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The Mother of All Bubbles

Get ready for the runaway inflation of the mother of all bubbles – government debt...

SO JUST HOW DOES AN INVESTOR prepare for an inflationary bubble? asks Dan Denning in the Australian Daily Reckoning.

Some concrete ideas below. And the simplest idea of them all – when you consider soaring government deficits – is to sell government bonds and buy beaten down, world-class equity.

Mind you, this is only if you want to be in the stock market at all. There is a very good case to be made for NOT being in the equity market this year, or only being in those asset classes (such as Gold Bullion) and single stocks you think will appreciate (or grow earnings) faster than the rate of inflation.

But let's be more direct and say that this is still a bear market for equities. The bear market began in 2000 with the popping of the Tech Bubble. The Fed fought back in 2003, setting a low-interest rate policy the rest of the Dollar-pegged world followed. This kicked of leveraged booms in residential housing, credit derivatives, and stocks, bonds and commodities.

All those bubbles are popping. You do not wipe out twenty five years of credit and leverage excess in a mere eighteen months. We are barely halfway through the liquidation/loss realization phase. The essential question is which assets are going to perform the best as governments inflate and create a new bubble in government debt? And by the way, it's going to be very large bubble.

Forget the $1.8 trillion deficit the Obama White House admitted to Monday. Forget the A$60-$70 billion deficit Wayne Swan is going to shove onto Australia Tuesday. The true scope of government borrowing is breathtaking, and rather sickening. More importantly, you have to wonder where the money is going to come from, and what will happen when it's not forthcoming from private investors.

Consider the chart below, courtesy of Niels Jensen, writing in John Mauldin's "Outside the Box" e-letter. Niels shows that according to IMF estimates, twelve governments around the world (the 'Dirty Dozen') will have to issue $10.2 trillion in bonds to cover future banking losses and funding requirements in the credit markets as a result of the ongoing financial crisis.

Ten trillion is a huge number. But there's every chance the number is, in fact, a conservative estimate of government borrowing requirements. It is based on smaller than expected losses in the banking sector (the bogus scenarios modeled in the US Treasury's 'stress tests') and a lower-than-average increase in public borrowing to deal with a financial crisis.

The IMF estimate is that public sector borrowing will grow to an average of 27% of GDP in Western or industrialized countries. But according to a study by economists Carmen Reinhart and Kenneth Rogoff published last year, governments almost always underestimate the amount of public borrowing that takes place in the wake of a banking crisis.

They underestimate the size of public debt because – as the government here in Australia has done – they underestimate the blow to tax takings that comes from lower bank lending and lower economic growth. Tax takings fall while spending generally increases, especially borrowing to subsidize lending in key sectors like say, high-risk mortgage lending and property development. Think of the AOFM's role in buying securitized residential mortgage backed securities and Ruddbank.

So how big could government bond borrowing needs get? Under the 'best case' scenario (lower loan losses, quicker economic recovery) Rogoff and Reinhart say public sector debt would grow to an average of 40% of GDP, leading to global borrowing needs of $15 trillion – some 50% higher than the IMF's estimate.

But that's just the best case scenario.

Using the chart below, Reinhart and Rogoff suggest that in previous banking crises, government borrowing as a percentage of GDP has risen to an average of 86%. Under that scenario, now you're talking $33 trillion in global government bond issuance in the coming five years to deal with the rest of the losses in the banking system.

You can see why we think all this talk of recovery and rally is a bunch of hokum. Maybe it won't be quite 86%. Or maybe it will be more. But we know for a fact that global governments are going to flood with world with bonds in the coming years. But will investors buy them? If they don't, you can expect much higher bond yields and much more money printing. That means inflation.

If you think this is just an American problem, think again. Professor Paul Kerin of the Melbourne Business School says Australia's government has already over-responded to the crisis with its policy response. Writing in yesterday's Australian, he says, "I estimate the 2008-09 and 2009-10 deficits announced tomorrow [tonight] will exceed $32 billion and $55 billion respectively, and that net debt will exceed $250 billion by mid-2013.

"In the past half-century, the cash deficit has never exceeded 4.1 per cent of GDP – that was in 1993-94, when unemployment was running in double digits. Net debt has never exceeded 18.5 per cent of GDP – that was in 1995-96, the sixth straight year of deficits run to fight high unemployment...Yet the 2009-10 deficit will exceed 4.5 per cent of GDP – topping our 1993-94 record. And net debt will exceed 17.4 per cent of GDP by mid-2013, beating the 1995-96 record."

As you can see from the chart below, the government's deficit spending and borrowing ambitions have already steepened the Aussie yield curve. This makes long-term debt more expensive for ALL borrowers in Australia and will probably push up mortgage rates too, gagging the rebound in the housing bubble and jeopardizing the one sector that's held up the economy through the early stages of this so-far mild recession.

One last note on this before we move on to the investment strategy. A lot of Aussie Daily Reckoning readers ask how hyperinflation can happen in Australia if the US Dollar is weakening against the Aussie Dollar. Further, you might wonder how the expanding American deficit has any bearing on the fiscal stability of the Australian economy. They are great questions.

There are four factors that we believe will lead to an even weaker fiscal position in Australia and lead to more borrowing and a weaker Aussie Dollar – despite the circumstances that are undermining the US Dollar. Or to be plainer, US Dollar weakness is not going to be enough to keep Australia's currency sound.

