The Global Economy

In 2008, the economic crash that I had been predicting for much of the past decade, and that was described in detail in my 2007 book Crash Proof, finally began in earnest. The fallout in the financial markets has thus far been enormous.

Stock markets around the world are off nearly 50% from their 2007 highs. The credit markets have mostly frozen. The U.S. financial services industry is a shadow of its former self, causing severe disruptions in the operations of the global financial infrastructure. Losses on mortgaged-backed securities and other debt products tied to U.S. consumers have blown gaping holes in the balance sheets of the largest banks worldwide and have even bankrupted entire countries. Unfortunately, the pain is far from over. In fact, it is likely just beginning.

We are currently experiencing the rumblings of a global economic realignment which reflects the realities of wealth creation and dissipation that have evolved over the past three decades. Although most modern economists are completely unaware, wealth is created through savings, investment, and production. Wealth is destroyed by borrowing for uneconomic purposes and by spending on goods and services that produce no long-term benefit.

Living standards are supposed to rise where wealth is produced and to dissipate where it is destroyed. Like gravity, these forces can only be overcome through tremendous effort. The accumulation of trillions of dollars in U.S. budget and trade deficits, and a corresponding swell in foreign exchange reserves held by Asian central banks, have been the mechanisms which have, thus far, maintained the status quo. But, given the dangerous imbalances these policies create, the global commitment cannot endure perpetually.

The crisis had its roots in the easy monetary policies pursued by the Alan Greenspan-led Federal Reserve, and the strategic decisions of the Asian governments to support the value of the dollar through unlimited lending to the United States. The result was a massive misallocation of resources that inflated bubbles in the U.S. housing and equities markets.

An economic realignment that reflects underlying economic realities will gain momentum in the coming years. I feel strongly that investors who recognize this trend have the ability to position their portfolios in order to maintain their wealth.

The U.S. Economy

As I wrote in Crash Proof, the deleveraging that would result from the bursting of the U.S. real estate and credit market bubbles would not be the cause, but the result, of America's economic collapse. In fact, these violent episodes, however painful, would finally put our economy back on track after years of reliance on credit-driven consumer spending. But what I feared then, and what is even more obvious now, is that the federal government would completely misread the situation and propose "solutions" that would hamstring the free markets, re-inflate the collapsed bubbles, and completely subvert whatever economic vitality remains. The Obama Administration seems intent on forcing our economy back onto the same track that led us to stagnation.

Large swaths of the American economy are headed for bankruptcy and would, in fact, already be bankrupt if not for massive government life-support. However, the public and press do not seem to register that the American government itself is already hopelessly in debt and has no prospect of legitimately raising the funds it is currently showering on the economy. For now, America remains afloat largely because our foreign creditors continue to lend to us. We believe their largesse will be exhausted in the not-too-distant future.

The bursting of the housing bubble, the largest speculative mania in American history, has created many trillions of dollars of real losses for which we need to account before our economy can recover. For political expedience, the Federal Reserve, Congress, and the President are trying to delay this reckoning.

To reconstruct the collapsed credit and housing markets, their tools of choice are bailouts, stimuli, tax cuts, deficit spending, and inflation. They are chasing phantoms. Just as FDR's New Deal prolonged and deepened the Depression, the current efforts will magnify the severity of the current downturn and make the ultimate contraction that much worse.

Unfortunately, the most probable outcome is an inflationary depression, which could be more painful than the Great Depression. At that time, the burdens of unemployment and financial losses were at least offset by falling consumer prices. The worst case scenario this time, the odds of which seem to be increasing daily, involves a period of a hyper-inflation which could render the U.S. dollar, and all U.S. dollar-denominated assets, practically worthless. Extreme financial, political, and social unrest would surely follow. As a result, we recommend complete divestment of dollar-based assets for our clients.

The above forecasts are made with much regret, as we realize that they foretell significant hardships for millions of our fellow Americans. However, it is our mission to caution as many of our countrymen as possible about the fate that we foresee. In fact, we feel that it is our patriotic duty to help as many Americans as possible to safely protect their wealth though the acquisition of foreign assets. We believe that it is only through such actions that at least some Americans will retain ownership of their financial wealth, which may be repatriated in the aftermath of the collapse.

