The End of the Recession

If you watch financial television, you know that a new consensus has developed…the recession is over and the world is about to return to normal. The stock market, corporate bonds and many commodities have soared in price. The banking system has stabilized and the threat of systemic collapse has receded into the far distance. Welcome to the scariest depression we never had. Fear has left us and greed is back.

Gold has performed rather well given the new consensus. Its traditional role as a hedge against default…gold is universally accepted as final settlement…is no longer in fashion. Gold’s other role as a hedge against currency debasement remains in favour among the minority of investors who fear inflation down the road because they do not believe the monetary and fiscal authorities when they promise to remove the excess stimulus they have created.

We at Seabridge have an alternate point of view for you to consider. Is it possible that unprecedented stimulus has re-ignited the bubble in financial assets, as the fiscal and monetary authorities appear to have intended? (Note that the U.S. equity market is now trading north of a 760 multiple on reported earnings). Is it possible that the real economy is not recovering and may not do so for some time? Is it possible that we could have another collapse in asset markets followed by another round of stimulus which pushes inflation onto the near term agenda and raises the perceived risk of sovereign defaults? We believe these are substantial risks in the months ahead.

Is not our pleasure to raise such negative questions. But consider our track record of predictions in these pages. Years before the herd, we observed that the world was in a midst of an historic credit bubble and we predicted the collapse of asset markets being driven by excess credit. We warned about crashes in mortgage debt, real estate and structured finance and their impact on the banking system. We predicted a deflation scare to be followed by a wave of inflation-generating stimulus unleashed by governments and central banks. We remind you of this track record because our current outlook is once again significantly out of step with the majority and the new consensus.

Our observations:

The banking system remains extremely undercapitalized and fragile. In Europe, leverage and exposure to risky, illiquid assets remain impossibly high. Throughout the developed world, write-downs and reserves allocated against anticipated losses trail delinquencies by a large and growing margin. Accelerated default rates which began in subprime mortgages have moved on to home equity loans, consumer and credit card debt and business obligations. Commercial real estate and residential prime mortgages are likely next and they weigh heavily on bank balance sheets. A new wave of mortgage resets is about to hit the U.S. market. Nor is Asia’s banking system exempt from difficulties. China’s lending boom is perhaps the scariest of all, as banks literally force money into uneconomic ventures to meet government quotas while capacity utilization continues to decline. Recent upticks in bank profits owe far more to trading profits and accounting rule changes (permitting asset re-valuations on the balance sheet) than the traditional business of banking. If we are correct in anticipating a period of declining asset prices and rising unemployment, we would not be surprised to see a second coming of TARP.

Consumers are cutting back, increasing their savings and reducing leverage.  Retirements funded by rising house prices and stock portfolios are no longer perceived as a certainty. In our view, the all-important American consumer will not return to form. Looking at the first iteration of the U.S. second quarter GDP report, David Rosenberg, former Chief Economist at Merrill Lynch and now Chief Economist at Gluskin Sheff writes: “Consumer spending came in at -1.2% annualized, twice the decline expected by the consensus. This occurred in the face of gargantuan fiscal stimulus and leaves us wondering how this critical 70% chunk of the economy is going to perform as the cash-flow boost from Uncle Sam’s generosity recedes in the second half of the year. Imagine, government transfers to the household sector exploded at a 33% annual rate, while tax payments imploded at a 33% annual rate and the best we can do is a -1.2% annualized decline in consumer spending in real terms and flat in nominal terms? What do we do for an encore?”

If consumption fails to recover, as we anticipate, this will have a depressing impact on business investment which is traditionally a major driver of economic recovery and job creation. We expect unemployment to remain stubbornly high for many months to come. What about the celebrated “green shoots” of economic recovery? After deducting the impact of government outlays from the economic data showing improvement, it is difficult to see anything but continuing decline in private demand and investment.

A further round of fiscal and monetary stimulus is likely as the economy continues to stall. In the U.S., the current fiscal year’s deficit is already verging on US$2 trillion while total monetary and fiscal stimulus commitments now total US$13 trillion. World-wide, funding requirements this year for fiscal deficits require the borrowing of an estimated US$5.3 trillion. These amounts cannot be met from savings. Merely attempting to fund these deficits out of the bond market would put enormous upward pressure on interest rates and crowd out the private wealth-generating investment the economy needs. Clearly, quantitative easing (the printing of money to purchase debt) will need to be accelerated. We would not be surprised to see more aggressive central bank purchases of gold to offset the risk of holding other currencies, particularly the US dollar.

In our view, it is the funding crisis that poses the greatest threat to the financial system and the stability of the world’s major currencies. The issuance of government obligations in excess of savings is the very definition of inflation.

Deflationists argue that we will not see the effects of monetary inflation until we have closed the so-called “output gap”…the difference between the economy’s theoretical growth potential and its actual performance…which represents underemployed people and underutilized capacity. This output gap is an elegant economic theory with considerable logic to back it, but alas, no supporting facts. As Jim Grant points out in the June 28, 2009 edition of Grant’s Interest Rate Observer, economic history has many examples of inflation rising hand-in-hand with joblessness and negative real growth. And as Paul Kasriel, Research Director of Northern Trust notes in his June 1st report, there is no correlation between the real output gap and the inflation rate in the U.S. However, he does confirm a positive correlation between inflation and increases in the money supply which is continuing to grow.

At Seabridge, we believe the economy is headed in the wrong direction, not towards real growth but towards inflation, not towards savings and investment but towards government redistribution of income, loss of confidence in fiscal and monetary authorities, declining faith in fiat currencies and a much higher gold price.