Stagflation & Gold
Gold has gained more than 60% in terms of global equity prices since Bear Stearns kick-started the banking crisis last summer...
IN TODAY'S lightning fast and violent markets, where a constant barrage of news and noise flows into the marketplace each day, it's easy to forget a vital piece of information that was released just a few hours or days earlier, writes Gary Dorsch of Global Money Trends.
Trader sentiment is often swayed by the price action of the moment, and it's easy to lose sight of the mega-trends and core issues driving the longer-term movements.
It was nearly one-year ago, on 17th July 2007, when Bear Stearns said in a letter to investors that two of its troubled hedge funds betting heavily on risky sub-prime mortgages were as good as bust.
Gold was trading at $666 per ounce. It's risen some 40% against the US Dollar since then, adding some 66% against the value of global stock markets as measured by the MSCI index and setting a new all-time record Gold Price of $1,032 per ounce on 17th March 2008 – the day Bear Stearns was sold to J.P.Morgan in a Fed-supported bail out.
"The preliminary estimates show there is effectively no value left for the investors in the Enhanced Leverage Fund and very little value left for the investors in the High-Grade Fund, as of June 30, 2007," Bear Stearns said last July. It reckoned that the net asset value for the High-Grade Structured Credit Strategies Fund was about 9 cents on the dollar.
BSAM – its asset management division – said it would "seek an orderly wind-down of the funds over time. This is a difficult development for investors in these funds and it is certainly uncharacteristic of [our] overall strong record of performance.
"The losses reflected unprecedented declines in the valuations of a number of highly-rated AA and AAA securities," the letter said.
At the time, few traders could envision the chain of events that would follow from that letter. But since the $1.6 trillion US sub-prime mortgage crisis began to appear on investors' radar screens, about $11 trillion of wealth has evaporated from the global stock market. Banks and brokers worldwide have been forced to recognize $420 billion of losses from investments in the sub-prime mortgage market alone, and the IMF projects total losses to ultimately reach $1 trillion.
- The Dow Jones Industrials lost 14.5% in the six-months through June 30, its worst start to a year in four-decades;
- The Euro-Stoxx-50 index, a top gauge of the 15-nation Eurozone, lost 24%;
- Shanghai red-chips plunged 48%, the worst half-year since 1992, while India's Sensex Index lost 38%.
All told, that left the SCI All World Stock Market Index teetering on bear market territory, down almost 20% from its top, the worst performance since the Dot.Com Bubble burst at the beginning of the decade.
Quite apart from the biggest banking crisis since the Great Depression, global stock markets are also haunted by the ghost of "Stagflation" – that rare mix of a stagnant economy plagued by high and rising inflation.
Last seen three decades ago, stagflation is a toxic witching brew for the global economy. A historic commodity boom has doubled agricultural and energy prices, while wage gains are lagging far behind. Factory profit margins are squeezed by soaring energy, raw material, and transportation costs. Trade balances are going negative in oil importing nations.
Stagflation & Gold: Oil vs. the Stock Market
Stagflation was last seen in the 1970s, when high oil prices fueled double-digit inflation. Back then, every time the Fed lowered interest rates to boost job growth, inflation took off, causing a vicious price spiral. And on April 9th this year, former Fed chief Paul Volcker said the present climate reminded him of the early '70s.
Then as now, certain commodity prices were rising fast; Volcker cited crude oil and soybeans as two examples. Then as now, these were explained away by government officials as speculative price run-ups and not as a harbinger of a big inflationary trend.
The Fed let inflation rage for so long during the 1970s that Volcker finally pursued a policy of targeting the money supply in 1979-82 in order to rein in a 14% inflation rate. However, the cost of bottling-up the inflation genie was a deep recession, with unemployment hitting 11% in 1982.
With commodity prices now spiking again – soybeans are $16 a bushel today compared to $7 a year ago, while crude oil above $135 per barrel also represents a double – Volcker just warned US Treasury chief Henry Paulson and Fed chief Ben Bernanke against letting inflationary expectations become embedded once again.
