The Road Ahead

By Tony Allison, May 11, 2009

The road ahead may be a little smoother than the wild ride of the past year, but no one really knows what lies around the next bend. Everything is subject to change, especially in today’s world. Permanent, dogmatic opinions can be hazardous to one’s financial health. But given the unwavering fiscal and monetary policy of our government to re-inflate the economy at all costs, the road is becoming somewhat more visible looking forward.

The US may end up borrowing nearly three trillion dollars this year in its efforts to stimulate the economy, and run a budget deficit in excess of two trillion dollars. Expect interest rates to start ticking higher under this avalanche of supply, despite the quantitative easing. Even more ominous are the overall costs of this stimulus/bailout program thus far. According to data from the Federal Reserve and the Congressional Budget Office, the government has made hard guarantees of $12.9 trillion ($8.2 trillion by the Federal Reserve, $2.7 by the Treasury Dept. and $2.0 trillion by FDIC). Of this $12.9 trillion in government guarantees and spending, only 1.5% is directed toward infrastructure, or just $190 billion. In addition the government has made asset purchases of $2.3 trillion, implicit guarantees of $7.3 trillion to Fannie Mae, Freddie Mac and Ginnie Mae, and “soft” guarantees of $6.6 trillion to the banking system. It all adds up to a cool $29.1 trillion.

Trillions are not billions

For those whose eyes glaze over at large numbers, a trillion dollars is serious money. As I’ve mentioned before, a trillion dollar stack of $1000 bills would reach 69 miles into the darkness of sub-orbital space. Another way to comprehend the number is imagine spending one million dollars every day since the birth of Christ, over 2,000 years, and that only gets you about 3/4 of the way to one trillion dollars. The multiple trillions are too big for most of us to comprehend or understand, which is just fine with the government. Just remember that these trillions must be borrowed or simply printed. As the world’s largest debtor nation, the US (unlike China) has no reserves.

China may lead the global recovery

In its first quarter earnings report, Caterpillar noted the disappointing lack of infrastructure spending.

“We think the impact on total construction spending will be fairly limited. Up to $70 billion could be disbursed in 2009 and that would represent about 6.5% of last year’s total construction spending. The infrastructure portion of the stimulus package was disappointing in that it was less aggressive than other countries and missed an opportunity to correct past underinvestment in US infrastructure. For example, China, with an economy one third the size of the United States, is allocating over three times as much for infrastructure and initial results from this package look promising.”

It appears that China, with its massive reserves and willingness to spend them on productive infrastructure projects, may lead the world back to recovery before the western nations are able to dig themselves out. Chinese stocks have already rallied 41% from the 2008 lows. Of even greater significance, the Chinese government recently admitted to having added approximately 454 metric tons of gold to its reserves, a 75% increase to its holdings since 2003. The Chinese are quietly accumulating a hedge to their 2 trillion in dollar reserves. They are also likely to continue to buy and stockpile base metals and raw materials while they are relatively cheap in dollar terms.

Will the stimulus program work?

While most of us certainly hope that the massive stimulus programs will kick-start our economy on the road back to full recovery, no one can be certain that it will work. In his latest GMO Quarterly Letter, Jeremy Grantham has some thought-provoking opinions on the stimulus program.

“The stimulus program is not based on either persuasive economic theory (if that is not an oxymoron these days) or on solid historical studies; there are simply too few examples and absolutely no controlled experiments, so we are reduced to guesswork. Almost everyone has had the thought that if over-consumption and excessive debt have caused our problems in the US, then pushing rates so low that they practically beg us to borrow and consume some more seems an odd cure.

Yet we all override this thought by saying that because a great majority of dignified economists, although they all disagree on the details, seem to think stimulus is necessary, surely they must collectively have it right. However we in the investment business are blessed by an example that allows us to keep an open mind. The widespread acceptance of rational expectations and the efficient market hypothesis has taught us never to underestimate the ability of the economics establishment to get an idea brutally and expensively wrong.”

Commodities - favorable fundamentals

Given the uncertainties that lie ahead, one should seek out investment sectors where the fundamentals appear favorable. Given the unprecedented stimulus-inspired money creation that will eventually work its way into the global financial system and devalue paper currencies, investors are likely to search out investments with tangible value, such as the commodity sector. In addition, the medium to long-term commodity sector fundamentals certainly seem very positive.

Raw material demand will continue to grow, especially in Asia. There is still powerful structural demand playing out against limited supplies of raw materials that are costly and very time-consuming to locate and bring to market. During this global recession, spending for exploration and development of commodities (especially energy) has been severely curtailed.

At some point down the road, the combination of economic recovery and more than ample liquidity will meet the head-long rush for energy and raw materials. The ensuing price discovery process could get quite frantic. Simply put, the dynamic forces of supply and demand will likely make commodities increasingly attractive, especially in combination with a depreciating dollar.

In a recent interview in Forbes Online, Jim Rogers gives his experienced opinion on the fundamental case for commodities.