We remain hopeful that dire economic conditions will, at least, create a climate in which America can finally return to her constitutional traditions of sound money and limited government, providing a foundation upon which a stronger economy can one day be rebuilt. If out of the ashes of this collapse, the spirits of our founding fathers can rise again, it may one day be possible for America to reclaim her former glory, and once again be that shining city of which Ronald Reagan so eloquently spoke.

The U.S. Dollar

Without question, 2008 saw one of the most unexpected rallies in the history of the U.S. dollar. After steadily drifting downward for much of the last decade, and losing more than a third of its value in the process, the U.S. dollar reacted to the sudden credit crisis in the first quarter of 2008 by staging a stunning rally in which all of its losses of the prior five years were erased.

However, we feel that this rally, which largely fizzled out in the first quarter of 2009, is solely based on fear, not fundamentals. Investors around the world reacted to the financial crisis, sparked by the bursting of the housing and credit bubbles in the U.S., by fearfully scrambling for "safe haven" investments. To a large extent, they chose U.S. Treasuries. The resulting fund flows pushed up the value of the dollar by more than 25%. We feel that this trend will reverse in the near-to-medium term, when foreign investors come to understand the relative safety of their home markets and the danger of hyper-inflation in the U.S.

U.S. Residential Real Estate

Throughout the middle years of this decade, my dire forecasts for the collapse of the housing and credit markets attracted derision and dismissal. In retrospect, it is astounding that the belief in perpetually rising real estate prices could become so completely ingrained in the American psyche. This unexamined doctrine, so assuredly argued by politicians and Wall Street economists, created the conditions by which tens of trillions of dollars were loaned without the slightest regard for risk. These loans, in turn, became the catalyst for the collapse of a structurally weak economy.

As I had so often predicted, home prices have not merely fallen, but have plummeted. As of March 2009, national home prices are off more than 30% from their 2006 peaks. In some markets, the declines exceed 50%. Washington is now struggling to reflate the bubble through a combination of incentives for home buyers and lenders. Once again, it won't work. Based on analysis of long-term home price trends, fundamental cost analysis, and the realities of excess home inventory and credit availability, we believe that home prices still have far to fall.

The housing industry had become a bulwark of the American economy. Home building, selling, financing, and remodeling created much of the job growth of the past decade. Now that the market has collapsed, so too have those industries. Those jobs will not come back, but will instead migrate to more productive areas of the U.S. economy.

U.S. Stocks

Despite a 50% decline in the U.S. equities markets since the end of 2007, we believe that U.S. stocks remain substantially overvalued given the likely declines in earnings that have yet to be realized by U.S. corporations. As such, we are bearish on the broad U.S. stock market and only find value in certain carefully selected U.S. equities: those companies that are export-oriented and/or commodities-based, primarily in the mining and energy sectors.

Although the nominal declines in U.S. stocks may be arrested by the ongoing bailouts and stimuli, the real value of the assets will nonetheless decline with the resulting inflation. This phenomenon will confuse lay investors, and probably most pundits, into believing that a recovery is underway. Our analysts will be indexing any nominal recovery against realistic inflation figures to make investment decisions based upon real economic trends.

U.S. Bonds

In 2008, U.S. government bonds were the best performing asset class on the planet. That rally has continued into 2009. However, we feel that the continued accumulation of U.S. government debt, primarily by foreign central banks, represents the largest and most dangerous asset bubble that we have yet encountered. Given the absolute impossibility that the federal government can repay these debts through any means beside the printing press, it is a certainty that government bonds, which currently offer yields approaching zero, will lose purchasing power before they mature. We believe that the bonds are currently being purchased for political rather than financial motives. These motives can and will change. When they do, the bottom will fall out of the Treasury market, causing a spike in interest rates and a collapse of the dollar.

We also believe that the coming recession will be as severe as anything since the Great Depression, perhaps more so. As a result, defaults by U.S. corporations will increase dramatically. Similarly, U.S. municipalities, whose abilities to raise revenues are dependent on residential property taxes, will also see a wave of defaults.

