It has often been observed that being a successful
investor is not easy. And how could it be, given that much of what drives
investment returns can be tracked to the economies that serve as the
foundation for those investments. That, in turn, brings into play the study
of economics, which is where things begin to get very wiggly.
That's because, other than in the most primitive
societies, the modern economy is a complex system containing so many moving
yet interlocking parts as to make predicting outcomes impossible.
Even so, there have been periods in history when the
largest of the moving parts were relatively stable, in which case, in the
absence of a black swan, a certain predictability
This is not one of those periods.
Which brings me to a quick review of
just a couple of the larger moving parts in today's economy. While my perspective is largely derived from the fact
that my derriere is presently parked in the USA, globalization has served to
link up these same moving markets across any number of economies.
So, what are these moving parts? In no particular
Trade. The amount a
country exports vs. imports can be netted out to give you some sense of the
vibrancy of an economy. Simplistically, a trade surplus typically means that
there is external demand for the products and services produced by a country.
Because trading partners usually need to first buy your currency before
buying your output, a trade surplus is supportive of a country's currency.
The importance of a trade surplus can be seen in the
case of Japan where – despite the weight of many worries on the back of
that country's economy – the demand for its cars, electronics and so
forth has, until recently, kept it in surplus and therefore helped to support
the yen. With that country's trade now in deficit, things could get very
dicey, very quickly.
(As an aside, the switch over from trade surplus to
deficit in Japan is due to a number of factors, not the least of which was
the overreaction to the Fukushima fiasco that caused the politicians to close
down all but one of the nation's nuclear power plants, requiring the
resource-weak country to spend billions importing oil.)
A trade deficit of a sufficient size and duration can
have the opposite effect of a surplus, effectively requiring a nation to
export its wealth to trading partners in exchange for products people want
– flat-screen televisions and cars and such – as well as
resources the country needs, such as oil.
The net effect of the trade deficit, in the case of the
US, is that much of what we import ultimately adds nothing to the country's
capital stock or productive capacity, but rather is burned up or ends up in
landfills. Concurrently, our trading partners end up with lots of American
cash – credible estimates put the number at roughly $7 trillion –
which they can then use to buy up assets with tangible value, from real
estate and US businesses, to gold and other useful commodities.
This is, of course, a simplistic view of the situation
– because, for instance, many of those expatriated dollars have been
reinvested in Treasury bills or otherwise parked and are at risk of suffering
from the same devaluation as all dollar-based investments. Thus, the
country's primary trading partners, if caught unawares, could end up watching
their dollar holdings go down with the sinking ship… or, growing
concerned, could start unloading those dollars by dumping Treasuries and
using the proceeds to buy "stuff," helping to greatly exacerbate
the coming inflation.
So, how has the whole trade thing been going in these
United States over the last little while?
The reality is much worse than even that dismal chart
reflects, because the last time the US ran a trade surplus was in 1975,
almost four decades ago.
Government Spending. A government that spends a lot more than it takes in
will eventually be forced to engage in all manner of machinations and
manipulations in order to cover its bills – bills that include the cost
of paying interest on all the debt it has racked up.
Saving myself some time in raking together all the data
points on how things have been going with this particularly important moving
part, following are a couple of data points from a recent article by periodic
Casey Report collaborator James Quinn, writing on his
- We've increased our national debt by $5.6 trillion
in the last three and a half years. It took from 1789 until 2000, two
hundred and eleven years, to accumulate the first $5.6 trillion of debt.
- Our average annual deficit from 2000 through 2008
was $190 billion. Our average annual deficits since 2008 have been $1.3
trillion. Our deficits never exceeded 4% of GDP prior to 2008, but now
they exceed 9%.
- The national debt will reach $20 trillion by 2015,
and if interest rates normalized to the same level they were in 2007
(5%), annual interest expense would be $1 trillion, or 45% of current
tax revenue. (Ed. Note: More on interest rates momentarily.)
- The unfunded liabilities of Medicare, Medicaid and
Social Security exceed $100 trillion and cannot possibly be honored,
leaving future generations to fend for themselves.
