Don't Cry For Me Argentina — September 15, 2008
So far this financial mess is unravelling as I thought it would. The nationalization of the banking sector in the US has begun and the Wall Street pundits are still hollering that this is the bottom and that things should improve from here on. In my opinion, we have entered the third inning, with this mess continuing to unravel, and the clean-up bill going higher and higher. To me, this is a global-scale replay of what transpired in Latin America, many, many times over when their governments could not pay for the promises they made. In Latin America as in the US, and many countries around the world, today the government response is to continue printing US dollars to keep the financial system alive; consequently, developing the next major global crisis to come our way: inflation.
The individual investor has to wake up to this reality and understand that the traditional models of money management are not — and cannot — work under these conditions. Actions must be taken to protect your savings. As evidence we need only look at the current portfolio of your average value-style money manager. Take Brandes Investments for example: they rode Fannie Mae and Freddie Mac right down to zero and they are still holding and adding to this sector. I for one truly admire and appreciate the consistency of their process, as I know that at some point the trend will change and that they will be holdings those stocks when they finally outperform. My clients however want capital preservation and growth. You have life expenses (children's tuitions, mortgage, cottage, eldercare, etc.) that need to be paid for through the current market trough — I understand this. This is why I'm greatly reducing my exposure to the value picks, and will wait to add more of them when we have sailed out of the coming inflationary storm. Same goes for the growth-style stocks: I'm reducing exposure to those underperformers as well. These market conditions call for a new approach to investing.
Many Wall Street pundits have been calling for deflation going forward; in other words, for a continued depreciation in prices as the economy slows down and the credit bubble unwinds. I disagree that this is the long-term situation we're facing, because in order to keep the banking system going, global central banks will be forced to monetize these putrid investments while the banks go bankrupt. The financial news of this past week supports this view, and in order to pay for the latest bailout the Fed will be forced to lower rates and print the money required. In the short term we will probably see the global economy slowing down and many will interpret that as deflation. In my opinion this will be that last chance for the rational investor to acquire real assets prior to the cresting of the inflationary tsunami that is coming our way.
In the short term I expect that the Dow will pullback to reflect more reasonable valuations. The Elliott Wave model of valuation, which uses dividend yields, tells us that at the very least the Dow needs to pull back below 11,000 to reach a justifiable bull market premium and by 50% to reach a bear market premium. The bottom is somewhere between these two numbers. In this environment I have raised my cash levels by selling some gold, oil and agricultural assets in order to take advantage of lower valuations in the things that I want to own long term. Even though I feel very positive about real assets during an inflationary storm, I also know that money managers will be forced to sell their best performing assets (commodities in the areas I've highlighted) to meet redemptions, so I'll just wait to buy those commodities at much better prices in the near future.
The current weakness in the market will settle and set up the foundation for the next phase of the commodity bull market that started in 2003. I feel very strongly about this due to the acceleration of the same forces that propelled the "stealth" phase of the commodity bull market; namely, the current low level of inventories in the resources needed to satisfy the quality of life of 3.5 billion people now considered middle class, and the resulting inflation of the monetization of debt needed to keep the global banking sector functioning. These were the same forces that propelled the phase that started in 2003, this initial move took gold from $250 to $1000, oil from $12 to $150, corn from $2 to $8, copper from $0.50 to $4, and finally the $US from $1.20 to $0.70 against global currencies. In the next phase, the differences will be even greater as these fundamental imbalances are accelerating because of inflation and commodity scarcities.
THE US DOLLAR
The latest market fluctuations were caused not by a pullback in commodity prices, but by a reversal in the value of the US dollar. The rational investors must analyze the next move from his/her perspective in order to assess how to position his/her assets. The Argentinean investor had only to transfer his assets to the US and the safety of the US$ to shelter himself from inflation. This not a simple matter when the inflationary problem is within the US. In addition, since all commodities trade in US$ their value will be negatively correlated to the US$ — and this is the key to understanding how to position yourself to benefit from the coming inflationary storm.
The first thing one must understand is that the fiscal needs exceed the available money. In order to deal with the banking mess we have written off $500 billion, yet and the latest (and growing) estimate is at $1.6 trillion — and this amount does not include the cost for the bailout of Fannie and Freddie. The Fed has already used up 45% of its assets. FDIC used up 50% of its assets with the nine banks that have folded this year, and it has identified 100 more that are suspect of default. Fannie and Freddie will cost more than the $250 billion, as estimated by Mr. Paulson, because we all know they control $6 trillion in mortgages that are currently at least 20% underwater. The bailout will require lower interest rates in order to allow for the rollover of maturing mortgages and this will lower the US$. Current liabilities of the US government stand at $10 trillion, not including Freddie and Fannie, and the deficit adds another trillion annually. The war in Iraq and Afghanistan are not even included in the figures. Lastly, the long term costs of Medicare, Medicaid and Social Security stand at $100 trillion and more and more of these liabilities will automatically transfer to current liabilities over time.
