With a Gloomy Start to 2016, a Bust Seems just Around the Corner
Markets have corrected substantially since the beginning of the year as most of the gains of the past two years have been erased. According to Bloomberg, 40 out of the largest 63 markets have dropped over 20%. The image below shows the performance of markets word-wide since their most recent peaks. Most markets are in a bear market phase or are at best experiencing a strong correction. The world is red!
Where do global markets stand?
A heat map of global stock markets by Bloomberg – click to enlarge.
China’s economy is slowing down and oil prices have slumped to a new multi-year low. Is this the bust phase of the cycle that started in 2008? In our ‘Clean Slate’ report about Austrian Business Cycle Theory, we explained that there appear to be short-term cycles in operation, which last approximately 7 years, but also long-term cycles with a duration of around 50 years.
Those familiar with the bible are aware of the term “jubilee”, which signifies the end of a 50-year long-term debt cycle, when all outstanding debts are annulled and slaves are freed. But before the “jubilee” of our time happens, things are likely to get worse. Governments are apt to take measures that will constrain our liberties further. Their objective is to maintain an artificially centralized system by force – however, eventually this system will fall apart.
Past recessions, such as the oil shock of 1973, the double-dip recession of 1980-81, the stock market crash in 1987, the bond market crash in 1994, the dot-com bubble’s demise in 2001 or the 2008 financial crisis were all busts operating within short-term cycles. We believe that we are approaching the end of the current 7-year cycle.
In a report we published at the end of 2014, we expected a sharp correction in equities (and other inflated assets) within two-to-three years, and it appears we may have been right. Although we have reason to believe that we will not witness a hard landing of international markets in 2016, we are convinced that the bust of our current money-printing induced cycle will come very soon.
China’s Slowdown is no Surprise
Many believe a slump in China’s economy will be the start of a chain reaction that will take the world into the next global recession. Global investor Felix Zulauf believes that the slowdown in China will present a threat similar to the sub-prime mortgage crisis in the last financial crisis. One can imagine the potential global impact of such an event.
The emerging crisis in China is a logical consequence of the long boom of the past 20 years. In 2010 China registered GDP growth of 10.4%. Only a couple of years later this growth rate has deteriorated to an estimated 6.9%. We don’t necessarily believe in government statistics – especially those provided by China – and we assume that the growth rate is in reality much lower.
The problem is not the deceleration itself, but the reason for the deceleration: the boom was not characterized by consumer demand growth, but rather by investment growth. Many of these investments wouldn’t have been undertaken without debt accumulation and an expansionary monetary policy. The chart below shows the exponential growth of the money supply and bank lending in China.
Growth of China’s broad money supply aggregate M2 and bank loans since 2001 – click to enlarge.
It was Chinese investment (50% of GDP) and rather than consumption (40% of GDP), which has driven this lengthy, enormous boom. The Chinese invested in excess: excess real estate, excess infrastructure construction and excess manufacturing. Real estate-related activity, including related industries such as steel, cement, etc. represents 25-30% of GDP!
The erection of all this overcapacity went hand in hand with staggering credit growth. China’s policymakers have set a credit bubble in motion with the overall debt-to-GDP ratio estimated to have climbed to more than 240% in 2015 from a mere 160% in 2007.
China’s astonishing debt binge
The recent slowdown will have consequences for both China’s domestic market and the world at large. A recession or massively lower growth rates and a halt in industrial development appear likely in China. Against the backdrop of a weaker renminbi, imports to China will decline while Chinese exports will become cheaper.
International markets will be challenged by cheap Chinese exports. More problematic though are capital outflows: China’s total capital outflows have climbed to USD 1 trillion in 2015, a number that is growing along with negative investor sentiment on the Chinese economy. China’s government is trying to support its currency by deploying its foreign exchange reserves, which have dropped to USD 3.23 trillion, according to Bloomberg the first annual decline recorded since 1992.
This creates the threat of China “exporting deflation”. A particularly strong impact on already heavily indebted economies such as the U.S., Europe and Japan would have to be expected. We believe that central banks will fight price deflation by any means possible. Central banks, including the Fed, are therefore likely to keep interest rates low, or may increasingly resort to imposing negative interest rates.
Yes, we all should be concerned – but we definitely should not be surprised. As Steen Jakobsen has put it:
“China is the easy scapegoat, but seriously if anyone is surprised about China’s growth slow-down and its needs to buy time for changing its economic mix-up, they need their school money back.”
China’s slowdown is just confirming what should be obvious: bubbles driven by credit expansion are bound to burst.
