Credit Crisis Morphs Into Stagflation- Protect Your Wealth!

By: Nadeem_Walayat

The credit crunch that broke with the two hedge funds failing in July 2007 is now into its ninth month with announces losses / bad debt write downs of £163 billions. Way back in July the expectations were that sub prime related losses would be in the region of some $140billions. With some venturing as far as possibly suggesting losses of $200, with some mavericks venturing to as high as $400 billion which was larger than that of the Savings and Loans crisis of $160 billions that required a US Tax Payer bailout of $124billions. The article of July 07 (Hedge Fund Sub prime Credit Crunch to Impact Interest Rates ) pointed out that the consequences of the credit crunch would be the worlds central banks ratcheting up money supply growth and making deep cuts in interest rates despite the inflationary consequences as the Central banks attempted to counter the credit crunch liquidity squeeze.

Losses of up to $400 billion was an astronomically high figure at the time but now some 9 months on the banks are starting to publicly wake up the magnitude of the losses. UBS last week declaring that the credit crisis losses could now reach as much $600 billions. This sent shock waves through the financial sector leading to sharp sell offs in stock prices , though you could say its better late then never, as the banks have a vested interest in talking down the credit crisis, therefore UBS announcement is a break from the consensus of where one week banks tended to issue benign statements that everything is okay, only to be followed few weeks later with announcements of further large bad debt provisions.

To date declared losses of $163 billions has devastated many of the major banks balance sheets with stock prices down well over 50% in most cases, Sovereign Wealth Funds have stepped in to take advantage of the distressed state of many major banks by injecting capital at usually punitive rates of return, as the SWF's attempt to pick up major stakes in large financial institutions that in other circumstances would have drawn a great deal of political protest.

The problem that we have today is that the credit crunch contagion is still spreading, rather than expectations that by now much of the bad news would be out, we are perhaps not even 1/5th the way there. From sub prime mortgage borrowers defaulting on loans they should never have been given, to the collapse of Bear Stearn hedge funds, to mortgage banks going bust, to SIV rescue packages to monoline bond insurers requiring billions in capital injections to prevent Rating agency downgrades and next in the pipe line are the Variable Interest Entities. Despite deep cuts in US interest rates, with further cuts in the pipeline all the way to below 2%, coupled with central banks pumping in excess of a trillion dollars into the financial system by offering to lend money against bad debts as collateral.

The Cry from Wall Street is for More Bailouts

The US tax payer is being asked to step forward and finance the $168 billion stimulus package to boost the US economy. This is perhaps the tip of the eventual bailout iceberg which a year or two down the road may total well over $1 trillion dollars in tax payer dollars, much of which will go to support Wall Street banks. A trillion dollar bailout ? Never ? Ask the UK government which was forced to nationalize Northern Rock Bank to the tune of over $100 billion, and may have to repeat the process at least once more as the UK housing market tracks the Market oracle 2 year forecast for at least a 15% decline as of August 07.

To illustrate the growing risks to the US Tax payer in funding ever larger bailouts, the Sunday New York Times recently reported: “As losses from bad mortgages and mortgage-backed securities climb past $200 billion, talk among banking executives for an epic government rescue plan is suddenly coming into fashion. A confidential proposal that Bank of America circulated to members of Congress this month provides a stunning glimpse of how quickly the industry has reversed its laissez-faire disdain for second-guessing by the government — now that it is in trouble. The proposal warns that up to $739 billion in mortgages are at “moderate to high risk” of defaulting over the next five years and that millions of families could lose their homes. To prevent that, Bank of America suggested creating a Federal Homeowner Preservation Corporation that would buy up billions of dollars in troubled mortgages at a deep discount, forgive debt above the current market value of the homes and use federal loan guarantees to refinance the borrowers at lower rates.”

Stagflation Danger

The effects of rampant money supply growth is inflation. Whilst politicians confuse the public with the consequences of money supply growth through misdirection by blaming Emerging market growth, and commodity bull markets across the board. The true reason for inflation IS money supply growth, which in the US is running at over 8% and therefore pulling manipulated inflation statistics higher towards it.

Nine months ago, the situation looked containable. In fact it even looked bullish for stocks in certain sectors, as deep interest rate cuts which are transpiring would suggest much of the economy would be supported. However, what we are now witnessing is the clear and present danger of the West at least slipping into Stagflation.

The problem the Fed found itself last September as I pointed in the article ( Bernanke's Mission Impossible ) was the realization that the US could slip into recession during 2008, an election year. Fearful of the political consequences of allowing an recession to occur during an election year. The Fed gave up the fight against inflation and the defense of the dollar with the primary aim of preventing a recession during the 2008 Election year.

The original sub prime crisis has now morphed into something quite dangerous, as the rampant money supply growths coupled with declining economic growth rates implying a stagflationary environment all coupled with asset price deflation as evidenced by the 20% drop in stock prices and 10%-15% drop in house prices in the US. This coupled with devaluation of the dollar, and increasingly being joined by the British Pound presents the potential for a great deal of loss of wealth.

The Feds Days are Numbered?

The stagflation demon will only be slain by raising interest rates much higher than where they are today which would result in a recession. However any interest rate rises are not expected to occur until after the US election as the Fed attempts to delay a US recession until after the November Election. Failure to do so will bring the full wrath of the political establishment onto its back which may result in reform of the Fed during the next Presidency as the public demand greater accountability and competence.

