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More Predictions

Fri, Sep 19 2008, 06:22 GMT
by Comstock Partners Team

Comstock Partners Inc.

We have been going out on a limb this year making predictions that seemed to be outrageous when they were made but don't look so bad now. In all honesty, we wish that we were wrong. We have predicted that this country will go into a severe recession that will spread abroad and wind up throwing us into a global recession. We also predicted that this global recession will cause unprecedented "demand destruction" causing a collapse in commodity prices. While most market observers will take the collapse in commodity prices to be very positive for the stock market (since most observers thought the reason the market peaked in October 2007 was caused by the rise in commodities -especially energy prices). We expected the S&P 500 to decline below 800-900 (see "What is the Real P/E" in our special reports or the latest article from Barron's in "Comstock in the News" on our home page). The S&P analysts just lowered their earnings estimates this week, so we may be too optimistic. The next prediction we would like to make is that soon you will be hearing more and more about the two concepts of "competitive devaluations" and "beggar-thy-neighbor" that we have been discussing for some time.

These two expressions are used in the "Cycle of Deflation" chart we have used on these comments for years now. They both relate to what trading partners are forced into doing when things go south in the global economy.
When a country is in a severe recession and credit crisis (as we are experiencing presently) the first thing the leaders do is send out checks to the citizens. We have just done that and will probably do another round of stimulation late this year or early next year. The leaders eventually realize that "dropping money out of helicopters" does not work in the long run.
When a country's entire economy is based upon a "borrow and spend" mentality and then the credit market shuts down, the consumer and the economy "hits the wall". After trying all the alphabet auctions (which substitute Treasury securities for mostly toxic paper) and sending out enough money to drive the budget deficit to astronomical levels they eventually resort to other means of devaluing their currency.

Remember, if we attempt to lower our currency (in order to sell more domestic goods abroad) it can only happen relative to another currency. So, for example, if we hope to lower our currency vs. the Euro we could expect to do this by lowering our interest rates. And if the Euro-zone keeps their interest rates at the same level the Euro currency will gain in value relative to the U.S. dollar. This makes our goods and services relatively more attractive in the Euro-zone. If the economy of the Euro-zone area suffers, that would force the Euro Central Bank (ECB) to lower their rates. That is how you get the competitive devaluations started and this could spread to Asia and other trading partners.

The Wall Street Journal had a recent article about how Russia and South Korea were intervening in the foreign currency markets to "shore up their currencies by selling billions of dollars from their stockpiles of reserves". It was a factual article but we suspect strongly that these policies will be reversed soon in order to shore up their economies. Russia stopped trading in their stock market yesterday after dropping about 60% over the last 3 months.

Notice that the ECB and Bank of England kept their rates unchanged last week at 4.25% and 5% respectively. We strongly suspect this will change in their next meeting and, although they both claim to be worried about inflation, the worsening economies will overshadow their inflation concerns.
The ECB and Bank of England kept their benchmark interest rates unchanged due to mounting inflation fears and slowing economic growth across Europe. The ECB 's rate is at a seven year high when it increased the rate ¼% in July, while the Bank of England left its rate unchanged at 5% since April when it lowered the rate by ¼ %. The euro-zone, a bloc of 320 million people that accounts for 15% of the world's GDP, will probably be negative in the second quarter.

Alex Weber, a German representative on the ECB Governing Council in a recent interview claimed to be very concerned about the risks of inflation accelerating as wages are rising. He seemed to think the weakness in the second quarter was just offsetting the strong first quarter. He stated that the growth rates of credit have only come down a little and doesn't expect a credit crunch. Let's see how that changes before the next meeting. We expect to witness all of these countries including the U.S. to compete on how fast they can lower rates to reduce their currencies in order to sell goods abroad and avoid shutting down plants. The next step after competitive devaluations will be "beggar-thy-neighbor" policies which mean seeking benefits for one country by means which tend to worsen the problems of other countries. This usually takes the form of instituting tariffs and quotas on imports or by selling goods and services at cost or below cost to avoid the economic slowdowns from getting out of control and keeping their plants from closing.

Published on  Fri, Sep 19 2008, 06:25 GMT