When we look at the world economy today, wherever we
turn we see a wall of risk. And sadly this is an insurmountable wall with
risks that are totally unprecedented in history. There has never before been
a potentially catastrophic combination of so many virtually bankrupt major
sovereign states (US, UK, Spain, Italy Greece, Japan and many more) and a
financial system which is bankrupt but is temporarily kept alive with phoney
valuations and unlimited money printing. But governments will soon realise
that they are not alchemists who can turn printed paper into gold. The
consequences of the global financial crisis are potentially catastrophic.
As the Austrian
economist von Mises said: “There
is no means of avoiding the final collapse of a boom brought about by credit
expansion. The alternative is only whether the crisis should come sooner as
the result of a voluntary abandonment of further credit expansion or later as
a final and total catastrophe of the currency involved.”
In our view,
governments like the US and the UK and many others will not abandon further
credit expansion. They are committed to printing increasing amounts of
worthless paper money in order to finance the growing deficits and the rotten
financial system. Therefore
there is no chance of Quantitative Easing ending but instead it will
accelerate in 2010 and after. The consequence of this will be
a hyperinflationary depression in many countries due to many currencies
becoming worthless. No economy in the world, including China, will avoid this
severe economic downturn which is likely to have a major impact on the world
economy for many, many years to come.
Investors are
ignoring the risks
What makes the
current situation in the world economy so intriguing is that most investment
markets have not recognised the risk. Stockmarkets and bond markets rallied
substantially in 2009, totally oblivious of the risks. The housing market is
down in the US and some European countries like Spain and Ireland. But in
many other countries it is still near the bubble highs created by low
interest rates and reckless lending.
The most
important criterion, when taking investment decisions, is understanding the
risks involved. Matterhorn Asset Management has in the last few years warned
investors about the risks in the financial system due to the massive
worldwide credit expansion and money printing. We have found it difficult to
fathom so few people realise that the world economy has become a time bomb
waiting to explode or more likely implode. All the so called experts have
declared that it is impossible to identify the problems in the financial
system in advance. For example, Greenspan, Bernanke, Geithner, other central
bankers and government officials as well as Blankfein of Goldman Sachs and
many bank heads have all stated that they couldn’t see it coming.
Either they are lying or they are stupid. Sadly, it is most likely the
former. It is virtually impossible to find an honest politician. They have
one major objective – Power. To attain power they have to buy votes.
But to buy votes they cannot tell the truth. No politician ever forecasts bad
news because bad news does not buy votes. (Yes, there are exceptions like Ron
Paul in the US). And as regards the bankers, it is definitely not in their
interest to worry about risks to the financial system. For every year that
they issue additional toxic debt and derivatives they earn more in that
single year than most normal people earn in a lifetime.
Sovereign
Defaults
The list of
countries at risk of bankruptcy is increasing by the day. The acronym used to
be PIGS (Portugal, Ireland, Greece and Spain). It is now PIIGSJUKUS and
growing. The main contenders are currently: USA, UK, Japan, Spain, Italy, Greece, Ireland,
France, Portugal, Baltic States, Eastern Europe and many more.
On a proper accounting basis all of these countries are already bankrupt, but
since many nations can either print money like the US and the UK or increase
their already high borrowings, like Greece or the Baltic States, they have
technically avoided bankruptcy although in reality all the countries in the
list above are basket cases with very little chance of a return to normality.
Shown below is what we call the Sovereign Time Bomb. The bomb consists of
countries that have a combination of budget deficit and borrowings relative
to GDP which puts them into the category “Time Bomb” or high risk
of default. These countries have budget deficits from 6% (Italy) to 12.5%
(UK, Greece) of GDP and their Public Sector Debts are ranging from 60%
(Spain) to almost 200% (Japan) of GDP.
The
Sovereign Time Bomb
The problem is
not just the current debt levels of these nations, because the deficits in
all the countries are rising. Tax revenues are collapsing and with rapidly
rising unemployment, the governments’ expenses for social charges are
soaring. In the US for example the federal deficit in 2009 was $1.5 trillion
(10.7% of GDP) and is forecast to stay around that level for many years. The
plight of the US states is just as bad. Out of 50 states only 4 are expected
to have a balanced budget in 2010. Up to 40 states, including California, New
York, Florida, Illinois, Michigan, Ohio, North Carolina and New Jersey, are
virtually bankrupt.
