed money and difficulties finding cheap oil.

Stagnation – Resource Constraint: All the time, the level of global oil production stays static. Oil consumption in the USA and Europe drop slightly and oil consumption in Asia, Africa and the Middle East continues to rise sharply. The net effect is that western economic growth is stagnant with high inflation and lowering oil consumption. Eastern economic growth remains high with rapidly increasing oil consumption. The OPEC oil exports shift from the USA and Europe to the Far East and South Asia. The growth engine is in the east and the region of consumption decline is in the USA and Europe. This should last at least another decade. Its not going to go away.

US Reserve Currency: A big driver behind this economic trend is that the USA continues to have the global reserve currency for trading – the US dollar – and they continue to debase their currency by printing gigantic quantities of new dollars from thin air. It is a true fiat currency. Meanwhile the Chinese get their own back by pegging their currency to the debasing dollar and therefore are able to export giant quantities of goods, products and services to the USA and western nations using cheap labour - this is their hedge against the devaluing dollar. The Europeans need to join in by making sure their currency does not rise too far – by printing their own money – to keep Europe competitive. Because the economy is now truly global with few trade barriers exist, the outcome of the US printed money is not at all confined to the USA. The printed money affects all parts of the world. It creates bubbles in many different places – for example – the giant amount of printed dollars:

·         Caused global oil prices to sky-rocket

·         Caused global food prices to rise sharply

·         Caused a real estate boom in China

·         Caused general inflation around the world

·         Caused gold and metals prices like copper, lead etc - to surge

The rich have used this flood of cheap money to speculate and have made giant profits from these activities. The poor have had to pay for high fuel prices and high food prices – and this has been part of the reason for the “Arab Spring” uprisings and riots. Pressure for food, water and fuel – with high inflation and lowering real standards of living in highly populated desert areas.

They Won’t Change Their Money Printing Ways: There is really little use in continually complaining about this money printing binge – since the Fed, Politicians and ruling elite will never listen to minnows like us. It’s probably better to channel ones energies into making sure as investors one can use these policies to make high returns - catch the wave. In a simple way, one has to follow the cheap currency around – because we know that bubbles will form in such an economic environment – asset prices will rise – then pop and crash back down again. It’s a question of riding the waves, as they rise, then jumping off before they crash back down again. Buy low. Sell high. Protect oneself from the rampant inflation that is almost invisible but quietly eating away at everyone’s wealth.

Physical: As we have described before, during inflationary times it’s very important to:

·         Own physical assets – that you can touch, feel, see and own – like gold, silver, oil, land, property, artwork

·         Avoid paper, debasing currencies, bonds, treasuries and government debt that could default

Paper:  If you "do" want to have a huge stash of cash – a currency (not real money as such) – the best ones in our view are:

·         Swiss Franc – backed by gold and a stable safe haven

·         Japanese Yen – strong because of exports/manufacturing

·         Norway Kronor – strong because of huge budget surpluses and oil/gas exports and a small population

·         Australian Dollar – strong because of huge mineral/gas wealth, a large country with small population

·         Canadian Dollar – strong because of huge mineral, oil/gas wealth, a large country with small population

·         Chinese Rhimbi - manufacturing exports and internal consumption growth from developing economy with 1.2 billion people

Fiat: The currencies to avoid are:

·         Euro – mainly because of the uncertainty and possibility of default in this developed region with aging populations and almost non-existant growth (however, if Germany introduced the Mark back again, then this would be an opportunity to acquire a strong currency).

·         US Dollar – likely to crash and country could default with $75 Trillion unfunded liabilities, no deficit reduction plans and expensive aging baby-boomers (Medicare, Medicaid, giant healthcare inefficiencies) 

Inflation All The Way: We think Central Banks will never allow deflation to occur for any significant period – they appear to be printing as much money as required to create a fair amount of inflation. But this is a very dangerous action because eventually it always gets out of control. This is when people don’t turn up to the bond auctions – or people sell their bonds – bail out and this wave of money hits the streets and people panic. Then they try and offload the money, buy assets and inflation goes through the roof before a general crash. What we are saying is that – with the printed fiat money – these currencies will eventually fail. Yes fail. It's just a question of time. No-one really know exactly when, but our feeling is – the time is getting far closer now. The most likely time would be 2013, but they may be able to put it off to as late as 2016. It could start with a run on the US dollar as their rating is further downgraded or people start to loose all confidence in their ability to pay debt and their ability tp get away with printing so many dollars.

