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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
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