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Weekly UpdatesThe United States is now operating in a new investment environment, the result of the government's response to the financial crisis--in which we are witnessing both a massive transfer of private sector debt to the public sector and the most aggressive monetary reflationary efforts in modern times.
The amount of stimulus and intervention needed to stabilize the financial sector is likely to be excessive, in terms of its impact on the transaction sector of the economy. The result should be both economic recovery and much higher inflation.
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The Federal Reserve's balance sheet has expanded to $2 trillion and is likely to grow to $4 trillion based on announced programs. Nothing of this magnitude has ever been undertaken previously. In the past six months, M2 money supply has expanded at over 18 percent on an annualized basis, exceeding the previous peak in the early 1980s.
It's excessive
In real or inflation adjusted terms, the current growth rate is even more excessive. Rapid monetary growth has always led to economic recovery within about six to nine months. Although we have serious banking issues, in many respects this recession is not as serious as those in 1973-74 or 1980-82. Since aggressive monetary policy succeeded in those prior periods,
I expect that it will this time as well. It has now been some six months since this aggressive stimulus commenced. Recent economic indicators have begun to indicate a bottoming process in the economy.
Finally, two stimulus bills now have been enacted, the first under the Bush administration, and the more recent $800 billion one under the new Obama administration. This second stimulus bill should begin to impact the economy by the second half of 2009. It should be even more of a stimulus in 2010, based on forecasts of spending rates.
In addition, the new budget is forecast to be larger than the previous year's budget. Taken together, these monetary and fiscal actions are unprecedented. Regardless of negative private sector psychology, these programs will overwhelm current weakness, and lead to a recovery accompanied by rising inflation.
As budget deficits ballooned during the past two decades, the U.S. current account deficit also increased dramatically. As a result, foreigners financed the U.S. domestic deficits. This had the effect of keeping inflation and interest rates lower than they might otherwise have been.
The account deficit is now shrinking, as it often does in a recession, while the budget deficit is ballooning. Even though I would expect the current account deficit to expand somewhat when the economy begins to grow once again, budget deficits are likely to remain much higher than the current account deficit.
This means that U.S. debt will have to be financed domestically. Either the private sector will suffer from "crowding out," whereby private financing will lose out to government debt issuance or the Federal Reserve will be forced to finance government debt issuance.
The tenuous state of the housing/mortgage sector will also keep pressure on the Federal Reserve to maintain artificially low interest rates. Through 2010, a significant number of variable rate mortgages will be facing interest rate resets. The Federal Reserve therefore will be pressured to keep interest rates artificially low in order not to kill off the recovery.
Major foreign holders of U.S. debt, such as the Chinese, are keenly aware that current American policy could create dollar weakness, thereby devaluing the value of their U.S. debt holdings.
New currency system?
As a result, the Chinese are now calling for guarantees or a new currency system to replace the dollar as the world's reserve currency. The U.S. is unlikely to concede its privileged position. The Chinese and other debt holders will be forced to alter their past policy of blindly accumulating dollars.
In the future, the Chinese are likely to diversify away from U.S. debt holdings by making equity and infrastructure investments in the United States or in multinational corporations, and to make investments in global natural resource investments and in larger stockpiles of key commodity imports.
Since U.S. interest rates are being held too low to attract private foreign buyers, the buyer of last resort of U.S. Treasury and agency debt will be the Federal Reserve--once more normal financial market conditions prevail. If this occurs, it will fuel excessive monetary growth and quickly reignite inflation.
However, inflation is next year's problem. The immediate problem is stabilizing the financial sector and restarting the economy.
As stated earlier, it is my conclusion that policy now in place will be successful in restarting the economy, but that it will be politically difficult to take excess liquidity out of the system in a timely manner. Based on this assumption, gold should continue to provide the highest absolute and relative return for the next several years.
Gold's relative strength versus the S&P 500 has persisted throughout the past decade, with only minor pauses. Currently, the gold market may be in a temporary pause, as greater confidence returns to more traditional financial assets.
However, gold's price strength should continue, based on the relative difference in supply growth of gold versus debt and other financial assets. The metal's role as an alternative store of value should continue to grow, leading to continued price strength both in absolute and relative terms.
I also assume that the stock market is completing a cyclical base. Because the United States will be living with excessive monetary and fiscal stimulus, and because key commodities are likely to quickly return to an environment of scarcity, the best equity returns should be in energy, energy service, alternative energy, basic materials, agriculture, and selected technology
John R. Hummel is president and a founder of AIS Futures Management LLC and AIS Capital Management LLC, a registered investment advisor Hummel's papers and published articles can be found at the website www.aisgroup.com. His e-mail is jhummel@ais.com.
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