Stagflation? Stag-flagration!

Think the economic news is bad today? Remember that non-US owners of Dollars don't get a US vote...

WE'VE BEEN on-the-record stock market and economic bears here at Casey Research for several years now, writes David Galland, managing editor of the new Casey Report.

   Lest you think that's loose boasting, I can offer proof in Doug Casey's August 2005 article, the dramatically titled Profiting from the End of Western Civilization.

  
In that article, Doug advised Buying Gold as he looked ahead and saw inflation as the inevitable consequence of the government's loose money policies.

  
To quote:

"Of particular importance is that the US Dollar has been used as a Gold substitute for decades by other countries. This has been very convenient for the United States – we can create almost infinite numbers of greenbacks and give them to people in other countries in exchange for real wealth.

  
"Idiotically, central banks abroad have been holding those Dollars as backing for their own currencies. Now the amounts involved have grown so immense, and the eventual grim fate of the Dollar has grown so obvious, that foreign central bankers are now looking at each other, trying to figure out who will head for the exits first.

   "Many central banks are diversifying from Dollars into other currencies, which are themselves backed mainly by other paper money, mostly Dollars. And at some point, eventually, there's going to be a panic out of US Dollars that's going to dwarf any financial event in history."

   In that same article Doug also predicted the current collapse in the housing bubble that the loose money had made possible. Another quote:

   "What's going on now in the residential real estate market is much like the tech bubble, but potentially much, much more serious than what went on in stocks a few years ago."

   Jumping ahead three years to today, the unhappy scenario Doug then foresaw is now unfolding. Right on schedule, the US investment markets are heading inexorably toward what might be termed the Scorched Earth Phase.

   Even a casual glance at the devastation now being wrought on the very building blocks of the economy confirms the appropriateness of that term.

   For instance, consider the US financial firms, the single largest component sector of the S&P 500 stock market index. So far, the losses to these firms are approaching half a trillion dollars. And the odds are high that there's much more to come.

   With the exception of Bear Sterns, the big name financials have been able to cobble together the billions of dollars in additional capital needed to shore up their balance sheets. But they are quickly running out of rope. That becomes apparent when you consider that many of their major revenue centers are now either severely wounded or in the morgue.

   Last quarter alone Morgan Stanley saw its investment banking fees fall by half. Sales of toxic paper (umm, I mean "fixed income") and trading revenue collapse by over 85%. And this was at a time when these same firms were being forced by regulators to repatriate their off-balance sheet assets...to wit, the aforementioned toxic paper.

   Will Sovereign Wealth Funds (SWF) ride to the rescue? Not anymore. Those that initially rushed in were seriously burned. Now many are on record ready to stay on the sidelines. But any that might wish to take a second roll of the dice will only do so if they get much better terms, which is dilutive to existing shareholders.

   Meanwhile, the housing meltdown persists and will continue for at least another year or two. Unless, of course, the government gets serious about "doing something"...in which case the downturn could last 5 or 10 years.

   Why do I say that? Because what the market needs most of all right now is for house prices to fall, as quickly as possible, to a market clearing price. The problem, of course, is that thanks to the self-serving exuberance shown by many appraisers during the real estate bubble-mania, at this point nobody actually knows where the bottom is.

   Another 10% down...? 20%...? 30%...?

   There really is only one way to find out. Let the brush fire burn, as painful as that will be.

   But as I don't need to tell you, "doing nothing" is not a concept that politicians in an election year are very comfortable with. And so, like trained seals leaping after vote-fish, the politicians will jump though any number of hoops to keep people in their homes even though many can't afford the carrying costs, let alone the mortgages.

   That only prolongs the pain and increases the government deficits that are at the core of the current crisis. So we have a tumbling collapse in the largest component of the stock market, coinciding with a tumbling collapse in the largest component of people's net worth, their homes.

   And we aren't even warming up yet.

   For a more complete accounting, you also have to add into the mix the intractable problems unfolding in energy patch, including the near-certainty that Mexico, the 3rd largest source of imported oil for the US, will stop exporting oil within four to six years...max.

   Rather than rushing ahead with emergency initiatives to open up new energy sources, the US Congress just passed emergency legislation to prevent so much as exploring for uranium anywhere near that big hole in the ground, the Grand Canyon. It is this perfect world mentality that assures that the cost of what energy is available, will only get more, not less, expensive.

