Stagflation - the financial pandemic

A fundamental shift is underway in capital markets. Capital risks are now being fully factored into decisions by traders around the world, effectively for the first time since 2001.

The bottom line is that, should you decide to stay long, without protecting the majority of your holdings, your portfolio is going to suffer a debilitating, even life-threatening, virus in the next few months.

Why, to start the 4Q2005, are we in this predicament?

Well, it's a story that goes back to 2001. In order to shore up investor confidence after the 9/11 crisis, including the economic slowdown that followed, the Federal Reserve Bank set loose monetary policies. With adequate funds in the system and record low interest rates, the real estate industry thrived from that point forward.

That so-called wealth effect, of course, led to an enormous increase in debt by individuals.

Shortly thereafter, the U.S. Administration embarked on costly war initiatives in Afghanistan and Iraq, which drove the government debt to record levels.

It really is the most basic of economic principles that in every business cycle there must be a balance in the growth of debt and what I call productive assets, in order to sustain economic growth with acceptable levels of inflation.

But that situation has not happened.

In wartime, any asset growth happens to be in intangibles (e.g., future peace) because there is no economic return from the bombs and the fighting soldiers and so forth. War, in fact, is the primary cause of inflation.

When the world is not at war, the economy is always disinflationary, which simply means that real wealth is being created at a faster rate than inflation.

Getting back to the real estate market, which is an international phenomenon, had the unit growth been in the industrial-commercial segment rather than the residential segment, there may have been satisfactory economic returns. A stronger economy would have caused that result.

The problem, of course, is that non-industrial-commercial, i.e., residential, markets are ones that people buy homes to mostly live in, where there is no economic return.

And the problem with this business cycle is that the rental real estate market is paying uneconomic returns. That is to say that a five or six percent cost of capital to buy those homes has been returning two to four percent, which is a losing proposition.

Then why has there been a strong rental residential real estate market?

That's easy; the owners are counting on price inflation.

And the renters who are chasing higher rents are the ones pushing wage inflation. That's because, in addition to rising rents, the consumer is paying inflated costs of energy, and property taxes, and other living expenses and so forth.

So when you have governments and consumers that have reached their borrowing limits, in terms of their ability to service debts they took on in recent years, other purchasing decisions are impacted. That is what is happening today, and the net effect is that once-healthy and robust corporate earnings are now in danger of stagnating or even falling in some industries.

The U.S. Fed needs to raise rates to stave off inflation, which has already surpassed the Fed's upper limits of tolerance, which are similar to the central banks elsewhere. But in order to bring about that result, the Fed has to sell treasury securities. That takes money out of the system, typically from the banks and brokers of America, which raises rates, as you know.

The fly in the ointment, however, has been the People's Bank of China, because every time the Fed issues paper, China buys it.

That keeps rates low, and it also keeps America's banks and brokers flush.

And of course, America's house construction industry has been happy because low mortgage rates, and plentiful mortgage money means lots of house buying, which is what I stated earlier is a key driver (along with the war effort) of inflation.

What China is doing with their massively growing holdings of U.S. debt obligations is to use the paper as collateral on loans, which the country needs and has been using to grow their economy. China has in effect been playing the cross-border carry trade.

So, how can that situation continue unless China can exhibit "a balance in the growth of debt and what I call productive assets"? It usually can't.

Here's the rub. China has even more inflation than the U.S. Yes, assets are growing at 9 pct annual levels in China, but the debts are growing even faster. Real estate in Shanghai today is like Tokyo before its crash about 20 years ago.

And the equity market and the bond market in China are, for the most part, failing in the last year or two.

If you doubt me, compare the Shanghai index to the Nikkei or the Toronto Index or the indices in Brazil, Russia, and many other countries.

So, what really is the problem here? The answer is simply in the word "conundrum" as expressed by Alan Greenspan, which is to say that China's monetary policies have been unfair to the rest of the world in that the PBC never had to pay the price of inflation, which is a falling currency.