"There must be a forceful response to confront the danger that inflation expectations could rise appreciably, with all the attendant problems that would bring," agreed BIS chief Malcolm Knight on June 24th. "With inflation a clear and present threat, and with real policy rates in most countries low by historical standards, a global bias towards monetary tightening would seem appropriate, even though economic growth is likely to be hit harder than most observers expect."
So far, the Fed and US Treasury have ignored Volcker's advice. Instead, they're pegging the Fed funds rate fully 2.25% below the current rate of inflation in consumer prices, whilst also allowing the money supply to balloon at a 16.5% annualized rate.
That sounds like a prescription for hyper-inflation. Yet the Fed's aggressive rate cuts have failed to stop the bleeding in the S&P Financial Sector Index, which is off 50% from its 2007 record high.
On July 9th, the S&P Financials index fell 5.2% on the day, the biggest one-day percentage drop in six years, led by Freddie Mac – the government-sponsored mortgage agency – which dropped 24% to $10.26. Its sister organization, Fannie Mae, fell 13% to $15.31, also the lowest level in 16 years.
It's worthy to note; just as the true extent of the subprime crisis was becoming clear to stock-market investors, two famed investors – Jimmy Rogers and Marc Faber – both warned the Bernanke Fed to avoid the temptation to lower interest rates, as a quick-fix to solve the sub-prime debt crisis.
"Every time the Fed turns around to save its friends on Wall Street, it makes the situation worse," said Rogers on 18th Sept. 2007. "If Bernanke starts running those printing presses even faster than he's doing already, yes we are going to have a serious recession.
"The Dollar's going to collapse. There's going to be a lot of problems in the US."
Marc Faber, who oversees a Hong Kong-based investment company as well as writing the famed Gloom, Boom & Doom letter, concurred. "The cause of the problems we have today, they are due to artificially low interest rates, expansionary monetary policies, and extremely rapid credit growth that was fueled by a totally irresponsible Fed," he said.
"It's suicidal to cut interest rates," Faber warned, while Rogers added, "They should do something to stop inflation as soon as they can. If you don't do something now, if you don't nip it in the bud, it gets much worse down the road."
Yet a few hours later however, the Fed shocked the markets with a larger than expected half-point rate cut. Over the next seven months it took the cost of dollars right down to 2.0%, less than half the rate of inflation on even the official CPI measure. And by 7th July 7th 2008, after a doubling of agricultural and energy commodities – plus a 20% slide in the Dow Jones Industrials Average – San Francisco Fed chief Janet Yellen told America to grin and bear the pain.
"I see inflation expectations as reasonably well anchored," she said in a speech. "There is little monetary policy can do about rising commodities prices. If rising commodity prices reflect supply and demand fundamentals, then the situation is not likely to turn around any time soon."
Stagflation & Gold: Beijing Makes a Stand
Other central bankers, however, are less willing to suffer defeat at the hands of inflation without a fight.
The People's Bank of China (PBOC) is very worried about commodity-price inflation, as generated by the Fed and fed into the Chinese economy by the Yuan being closely tied – if not still pegged – to the US currency.
Food and energy make up 40% of the average household budget in China. So to counter commodity inflation, the PBoC has allowed the Yuan to rise about 1% per month against the Dollar, twice as fast as a year ago. The aim is to dampen the cost of raw material and oil imports in Yuan terms.
The PBoC has also sold huge blocks of government bills to soak up excess money flooding the system, and it lifted bank reserve requirements to a record high of 17.5% last month. "Food and oil-driven inflation is a global phenomenon," said PBoC chief Zhou Xiaochuan on June 27th. "Because oil and food are traded on international markets, and impact the whole world.
"Monetary policy needs to deal with this."
Besides moving ever more money into physical Gold last year, buoyed by negative real rates of interest, Chinese investors also opened 33 million new stock trading accounts, about ten times the number of the previous year, bringing China's investor population to 136 million.
They poured half of their savings, then stashed away in bank deposits, into the stock market, and bid the Shanghai red-chip market up to an all-time high – some five times higher inside two years – in Oct. 2007.
