Except from Powers Energy Investor, May 1, 2011 issue
One of the most important developments of the past several years has been the devaluation of the U.S. dollar against nearly every other paper currency and against the only two real currencies, gold and silver. I find it incredibly disturbing that U.S. Treasury Secretary Tim Geithner said on Fox News that there is “No risk” that the U.S. will lose its AAA credit rating after being put on negative credit watch by S&P. Mr. Geithner’s comment shows his complete ignorance, or at least his willingness to deny reality, as to the many problems facing the green pieces of paper with his name on them. In fact, Geithner’s denial of the U.S. dollar’s problems should be placed in the Denial Hall of Fame right next to Dr. Bernanke’s 2007 testimony before Congress that “the impact on the broader economy and financial markets of the problems in the subprime markets seems likely to be contained.” Neither of these men should have any credibility left, yet the market still gives them more than they deserve. In this issue, I will revisit the problems facing the U.S. dollar and discuss the likely fallout when the current orderly decline of the U.S. dollar turns disorderly, which it will most certainly will. Additionally, I will discuss how investors can profit from the U.S. dollar train wreck that is set to begin its terminal stage in the near future.
While Mr. Geithner is adamant that the U.S. has no chance of losing its AAA rating, I agree with Prudent Bear strategist Doug Noland that the U.S. has a 100% chance of losing its AAA rating in the next few years. Mr. Noland, one of my favorite analysts, unlike Mr. Geithner, saw the credit and financial crisis of 2008 coming years in advance and has spent more than a decade writing about the world’s unbalanced and fragile financial system for his employer. Here is what Mr. Noland had to say in a recent note (4/22/11) about the likelihood of an official downgrade of U.S. federal debt:
“S&P puts the odds of a U.S. debt downgrade in the next two years at 33%. Secretary Geithner says it’s zero. I’ll put the probability of a downgrade in the next few years at close to 100%. Until proven otherwise, I’m going to presume that policymakers will at some point come to the recognition that the economy and markets are vulnerable. They will choose to hold off on the difficult decisions - that is, until the markets force their hands.” - Doug Noland, Prudent Bear Funds
Fundamental to the downgrade of the U.S. federal government’s debt rating is the government’s inability to make meaningful inroads in reducing its annual spending deficits. I do not see how the world bond and currency markets will tolerate a U.S. deficit spending of 9% or more of GDP for as far as the eye can see. Europe is providing a real-time example of the pain involved in reducing deficits. The hangover from unsustainable deficit spending in Greece, Ireland, Portugal and Spain has resulted in economic contraction, increasing unemployment, fiscal austerity and higher interest rates. Despite the fiscal austerity measures of Greece, Portugal and Ireland, which were required under their bailout arrangements from the EU, all three countries have seen tax revenues fall as GDP shrinks. I see debt restructuring as the only way for these countries to end their death spirals.
With the 2012 election coming and not enough members of Congress willing to take a hard line on the deficit, I do not believe a solution to cutting the U.S. federal deficit will be found in an era of falling real estate values and stubbornly high unemployment. The U.S. federal government is beyond the point of having the ability to fix itself. Waiting until the spring of 2013 is too far off to avoid a crisis of confidence in U.S. sovereign debt and the U.S. dollar. It appears the world currency market is quickly losing its appetite for U.S. dollars. As I write these words on 4/27 the U.S. dollar just hit a three-year low of 73.49 against the basket of currencies that make up the dollar index and is poised to test its all-time low of 70.698 that was hit in July 2008. So what will a dollar crisis mean for U.S. investors? I see five very likely outcomes and they are as follows:
Outcome #1 --Wicked Stagflation: Unlike the 1970’s when wages and housing prices were increasing, the stagflation that is in the process of intensifying will become far more devastating. Inflation in the items we use everyday, such as food and energy, will accelerate while real wages will not keep up. For example, Walmart’s CEO recently told a USA Today reporter that “inflation is serious” and “We’re seeing cost increases starting to come through at a pretty rapid rate.” Stubbornly high unemployment in the U.S., which is vastly understated by the Bureau of Labor Statistics, is keeping wage inflation minimal. Lower-income and retired Americans are certain to feel the brunt of stagflation since government transfer payments will not keep up with inflation. Many economists, such as John Williams at shadowstats.com, have thoroughly documented how the U.S. government hideously understates inflation. Many economists mistakenly downplay the threat of inflation or stagflation on the basis that slack in the economy will not allow inflation to take hold. History tells us that inflation and hyperinflation can unfold in even the weakest of economies. Inflation and eventually hyperinflation ravaged post-WWI Germany despite plenty of slack in the economy. Hyperinflation destroyed Zimbabwe during a period in which an estimated 25% of its citizens were unemployed. Currently, Argentina is running 25% inflation despite an official unemployment rate of 7.3%. These three examples suggest that the printing of U.S. dollars will overcome any slack in the economy and lead to increasing rates of inflation.