Yes, China simply pegged their Renminbi or Yuan to the USD.

Can they do that? The short answer is yes, they have been, but only until the rest of the world wakes up to the reality that the capital risks in China, such as a blow-up like that of Japan, Russia, Brazil, Argentina, Mexico, etc, etc, increase significantly every day.

Unfortunately for all of us, if the China capital market collapses in the near future, that country ceases to be a key engine of economic growth. The PBC will have to stop buying U.S. debt instruments. Worse, they will have to flood the market with their current holdings.

What happens then? Interest rates will soar, the global real estate speculation will terminate abruptly, and the world will be facing a financial crisis.

Is this possible, you ask? Do you have the dates October 14-16 marked on your calendar? That's the date that Zhou Xiaochuan, Governor, People's Bank of China, and Chairman, PBC Monetary Policy Committee, will meet with U.S. Treasury Secretary John Snow and Fed Chairman, Alan Greenspan, in Beijing.

In addition, all of the G-20 central bankers and finance ministers will be there to address this problem.

Foreign exchange imbalance is the world's biggest problem, and these are the people who effectively hold control of the fate of global capital markets at this point in time.

Unfortunately, the China economic and monetary policies have brought about a condition in much of the world known as stagflation, where the stock cycle de-links from the business cycle.

The German economy, the British, the French, the Italian and the Japanese, are all in trouble. I define "trouble" as 1-percent growth or less in the GDP.

Aha, you say, America is clicking along at about 3.5 percent or higher, and the U.S. is the main engine of global growth. Some even talk about 5 percent growth had Hurricanes Katrina and Rita not been so devastating.

Unfortunately, in addition to weather storms, the U.S. is fighting wars, so that high 3.5-5.0 number is a myth.

Earnings through this period in the U.S. are not something you can respect. Factors like inflation (PPI and CPI) and company share buy-backs cause higher numbers and the appearance of a stronger business cycle than exists.

Starting today, the 3rd quarter earnings season is upon us. Analysts and traders are concerned - if not outright worried - that earnings will disappoint, both as to the failure to meet growth expectations as well as the built-in inflation component.

Equity markets started falling last week: The S&P 500 down -2.6 percent, the Nasdaq down -2.9 percent, Canada down -5.2 percent, the U.K. down -2.2 percent, and Japan down -3.5 percent. For weekly numbers, this represents a universally bad performance.

At the same time, the bond market has also suffered, and yields started to rise quickly.

The fact is no one knows with certainty how far the capital markets are going to move in the next year. But I am reasonably confident that the technical indicators in the many charts I follow are telling us that the direction is down, for stocks as well as bonds.

The S&P (1195) has minimal support at 1175, with the possible floor being 1100. The Dow (10292) has minimal support at 9800, with a possible floor being 9200.

And, depending on decisions to be made between China-U.S. monetary authorities this month and shortly after, the Dow 30 index could even drop to 8400 (approx start of current bull market) or possibly 7800 (levels seen right after 9/11/01 crisis).

Financial assets are failing, real estate is on the bubble, and gold, the best hedge, is rising.

Therefore, I must conclude that due to the anticipated major weakness for both stocks and bonds in the weeks ahead, a very defensive 80-percent cash weighting ought to be considered for most portfolios.

For the 20-percent long position, I would stick to the best quality income (or royalty) trusts in the energy field for say eight percent plus the best quality goldminer stocks, or the TSX goldminer exchange traded fund (XGD) for another eight percent. The balance (about four percent) should be diversified into some of the high quality consumer staples and healthcare stocks that have relatively very low PE multiples.

And the key to my future plans to become aggressive (i.e., to start to put cash to work) would be to watch the common stock of Wal-Mart and, to a much lesser extent, its two or three largest European competitors.

Until the problems with the Yuan-USD are resolved, I don't think we have seen the bottom for WMT.

All in all, this is a very negative report, but that's the nature of stagflation, which, you should be aware, is a killer virus for stocks and bonds.

Soon, people may be calling it a pandemic.