Bleak Outlook

By: Roy Darphin | Wed, Jul 7, 2004
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First let me tell you, that I have spent uncountable hours in the last months with reading up on economic and political issues, and that I am convinced that we are going to see a crash. When and how it will happen, I do not know. In my opinion, it may happen any time between today and 12 months. The reasons for a crash can be of multiple nature. The main ones being: US debt levels (government, consumers, corporations), terrorism and religious war, energy demand cannot be met with sufficient supply (e.g. major supply disruptions, the fall of the Saudi government, Russia and other countries rationing oil supplies for "national security" purposes), Japan's government debt problem hits the fan, China's and / or Japan's banks hit the wall with their loan portfolios, the USD loses foreign financial support (central banks start to sell to support their own currencies or buy gold with USD) and crashes, etc. Not to forget the latent debt problem in Japan, especially on government level. The impact will be felt worldwide.

The U.S. may take the most important hit due to the debt and deficit levels and the related financing required from foreign investors and lenders. This means, that apart from the real economy falling into a depression, the USD will tumble in spite of all efforts of the US government and the Fed. Specifically it means, that the US should raise interest rates to attract foreign investors to ensure the ongoing financing of its deficits and debt levels (and to deal possibly with energy price pressures), while at the same time, the state of the real economy would need low or zero interest levels. It is obvious that these needs stand in conflict to each other. Eventually, it seems to me, that the U.S. will have to let the USD depreciate by way of reducing interest rates rather to the need of the real economy than to the deficit financing. Income taxes will have to be raised - and the big belt tightening begins for many years to come. One can hardly imagine what this scenario will do to the assets of today's and the future retirees are counting on!

So far and historically, a natural hedge for a weaker USD has been gold and other precious metals, and lately also oil and certain other commodities. As the USD weakens, those prices have increased. In a crash scenario, I believe that oil and commodity values will not act as a hedge any longer, since consumption of those assets will be reduced sharply and therefore possibly create a temporary oversupply. On the other hand, it may very well be that precious metals will gain dramatically in value, and thus exceed the depreciation of the USD by far. Precious metals may gain an increasing safe heaven role.

While all economies will take a hit under these circumstances, many currencies, however, will gain in relative strength to the USD, because the economic basics of such economies are stronger than the ones in the U.S. I think, that the currencies of countries rich in natural resources will do well against the USD, such as Canada, maybe also Australia.

So how do I see a possible chronology of events to unfold? It might look like this:

1. Financial market crash. All values, including energy values will tumble. The only exception may be the precious metals. The USD crashes right along side with current foreign USD holder rushing to sell their USD holdings off.

2. The real economies - starting with the US and possibly China, Japan but later on a worldwide basis - will nose dive as a result of the developments in the financial markets. Imports to the U.S. will shrink to a trickle. Debt related default rates will go through the roof because assets needed to service debt have evaporated, or / and because of interest rates in the US staying high for a while. Defaults and debt servicing costs will further negatively impact the real economy and demand will fall for all goods and services. Even some (state) governments may declare bankruptcy, since they will not be able to reduce their debt levels by introducing severe austerity programs, but also due to a lack of tax income from a depressed economy. Prices will fall and cash will be king.

3. Into the crash, investment opportunities will arise in the sectors that provide basic needs or in hard assets: Energy, commodities, real estate. As to the timing to start investing again.... we will see since I foresee that this crash with its implications will take a considerable time to heal.

Investor psychology and financial markets are very jittery as can be seen from the market volatility as well as the low trading volumes. I fail to recognize any factor that may define any upside potential for markets while I see obviously lots of downside risk. The question is what will trigger the downside chute.


 

Author: Roy Darphin

Roy Darphin, Partner
Cottonfield Family and Investment Office
Zurich / Switzerland

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