With inflation picking up steam and interest rates destined to head substantially higher, I see a train wreck occurring in nearly every form of fixed income investment. Even Treasury Inflation-Protected Securities (TIPS) will fare poorly since the U.S. government massively understates the rate of inflation.
Outcome #2 --Dropping Consumer Confidence: Despite the uptick in April 2011 U.S. consumer confidence, after a big drop in March, a dropping U.S. dollar will crush U.S. consumer confidence over the next two years. Rising gasoline prices, due in part to a dropping U.S. dollar, make U.S. consumers feel poorer every time they stop at a gas station.
With nearly every imported item certain to rise in price over the next 12 months due to a falling U.S. dollar and rising transportation costs, look for countries dependent on exports to the U.S. to see slowdowns in economic activity. For example, Best Buy, a consumer confidence bell weather that imports the vast majority of its merchandise from Asia, recently reported a 5.5% same store sales drop in the U.S. for the quarter ended in February 2011.
Weak consumer confidence is also reflected in the continued deterioration of the Case-Shiller Home Price Index. The index showed that U.S. home prices declined in February by 3.3% compared to February 2010 in its 20-city survey. More importantly, according to the index, home prices have dropped eight months in a row and are on the verge of breaking through their April 2009 lows.
Outcome #3 -- Higher Gold and Silver Prices: As market historian and analyst Jim Grant is known to say, the price of gold is the inverse of confidence in paper money. I fully agree with Mr. Grant. Despite the Federal Reserve’s recent theatrics that occurred when Chairman Bernanke hosted the Fed’s first news conference in the organization’s 97-year history, the world is quickly loosing faith in the U.S. dollar. I found it very telling to see gold move to new all-times highs shortly after the Fed’s news conference began.
While the move in gold has been powerful, I see nothing to stop it from going much higher in the months and years ahead due to the continued money printing, deficit spending and a Fed Funds rate that is in no danger of rising in the near future.
The rise in silver has been nothing short of spectacular. However, investors in silver should be aware of the commodity’s brutal volatility. Due to the relatively small size of the silver futures market, compared to other commodities, the recent rise in silver prices has been largely the result of investment demand. As we saw in 2008, when purchasers of commodity future contracts for investment purposes dishoard for whatever reason, volatility can rise quickly. While silver prices will continue to rise for the several more years due to its strong fundamentals, I expect silver to prices to exhibit enormous volatility.
After a decade of a stealth bull market, I believe the precious metals bull market is undergoing a very important metamorphosis. As I have discussed in previous issues, confidence has eroded in the U.S. dollar to the point that it is no longer viewed as store of wealth. Instead, precious metals are increasingly seen as the “risk-free” asset class. A move by investors into precious metals and NOT the US dollar at a time of market chaos is a stark contrast to what occurred in nearly every financial crisis over the past two decades. Precious metals markets and stock markets can produce the most inexplicable behavior at times, but I believe we are entering the final and most profitable stage of this decade long bull market in precious metals where there is wide-scale investor participation.
As I have discussed previously, I have been a long time owner of both gold and silver bullion and junior miners. I feel very fortunate to have found two junior mining companies eight years ago while I was in Canada speaking at a resource conference and have shared those with my subscribers.
Outcome #4 -- Increased Market Volatility: Though the path of least resistance in recent months has been for the equity market to trend higher, further dollar weakness may result in increased volatility in world equity markets. Since the decline in the dollar has been orderly, equity markets around the world have been able to digest moves in the dollar. U.S. equity market complacency is best reflected in the S&P 500 Volatility Index reaching a 52-week closing low of 14.62 on 4/28. While the U.S. market has been able to rally in the face of a falling dollar since shares are seen as beneficiaries of a weak currency, eventually a falling currency causes weakness in share prices.
The best example I could find of how share prices rose in the early stages of a currency debasement were in the final years of the Weimar Republic. As documented in Costantino Bresciani-Turoni’s fantastic 1931 book entitled “The Economics of Inflation – A Study of Currency Depreciation in Post War Germany,” many investors sought refuge in German industrial shares as a hedge against a depreciating mark during 1920 and 1921. However, the purchase of industrial shares did not continue in 1922 once the depth of Germany’s problems became the market’s focus. Below is how the author describes the change in investor sentiment:
“Already in the spring of 1922 the Bourse began to discount the approaching end of relative prosperity of German Industry, which had begun with the depreciation of the mark and with the establishment of a great divergence between the internal value and the international value of German currency. It was realized that the artificial stimulus given to German industry by the continuous increases in the foreign exchange rates could not act indefinitely…. It is certain that a great lack of confidence spread among the German people in the summer of 1922, a lack of confidence which provoked feverish purchases of foreign exchange, and consequently suddenly increased the dollar exchange rate, while the share market was neglected.” -- “The Economics of Inflation – A Study of Currency Depreciation in Post War Germany”, p. 268.
