The following is an excerpt from the May issue of International Speculator.
If the current global economic situation were a movie, it might be titled "The Good, The Bad and The Ugly". Our protagonist, gold ("The Good"), prevails in the end, while as the antagonist, the U.S. dollar’s ("The Bad") fate is sealed from the start. And what would a movie be without a sidekick, in this case the American Government ("The Ugly"): an often-misunderstood character whose unpredictable actions inevitably have an impact on the outcome of the fortunes of the two central characters. If you think you have seen this movie before, you are right, since this movie has played time and time again throughout history. Other than regular changes to the names of the currencies and the nations, the movie usually ends much in the same way. Unfortunately, the lesson in this story - the dollar’s unfortunate fate - seems lost with most people today.
The Good
There are a multitude of forces at play behind the current bull market in gold. So, I think it misleading, that so much attention is given to the daily gyrations of the gold price, which in turn takes focus away from the true nature of the forces behind this bullish trend. Commentators, both bulls and bears, are quoted daily on the reasons for that particular day’s price move. Invariably, most attribute the recent moves to either the fear of a messy war with Iraq or the dissipation of those fears. My reaction to all this daily noise - is to ignore it. We are in a secular bull market in gold that is driven by macro-economic events that have little to do with the immediate Iraqi situation. This trend will continue for a number of years, and while the daily ups and downs of the gold price may make bulls suffer anxiety and give the bears opportunity to declare the end of the bull market on a regular basis -- the trend is clearly up.
Remember, every bull market, whether it’s in stocks, bonds or gold, "climbs a wall of worry" in the early stages and it never goes straight up. In addition, gold is especially volatile given its lack of liquidity compared to other financial assets. As an example, witness the 1970’s gold market, which I believe bears many similarities to the current market. It took ten years of dramatic ups and downs before it eventually climaxed with an $800 gold price in 1980.
Gold is the chicken soup of all economic maladies that ail the world. It has taken many years and plenty of abuse to the system to create the necessary environment for the major gold market we are now seeing. The gold price will continue to move higher as the effects of that abuse are recognized and fully understood. The corrective process will be beyond what most people are prepared for. In the end, the standard of living most Americans took for granted will be lowered significantly. The structural deterioration of the system is the end result of such things as an aftermath of a stock market bubble, unprecedented high levels of public and private sector debt, and a U.S. currency whose meteoric rise and subsequent abuse allowed it to permeate into every financial corner of the world.
So although factors such as declining primary production (2002 gold production fell for the first time in seven years), ever increasing de-hedging policies by gold producers (hedge books contracted by 423 tonnes in 2002, almost three times as much as the previous year), a forty-year-low interest rate environment and its re emergence as a preferred asset class (with the underperformance of financial assets, gold purchases for investment purposes more than doubled from 2001 to 2002), will continue to help the gold price move higher, gold’s status as a currency and store of wealth will be the driving force behind its long-term upward trend. Since gold and the dollar have a historical high inverse correlation, the degree to which the importance of the U.S. dollar waivers or falls, will have a corresponding positive effect on the price of gold.
The Bad
I am fairly sure that the folks who brought us such religious ideas as Judaism, Islam and Christianity, did so with the best of intentions. The eventual success of these religions made them so powerful, that the temptation to abuse them was too much to ignore. Similarly, the folks that created the concept of fiat currencies also had the best of intentions as they attempted to smooth, and perhaps even eradicate, the business cycle. But, as with religion, the tremendous success of the currencies, which have represented all of history’s global powers, also begged for abuse. For a number of reasons, the U.S. dollar has achieved such a dominant status as the premier global reserve and transaction currency, that its abuse as a tool to exercise power goes barely noticed.
By all measures (as against other currencies and commodities) it is evident that the dollar is loosing ground….but why? There are many reasons, but in general terms, abuse by U.S. policy makers and citizens alike, allowed it and the system backing it to get so corrupted, that spooked foreign dollar holders began switching into other currencies and gold.
