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The Golden Truth: No solution in sight
May 27, 2010

LIBOR rates starting to soar, Stocks getting battered, Corporate Debt issues drying up - does this feel like dejavu, reminiscent of the build-up to the 2008 crisis? Well, that seems to be quite a prevalent feeling these days amongst investors at large, with many questioning the probability of a following meltdown. Investors are concerned about the system, anxious to know if the sovereign-debt crisis will morph into a bigger systemic disaster.

Each one has their own reasoning of the current financial turmoil - fears of the spreading of the debt problem, expected financial regulatory reforms, liquidity crisis, bad economic data, etc.

Many cite stricter financial control by policymakers as the reason for the recent carnage in financial markets causing the unwinding of positions. Especially since, the Germans have already banned short selling and given that President Obama is likely to pass the new financial regulation bill which will tighten the reins on banks.

However, the most common reason for the current fallout has been signs of Greece’s debt contagion. In the Euro-zone again, Spain’s ailing banks signal a widening European debt crisis. Post the International Monetary Fund urging to overhaul its financial institutions, four Spanish banks are planning to combine as regulators to push lenders to merge with stronger partners. Strains evident in Spain’s banking system are signals that the Greek debt crisis may spread and significantly impact global economic growth.

Credit concerns are taking over as the driving force behind the cost-of-money in the interbank market. Doubts about government solvency have unraveled the guarantee that stabilized credit concerns and LIBOR over the past year. LIBOR has more than doubled this year as the European debt crisis fueled speculation that the quality of banks’ assets used as collateral will be impaired. Three-month LIBOR is a benchmark for about $360 trillion of financial products worldwide, ranging from mortgages to student loans. The rates paid by banks for three-month loans (in dollars) increased to 0.536%, the highest since July 7.

The issue here is that the solvency crisis is misread as a liquidity crisis. No, this is not a liquidity crisis; it’s a structural problem at hand.

All in all, signs of risk aversion are back and now it's all about principal protection. This is almost in complete opposition to the facts that drove the market higher since last March. Just as parts of the rally, so called "Green shoots", were dubious at best, parts of current fear seem premature and even dangerous in the sense that they could trigger actions that would threaten global markets.

No solution in sight
With the need to act fast, smart fiscal planning seems to be forgotten. The recent austerity measures aim to undo the rich pensions and early retirements. It is highly doubtful whether these measures would work. One important note here is that these governments were running deficits even in the boom years and now that the revenues have fallen significantly, can they earn surpluses? It’s a structural problem and these cuts can minimize the pain to some extent or prolong the issue but, unfortunately, can’t solve it. What is needed is for the economy to be put on a growth path built on its own fundamentals and not on temporary stimulus programs.

As Europe is being hit with new realities and forced austerity measures it's sure to slow the global economy. This has been a dilemma for a long time, especially in America. While the U.K. and Europe are ready to make major overhauls in welfare programs, the United States is passing one spending program after another, and people are shopping with money they only saved a few months ago.

The recovery that many were talking about in the U.S is clearly on life support i.e. on back of stimulus programs. Earlier we saw higher car sales thanks to the ‘cash for clunkers’ programs of the U.S government. It is by now clearly evident that it was a temporary push. Now there are tax credits for home buyers, which are supporting housing prices; which will also end soon. While more welfare spending and easier credit can temporarily help to shore up economic activity, they could in the medium term make the problems that caused the current crisis worse. The recovery is completely artificial which is evident from the current unemployment level. Initial jobless claims have gone through the roof, and mass layoffs are still happening. How can these many people still be seeking jobless benefits, this deep into the recovery?

It is only a matter of time before we find even the U.S witnessing such debt crisis. It also has similar issues that Greece or other European economies face today - rising deficits, ballooning debts, large unfunded liabilities.

How are they going to pay them?

I heard you say, "They will print their way out".

Yes, that seems to be the obvious response. It looks like they will continue debasing the dollar. Even on individual level, savings built up in 2009 are already being wound down to support frivolous spending habits. It seems the attitude remains: "why work hard? The ever inviting palm of the government is there to offer food stamps and stimulus checks."

It is probable that the debt crisis will continue to spread to other developed countries. Also, eventually it will turn inflationary as central banks continue to pump money and monetize their debt. Gold seems to be the only logical place to be, as government solvency is increasingly questioned. Going forward, you’ll definitely see some more central banks and other investors converting money to gold. A good allocation would be - 15% to gold as a hedge against globally lingering uncertainty, financial crisis and inflationary prospects. Grab your gold before the gold rush accelerates.

Disclaimer:
The Golden Truth is authored by Chirag Mehta. Chirag is Fund Manager - Commodities at Quantum Mutual Fund. Views expressed in this article are entirely those of the author and should not be regarded as views of Quantum Mutual Fund, Quantum Asset Management Company Private Limited and Equitymaster. The views constitute only the opinions and do not constitute any guidelines or recommendation on any course of action to be followed by the reader. Equitymaster has not verified the facts contained in this column and it does not accept any responsibility for the same. Please read the detailed Terms of Use of the web site.

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