In other words, the moving part of government spending
is moving quickly… in the opposite direction of where it should be
moving. So much so that yesterday the Egan-Jones rating service downgraded
the credit rating of the US to AA from AA+ yesterday, stating:
debt-to-GDP exceeds 100 percent, a country's financial flexibility becomes
increasingly strained," Managing Director Sean Egan wrote in his report
on the downgrade. "For the first time since World War II, U.S. debt
exceeds 100 percent."
As far as machinations are concerned, the list is far
too long and too complex to recap here, but because of the size of the debt
at this point, no machination is of greater importance to the government than
keeping interest rates capped at or near today's historic lows. That's
because, as James Quinn points out, the consequences of interest rates rising
even to the 5% level last seen in 2007 would be as devastating as a tornado
on the nation's already fragile finances.
Given the size and unpayable
nature of the government's many obligations, the odds are very good that once
rates start to rise, they will not only hit 5% but blow past that
level… perhaps to 10% or higher. Which means that, if it were possible
for it to happen (which it isn't, things will melt down well before that
point), virtually all US government revenues would have to go to paying
At that point, everything changes, and none of it for
the good (at least in the short run).
And that brings me to an analysis prepared in the wee
hours this morning for today's edition by Casey Research Chief Economist Bud
Conrad. (When I say wee hours, I'm not exaggerating – I received the
first email from Bud at 3:00 am his time. Thanks, Bud!)
In addition to interest rates, he touches on the
closely related matter of credit, another of the big moving parts in an
in Lending May Pressure Rates Higher
By Bud Conrad
economy is growing, there is a demand for credit. We have just gone through
the biggest collapse in credit since the Great Depression. But credit is now
rising again, as banks are making loans.
below indicates what loan recovery may mean for interest rates. When credit
demand is low, as it was in the crisis of 2008, banks are not making new
loans and total bank credit collapses.
The blue line
shows the annual growth in credit, which was actually in decline for the
first time in the data available. The red line of the fed funds rate was
forced to zero by the Fed, and that matched the low growth in credit. But
bank credit is now rising, indicating the potential of pressure on rates to
rise as well. The correlation is not precise, and there are other forces, but
there is a relationship. We are seeing recovery in the economy, so it is
logical to expect that the Fed could let the fed funds rate rise from the
record-low and record-long zero-interest-rate level.
In support of
the potential that the Fed may be forced to raise rates, Fed governors are
now openly discussing the possibility: on April 4, speaking on Bloomberg
television, Fed Governor Jeffrey Lacker suggested
that the economic recovery might bring a rise in rates in 2013. The Fed would
have to institute further massive Quantitative Easing to continue to keep
rates so low, and the Fed minutes show no indication that they are currently
preparing another round.
A Note on the
Data from the Fed on Total Bank Credit
The closer picture
of total bank credit is presented below, with two versions of the data. The
Fed's data on total bank credit shows two big jumps in 2008 and in 2010, of
$400 billion in one week. Banks did not suddenly adjust their balance sheet
by such a huge sum in one week.
I removed the
spikes to smooth the data. The data of the red line was used in the analysis
above. Without the decreases from what I claim is
distorted data, the picture of increased credit would be even more supportive
of rates rising. Here is a close-up of the data from the Fed, and my
credit markets, which have been distorted greatly by the government in recent
years, will be essential in projecting the future of the US economy. Interest
rates are driven by the supply and demand for credit.
article to be published in The Casey Report next week analyzes the
forces of demand for credit from the federal government compared to the
supply from the Fed to explain these pressures. I am also analyzing what
effect higher rates might have on government deficits.
(Ed. Note: There's never been a more important
time to understand the most powerful economic trends in motion and how to
invest to take advantage of those trends – the mandate of The Casey
Report. But don't take our word for it – instead click here to take us up on our no-risk trial
David again. As this stuff is quite complex, it's easy
to lose the thread (something I am prone to under the best of circumstances).
