by Cam Fitzgerald
from Rick Ackerman (Rick’s Picks)
Posted originally Dec 13, 2010
THE T-BOND MARKET IS GROANING. Like a great, creaking ship lurching to one side, the sounds of shifting portfolio positions have grown louder and more ominous by the hour, accompanied by the clamor of bailout pleas and a mad scramble for the life rafts. Rates are on the rise and prices falling. Bonds are dead, long live Bonds!
The pirates off the stern, meanwhile, smell blood and are sizing up the opportunity to take down one of the fattest, easiest targets they have seen in all their sorry lives. They know they can take this craft down with words alone. If only they can spread fear above board and on the decks, they know the crew and its passengers will rush for safety, setting off a panic that sees all hands clinging to the rails on one side, capsizing the ship. But there are not enough life preservers! Blimey! It’s a salty, seafaring epic in the making.
Meanwhile, back in the landlubber’s world there seem to be quite a few asset classes that are being stretched and distorted. Equities in domestic markets have virtually regained their pre-recession highs in the absence of any real buyers other than high-frequency computer traders. Most other investors, insiders, mutual funds and individuals have abandoned equity markets in fear already. And yes, that is a bit of an exaggeration, because many people do remain invested. But we all know the big picture has changed. There are nagging doubts about the sustainability of markets. Who is really interested in buying stocks anymore when markets are looking overbought by computers alone?
We have to also contend with currency debasement, which means in other words that holding cash itself is not a good investment at this time, particularly with record-low interest rates. Well, if Bonds are in a bubble about to burst, and holding cash is just a surefire way to watch your wealth and buying power decline, then where do you go for safety?
In the background, the world’s third biggest economy, Japan, struggles under a debt burden that is almost epic, while the United States itself appears headed for a crisis of confidence as it monetizes its own debt obligations, guaranteeing a very painful adjustment in the future. Europe, as we all know, is on the ropes, and the likelihood that its currency union will fail seems a foregone conclusion. It is all about variables. In Europe there are just too many conflicting ideas about engineering a real recovery that have come up against a wall of public disenchantment, political bickering and even rioting from Athens to Paris. Even London is getting in on the action. Clearly, there are just too many moving parts in the machine.
And now China, the engine of the world’s functional economy — the country the world has pinned its hopes on to lead us out of deep and seemingly intractable recession, is itself forming what could prove to be the biggest real estate and credit bubble the world has ever seen. When that bubble bursts, the crash will be worldwide, since China’s influence now reaches all corners of the globe. With major investments on every continent from Africa to South America, and a regional dominance that encompasses dozens of countries, including Japan, Korea, Malaysia and many others significantly dependent on its trade, we now have the makings of something far worse than the Asian contagion of years gone by. With Western nations now heavily invested there too — from the corporate level all the way down to Ma and Pa’s nest egg being held in Asian growth-mutuals, there is no escaping the day when China’s real estate bubble implodes. And it will. It’s just a matter of time, unless the basics rules of economics suddenly cease to exist.
Bullion Rising on Fear
Gold and silver, meanwhile, are rising on fears of global indebtedness, sovereign default risk, inflation, and the aggressive debasement of the world’s reserve currency, the U.S. dollar. Those who think a bullion bubble is forming are steering clear of its bull market.
Others, mainly those with weak stomachs and a fear of heights, are moving toward the exits but finding few compelling alternatives. Piggybacking on the heated interest in precious metals, commodities such as cotton and copper are in parabolic rallies. Speculative plays that most people thought were dead following the credit crisis have actually sprung back to life with a vengeance. J.P. Morgan was recently revealed to have stretched the limits by buying up almost half the world’s inventory of copper and warehousing it in London. That gambit could secure their very survival if their paper investments or widely reported, massive short position in Silver blow up.
And they are not alone. A single European buyer attempted not long ago to corner Cocoa, while only months ago we watched from the sidelines as the world’s largest miner, BHP Billiton, came within a whisker of controlling almost half the world’s active potash deposits. The Chinese, meanwhile, have shown a sudden reluctance to share their unique wealth in rare-earths. As controllers of 97% of the global supply, they are in the catbird seat as the rest of the world looks no, wondering how they will obtain crucial supplies.
