Are we heading towards an Iceberg?
Early evening on the April 14th 1912 and a passenger on the first class deck of the Titanic would be, no doubt, enjoying the opulence of their surroundings, and the wealth that the British Empire had created. More recently, the “Celtic Tiger” has created new wealth in Ireland so that one can now enjoy a similar fine dining experience as the passengers of the Titanic as the menus show. Yet, we know that the very next night it all lay at the bottom of the Atlantic and no amount of Edwardian engineering could save the ship. One of the key lessons learnt from the Titanic tragedy was that there weren’t enough lifeboats for all the passengers. Today, we are in the midst of a Global crisis and potentially face a new breakdown in the established world order. Just as the death of Queen Victoria in January 1901 at the peak of the British Empire was followed by two World Wars and the emergence of the United States as the dominant Global Hegemonic Power, many commentators such as Paul Kennedy in his bestseller The Rise and Fall of Great Powers, are claiming that Global Hegemony is in the process of shifting. It is possible if not probable that even within our lifetimes, this power will shift east to China or India and just like the situation faced by Great Britain at the turn of the Twentieth Century there is nothing the United States can do about it. This time it isn’t Edwardian engineering that is failing to save us, but financial engineering. Of course nobody knows for sure how events will play out or if we are heading for a recession or even a depression.
Monetary policy to save the financial system comes at a price
Action is being taken by the monetary authorities, such as the most recent 25 basis points cut by the Federal Reserve, and this seems to be supporting the stock markets. But these massive injections of liquidity will have to return in the form of inflationary pressures. It is our view that the markets are understating the scale of the problem and consequently the markets lack fear. Concern seems to be in a narrow concentration in banking and property and with a nod to a slow down on the high street. Investors need to look to indicators such as the price of gold and oil in order to grasp the potential enormity of the situation. Rises in commodity prices point to higher inflation in the future. As investors we tend to suffer from recent events syndrome. The last 20 years have been especially good for Property, Bonds and Equities. Therefore we suppose that the next 20 years will be equally good for these assets and we invest accordingly. We think that investors need to re-learn how to deal with inflation. Most of the passengers on the Titanic didn’t drown, they froze in the water. Just like on the Titanic, the key is to get into the lifeboats to survive. The problem is that there aren’t enough to go round. Inflationary lifeboats are assets like gold and index-linked government stocks which are in finite supply.
This is one of the reasons why they do what they do. Increased demand for an asset will, all other things being equal, lead to an increase in the price of that asset. Unlike dollars or other currencies, the monetary authorities cannot simply print more gold. The key to the current crisis is the existence of a massive debt overhang. When the time comes this debt must be repaid, the cost is going to be in terms of lower growth and falling asset prices. Investors are slowly coming to appreciate the potential extent of the problem and that it isn’t contained to a single sector of the market or a single country. We have seen large companies like Northern Rock in the UK and Bear Stearns which was the 5th largest investment bank in the United States coming to grief. There is a desire, almost a yearning to “get back under-way” and to return to the old world order.
Yet, just as the British Empire never recaptured its position after World War I, we now have to face the fact that, in the words of economist Roger Bootle, ‘the umpteen billions of dollars which have been magicked out of nowhere must return whence they came.’ The Chairman of the Federal Reserve, Ben Bernanke, has been very clear as to where he sees his role: providing liquidity and resources to the financial system. As we can see in the markets, to date, this approach has been well received by Investors. Equally, we shouldn’t worry if the Fed has enough capital to continue this fight since it is Bernanke who controls the quantity of dollars, and he is choosing, as he always said he would, to create as many as it takes to preserve the financial system. The sums being poured into the financial system are simply huge. Northern Rock alone required £100 billion or roughly 15% of total UK government debt. Such sums are in fact so large that as we have seen this year, the integrity of the currency is questioned. We should be concerned about this because one of the consequences of a fall in the value of a currency, especially for a country heavily dependent on imports of raw materials and energy, is that inflation is imported into the economy.
The extreme case of inflation is Hyperinflation. The main cause of hyperinflation is a massive and rapid increase in the amount of money, which is not supported by growth in the output of goods and services. The result is an imbalance between the supply of and demand for money (including currency and bank deposits), accompanied by a complete loss of confidence in the currency, similar to a bank run. Most of us are familiar with the hyperinflation that was experienced in Germany in the 1920s. In 1923, the rate of inflation hit 3.25 × 106 percent per month (prices double every two days). The most severe known incident of inflation was in Hungary after the end of World War II, peaking at 4.19 × 1016 percent per month (prices double every 15 hours). In such circumstances, currency simply ceases to operate as a store of wealth.
Clearly Bernanke is not going to want to invite Hyperinflation into the economy, but perhaps he is willing to accept a steady reduction in the real value of the dollar through both the exchange rate and retail price index in order to make the unwinding of the credit bubble manageable, it would seem that he is prepared to compromise the dollar rather than risk the real economy. Echo’s of Harold Wilson’s famous “pound in your pocket” speech in 1967; “It does not mean that the pound here in Britain, in your pocket or purse or in your bank, has been devalued."
In the UK, Real interest rates in the 1970s were negative and with the benefit of hindsight, it made perfect sense to borrow as much money as possible and buy property. Provided real interest rates remain below inflation, the credit crisis will unwind as the burden of debt is reduced in the economy. Those with existing debts will see an improvement in their financial position whilst those with savings on deposit, will see the value of their savings reduce. Given that banks are reluctant to lend to each other, it probably won’t be as easy to leverage into the property market this time round. Indeed mortgage rationing is already starting to be a reality for borrowers with little or no deposit. Low interest rates and high inflation will be terrible news for investors and the inflationary lifeboats, as we have seen, are strictly limited.