Chinese investors ignored the warnings of Cheng Siwei, vice-chairman of the National People's Congress, who had warned in Feb. '07 that "There is a bubble growing. Investors should be concerned about the risks. But in a bubble market, people will invest irrationally.
"Every investor thinks they can win. But many will end up losing. But that is their risk and their choice."
Ten months later, on 16th Oct., PBoC chief Zhou warned speculators that the central bank's top priority was combating inflation. The stock market's value was not a key factor in setting monetary policy.
Few traders took Zhou's warning seriously at the height of the Shanghai bubble. Chinese leaders have a long-history of broken promises when it comes to controling the explosive growth of the money supply. But the PBoC stunned stock market speculators by engineering a 60% correction in the Shanghai red-chip index from its peak of 6,150 to as low as 2,500 last month, even before the upcoming Olympics in August.
Nearly $2.4 trillion of shareholder wealth has been wiped out in Shanghai over the past eight months. The PBoC is tightening its monetary policy even at a time when China's factory orders have plunged due to a sharp drop-off in US exports, falling to a reading of 50.2 in June – the lowest in three years.
At the same time, raw-material and fuel costs for Chinese factories rose to an all-time high, squeezing profit margins. Wages for Chinese factory workers are 18% higher from a year ago. Net income for Chinese industrialists fell to 1.1 trillion Yuan ($160 billion) in the first five months of 2008, or 55% less than a year earlier, ravaged by today's global stagflation.
Stagflation & Gold: The Single Needle in the ECB's Compass
Ever since the world's monetary system was cut free from physical Gold reserves, the most precious commodity a central bank chief has is credibility. And with inflation spiraling higher around the globe, most of it inspired by US-dollar weakness, "price stability" is the key buzzword at the European Central Bank, even as signs of recession abound.
Politicians are calling upon the ECB to turn on the printing presses in order to shore up a flagging economy. Much like the PBoC, however, the ECB hawks are proving their mettle under stressful stagflation conditions.
Both service and manufacturing companies last month saw their Purchasing Managers Index fall below a reading of 50, signaling the first contraction in the Eurozone economy in five years. German factory orders fell for a sixth straight month in May, adding further evidence that Europe's largest economy is losing momentum. But Eurozone inflation jumped to a record 4% in June, and the ECB stands ready to hike rates again after raising to 4.25% at the start of July, aiming to prevent inflation expectations from getting out of control.
"We know where we must go, and there is no doubt about our goal," ECB chief Jean 'Tricky' Trichet said back on 17th Dec. last year.
"We don't know whether and when there will be a thunder storm, when the sea will remain calm, whether we will get a headwind or a tailwind. But everyone knows that the ship's crew will make all the necessary decisions to arrive at its destination – price stability."
Two days later, on 19th Dec. '07, Trichet was asked by German television channel N-TV if the bigger danger to the Eurozone economy was the banking crisis or inflation.
"The response is very clear," he replied. "We have a mandate. The primary goal is to preserve price stability. We are alert, and everybody must know that we will do whatever is needed, to deliver price stability in the medium term, and be credible in that delivery.
"The single needle in our compass is price stability."
A few days later, the German DAX index of Frankfurt stocks began to meltdown, tumbling 20% before hitting a panic bottom low of 6,400 this month.
But Trichet and the ECB hawks have little sympathy for the plight of stock market speculators. After surveying the damage from the meltdown storm, Bundesbank deputy Juergen Stark told the Belgian business paper De Tijd back on Jan. 25th that "we must not dramatize and panic over the current stock market turbulence. The current market volatility is turbulence, rather than a full-scale financial crisis."
Ruling out an ECB bailout with rate cuts, Stark added that "an inflation rate of more than 3% is not acceptable. The ECB's goal is to keep inflation close to 2%."
Seizing the mantle as the G-7's sole inflation fighter, the ECB hawks shocked the markets on June 5th, by signaling a quarter-point rate hike to 4.25% for July. Tricky Trichet, who has a penchant for fooling most of the traders, most of the time, guided the German two-year schatz yield to a seven-year high of 4.80%, aiming to rein in the upward spiral in the North Sea Brent oil market.
