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“Paper money eventually returns to its intrinsic value ZERO” - Voltaire 1729

August 27, 2009


A Shocking Fall

by Egon von Greyerz – Matterhorn Asset Management

This month we will discuss what is likely to be a major change both in sentiment and in the economy in the next few months. The autumn of 2009 will be full of shocking surprises in the banking sector, in financial markets and in the world economy.  The events that we outlined in our previous newsletter, “The Dark Years Are Here” are going to start unfolding. There will also be shocking falls in stockmarkets, in the dollar and in bond markets. But these falls will create major opportunities for investors which we will also discuss.

The syndrome of hope and false expectations

Some readers might feel that we are prophets of doom and that there is only gloomy news coming out of Matterhorn Asset Management. For people who want only good news we suggest that you listen to politicians or read the newspapers or your average stockbroker’s forecast. This is where you find the good news. But if you do listen to these people, remember that virtually nobody warned you about the events in the last couple of years, and that today most of these people are saying that the worst is over. And this is also what stockmarkets are telling us, isn’t it? These “optimists” whether they are politicians, bankers or from the media all make their living based on good news and this is why they will continually tell you lies and never warn you about the risks.

Investments are all about managing risk and our responsibility is to understand risk and warn investors when risk is unacceptably high. We have done this for many years and we will continue to do it. Sadly most investors base their investment decisions on hope. When government, private and corporate debt explodes the risk to the economy becomes very high.  And when bank credit  is growing exponentially and bank leverage is 50 times or more, this is very high risk. When derivatives reach $ 1 quadrillion with virtually no reserves against this astronomical exposure then investors should run for cover.

Investing, whether it is real estate or stocks, has been an easy game for many decades. Governments have in the last 100 years and especially since the early 1970’s printed money and expanded credit at a rate which has never been done before in world history. This has led to a massive asset inflation and a destruction of the purchasing power of most currencies. Risk taking and leverage have paid off handsomely. But this is now changing. In the next few years the leverage will hit back with a vengeance and the deleveraging of asset bubbles and credit bubbles will have a devastating effect on the world economy. This will lead to a massive deflation of assets and credit. Governments will continue to print money at an accelerating rate. Eventually the money printing will lead to a collapsing currency creating  hyperinflation in many countries and especially the US and the UK. But even with hyperinflation many assets such as real estate and stocks will decline in real terms.

Governments living in cloud cuckoo land

Never before have governments in the world expanded deficits and credit to the extent that we are seeing now.

In 2009-10 government budget deficits will be at least $5.5 trillion. This amount needs to be raised by all the countries running deficits. The US, of course,  has the biggest black hole and will need at least $3 trillion during this period. But these sums, which are unlikely to be sufficient, are just budget deficits and do not take into account the likely rescues of banks, other financial institutions, corporate failures, pension funds, insurance companies, cities, states, local government etc.

The US has lent or committed $13 trillion to prop up its collapsing financial system and economy. Virtually none of these funds have been written off yet and there will be a lot more to come in the next couple of years. It is still our view that the total cost to the US alone of the current crisis will be at least $25-30 trillion.

And where is the money coming from? Well, this is where Alchemy comes into the picture. Governments believe that they have found an unlimited source to prosperity. They have found the Holy Grail. Especially the US and UK governments, being the biggest culprits,  believe that they can  manufacture endless amounts of money and that this will create eternal wealth for their economies.

How do they do it? Governments use fancy terms like Quantitative Easing in order to confuse the people. In simple terms it means borrowing money that doesn’t exist or just printing money. To borrow money that doesn’t exist must be fraudulent and both against the law and the constitution. Yes of course the government is breaking the law and the constitution. But not only that , they are actually stealing money from the people, money  that the people doesn’t have,  but that they will have to work for generations to pay off.

But governments are not just creating money out of thin air. They are also looking after their affairs better than any other group in the economy. The only net increase in jobs in the last few years has been in the government sector, both in the US and the UK. Whilst the rest of the economy is suffering and cutting down, government is adding hundreds of thousands of jobs. Also pay and pensions in government jobs are superior to the private sector. So the main growth sector in the economy in the last few years has been the government sector that produces nothing but consumes 50% of GDP. No wonder we are all in trouble.

