In our January 2009 Newsletter we forecast that there would be a correction up in the US stock market similar to 1930 when the market went up 50% from the low and then declined by a total of 90% and resulted in a depression. None of the fundamentals have changed and we are going to see the most horrendous hyperinflationary depression that the world has experienced for at least 200 years. It will be worse than the 1930's because the world is now totally interconnected both financially and economically and because there has never been in history a worldwide asset bubble and credit bubble of this magnitude .
THE US GOVERNMENT HAS LOST ALL CONTROL
The US Government is not running the country. It is running around like a headless chicken reacting to events and firefighting. It doesn't have a cohesive or proactive plan how to deal the biggest financial crisis that the world has ever experienced. So it hasn't taken a single measure that could solve the crisis. The only thing it knows is to print money. The US Government doesn't understand that running the printing presses ever faster can never be a solution to a problem that was caused by excessive credit and deficit spending.
Wall Street is in control
All reactive decisions taken by the Government are governed by Wall Street who are more in control than the Government. Wall Street understands the problem much better since they are the principal beneficiaries of the current financial crisis. The crisis was created by the loose monetary policy of the US Government. Wall Street took advantage and exacerbated the problem by issuing unlimited amounts of toxic debt and derivatives. Wall Street obviously had the total blessing of Government which benefited greatly from political donations and the perceived prosperity that the credit bubble created. So not only did Wall Street make immoral amounts of money during the credit bubble but they are now the main beneficiaries of the Governments money printing. So far the US Government has lent, invested or committed $ 13 trillion since the crisis started in 2007. The majority of these funds are being used to save the financial system.
Wall Street by, being too big to fail, has created the perfect situation for itself. Losses are being socialised and absorbed by the Government and profits are privatised. So whilst the economy as a whole is suffering greatly due to financial crisis, most of the financial sector is continuing to prosper. In the medium term such unfair inequality will have political and social consequences. What the US Government doesn't understand is that directing virtually all their rescue efforts to Wall Street is not going to solve the problem. The Nobel Prize winning economist Joseph Stiglitz said in a recent interview that the bank rescue efforts will probably fail because the programs have been designed to help Wall Street rather than to create a viable financial system. Stiglitz went on to say: "the people who designed the plans are either in the pockets of the banks or incompetent".
US debt growing exponentially
The US Federal debt in 2009 is likely to grow by at least $2 trillion and reach 100% of and GDP at around $13 trillion. In 1929 Federal debt was only 15% of GDP! Also in 1929 the US was a creditor nation as against today when the US can only survive due to its foreign creditors. In 1929 total US debt (private, commercial, state, federal, etc.) was 170% of GDP. In 1932-3 it reached 260%. In 2009 total US debt to GDP (excluding unfunded liabilities of circa $ 60 trillion) will be around 425%. Before this crisis is over this percentage will be significantly higher and possible even exponentially higher.
What is important to understand is that the US and the rest of the world is entering this crisis in a much worse position than in the 1930's. This is one of the reasons why the current crisis will be much worse. But it will also be worse because the whole world is in a similar situation which is unprecedented in world history. What makes this crisis totally insoluble is the toxic debt and the derivatives outstanding of over $1 quadrillion. We have in the last few years consistently stated that a major part of these derivatives is worthless. Fudging the valuation methods of the derivatives is not going to solve the problem. at best it will defer the eventual collapse for a few months.
The Stress Test of US banks
In our April 2008 Newsletter we stated that the US banking system was a house of cards. A stress test has just been done on the US top 19 banks in order to ascertain their strength under various economic scenarios. The results are expected to be published on 4 May. Unofficial and unconfirmed advance reports of the stress test state that 16 of the 19 banks are technically insolvent. Not one of these 16 banks can withstand further disruption of cash flow or deterioration of loan portfolio without further injection of funds. The 5 top banks are so severely under-capitalised that there is doubt about their ability to survive.
The findings of the Stress Test are unlikely to be published without major censorship. Like most reports emanating from the US authorities the final publication will bear little resemblance to reality. Also the problem with the stress tests is that the criteria set assumes a relatively mild downturn and not the severe crisis that is going to unfold.
The fact that the whole financial system is bankrupt is not new to our readers who have been told that this was the case for the last few years. It is now a certainty that the biggest US banks cannot survive any further losses without additional government money. And since there are still $ trillions probably tens of trillions of losses to come, it is guaranteed that the money printing will continue at an even faster pace.
US AAA Rating - a farce
US Federal debt is still triple A rated. This is an absolute joke. We are looking at a country which has lent or committed $13 trillion in the last 12-18 months on top of a Federal debt of $11 trillion and unfunded liabilities of $60 trillion. Government debt is set to grow at an accelerating rate for many years to come since there is no chance of balancing the budget with escalating outgoings and revenue falling rapidly. US Government debt will therefore grow exponentially and there is no possibility that this debt will ever be repaid in today's money.
The rating agencies never anticipate major problems with either sovereign or commercial debts issuers. They always react after the event and therefore serve very little purpose in protecting investors. They are commercial organisations that are paid by the debt issuers and therefore they are more interested in pleasing their paymasters than the investors.
If the rating agencies had integrity and understood what they were doing they would have downgraded US debt long ago. However, the consequences of downgrading the US would be so dramatic that they are unlikely to take any action before the dollar and treasury debt have collapsed.
World trade collapsing
The table below shows the decline in exports from 15 major exporters for the 12 months to February 09. The top exporters had the following declines China -41%, Japan -38%, Germany -32% and USA -22%.
