King Dollar’s Precarious Perch

By Seth Van Brocklin. Extracted from the December 2014 issue of Independent Living News

From tumbling oil prices to record stock prices to the end of Quantitative Easing and rising market volatility, the latter half of 2014 has brought us close to an inflection point. What now lies ahead for investors?

We normally put out a “Where to Invest” Special Edition of Independent Living every January. In it we assess what may drive the markets in the New Year. But with major events in November, including the election, we thought it would be helpful to give readers a head start on preparing for what could be a major transition year in the economy in 2015.

Is a Surprise Recession Around the Corner?

Most Wall Street firms from Goldman Sachs on down are projecting economic expansion in 2015. However, some credible contrarians are forecasting a recession. Jerome Levy Forecasting Center, in 2007, foresaw a deflating housing bubble that would tank the economy. It now sees a 65% probability of a recession in the U.S. before the end of next year.

A recession in 2015 is no sure thing. But the risk of an economic downturn is much greater than most investors are positioning themselves for. The stock market certainly isn’t pricing in a high likelihood of a recession.

U.S. stocks have benefited from foreign capital flows out of Europe and Japan, whose central banks are trying desperate measures to stimulate growth. As the euro and yen have slid, the U.S. Dollar Index has soared.

U.S. multinational corporations depend on foreign buyers for their products. American companies now receive a historically large proportion of their earnings from abroad, with exports now representing 13% of U.S. GDP. Dollar strength makes U.S. goods less affordable to foreigners.

The question before investors now isn’t, When will the Fed move to support the dollar? But rather, When will the Fed move to depreciate the dollar?

The question before investors now isn’t, When will the Fed move to support the dollar? But rather, when will the Fed move to depreciate the dollar?

Deflation Warnings: Take Them with a Grain of Salt

The recent upsurge in the U.S. Dollar Index and fall in commodities prices has deflation bugs buzzing.

  • “Spreading deflation across East Asia threatens fresh debt crisis,” warns economic commentator Ambrose Evans-Pritchard in The Telegraph (November 12, 2014).
  • “Deflation comes knocking at the door… There is little doubt that deflationary risks have increased in recent weeks,” wrote Alasdair Macleod last month for GoldMoney.
  • “Deflation Rearing its Ugly Head in Subtle and Not-So-Subtle Ways Around the Globe,” blared a headline from the November 2014 Elliott Wave Financial Forecast.

The Elliott Wave people have been calling for deflation and a Dow Jones crash to below 1,000 since the 1990s.

If it weren’t for the intervention of the Federal Reserve, their forecast might have come a lot closer to pass in 2009 than it did. The reality is that a sustained deflation probably never will come to pass under our monetary system. The Fed’s multi-trillion-dollar virtual checkbook is a more powerful influence than Elliott waves or four-year cycles or any other apparent underlying rhyme or reason to where the market goes.

The Unstable Forces Underlying the Economy’s Apparent Stability

Inflation at the consumer price level has remained tame over the past few years. As officially measured, inflation has even run slightly below the Federal Reserve’s stated target of 2%. Yes, the official CPI number may understate real-world inflation. But even by alternate measures, inflation isn’t packing much of a punch.

Yet there is some violent push and pull going on between the forces of inflation and deflation. I liken it to a tug-of-war where both sides match up about equally. The rope doesn’t appear to be moving much.

But it is under severe stress from both sides tugging. At some point it will move decisively in one direction when the other side becomes exhausted. Here’s how “Sovereign Man” Simon Black describes the situation:

“The bubble in fiat currency is now so large that it has simultaneously created all-time highs in nearly every major financial asset class, particularly stocks and bonds. Bear in mind that these are not tangible assets, but rather ‘paper assets’— nothing more than claims on promises made by others (stockbrokerages, politicians, etc.)

“So in other words, the explosion in the supply of paper money has created dangerous bubbles in paper assets. Funny how that works.”

“And at this point there are no good options remaining to gracefully end the experiment. Any direction that central bankers go risks inflation, deflation, hyperinflation, or the collapse of financial markets.”

One of the forces keeping a lid on inflation is the weak job market. Despite lower headline unemployment rates, the number of people who don’t actually have a job is at all-time highs. Wages have been stagnant. However, wages appear set to move modestly higher.

Several states will raise their minimum wage in 2015 and 2016. Democrats want to raise the minimum wage at the national level. Some political observers believe it could happen as part of compromise legislation that gives Republicans something they want.

If the GOP-controlled Congress denies the left items on its wish list, then it may fall to the Federal Reserve to undertake new interventions in the final two years of Obama’s term in office. Fed chair Janet Yellen is an ideological ally of Mr. Obama’s. And thanks to the retirement of two dissenters on the Federal Reserve Board, Ms. Yellen will have little internal opposition to her activist agenda starting in 2015.

Former Fed Chief Reconciles with Gold

The Fed can manipulate interest rates and even boost asset prices, but it can’t generate real prosper prosperity. In other words, the only thing the Fed can do to combat deflation is generate inflation. That’s exactly what former Federal Reserve chairman Alan Greenspan thinks will happen.

In a recent talk to Beltway elites at the Council on Foreign Relations, the 88-year-old Mr. Greenspan was remarkably candid. He stated flatly that he thought gold would go “measurably” higher in the years ahead.

“Gold is a currency. It is still by all evidence the premier currency, where no fiat currency including the dollar can match it,” he said. “If you’re looking at the question of turmoil, you will find as we always have in the past, it moves into the gold price.”

In any kind of turmoil, gold usually holds up better than most assets. Lately, the phony stories about the economy recovering coupled with the very real injection of lower oil prices have driven investors out of gold and into U.S. stocks. This trend won’t last forever. All markets are cyclical.

Physical Silver Buying Picks Up

And if inflation starts becoming a headline concern for investors again, then silver will be one of the premier assets to hold. It can be expected to majorly outperform gold during inflationary times. Silver prices have been beaten down so hard over the past three years that silver presents itself as an incredible bargain here, even assuming inflation remains tame.

In October, demand for Silver Eagles neared a record high. In mid November, as silver prices sold off sharply, the U.S. Mint had to suspend delivery of its Silver Eagle coins. The Mint admitted that it just couldn’t keep up with demand.

The bull market in demand for physical silver among investors is back! Spot silver prices will likely follow in the months ahead.

The biggest fundamental reason why silver is underpriced is because the all-in costs of production for primary silver mines exceed recent silver spot prices by a significant margin. Miners can’t mine at these prices, which portends a diminution of supply.

Oil Prices Dip Below Critical Level

A similar dynamic may play out in the oil market. In November, crude oil prices dipped below break-even costs for some of the shale oil producers.

You’ve heard a lot about America’s energy renaissance, and it is a very real phenomenon. What we actually have is huge supplies of relatively high-cost oil. At oil prices below $80, those supplies start to diminish.

The energy sector has taken a pounding in the second half of 2014. Lower oil and gas prices make higher-cost alternatives such as wind and solar less economic. But oil and gas operators that pay good dividends are still viable. For instance, ExxonMobil (XOM)’s dividend is back above 3%. Exxon’s dividend goes up every year, regardless of what oil prices do. Investing in the highest-quality dividend stocks in the energy sector is one way to survive deflation, should it come, as well as gain from the onset of the next inflationary cycle. Which inevitably will come eventually.

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