Gold and Energy Advisor: Gold, Oil & Energy Markets Investment Research
James DiGeorgia, Mr. Macro
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Mr. Retirement

Newsletter #118  12/18/2012



“Coming in 2013: Perhaps the Most Challenging Year Ever for Investors!”

“We’re facing the most challenging investing environment we’ve seen in a long time. And the fireworks begin in just a couple of weeks.

“Many Americans are so caught up in the holiday rush that they’re ignoring what’s going on in the markets. Don’t be among them!”

Photo-of-James-DiGeorgia

In past issues of GEA, I haven’t said much about the ‘fiscal cliff’ that’s due to arrive on January 1. There wasn’t much point in talking about an event months before it arrived.

After all, Washington had plenty of time to deal with this. And surely, with such a crucial deadline approaching, Congress would set aside its usual bickering and get something accomplished, right?

Right?

Of course, that didn’t happen. And now the United States is about to begin its…

Plunge Off the Fiscal Cliff

The media are talking nonstop about the approaching cliff—and for good reason.

This issue of GEA is scheduled for publication by December 18. This means that:

  • We’re just two weeks away from dramatically higher taxes (as the Bush-era reductions expire).
  • We’re just two weeks away from draconian and indiscriminate spending cuts, required by law across the board.
  • We’re just two weeks away from a two percent hike in Social Security taxes.
  • We’re just two weeks away from the new taxes included in Obamacare.
  • And we’re just two weeks away from a steep hike in the Alternative Minimum Tax (AMT), which will smack an additional 26 million American households. According to the Washington Post, the average additional tax bill will be a whopping $3,700.

(By the way, the AMT hike is retroactive—it will apply to your income from this year.)

This financial time bomb is an unprecedented threat to the American economy.

Morgan Stanley predicts it will slash our GDP by up to five percent. I’m sure you’ve also heard all the other grim forecasts that are circulating right now.

So why hasn’t Washington done anything to avoid it? Because both political parties have taken hardline stances that prevent them from agreeing on anything.

Obama campaigned on a promise to raise taxes on “rich” households (those making more than $250,000 per year).

However, many Congressional Republicans have signed a pledge to prevent taxes from rising.

(As the old philosophical question goes: What happens when an irresistible force meets an immovable object?)

Meanwhile, Republicans want to cut spending—which the Democrats fiercely oppose.

So far, there’s been no middle ground for compromise. Both sides are unyielding. That means one side has to win, and the other has to lose.

Which side will lose? The way it’s going right now, all of us will lose.

It’s a fair bet that we’ll have to “go over the cliff” for at least a short time, before the two sides are forced into some sort of compromise.

And as dramatic as the struggle has been so far …

The Worst Battle Is Yet To Come

I’m talking about the looming trainwreck of Social Security, Medicaid, and Medicare.

Without reforming these social benefit programs, we can’t possibly get our fiscal house in order. Both parties know this.

But as the saying goes, social benefits are the third rail of politics. Whoever touches them gets electrocuted.

So, neither side wants to be the first one to propose social benefits reform, because that party will take the blame from outraged voters. (No doubt, the party which didn’t move first will encourage this outrage.) Instead, both parties are trying to maneuver the other one into moving first.

While Democrats and Republicans play chicken over social benefits, daring the other side to be the first to talk about reform, the fiscal cliff is approaching fast.

And if you thought the gridlock and finger-pointing is bad now, just wait until Social Security and Medicare are finally on the table.

Can this disaster be solved in the next couple of weeks? Hardly. After all, it’s been two years since the National Commission on Fiscal Responsibility and Reform issued its Moment of Truth report, warning that “The era of debt denial is over,” and, “We cannot play games or put off hard choices any longer. Without regard to party, we have a patriotic duty to keep the promise of America to give our children and grandchildren a better life… Our challenge is clear and inescapable: America cannot be great if we go broke.”

But in the last two years, absolutely nothing has been done. Social Security hasn’t been fixed. Medicare hasn’t been fixed. The expiring tax cuts, mandated spending cuts, and everything else rushing toward us have all been completely ignored.

So here we are, just two weeks away from the onset of Financial Armageddon.

To be clear, the American economy isn’t going to blow up on January 1. It will take time for the higher taxes and so on to fully grind down our GDP. But January 1 is when the grinding begins.