For these reasons, we recommend that investors maintain minimum exposure to any long-term dollar-based debt instruments, be they treasury, municipal, or corporate. Those holding U.S. dollar-denominated debt instruments should restrict ownership to only the highest-quality short-term maturities. Even those high income investors seeking tax-favored yields are cautioned that avoiding the inflation tax, which stealthily confiscates principal, is more important than avoiding mere taxes on income.

Gold

In a world in which fiat money-substitutes are continually debased by governments around the world, we believe that gold remains the most honest and accountable form of money. When financial uncertainty abounds, it becomes increasingly important to hold assets with value that cannot be diluted by government monetary policy. Gold has been chosen as a store of value and unit of exchange since the dawn of civilization due to its inherent properties: rarity, durability, fungibility, divisibility, and portability.

Ultimately, as the current crisis runs its course, the value of a gold-based monetary system may once again gain favor with productive nations looking to safeguard the value of their savings. In such a scenario, gold would spike in value as central banks became net-acquirers of gold, rather than net-sellers.

Gold appreciated steadily for most of the current decade, ultimately breaking $1,000 per ounce in March 2008. Although prices pulled back by as much as 20% later in the year, gold qualified as one of the best asset classes for 2008. We believe that gold is still in the early stages of a secular bull market. Conservative investors are advised to have a portion of their savings allocated to physical bullion, while speculative investors are advised to own shares of carefully selected mining companies, both domestic and international.

Commodities

Commodities such as metals, grains, and crude oil were driven up relentlessly for much of the past decade due to continued dollar debasement by the Fed and increasing demand for raw materials by the industrializing Asian economies. However, the financial crisis of 2008 fell most heavily on commodity prices, which saw violent price corrections. In many cases, price declines reflected a belief by investors that the global economy would enter a protracted depression which would eliminate demand for commodities. We disagree.

We do not believe that industrialization in Asia will be significantly impaired by the stagnation of the American consumer economy. As a result, we believe that demand for industrial metals, agricultural commodities, and energy staples will push prices back up. For investors, this upward movement will be magnified by foreign exchange benefits as the U.S. dollar loses relative strength against Asian currencies.

Like gold, we believe that commodities in general are still in a major long-term bull market. Therefore, conservative and aggressive investors should seek out respectively appropriate ways to gain exposure to this sector.

Foreign Stocks

As was the case for U.S. equities, global stock markets experienced significant sell-offs in 2008, in some cases outpacing losses seen by the S&P 500. However, despite the precipitous decline in share value, foreign firms show fewer signs of fundamental distress than similarly situated American companies. Although foreign firms which relied heavily upon the debt markets to fund continued operations suffered grievously as credit markets froze, the majority of companies continued to show good earnings

Combined with the recent declines in local currencies relative to the dollar, we believe that there now exists an exceptional opportunity to invest in carefully selected foreign equities, particularly those that have minimal exposure to U.S consumers or the American economy. In many cases valuations are low, yields are high, and the prospect of earnings growth is favorable. We believe that foreign stock is one of the few asset classes that offers dependable protection from declines in the U.S. dollar.

Foreign Bonds

Given our bearish outlook for the dollar, bond investors should concentrate their holdings in instruments denominated in select foreign currencies. However, given our global outlook of higher interest rates and rising inflation, shorter maturities are still preferable. Due to current U.S. tax law, we advise those seeking conservative, income-generating investments to concentrate on holding high-dividend paying foreign real estate trusts, utilities, energy trusts, and natural resource-based companies.

Where We Stood

To get a sense of the accuracy of our market predictions over time, please take a look at how we analyzed financial conditions before the economic collapse became a matter of history rather than conjecture. The outlook below occupied the "Where We Stand" portion of the Euro Pacific Website from mid-2004 through the beginning of 2009.

U.S. Stocks

We believe that in general U.S. equities remain substantially over-valued, and that despite nominal new highs for some popular stock market averages, they remain in long-term secular bear markets when adjusted for inflation. As such we are bearish on the broad U.S. stock market, and only find value in certain carefully selected U.S. equities, generally those companies that are export oriented and/or commodities based, including mining and oil and gas.