I hope that all of these recent developments are not being lost on investors, because there is a common thread running through them. It should now be perfectly clear that this commodity boom has significant, long-term implications for all of us. And it has legs, so not being invested is just foolhardy. By now, too, nearly everyone has recognized the strong correlation between Gold and most natural resources. These asset classes should outperform for many years, gaining impetus as populations explode higher and demand from the developing world accelerates at an increasing rate, while in the background sovereign default risk crowds out the willingness to lend.
Paper at Risk
One thing else should now be clear: Some paper investments and cash itself are the risk trades in a world of growing scarcity and expanding populations. Currency trading remains the flavor of the day nonetheless, and I have noticed lately that people with virtually no investment experience are taking an interest. This is just one more destabilizing factor among a phalanx of hazards that are gathering steam. Meanwhile, anyone capable of controlling a single commodity class is almost certain to reign supreme. The new landlord owns much more than land these days. He controls the rights to access of critical resources like food, metals and energy. He holds the keys to power that governments are losing as they destroy the value of their respective currencies. This trend augurs the basis of a new power game. Not that it did not exist all along — only that today there are so many more interests competing for fewer resources, and that is certain to continue driving prices even in the absence of real demand. The new interests include countries, of course, and some of them have very deep pockets. We are nearer the middle of the next great bubble, in my opinion, but this one involves all regions, all countries and every last soul on earth.
So the gold rush in resources is alive and well, but it too represents a distortion in our system as food prices have now almost doubled in the Third World. Famine awaits where intervention and support will not go, and it is one whose roots are not found in drought but in outcomes of a global financial system straining to remain in balance and a banking system that many still believe is in tatters. Its roots are in the shift of money from perceived risky investments into those that are real. Hard assets are today’s play.
The outcome of sudden price increases in commodities is certain to set off political instability in some the poorest places on earth. Food is a big worry in countries where incomes range below a dollar or two per day. Food is a big worry for those governing too, as they are often toppled as an outcome of a food crisis. This is a concern for everyone. The last thing the world needs right now is more political instability, and it is not just Africa, (Egypt and Ethiopia coming first to mind) that are now primed for discord over price hikes.
Many of you will recall, for example, the food riots that broke out across the Third World in 2008. There is also widespread poverty in regions of India, Pakistan and even rural China, where wages are minuscule compared to the West. Food price-shocks are seen as very threatening to the governments of those countries. The advent of rising interest rates does nothing to quell the fears of many in the developing world as its low standard of living drops further yet.
That is only the beginning, though, and we need to keep in mind that as energy prices rise (which I fully expect) that the underpinnings of discord will arrive on the shores of North America too. Unlike Africa, we need to heat our homes, and it is not cheap. Nor will it get less costly as this boom accelerates. We are a widely dispersed population, dependent on vehicles that are in turn dependent on fuel to operate. An energy-price shock here will be met with dismay. Inflation will be the outcome, but it is the wrong kind because this inflation will not be accompanied by rising wages. On the contrary, wages will be falling due to ongoing global competitive forces that seem to still be a mystery to most people, particularly the trade unions. Hello! Those foreigners do all the same things we do nowadays, and they do it much cheaper. What did you think the outcome would be?
In any event, energy costs are set to rise. It is an inevitability that cannot be avoided.
But here again, the commodity boom is just another distortion in the system. Just as all hands on board the “Good Ship Bond” I mentioned above, and the analogy of passengers scurrying from port to lee, we are seeing investors everywhere looking for refuge from a coming storm, yet finding little real safety or even understanding how to both protect their wealth and build on their investments.
So they run from pillar to post in confusion, like so many headless chickens. A great deal of money is shifting to hard assets at this time, and it is not uncommon for a portfolio to have a resource hedge against an unknown future. The hedge is also likely to hold some fraction in gold these days, although many will be feeling underweight, especially after having seen the spectacular returns their neighbours have earned.
Well, this is where it all gets so interesting. Partly as a result of the credit crisis, partly as a result of past excesses and bubbles, many are living through a period of confusion and loss. Many more have never fully regained confidence in our systems nor in our investment choices of the past. There is no certainty anymore. The massive transfer of wealth into bonds has not yielded results so much as it has extra risk. Many even question if the original investments will be returned, given all the default fears. Nothing looks secure anymore — not cash, not bonds, not equities and not real estate. Distortions keep appearing as cracks in our banking and financial systems, as well as in countries themselves. The overriding concerns naturally are related to worries about debt that cannot be serviced in the future and obligations that cannot be met.
