A Possible 'Butterfly Effect' From the DSK Scandal

 |  Includes: AG, CAT, FXE, GLD
by: Dr. Stephen Leeb

Recent events call to mind a classic science fiction short story by Ray Bradbury, “A Sound of Thunder.” It’s a tale of time travel, in which a group of hunters pay a guide to take them back to prehistoric times for a safari aimed at bagging a Tyrannosaurus Rex. After they arrive in the past, the guide warns the hunters about the necessity of minimizing their impact on the environment by staying on a designated path and not touching anything, since even tiny alterations to the past could snowball into large and possibly dramatic effects on subsequent history. As far as the hunting, they will be killing only animals that were going to be dying at that moment anyway.

Without going into the details and complications of the plot, of course one of the hunters veers off the path and does a number of things that affect the local landscape in what seem like only small, very minor ways. Once the party returns to the present, things appear to be generally the same as they remember – at first. But then the time travelers start to notice some subtle and not-so-subtle differences – certain words are spelled strangely, people behave differently, and worst of all, the results of a recent presidential election are not the same: The extreme right-wing, racist candidate who had lost the election to a moderate candidate before the trip back to prehistoric times is now the winner in what is clearly a different form of the present.

As you may have already observed, the message here is actually a common theme in fiction and the basis of chaos theory’s “Butterfly Effect,” namely: Very small changes can have very big effects.

We hope this is not the case in the world today, but clearly the incidents surrounding Dominique Strauss-Kahn, managing director of the International Monetary Fund (IMF) until his recent resignation, continue to reverberate throughout the financial world.

We awoke this morning to find that Italy, and perhaps Spain, could be close to needing bailouts. The euro is clearly much more on the precipice than it was last week or even any time recently. It’s possible that things will work out, that European leaders will be able to cobble together some sort of rescue plan, etc. But plainly what it amounts to, in our opinion, is a crisis of confidence.

This is by no means to suggest that the euro is on firm footing. We have always believed there is no long-term future for this currency, for many reasons, chiefly the differences in the various economies and cultures of the participating countries. But obviously a sudden collapse would be horrific for all economies, and would be coming at a time when most economic signs have started to point upward.

As a sidebar, we should mention that a strong dollar, if that turns out to be the result here, would not be a good outcome for the U.S. Up to now, it has been a weak dollar that has been the strongest economic factor in fueling very high profits for U.S. corporations. A strong dollar would put that factor in jeopardy, but even more important, it will raise the prospect of a monetary crisis. I should hasten to add that this is not a prediction; it shouldn’t happen right now, because as we point out in the following remarks, most factors, including strong profits, have started to point toward a strongly improving economy.

Indeed, odds are high that the economy is going to improve in the next six to 12 months, so investors betting on growth and inflation are likely to be well rewarded. This forecast may seem a bit off-base given the poor readings on the employment front, but as is so often the case, employment is much more a lagging or coincident indicator rather than a predictor of what is to come. Actually, the key predictors of economic activity, in contrast to the employment data, are clearly pointing to better times than Wall Street currently expects.

One such critical predictor that has not been getting much attention lately is money supply. This isn’t surprising as since mid-2009, money supply, as measured by M2, has been barely growing despite the record injection of liquidity into the banking system. The Federal Reserve’s quantitative easing flooded the banks with record sums of cash, yet the torpid behavior of money entering the economy suggests that banks have been extraordinarily stingy in lending to businesses and individuals. Very recently, however, there has been a dramatic change, as M2 has surged. This indicates that the dike of fear keeping lending in check seems to have cracked. Given the reserves sitting on the books of banks, we believe at least a mini-flood of money is likely to wash its way through the economy.

In addition to money supply, the other very big deal has been the release of oil from the International Energy Agency’s (IEA) strategic petroleum reserves. Though the 60 million barrels (which include 30 million from the U.S.) only amount to a small fraction of what the world uses – over 85 million barrels a day – it is still enough to keep oil prices from spiking higher, especially given the IEA’s assurance that, if needed, it will release more. As we have often pointed out, the critical statistic in evaluating the effect of oil on the economy is the year-over-year change in the price of oil. Eliminating oil prices as a threat to the economy removes the biggest threat there is, at least for the next two or three quarters.

Another development which, like oil, falls into the category of “no longer negative” is improvement in the Japanese economy. The horrific tsunami knocked out a significant portion of the world’s supply lines of many products. In the U.S. the auto industry was affected – a major reason why recent GDP figures have been considerably less than expected. Auto assemblies are now scheduled to rise sharply over the remainder of the year, which promises to add to GDP.

There is also pretty good news from the world’s second-largest economy, China. While we doubt that the monetary authorities are ready to put pedal to the metal, we do think the recent bout of tight monetary policy has probably run its course. And that means China’s demand for goods both domestic and foreign should increase – which is good news for the U.S. and the rest of the world.

Other than Europe, the biggest caveat is that this recovery is likely to be short-lived. Sometime in 2012 or even before, all this growth is likely to result in surging prices for commodities. In a resource-scarce world you have to take advantage of the good news, as it rarely lasts for long.

To return to today’s news and the effects of the DSK scandal: given the generally strong positive economic factors currently prevailing, we view the most recent news from Europe as, again, a crisis of confidence. The IMF has replaced a seasoned veteran (whatever DSK’s deep flaws, unifying disparate groups and inspiring confidence were not among them). His successor, Christine Lagarde, appears to be very competent person who has made a name for herself in the legal profession and whose knowledge of economics may be more than average. But this is certainly not an average situation, and it remains to be seen if she can bring the required level of gravitas to the situation in Europe.

The IMF is not, to be sure, a European institution as such; nevertheless, it has played a central and crucial role in managing the European debt crisis. So its leadership is an issue of paramount importance for Europe’s economy at this time. That said, we hope that Lagarde can negotiate an incredibly steep learning curve and will be able to manage her way through the current crisis. As we already noted, there are a lot of positive factors in today’s world economy, suggesting that she at least has an edge in coming to grips with the challenges.

For now, we are going to stick with our view that the world is poised for a recovery, that the near-chaos in Europe will be managed, and that the rest of the year will feature strong economic growth, the emergence of inflation, and be very kind to inflation and growth-leveraged plays. These range from cyclical companies like Caterpillar (NYSE:CAT) to silver stocks like First Majestic (NYSE:AG), and of course to a wide range of gold favorites. And if we are wrong and the center does not hold, it will be gold that is the best shelter in the storm.

Indeed, perhaps the overriding message here is that in this fragile and very vulnerable world, holding gold is an absolute necessity to your financial health.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.