It took almost
200 years for US Federal debt to reach $ 1 trillion which it did in 1981. In
2009 the debt increased by $ 1.9 trillion in just that year to $ 12.4
trillion. In the next ten years the US debt is forecast to reach $ 25
trillion. And this doubling of the debt does not include any funds to prop up
a bankrupt financial system or the spending of tens or maybe hundreds of
trillions of dollars on worthless OTC derivatives. The forecast also assumes growth
in GDP which is extremely unlikely especially for the next 2-5 years.
Currently US Federal debt is six times what it collects in tax revenue every
year. With debt exploding and tax revenues collapsing, there is no chance
that the debt can ever be repaid with normal money. Also, with debt out of
control interest rates will rise substantially to 10-20% per annum. Applying
a 15% interest rate to a $ 25 trillion debt would give an annual interest
bill of $ 3.75 trillion which would be substantially more than tax revenues.
The chart below
shows the US Federal Debt per person. In the last ten years it has gone from
$ 20,000 to $ 40,000. Total
US debt, including private and corporate debt as well as unfunded
liabilities, comes to $430,000 per individual. It is an absolute certainty
that every man, woman and child in the US cannot pay off almost half a
million dollars with normal money. Only massive money printing will take care
of that.
With these levels
of deficits for the next ten years on top of an already massive debt, there
is no possibility whatsoever that the US economy can avoid bankruptcy. No
country has ever abolished debts of this magnitude by printing paper and the
US will not be the first one to succeed either.
Only Lose
– Lose Options
Governments have
two choices – continue to borrow and print money or reduce government
spending. This is a lose – lose situation and whatever choice
they make it will end in disaster. Countries within the EMU like Greece
or Spain are introducing austerity programmes that forecast their deficits to
come down to 3% of GDP which is the EU maximum deficit limit. These are
totally unrealistic targets that are mainly based on an improvement in the
economy which is total fantasy. The dilemma is that not one single country
within the EU is below the 3% limit, not even Germany. And the effect of the
austerity programmes will lead to such a major contraction of the economies
that tax revenues will collapse, further exacerbating the plight of these
countries.
The alternative
is to print or borrow more money. Printing is not a luxury that individual
EMU members have and for these insolvent countries to borrow money is
becoming almost impossible or very costly. But the European Central Bank can
print money and this is likely to be the path they will initially choose to
save Greece and possibly Spain. Countries like the US and the UK can still
borrow and print money. And this is what they will continue to do. With
rising deficits, rising unemployment and the problems in the financial system
re-emerging they have no choice. Both the UK and the US are set upon a course
of self-destruction. We will see trillions of pounds and dollars printed in
the next few years. But the only buyers of these government securities will
be the US and UK governments. The rest of the world will dump their holdings
which will result in both the dollar and the pound dropping precipitously and
interest rates rising substantially.
Hyperinflation
– Consequences
The effect of a
collapsing currency will be a hyperinflationary depression. This is the
inevitable outcome for the UK and US and there is sadly no action that the
governments of these countries can take to alter this course. We discussed
the consequences of this outcome in our July 09 newsletter – “The
Dark Years Are Here”. There will be extreme poverty. None of the social
safety nets will function. So most of the social security payments that
people in need have been used to will disappear or be worthless due to
hyperinflation. There will be severe shortages of food which will lead to
famine and social unrest. Hungry people are restless people that will take
the law into their own hands. This will lead to violent protests, lawlessness,
theft and violent crime. And there is unlikely to be a force of law that is
paid and functional to deal with the problems. Already today, many US cities
and states are cutting down on the police force and their equipment. This
trend will accelerate during 2010 due to budget cuts and lack of funds.
There will be
massive cuts in education and many schools will close due to lack of
resources. Pensioners will be major sufferers. Many pension plans are
unfunded but also the funded ones will be decimated. Pension funds are
invested in three areas – equities, bonds and real estate. All three
are likely to go down by at least 50% but probably more like 75% at least,
all in real terms.
Deflation and
Inflation
Most economists
and financial analysts disagree with the hyperinflationary scenario and
believe that the deleveraging of debt will lead to a deflationary downturn.
