What Next For the Real Economy?
The Economist Magazine posed this question on the cover of this week's magazine with an illustration of the various pieces of Wall Street machinery being sucked into the vortex of a tornado. The market appears to have stabilized which was the intent of Secretary Paulson in the unprecedented actions he took last week. What comes next for the bailout plan are more goodies from Congress. Why stop at $1 trillion? What comes next for the real economy is going to be the aftermath of this Pyrrhic victory the Fed, SEC, and Treasury jointly scored last week in preventing financial Armageddon.
The economy was already rolling over before this fiasco started. If the US Government could agree to a 700 billion dollar bailout for Wall Street in two days just think what they will come up for Main Street over the next two years . Steve Rattner, the highly-respected managing principal of the Quadrangle Group wrote in The Wall Street Journal last week, "And make no mistake, the crisis on Wall Street will spill over to Main Street. With the economy already continuing to soften, the inevitable further contraction of credit - as well as the ripple effect of so many lost financial-services jobs - may well tip us into a modest recession." Kenneth Rogoff, the former chief economist at the IMF, wrote an editorial in the Financial Times ("America will need a $1,000bn bail-out") just a day before the rescue package was announced where he ominously warns: "...at this juncture, there is every possibility that the credit crisis will radiate out into corporate, consumer and municipal debt. Regardless of the Fed and Treasury's most determined efforts, the political pressures for a much larger bail-out, and pressures from continued volatility in financial markets is going to be irresistible."
And what comes after that is monetization. We aren't going to dig our way out of this one any other way. Citigroup analysts, John Hill and Graham Wark are calling the period we are entering "muddle-through and monetization." This is the best case and most likely scenario. The alternative is "gloom and doom." They write: "A more likely macro outcome involves slow-growth accompanied by monetization and socialization of derivative losses. Actions such as the US takeover of GSE/mortgage and insurance entities and lending/guarantees to derivatives-laden banks, replicated globally, are likely to act to the detriment of paper currencies relative to hard assets and gold." And they wrote this before the comprehensive bailout package was announced.
Influential investor and institutional advisor, Dennis Gartman, seconded the sentiment, quoted in a Bloomberg article ("Dennis Gartman 'Joining Gold Bugs on Outlook for Inflation") saying, "Gold tends to rally during inflationary cycles, and we see the Fed as embarking in precisely that sort of thing. The Fed shall have to buy Treasury securities from the dealers to make certain that very high-powered money is made available to them, and in the process, it shall reflate the economy.' Rogoff also envisions inflation on the horizon: "The shrinking financial system will also undermine another central foundation of the strength of the US economy. And it is hard to see how the central bank will be able to resist a period of allowing elevated levels of inflation, as this offers a convenient way for the US to deflate the mounting cost of its private and public debts."
Felix Zulauf, founder of Zulauf Asset Management and long-time contributor to the "Barron's Roundtable" in this week's interview section of Barron's notes that "the level of Treasury paper on the Fed's balance sheet has now reached such a low point that it cannot expand more without really monetizing debt." He goes on, "You can't stop this [downturn] or turn it around without going to monetization, a step the central bank hesitates to make. But eventually the developments will force the Fed to do it."
Zulauf has an outstanding track record -- probably the best of the ten or so who participate in the roundtable. Most of the others tend to represent more 'mainstream' thought. The coming debate among the pundits set to dominate the airwaves of financial TV over the next year or so will be whether or not the Fed will be forced to monetize. The same congenital optimists who have been incorrectly calling market bottoms, telling us that the worst for the financial firms is behind us, and that the 'economy' is merely stumbling, will passionately make the argument that talk of monetization is crazy.
After the last three years, these guys (and much of the mainstream) should have very little credibility. Yet many of them are still selected to host the financial TV shows with the largest audiences. That is scary. Why would you listen to them? They have been mostly wrong for the last decade. In addition to the credit crunch and the collapse of our financial institutions, most of them missed the housing bubble, and almost all of them missed the bull market in commodities. They have been on the wrong side of almost every secular trend this decade. Do yourself a favor -- listen to strategists and managers who were on the right side of these movements. They are out there, and are occasionally featured on the programs.
And as far as our government officials go, you know that they are going to emphatically try to suppress any talk of monetization, decrying it as "silly." Of course, they are the ones who have been errantly reassuring us that housing prices had stabilized, the economy is strong, the credit markets would not freeze up, there would be no need to save other financial institutions, and the list goes on. Even if they are correct this time, you would be foolish to place any trust in a group with a track record like that. To the contrary, it would be more reasonable to think that they will not succeed in preventing monetization. It looks like the market may now be looking to discount the prospects for monetization and higher inflation.
It appears that another pivot point might have been reached on September 15. The "long deflation, long dollar, long US Stocks/short commodities and hard assets" trade that began on July 15 seems to have reversed. The pivots in the oscillations between inflation and deflation tend to be swift and vicious. The deflationists might be lining up to go the investment guillotine this time around. The US dollar failed to poke through the "80-level" where it encountered massive resistance. It will be difficult for gold not to stage an impressive rally from where we are today. A little over a week ago, it felt like we were caught in the vice grips of inescapable deflation. In one fell swoop, the "Paulson Plan", certain to only grow in size and scope from here, has completely reversed the landscape to an inflationary/stagflationary one. Prices go up and growth goes down.
The bottom line is that as the relief we have survived another crisis and the threat of annihilation wears off, the reality of negative impact all of this is going to have on an already weakening world economy is going to sink in. Psychology is going to turn sharply negative quickly. Here, I don't mean the monthly indicators which measure sentiment and are prone to bounce all over the place. Rather, I am referring to the long-tem psychology and the recognition that deleveraging is not an event, but rather a painful process that is going to be with us for years. Hope will turn to despair and this will have the effect of exacerbating the negative feedback loops which are now ramping up to work full throttle. This is what comes next.
Excerpted from the 9/22/08 Global MegaTrends Portofolio's Newsletter: To learn more about Kurt's Kasun's Global MegaTrends Portfolio, click here.