And we’ll be lucky if a deep recession is all we get, because…

A Grave Threat Is Ahead

Washington’s favorite approach—actually, its only approach—to our deep financial imbalances has always been to kick the can further down the road. But that’s not an option this time.

This time, Congress and the White House need to pull their heads out of their backsides and accomplish something. If not—if they can’t do it now, when the whole world is watching and the consequences of failure are so disastrous—they’ll never be able to do it.

At that point, the game will be up. At that point, international markets could no longer pretend that the US will get its act together later. They could no longer pretend that the US will cut back its trillion-dollar annual deficits.

Most importantly, they could no longer pretend that US Treasuries will be repaid in dollars that were still worth anything.

And that’s…

The Worst Danger of the Fiscal Cliff

Once Washington’s complete and utter dysfunction is fully on display for the world to see, Treasuries would get whacked. Who would want to lend money to a government like that?

The carnage in bond markets will get even worse once the ratings agencies downgrade their ratings of US debt, as they would be forced to do.

Many institutional investors can’t hold anything but the highest-rated debt instruments. They’d be forced to dump their Treasuries.

Obviously, once that starts to happen, Treasuries will go into free fall. This would force interest rates up—which the Federal Reserve is desperate to prevent, as I described last month.

So, to keep rates down, the Fed would be forced to monetize the debt: to print money and use it buy Treasuries.

Even though the Fed has been manipulating the Treasury market for quite some time, its involvement has been indirect—so far.

But a direct monetization of government debt will move the US into banana-republic territory. And that usually means ruinous levels of inflation.

I’m not alone in seeing how grave the danger is. The markets are reflecting near-record levels of uncertainty and fear, as shown here:

[Chart: Market uncertainty]
Credit: policyuncertainty.com

In the recent past, the worst events to rock the markets were, as labeled above:

  1. The October 1998 Russian financial crisis and the collapse of Long Term Capital Management
  2. The Bush/Gore election controversy
  3. The 9/11 terrorist attacks
  4. The Second Gulf War in March 2003
  5. The beginning of the 2007/2008 financial crash, which included panicked interest rate cuts and massive government stimulus programs
  6. The August 2011 showdown in Washington over raising the debt ceiling
  7. Today’s level

Note that today’s level is higher than any of these, except for the brief debt-ceiling crisis.

And that’s just domestic uncertainty. As investors, we also have to include the global outlook in our planning.

And that’s even more ominous than our domestic situation, thanks to…

The Coming Collapse of Europe

Frequently in 2012, we heard about the possibility of a “Grexit”—the departure of Greece from the Eurozone.

The Greek economy is groaning under the (perceived) stranglehold of austerity measures. Sky-high unemployment and plummeting standards of living have hit everybody hard, rich and poor alike.

Most of the Greek population blames Northern Europe (especially Germany) for this. There’s widespread anger and resentment.

The all-too-common question is, ‘Why should we suffer, just to keep the northerners happy?’

After all, if Greece just defaulted on its national debts, all the pain and suffering would go away (or so it seems).

A common perception is that a default wouldn’t hurt anybody except some fat-cat bankers and rich creditors in the north—the exact groups who are the growing target of Greek rage.

And lest we underestimate the extent of Greek rage, remember all the news footage you’ve seen of Athens burning in anti-austerity demonstrations. Or, just take a look at this Greek poster of German Chancellor Angela Merkel:

[Poster: Merkel as Hitler]
Credit: AP images

That’s a good summary of how most Greeks feel about the Germans.

Unsurprisingly, Greece’s leaders are deeply divided over whether or not they should stay in the European Union (EU). So far, the pro-Union leaders are still (barely) in control.

But that could change at any time. Every few months, a new tranche of bailout money is necessary to keep the Greeks in the EU so they keep paying their debts. Every few months, a bitter argument arises in Greece about whether or not to accept it.

Greece could bail out of the European Union at any time.

In past GEA issues, I’ve written about the potential outcomes of this. Indeed, the fat-cat northern bankers would be hit hard by a Greek default.

So hard, in fact, that the entire European banking system could collapse in a series of cascading cross-defaults.