Let’s recap in more detail – the U.S. was the recent host to the greatest stock market bubble in history, which burst three years ago. Even so, like the villain in a B movie, the U.S. stock market continues to resurrect no matter how many fatal blows it receives by way of bad news. Consumers, government and corporate debt have grown to levels totaling well over $30 trillion with only corporations showing any recent signs of restraint. Consumers, the worst offenders, continue to pile it on – having increased their debt load by 500% in the last twenty years and are continuing to borrow at a rate which is ten times faster than Gross Domestic Product growth. For its part, the government, having doubled its debt load to $6.4 trillion in the past ten years, borrowed an additional $750 billion in the past eighteen months alone. Also, short-term interest rates are at forty-year-lows, allowing for nothing more than further speculation in stocks, bonds and real estate, while the widening real interest rate differentials are potentially disincentivizing foreign purchasers of U.S. government debt. Throw in America’s aggressive foreign policy (which will help push the federal deficit to almost $500 billion this year), the Fed’s threat to print money as a means to avoid deflation and an annual current account deficit representing 5% of Gross Domestic Product - it doesn’t require much imagination to see why foreign holders of dollars may soon look to the exits.
Let’s look briefly at all these factors, starting with the stock markets. Even though the bubble burst three years ago and equities are off between 30% and 75%, depending which exchange they are listed on, it’s still hard to justify current valuations. With the S&P 500 trading at thirty times earnings it’s hardly a steal. Worse still, if one factors in the current reality of rising energy, insurance and health care costs (which have all increased dramatically), pension plan losses (once reality replaces the current policy of reporting fictional gains), excess capacity, lack of pricing power, declining consumer demand and how all of these factors impact corporate profit margins, the "E" part of P/E (price to earnings) forecasts suddenly become suspect. As in the last couple of years, after barely hitting recently downgraded earnings, corporations are ratcheting down their earnings guidance for the rest of 2003, and as usual the analysts are ratcheting down current quarter market forecasts and back loading the higher growth in the third and fourth quarters. With economic indicators such as ISM (Institute for Supply Management), factory orders, retail sales and initial jobless claims worsening, I wouldn’t be surprised if we don’t soon double – dip into recession, foretelling a further drop in earnings.
So why are equity valuations so high? The Fed’s continuing easy money policy fuels the fire, I am sure. And for some reason Wall Street strategists and economists continue to retain credibility with their wacky market and economic growth forecasts. But, I think it has more to do with a change in investors’ attitudes and perceptions. For years, a pervasive media and the spin meisters - who know how to use it, have shaped these perceptions. CNBC in my opinion is the biggest purveyor of optimism in the market place, although they are not alone. You would think it might be difficult to consistently put a positive spin on an endless string of bad economic data. But by a combination of what appears to be selective emphasis (i.e. no repetition or follow-up on bad economic news and repeating the trivial stuff ad nauseam) and allowing "industry experts" (who all have an interest in keeping investors in the game) to comment and opine on the data, and finally switching to sports and entertainment news on days when the economic news is particularly bad, investors never have a chance to do the right thing….and panic. Instead, investors feel obliged to pile into overpriced stocks with the tenacity of a pod of pilot whales beaching themselves. As for CNBC, who knows, maybe its parent GE will recognize this winning formula and license the format to foreign territories suffering with sagging stock markets in need of a boost.
Irrespective of all this hype, equities will inevitably come down to earth. The effect this will have on the dollar will be very negative, as approximately $1.5 trillion worth of all U.S. equities are foreign owned. Consider what must be the growing disappointment of, say a European, whose U.S. equity portfolio may be down a nominal thirty percent or more, but is actually down over forty percent in his home currency terms. At some point he will cut his losses. That said, it is always difficult to predict short-term market performance and with all the liquidity currently being pumped into the system, it’s quite possible that the U.S. dollar will decline against the backdrop of a stock market rally.
With regards to the debt situation, foreign lenders who own over 40% of U.S. government debt, 23% of U.S. corporate bonds and over 20% of mortgage debt must, by now, be waking up to the fact that the U.S. is a nation of savings-deficient, debt-hooked consumption junkies. Furthermore, it is governed by an administration that is hell-bent on creating $1.8 trillion - according to the Congressional Budget Office (CBO) - of deficits over the next ten years. It may end up even higher as it looks as if current budgeting of U.S. Social Security benefit costs will prove totally unrealistic. Just two years ago the CBO projected a $5.6 trillion surplus in the same period. One might think this kind of swing would raise some eyebrows in the global currency markets.
But, if history provides any clue, it is that eventually there should be a "tipping point", when the creditworthiness of America will come into question. It is impossible to guess when that day will come even though the cracks are beginning to show. At best we will see a decade-slow deterioration of America’s creditworthiness accompanied by continued dollar devaluation and, at worst, outright panic followed by an Argentina-style (they also had a lack of domestic savings when foreign lenders cut them off) dollar collapse.