Government spending has gone from 10% of GDP in 1932 to almost 50% in 2008


Even more intriguing  is of course that the financial institutions that caused the crisis, mainly through greed, are the ones that benefited from the bubbles they helped to create.  They are also the beneficiaries of the trillions of dollars that governments have printed to rescue the system. This is like giving somebody who has robbed a bank the reward money.

This is Robin Hood in reverse, with  governments robbing from the poor in order to reward the rich for their misdeeds.  The poor, who are likely to get much poorer in the next few years, are unlikely to accept their fate without a fight. With the next stage in the downturn, due to start in the autumn, social unrest will grow and it could easily get out of hand in the next 2-3 years.

The law of supply and demand has not been abolished

A student of economics will know that there are simple rules that determine supply and demand.

In very simple terms if there is unlimited supply of something the price will go down to zero and if an item is very scarce, any demand will force the price up dramatically. (For more serious student the elasticity of supply and demand is also important but we don’t need to go in to that now).

So let us now look at a couple of sectors where the law of supply and demand has temporarily been tampered with:

US Dollar UK Pound (and many other currencies) will have major falls

Both the US and UK governments have for years printed their currencies. From 2007 when the current crisis started the printing of dollars and pounds have accelerated. In the case of the US dollar we are looking at trillions of new dollars. So when money is created which has only air behind it and no assets or substance, is this money not worthless? Yes of course it is but because governments and financial institutions worldwide have benefited from a strongish dollar, no one has said that the emperor is naked although everyone knows he is.

Supporting the dollar has also benefited the Chinese who have built up their own industrial base by financing the US deficits and excesses. But the Chinese with over $ 2 trillion in reserves of which as much as 2/3 could be in US dollars have now said in their veiled but very clear language: “The Emperor has no clothes”. The Chinese have now told the US to clean up their act but the Chinese know and the Americans know that their is no chance whatsoever that the US can reduce their deficits and dollar printing.

Therefore the dollar is living on borrowed time and as we outlined in last month’s newsletter “The Dark Years Are Here”, the autumn of 2009 will see a precipitous fall of the dollar. It will be relentless and greater than anyone can imagine. There is always a day of reckoning when the law of supply and demand is out of kilter and that day is now here. The move will be unexpected by many and this will mean that everyone will run for the exit and dump their dollars thus exacerbating the fall.

The situation for the pound is not much  better due to the dire straits of the UK economy. The pound may not fall as much as the dollar and probably not at exactly the same time. Normally a currency is attacked one at a time so we might first see the dollar moving and then the pound. But the pound has started to move down against the Euro and Swiss Francs in August and it is also possible that it will fall with the dollar against other currencies.

So what currencies will rise and how should investors protect themselves? We will discuss this later in the report.

Gold (and silver) – a spectacular rise

Investors who understand markets, know that if something has a major fall, something else will have a major rise. All you need to do is to turn the chart upside down.

The major beneficiary of the dollar fall will be gold (and silver). Gold has all the advantages that the dollar has not:

  • Gold can’t be printed
  • Gold has no debt attached to it
  • Gold has represented real money for 5,000 years whilst no paper currency has ever survived in tact throughout history
  • Gold has limited supply – Gold production is declining and demand increasing
  • Total annual mine production of gold is only $75 billion per annum which is 0.05% of world financial assets
  • Total increase in debt in 2009 in the US alone will probably be in excess of $5 trillion against an increase in gold of $75 billion – a 66 to 1 ratio
  • Central banks which have been net sellers are becoming net buyers of gold
  • China and Russia are major buyers of gold and only declare increases in holdings with long delays
  • Retail demand of gold in China and India is very high – These are nations who understand the virtue of gold as savings

With world debt probably increasing by as much as $7.5 trillion in 2009, there will be at least 100 times more paper money created than new gold produced. It can’t be difficult to forecast which money is likely to appreciate the most in the next few years – paper money with an unlimited supply or real money, GOLD, with very limited supply.

Short term gold is being suppressed by governments with the help of their bullion bank friends. Also, we would not be surprised if central bank gold has been lent to the market via the bullion banks. There has been no independent full audit of the gold in Fort Knox for decades.  But we are convinced that gold cannot be held down for much longer. In the next few weeks gold will pass the $1,000 mark. Once firmly above $1,000 gold will move swiftly to probably $1,400-$1,600 in 2009. Even without the effects of hyperinflation gold will go up several times from current levels in the next couple of years.