That’s why European officials have been desperately shoveling bailout money at the Greeks, so the Greeks can give it back as debt payments. The circular nature of this—and the inevitability of this system breaking down eventually—doesn’t seem to matter. The Europeans are determined to kick the can down the road as far as they can. (They seem to expect some miracle to somehow show up later and magically solve the whole nightmare.)

Meanwhile, other nations are headed down the same path. In fact, Spain is rapidly becoming an even bigger mess than Greece is.

The Spanish weren’t content to just copy the Greeks in having blowout levels of spending and ruinous levels of national debt. No, the Spanish were determined to have a much bigger meltdown, which is ongoing now. They’ve also added a real-estate crash and a banking crisis to the mix.

Spanish unemployment has hit a staggering 25 percent. A full 50 percent of youth are unemployed. This is a statistic that raises fears of civil unrest.

An example of this is the Spanish province of Catalonia, which is making noises about seceding. (If Spain breaks up into two countries, will the “new” one automatically be part of the European Union, or will it have to apply for a new membership?)

And while that’s going on, Italy is working on an economic disaster that would dwarf both the Spanish and Greek crises. Italian unemployment has already hit the highest level ever recorded since statistics started being published in January 2004.

The Italians aren’t as far along in their crisis as their neighbors, but they have the eighth-biggest economy in the world. The crisis they’re building is a much bigger one than anybody else in the EU.

So Greece is only the first of a series of economic detonations that will rock Europe. Greece is also about to demonstrate…

The Bitter Futility of Austerity

The harsh austerity measures that were supposed to solve Greece’s problems have made them far worse instead.

Spending of all types has collapsed, tax revenue is plummeting, and unemployment is skyrocketing.

Although austerity has reduced nominal government debt, Greece’s GDP is simultaneously crashing hard. So the debt-to-GDP has skyrocketed:

[Chart: Greek debt]
Credit: tradingeconomics.com

Greece is trapped in a downward spiral, and austerity is the 1,000-pound weight that’s pulling it down.

Even the International Monetary Fund is complaining that German-enforced austerity is crushing Greece under “obligations that they simply cannot deliver on.”

And who seems to be the only ones benefiting from Greece’s woes? Northern bankers!

Thus, there is a growing number of people in Italy and (especially) Spain who are asking the obvious question:

‘Why should we follow Greece into the toilet bowl?’

Their reasoning goes like this:

‘The northerners are starting to make the same austerity demands on us that they’ve hung around the necks of the Greeks. These demands are outrageous and completely unfair. Let’s tell them to go pound sand…

‘And if they shut off the flow of bailout money, fine. We’ll just default on our debt, and they can choke on all that worthless paper we sold them.’

So a “Grexit” isn’t the only potential catastrophe in store for Europe. There’s also a Spanish debt default and departure from the euro (a “Spanxit”?), possibly followed later by an Italian version of the same scenario.

It’s hard to overestimate the upheaval that all this would cause. European banks are still horribly exposed to sovereign debt from Greece, Spain, and Italy. The only way to prevent a full-blown Continental banking meltdown would be to print mountains of money and use these floods of liquidity to prop up banking balance sheets.

And European officials are busily printing those mountains of money as you read this. They’re determined to print as much money as necessary to save Europe.

Perhaps they’ll be successful. But the price will be horrible—a deep black hole of debt that will cripple the European economy for generations to come.

And to avoid that fate, some people in Northern Europe are openly discussing the unthinkable: a possible German departure from the European Union.

Forget about the Grexit, or Spanxit, or whatever. This idea (a “Gerxit”?) is nothing less than…

A Breakup of the Entire European Union

Germany is the powerhouse economy of the Eurozone. If it leaves the EU, the EU might as well not exist.

Notwithstanding that fact, many analysts believe a German exit from the euro and the EU makes a lot of sense.

First of all, the German population is tired of being the cash register that gets raided every time the Greeks need another bailout.

The Germans correctly perceive themselves as the economic backbone of Europe. They also perceive themselves (less correctly) as the only people in Europe who actually get any work done.

Fair or not, that last idea really sticks in the craw of a hard-working German who sees his standard of living eroding, and his national debt rising, all because of a bunch of Greeks who want to laze around drinking wine and soaking up the Mediterranean sunshine.

