Financial Crisis Turning Into an Economic Crisis
Economics / Credit Crisis 2008 Oct 24, 2008 - 05:27 PM GMT
With all of the chaos in financial markets, and also commodities, how are the USD and the Euro affected and also the precious metals?
Well, first of all, we need the proper context of this world market situation. We are in the middle of a super world crash. These take a year to get into full swing. They develop over time. Minding that, realize that we may not see the worst for another year for the world stock markets. We are in the midst of a crash.
This situation is no ordinary financial crash, this is definitely on par with what happened in the Great Depression. If you look at that, you find the US did not go into a full depression until a year or two after the first stock crashes. Then by 1933, the Dow had lost about 90%. So, the point is, if I am right and the world is heading into a real depression and not just a recession, we won't see bottom for several years.
CNBC for example is so fast paced that they are constantly looking for a bottom now, but that seems way too premature. Then again, they seem to see themselves as stock market cheerleaders. It's kind of hard to be cheerleaders when your team is losing badly. But, the point is you need to keep from getting caught up in the instant news viewpoint looking for something to happen right now that is a ways down the pike.
Scope of this financial crisis
Just take a look at this partial list of nations in big currency trouble as of now, all due to the rapidly deteriorating world financial/economic situation:
Argentina – Just nationalized the pension funds to help with their ongoing financial deficits, their stock and bonds are falling drastically – again.
Russia – Russian stocks collapse in recent weeks causing weekly market shut downs. The Ruble severely falls. Russian Oligarchs lose hundreds of $billions in the stock crashes. The Russian central bank is using a great deal of foreign reserves to prop up Russian banks. There is actually talk of another Russian default in the future by credible media. Oligarchs have to repay $47 Billion in the next two months in various ways, and it's doubtful they will be able to.
Iceland – In the midst of a drastically falling currency and literal bankruptcy as they guarantee all deposits in banks that had lent out many times the GDP of the entire country. They now cannot even import food without paying in advance in foreign currency.
China – Said to be a ‘house of cards' by Andy Xie, former chief economist for Asia of Morgan Stanley. China has supported its economic growth by excessive lending to its industries over the last ten years and hidden non performing loans. China has acted to prop its stock markets. China has a huge hidden banking crisis about to unfold. 50% of China toy manufactures out of business as an example.
Hungary – In the middle of a currency speculative attack as they try to deal with foreign exchange and the collapsing financial/credit markets.
Korea – Won falls 9% in a day as companies lose $billons apiece in foreign exchange losses when their hedges against the USD turn south. Korea has foreign exchange problems amidst the disastrous credit markets. Doubts are now floating about how many developing and even developed trade partners of the West have enough foreign exchange reserves to defend their currencies.
And last but not least in this sampler – the US – and unmitigated banking disaster, and it's said that if the US did not take the huge steps to quasi nationalize the banks here, the entire US banking industry would have totally collapsed. US corporations are having to hoard cash to operate, whereas normally they use short term credit to fund payrolls, operations, etc. This lack of short term credit is a huge constriction on US and all Western economies right now. These same problems are now spilling over into Asia, once thought to be relatively immune.
EU- Said to have even worse exposure to the credit crisis than the US if that can be believed. They bought heavily of all the bad financial paper emitted from the US, and had their own credit bubble as well. Major EU banks have lent heavily to the developing Easter European regions, and now are on the hook for trillions. Etc, Etc, I'm just glossing over this. There is lots to say. EU employment, especially in the Club Med (southern EU) nations in the tank, and so are their economies.
Japan – Again falling into deflation which they never really exited since 1995.
That's for a very brief sampler of the economic chaos out there worldwide.
The USD, Gold, oil, commodities, Euro
So that's a view of the world economic situation. In short, it's a total unmitigated disaster. The only question is when all the layoffs appear everywhere. If we go back to the last great world depression in the 1930's, all the layoffs started in earnest about a year after the financial crashes. By 1933, the US had over 25% unemployment, and stocks had fallen 90%.
Ironically, the USD is benefitting from these crises. Since the resource correction this year, all the BRIC nations and commodity economies have taken big hits. That is causing sell offs in emerging markets, which drives demand for USD that repatriates back to the US. Everyone worldwide wants dollars as markets deleverage.
