Economic Forecast 2005 (Part 2):
Watch Out for Stagflation and Recession
BY AL MARTIN

It should be noted that in Q4 of 2004 both business and wholesale inventories, which are two separate statistics maintained by the Department of Commerce, reached record levels while the so-called sale-to-inventory ratio at 1.26 also reached a record number. This means that wholesalers are only selling 74 cents of every 1 dollar of product to retailers, purchased from manufacturers, which caused inventories to rise. The implication, then, is look out for inflation. This can be called an “extremely recessionary” environment. What does that mean?

Historically speaking inventories rose throughout 1972, prior to the onset of the 1973-74 recession. Inventories, again, rose late in 1979 and throughout 1980, prior to the onset of the 1981-82 recession. When inventories rise and sales begin to fall at the wholesale level, it has classically been a very important indicator of an impending recessionary period. This has been even more true when inventories are rising at the same time that inflation and interest rates are also rising, in that it is rising interest rates and inflation which pressure consumer demand.

This means that we can expect a sharp slowdown in consumer spending.. Pro-Bushonian economists will admit that consumer spending is slowing down because of record consumer debt levels, but they claim that business capital investment and IT spending will carry the day. This is complete nonsense.

Business spending cannot continue to increase if inventories are continuing to increase because it means that manufacturers are simply producing too much product relative to end demand.

These then are the ramifications of a slowdown in consumer spending in 2005. A slowdown in consumer spending combined with rising interest rates and inflation equals the economic condition known as “stagflation” that was experienced in the late 1970s.

Stagflation means inflation combined with a growing recessionary trend; that is, falling investment, falling consumer purchases, yet prices continue to rise even though demand is falling. The first time this so-called stagflation had been created was in the late 1970s. The end result of stagflation is the bursting of speculative bubbles in real estate, as well as in stocks and bonds, and all other tangible asset classes, which leads inevitably to a sharp recession, wherein inflation and interest rates continue to rise, at least for a period of time, as we saw in 1981 and `82.

Stagflation then becomes a precursor to a very sharp and pronounced recession. The Bush-Cheney regime has attempted to do what the Carter regime attempted to do. If you want to compare Carter economic policies 1977 to `79 compared to what this regime has done, they are very, very similar, By this we mean that the regime has used tax cuts for individuals and increased tax incentives for business in order to mask or to make up for falling consumer demand due to ever-rising debt levels in an environment of declining real wages.

Now, what happens, of course, is that budget deficits will continue to mount in this type of environment, as they have now mounted to record levels under the Bush-Cheney regime. Hence we now enter a period of time, beginning January 1, 2005, where the regime cannot provide this fiscal and monetary stimulus any further. It cannot provide any further tax cuts. It cannot provide any further tax incentives to business without threatening to dramatically increase Bushonian budget deficits.

Therefore the stimulus that had been provided, that was artificially creating production relative to demand, is now gone. Demand is falling and production has exceeded demand for nearly two years under this regime. Then what happens is manufacturers, wholesalers, and even retailers wind up with an increasingly large amount of unsold product. And consequently capital spending by business has to fall.

So, assuming there is stagflation that will lead to recession, what should people be ready for?
Stagflation can be immensely profitable for those that know how to capitalize on it. We have already seen the beginning of a stagflationary period in recent years, thanks to a declining dollar and rising commodity prices. For those who own stocks in companies that own or mine these commodities or own them in the ground, as it were, rising commodity prices have produced very handsome returns. Those who have owned these metals and minerals directly through commodity futures or exchange-created funds or other types of investment vehicles have also done very well.

What is likely to now happen is that we are relatively in the same situation in terms of commodity prices versus a declining currency that we saw in very late 1979, where there was a temporary dip in gold and silver. A temporary dip developed in monetized metals because industrial metal (steel, aluminum, nickel) began to fall as economies worldwide began to slow. This is what is now occurring.

We have seen, for instance, throughout the 4th quarter of 2004, dramatic falls in the price of industrial commodities, like steel, nickel, aluminum, etc. This traditionally happens when an inflationary trend that had been created through fiscal stimulus begins to wear off; that is, the fiscal stimulus can no longer be provided.

The real estate bubble, which we have discussed at length, began to bleed air in the 4th quarter of 2004 in earnest, as we had pointed out, in last week’s article. And now, even in the last week, we are now seeing a weekly deterioration in real estate prices and mortgage applications, refinancing. Those things that underpin a speculative bubble are now being taken away. Consequently air is now bleeding out of the speculative bubble in real estate prices at a progressively faster pace.

What is so damaging about the collapse of a real estate bubble is not the imminent economic impact but the psychological impact.

This means that as real estate begins to come down in value or soften in value, you remove from the economy the factor known as the wealth effect. Consumer spending is increased which comes from rising home values when people felt more secure in spending and increasing their installment debt because they knew the value of their principal asset, their home, was rising at a proportionately faster pace.

Nothing shakes confidence, particularly for citizens wearing their hats as consumers, like declining real estate values. In this speculative bubble, which has been, in terms of price appreciation, the greatest real estate speculative bubble ever seen in the nation, people suddenly start to look at their installment and credit card debt and they suddenly realize that they have refinanced their mortgage umpteen times and that they have had equity home loans that they’ve taken out to support their spending.

Then, as real estate values soften and come down, people become very frightened, particularly if they become upside down in what is their principal asset.

So what we can expect is that people will have this sudden realization that they are living beyond their means.]