After all, why should he pay for the 37 days of paid holidays (plus weekends) that a state employee gets in Greece? (Even German Chancellor Merkel has complained, “We can’t have a common currency where some get lots of vacation time and others very little. That won’t work in the long term.”)

The continuous bailouts of Southern Europe are deeply unpopular in Germany. (And seeing their Chancellor compared to Adolf Hitler certainly isn’t helping.)

Therefore, German political leaders have faced stiff domestic opposition in getting the bailouts funded. They’ve succeeded (so far) by arguing that the fallout from a breakup of the EU would be far worse.

But a growing number of voices are arguing that this isn’t true. Many analysts point out that…

Staying in the EU is hurting Germany deeply, and it’s time to leave.

They say that being in the EU has slowed down the German economy. Paying huge subsidies to Greece, Spain, Italy, and everybody else who lines up for a handout is sucking the lifeblood out of German labor and transferring it to others.

As Charles Dumas, chairman of Lombard Street Research, recently wrote in the New York Times, “European Union membership has slowed the German economy and left Germans worse off. If Italy and Spain retain the euro, this will require Germany and other ‘core’ euro zone countries to pay them huge subsidies. Worse, Mediterranean depression can be avoided only if Germany generates major inflation for at least a decade…

“German growth has decelerated sharply over the past decade, despite financial and export strengths and labor market reforms. Productivity growth has been cut in half, from 2 percent in the 1990s for output per worker-hour to 1 percent over the past decade. Meanwhile, German citizens have accepted severe wage restraints without the former benefit of a strengthening currency, leading to negligible gains in consumer welfare.”

Even those who want Germany to stay in the EU admit that there would be many advantages to the Germans if they left. For example, Aristides Hatzis is an associate professor of law and economics at the University of Athens. He recently wrote an article in the New York Times arguing for the Germans to retain its EU membership. But as he grudgingly admitted:

“Are there any good reasons for a divorce? There always are: Germany would enjoy the advantages of independence without having to be responsible for its “immature” southern partners or for having to share decisions with wishy-washy mommy-figure France. Even former euro zone siblings will breathe freely after the over-achiever leaves the family: a depreciated euro would supposedly boost competitiveness and trim Germany’s debts.”

There are also many non-financial reasons for Germany to leave the EU. As Stefan Homburg, professor at the Leibniz University of Hannover and the director of its Institute of Public Finance, recently wrote in the New York Times:

“The legal framework of Europe’s common currency has been corrupted to the core. The protective measures of the Maastricht treaty — limited budget deficits, prohibition of bailouts and the ban on state financing via the money press — have all been breached. The resulting climate of illegality is unacceptable for anyone believing in the rule of law.”

Homburg also pointed out that “adherence to the common currency is apt to poison Europe’s political atmosphere all the more.” One of the euro’s primary purposes was to be “a peace project intended to sponsor coherence and team spirit.” But this has backfired.

Before the euro was introduced, European nations got along well. But today, a rapidly-widening gap of suspicion, resentment, and perhaps even hatred is growing in Europe, especially between Germany and Southern Europe.

If Germany were to abandon the euro as its currency, and resurrect the deutschemark, here’s what many analysts predict would happen:

  • Without its largest and most powerful economy, the euro would plunge in value.
  • Germany’s debts, public and private, are denominated in euros. As the euro fell, these debts would in effect shrink.
  • Not only that, the deutschemark would be much more highly valued internationally than the euro. This means that the Germans could pay off a shrinking debt with a rising currency, making the debts even easier to pay off.
  • Ultimately, Germany would be in a very enviable position. It would be the sole issuer of a highly desired and sought-after currency. Nations in this position enjoy tremendous economic benefits. (For an example of this, look no further than the United States.)

Are there any drawbacks to this plan? Yes, but they’re not as bad as might be expected.

As a net exporter, Germany would seem to be heavily dependent on the EU’s tight integration and elimination of trade barriers.

But as a recent study by the Centre for European Policy Studies (CERPS) has shown, a German departure from the EU wouldn’t be as costly to the Germans as everybody used to believe.

Previously it was thought that a ‘Gerxit’ would be self-defeating to the Germans, since it would erect steep trade barriers between their nation and the rest of Europe. Since Germany usually runs large account surpluses within the Eurozone—in other words, they make a lot of money selling stuff to their neighbors—leaving the Eurozone would be foolish and self-destructive.