Might the whole system unravel almost overnight? Are we entering a moment in history where all investments carry a high degree of risk, and a major failure in any part of the system could bring down all of the others? We all “know” that something has to give, but we are collectively helpless to prevent it. Systemic risk is obvious to everyone. System risk suggests that if Japan, for example, touches off an orgy of monetization that sends them down the hyperinflationary road, we will all suffer the consequences. No country would be immune. Unfortunately, this is hardly unlikely. The Japanese are growing less and less confident in their government, and an aging population is facing retirement with a much lower standard of living. Peace and tranquility are not the words that spring to voters’ minds there. Borrowing, meanwhile, cannot help them pare current debt levels that seem to be pointing toward insolvency.
Not Just Japan
But it is not just a risk that Japan will default against her own people, as there are in fact a myriad of other distortions around the world, each a potential mine field — from the growing threat of a real estate bubble in China, to the very real possibility of European debt defaults and a pan-European currency failure. Even America’s moribund economy starts to look like an attractive investment, relatively speaking. To some of us, the housing collapse looks to be closer to its end than its beginning. Prices may well fall another 30%, but there is a certainty of a bottom, and that should not be doubted by anyone. It is just a matter of when.
So let’s recap. Bonds may well be headed for the trash heap. With rates on the rise, cash is a loser, buying power erodes, resource speculators rule, and stocks are expected to plunge momentarily. We cannot invest safely for the long term in Europe, Japan or China while politics, debt default, credit bubble concerns and currency issues weigh variously on those regions and all of their satellites. I suppose there will always be canned goods, roasted gopher with mint sauce, and buckshot, but something tells me the problems we will confront are much bigger than that, and there is nowhere to run. We are all in this mess together, and we need solutions now. Do we have a “Plan B” if The System actually crashes? In fact, we are trying to live in a world community that cannot even agree on the basics of banking — a world where small minds scuttle every good idea, and true leadership is in extremely short supply. If ever there were a time for serious discussions between nations, it is now. We need a back-up plan, and quickly. The System could unravel at any moment.
Mother of All Shorts?
So perhaps bonds are going to be the Mother of All Shorts. I am not so sure the pirates will collect their booty in a currency that has much value to them, though. The other long trade in a growth pattern now is commodity-based, since resources are at the heart of the shift in power across the globe. Poorer nations are struggling to maintain their fair share of the wealth, while stronger, militarized nations seek to protect their rights. I anticipate considerable political upheaval, and that in essence is what this article is trying to warn you about today.
By that same token, we can understand on an intuitive level the part that resources will play in settling debts between nations in the future. It cannot be understated that the day may come when we will trade off ownership and rights to those to whom we are indebted. This is hardly an unusual relationship, and it is worth noting here that Germany itself made war reparations in the form of agricultural products, industrial goods and other resources. Some have noted that U.S. debt levels can only be compared to similarly high liabilities run up during a war — food for thought and a partial explanation of the rush into commodities that is under way around the world.
Back to Serfdom
The resource trade will not be without its pitfalls, not from an investment standpoint. Nor will it be free of political unrest as rich and poor go eyeball to eyeball. Some serious setbacks are already on the horizon, particularly if China’s real estate markets suffer the same fate as all bubble markets do. Commodity prices will certainly decline; however, it is becoming increasingly clear that strong hands will move in and buy on weakness, exchanging their falling currencies for rights to build mines, cut forests, farm lands or dam and drain rivers and lakes. So the trend will remain intact as companies and governments coalesce around what is in the ground and steadily move away from paper trades that could become worthless overnight.
In the dark ages, the big land holders held all the power, serfs lived and died at the whim of their masters, and those without resources or armies were the weakest of all. We may not see an exact repeat of those bitter times when getting kicked off the land was a virtual death sentence, all but guaranteeing starvation, but it could be close. We’ll need to keep in mind the poorer nations, whose resources we often covet, as we attempt to rebalance the world’s financial relationships. Sharing the gains is essential for stability, particularly as it impacts our key allies and trading partners in far-flung corners of the globe.
Meanwhile, it seems that not much has changed concerning the dynamics of power over the centuries. It is impossible to avoid inequities, but we can still strive for fairness. We live in an age of discord and imbalance in search of a new kind of stability. The planet is being divvied up and there are already big winners and big losers. The developing world is on the rise and wants its fair share. It will come down to who owns the real goods, the hard assets and the lifeblood of the global economy. That is where the real money is.