By anchoring the Euro near its all-time highs with a rate hike, the ECB is shielding industrial companies and consumers from the full brunt of soaring energy and raw material import prices. A continuation of the "Commodity Super Cycle" to new high ground could trigger another ECB rate hike to 4.50% in the months ahead.
Stagflation & Gold: South Korea Declares War on Forex Speculators
Most major foreign currencies have risen sharply against the US Dollar since the Bernanke Fed began its rate cutting spree last August.
But one currency that went in the opposite direction is the Korean Won. It fell by 10% against the Dollar from a year ago, even though the Won enjoys a hefty 300-basis point interest rate advantage.
Why? Foreign investors have been fleeing Korea's bond and stock markets, because the central bank is allowing the growth of its M2 money supply to ratchet up by 15.8% annually, its fastest rate in ten years, weakening the Won and further fanning the flames of inflation.
When President Lee Myung Bak took office earlier this year, he said stimulating economic growth was his top priority, and currency traders assumed that Seoul would be happy with a weaker Won to help boost exports, the key engine of growth for Asia's fourth largest economy.
But the sharp slide of the Korean Won is also intensifying upward pressure on inflation in the local economy, which imports almost all of its energy and natural resources, to fuel its huge industrial base.
Korea's consumer inflation rate hit 5.5% last month, a seven-year high, and the producer price index is 15.2% higher from a year ago.
Korea's industrial giants are watching their profit margins shrink, as input prices for key raw materials are rising much faster than their ability to pass the cost increases along. Meanwhile, slowing economies abroad led to a $2 billion drop in exports last month.
Hence Korea is caught in the "stagflation trap", but Lee Myung Bak is opposed to giving the central bank a green light for a rate hike to control the explosive money supply growth. So the Korean bond market vigilantes took matters into their own hands.
Selling bonds hard, they jacked up the government's five-year bond yield by 110-basis points, up as high as 6.15% and tracking the direction of crude oil. In turn, the Korean Kospi Index of stocks has been slammed by a "double whammy" – soaring oil prices and higher interest rates – tipping into a nosedive and losing 20% of its value in the past two months.
On June 24th, Myung-bak told his cabinet that "price stability" is now the government's top policy goal and that the battle against inflation would center on foreign currency intervention. By the second week of July, the Bank of Korea was stepping up its intervention in the forex market, selling $5 billion US dollars to buy Korean Won.
In a market that trades an average $27 billion per day, the BoK sales knocked the US Dollar about 4% lower on July 7th, its biggest single daily decline in 10 years.
According to estimates by currency dealers, the BoK has spent $17 billion from its foreign currency stash of $265bn intervening to support the Won since the beginning of March. By then draining Korean Won out of the banking system through further intervention, the BoK is clandestinely tightening its monetary policy.
All in all, it's an unorthodox approach to dealing with stagflation, but it's a smarter approach than the Federal Reserve under Ben Bernanke, which is eroding the purchasing power of its citizens.
Gold: a Safe Haven from Stagflation & Instability
The clock is ticking on George W.Bush's presidency, with his approval rating stuck at 23%. Since Bush took office in 2001, the US national debt has ballooned by $4 trillion dollars, and 2.6 million manufacturing jobs were shipped overseas. The US banking industry is mired in its worst crisis since the Great Depression, and the US economy has lost 432,000 jobs over the past six months.
Washington is now spending $10 billion per month in Iraq, and the American electorate wants change. So according to traders at Dublin-based inntrade.com, the Democrats will gain complete control over the White House and Congress in 2009. If correct, that vieew could lead to sweeping changes in trade policies with China, plus a quick withdrawal of US troops from Iraq within sixteen months.
Such big changes could have a major impact on the foreign exchange and metals markets, including Gold, in the years ahead.
But will President Bush leave the file on Iran's nuclear weapons program to Illinois Senator Barrack Obama, or will he opt for a naval blockade of Iran before the November elections?
