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INVESTMENT OUTLOOK FOR 2008 AND BEYOND

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Published : November 25th, 2007
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Our Newsletter...
Category : Editorials

 

 

 

 

Sadly we are not bearers of good news for the upcoming holidays or for 2008.

Let us first summarise what we are predicting in this report:

The current problem in credit markets are likely to develop into a major recession or depression for the world economy in the coming years. The only question is if we will have a short period (12-24 months) of stagflation first, fuelled by money printing. The result would be the same whether it starts now or in a few months’ time, namely a deflationary downturn that will last for several years and have a devastating effect on the world economy.

 

The credit crisis is deteriorating

 

The liquidity and credit crunch in international financial markets has deteriorated to the extent that it is now worse than when the crisis started back in August. And this is in spite of the hundreds and billions of dollars that the Fed, the ECB and other central banks have injected in the financial system and in spite of the ¾% cut in the Federal Funds rate in the US.

 

The interbank lending market has almost dried up totally and interbank interest rates (Libor) are rising sharply above government bond yields. This is a sign of very tight credit markets as well as a flight to safety. Some market participants are saying that the markets are in “virtual panic mode”.

 

In order to try to alleviate the situation both the ECB, the Fed as well as other central banks have made it clear that they will continue to provide virtually unlimited liquidity. The latest concerted action of the central banks of $ 100 million is a mere drop in the ocean compared to the size of the problem.

 

So far banks have written off some $ 60-70 billion of subprime debt. According to our estimates which are confirmed by several market analysts this is only the very beginning. There is at least another $300-400 billion of subprime debt that is likely to be written off. These write-offs will have continued pressure on liquidity. (In simple terms; for every $ 1 of write-off a bank has to reduce lending by $ 10). Citigroup’s major write-offs of at least $ 11 billion have necessitated a capital infusion of $ 7.5 billion from Abu Dhabi at a rate of interest of 11%. This is a clear sign that Citigroup is in dire need of capital since they have to pay significantly above market rates to attract funds. And $ 7.5 billion is probably not enough. Next was UBS to announce another write-off of $ 10 billion and a capital injection from Singapore and the Middle East in order to strengthen their weakened balance sheet. Most banks are underestimating the size of the problem and are likely to be under continued pressure in the coming months.

 

Mortgage loan resets

 

The mortgage markets have just started to suffer and there is a lot more to come. Both in the USA and in the UK a very large percentage of loans are currently being reset to market rates. This will continue in 2008. Thus borrowers who initially enjoyed very low initial borrowing costs could see borrowing costs double. This will lead to major repossessions which have already started in the USA but will accelerate in 2008.

 

Credit default swaps (CDS) is the real problem

 

The biggest problem in the credit markets is the Credit Default Swap Market (CDS). This is a form of insurance that is supposed to insure subprime loans as well as other loans. The total amount of CDS outstanding is $ 45 trillion (almost four times US GDP). The biggest issuers of CDS are banks followed by hedge funds and insurance companies. Since a major part of subprime loans are under water this triggers the CDS liability to pay out. However, most issuers of CDS have no reserves to cover potential losses. The CDS contracts have been treated as an off balance sheet item and since banks have “reinsured” or hedged their risk they have not made any reserves for the CDS. However, we are here looking at a massive counter party risks since the issuers of CDS assume that all counterparties will pay out. If we assume only a 5% default in the CDS market, this would amount to over $ 2 trillion. This sum would be sufficient to eradicate the equity of most the major banks in the world. And here we are talking only about CDS derivatives. Total derivatives outstanding are $ 500 trillion. Most of these are off balance sheet with virtually no reserves for possible defaults. A 1% default or $ 5 trillion would be catastrophic for the world economy.

 

So far, the problems in the CDS market has mainly been in connection with subprime loans. Although this is big enough to upset the world’s financial system it is only the tip of the iceberg. The leveraged loan and junk bond markets are a far big problem than the subprime market. This market which is also “insured” by CDS has grown exponentially in the last few years. This is a market which historically has had a very high default rate particularly in an economic downturn.