But the point is that the government has to finance its historic levels of
spending somehow. Once investors are able to deploy their funds into more
attractive income-producing investments, or get scared that the money they
are lending to the government via Treasury bill purchases isn't safe, the
government will have almost no good options left when it comes to preventing
interest rates from rising.
For instance, one way that the Fed has suppressed
interest rates in recent years is by directly or indirectly buying up
Treasuries at the regular auctions – but as it is already buying the
stuff by the boatload (61% of all Treasuries issued in 2011), any more
aggressive buying is likely to set off the alarm bells about the ill effects of
monetizing government debt, causing investors to demand even higher rates.
As we have discussed at some length in past editions of
The Casey Report, the problem is already exacerbated by the exodus of
foreign investors from Treasury auctions. Quoting a recent article from Newsmax, further quoting the Wall Street
Journal quoting former Treasury official Lawrence Goodman…
that foreign investors like Japan and China that once scooped up U.S. debt
are shunning it. In 2009, such foreign purchases of U.S. debt amounted to 6
percent of GDP and have since fallen by over eighty percent to a paltry 0.9
The bottom line is that US interest rates cannot be
maintained at historic lows in the face of historic levels of debt and
deficits. And so rise they must. Getting back to the point of this exercise,
the challenge for investors is deciding where and when to deploy their money
to take advantage of rising rates or, more importantly, ducking the falling
piano increasing rates will cut loose.
While avoiding anything but short-term bonds (and with
rates as low as they are, why bother investing in
them at all?) is one obvious conclusion you might come to, what about the US
stock market? Commodities? After all, if the government is forced to cut back
its excesses, then the barely recovering economy is likely to get crushed
and, along with it, the stock market that represents that economy.
There is, of course, the other alternative – the
one governments throughout the ages have fallen back
on in times of trouble: monetizing the debt and debasing the currency as a
form of hidden taxation and wealth transfer. More on this momentarily.
For now, it's back to the larger moving parts.
Employment (or Lack Thereof). Again setting the tone, I lean on James Quinn, whose
writing on the topic of employment seems to indicate a
certain skepticism, and even a dose of sarcasm.
- There are 242 million working-age Americans, and
100 million of them are not working. But don't concern yourself. The
federal government reports that only 13 million of these people are
actually unemployed. The other 87 million are just kicking back and
living off their accumulated riches.
- The economic recovery has been so great that the
7.5 million people added to the food-stamp rolls since the recession officially
ended in December 2009 isn't really an indication of severe stress among
the 99%. Only 46.5 million Americans (15% of the population) need food
stamps to survive.
Just to keep even with population growth, the job
market has to add on the order of 250,000 jobs a month. In the latest data,
out today, a recent upwards blip in employment was again reversed, with just
120,000 jobs added last month.
So, what's the government to do (because, of course, it
always feels compelled to do "something")?
Cut the egregious spending? Hardly. Not when the
prevailing wisdom is that the government needs to be doing more, not less, to
stimulate the economy. Otherwise there is very real (and justifiable) concern
that government will find itself confronted with the sort of social unrest
now breaking out in places like Greece and elsewhere that austerity is even
Leaving the only politically acceptable alternative of
more spending, more debt and more currency debasement.
Energy Prices. There's no two ways around it, energy makes the world
go 'round. The correlation between energy use and GDP growth is well
established, and for obvious reasons. If a nation can't effectively access
the energy it needs to make stuff, or grow crops, or get from point A to B, then
forward progress will slow, stop or even go into reverse.
The bad news is that even though the Western economies
remain stagnant, the price of oil has risen by over 340% over the last ten
years and has remained at over $100 a barrel going on a year now. Meanwhile
the Luddites are continuing to turn new supplies back at the gate –
most notably oil from the Canadian oil sands.
If today's high oil prices truly are the "new
normal," then the economy is in for a rough ride, as the price of
everything that relies on energy – which is most things – will
have to continually adjust upwards.
Government. While there are a multitude of moving parts that one needs to pay
attention to when setting a course for an investment portfolio, I will begin
to wrap up with the moving part that should be obvious to all as the most
important of the lot: government.