That scenario would be more likely if countries like the US and UK were not
printing endless amounts of fiat money. As we have explained above the
printing presses will not slow down but they will accelerate in coming years.
The UK’s announcement that they will cease Quantitative Easing is just
a temporary measure that won’t last. Governments detest
deflation because they know that deflation after uncontrolled credit growth
would lead to an implosion of the financial system and the economy. Virtually
all bank loans and OTC derivatives have been issued against inflated and
unsustainable asset values. In a deflationary economy with falling asset
values, falling wages, falling corporate profits and falling government
revenues, there is no possibility that the massive amount of bank credit
outstanding can be serviced or repaid. Therefore the banking system would not
survive due to their massively inflated balance sheets and low equity. This
is why governments are petrified of deflation after a sustained period of
asset and credit bubbles. So their only option is to print whatever money is
required to stave off deflation. And this is what they will do. There is
absolutely no doubt about it. But they are doing this in total
ignorance of the consequences.
Governments
created the financial crisis
The current
financial crisis was not created by the banks. It was created by
governments’ irresponsible policies of buying votes by manipulating the
financial system through constant money printing, especially since the
creation of the Fed in 1913 and the abolition of the gold standard in 1971.
In addition they have used interest policy as a popularity contest thereby
creating a totally artificial market which distorts the normal laws of supply
and demand. It is clearly ludicrous to artificially keep interest rates at 0%
and print massive amounts of money. Neither governments, nor banks
should be allowed to create money out of thin air or interfere with market
forces by artificially setting interest rates. It is this corrupt
manipulation of the financial system and the economy that has totally
destroyed the value of money in the last 100 years. Measured against gold,
the dollar and the pound have declined by 99% since 1913. This would not have
happened if governments had not been allowed to use the financial system as a
voting machine. But sadly this will continue at an accelerated pace in the
next few years. Governments
seem totally incapable of comprehending that they cannot solve the
world’s greatest financial crisis by applying more of the same toxic
medicine that created the problem in the first place.
The prosperity
illusion
When you live in
the midst of history you don’t realise that you are part of making
extraordinary history. Therefore most people don’t understand that the
last 100 years has been an extraordinary period in history and even more so
the last 20-30 years. The perceived prosperity and increase in living
standards have been achieved primarily through massive increases in
borrowing, both by governments and by individuals. Take away the enormous
debt that has been created during this period and the world would be a lot
poorer. Alternatively, apply a market rate of interest on the debt. If
governments had not manipulated interest rates and set them at artificially
low levels, the normal forces of supply and demand would have forced rates
considerably higher, most probably in double digits. The higher rates would
have reduced demand for credit and thereby prevented the credit and asset
bubbles that have caused the worldwide financial crisis. In recent
years, Greenspan reduced rates from 6% to 1% between the end of 2000 and
2003. And Bernanke again applied the only remedy that central bankers know,
in addition to printing money, when he reduced rates from 5% to 0% between
2007 and 2008. These people seem incapable of understanding that simple
laws of supply and demand would have repaired the economy automatically
without their incompetent and desperate interventions. By leaving monetary
policy to market forces we would have normal recessions and minor booms that
would be totally self-regulating. What the central bankers instead have
created is the most enormous bubble in world history. And sadly like all
bubbles, this one can only end in a disaster of a magnitude that will affect
the world for a very, very long time.
So the last 100
years will be seen in history as an extraordinary period when governments
thought that they had invented a new economic miracle based on unlimited
credit and money printing. But sadly this miracle will be seen by future
historians as another failed delusional economic theory dreamed up by
politicians.
Risk of systemic
failure of the financial system
The current
financial crisis started due to the uncontrolled, worldwide debt and asset
bubbles. The subprime defaults were just the first symptom of the lethal
concoction of credit and OTC derivatives that the bankers had constructed for
their own personal gain with no understanding of the risks or the
consequences. Governments and central banks worldwide injected or guaranteed
around $20 trillion just to save the financial system. But the only people
who have benefited from this are the people who caused it. Very little of
these enormous sums went into the real economy. In addition to this enormous
liquidity for the benefit of the banking system, governments have allowed
banks to value their assets at totally false prices not based on market
values but on the hope that they will achieve full value at maturity. To
further assist the banks governments worldwide have reduced interest rates to
zero percent. So with trillions in fresh liquidity, zero interest rates and
valuing assets at fantasy prices, many banks have produced record profits and
paid record bonuses.