 

Personal loans and credit cards are choking the consumer

 

The next major area which will experience problems is personal loans, credit cards and car loans. This area has virtually exploded in the last few years in the US, UK as well as in many other countries. Defaults are now increasing at a fast rate but are still at a relatively low level. The combination of an economic downturn and rising unemployment would have a disastrous effect on the personal credit area. Many Americans and Brits are only one pay check from bankruptcy.

 

What will the consequences be?

 

We have in the last few months repeatedly stated that there are only two possible outcomes of the present credit crisis:

 

· Either central banks and governments will succeed with their money printing exercise by continuing to flood markets with liquidity. This will lead to hyperinflation / stagflation. Short term this could keep economies going and stockmarkets could even go up as they did in the Weimar Republic and in Zimbabwe. However in real terms, taking out the effect of inflation, stockmarkets would go down. As an example the Dow has lost 66% of its value against gold since 2000. The dollar would continue its collapse and go down by another 30-40% at least.

 

But even if this inflationary scenario would work in the short term it would still eventually lead to an implosion of the credit bubble.

 

· The only alternative to the inflationary/stagflationary scenario is that governments don’t succeed in inflating the world economy. This would lead to a deflationary downturn which would be extremely severe and result in a massive contraction of credit resulting in a severe economic downturn. It would most probably lead to a recession/depression with major bank failures. In our view there is no question that world economy must undergo a major correction which will be severe and long. The only question is when it will happen and the degree of the downturn.

 

· Our view is that the downturn has started and will accelerate during 2008 and that we will not see a bottom until 2011-12 at the earliest. The only question is if the downturn will start with a stagflationary growth period first followed by contraction and deflation or if the deflationary period starts from here.

 

So what should investors do?

 

The current problems in the financial system are unlikely to be of a temporary nature. The combination of an unprecedented credit bubble worldwide, a derivative bubble of $ 600 trillion, colossal budget and balance of payment deficits, and a housing bubble is sufficient to define the world’s financial health as extremely unsound if not extremely sick. That does not mean that the money printing by central banks can’t go on for yet sometime thereby temporarily delaying the inevitable. But what it does mean is that risks are higher than ever and the necessity to preserve at least a major proportion of one’s capital is greater than ever.

 

· There is only one asset class which perfectly fulfils the dual criteria of safety and capital appreciation which is precious metals.

 

· If the inflationary/stagflationary scenario occurs first gold will soar since it is real money and cannot be printed. Historically gold has always appreciated in inflationary periods.

 

· Normally deflation is linked to falling asset prices. This will be the case for many assets such as shares, real estate, paintings, base metals etc. However, this time it will not be a normal deflation. It will be a deflation linked to the most massive contraction of credit and money supply that the world has ever experienced. This will lead to serious problems in the world’s financial markets with the banking system fighting for survival. Today the interdependence of the world’s financial system is at a level which has not existed before in history. And it is not only banks. It is hedge funds, insurance companies, pension funds government and local government funds (we have recently seen both Norwegian towns and Florida State losing fortunes in subprime investments). Nobody knows where the risk lies and where the next problem is likely to emerge from. Therefore investors won’t even know what is safe. Size, like a big bank, is definitively not safer. Triple A ratings are meaningless as we have experienced with the subprime saga. Many local governments are losing money today and many sovereign states will be under severe financial pressure with falling tax revenues and increasing expenditure. In this deflationary scenario, the flight to safety will put severe upward pressure on precious metals.

 

We have invested in gold and silver since 2002 and our investors have enjoyed major capital gains as well as peace of mind during the last few years. Already back in 2002 we recommended up to 25-50% of assets in physical precious metals stored outside the banking system. Today we would recommend at least the same percentage if not higher. Gold has gone from $ 250 to $ 800 in the last seven years. We would expect it to appreciate to several thousand dollars in the next few years and to gain significantly in value against all currencies.

 

Egon von Greyerz

Mattherhorn Asset Management AG

 

 

Also by Egon von Greyerz

 

 

 

 

 

 

 

 

Data and Statistics for these countries : Singapore | Zimbabwe | All
Gold and Silver Prices for these countries : Singapore | Zimbabwe | All
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Egon von Greyerz is the managing director of Matterhorn Asset Management AG based in Zurich Switzerland. He specialises in wealth preservation with the special emphasis on physical gold stored in Zurich outside the banking system.
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