So what are the four factors? First, government tax takings are going to fall more than expected. This is already the case. Lower commodity prices are going to compound the problem in the second half of the year. Barring a full recovery in the job market, the government is factoring in revenues that will not be there, while increasing spending.

But the big increase in Aussie government borrowing will come elsewhere. If indeed there is a "second half" to the capital crisis in American and European banks, it means financing needs for the Australian economy are going to have be backstopped by government guarantees or direct loans (Fed style, a la the TALF).

Sectors that the Australian government may have to borrow on behalf of or loan to include the commercial property market, the residential property market, and the corporate bond market. Right now the Australian Office of Financial Management reckons it won't have any trouble selling $1.4 billion per day to finance growing government deficits. But how much larger will Australia's borrowing needs become if the government must become the lender of last resort to all these other credit markets?

And if Aussie government – competing with all those other countries for global savings – can't sell its debt abroad-how do you think it will pay for it? The Reserve Bank will do what the Fed, the ECB, the Bank of Japan, and the Bank of England are doing. It will print money to buy government bonds. It will monetize the debt. Quantitative easing will begin in Australia and inflation will have arrived.

Does that seem impossible to you? Is it just Doom and Gloom pornography? We're certain a lot of people will find this scenario absolutely unbelievable. But in a worldwide credit depression where government borrowing needs amount to nearly one third of all global savings, you have to wonder how Australia is going to raise money against the likes of the UK, Japan, and the United States. If it can't do it, it'll have to print.

So back to the question. What does an investor do? Well it's worth noting that Microsoft appears to be preparing for massive inflation by borrowing. The company is selling $3.75 billion in debt in order to buy back some of its own shares. Obviously Microsoft reckons the real value of the debt will diminish with inflation while the current purchasing power of the borrowed money allows it to buy back its own shares.

It's a nifty trade and provides the example of buying equity in world-class businesses at cheap prices. There have to be a lot of investors in the world out there who see the end-game of this explosion in government debt and would much rather buy equity. That alone means the "weight of money" argument for equities could send shares higher.

We have to admit we are extremely dubious of this strategy because it says nothing about how these businesses will perform in a world saddled with so much debt. But we suppose if you are a truly a long-term investors and have decades to wait, buying equities at these lows is, a) a much better idea than buying government bonds, and b) about the only sensible investment strategy if you're going to stay in the equity markets.

But let's say you don't want to buy-and-hold blue chip stocks. And let's say you want to be in the market and not just in gold, vodka, bullets, and canned goods (although if you are preparing in that way, you should check this out). If you're a "financial survivalist" what else can you do?

Try uranium and lithium (as investments, not meals). In late November, we tipped an Aussie-listed uranium producer in our Diggers and Drillers letter. The stock is up 90% since then. And this was a relatively "safe" stock because it's already producing from mines in Africa, with plans for a joint venture in the Northern Territories. It also owns some excellent ore bodies in Queensland, if the government there ever decides that it would like a uranium mining industry. We reckon the government WILL decide that because energy is an industry that's going to survive the credit crisis. China is building twenty one-gigawatt nuclear reactors at the moment. It will not be able to supply its own uranium needs. Australia, with over 30% of the worlds proven uranium reserves, is in position to capitalise, should it so choose.

According to Scotia Capital Inc. China strategist Na Liu, China's nuclear industry will consume 15,700 tonnes of uranium per year by 2020. "At this rate," she writes, "China's currently known uranium resources can only last for five to 10 years. Clearly, in our opinion, it is imperative for China to secure long-term supply through imports or investment."

For the resource speculator, an inflationary bubble can be the best of times. It is a high-risk exercise. But junior resource stocks are one of the asset classes the CAN go up faster than the rate of inflation. And if, as we believe, the explosion in government bond issuance is going to lead to an inflationary rally in stocks and hard assets such as Gold Bullion, then dabbling in the junior resource stocks and small caps is like hitching a front seat on a rocket.

Remember, this is pure speculation. You only hope your rocket is like Richard Branson's new Virgin Galactic space plane, and note the nuclear missile Slim Pickens rides in Dr. Strangelove. But what about red wine? The bottle shop across the street from the Old Hat Factory is closed for renovations. In its clearance sale, we were able to pick up a few bargain bottles of Penfolds Bin 389 Cabernet Shiraz. That is wealth you can either drink or store. We've done a little of both.

But you can also sell it! There appears to be a roaring trade in Penfolds wines on e-Bay. There are certainly worse things you could spend depreciating paper money on. We're also hearing that the 2004 vintage of the Penfolds Grange is the best ever. Can't wait to find out...

Best-selling author of The Bull Hunter (Wiley & Sons) and formerly analyzing equities and publishing investment ideas from Baltimore, Paris, London and then Melbourne, Dan Denning is now co-author of The Bill Bonner Letter from Bonner & Partners.

See our full archive of Dan Denning articles

Please Note: All articles published here are to inform your thinking, not lead it. Only you can decide the best place for your money, and any decision you make will put your money at risk. Information or data included here may have already been overtaken by events – and must be verified elsewhere – should you choose to act on it. Please review our Terms & Conditions for accessing Gold News.

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