The Decline in Oil Prices may be More Meaningful than Previously Thought
The world is also concerned about a major industrial commodity: crude oil. The oil price recently broke briefly below USD 30, to the lowest level in more than a decade. Everyone is wondering what this means, and whether the price will go even lower. According to former Congressman and freedom activist, Dr. Ron Paul, the slump in oil prices has major implications for the international economy. It signifies the end of an era – a potential paradigm shift in the international monetary system that we’ve known since Nixon closed the Gold Window. As Ron Paul remarks:
“The chaos that one day will ensue from our 35-year experiment with worldwide fiat money will require a return to money of real value. We will know that day is approaching when oil-producing countries demand gold, or its equivalent, for their oil rather than dollars or euros. The sooner the better.”
WTI crude, April 2016 futures contract – there have been two dips below the $30 level recently – click to enlarge.
Let me take this opportunity to talk more about Ron Paul’s perspective: The U.S. dollar became the world’s premier reserve currency with the implementation of the Bretton Woods system after WW 2. In 1971, Richard Nixon closed the Gold Window to stop pressure on the Treasury’s gold reserves, as an increasing number of foreign countries, most notably France, began converting dollars into gold.
The closing of the Gold Window meant that governments could no longer convert dollars into gold at the promised fixed exchange rate which implied declining demand for dollars and accordingly a weaker dollar on world markets. This was of course unacceptable to the U.S., government. So it needed to create demand for the dollar and motivate countries to hold and use dollars.
This is where oil comes into play. Oil became the commodity that would guarantee strong international demand for the dollar. And this guarantee was achieved by a classic political-strategic alliance with mutual benefits between the US and Saudi Arabia, the holder of the largest oil reserves and leading OPEC member. This was a milestone for US interests; in essence the era of the petrodollar has allowed the US government and its citizens “to live beyond their means”, according to Dr. Paul.
Americans managed to live beyond their means, as their government felt comfortable to pursue an expansionary monetary policy (after all, who would not need to buy oil?), which in turn encouraged American citizens to accumulate more and more debt and consume aggressively.
Richard Nixon: his decision to default on the gold-dollar convertibility promise gave birth to the completely unanchored fiat money system still in place today – which has led to a historically unique explosion in global debt.
What we have now is an entire monetary system essentially built on a political alliance, an alliance that is currently on shaky grounds for a number of reasons, including growing instability in the Middle East. This system may well be on the verge of collapse, and if it does collapse, a major factor underpinning dollar demand will be gone. As a result, the dollar could lose its status as an international reserve currency.
Domestically, peoples’ wealth would be severely impaired in this case. How so? The government would likely resort to desperate measures: capital controls, wealth confiscation, price and wage controls, the nationalization of pension plans, etc. The dollar’s fate is closely linked to oil and the petrodollar system. Its failure would threaten the wealth of American citizens, who would find it difficult to protect themselves against a state that is no longer able to finance itself with ease.
The Euro Zone Crisis Keeps Festering
The euro zone remains in crisis conditions – not only because of the refugee crisis, which will most likely accelerate due to the ongoing wars in the Middle East, but also due to weak oil prices. More people are bound to flee their home countries. The open-border policy of the “Schengen Area” is collapsing and certain countries in Europe have already begun to reintroduce national border controls, which are opposed by Brussels.
Economic growth is nowhere to be seen and in real terms investment in the euro zone has fallen tremendously since 2008. The ECB has announced that it will inject as much liquidity as needed and is purchasing all sorts of bonds (sovereign bonds, agency bonds, ABS and covered bonds). Constant redistribution from the northern to the southern nations is necessary to keep the euro zone together.
Some leave, some stay …
This, in combination with a possible exit of the U.K. From the EU, could be the trigger that will tear the euro zone apart. Therefore, we expect to eventually see a flight out of the euro, as a logical consequence of all these uncertainties. The idea of a centralized plan for Europe has failed and until it actually does fall apart, wealth redistribution from the North to the South is bound to go on and will continue to undermine the middle class.
We are Approaching a Great Shift
With a global slowdown triggered by China, and the potential demise of the petrodollar system, we believe that the game is changing fundamentally, and with it, the rules. We expect the bust to begin in the foreseeable future, but not necessarily in 2016. However, we are certainly getting closer to a great shift: a crisis of the monetary system that may pave the way for a free market economy and a transformation of the global currency system. The crisis is inevitable. Ludwig von Mises said:
“There is no means of avoiding the final collapse of a boom brought about by credit expansion. The alternative is only whether the crisis should come sooner as the result of a voluntary abandonment of further credit expansion, or later as a final and total catastrophe of the currency system involved.”
