For the last two decades, we lived in a speculative economy where one bubble appeared after another in rapid succession. We had the hot money bubble in Asia that ended in 1997, then the dot-com bubble in the late 90's, followed by the housing bubble, and then finally the commodities bubble in energy and metals. As each one ended, the financial system was not allowed to wring out its excess because central banks and governments around the world churned their printing presses, and pumped incalculable amounts of money into the economy in order to rescue it from the short-term aftermath of each bubble. The result was that when each bubble burst, a new one began almost immediately, fueled by the flood of excess liquidity. It is not over just yet - I believe we have one final bubble to work out.
The final bubble is the US dollar itself, whose current strength is fueled by a flight to safety of investors away from all risky asset classes. The flock of investors buying US Government debt has allowed a gargantuan amount to be issued without the repercussion of sky-high interest rates, which enabled the Federal Reserve to massively expand its balance sheet, and Congress to take on an astronomical amount of debt without a significant increase in borrowing cost. It was made possible by the reserve currency status of the greenback, and its perceived safety relative to all other asset classes.
This too, will end. In our epic game of musical chairs, we are now fighting for the last chair. This is how I think it will play out. For the time being, the bubble will continue in the short term. We will continue to see strength in the US dollar insofar as it is still perceived as the safest asset class. At the same time, even though the Fed is pumping liquidity into the system, the economy is still in the process of LOSING liquidity due to credit contraction. The funds that are pumped into the financial system are getting sucked into a black hole, because the credit market is frozen and the funds going in are not coming back out as loans. As long as banks refuse to lend, we are going to see destruction of liquidity, which is deflationary in nature. And the best asset class to hold during a deflation cycle is cash - which means as long as the financial system is in trouble, the bubble in the US dollar and its equivalent (e.g. treasury bills) will likely to continue.
Ironically, the eventual recovery of our economy will set the stage for its ultimate collapse. Firstly, the up-tick in the general economy will eventually cause institutions to start lending again, which will reverse the conditions from credit contraction to credit expansion, and turn deflation into inflation. Secondly, investors will have less need for safety, thus selling off safe-haven asset classes such as US treasuries and gold, putting pressure on the debt that US Government owes. Both of these are pillars that are currently supporting the US dollar, and as they disappear, we will suddenly realize that the US owes tens of trillions and it has no way of repaying. The US government will not default on its debt, but it will try to print its way out of trouble, which will likely burst the USD bubble, drive the dollar towards zero, and trigger hyperinflation.
Nobody is sure exactly what will happen when the US dollar collapses, except that it will be bad. There will probably be chaos in international trade, as a large portion of goods are priced in USD. There will be chaos in the derivative markets, as majority of the derivative models are driven by the US treasury yield with the assumption that it is "risk-free". The currency reserve of most of the world's central banks will become virtually worthless. The world's largest importer, the United States, will suddenly lose its purchasing power. There will be riots on the street similar to those that happened after the collapse of Iceland, except it will be worse by orders of magnitude.
Where will be good places to park our funds in this scenario? To be honest, there aren't very many. A lot of countries are in a similar predicament as the US. The UK banking system and fiscal situation is just as bad, if not worse, so the British pound will collapse along with USD. There are already secession talks from some of the fringe EU countries, who are soon to be facing the stark choice of either bankruptcy or abandon the Euro because the countries have no control over their own money supply, so the Euro may not survive this crisis. The Japanese have a public debt that is a larger percentage of their GDP than the United States, and it is to be serviced by a population that is aging quicker than the United States.
This leaves a few places in the world. The Canadian banking system is currently the most stable in the world, and its fiscal and trade balances are in relatively good shape, so I am bullish on the Canadian dollar. Same goes with some of the major emerging markets: Brazil, China, and India (not Russia, whose government seems set on reversing all the progress they have made in economic liberation since the collapse of USSR). Their currencies will do well versus the rest of the world, although their equity markets will not due to the export-focused nature of their economies, and their biggest trading partners will be the countries whose purchasing power disappeared. It is my view that Hong Kong will unpeg its currency from the United States when it becomes clear that the USD is on the path of disintegration, and China will also float its currency when the rest of the world goes to hell.
Gold, traditionally a good inflation hedge, will retain its value as the major fiat currencies collapse. However, I believe there will be a chance for us to go into gold at an entry point cheaper than now, during the early stage of the economic recovery, and before inflation truly appears. When that happens, I recommend moving a sizable portion of our net worth into gold, but not so much that we would miss out on a benign recovery if the Armageddon thesis turns out to be false.
There will likely be a short-lived, but voracious, stock market rally when signs of economic recovery first appear, and we should use that opportunity to off-load certain names in our stock portfolio. Companies that sell to the United States or the other failing countries will not do well, which means BRIC and Canadian exporters, and companies that serve the US, UK, European domestic markets. The banking system will implode so financials is also a sector to avoid. To the extent that we must keep some equities in our portfolio, we should focus on the ones that may outperform, relatively speaking. Domestic-focused emerging market companies should do OK (like emerging market real estates and utilities), as well as US exporters (like General Electric (GE)), and companies in industries supported by major tailwind (health care, mining, alternative energy, and technology).
Instead of trying to get the timing exactly right, let there be humility as the aforementioned strategy is implemented, in that it should be implemented in a piece-meal fashion. I would sell a little bit of the positions that don't fit the overall strategy at each major rally of equities, and I would add a little bit to gold at each correction of the metal.
Getting back to gold, the instrument a lot of retail investors will be using for their gold investment will be the SPDR Gold ETF (GLD), because that is the simplest way one can invest in gold through regular brokerage accounts. However, I recommend that we purchase some physical gold coins or bars as well when the prices go down a bit. Ultimately, the rationale for buying gold is the same as that of the people who are stocking up on guns, ammo, and water: "just-in-case". In the "just-in-case" scenario, which is the complete annihilation of the existing financial system, the fund company that offered the Gold ETF may not survive, and the banks where we opened our brokerage accounts may cease to exist. To fully hedge against this possibility, we will all need a little bit of physical gold, stored in several different undisclosed locations that are known to be safe.
Disclosure: Long GE, no position in GLD.