Hedge funds and big money market funds are having huge redemptions. That drives demand for dollars, and stocks are falling and will continue to fall. In short, as markets deleverage worldwide, and there is flight to US Treasuries by all, (and other good sovereign bonds) and demand for the USD rises.
The Euro falls as it becomes clear they cannot coordinate policy to deal with the collapsing credit markets there, as well as bailing out their failing banks. As the USD rises, the Euro/USD falls and it's said the Euro may be headed to par with the USD! That also seems to be happening faster than many people thought.
Commodities fall drastically. Copper, the quintessential economic barometer, is way down for example. The resource investing mantra is old hat, last year's story. If we have a real world depression (and it sure looks like it) then demand for the bubbled commodity sector falls drastically. The shipping indexes which indicate demand worldwide have halved or more.US trucking is way down. The Baltic Dry index, a world shipping measure, is way way down. World economic demand is, well, collapsing.
And that collapsing demand is scaring the hell out of China and the rest of the Asian exporters.
As it becomes clear that the resource sector is collapsing because of falling world demand, hedge funds are bailout out in a big way, and that is driving the bubbly commodities down further. The commodity sectors is heavily deleveraging and spilling off the speculative froth.
As funds of all types get massive redemptions, all the bubble sectors they were recently in fall (what was hot in the last 5 years?). That includes resource stocks, commodity futures and so on. Oil also is falling due to this bailing out by funds.
The Fund redemptions are so bad that the US just stated this week they will back them with an astonishing $540 billion to help them deal with redemptions so they don't have to crash the markets!
In short, every hot sector in the last 5 years is deleveraging and funds are being forced to liquidate due to redemptions.
Everyone is going to cash.
Gold and gold stocks are taking a hit as funds desperately sell it to help them with liquidity. Even though the Fed and ECB alone have now infused close to $7 trillion worth of financial help to markets, the deleveraging is continuing. The deflation in all markets is so severe that those infusions pale compared to the $25 trillion wiped from world markets in the last year.
Because deflation is outrunning the actual cash going out to combat it, there is a huge loss of wealth/money out there. That is classic deflation. So, deflationary forces are winning out, and the USD strengthens, (classic demand for cash in deflation). Gold falls accordingly.
Gold stocks, hit by massive fund liquidation and redemptions, also are being negatively correlated to the general commodity sell offs. And in the near future, that does not look to change.
The arguments that gold will react primarily to the inflationary central bank bailouts makes sense, but they do not take into account the depression developing, which is highly deflationary.
Now, as the credit crisis developed over the first year, we found that gold reacted immediately to any major developments in the credit crisis. For example, gold rose drastically when new credit crisis emergencies developed after Aug 07, but then fell dramatically when the Bear bailout was announced in the Spring of 08.
Now, gold is getting caught up in huge deleveraging of world stock and commodity markets. So, even though gold still reacts strongly in flight to safety in ongoing credit problems, it's being overwhelmed by the stock and commodity deleveraging.
Also, the gigantic efforts of the central banks to loosen the credit markets (remember gold reacts to any major credit developments) has made a case for a lower gold price as the credit markets have eased a bit recently (albeit a miniscule amount).
Now world economic crisis and not just credit
However, I expect things to worsen in the world going into 09. Economically, employment will fall, the recession develops progressively worse worldwide. All the basic economic stats that drive stock markets will be worse and worse. If the credit markets continue to worsen and there is a Russian default, or other currencies collapse, or Korea loses control of its falling currency, etc, then gold may easily regain much of its losses due to more deterioration in the credit markets. That remains to be seen. But gold will always have strong flight to quality.
Flight to quality going to Sovereign bonds
But flight to quality is primarily going into the major sovereign bonds, the US, Germany, even Japan. And as long as that continues, gold will be held lower than it would otherwise if things were more normal, but merely a credit crisis. Now we are adding the emerging economic crisis to the credit crisis and deflation.