Gold 26.8.10

Interest rate manipulation will fail

Short term rates in many countries are virtually zero. In a free market with supply and demand in balance, an unlimited demand for credit would have driven interest rates sky high. But the interest markets are controlled by central banks who act on behalf of their governments. Since governments main driver is to remain in power, they buy votes by making money cheap and credit plentiful. This gives the people a temporary sense of affluence. Sadly most people don’t understand that the improvement in their living standards has been based on credit and printed money.  But now when credit is being withdrawn and people are losing their jobs, we are likely to see devastation which will be worse than in the 1930’s.

Governments can hold down short interest rates for very long periods but eventually market forces will prevail. Long term rates are more linked to supply and demand and this is where we will first see rates moving up. We forecast in our January newsletter that the biggest surprise in 2009 would be long rates going up. So far the US 30 year treasury bond has gone from 2.5% to 4.5%.  But soon market forces will prevail and all the countries that have been financing the US deficits for years will become net sellers of US debt. This will lead to long term rates shooting up dramatically and in that process forcing short rates up  in countries like the US and UK which have massive ongoing financing needs and no one willing to lend them. This will lead to more money printing, falling currencies and eventually hyperinflation.


The fall of the dollar and the pound and the fall in US and UK government bonds (creating higher interest rates) will happen this autumn and will be much more dramatic than most people can imagine.

The consumer is the loser and so is the nation

Trillions of dollars  have been created to prop up the financial system. Almost all of this money has gone to the banks and financial institutions.   A very small percentage has gone to industry. But the consumer who is the main victim of the crisis is getting no benefit at all. Instead the consumer will be progressively worse off as the crisis unfolds. Many will be unemployed. In July there were 126,000 bankruptcy filings in the US, up 34% from a year earlier. In the US the real unemployment today is 20%. or 30 million people. With dependents it means that around 100 million people, or 1/3 of the population, are affected by unemployment already. This number is likely to grow dramatically. In the UK official unemployment  is 2.4 million or 6.5%. But real unemployment including benefit seekers is 6.4 million or 17%. This means that including dependants circa 20 million people or 1/3 of the population are affected by unemployment today also in the UK.

It is not possible for two major economies like the US and the UK to function with 1/3 of the total population being affected by unemployment. This will lead to major economic, financial and social disasters as we outlined in our last report “The Dark Years Are Here“.

Consumers will be hit by increased costs and falling income. There will be energy and commodity inflation pushing fuel and food prices up. Interest will go up substantially, making mortgage payments rise. Government deficits will mean higher taxes.

“Government expenditure is surging and revenue collapsing.
This is a recipe for bankruptcy“
(see chart)


House prices will decline in real terms making consumers poorer and many will lose their homes. A Deutsche Bank analyst estimates that 25% of US mortgages are under water currently and that 48% of US mortgages will be in negative equity by 2011. With almost 50% of US consumers insolvent  and with real unemployment probably reaching 30% by 2011, the US will  be a bankrupt nation by then. Add to this a government which is already bankrupt today and it is easy to see that the US is facing total disaster in the next few years.

Bank problems as big as ever

In the US 81 banks have gone under so far in 2009. There are on average 2 1/2  banks going under every week and the trend is deteriorating. The last bank  to fall was the Guaranty Financial Group of Texas with $3 billion in losses. Many of these banks have been bought by other banks but the losses are left with the Federal Deposit Insurance Corporation (FDIC) which is soon running out of money.

At least another 200 banks and possibly as many as 500 are estimated to go under in the next couple of years. The FDIC which insures the depositors of failed banks has around $10 billion in reserves today. These $10 billion are there to insure $6 trillion of bank deposits. That means that the FDIC has a reserve of 0.17%. A 10% default rate, which is $600 billion, is very likely and it will probably be a lot higher. So the government will need to print a lot more money to fund the FDIC.

An excellent article by John Mauldin in his Frontline weekly newsletter discusses bank leverage. In the last 10 years leverage has gone from 20 times tangible common equity to 45 times in the US, 55 times in the UK and Euro Zone and an incredible  70 times in Switzerland.

