As our consumer dominated economy faces the threat of imminent stagflation (economic recession and financial inflation at the same time), losses will not be limited to the poor. Many get-rich-quick investors also will become poorer!
The effects of recession, falling asset prices, insolvency, inflation and a falling dollar are set to have a sometimes devastating effect on the real value of many investment portfolios, including those of the wealthy.
Why are the rich going to lose money when many have had expert professional advice? The answer is in varying and individual combinations of greed, arrogance, ignorance and a naive belief in government propaganda, both by investors and their professional advisors. Ignorance led them to believe government figures. Arrogantly, they assumed they had discovered a new world in which asset prices would continue to boom. They were tempted by the greed that held that the higher the leverage, the greater the returns. Naively, they appeared to buy into the belief that America could go on consuming more than it produced, financed by foreigners that had an endless appetite for American government debt.
There is little doubt that the vast amounts of cheap, U.S. dollar liquidity pumped into both American and international economies by the U.S. Federal Reserve Board (particularly under former Fed Chairman Alan Greenspan) averted some naturally occurring and corrective recessions and led to a series of unprecedented asset booms. The mistake was in thinking that this virtual world of financial make-believe would go on forever.
Added to the vast new Fed-inspired liquidity boom was a new type of leverage created by means of derivatives, particularly the Collateralized Debt Obligations (CDO’s) used to ‘securitize’ real estate mortgages. In 2006, The Economist reported that a hedge fund, investing in CDO’s through property vehicles, could leverage its capital by some 52 times. In other words, a fund with paid-up capital of $100 million could command property investments of a staggering $5.2 billion.
Of course, leverage of 52 times yields massive returns, provided that the prices of the underlying assets continue to climb, as they did under Greenspan. To give some idea of the size of increases in asset values, The Economist further reported that the value of residential property in just the developed world rose by an unprecedented $25 trillion between 2001 and 2006!
Vast fortunes were made, as CDO’s with a rating of ‘triple A’ were sold to wealthy investors throughout the world, greedy for unusually high dollar returns.
It was not only real estate that benefited from the largesse of the American Fed Reserve Board. Auto and credit card lending boomed, adding greatly to the funds of the wealthy. Indeed, things became so good for borrowers that what became known as ‘covenant-lite’ loans were made by lenders who were both greedy and foolhardy.
The abundance of liquidity boosted consumer demand and corporate profits. Increased earnings were reflected in stock market prices that climbed to new nominal record levels.
However, the real financial implications of imprudent lending and borrowing and the rising level of U.S. government debt did not go unnoticed by the foreign exchange markets. The U.S. dollar began a dramatic decline, depreciating by more than 20% percent against the Euro in the past two years.
Now, the whole vast economic model of abundant liquidity and excessive leverage is moving in reverse. The liquidity boom has morphed into an insolvency crisis, aggravated by a fall in asset values. American consumer demand is falling dramatically. In a consumer economy, where 72 percent of GDP is comprised of consumption, American domestic corporate profits and stock markets look set for dramatic falls, leading to margin calls and yet more forced asset sales.
In short, a great ‘de-leveraging’ has embraced the American economy. The massive and excessive liquidity is now being squeezed out of the price of most assets. Investors, who remain owners of leveraged American domestic assets, stand to be hit hard–very hard. This financial suffering will be made worse as investors realize the effects of taxation, inflation and the debasement of their dollar currency upon any positive nominal returns they salvage.
The astute investor can insulate himself from this mounting financial dilemma. He should diversify immediately out of U.S. dollar-based assets into high (total return) yielding assets denominated in strengthening currencies of ‘producer’ nations such as those of Switzerland, Australia and Canada. In light of current conditions, it is then and only then that the astute investor is likely to become richer, not poorer.
For a more in depth analysis of our financial problems and the inherent dangers they pose for the U.S. economy and U.S. dollar denominated investments, read Peter Schiff’s book “Crash Proof: How to Profit from the Coming Economic Collapse.???