Fund redemptions
It has been said recently that the gold stocks are anticipating lower gold prices, but what I really think is happening to gold stocks is the Fund redemptions are finally coming in a big way. That, and the general commodity sell off as that bubble bursts. Around April of this year, we warned subscribers that there would likely be a general commodity selloff as the world economy slows, which has happened. That's because all the funds had piled into commodities in the last years and, as they slow, the funds bail out.
Now, with redemptions finally happening in a big way (just look at the US attempts to slow redemption selling with the $540 billion this week to back the funds!) the gold stocks have gotten hammered two ways. First, gold had been bubbly earlier this year, and then, that corrects itself, then on top of that, funds sell gold to help meet margin calls. So, the fund liquidations are really hitting the metal stocks, and gold itself too.
We were waiting all year to see when there would finally be a stampede out of all kinds of funds as redemptions pile in. Well, exactly a year after the credit crisis exploded in Aug of 07, those chickens finally came home to roost. And more of this is coming.
What happened is people finally realized a year after the first big problems emerged in 07 that they need to get out – get liquid. So, for example, all the fund redemptions now, and also for the same reason the USD rises.
At PrudentSquirrel, we have emphasized for years that the best way to have metal is in coins or bullion. That way when the exasperating stock swings happen, you always have the same number of coins when you started. Yes, the prices fluctuate, but whatever number of coins you have remains static.
But with stocks, you always have the issue of stock dilution and mines that are costly to operate.. So, with metal stocks, you are subject to their operational cost issues and so on. Therefore, we felt that metal stocks are a second best way to have metal positions. In any case, they do fluctuate a lot.
Metals are still one of the safest ways to save money – coins in particular. And never forget that when the next phase of the world economic crisis hits – then you will definitely want metal coins. The next big shoe to drop will be a USD crisis most likely, (although that may be preceded by other currency crises and defaults like Russia for example).
But, when the USD shoe drops we are talking world financial Armageddon. That is not indefinitely postponed just because the USD happens to be rallying right now in flight to cash.
As far as the prospects for gold and the USD and the Euro going to the end of the year
By the end of the year we have the following:
There is massive flight to cash in general. Also flight to US Treasury bonds. That is USD bullish. The Euro is weakening and may even get to par with the USD soon, possibly even by early 09.
This is gold and oil bearish. There is also a lot of flight to cash and USD as the end of the year approaches. And also, many businesses and financial institutions are being forced to hoard cash just to operate, as they cannot get their normal short term credit facilities to cover operations/payrolls etc. That is USD bullish too.
So, going into 09, the USD is likely to continue to strengthen and the Euro to weaken.
But, the next question going into 09 won't be only the credit crisis, or what is now the credit crisis combined with economic contraction and layoffs and falling profits. The next big question in 09 will be will the USD hold together. That's the next shoe to drop.
The economic mess has developed as follows since Aug 07:
First, Credit/bank crisis in the US and West.
Then Credit crisis combined with economic recession/coming layoffs and lower profits, and that is now starting to include Asia.
The Next big phase will be Credit crisis plus severe economic recession worldwide plus a possible USD crisis in 09.
So, no matter how painful having metal is now with all the forces causing it to sell off, everyone is still going to have to be prepared in whatever way for a possible USD crisis sometime in 09. This is very counterintuitive with the USD rising now.
Also, as I mentioned, we need to be alert now for possible Russian, Korean and other big economies having a currency and or default crisis. It's one thing for Iceland with a total of 300,000 people to have one. But if Russia or Korea has one, then the markets will get totally hit in everything.
Stay liquid and stay loose.
By Christopher Laird
PrudentSquirrel.com
Copyright © 2008 Christopher Laird
Chris Laird has been an Oracle systems engineer, database administrator, and math teacher. He has a BS in mathematics from UCLA and is a certified Oracle database administrator. He has been an avid follower of financial news since childhood. His father is Jere Laird, former business editor of KNX news AM 1070, Los Angeles (ret). He has grown up immersed in financial news. His Grandmother was Alice Widener, publisher of USA magazine in the 60's to 80's, a newsletter that covered many of the topics you find today at the preeminent gold sites. Chris is the publisher of the Prudent Squirrel newsletter, an economic and gold commentary.
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