Many investors and individuals fear the words “bust” and “recession” and their implications. What will happen before we hit rock-bottom? The answer is simple: massive defaults and deflation. Asset prices that have been propped up with artificially created liquidity are going to correct massively. Economies will temporarily come to a standstill.
That will leave us with one of two options: 1) attempt another temporary fix, which will not solve the root of the problem, but only postpone the inevitable bust that will then hit even harder than it would now; and, 2) accept and endure the “correction”. The correction needs to be seen as something positive, as it will correct the mismanagement and mistakes of the boom and rectify the associated imbalances. This correction is inevitable anyway and has been a long time coming.
Even the Bank of International Settlement has come out in support of this view in a 2013/14 report:
“To return to sustainable and balanced growth, policies need to go beyond their traditional focus on the business cycle and take a longer-term perspective – one in which the financial cycle takes center stage. They need to address head-on the structural deficiencies and resource misallocations masked by strong financial booms and revealed only in the subsequent busts. The only source of lasting prosperity is a stronger supply side. It is essential to move away from debt as the main engine of growth.”
Since 2008, total credit has increased from USD 140 trillion to USD 200 trillion. USD 60 trillion have been artificially created by central banks worldwide to bail out the banking system. It is clear that nothing has helped to truly rectify the situation – all this money was only a temporary fix to avoid what should have happened in the first place: enduring the painful but urgently needed “correction”. It is gratifying to see that more and more people are coming to understand how flawed the current system is.
Global debt-to-GDP ratios by sectors and countries, as of Q1 2015
Timing is always the big uncertainty. As we have mentioned above, we believe interest rates will stay low. The Fed has only increased its administered interest rate by 0.25% so as to fool the masses into believing that the situation is normalizing, with the aim of keeping them invested in paper securities. Once people realize that we will not see higher interest rates in the future, they may start shifting into hard assets. These have stronger potential upside in such an environment, as they no longer have to compete against yield, and are scarce compared to paper and computer digits created out of nothing.
Regarding equity markets, we believe that volatility in financial markets will continue to be elevated, however based on the actual price/earnings ratio of the S&P 500, stocks do not seem to be extremely overvalued yet. At the moment, the ratio is about 20 and in 2001 we stood at 45 and in 2008 at 28 – so there may still be some room for equity markets to move higher. We cannot rule out a possible recovery of the stock market in the near future. However, we believe people should use this as an opportunity to prepare for the worst.
Are You Prepared for the Bust?
In a number of countries policymakers appear to have realized some time ago already that the dollar is just an artificial currency that is not backed by any tangible value. And even though practically everyone has been stuck in this artificial monetary system, they sought to support their countries with the highest quality asset out there: Gold! Central banks seem well aware of the need to prepare for a downturn and have been active buyers of the metal,building up their gold reserves, particularly since 2010. China and Russia have been the top buyers up to early 2015.
Central bank gold demand over the past decade, net
We are convinced that 2016 will be a good year for gold. It is possible that the price of gold might come down in the next couple of months, however several trustworthy gold analysts that we follow see upside of around 20% for gold in the second half of the year. We also find the acceleration of physical demand for gold and silver coins, especially in the retail market, such as in the U.S., Germany, but also in Switzerland, very interesting. It shows that more and more people understand that gold and silver act as protectors of property rights and that current prices are very attractive.
Gold is not only an inflation hedge. Even in a deflationary environment people will want to shift their investments to high quality assets with little or no counter-party risk. In short, it is a flight to quality and the hardest currency for the past few thousand years has been and still is gold. Conversely, in a boom, or inflationary environment, people will tend to move their money toward high-risk assets.
Today’s uncertain situation calls for capital preservation. Gold serves as a hedge in an uncertain economic environment with negative interest rates. In fact, gold is a better option than bond investments. In comparison to bonds, gold tends to be much more volatile, nevertheless it is the only asset without any form of counter-party risk and it has been considered valuable for millennia. Gold is an investment that takes one away from financial institutions and government intervention. In essence, it serves as protection from governments and the vagaries of financial markets. We cannot predict the future with certainty, but we can certainly prepare for it!
We would suggest one should begin to accumulate precious metals, as we are likely at the beginning of the next phase of the bull market. If you believe the system will crash, you need gold; or, if you believe that saving money makes sense because you don’t trust the government’s promises that it will take care of you in coming years, holding gold makes sense as well.
Gold is your insurance and you need to own it physically. We advise you to store some of your gold outside the jurisdiction you live in as your personal "Plan B."