Sponsored Link:

Beware of the Obama Stimulus Trap

By Martin Hutchinson
Contributing Editor
Money Morning

Upbeat headlines have been everywhere in recent weeks, and they all seem to point to a single conclusion: The U.S. economy is in the early stages of a very rapid recovery.

In fact, when you peruse the news it’s difficult to come to any other conclusion. For instance:

But while many experts will look at these developments as an excuse to celebrate the looming rebound to come, I actually see them as a real cause for concern. The reality is that these reports, when viewed in concert with other data, are actually a sign of a re-inflating financial bubble.

This is actually an “Economic Recovery Trap” that – when sprung – will inflict a lot of pain on overly optimistic investors. Now that we’re sufficiently forewarned, we should re-orient our money accordingly.

Doomed by Deficits

It’s not surprising that the U.S. economy has shown signs of strength in recent weeks; it has had huge amounts of money thrown at it.

On the fiscal side, the Obama administration’s May budget plan suggested deficit for the 2009 fiscal year (which ends in September) would reach $1.83 trillion – about 13% of gross domestic product (GDP).

However, subsequently released unemployment figures have shown that the U.S. jobless level reached 9.5% in June, far above the 8.3% rate assumed in the budget. And unemployment is expected to spike further in the second half of the year.

This worsening unemployment situation strongly suggests that the true budget-deficit figures will be even worse than those already announced, a supposition strengthened by the postponement – from mid-July to mid-August – of the normal mid-term budget review. Since U.S. President Barack Obama is currently attempting to steer two difficult and expensive pieces of legislation – the cap-and-trade energy bill and the healthcare-reform bill – through Congress, he does not want unfavorable budget numbers appearing that might be used to persuade wavering legislators to oppose them. 

Even at 13% of GDP in fiscal 2009 and 10% of GDP in fiscal 2010, the U.S. federal deficit is far above any previous level reached in peacetime, so it’s likely that if the economy begins to recover these deficits will prove difficult to finance, meaning the budgetary shortfalls will push up long-term interest rates.

That escalation in long-term rates, in turn, could choke off the economic recovery, which to be healthy requires a rebuilding of inventories, extensions of credit to new domestic-and-foreign customers, and a revival of enthusiasm for such large-ticket items as housing and automobiles.

With the yield on 10-year U.S. Treasuries already up from a low of 2.07% in December to a recent level of 3.60%, the dampening effect of rising interest rates may already be becoming apparent. In any case, the deficit is a dark cloud that threatens to obscure the economic outlook.

And that dark deficit cloud will be very difficult to remove.

Know Your (Real) Enemy

The other main problem with today’s economy is the likely resurgence of inflation. Even the U.S. Federal Reserve – which under central bank Chairman Ben S. Bernanke for a long time apparently maintained a fear of deflation above all else – admitted in its last meeting that the likelihood of deflation had receded.

That’s not surprising: In the last six months, core consumer price inflation (excluding food and energy) was a reported 2.4% annually. Although the “headline figure” has been low because of the sharp drop in energy prices the United States economy has experienced since last year, that effect is about to disappear, as energy prices peaked in early July 2008 and fell sharply throughout the fall. Thus, even reported consumer price inflation – on a year-over-year basis – is likely to surge in the months after this one (July).

Moreover, the reported inflation figure may be low. Each month, the U.S. Bureau of Labor Statistics “seasonally adjusts” consumer price statistics to remove normal seasonal patterns from the data. That seasonal adjustment process is thoroughly opaque, and is subject to manipulation. In the early months of 2008, for example, when reported inflation was high, the downward seasonal adjustments were consistently much larger than the average of the decade 1998-2007. The process was then reversed late in the year, when reported inflation was negative, but the upward seasonal adjustments made it less negative. For the year as a whole, “seasonally adjusted” inflation was 0.5% below unadjusted inflation, which shouldn’t happen, except by bizarre rounding effects.

In the first six months of 2009, the negative seasonal adjustments have re-appeared, to the extent that total seasonal adjustments for the six months were minus 1.2%, compared with a 1998-2007 average of minus 0.61%. If the seasonal adjustments are indeed wrong, and should have been at only the average level, then “core” price inflation in the six months to June would have been 3.6% annually.

Not only is that not deflation; it suggests accelerating inflation.

Money Supply Moves

Another reason I wouldn’t be surprised by a reappearance of rapid inflation is the big increases in the money supply we’ve seen over the last year.

According to St. Louis Fed data, the M2 money supply has increased by 8.8% in the last year. The St. Louis Fed’s own Money of Zero Maturity (MZM) – the best measure of the broad U.S. money supply available since the central bank ceased reporting M3 in 2006 – jumped 10.2%. And the overall monetary base zoomed an astounding 92.8%.

In addition, the Federal Reserve has bought $300 billion of government bonds, always an inflationary warning signal since it monetizes the deficit. Furthermore, the Fed and the government together have engaged in rescue, stimulus and guarantee programs totaling an astounding $23.7 trillion, according to Neil Barofsky, inspector general for the government’s Troubled Assets Relief Program (TARP). A “gross” number if ever there was one, that figure is nearly twice overall U.S. GDP.

Sign up below…
and we’ll send you a new investment report for free:

“Credit Crisis Report.”

Let’s face reality: We’re going to be paying this bill for decades to come – almost certainly largely through resurgent inflation. In those circumstances, the recovery in the stock market is based not on reality, but simply on a bubble – an assertion that’s already been vindicated by the extraordinary afore-mentioned profitability of the Goldman Sachs and JPMorgan Chase trading operations, which typically benefit enormously when bubbles are inflating and there is too much money sloshing about.