Inflation / Deflation

The western world at least is moving into a stagflationary environment, given that most of the worlds central banks follow the US Fed, i.e. by pegging their currencies to the worlds reserve currency, the US Dollar, therefore they have and will continue to follow the US into inflation into the next election, however following the election the US Fed which is increasingly perceived as weak in its fight against inflation will reassert itself against its primary goal for an boom into the 2012 election, therefore its new political masters will grant it free reign to confront inflation. therefore post election we can expect interest rates to be raised sharply despite the US slipping into recession. However as soon as inflation shows signs of being tamed due to increases in interest rates and the slowing global economy we can expect interest rates to be cut. The best outlook under this scenarios is for a shallow recession during 2009 and going into 2010.

Investing and Protecting Your Wealth

Housing Market - Real estate markets built up during the credit boom looks set to continue to unravel in the US and house prices have barely begun to decline in the UK. Whilst the banks are barely 1/5th the way towards clearing their balance sheets of bad debts. Therefore it is highly unlikely that favorable credit terms are about to reappear anytime soon to sustain house prices in the US and especially the UK where they have reached more than 6 times earnings. So inflation will not help to sustain this asset, in fact we will witness an even greater inflation adjusted decline than nominal price declines would suggest.

Commodities - An inflationary environment suggests the the best prospects would be in commodities, the worlds favorite hedge for inflation proofing is gold, then silver and then the other precious metals. Industrial metals are more prone to economic activity so post November they may experience some significant contraction. The problem with direct investments in gold and silver is that they do not provide interest, therefore its not something that I would consider a long-term investment, only suitable whilst the trend remains in force. There is also the expectation that the worlds central banks will follow a post election Fed in its fight against inflation, thus what happens to gold and silver under that regime ? A 2 to 3 year bear market ?

Off course the Fed could fail in its fight against inflation and we may go into a protracted period of stagflation for a decade or more. I would favor investment in dividend paying gold miners and mining companies such as BHP over direct stakes in the metals themselves . The Same goes for soft commodities.

As for ETF's - Well there has definitely been an explosion in this type of investment product of late, and I am starting to wonder if we may see some form of crisis associated with the ETF's later this year, much as we watched the hedge funds blow up last August.

Treasury Bonds - The natural home in times if uncertainty and recessionary environments is in US Treasury Bonds, however how safe are the bonds in an stagflation environment?

Inflation linked bonds - Such as the UK 2030 index linked 4 1/4 government stock. Other 100% safe index linked products are the National Savings Certificates. Similar indexed bonds are offered by many governments across the western world including the US.

Fixed Interest Bonds - The liquidity squeeze continues to provide some opportunities for UK investors particularly in being able to fix for 1 , 2 or more years at rates of more than 6.5%, whilst the rates of 6.8% disappeared in October, 6.5% still represents a decent fix, especially since the Government in the wake of the run on Northern Rock bank looks set to provide 100% guarantees to all UK savers against a bank bust of at least £100,000. In fact as Northern Rock bank is now owned by the government, probably the safest place for savers now is to invest in Northern Rocks fixed interest products, with their 1 year fixed rate bond yielding 6.45%.

Asian Stock Markets - Starting late October I have been consistently bearish of asian equity markets, specifically, China, Hong Kong, India and Japan which coincided with peaks in the markets across asia. With many asian markets down some 20% and markets such as china full filling the original targets, I am now contemplating entering into India, China, Hong Kong and South Korea, which requires an asian markets update so stay tuned. As for Japan, as I posted way back in mid November I just cannot understand why so many analysts are obsessed with piling into Japan, which I have long considered a basket case investment. This is one of the consequences of pseudo democracies which Japan is, and an example of what we will probably experience with China some day, being a totalitarian state in that they are political weak and unable to take the economic medicine when they need to and hence make things much worse. Another risk to add to China investments is the fact that when things get tough and the population shows dissent, the government will send the tanks rolling in. So investors in China need to keep a close eye for such eventualities.

Stock Market Sectors - Utilities & Oil Companies - Recession proof utilities such as water and electricity that provide high dividend yields look enticing on current valuation, as do oil companies which look set to be supported for as the world is running out of easy oil. Therefore crude oil prices will definitely be one of the commodities that will whether an economic downturn. The same goes for natural gas stocks.

As I read the above, I am amazed that very little of my investment selections has changed since August 2007, made on the eve of the peak in UK housing market. The world is still trending towards tighter credit and demand for commodities continues to grow. The only significant difference now is that the financial sector losses look set to be far far larger than previously thought of and therefore the stagflationary environment looks set to last that bit longer.

Your stagvesting analyst.

By Nadeem Walayat

Copyright © 2005-08 Marketoracle.co.uk (Market Oracle Ltd). All rights reserved.

Nadeem Walayat has over 20 years experience of trading, analysing and forecasting the financial markets, including one of few who both anticipated and Beat the 1987 Crash. Nadeem is the Editor of The Market Oracle, a FREE Daily Financial Markets Analysis & Forecasting online publication. We present in-depth analysis from over 120 experienced analysts on a range of views of the probable direction of the financial markets. Thus enabling our readers to arrive at an informed opinion on future market direction. http://www.marketoracle.co.uk

Disclaimer: The above is a matter of opinion provided for general information purposes only and is not intended as investment advice. Information and analysis above are derived from sources and utilising methods believed to be reliable, but we cannot accept responsibility for any trading losses you may incur as a result of this analysis. Individuals should consult with their personal financial advisors before engaging in any trading activities.

Attention Editors and Publishers! - You have permission to republish THIS article if published in its entirety, including attribution to the author and links back to the http://www.marketoracle.co.uk . Please send an email to republish@marketoracle.co.uk, to include a link to the published article.

© 2005-2022 http://www.MarketOracle.co.uk - The Market Oracle is a FREE Daily Financial Markets Analysis & Forecasting online publication.