Leveraging Stagflation and its Victim - The US Dollar

Includes: LMC, SLW, TRX
by: Sufiy

With the latest report of anemic GDP growth in the 1st quarter 2007 of just 1.3% annualized, we should carefully examine the situation of the US economy and stock market health. At the moment, "stagflation" is a word about which you should know. It is defined as:

Condition of slow economic growth and relatively high unemployment - a time of stagnation - accompanied by a rise in prices, or inflation. Stagflation occurs when the economy isn't growing but prices are, which is not a good situation for a country to be in. This happened to a great extent during the 1970s, when world oil prices rose dramatically, fueling sharp inflation in developed countries. For these countries, including the U.S., stagnation increased the inflationary effects.

Should I remind you of the price of gold at the end of the seventies/early eighties? Stagnation is becoming apparent with growth below 2%. And if you subtract inflation, Real Output is already negative. The inverted yield curve has been showing it for months, signaling recession. The only way out of recession and to prevent a slowing economy from spiraling into deflation (which has put Japan on hold from nineties) is the printing press.

Printing presses have now taken many exotic forms, but they are all one in the same. They all increase the amount of credit available to consumers and other market participants. Easy credit on a domestic scale has allowed people to consume without normal boundaries of financial health. Liars' loans have allowed people who could never have afforded it (and should not have been able to afford it for their own good) to become homeowners. New artificial demand has put pressure on house prices and we had the first bubble in housing which is bursting right now. People have turned their homes into ATM machines and have supported the economy by taking equity out of their house's "perceived" value to cover real cash outflow, like interest payments on credit cards.

Everybody became property tycoons. The least prepared people have taken the most possible leverage. Go and try to borrow against your gold mining stock portfolio. See what sort of discount you will receive if anyone grants you a loan. But with housing you could get it without any down payment and with an interest payment only, or even a negative amortization loan. The entire nation is living on a borrowed future.

But the most devastating part will be the financial bubble bursting in the derivatives market. Money creation by the Fed has multiplied without any control by the derivatives market in which you can get economic exposure for a fraction of the real cost of an asset. In this way, using the same capital, you can actually take risk on more positions. "Academically" speaking, this is believed to reduce risk by spreading it among market participants. But in actuality, this is creating an "artificial" demand for assets and will drive their prices up. And the risk will be "spread" to those who are least prepared. This flood of liquidity chasing all asset classes created bubbles all across the US economy, which has become financial in its nature. Just look at how GM (NYSE:GM) is making more money in their different financial services than by making cars.

So when liquidity dries up in the form of a tightening credit supply, the bubbles will start bursting and the consumer will become squeezed without any more easy credit available. Two thirds of the economy is without an engine for growth now. So in the best case scenario, growth will be anemic and we will have stagnation. But interestingly enough, this does not automatically mean that inflation will come down. The trick is that the US is a net importer of oil and other commodities and is competing for supply on the world markets. Commodities are priced in USD and foreigners are ready to pay more in USD, with their own currency rising, in order to secure the supply. So the US is effectively importing inflation back home with rising oil and other commodity prices which are underlining for all other prices.

The problem here is that the US has a huge budget and foreign trade deficit. In order to finance the deficit, the US is selling IOUs in the form of treasuries. The US will only find buyers if the interest is at an attractive rate. You have to keep the "perceived" value of the dollar at a high level if you want to continue playing this game. How long will it be before foreigners will stop accepting effectively IOUs for their oil and commodities? The USD is the reserve currency of choice and nothing else. You need to tighten credit supply and increase rates in order to protect the value of your currency, but your hands are tied. The economy is melting and waiting for a cut. The economy wants a larger supply of money.

So what will be the choice? Another war? The economy will not be able to handle it. So keep the economy on hold and we have the following scenario: stagnation without stimulus, a housing market in a painful downslope for years, markets that are flat (the best dream) accounting for inflation and eroding value in real terms accounted in gold, milk or egg prices. Inflation is rising. You are chasing reluctant foreigners to buy your IOU to finance the deficit but they are demanding larger and larger discounts. The USD is falling against other currencies and all real assets. Foreigners start to diversify from the "reserve" currency which helps to further erode its value. The USD becomes the chosen victim because the only way to pay less on your debts in real terms is to inflate them out and repay in the depreciated currency.

So how can you preserve your wealth? Look for real value. Look for growing populations, rising and emerging markets that are creating industrial infrastructures and demanding commodities for its growth. Look for rising powers and their wealth which they will protect from the falling dollar. Commodity hunger will shine the spotlight on companies like Tenke Mining and Lundin Mining (LMC), which have secured huge deposits of basic metals like copper and zinc with demand for years to come. The falling USD will ignite investment interest in companies leveraged to the price of gold and silver like Tanzanian Royalty Exploration (TRE) and Silver Wheaton (NYSE:SLW).

It is important to mention that these markets are relatively small and even a fraction of money coming out of the general market will lift this sector in the next bull leg up from its consolidation phase. This sector is very volatile and you need to apply all proper due diligence and asset allocation rules, but until you can buy companies with trustworthy management with copper at 10 cents, gold at 50 dollars and silver at 1 dollar in the ground, pay day will be worth the risk.