The Ugly
There is no doubt that currently America is the most dominant economic and military power on earth. Although the world has seen many great powers come and go, including the Spaniards, the French and the British, America’s influence in all global matters, whether economic, military, technological or cultural, is a phenomenon the world hasn’t seen since the Roman Empire.
Sadly, the mistakes that brought about the economic demise of all the past global powers are being repeated with impunity by America’s government and citizens alike. When confronted with these historic similarities, most Americans will likely dismiss the danger, convincing themselves that their current superiority is deserved and permanent. They believe that their system is so advanced and sophisticated that policy makers will always manage to keep things under control. Even when the system shows signs of strain; they all work feverishly to spin the information such that the masses do not panic. This game of confidence (or otherwise known as a "confidence game") will continue until something gives. For their part, the masses are happy for the reassurance, even though their gut may tell them all is not well. Since most people can only relate to their own lifetime experience, they will believe when told that the current malaise is a run-of- the-mill recession. Very little attention is paid to the fact that the current system has structural flaws that have deteriorated over the last three decades. These flaws are worsening in an exponential fashion, and still we would rather believe that this is a garden-variety recession that can be remedied with the traditional tools of fiscal and monetary policy.
It is becoming increasingly evident, to some at least, that these policies are not working this go around. When a system is overloaded with debt and over capacity and there already exists a gross imbalance between consumption and production, no amount of monetary or fiscal stimuli (which are meant to inspire demand) will work. Conversely, it makes the situation worse by fueling asset speculation and increasing public and private sector debt.
Looking back, it is difficult to argue that, historically speaking, America was initially a great experiment. The American standard of living is the envy of the world and was achieved by a combination of a political system that allowed and rewarded success by anyone regardless of class, and by a puritan work ethic that didn’t exist elsewhere. Both these characteristics held true for most of the 20th century and started to deteriorate only in the last several decades. This path to economic perdition was a result of an ever-increasing societal shift from production to consumption, and by transformation from a nation that was once the number one creditor to the world to one of being the number one debtor. Americans are holding on to their standard of living not as a function of their productivity, but at the sacrifice of the family unit (since it now requires both spouses working to maintain a standard that forty years ago took only one), and at the expense of their own future generations (as the result of the increasingly heavy debt load), and at the expense of the rest of the world (a function of its record and ever-growing trade deficit). How long the world’s other 5.7 billion people will continue to trade their products and standard of living for U.S. dollars is anyone’s guess, but I suspect that with the Current Account deficit running at $500 billion per year (and expected to rise to $600-$700 billion) and the U.S. government’s printing of dollars and issuing debt at historic proportions, it won’t be for long.
The ever-increasing government fiscal deficits are the result of a system that refuses to sacrifice consumption while its government embarks on a military adventure to reshape the world in its own image. It has to be a historical precedent that a debt-laden government goes to war and proposes to cut taxes simultaneously. Keep in mind that the CBO forecast mentioned earlier does not include the cost of waging a long-term war on all that is anti-American.
Government deficits can only be satisfied by borrowing from either its own citizens (an indirect form of taxation) or from foreigners. Already foreigners own over 40% of the $6.4 trillion in government debt. Add to that the projected accumulated deficit of at least $1.8 trillion (I believe it will be a much higher number, given this year alone the deficit could reach $500 billion) over the next decade plus borrowing for other "capital expenditures" and the total debt becomes a whopping number. Then assume the same ratio of foreign holdings and it becomes apparent that the U.S. will have a difficult time servicing that debt, never mind ever paying it back in anything resembling current dollars. Of course, the alterative solution is to inflate the debt away by printing more dollars, which is exactly what the Fed has already threatened to do to stave off looming deflation. Conveniently, the government would repay the debt in dollars that would be worth a lot less than today’s dollars. Again, there is nothing new in this little game. Every global powerhouse in history has played the same game. What is amazing though, is that judging by the dollar’s current value, it seems that very few foreign dollar holders have fully caught on. God help America the day when everyone catches on.