The US government – and of all the governments of
the major deadbeat economies – are jumping around like a cat on a hot
griddle (what a horrible metaphor, I wonder what sick twist came up with that
one?) to avoid getting burned.
The resulting machinations, manipulations and
changeable regulatory environment makes predicting the future near impossible
for individuals, business owners and investors alike. To name just one
example, we think the Bush tax moratorium will come to an end, so we convert
our retirement accounts to Roth IRAs and look to sell stocks before the
capital gains rates go up. Could that help send the stock market into a
tailspin? But if the Republicans win, could those trillions in new taxes be
Will the Fed actually cut back its spending, or unleash
QE3? It says it won't do the latter, but only the most naïve believe
that the Fed will step aside should the nascent recovery begin to falter as
it almost certainly will. If the Fed doesn't unleash more QE, won't interest
rates have to rise? If they do, won't interest rates have to eventually rise
even higher (either way, interest rates are going to have to rise)?
The list of moving parts directly linked to the
government makes it a fulcrum whose actions are amplified throughout the
economy – and most investment markets.
Speaking frankly, unless and until these governments
become so thoroughly discredited that the politicians are forced to take
lessons on the finer points of dodging shoes, the magnitude of their meddling
will continue to make every investment sector unpredictable and therefore an
active risk to your wealth.
Over the past decade, we have advocated the hard assets
of gold and silver as a core portfolio component – and that has
generally been the right call. But even the safety of the monetary metals
can't be guaranteed – at least not over the short to medium term
– for the simple reason that the government and its minions can
literally change the rules overnight.
So, what's an investor to do? Some thoughts:
- Be cautious. While the government has, with all its
unsupported spending, managed to eke out a modest recovery, the biggest
of the moving parts remain highly unstable and, in the case of the debt,
broken beyond repair.
- Diversify. With all sectors at risk, the best hope you have
for coming through this without getting wiped out is by spreading your
assets around a variety of investment sectors.
- Focus on quality. While there is a healthy debate about the merits
of value vs. growth, given the likely pressure on growth, I personally
skew toward the deep-value stuff myself. The way I see it, if you can
buy a truly excellent company with a rock-solid franchise and do so at
rock-bottom prices – and you are able to hold on for the next few
years until the dust settles – you stand a good chance of coming
out just fine. But, per #2, a mix of growth and deep value probably
makes the most sense.
- Don't forget the hard stuff. Precious metals definitely have
a role to play. Whether it's our 33% recommended allocation or a smaller
number for the more traditional among you – the thing that counts
is to have exposure to the only real form of money, then forget about
it. That said, at this point pretty much any tangible asset makes sense,
including real estate – but only if the price is right, the
carrying costs manageable and the local market prospective.
- Gold and silver stocks. While gold stocks don't quite fit into either
the growth or value category, by historic metrics, they are undervalued
at this point and so should offer portfolio-lifting returns over the
next year or two. (More on a special program Casey Research is putting
- Go international. It is foolish to keep all of your eggs in one
basket, not when the world offers so many opportunities – if you
know where to look. The only service I recommend for investors looking
to build a core of deep-value international investments is the new World Money Analyst from InternationalMan.com.
- Cash isn't trash (yet). It will be, but for now having powder to act on
new opportunities, or as a buffer against some very bad days, makes a
lot of sense to me.
There are more things you can do – for instance,
either pay off your debt or refinance it for 30 years at today's ridiculously
low rates. And you can shore up your personal value through a daily course of
study on something you are interested in – investments, for instance.
A Closing Thought
As I said at the beginning, realistically there is no
way to predict where things will stand a year from now – though the
totality of the inputs suggests that the economy, and by extension most
investment markets, will remain in a state of uncertainty and heightened risk
for quite some time to come. By the time it's over, it wouldn't surprise me
in the slightest to see some serious social unrest. That's because, as should
be obvious to everyone, the template the world operated on until a few years
ago is broken and can't be fixed.
The transition to whatever's next is unlikely to be
smooth. There's no need to panic; just be extra thoughtful as you go about
arranging your affairs. If there's good news, it's that being aware of the
way things stand puts you well ahead of the crowd.