   And of course, as energy is required in the production of...well, of everything!...so the cost of everything will go up. And that includes, food – which, as I don't need to tell you, has been on a tear of late.

   Sure, opportunistic new plantings will help, over time, to moderate the higher food prices...but not overnight. Meanwhile, the cost of filling the old tractor and shipping food to market will keep going up.

   So to add to the list of serious problems for the economy, we have to add persistent high energy and food prices. But even those fall short of the KING KONG of the set piece...the collapsing fiat monetary system that helped created the recent series of bubbles in the first place.

   In a fiat monetary system, the only tangible barriers to money creation are provided by a loss of stakeholder confidence. While the average American is, sad to say, almost completely ignorant of what a fiat monetary system is, let alone its consequences as demonstrated throughout history, the same cannot be said of those foreign governments and investors holding an unprecedented $7 trillion today.

   To be a touch more specific, by unprecedented I mean as in "never happened before". Under other circumstances this fact might evoke a raised eyebrow or a concerned comment over cocktails; but going into the jaws of a vicious economic/dollar crisis those foreign dollar holdings become akin to playing toss with a lit stick of dynamite. He who holds the dollars when the fuse meets the powder are in for a very, very bad day.

   As a result, the foreign holders are watching the moves of the Fed very closely. Trying to avoid that scrutiny, the Fed – like a curbside three-card Monty dealer – has come up with some clever sleights of hand, including lending directly to investment banks and swapping Treasury bills for toxic paper. But that has accomplished little more than buying some time; it does nothing to resolve the "rock and a hard place" dilemma. Which remains as thus:

   If the Fed raises rates to prevent a sell off in the Dollar, they'll crush the highly indebted and already struggling populace. In so doing, they'll unleash a serious economic crisis.


  
But if the Fed keeps rates where they are, or even lowers them, they'll trigger a Dollar sell-off and unleash a serious economic crisis all the sooner.

   Either way, the story ends the same: a serious economic crisis. And at this point, our bet remains that the Fed will go into default mode – which means cranking up the printing presses into the red zone, and letting the Dollar move ever closer to its intrinsic value: zero.

   That they'll follow this route is suggested by two inputs. First, a depreciating Dollar means a reduction in the value of all those trillions in obligations now owed by the US government to foreign central banks. And, secondly, foreign holders don't vote.

   So we are calibrating our investments toward a serious economic slowdown, but with high inflation. Some people would call that Stagflation. But given the severity of both sides of that formula, the situation may be better described in terms of Scorched Earth.

   Or rather Stag-flagration.

   Businesses and personal net worth will be devastated at the same time that costs run out of control. Our strongest recommendation is to position your portfolio in anticipation of higher inflation and, in time, a turnaround in interest rates. The latter is because interest rates, which are still near a 50-year low, can only go up as the inflation rises to the point of banner headlines (at which point, the government is hoping, the economic downturn will have moderated).

   In fact, we think the move towards higher interest rates is a trend that will surprise many, but, once it gets going in earnest (and corporate bond yields are already on the rise) last for at least the next several years.

   In terms of other investments, it's worth noting that in the last major bull market for tangibles, back in the 1970s, oil was the best performing investment, followed by Gold, US coins, silver and stamps.

   Today the range of investment vehicles you can use to make the trend your friend is greatly expanded. And while they continue to require patience, the highest quality junior Canadian gold exploration stocks remain one of the most prospective investments you can make. A number of these companies are now sitting on proven big discoveries, but thanks to the stop-start markets, are significantly undervalued. They won't stay that way long.

   Whatever you do, don't be complacent at this point. If we are right, then the economic crisis will soon head into its next and most dangerous stage. Certainly, we should feel the heat, and maybe worse, by the end of the year. Therefore, at the very least, you'll want to take measures now to protect yourself. For our own portfolios, we believe that the best defense is a good offense, and so are positioning ourselves in the sectors that will profit, and profit big, as the stag-flagration sweeps across the global economy.

   Then it's just a matter of sitting tight and being right.

David Galland is the Managing Director of Casey Research LLC, publishers of Doug Casey's International Speculator. He's also recently launched a brand new monthly advisory, The Casey Report, which focuses on the most powerful trends now driving the US and global economy, and how to profit from those trends. You can get a special introductory offer here...