The current situation with Iraq does not bode well for the future economic well being of America. Firstly, now that the coalition has declared military success it will only mean the end to the easy part of the entire exercise. The administration of Iraq under the auspice of the U.S. military and the effort to create a functioning democracy may end up being a long and bloody exercise indeed. History has shown that the Middle East does not respond well to occupation by the West. From the Crusaders to the Brits, the eventual outcome is always an exhausted retreat. Trying to impose democracy on a region populated by a multitude of sects and tribes that all hold grudges that go way back (in some cases more than a thousand years) and was only held together with totalitarian force, may be challenging to say the least. Furthermore, given that the U.S. will have influence as to which specific Iraqi groups and people will be allowed to participate in this process, it will create further suspicion and turmoil. Democracy is a concept that must evolve, with groups of people that wish to live together and with a proper institutional infrastructure in place. I doubt it can be ordained at will. Secondly, whatever is being promoted as the reason de jour behind the invasion (oops, I mean liberation) of Iraq, i.e. elimination of weapons of mass destruction, preventing state-sponsored terrorism, regime change, the freeing of the Iraqi people, etc., it is increasingly evident that there is a much larger plan at play. Recent rhetoric suggests that once America succeeds in replacing the Iraqi regime, its focus will turn on other countries in the region. It’s astonishing that without even pausing for breath, once the Iraqi regime fell, Administration attack-dogs Rumsfeld and Wolfowitz started accusing Syria with the whole terrorism/sponsorship/WMD thing. Iran may be next, and eventually even old friends like Saudi Arabia may find themselves in need of an unsolicited American-sponsored regime change. Also lurking and simmering in the background is North Korea, which is preparing itself for some type of confrontation with the U.S. Unless it can negotiate a non-aggression pact (something a recently battle-victorious U.S. is unlikely to give), it will continue to play its nuclear hand
How Iraq’s Arab neighbors react to all of this is hard to predict. For one, they certainly don’t trust America’s motives and their rulers haven’t done much to prevent recent public outrage over America’s attack on Iraq out of fear their citizens will turn on them and partially to take the heat off how badly they have run their own countries. Ironically, many of the Arab countries are run by regimes which would be deemed illegitimate by American standards but who, nonetheless, are propped up by the Americans. In the end, the rulers of these countries will likely keep a fairly low profile while quietly rooting the U.S.’s occasional stumble. Their enraged citizens, on the other hand, may eventually behave less predictably and this is when the entire region may turn into hell on earth. If at that point the Americans are still in the region, it will become a bloody conflict beyond what America is prepared for.
It is doubtful that the average American will choose to sacrifice his standard of living once the combined economic reality of the accumulated excesses and the costs of American foreign policy collide. Sentiment will eventually parallel that of the Vietnam era rather than say, WWII. Waging wars in far off lands that pose no "immediate threat" while impairing the comforts of daily life at home, have never succeeded in popularity for long. I am not sure what will happen at that point, but suffice to say, that America will be a less happy place to live in.
The debate over current U.S. foreign policy will continue. I will leave it to future historians to judge whether America was acting in self defense and for the benefit of the oppressed in need of freedom, or whether it was acting out of economic self-interest. I will say though, that, "freeing the world from evil" might be a long and expensive exercise. For the purpose of this analysis, it only matters how much this current adventurism will cost the U.S. economy and how the rest of the world perceives Americas intentions. The magnitude of the economic costs will negatively impact the U.S. dollar and foreign perception may amplify its fall.
In the long run imperialism and over-consumption are a recipe for economic decline. We only need to look back at the 16th century Spaniards, the late 18th – early 19th century French or the late 19th century – early 20th century British for historic examples of countries trying to run concurrent war-monging and consumption.
Of the three, the experience of the 16th century Spaniards makes for the best comparison with the Americans of today. For nearly 100 years immense supplies of gold and silver (the likes of which Europe had never seen before), plundered from the natives of Central and South America flowed into Spanish coffers. Sadly, this 16th century version of excessive money supply growth managed only to fuel the nations’ spending habits, while at the same time disincentivizing their willingness to produce. Instead of turning this windfall into productive wealth, Spain used it to buy "consumer goods" from other nations. As a result, Spain’s debt to foreigners soared and all the gold and silver was exported out of the country (think current account deficit without the ability to "print" more gold). With all this new-found wealth, it didn’t take long for the kings of Spain to think themselves superior and embark on a mission of bending the world to their will. Charles V, not satisfied any longer with being a mere king, lobbied intensely, using bribes and threats and eventually convinced a "coalition of the willing" to make him emperor of the Holy Roman Empire. After loosing quite a few of its booty-laden ships on the high seas, Spain, claiming self defense, declared that it would no longer make a distinction between the pirates and the nations that harboured them. To eliminate this "state-sponsored piracy", they decided to strike at the worst offender – Britain (although I doubt that Philip II ever suggested that he was merely trying to free the British people from oppression). Boasting their technologically superior Spanish Armada (not dissimilar to America’s air supremacy), they waged what proved to be a disastrous war against Britain whose smaller ships proved far too wily. Years of wars ensued with a variety of other countries that did not share Spain’s view of the world. Having already traded their gold and silver for consumer goods, the nation had to turn to debt-finance to pay for these wars. As Spain’s tab reached the limit, their lenders, the Fuggers of Augsburg (16th century version of the Japanese) were forced to convert their debt into long-term loans. Eventually, Spain’s creditors cut them off and the nation, now bankrupt, introduced to the world the now time-honored tradition of default by a sovereign state.
