For the past two years I have mentioned a bubble will form in an asset class. I was not sure which asset class, but I suspected basic materials and agricultural commodities. I believe I have identified the next bubble to be imploded: the United States Debt. A $1.5 trillion deficit for the next annual budget is unsustainable. A storm is coming! An enormous financial storm that has the potential to change our way of life forever; a tsunami to clean the slate and re-balance the economy! Some things have already brutally corrected such as the Real Estate Market in the Sand States. Some are going to like the soft commodities such as cotton. Nothing will ever be the same again. There are decisions to be made, choices to make, plans to formulate. It is not time to be scared; it is time to be prepared! It is time to implement inflation protection.
The economy is slowing quickly and signs are mounting that deflation of assets, both financial and some commodity assets may be underway. As I have mentioned previously, bad to toxic commercial paper held by many financial institution was transferred to the balance sheet of the Federal Reserve, the FDIC, the Treasury, or absorbed by other government sponsored entities such as Fannie Mae (OTC: FNMA.OB) or Freddie Mac (OTC: FMCC.OB). These bad assets coupled with ballooning entitlement programs, especially those targeted to an aging population, have produced an untenable situation which probably will resolve itself soon and unpleasantly. There are only two paths: Default or Re-Organization of the debt, which may be accomplished under different scenarios, none of them pleasant. Or a globally orchestrated attempt to devalue further the U.S. Dollar and inflate the value of all hard assets and re-pay old debt with much cheaper, probably extremely cheaper, dollars.
The raising of the debt ceiling has bought the US some time, about 12 months and counting. The projections for repayment include a growing economy of close to 3% GDP, robust employment adding jobs and higher tax revenue; these rosy projections likely will not be met. There are many possible catalysts capable of initiating a decline, ranging from a sovereign default in the Euro Zone to an attempt to replace the US Dollar as the reserve currency of the world, or simply by the slowing of the business cycle, which is currently underway. With the economy vulnerable to an economic or political shock, growth is slowing perceptively and government growth projections are certainly suspect. As the economy slows or worse, sustains a shock, prices on the world market will tumble dramatically. The worldwide recovery has been very beneficial to commodities; prices of iron ore, copper, coal, oil, natural gas, cotton, and sugar have all soared over the last three years as well as many industries related to them including pipelines, railroads, and heavy equipment makers to name a few.
These industries will experience hardship as supplies increase due to lessening demand, and as prices that had so reliably risen begin to fall. Income vehicles that derive their dividends from the sale of commodities such as Natural Gas, Oil, Coal, the Master Limited Partnerships, will suffer both price and income corrections. This decline will spread and perhaps feed on itself causing risk assets to decline precipitously. As the commodity markets decline, the Dow, S&P, and Nasdaq will also drop, affecting the spending habits of most of the population spreading from a financial correction to an economic correction; a recession or worse will be underway. As risk avoidance accelerates, the asset class that will benefit most, contrary to many current pundits, will be the US Dollar and long-term US Treasuries. Long bonds will not only deliver dependable income, but rise in value; Agency, Mortgage-Backed, Municipal (both insured and uninsured) will suffer as state and local government revenues drop jeopardizing payment of their obligations and as the ability of the insurance companies to cover losses is questioned. The federal government will have limited ability to rescue cash strapped states, counties, and cities, and jobs will be at risk again.
The coming slowdown will be evident soon. As the economy slows, the US Dollar will rise, exacerbating the decline in commodities as prices are expressed in dollars; and risk assets and asset-backed currencies such as the Australian and Canadian Dollar lose value due to slackening demand for their mineral and forest products. U.S. bonds especially long term securities will initially benefit tremendously as the markets perceive Treasuries as a “Safe Harbor”. Negatively correlated ETF's will soar in value as the stock markets suffer on reduced earnings estimates; a recession is probable with global implications.
Past economic slowdowns have been blunted and a few times averted by Federal Reserve and US Treasury action: reducing interest rates and expanding the balance sheet. This will be vastly different as rates are already as low as they can possibly go; while the dollar is the reserve currency of the world, the Fed can print money and buy US Treasuries; the current deficit will curtail the ability of the US Government to add stimulus and lower taxes as revenues from taxes will be dramatically reduced. Government spending will be limited and possibly reduced further curtailing economic activity. The debt will become extremely burdensome as government revenues are earmarked for interest repayment and entitlement programs. The usual remedy of deficit spending to spark the economy will not be available as the worldwide slowdown diminishes the Emerging Markets’ surplus cash flow that has been used to fuel the US debt binge. The Federal Reserve will become the last defense of the economy and will print more money and add more debt. Deflation should result with the ensuing decline in most asset classes. As wealth evaporates and debt becomes extremely burdensome, governments across the world will hold coordinated meetings in an attempt to address the financial crisis.
Bondholders BEWARE; this will be a SIGNPOST to sell and take the enormous profits that have probably been made and re-position a portion in gold. There will probably be an attempt to restructure all of the debt, first addressing sovereign debt held by nations across the globe; the trillions of dollars held by China and Japan may be repaid or restructured at 20-30% of value. The Federal Reserve balance sheet of printed money may be completely eliminated, and the toxic debt held by Fannie Mae and Freddie Mac will be at risk of severe discount as their status as a government entity is attacked and their debt repudiated. Likewise municipalities will attempt to restructure to sustainable levels. Havoc will ensue!
Should the US attempt to re-structure debt, the status as the World's Reserve Currency will be jeopardized and perhaps lost. There will be talk of a world currency and a World Central Bank. If commodity prices were to be expressed in Yuan or the Euro, then virtually all goods in the US will skyrocket as our currency devalues. Without the status as the reserve currency, almost everything manufactured will become much more expensive; the once mighty manufacturing base of the US is now offshore. Wheat and corn, livestock, vegetables, and all prepared foods will jump in price; a one dollar menu is not the same as a one euro menu.
This possible scenario comes with the possibility to profit handsomely. The initial stages will require the identification of the tipping point in the economy. The decision to become defensive is easy by reducing or eliminating security positions to a basically cash position. To become pro-active is much more difficult; recovery rallies might be viewed as an opportunity to add to short positions and accumulate long term US Bonds. If a recession becomes obvious, commodity securities will become cheap for a short period of time. MLPs will yield double-digit dividends. This would become an opportunity as much higher food and energy prices would be just around the corner. Rates would bottom and long-term bonds will have reaped enormous profits, and could be sold to redeploy the capital in the commodity sector.
Precious metals have risen over 700% and are still rising. Perhaps the markets are telegraphing worsening currency conditions or future inflationary expectations. This market may correct some, however, the depressed Real Estate Market will offer tremendous opportunity. Strategic Real Estate offers an income stream to combat deflation, an income stream which is much higher than money market or bond funds, while also offering a tremendous hedge against the equally possible scenario of runaway inflation caused by crisis driven governments pouring liquidity into the markets to stave off an economic collapse. The downside risk to Strategic Real Estate has already been mitigated as this asset class has been deflated and hugely discounted. Further, a steady source of long term tenants is assured as the economy declines and underwater and foreclosed properties are liquidated. In a risk adverse financing environment, new construction projects will be curtailed, further restricting the supply and driving rental demand. With looming economic problems, the burden of over-encumbered “underwater properties” or non-cash flowing real estate need to be liquidated.....NOW!
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