14 November 2008

Deflation Hoax

by Puru Saxena

The markets continue to bounce along the lows in what seems to be a base-building period. On Thursday, strong buying came in during the last hour of US trading and this reversed the day's losses, resulting in huge gains. At the close of the session, the Dow Jones, S&P500 and Nasdaq were up by more than 6%. Now, it is too early to say whether we have seen the lows of this bear-market, but the benefit of the doubt can be given to the upside for as long as the US markets remain above the intra-day lows recorded on 10 October 2008.

In my view, the economic news will continue to disappoint in the months ahead, business activity will remain sluggish and corporate earnings will shrink. However, the financial markets are a discounting mechanism and I suspect most of the bad news has already been absorbed by this market. Furthermore, investor sentiment is horrendous today and we have witnessed genuine distressed selling in the past few months. So, I wouldn't be surprised if we get a rally from these oversold levels. Now, whether or not this rally will fail in a few months time is anybody's guess but I suspect the financial markets will be significantly higher in 4-5 years from now. I must admit that I don't have a clue about the short-term prospects (neither does anybody else) but I do know that stocks are now poised for above-average long-term gains.

Central banks and governments are printing TRILLIONS of paper currencies around the world, the US has now become a socialist society and all this money-creation should result in a huge inflationary tsunami in the future. In my opinion, those who are forecasting deflation, don't understand our monetary system. What we have seen in the recent past is not deflation but a contraction in asset prices due to liquidation. Today, governments and central banks have the ability and motive to expand the supply of money ad infinitum and you can bet your house that paper currencies will lose tremendous purchasing power over the next decade. So, cash and fixed income assets will probably turn out to be the worst assets to own. In fact, I would argue that US Treasuries are grossly overvalued today and they are likely to crash somewhere down the road. In a few years from now, long-term interest rates in the US will go through the roof as the US Dollar and its overvalued bond-market collapses.

In such an inflationary environment, commodities are likely to provide the best returns. Now, I am aware that most commodities have faced intense selling pressure in the past few months but it is worth noting that all assets have been sold indiscriminately over the same period. Despite the recent rout, the underlying fundamentals of most commodities remain strong. And even today, top-quality resource stocks are announcing record profits and cash flows. When the dust settles, the enormous amount of cash sitting on the sidelines (US$4.5 trillion) is likely to rush towards the only profitable sector within the economy.

A couple of days ago, the International Energy Agency (IEA) released its World Energy Outlook report. According to the IEA, our existing oil fields are depleting by a shocking 6.7% per annum and we would need to find an additional 60 million barrels per day of new oil supply in 20 years to meet global demand. Now, it is worth noting that it has taken out world roughly 100 years to produce 86 million barrels of oil per day and this includes crude oil, natural gas liquids, hydrocarbon processing gains and bio-fuels. So, it is highly unlikely if not impossible that we will be able to find new supply of 60 million barrels per day in 20 years time! Given the harsh realities of Peak Oil, I find it absurd that the price of oil has declined by roughly 60% in the past 4 months. In any event, I don't expect this correction in energy to last forever so this may be the final chance you'll get to load up on quality energy stocks which are being given away at today's prices.

Moreover, agriculture is another area worth looking at. Global stockpiles of food are at multi-decade lows, food usage is rising and supplies of agriculture should remain tight for many reasons. First and foremost, arable land is shrinking, we have water problems in several nations and shortages of farm equipment, energy, fertilisers and farmers. So, the recent decline in agriculture stocks could turn out to be a fantastic buying opportunity for the long-term investor.

Finally, I think it is only a matter of time before gold and silver power ahead. Precious metals were hit hard by global deleveraging and they should shine again; thanks to the money-printing abilities of the establishment. These ridiculous government bail-outs are hugely inflationary and will further erode the purchasing power of paper currencies. I urge you not to be fooled by the recent strength in the US Dollar. This is nothing more than a short-covering rally and the American currency is likely to witness an epic crash in the future. There is no way you can have a strong currency when you are the greatest debtor nation in the world (debt of US$54 trillion). Furthermore, the Fed has recently expanded its balance sheet by US$1 trillion and in my view, the US has now embarked on a hyper-inflationary road to nowhere. As the jokers in Washington continue to 'save' the US economy (i.e. bail-out their rich friends on Wall Street), the US Dollar will eventually become worthless or it may be replaced by another currency. So, I would suggest that you take advantage of the recent rout in the markets by converting more of your cash to hard assets. If you are fully invested, please do not buy into the deflation hoax and simply ride out this weakness which should prove to be temporary.


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