Of course, in their time very few of the above mentioned governments or their citizens would have ever believed such an economic fate would befall them. I suspect most Americans today wouldn’t either. Truly amazing when one looks at the current sad state of America’s public and private balance sheet and its voracious consumption appetite. For although past global powers had their excesses, it took the Americans to really put the "pro" in the term profligate.
... And Back to the Good
So what has all this to do with the price of gold? The current economic and geopolitical direction of the U.S. will, unless corrected, lead to a long-term decline in America’s standard of living. How quickly all of this unfolds is subject to many unpredictable factors. There exists a small chance that this decline can be prevented, but that would take political courage and economic sacrifice that just doesn’t seem to exist anymore.
It may take several decades for the collapse of the U.S. financial system to occur or it could happen this decade. In a few years we may witness a new bull market in equities (although I doubt it) after this current bear market plays out. That said, the current macro-economic trend and its eventual outcome is undeniable.
Regardless how it plays out, there is one thing for sure. The world is dangerously awash with U.S. dollars. In addition to the previously mentioned levels of foreign owned U.S. debt and equities, it’s notable that more than three quarters of global central bank reserves are in U.S. dollars. The downward trend in the dollar began two years ago and is very much intact. Although it has fallen approximately 25% against the U.S. dollar index, it is still over valued and will most likely fall a further 15% in the next two years alone. In the long run it may go down a lot further. This bodes well for gold for several reasons. Firstly, as gold is priced in U.S. dollars, the dollar’s decline will make it cheaper to purchase in other currency terms and less attractive for non-U.S. gold producers to produce.
More importantly, if its imperial status is severely challenged and no other currency emerges as a viable alternative (only two are sizeable enough, the Euro and the Yen, and both have more than their share of problems), then gold will regain its historical status as the currency of last resort and the ultimate store of wealth. In this scenario, the price of gold would reach levels never seen before.
Unfortunately, it seems most Americans are impervious to the current economic trend, foolishly ignoring 2,500 years of monetary history. A history which is littered with lessons about the consequences of virtually every monetary and financial phenomenon we are witnessing today. Excess debt and consumption brought down every major power in history. Stock market and other asset bubbles, whether they were speculative manias (the tulip bubble of the1600’s), market frauds (the South Sea bubble of 1720), easy money bubbles (the Mississippi Company of 1721), or bubbles caused by innovations (the canals bubble of 1837 and the railroad bubble of 1873), all ended with crashes and subsequent depressions. Additionally, we are all familiar with the economic aftermaths of the 1929 stock market crash and the more recent 1989 Japanese stock market and real estate crash. Finally, "preemptive" wars and other types of military adventurism are also nothing new and the end result in economic terms is never very pretty.
Inevitably, a combination of these events is almost always followed by subsequent currency debasements (as invented by Dionysius of Syracuse in 400 BC and practiced regularly by every major world power since, especially with the introduction of paper money). America will be no different. It’s only a question of time. Since none of us knows how long before that day comes, I suggest that at the very least investors should diversify out of U.S. dollars and hedge their portfolios with at least 15% gold content.
As for the lesson in this story, unfortunately it will be learned time and time again throughout history and our protagonist, gold, will always be around to provide refuge from man’s inherent need to push things too far.
Finally, for those that read this and dismiss it as apocalyptic ramblings, consider that all I predict is a repetition of history, not the end of it. The day will come when it will be prudent to sell one’s gold holdings and invest in paper assets. Furthermore, although corporate America may be in decline, investment opportunities will always exist. And if not in America, then in other parts of the world, perhaps in emerging economic powerhouses such as China. On the bright side, who knows, perhaps in 50-100 years, it will be the Chinese who will play the "Ugly" role in our movie.
O Clubeinvest.com informa que nenhuma da informação
aqui facultada deverá ser entendida como conselho ou recomendação
de qualquer tipo de transacção ou investimento.