This is absolutely disastrous for the world economy and will have a very serious impact on world GDP and the world economy. The fall in world trade has severe repercussions on company profitability and cash flow as well as for employment worldwide. Unemployment is now moving into the teens in many countries and before this crisis is over it is likely to reach well above 20% in several industrialised countries. Spain is almost there already and USA also (with proper counting). Industrial production is at the lowest since it started being measured in 1967. World consumption will fall dramatically and this will obviously put further pressure on already haemorraghing government finances. And finally the implications for an already bankrupt financial system will be the final nail in the coffin, making any rescue attempt totally futile.
US individuals one month from bankruptcy
So the US Government and the financial system are bankrupt what about the consumer? The US insurance company MetLife has made a study on the solvency of the Americans. The survey found that 50% of Americans could only meet their financial obligations for one month if they lost their jobs. But it gets worse, 28% could only survive financially for two weeks if they lost their jobs and 29% of those earning $ 100,000 or more said they could only pay their bills for one month after losing their job. Currently almost 6,000 Americans are declared bankrupt daily. This figure will grow substantially in the next few years.
In the 1930's non-farm unemployment reached 35% and total unemployment 25%. Real US unemployment in 2009 is circa 20%. This figure includes unemployed people who have stopped looking for a job and adjustment for part-timers. Since we are still only in act one of three of this crisis, it is not unlikely that unemployment will surpass the 35% in the 1930's. The combination of potentially 35-40% of the population being unemployed and 50% percent being one month from bankruptcy does not bode well for the US or world economy. We are facing at a potentially disastrous situation both financially and socially.
Deflation or Hyperinflation
The short answer is both.
The prerequisite for hyperinflation is a deflationary depression. There is a major misconception among many economist and financial experts that the deflationary scenario we are in now will lead to a deflationary collapse. But this is a fallacy. The current deflation is the necessary initial stage of hyperinflation.
We are currently experiencing massive deflationary pressures. The total global losses in stockmarkets, real estate and commodities are estimated at $85-$95 trillion. This is what governments are fighting. The effect on the heavily leveraged financial system of a fall in assets of this magnitude will require additional money printing of massive proportions. The financial system has issued debt instruments and derivatives of $100? s of trillions, linked to these assets . This is why the financial system is bankrupt and this is why the amounts printed by governments so far are a mere drop in the ocean. But we haven't seen the end of the asset deflation yet. We are likely to see worldwide asset losses of at least $130-$170 trillion before this is over.
Governments will of course continue to print money to attempt to "save" the world. But what government don't understand is that no amount of money printed is going to save the financial system or the world economy. Throughout history no country has ever solved a credit crisis by printing more money.
The consequences of this deflationary asset and credit collapse will be hyperinflation in many countries including the US and the UK.
So how do we go from a deflationary collapse to hyperinflation. If we take the USA as an example, their continued money printing will lead to a collapse of the US dollar and a total refusal by countries like China to continue to finance their deficits. This will in turn lead to rapidly rising interest rates and collapsing bond prices. That is the beginning of the hyperinflation, in simple terms. Hyperinflation is a currency event and it is the dramatic fall in the value of the currency which will lead to hyperinflation. Prices will rise very fast, there will be a scarcity of most items and the government deficits will escalate rapidly leading to further decline of the dollar and more money printing. It becomes a vicious circle just like in Zimbabwe.
Current hope of improvement will fade later in 2009
The slight bounce back of equity markets was totally expected as we stated at the beginning of this Newsletter. Also the banking system has had a temporary reprieve due to the massive government injection of liquidity worldwide. This has led economists and political leaders to forecast that the worst is over and that we will see an upturn by the end of 2009. But this optimism is sadly totally misplaced.
We are in act one in a tragedy which will turn for the worse later in 2009. Nothing ever goes straight down without major corrections. We are in such a correction now. If we take the Dow Jones as an example we have only seen, so far, a correction up of circa 20% of the fall from October 2007 (see chart). We could reach 10,000-10,300 on the Dow which would be a 50% correction. Bear market rallies are called sucker rallies for the simple reason that they suck everybody in and make everyone bullish before the market turns down again with a vengeance. A 50% correction in the Dow or any other stockmarket would of course be nice for anyone who still owns equities and intends to get out. But it is important not to get too greedy here since this is a bear market of a magnitude that we haven't seen since at least the 1930's. We still expect a fall from the peak in most stockmarkets of at least 90% in real terms , in the next few years. And remember that it took over 25 years for the Dow Jones to get to its 1929 peak after the bottom in 1932.
The fall in bonds and rise of longer term rates will be a big surprise to investment markets later in 2009. It does not fit in with most investors perception of a continued deflationary environment. US rates are likely to be the first ones to rise in conjunction with a falling dollar. In the next 2-3 years we could see US rates well into double digits. The UK and many other countries are likely to follow.
We are in the era of competitive devaluations. Since virtually all countries are printing money, all currencies are continually losing purchasing power and value. The way markets work is to attack one currency at the time. We have seen the pound weaken and we have seen the Euro weaken. The next currency to fall will be the US dollar. The US financial system has the most toxic debt and derivatives of any country. The trillions or tens of trillions of dollars that need to be printed to save the US economy will finally break the hegemony of the dollar as a reserve currency. The dollar fall is imminent and will surprise by its rapid decline. This will in turn lead to acceleration of the fall since a major part of the world's currency reserves that are held in dollars will liquidate their dollar holdings.
Gold and silver will be major beneficiaries of the fall of the US dollar. In spite of a temporarily strong dollar gold has in 2009 made new highs against most currencies except for the dollar. During 2009 gold will finally break $1,000 for good and never look back. We have consistently said that gold will go substantially higher in the next few years. We have specific time and price targets and Matterhorn's investors will be informed of these as we approach them.
Egon von Greyerz