The saber rattling between Jerusalem and Tehran has reached very high decibels, but this is "nothing new under the sun" in the Middle East.
Even so, the war of words heightens risks of a clash in the Gulf – not least with Dubya about to quit the world stage – and is lending support to safe-haven Gold Investment whilst also inflating an Iranian "war premium" in oil prices.
On July 5th, Iran's elite Revolutionary Guards General Mohammad Ali Jafari, warned that if his country came under attack "the Guards are equipped with the most advanced missiles that can strike the enemies' vessels and naval equipment with fatal blows." He would also shut down the Strait of Hormuz, a vital outlet for 40% of the world's oil exports.
"Blitzkrieg tactics and operations of the Guards' boats will not leave a chance for the enemies to run away," Jafari warned. Then on July 8th, Ali Shirazi – an aide to Iran's Supreme Leader, Ayatollah Ali Khamenei – added that "the first bullet fired by America at Iran will be followed by Iran burning down its vital interests around the globe.
"If they commit such a stupidity, Tel Aviv and US shipping in the Persian Gulf will be Iran's first targets, and they will be burned," Shirazi said.
And the destruction is mutually assured; in April, Israeli minister Binyamin Ben-Eliezer told the media that "an Iranian attack will prompt a severe reaction from Israel, which will destroy the Iranian nation," hinting at a nuclear response.
Iranian President Mahmoud Ahmadinejad, a very high-skilled poker player, countered that the Washington neo-cons are not in a position to make an assault on Iran. "In the US, wise scholars will not allow Mr. Bush to commit political suicide, and of course the economic, political and military situation will not allow Mr. Bush to do that.
"Bush is not in a situation to change circumstances in his favor. I assure you, and don't be worried, that there will not be a war in the future," Ahmadinejad said in early July.
Yet only eight-hours later, Iran tested nine long and medium-range missiles, including a new version of the Shahab-3 missile with a range of 1,250 miles, and armed with a 1-ton conventional warhead.
A missile with that range could strike Israel, Turkey, the Arabian Peninsula, Afghanistan or Pakistan. An Iranian military official said "the missile tests would show Iran's enemies its resolve and might." Back in June, Israel had already conducted aerial exercises involving its best jet fighters, widely seen as a rehearsal for a strike against Iranian nuclear facilities.
Arizona's Republican Senator and presidential hopeful John McCain said on July 9th there is "continuing, mounting evidence that Iran is pursuing the acquisition of nuclear weapons." The House Foreign Affairs Committee Chairman Howard Berman (Dem., CA) said that "stopping Iran's nuclear threat is our most urgent strategic challenge.
"No one knows precisely when Iran will produce a nuclear bomb. But it will be soon."
During times of extreme stress in the global banking system, geopolitical tension in the Middle East, explosive growth of the world's money supply, the biggest energy crisis in history, and the bungling of the Fed's monetary policy, investors have fled the global stock markets and found a safe-haven in Gold.
When measured against the monetary metal, the MSCI World Stock market index has now lost 40% of its value and can only fetch 1.5 ounces of gold today, compared to 2.5 ounces back when the Bear Stearns hedge fund revelations first came to light in July 2007.
In emerging markets such as in China and India, gold and silver are widely revered as solid hedges against inflation, assets that preserve wealth when central banks are running the printing presses at full speed. And with good cause. Because in China, the M2 money supply has been growing at an 18% clip for the past five years. India's M3 is 21% higher from a year ago.
So it's not surprising that wholesale inflation in China is raging ahead at a 8.6% clip, and 11.6% in India, its fastest in 16 years. But there has been a fanciful notion among the Chinese and Indian masses that any "paper asset" which couldn't be printed by central banks – such as company shares on the Bombay and Shanghai stock markets – could also serve as a viable hedge against inflation.
Such fairy tales are often peddled by Wall Street salesmen as well. But with the implosion of the Chinese and Indian stock market bubbles this year, compared to an ounce of Gold, there is little debate today about the special stature of precious metals, when "Stagflation" abounds.
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