“May you live in interesting times” goes the oft-quoted Chinese proverb. This year certainly qualifies, although for most the word “uncertain” is more appropriate. While the public reels from recession, and soaring food, energy and health care costs (among others), the road ahead appears shrouded in fog.
Down Goes Bear Stearns
Last Friday Bear Stearns in effect had a “run on the bank” and received emergency resuscitation from J.P. Morgan and the Federal Reserve. Over the weekend, we learn that J.P. Morgan bought Bear Stearns for a mere $2 per share (down from $170 in January 2007), staving off bankruptcy. Lehman Brothers recently received a $2 billion credit line. Other “too big to fail” banking institutions may soon be on the “watch list.” To use a Ben Bernanke term from last spring, the credit debacle is less than “well-contained” as the de-leveraging of the financial system continues at a torrid pace.
The Federal Reserve invoked an obscure Fed statute to lend capital to a private, non-commercial bank institution last week. It wouldn’t reveal how much cash it loaned, but this rare action goes back to the dark days of the early 1930’s. Could things be worse than the Fed is letting on? Some analysts believe so. If Bear Stearns were allowed to go under, "it has the potential of bringing down the whole market," said Richard Bove, an analyst at Punk, Ziegel & Co. We are indeed in uncharted territory, and this year may well be one for the history books.
In August 1979, Paul Volker was appointed as Chairman of the Federal Reserve by Jimmy Carter. He faced double-digit inflation and a country struggling through a decade-long malaise. Showing unusual political courage, Volker took bold action to limit the money supply, jack up interest rates, and promptly threw the country into a recession. He faced the strongest protests and political attacks against the Fed since the early 1920’s. Volker’s stern medicine brought inflation down from nearly 14% in 1981 to 3% by 1983. The recession also contributed to some of the highest unemployment rates since the Depression.
The point of this history lesson is that it took strength and courage to not pander to politicians, Wall Street, and every special interest group damaged by higher interest rates. The fact that Volker could take this action says even more about the 1970’s than individual courage. The country had suffered for most of the decade from growing inflation and the aftermath of the Vietnam War. It was ready for change, even if the medicine was painful. Noting the chart below, the severe recessions of the early 1980’s cleared out the imbalances and misallocations of the 1970’s, setting up the economy for two decades of unprecedented growth and low inflation.
Start Up the Helicopters
The contrast today could not be more stark. The Federal Reserve, under intense political pressure, has chosen to bail out the banking system, and hopefully, the economy, while worrying about inflation and the imploding dollar in future years. The fact that the US has not had a serious recession in over 25 years is not necessarily wonderful news. There has been very little market rebalancing and creative destruction from poor economic decisions. The decades of bubbles, excesses and misallocation of resources created by the Fed’s unlimited fiat money printing have led us to this spot between a giant rock and a very hard place.
Election Year Bailouts
As this is a presidential election year, the level of questionable decision-making is sure to escalate. The legislature is currently preparing numerous bills to “help out the little guy.” The reality will likely be a bailout of the financial system on the backs of the taxpayer. The problem is finding the hundreds of billions of dollars, if not trillions, necessary for these and other proposed programs. The taxpayer is pretty well tapped out. The US is already borrowing over two billion dollars every day from foreign creditors. The $400 billion federal deficit will likely expand rapidly. Foreign holdings of Federal debt reached 45% in 2007. Will foreigners continue to purchase a depreciating asset at these levels in future years?
As the economy continues to slow, so will income tax receipts. This will only lead to more Fed money creation out of thin air, leading to a still weaker dollar and more commodity inflation.
The theme here is that the more intervention by the Federal Reserve and the government, the worse the situation becomes. Without the checks and balances of a sound money system, the Fed has no limitations on its actions. Watch for the bailouts. They are on the way, and your wallet is the target. And following bailouts, looming on the horizon are new regulations, tax increases and capital controls.
Bailouts in an election year are an entirely predictable response of political self-preservation. The aftermath in 2009 and beyond is not of current concern. Continued dollar destruction and growing inflation are problems for future years. Unfortunately, the Federal Reserve and Congress will make these problems much worse through their “heroic” rescue efforts.
As the inflation horse has been let out of the barn by the Fed, the likely implication is that inflation will increase at a faster rate. This is already in evidence if one looks at the rate of increase in the oil price over the last two years. With further government intervention and additional money printing nearly inevitable, the commodity sector will continue to thrive. Of course even the strongest bull markets have severe pull-backs along the way, so don’t be surprised to see one this year. Use it as an opportunity to buy. The inflation story is just getting under way, and the next Paul Volker is nowhere in sight.
Global investors now own the largest amount of liquid “paper” wealth in recorded history. It is instructive to look at the current breakdown of global liquid wealth (not including derivatives). Equity Markets: 45%, Bond Markets: 15%, Bank Deposits: 39%, Gold: 1.4%.
If just one or two percent of the world’s liquid wealth moved into gold in future years, the price rise would be explosive. Over the last seven years, all that liquid wealth (especially investments in dollars) has been losing value against tangible assets; specifically oil, gold and other commodities.
When the inflation story begins to dominate the headlines in future years, a growing portion of this liquid wealth will likely be on the move into tangible assets and commodity-based equities. Many are expecting the Sovereign Wealth Funds to lead this strategic shift of liquid wealth. The key question is how large a portion of global wealth will move into commodity-based assets. The smart money appears to have already packed its bags and set sail.
U.S. stocks late Monday shook off the bulk of stiff losses, with J.P. Morgan leading a blue-chip rally one day after its heavily discounted bid for Bear Stearns and the Federal Reserve's discount-rate cut.
The Dow Jones Industrial Average gained 21.16 to close at 11,972.25. The S&P 500 Index did not follow suit, closing down 11.54 at 1,276.60. The Nasdaq also closed lower, ending at 2,177.01, down 35.48, or 1.6%.
The dollar index, which measures the greenback against a basket of six major currencies, was at 71.284, down 0.5% but up from its overnight low of 70.698.
In an extraordinary move, the Federal Reserve said Sunday night it was cutting its discount rate by a quarter percentage point to 3.25% and offered to lend money to an unprecedented list of firms. The Federal Reserve is expected to engineer an extremely rare cut of one percentage point in overnight interest rates on Tuesday.
Wishing you a good evening,