While I am very aware that tremendous differences exist between the equity market in Germany of the early 1920s and today’s U.S. equity market, there are striking similarities. Both the German equity markets of 1920 and 1921 and the contemporary U.S. equity market were beneficiaries of incredibly easy monetary policy and depreciating currencies. The 1920-era German Reichsbank (Germany’s central bank) and the present-day U.S. Federal Reserve have monetized significant portions of the debt needed to pay for deficit spending. Finally, the most important similarity between Germany of the early 1920’s and the U.S. of today is both countries use of a fiat currency that is not backed by anything tangible. When a central bank has the ability to print marks or dollars at will or monetize its debt, domestic and foreign investors eventually lose faith in the ability of shares to protect purchasing power. Once faith in a currency is lost, investors move out of shares and into other stores of value.
So when does the music stop for the U.S. equity market? No one knows. However, given the increasingly poor outlook for the housing, banking, consumer electronics and auto sectors, look for world equity markets to suffer a severe bout of increased volatility in the next few months.
Outcome #5 -- Oil and Gas Big Winners from Falling USD: With exporters of oil and natural gas already choking on a surplus of dollars and few viable alternative currencies available, large exporting countries such as Saudi Arabia and the United Arab Emirates are now actively pursuing policies to keep oil prices elevated in dollar terms. Neither of these countries will aggressively attempt to expand production since they want oil to remain at or near current prices to make up for losses on their existing pile of dollars. Take Saudi Arabia as an example. The country took the unheard of step of cutting production at a time of triple digit oil prices. According to an April 17th Reuters article, Saudi Arabia cut oil production from 9.125 million barrels of oil per day (mbopd) in February to 8.292 mbopd in March. Also, the article quoted the Saudi oil minister as saying that April production would be slightly above March’s and that the production cuts were due to the market being “overbalanced”. (Source: https://www.reuters.com/article/2011/04/17/idINIndia-56391220110417 ) I cannot overstate the importance of Saudi Arabia cutting production at a time of spiraling prices since it clearly indicates the Saudis have given up on the charade of being the producer of last resort. Saudi Arabia is no longer even attempting to act as a moderator of oil prices. For much of the past three decades, Saudi Arabia has curried favor with Western government by increasing production at times of price spikes to help ease the pain of economic contractions. As I discussed in my November 2009 issue, I have long doubted the claim of Saudi spare capacity. Below is a quote from the November 2009 issue:
“The organization with the largest gap between actual and touted oil production capacity is Saudi Aramco. According to the company’s website: https://www.saudiaramco.com/irj/portal/anonymous the company has total production capacity of 12 million bopd. More importantly, the company has gone to great lengths through tremendous public relations campaigns to convince the world to “trust us” about its production capacity…
According to industry statistics, Saudi Arabia has yet to exceed its 1980 peak level of production despite the record high oil prices of recent years. I find it hard to accept that anyone believes Aramco’s proclamation that it has raised production capacity to 12 million bopd -- this new capacity would represent more than a 20% increase from its previous peak output.”
Now that Saudi Arabia’s oil production is falling rather than rising at a time of high prices, there is a strong possibility that oil prices will remain at elevated levels and potentially rise towards $175 per barrel by year-end. It is clear to me that the myth of Spare Saudi Capacity died on April 17th.
Conclusion: While sorting out the winners and losers from a falling dollar is very tricky, I believe there will be a few asset classes that dramatically outperform. Nearly all commodities will benefit from a lower dollar and will likely outperform most asset classes. However, the real big winners from a lower dollar and asset inflation are commodity equities. While commodity equities have largely underperformed futures prices, I believe the next stage of the bull market in commodities will see precious metal equities and energy equities have spectacular gains. Many high quality companies have seen their share prices languish despite huge rises in net asset value per share due largely to the belief in the investment community that today’s commodity prices are unsustainable. I disagree. I believe most commodity prices are headed higher due to a weaker U.S. dollar and strong fundamentals and that once equity analysts use realistic commodity prices, the shares of energy and precious metal companies will skyrocket. The asset classes that will be likely losers from a falling dollar will be nearly all retailers (with the exception of grocery stores and a few high end retailers), banks, home builders, bonds of all varieties and many highly valued technology companies.
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© 2011 Powers Energy Investor, LLC. Information presented in this article was obtained from sources believed to be reliable but accuracy, completeness and opinions based on this information are not guaranteed. Under no circumstances is this an offer to sell or a solicitation to buy securities suggested herein. The editor may have an interest in the companies mentioned. All data and information and opinions expressed are subject to change without notice.
