The economic slowdown now threatening the United States and other industrialized economies will probably lead to the worst recession in almost 20 years.
The world economy will continue to struggle with the heavy burdens of rising food and energy inflation. On top of that, industrialized nations are facing deflation in housing and bank credit. And all the while, consumption will continue to erode because consumers will save more and spend less to address balance-sheet erosion.
For the first time in the post-WWII era consumers are facing a bizarre mix of lethal food and energy price inflation and deflation (or declining prices) in real estate and financial assets (stocks and bonds).
Never in the post-war period have consumers and investors alike faced such a challenging environment. We’ve simply never had to deal with two powerful economic forces converging with lightening speed.
Deflation, not inflation, does far more destruction to consumers and the global economy. That’s because debt burdens become increasingly difficult if not impossible to finance.
That’s the lesson of the 1997-1998 Asian economic crisis, the Russian ruble collapse in 1998 and now, the credit and real estate deflation attacking the United States and Western Europe since August 2007.
Inflate or Die
In a typical deflation environment, credit “bubbles” deflate. This process or monetary phenomenon can take several years to control until finally the forces of inflation eventually win. At that point, global central banks usually try to print their way out of economic distress.
The only way to beat deflation or an environment of rapidly declining prices is to expand bank credit like there’s no tomorrow. That’s what Asian central banks did in 1998 and the United States started in 2001.
The last U.S. deflation, back in the 1930s, was eventually cured by the Second World War. The war led to renewed economic production as the United States converted from a sleepy, peaceful country to a wartime economic juggernaut.
But today, the sub-prime crisis has morphed into a diabolical monster as it spreads from one facet of credit to the next. In the process, debt deflation or credit destruction is now underway.
The entire gamut of credit deflation reads like a bad movie script – and it’s still unfolding.
Bank credit continues to tighten in the United States and Europe, particularly in the United Kingdom, Ireland and Spain. As a result, default rates are now rising for companies and consumers.
Credit card delinquencies are surging and even top-notch investment-grade companies are being denied credit. Corporate bond spreads trade at multi-year highs, banks’ capital ratios have plunged amid a blizzard of unprecedented losses, and mortgage markets are hemorrhaging.
The Debt Deflation Strategy
According to data from Morgan Stanley, only U.S. Treasury bonds posted gains during the last deflation or Great Depression of the 1930s. Gold, however, might have gained in value had FDR not confiscated ownership in 1933.
In my view, gold along with the U.S. dollar would post significant gains versus most assets, including foreign currencies in a debt deflation.Silver, however, might not appreciate as strongly as gold in a severe recession.
Silver remains mostly an industrial metal and I doubt it would appreciate in the same context as gold during price deflation. That’s because industrial demand for silver would collapse in a hard recession, unlike gold – viewed universally as a surrogate currency and a long-term store of value against fiat currencies.
Other commodities, including oil, are unlikely to rise in value if the current economic situation deteriorates further. There’s no historical case to be made for holding raw materials in a debt deflation. Not even China will save commodities from a major decline.
High quality Treasury bonds and non-financial A and AA-rated corporate bonds are also ideal hedges against credit destruction. As interest rates collapse amid an outright deflation or severe recession, long-term debt prices should rise markedly. Avoid junk bonds and any other category of bonds that aren’t of the highest quality.
The U.S. dollar is also poised to rise vis-à-vis most currencies as the recession unfolds. That’s because foreign economies lag behind the U.S. credit squeeze by about 12 months and will increasingly find debt deflation at their doorstep.
Foreign central banks will begin cutting interest rates in 2009 to offset rapidly deteriorating output. That makes the dollar more attractive on a relative basis because the Fed has already aggressively reduced lending rates to boost growth. That’s certainly not the case in Europe and Asia.
Get Out of Dodge While You Can
I would also consider opening a foreign bank account to hold some gold and U.S. dollars as a safe-haven strategy.
It is not unfathomable that some sort of foreign exchange control may arise over the next few years. If that happens, it will restrict your overseas transfers and stop individuals from opening a foreign account. The British government imposed such controls in the early 1970s during an economic crisis. It can happen again.
I have little faith, apart from the above short list of strategies, that other assets will protect investors. Debt deflation is the absolute worst nightmare for investors, central banks and the general populace.
The key is to protect what you have. At some point, as the crisis eventually subsides, great bargains will beckon in distressed debt, bankruptcy reorganization securities, common stocks and real estate.
For now, I’d brace for some difficult years ahead and start planning for a hard economic landing. In a worst case scenario, it’s better to be safe than sorry.ERIC ROSEMAN, Investment Director