Gold and Silver Suppression:  All the time, inflation will be raging and gold prices will be rising. Every once in a while, the Fed gets with JP Morgan and HSBC – then they drive the gold and silver prices back down again with gigantic shorts that spook the market. The faint heart get out of the gold and silver market. But this manipulation – meant to make the US dollar look good - will almost certainly fail one day. When it fails, very rapidly, gold and silver prices will go ballistic, a parabolic move upwards just like in late 1979. This is our very serious expectation. When we say ballistic – we mean it. We are talking about:

·         Silver from $32/ounce to say $400/ounce

·         Gold from $1660/ounce to say $6400/ounce

Gold Accounting For Dollars: Gold will try and catch up and account for all the fiat money that has been printed and circulated out there in the ether. If it truly caught up fully with the number of dollars created since the last gold bull market ended in early 1980, gold prices would need to be at least $60,000/ounce – some people even talk numbers like $250,000/ounce. But let’s be conservative and  think the gold price will equal the Dow Jones index eventually – a 1:1 ratio at the end of the bull run. So if the Dow was 10,000, then gold would be $10,000/ounce.

Savings Misery: Anyone with dollar savings will be rapidly wiped out. Anyone who owns physical gold bullion will be a winner. The gold bull run has hardly started. There is no bubble yet – but there will be bubble mania one day. No-one really owns gold as an investment or saving vehicle at this time – when people that you know own gold, then it will be starting to get into bubble territory. The exit strategy is to watch it skyrocket as panic sets in, gold mania takes hold, and get out into other assets or a stable currency before the bubble pops. Just to re-iterate our view – that gold and silver are in no way in our view currently in bubble territory. They have just been following a fairly orderly manner though lagging well behind the amount of fiat printed dollar currency.

Dollar Destruction: Just consider this. The US dollar has lost 97% of its value since 1920. It retains just 3% of its value. Since 1971 when the US came off the gold standard, it's value has dropped 80% - it is only worth 20% of what it was in 1971. In 1980, silver was $55/ounce – it is $32/ounce today. In 1980 gold was $850/ounce – it is $1660/ounce today. Gold and silver prices have been suppressed for years – because it is a rival to the mighty US dollar. Just imagine if OPEC countries started accepting gold instead of dollars for oil. At the moment, the status quo continues – namely, that OPEC keeps oil prices rising as the US dollar is debased – they keep to the US dollar as the petrocurrency because they need US arms to defend themselves against aggressors. The US drives oil prices higher with the printing of money, then the OPEC countries drive it high through low exports globally, then they use the high price and revenue to buy US arms to keep their countries stable - the dollars circulate.

Peak Oil Countries Crumble: It’s interesting to note, apart from Libya, the following countries have suffered severe riots-disturbances as soon as their oil production rates crashed (about 6 years after they reached Peak Oil):

·         Egypt

·         Syria

·         Yemen

·         Tunisia

·         Bahrain

The countries that have survived without severe riots are those that have stable high oil/gas production rates – Algeria, Saudi Arabia, UAE, Qatar, Kuwait, Iran, Oman.

Regrettably, the new country South Sudan is next on the list to crumble because they have stopped all oil production because North Sudan was charging $25/bbl pipeline fees - so expect this country to de-stablize in the next year - a sort of forced Peak Oil outcome.

Money Circulation: Iraq is stabilizing now that it is producing far more oil – and now this revenue to circulating in the economy – life is getting back to normal after years of strife. The regime in Libya might have fallen because the oil revenue was focussed on the people around Tripoli (Benghazi was a poor neglected area – rebels from this area led the uprising as you will recall). The point of describing this is just to highlight how important oil production is to these countries – and without it – they destabilise rapidly. No money to pay the military, security and public sector – these key workers and the general population then rise up as food and fuel prices rise. They can keep the economy afloat just about with oil production and revenue also because oil prices have risen – the minute oil production rapidly declines, the country cannot afford to pay its civil services - because they gave fuel subsidies but then have to start importing oil - the economy simply cannot handly the revenue shock. But a key piont is that this whole process is profoundly economically inefficient. Wasting financial resources on weapons and military, having high oil prices that then go into OPEC social spending programmes and increasing input prices for manufacturing all lead to wealth destruction. High oil priced periods lead to high food prices, high general prices, high unemployment and general wealth destruction - particularly in the less efficient and higher cost economies. This does not bode well for countries like Greece, Italy, Spain, Ireland, USA and Portugal, or desert countries with expanding populations and little or no oil production like - Jordan, Syria, Lebanon, Egypt and Tunisia.

Summary: One can see from the above analysis there are few safe places to invest at this time in the western world. The safest places with good economic outlook have to be Norway, Canada and Australia because they have huge exports of oil, gas and/or mining - coal/metals - relatively small but expanding populations and huge land areas. They also have excellent laws, are safe, very secure and crime is low. They are democratic and fairly prudent with their finances. They will all have strong currencies, less inflation than the USA and should have assets that retain their values. The ruling parties are not far left or far right. They treat women as equal to men - meaning half the population is able to contribute economically. They come out top in human rights and transparency international rankings. They have plenty of energy and reserves. The people are pleasant with few hang-ups. You are least likely to get ripped-off since business principles and standards are high.  






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