Money supply in
the US as measured by M3 is collapsing. The chart below shows how M3 has
declined almost 6% year on year. This particular indicator has been very
accurate in forecasting the major economic downturns in the last 40 years and
is now at the same level as before the 1970s recession.
None of the
problems that caused the banking crisis in 2007-8 have been solved. They have
just been swept under the carpet. In the US 140 banks failed in 2009 against
25 in 2008 and only 11 banks in the five preceding years. So far in 2010 a
total of 15 banks have failed and been taken over by the FDIC (Federal
Deposit Insurance Corporation). Virtually all the banks that fail show losses
that are far greater than the balance sheet valuations. Of the circa 6,000 US
banks, a major percentage will fail in the next few years due to rapidly
declining asset values. This will also be the case for many of the major
international banks. If their assets, and in particular their OTC derivatives
were valued at market, very few banks would be solvent today. In addition,
resets of mortgage loans, commercial real estate loans, credit card loans,
private equity loans etc are all problem areas that could bring major banks
down.
The risk of
terrorism
Terrorism is an
imponderable and it is therefore impossible to forecast where or when it
could happen. With 700 US bases in 120 countries and with the US, UK and
other countries’ involvement in Iraq and Afghanistan, the alienation
that this creates especially in the Muslim world, poses a major threat of
terrorist attacks especially in the US and UK. The terrorists are almost
always ahead of the intelligence agencies and security services. Therefore it
is impossible to forecast how, where or when the next attack will happen. It
could be planes, it could be shopping centres, or it could be a cyber war
against major international computer networks. The more troops that the UK
and US send to Afghanistan the higher the risks of terrorist acts against
them. The greatest likelihood of preventing or reducing terrorism would be
for the US and the UK to close all foreign military bases and to withdraw all
troops. Sadly, that is a very remote possibility.
Markets
In January 2009
we forecast that stockmarkets were likely to correct up to 50% of the down
move before continuing the bear market. The Dow Jones corrected just over 50%
but it took a bit longer than we expected. The correction is now finished and
the primary trend of all stockmarkets is now resuming its downtrend. We are
expecting very substantial falls during 2010. This will not be a year to be
invested in general equities. We expect precious metal shares to do very well
even though initially they will come down with the market.
Bonds
One year ago we
predicted that US long bond rates would rise. This is exactly what happened
and the 30 year Treasury Bond yield went from 2.5% to 4.6% during the year.
We expect US and UK bond rates to continue to rise in 2010. This will be as a
result of foreign holders selling their holdings of these bonds due to the
dire economic situation in the US and UK and the currencies weakening.
International investors are not prepared to finance bankrupt sovereign states
without getting ample reward for the risk.
Currencies
Most people judge
currencies on a relative basis. This is a very poor measure of the value of a
currency since it doesn’t take into account the total destruction of
paper money in the last 100 years. We showed in our December report
(“Gold is not going up – Paper Money is going down”) that
most major currencies including the dollar, pound, Dmark/Euro and Yen have
all declined 99% against real money – gold – since the creation
of the Fed in 1913. Thus, all currencies are weak and they will continue to
be attacked one at a time. Fundamentally the dollar is the weakest currency
and we would expect the next leg down to start relatively soon.
The Euro also has
its problems and is suffering from the problems of its weakest members
– Greece, Spain, Portugal, Italy, and Ireland. Like all artificial
currencies the Euro was doomed to have a relatively short life in its
original form. We predicted this long before its birth in Maastricht in 1992.
Short term the European Central Bank will support Greece and all other
EU nations that need support. Longer term, once too much worthless money has
been printed by the ECB without solving the problems, the European Monetary
Union is likely to break up.
But the current
fear over Euroland and the weakness of the Euro relative to the dollar is
overdone. The Euro zone budget deficit to GDP is 6.7% and debt to GDP is 88%
whilst the US deficit is 10.7% and debt 92%. So on this basis it is extremely
unwise to shift funds out of the Euro and into US dollars especially since
the underlying fundamental problems are much greater in the US.