Mauldin also discusses the GDP to bank assets in various countries. In Switzerland and Ireland bank assets are 7 times GDP, in the UK 5 times, Euro Zone 4 times and in the US bank assets are 2 times GDP. So in most countries the banking system is bigger than the state and therefore can’t be saved by the state without massive money printing.

But what John Mauldin doesn’t mention is that derivatives are not included in this calculation. Of the gross $1 quadrillion in derivatives outstanding, a major part is in the US. Just JP Morgan has almost $100 trillion in derivatives. If we include the derivatives gross exposure in the leverage it becomes infinite. Derivative risk should be measured gross since if there is a failure in the system and counterparties can’t pay, it is the gross risk which is exposed. There are virtually no reserves against these derivatives.

With between 45 and 70 times leverage, plus too big for the country to save, plus $1 quadrillion in derivatives, it is unlikely that the banking system will survive the next few years in its present form.

Wealth preservation will be back in vogue

To preserve wealth used to be the the most important investment criterion for centuries. To grow wealth took decades and was achieved by conservatively reinvesting profits and dividends. But with the asset inflation in the 20th century, due to expansion of credit and government money printing and due to massive leverage, the investment game changed. Investment returns which used to be measured over any years are  now measured every month or maximum every quarter. Annual returns that were not in double digits were not acceptable. With such high expectations conservatism and wealth preservation were thrown out of the window. The big Swiss banks which used to be ultra conservative are the best proof of the change in attitude based on greed. They went from the strongest balance sheet of all major banks to the weakest with now 70 times leverage. Stockmarket investments  which used to be held for years are now held for months only.
Although we now have a generation which doesn’t understand the need for wealth preservation they soon will! Once investors realise that the current stockmarket rally is just a correction in a major bear market, the present optimistic sentiment will quickly change. Add to that currencies falling, bonds falling and banks failing and fear will come back into the market again. The gold fever that took place in the autumn of 2008 will come back and stay for a long time.

Investors in countries that are likely to experience hyperinflation like the US, UK and certain Eastern European economies have the most to gain from protecting their assets. But due  to a precarious banking system worldwide and the fact that there is likely to be inflation in many countries, it is vital to protect assets whatever country you are in.

A wealth preservation portfolio should contain the following elements:

  • Physical gold stored outside the banking system. Gold is likely to reach $1,400-$1,600 in 2009 and much higher in the next few years.
  • A much smaller percentage of physical silver, also stored outside the banking system, Silver is considerably more volatile than gold so it is not for the faint hearted. Silver is currently $14.30 and could reach $25-30 in 2009 and considerably higher thereafter.
  • Gold and some silver mining stocks in a combination of some of the majors and some junior mining companies. The gearing to price increases in gold and silver is substantial, especially in the juniors which could go up manifold
  • Other potentially interesting sectors are; uranium and rare earth elements, food stuff and water stocks.
  • Currency management will be critical. US dollar and UK pound should be totally avoided. Norwegian Kroner, Canadian dollar Euro, Swiss Francs and the Chinese Renminbi will do much better. But since all countries will be printing money gold will do considerably better than any other currency.

The following areas should be avoided in a wealth preservation portfolio:

  • Long term bonds (especially in dollars and pounds). Interest rates will go up worldwide and bonds will drop
  • General stockmarket investments. Could go up in inflationary terms but not in real terms. In the short term the Dow Jones could technically go as far as 10-11,000 before it resumes its downtrend. But P/E’s on reported trailing earnings are now above 60 so the market is very overextended and could turn at any time.
  • Real estate, both commercial and residential.   Could also go up in inflationary terms but will go down in real terms. Commercial property will become a major problem in coming months both for investors and the banks.

The highest level of wealth preservation is gold and silver stored outside the banking system and also outside the country where you reside. Therefore an important percentage of a portfolio should be in this area.

Stocks in mining companies are potentially very profitable. But it must be remembered that they are subject to higher risks such as the custodian of the shares going under, confiscation or nationalisation of mines or very high taxation of mining profits. Thus in an emergency situation it might be difficult to access these investments.

There is clearly no absolute method of wealth preservation that protects investors against all eventualities. But it is vital to have a plan that gives the best available level of protection for peace of mind.

“I am more concerned with the return of my money
than the return on my money”

Mark Twain

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by Egon von Greyerz