Consumer spending always contracts sharply during a break of a speculative bubble in real estate. This was very noticeable in the break of the speculative real estate bubble which occurred from August 1989 until August 1991, in that 2-year period.

If we are at the beginning of a major recession, what should Al Martin Raw.com subscribers do to protect their assets?

Assuming we are right that a stagflationary environment is being created, which I believe is a correct assumption to make, particularly under a Bushonian regime wherein the value of the dollar will continue to fall and hence continue to propel inflation, what people want to be invested into is paper assets, whose future return is tied to inflation, namely, in straight stocks. The place you want to continue to own is companies that own hard assets that produce, for instance, precious metals or monetized assets. Debt investors want to be in TIPS bonds, since the yield on TIPS bonds is based on inflation and not on a fixed rate.

Bond people like Bill Gross of PIMCO, considered the wisest on the street, is right when he says -- where you don’t want to be is in mortgage-backed bonds or high yield junk bonds.

The spread between U.S. Treasuries and high-yield bonds, more commonly referred to as junk bonds, is now the lowest in 6-1/2 years. Generally, this compression happens during times of economic slowdown.

When a little inflation comes into the economy and interest rates begin to rise, you find that the yield spread quickly widens out. Moody’s Investor Services has said in recent weeks that noting the marked decline in credit quality of junk bonds in the 4th quarter, it is obvious that junk bonds (high yield bonds) is not the place you want to be anymore. Further, in a falling real estate value environment, combined with a record foreclosure rate, you do not want to be in mortgage-backed assets.

The place you really want to be is in TIPS bonds and gold. We will continue to reiterate that that is the place you want to be. Gold protects the purchasing power of an ever-declining dollar that you earn and that you spend.

TIPS bonds capitalize on inflation, in that the interest rate, or yield that they pay, is tied to a formula based on inflation instead of a fixed yield. It is the reason why so many bond fund managers led by Gross are recommending TIPS bonds. And they’re not recommending gold really because they’re bond people.

The other place that bond investors, or bond dealers, are recommending is foreign bonds, principally German bunds. But really, that is nothing more than a proxy for gold.

The reason why they’re recommending German bunds is that’s a dollar play, a dollar-euro play. In other words, the German bonds are going to become more valuable as the dollar declines and the euro rises. But in the last analysis, that trade is nothing more than a proxy for holding gold.

Therefore, we continue to recommend the purchase of the 10-year series U.S. Treasury TIPS bond, and gold through what we recommend as the new gold exchange-traded fund (tape symbol: GLD).

The reason why we recommend GLD for holding gold is that it has become increasingly risky under this regime to hold the physical gold – as we have pointed out in the past

So how else can we deal with recession and stagflation? If you have a lot of household debt outstanding, particularly longer term debt, now is the time, if you have not already done so, to begin to convert variable-rate debt to a longer term fixed-rate debt -- before rates begin to rise.

People don’t seem to remember just how many people, particularly working class people, were hurt in the late `70s because they had taken out what was then this very new concept of variable-rate mortgages. Then suddenly what they thought was going to be a 6% environment was, 4 years later, a 12% environment, and 2 years after that, a 15% mortgage.

When Greenspan spoke in the summer of 2004, he gave the first warning that rates were going to increase. It has generally been true that when a citizen wants to convert variable-rate debt into fixed-rate debt is when the Federal Reserve begins to raise the Fed Funds Rate from what had been a new low, which is precisely what is happening this time. Indeed, the Fed has now acted to raise the rate 5 times. It has clearly stated that it will continue to act to raise the rate.

People, however, are being lulled into a false sense of complacency because long rates have not really risen the way short rates have. But the reason that has happened is because of falling consumer demand. Therefore there isn’t as much pressure on long term money as you normally would think there is.

The average person isn’t smart enough to understand the signals economically, but it has given people a false sense of security because they’ve seen short-term rates rise but long-term rates, in some cases, actually fall slightly. So people think -- Well, I’ll hold on to my 1-year adjustable 30-year mortgage for a little bit longer. But you have to be careful of doing that because long rates are going to rise and can continue to rise just as a factor of inflation, even though the demand, the underlying demand for long term money, coming from consumers, can be falling; yet the price of that money (i.e., longer term interest rate) can still rise as a factor of a falling dollar and increasing inflation.

In the near future, I would like to continue to explain Social Security, since I learned that 9 out of 10 people do not even understand the basics of what Social Security is and isn’t.

People are still under the illusion that they have their own Social Security account with the government and that their FICA money goes into their account. Some people write in every year to Social Security Administration, and they then get a statement. But what people don’t understand and what we still have to explain (and we’ve got to stop this nonsense, this lie people labor under) that there are these so-called individual Social Security accounts that the SSA dupes you into thinking you have because they send you a statement along with the implied 3% rate of interest that your FICA tax payments earn is all fictitious. I couldn’t seem to get people to understand this!

People need to understand that the Social Security Trust Funds are fictitious. There are no assets -- only a $5.3 trillion debt. Your individual accounts are fictitious. The interest rate you are supposedly earning on your FICA tax payments is fictitious. You have nothing; it is worthless. Your FICA tax payment, 83% of them are going to support current retirees. The other 17% are being wasted by this regime because they’re being counted as general revenue in an effort to hide the actual size of Bushonian budget deficits in a return to the dangerous fiscal practices of the 1980s.

And that is the proverbial bottom line -- Social Security, in market parlance, is “Triple Net Worthless.”

Alphonse Ponzi would be not be proud of such an achievement. Rather he would be green with envy.