“It depends on the supply and demand. And we have had a dearth of supply. Nobody has invested in productive capacity for 25 or 30 years now. The inventories of food are the lowest they have been in 50 years. You have a shortage of farmers even right now because most farmers are old men because it has been such a horrible business for 30 years.

And as for metals, nobody can get a loan to open a mine as you know. Who is going to give you money to open a zinc mine? It takes at least 10 years to open a mine so it’s going to be 15 or 20 years before we see new mines come on. Nobody has been opening mines for 30 years and they are not going to. And in the meantime reserves are declining. As for oil, the International Energy Agency came out recently with a study showing that oil reserves worldwide were declining at the rate of 6% to 7% a year.

This does not mean that if suddenly the US goes bankrupt that everything won’t collapse in price. But I would rather be in commodities because it’s the only thing I know where the fundamentals are improving.”

Energy time bomb is still ticking

The idea that the Obama Administration can successfully tax fossil fuel output with its “cap and trade” plan to pay for clean energy programs (and other government largess) is highly dubious at best. We are in a flat-out race with global oil depletion, and we are currently losing. The International Energy Agency noted that we have to discover the equivalent of a new Kuwait every year in order to keep up with current global oil consumption of 87 million barrels per day. With a global depletion rate now estimated at 9.1% annually by the IEA, our new discoveries are not coming close to keeping up. In addition, trillions of dollars will be necessary to rebuild the rusting infrastructure of the global oil industry. By taxing oil, natural gas and coal production, where are the incentives to go out and find more desperately needed energy?

We are facing an energy crisis within the next decade, as a growing developing world will eventually drive demand well beyond available supply. The “Cap and Trade” plan, while politically attractive, will just lead us into the crisis at a faster pace. In addition, China and India have no plans to tax fossil fuel output, so we are ultimately taxing ourselves into a box, where our cost of energy rises and our options are limited. As I have written about previously, wind and solar make up only a tiny fraction of our energy production today, and nuclear is off the table in Washington. When the inevitable crisis arrives, politicians will be shocked, shocked as the cost of energy skyrockets. They will blame the greedy oil companies and schedule hearings. But they will be years too late to stop the damage.

The next energy crisis seems sadly inevitable, but may still be a number of years down the road with a little luck. Given this scenario plays out, it would make sense to invest in world-class energy companies when the price of oil is still at recession levels.

Follow the profits

Once again, there are no “sure things” in today’s highly volatile and uncertain world. But one should at least focus on areas with positive fundamentals. Given the prospects for a de-leveraging, risk-averse US economy in the foreseeable future, I would suspect that the fundamentals for banking, housing, autos, airlines and retail will be less than stellar in the next few years. As the US continues to print money in excess and the dollar depreciates, those companies in the commodity sector should benefit and remain profitable as commodity prices rise. Profits may be harder to find in other areas of our economy on the road directly ahead.

Beware the “financial-industrial complex”

Let me end with a cautionary note from Jeremy Grantham. He makes the case that the world would not have come to an end if some of our major banks had failed. Moreover, the ensuing environment may have cleansed our system more effectively than our current hyper-stimulus approach.

“If we had let all the reckless bankers go out of business, we would not have blown up our houses or our factories, or carted off our machine tools to Russia, nor would we have machine gunned any of our educated workforce, even our bankers! When the smoke had cleared, those with money would have bought up the bankrupt assets at cents on the dollar and we would have had a sharp recovery in the economy. Moral hazard would have been crushed, lessons learned for a generation or two, and assets would be in stronger, more efficient hands. Debt is accounting, not reality. Real economies are much more resilient than they are given credit for. We allow ourselves to be terrified by the “financial-industrial complex” as Eisenhower might have said, much to their advantage.”

Today’s Markets

Stocks fell on Monday, weighed by profit taking after a two-month climb and news of several banks' share offerings that cooled interest in the financial sector. The Nasdaq was slightly lower as buying of big-cap software makers' shares helped offset profit-taking.

The Dow Jones Industrial Average fell 155.88 to close at 8418.77. The S&P 500 Index was down 19.99 to close at 909.24. The Nasdaq also closed lower, ending at 1731.24, down 7.76.

Crude oil for June delivery ended down 13 cents, or 0.2%, to $58.50 a barrel on the New York Mercantile Exchange, taking back some ground after having fallen more than 3% to $56.78 earlier. The contract ended at $58.63 on Friday, the highest closing price for a front-month contract since Nov. 11, 2008. Crude rallied more than 10% last week despite government data that showed U.S. inventories at their highest level since September 1990.

Gold for June fell $1.40, or 0.2%, to $913.50 an ounce, after rising 3% last week. Gold had risen last week as the U.S. dollar moved lower and as investors bought the precious metal on worries that central banks' effort to pump liquidity into the market could raise inflation in the long term.

Wishing you a good evening,

Tony Allison

Contact Information

Tony Allison, Registered Representative
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