But that’s a reflection of how things used to be, not the way they have become. As the CERPS study showed, much of Germany’s income no longer comes from trade with other EU nations.

Instead, a tremendous amount of it is investment capital. Thanks to the pathetic financial condition of most non-German nations within the EU, there are few attractive places to invest other than Germany. Thus, European institutions and investors are pouring money into German assets.

The Germans are enjoying a large inflow of capital that would be unaffected by trade barriers. In fact, a Gerxit would probably increase Germany’s allure for international investors.

Plus, as Stefan Homburg wrote in the New York Times, “Clinging to the euro would be costly for a Germany that has already spent billions to support insolvent member states like Greece. The counter-argument — that a German euro zone exit would depress exports — may be valid for individual exporters but not for the economy as a whole because it makes no sense to export on credit when the credit is ultimately repaid by the German taxpayer” (emphasis added).

Thus, what used to be unthinkable is becoming not just thinkable, but very tempting.

Germany could reap tremendous benefits from abandoning the EU. And the earlier, the better.

After all, if you know a ship is going to sink, it’s best to escape it while it’s still on the surface. And it would be best to escape the EU now, before Germany gets sucked into the fiscal disasters unfolding in Spain and Italy.

The problem is that all the above sounds rather selfish to everybody who isn’t German. And despite the countless frustrations of being in the EU, the Germans are reluctant to bail out if it will destroy the economies of their neighbors.

However, there’s another way of looking at this. A growing number of people are arguing that it would benefit their neighbors if Germany bailed out of the EU.

After all, what has austerity done for the broke countries in Southern Europe? It’s crippled their economies and made things worse instead of better.

What Greece and the other PIIGS need is economic growth. And the best way to get that is to export more goods and services to other countries.

And the best way to do that is to have a currency that’s worth less than their neighbors’ currencies.

So here’s the argument. As I mentioned a moment ago, if Germany bailed out of the euro and EU, the resurrected deutschemark would become much stronger than the euro.

In addition, Germany would stop funding bailouts for Greece and other nations. Presumably, these nations would also leave the euro, and during this process they’d restructure their sovereign debt. At the same time, they’d set up their own currencies again—which would, no doubt, be much weaker than the euro.

At that point, the southern nations who left would have weaker currencies than their northern neighbors (especially Germany). Exports would naturally soar, and their economies would grow. Meanwhile, their debt burdens would have been reduced.

It’s win-win for everybody—or so the argument goes.

Would this work? There would be an extremely painful transitional period, but after that, it’s quite possible. And a growing number of political leaders are recognizing that having one currency for all of Europe was a stupid notion from the very beginning.

  • Financially, the euro was a terrible idea, because it forces widely disparate economies to share the same economic policy.
  • Politically, the euro is poisoning the friendship and goodwill in Europe. In particular, Germany is becoming estranged and isolated from the rest of Europe. (We’ve seen where that situation can wind up, and nobody wants to go there again.)
  • Economically, the EU is mired in a deep morass that will take at least a decade to fix. That’s assuming it’s fixable at all—which many are beginning to doubt.

Despite the billions of euros being created from thin air by the European Central Bank, the continent’s financial woes are not going away. The national debts are too high, and the tax bases (from which the debts must be repaid) are too small.

The old Europe is dead. What the new Europe will be, is still unknown.

Meanwhile, the US rushes toward its fiscal cliff.

Add it all up, and I think it’s fair to say that…

2013 Promises to Be One of the Most Challenging Years for Investors Ever

Challenging times bring great opportunities, but also great peril.

Here in GEA, we plan to take full advantage of the opportunities as they arise. Historically, our unique investing approach has done very well in challenging times, and I expect we’ll continue to do so.

As for the peril, you can and should protect yourself against it. Gold is a must-have in today’s environment—it’s one of the few assets that will not only protect your wealth, but can also be a spectacular investment in its own right.

If things get really bad, we could see gold blast up to heights that surprise even me.

As we reach the end of another year, this is a great time to evaluate your portfolio. Does it have a solid foundation of precious metals, to protect your wealth from whatever may come? If not, take care of that now. And ask your tax advisor about possible tax benefits of doing it now, before the year is over.

I wish you a happy and prosperous holiday season!