U.S. Bonds

We believe that the U.S. bond market is in the process of forming a significant top, in what has been a major long-term bull market. Once completed, we expect bond prices to collapse. Given the highly unfavorable long-term risk reward situation, we recommend that investors maintain minimum exposure to any long-term debt instruments, be they treasury, municipal, or corporate. Those holding U.S. dollar denominated debt instruments should restrict ownership to only the highest quality, short-term maturities. Even those high income investors seeking tax-favored yields are cautioned that avoiding the inflation tax, which stealthily confiscates principal, is more important than avoiding taxes on mere income.

U.S. Residential Real Estate

If it looks like a bubble, walks like a bubble, and quacks like a bubble, it's a bubble. The combination of artificially low interest rates, foreign central bank intervention, an irresponsible Fed, excessive credit availability, the proliferation of low or no-down payment, adjustable-rate, interest-only, and negative-amortization mortgages, a can't-lose attitude among speculators, validated by ever rising "comps," the complete abandonment of lending standards, wide-spread corruption in the appraisal industry, rampant fraud among sub-prime lenders, and the moral hazards associated with loan originators re-selling loans to buyers of securitized products who perceive minimal risk and an implied government guarantee, has produced the "mother of all bubbles." When it finally bursts, it's not just real estate speculators and home owners who will suffer, but the entire U.S. economy, its banking and financial systems, and anyone with U.S. dollar denominated savings.

The U.S. Dollar

We believe the U.S. dollar is in a major long-term bear market, and as such recommend keeping exposure to the dollar at an absolute minimum. All long-term savings and investments should be denominated in select foreign currencies against which we believe the dollar is likely to fare the worst.

Gold

We believe that Gold is in the early stages of a new, secular bull market. Conservative investors are advised to have a portion of their savings allocated to physical bullion, while speculative investors are advised to own shares of carefully selected mining companies, both domestic and international.

Commodities

Like gold, we believe that commodities in general are in the early stages of a new bull market, and that conservative and aggressive investors should seek out appropriate ways to gain exposure to this sector.

Foreign Stocks

We believe that unique opportunities exist in many carefully selected foreign equities, particularly those that have minimal exposure to the United States, and are in no way related to U.S consumers, financial services, or technology. Many foreign markets are counter-cyclical to the U.S., and have recently emerged from long-term bear markets. In many cases valuations are low, yields are high, and prospects for earnings growth are favorable.

Foreign Bonds

Given our bearish outlook for the dollar, bond investors should concentrate their holdings in instruments denominated in select foreign currencies. However, given our global outlook for higher interest rates and rising inflation, shorter maturities are preferable. However, given current U.S. tax law, we believe that those seeking conservative, income generating investments should concentrate on high dividend paying, carefully selected foreign property stocks, utilities, energy trusts, and natural resource based companies.

The U.S. Economy

We believe that the growing imbalances in the U.S. economy, its twin budget and current account deficits, its lack of domestic savings, and the erosion of its industrial base, have now reached a point where a severe recession, culminating in a substantial decline in the over-all American standard of living, is imminent. The Federal Reserve, Congress, and the President, for political expedience, are likely to continue seeking to delay this adjustment, unfortunately in ways which will exacerbate its severity, making the inevitable recession that much worse, and increasing the probability of a hyper-inflationary outcome, which would render the U.S. dollar, and all U.S. dollar denominated financial assets, practically worthless in terms of real purchasing power, potentially creating a situation of extreme financial, political, and social unrest.

The above forecasts are made with much regret, as we realize that they foretell significant hardships for millions of our fellow Americans. However, it is our mission to caution as many of our countrymen as possible from suffering the fate that we foresee. In fact, we feel that it is our patriotic duty to help as many Americans as possible to attempt to safely protect their wealth though the acquisition of foreign assets. We believe that it is only through such actions that at least some Americans will retain ownership of financial wealth which may be repatriated in the aftermath of the collapse. We remain hopeful that dire economic conditions will at least create a climate in which America can finally return to her constitutional traditions of sound money and limited government, providing a foundation upon which a sounder economy can one day be rebuilt. If out of the ashes of this collapse, the spirits of our founding fathers can rise again, it may one day be possible for America to reclaim her former glory, and once again be that shining city of which Ronald Reagan so eloquently spoke.