The near-bankruptcy of CIT Group Inc. (NYSE: CIT), and the losses recorded by the commercial banking sides of Citigroup Inc. (NYSE: C) and Bank of America Corp. (NYSE: BAC), demonstrate that even in a period when short-term rates are exceptionally low, conventional commercial banking is not currently a moneymaker.

Other then Goldman Sachs shares (whose prosperity is likely to be short-lived), it is clear that our investment dollars should be concentrated in two areas:

  • Conservatively run overseas economies.
  • And inflationary hedges such as gold and silver.

Let’s look at some investment opportunities in each category.

First, we should buy moderately priced shares in countries where “stimulus” has been limited and in which monetary and fiscal policies are close to balance. The two largest such countries are Germany and Brazil, so you should look at the Germany ETF iShares MSCI Germany Index (NYSE: EWG) and the Brazilian iShares MSCI Brazil Index (NYSE: EWZ).

Second, you should make sure that a substantial portion of your assets are in inflation hedges such as gold and silver, either in the metals directly through SPDR Gold Shares (NYSE: GLD) and iShares Silver Trust (NYSE: SLV) or through gold mining shares, the exchange-traded fund (ETF) for which is the Market Vectors Gold Miners ETF (NYSE: GDX).

Better still, my colleague here at Money Morning, Peter Krauth, is an expert on gold mining companies, so you may find his new Global Resource Alert trading service – which focuses on gold, natural resources and other hard assets – to be a worthwhile investment.

[Editor's Note: When it comes to global investing, longtime market guru Martin Hutchinson is one of the very best - because he knows the markets firsthand. After years of advising government finance ministers, crafting deals with global investment banks, and analyzing the world's financial markets, Hutchinson has used his creative insights to create a trading service for savvy investors.

The Permanent Wealth Investor assembles high-yielding dividend stocks, profit plays on gold and specially designated "Alpha-Dog" stocks into high-income/high-return portfolios for subscribers. Hutchinson's strategy is tailor-made for periods of market uncertainty, during which investors all too often go completely to cash - only to miss some of the biggest market returns in history when market sentiment turns positive. But it can work in virtually every market environment.

To find out about this strategy - or Hutchinson's new service, The Permanent Wealth Investor - please just click here.]

News and Related Story Links:

July 31st, 2009

Why Gold Will Surpass $2,500

Few investors realize that inflation is the least of the factors driving the bull market in gold. Other factors, like Venezuela's crackdown on gold exports, are likely to push prices higher. Find out how to play each of the "7 Key Drivers" in our Money Morning Publisher's Series report... Go here to get it for free.




This entry was posted on Friday, July 31st, 2009 at 11:00 am and is filed under Main Essay, Martin Hutchinson. You can follow any responses to this entry through the RSS 2.0 feed. Due to the amount of comments we receive Money Morning will not be able to respond to all questions. If you have not already registered to leave a comment, once doing so you will receive Money Morning's Daily Email.

There Are 7 Responses So Far. »

  1. Comment by Ralph on 31 July 2009:

    Excellent post. The deficit spending will have an impact on interest rates, the US dollar, etc. But with all the stimulus spending on infrastructure, US bridges remain in disrepair which should be the most important priority as far as the funds allocated to transportation. If a group of innercity kids can figure it out then I know adults can. To learn more go to http://www.newyorkshockexchange.com/content/view/99/37/

  2. Comment by Ruth Gibson on 31 July 2009:

    Enjoyed the article, but disagree about this being peacetime. The US is waging three costly wars – Iraq, Afghanistan and Columbia – all of which have been hugely costly, none of which appear will conclude successfully. The deficit ballooned because of these military mis-adventures, putting the budget in the red well before the housing bubble burst and the financial gambling melted down.

  3. Comment by Tom Berger on 1 August 2009:

    Tom,

    After you read this I would like to discuss with you what we talked about over lunch. I would like to short the marked.

    The market WILL reverse itself; it’s not “if” but “when.” I do not plan on sitting on the sidelines watching this correction.

    Thanks,

    Horace

  4. Comment by DEMETRIOS F. MAVROGIANNIS, BARRISTER - AT - LAW (SUPREME COURT DIVISION), ATHENS, GREECE on 1 August 2009:

    Rarely have i had the pleasure of perusing an analysis which combines breath-taking candour in tandem with a veritably scientific ratiocination competely devoid of wishful thinking or tergiversation rendered compulsory by individual (vested or otherwise) interests. Your analysis constitutes an exemplary specimen of deductive reasoning, permeated by the brilliant causal thinking of the Age of Reason which afforded the West a giant leap forward and which, now abandoned, pounces on us in the guise of inescapable Nemesis. However, there is an additional concern, which, i fear, has not, yet, been adequately examined: termination of industrial production, a plague which virtually emasculated the West during the last 20-year period guarantees inability to recover, both in the context of medium- and long term-restructring. I cannot but submit to the necessity of the deduction that the period of Western ascendancy, embarked upon by the First Crusade, is now concluding at break-neck speed.

  5. Comment by Richard on 3 August 2009:

    The KNUCKLEHEADS in Washington are on the way to ruining the USA via overspending and over taxing…(Obama is now saying he is going to raise taxes on the middle class) …this is not what he said during the election… There is a hiddden agenda in Washington and we all know it…or do we? Wake up…

  6. Pingback by Why the Obama Stimulus Has Us on a Collision Course with Inflation on 3 August 2009:

    [...] from that scenario – rampant inflation. In fact, U.S. consumers are probably headed for the worst bout of inflation since the 1980s. And that makes the so-called “exit strategy” of U.S. Federal Reserve [...]

  7. Comment by Steve on 3 August 2009:

    I disagree with your analysis.

    If long term U.S. interest rates rise and negatively impact the U.S. markets, other markets will be affected. All markets are now interlinked. Unlike thirty years ago, there are no safe zones.

    Regards

Post a Response