All the countries
of the major trading currencies – the Dollar, Euro, Pound and Yen
– have major economic problems that can only be resolved by massive
money printing. This is why it is a futile game to try to predict which
currency will be the weakest out of the above four. They will all weaken
substantially but not at the same time. Therefore, we will have incredible
volatility in currency markets in the next few years whilst speculators lose
their shirts jumping from one currency to the next. There will be very few
winners in that game.
So are there any
currencies that are better? Yes, relatively, the Norwegian kroner, the
Canadian dollar and possibly the Swiss Franc and Australian dollar will do better.
The Renminbi will also do well but is difficult to invest in.
Gold
So whilst many
paper currencies become virtually worthless in the next few years, gold will
continue to do what it has done for 6,000 years. It will maintain its
purchasing power and therefore appreciate substantially against all paper
currencies.
The recent
correction in gold is the weak hands getting out of speculative positions in
the paper gold market. There has been virtually no selling in the physical
market.
So far gold has
gone up more than four times in the last ten years in a stealth market that
very few investors have participated in. The table below shows the
extraordinary return that investors in gold have achieved in the last 5 and
10 years. There is no other asset during this period that has given such an
excellent return whilst at the same time providing the highest form of wealth
protection (provided it is physical gold).
Average
annual return on over 5 and 10 years
Period/Currency
|
US Dollar
|
Pound
|
Euro
|
Yen
|
Swedish Kr.
|
2000 – 2005
|
9.7% p.a.
|
5.2% p.a.
|
2.3% p.a.
|
8.8% p.a.
|
11.0% p.a.
|
2005 – 2010
|
20.4% p.a.
|
25.0% p.a.
|
19.1% p.a.
|
19.2% p.a.
|
19.4% p.a.
|
2000 – 2010
|
15.1% p.a.
|
15.1% p.a.
|
10.7% p.a.
|
14.0% p.a.
|
15.2% p.a.
|
Return
last 10 years
Over the last 10
years a US and UK investor would have made an average return on gold of 15.1%
per annum.
Return
last 5 years
In the last 5
years until the end of 2009, the lowest annual return on gold was in Euros
with 19.1% per annum and the highest in Pounds with 25% p.a.
These are absolutely
outstanding returns which most investors are totally oblivious of.
But the awareness
will change in the next few years as gold rises even faster.
Many investors,
including George Soros, who have missed the bull market in gold (or the bear
market in paper currencies), now believe that gold is overbought and
therefore it is too late to invest. The next chart disproves that theory
totally. The chart shows gold in 2009 dollars adjusted for real inflation.
Shadowstats.com is a superb service which analyses government statistics on a
true basis, taking out all adjustments, revisions and other manipulations.
Applying the true inflation rate on the gold price shows that the gold high
in 1980 of $ 850 in today’s terms is $ 6,400.
Governments have
suppressed the gold price in the last 30 years by both overt operations
(official gold sales) and covert operations (manipulations in the paper gold
market and unofficial sales). Central banks are supposedly holding 30,000
tons of gold but credible estimates suggest that this figure is around 15,000
which means that 15,000 tons of central bank gold has been sold covertly to
depress the price. But the effect of manipulation of any market has a limited
time span, especially if it is done in connection with a total mismanagement
of the economy. Central banks have now stopped official sales and China,
India, Russia and many other countries are major buyers. Production is falling
steadily and investment demand is soaring. With the fundamentals so much in
gold’s favour, it should have no problem to reach the 1980 inflation
adjusted high of $ 6,400. With inflation or hyperinflation gold will go a lot
higher than that.
During the next
phase up in gold which we expect to start within the next few weeks, main
stream investors will discover what only a few investors have understood in
the last ten years, namely that physical gold is one of the very few ways to
protect their assets and preserve capital.
Egon von Greyerz
Mattherhorn Asset Management AG
Matterhorn Asset Management has set up a separate
Gold Division called GoldSwitzerland (www.goldswitzerland.com) in order
for investors to purchase physical gold at very competitive prices and store
it in their own name in Zurich, Switzerland outside the banking system and
with personal access to their own gold bars.
|