Foreigners are having their own problems and are getting reluctant to put more money into what many in the industry are calling "The Titanic," i.e. the US banking sector. Bottom line: the money is just not there to pay for everything that needs to be fixed, but in the meantime currencies will keep getting printed in order to keep the system going. This will be very inflationary for the US$, and very bullish for primary resources. Lastly, this is no longer a financial sector mess but a systematic fiscal problem for the US government, and that is why I said it is just like Argentina.
COMMODITY SCARCITY
The main proponents for a deflationary outcome argue that the current decline in commodity prices will continue as a result of the decline in global growth. I disagree with this assessment as inventory levels of commodities are extremely tight and much lower than they were in 2002. I saw this first hand during my last visit to Peru as resource companies cannot even produce enough to meet the current production demand. I hear the same comments from clients in the resource sector in Chile. The fact of the matter is that global supplies are at an all time low and there are actual shortages of commodities, for example;
These are not the kinds of headlines we would be reading if global deflation is to take hold. As a matter of fact Brazil, Russia, India, China and the rest of the developing world could greatly benefit from a slowdown in the demand for primary resources to lower their internal inflation and reduction in their costs of subsidizing their energy and agriculture needs. This is especially poignant when one studies the long term fundamentals for the energy complex. In my opinion the world's greatest challenge is not the current cost of the banking mess or global warming, but the fact that the rate of depletion of oil reserves is accelerating and we are just not finding oil fast enough to replace them. Lastly, one has to also take into consideration the fact that the current credit mess has resulted in an almost complete shutdown of exploration among the juniors due to funding restrictions. The long term effect will be a lack of exploration, which will lead to a long term reduction in resource inventories. Things do not look very bearish for commodity prices long term.
WHAT ARE THE WEALTHY DEVELOPING NATIONS GOING TO DO?
This brings us to last piece of the puzzle and the other side of the US coin (pun intended). The IMF's states that currently there is about $US 8 trillion in foreign currency reserves globally. Most of this sum is controlled by the developing world; the US accounts for 1% with $75 billion in foreign currency reserves. In addition to the foreign currency reserves, there is another $4 trillion in Sovereign Wealth Funds. These economies have done very well during the last decade and sit on large nest eggs that have been losing their purchasing power because the value of the US$ has been steadily declining since 2002 (due to printing money to finance the war in Iraq and now deal with the credit crisis). This leaves the wealthy developing nations with three choices of action for their US$ savings:
- Do nothing and see the purchasing power of their savings continue to decline; or
- Bailout the banking sector and buy US financial firms as value investments; or
- Directly acquire the commodities they need to maintain their own internal economic growth.
I think the choice is clear. The evidence points to a continued decline of the US$, which will lead to higher commodity prices, which in turn will lead to greater scarcity of primary resources and developing countries will vie for control of the resources they need to maintain their economic growth.
PORTFOLIO RECOMMENDATIONS
The next phase of the bull market in commodities that began in 2003 will start once the US$ resumes its decline. Most investors will be motivated to act by fear in this phase. My advice is that each investor must first understand the forces that will affect their portfolios, and then lay out a plan of action that is in line with their investment objectives and risk tolerance. The rational investor should take this reversal as a good opportunity to reposition their portfolio in a way to benefit from the coming inflationary storm. At the very least, investment consideration is warranted within precious metals, energy, food and basic materials. I would recommend a full evaluation of your portfolio to assess its correlation to inflation in order to better develop a proper hedging strategy. Last but not least is the realization that traditional portfolio allocations are simply not working and are going to result in even greater depreciation of assets over the year to come.
UPCOMING MEDIA APPEARANCE
BNN has once again asked me to review my prognosis for this inflationary storm, and will be discussing these issues live from the TSX on Tuesday October 7 at 2:50pm EST. If you have any questions regarding my views or my practice please contact me.
REFERRALS WELCOME
Our door is always open to new clients, so if you have family members or friends who would like to understand the current market situation better and learn about how they can stand to preserve and even grow their assets over the coming years, please encourage them to contact me.
Jaime E. Carrasco, BA, CFP
Investment Advisor
T: 416-864-3623
C: 416-271-6630
E: jcarrasco@blackmont.com
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