I believe that the recent selloff in global stocks is liquidity-driven and will likely be short-lived. Many of our foreign creditors, particularly those using leverage, were forced to meet margin calls by selling assets to raise cash. Since the assets causing the problems had little, if any, value, they were forced to sell other assets instead, causing prices to fall sharply. In addition, the increased risk aversion that followed led to de-leveraging of other speculative positions, particularly yen carry trades, putting additional downward pressure on many of the foreign assets that had been purchased with borrowed yen.
In contrast to the recent declines in U.S. stocks, which are driven by deteriorating fundamentals and a poor outlook for corporate earnings and the U.S. economy, the steep drops in many foreign stocks do not stem from financial distress in the companies themselves, but simply from the short-term distress of their highly leveraged shareholders. Remember, the root of the problem lies in the inability of American borrowers to repay their debts. While foreign lenders may be getting stung a bit, they will take their losses and move on. On the other hand, American borrowers face much bleaker futures.
In a mortgage crisis such as the one we are currently experiencing, lenders typically get hit first. As it so happens at present, America’s lenders usually carry foreign passports. Although foreign creditors may be the first to take it on the chin, American borrowers will ultimately be knocked out by the combination punch of much higher interest rates and vanishing home equity.
Foreigners are suffering now because they loaned money to Americans who could not repay. But, as we are the ones who are broke, we are the ones who are in real trouble. Furnished with a greater appreciation of the risks, foreigners will now buy fewer dollar-denominated bonds collateralized by U.S. real estate, automobiles, receivables, credit card debt, etc. Without a ready secondary market for asset-backed debt, Americans will find it increasingly difficult to buy consumer goods or real estate on credit. As discretionary consumer spending grinds to a halt, real-estate prices plunge and our economy falls into a protracted recession, the developing bear market in U.S. stocks will continue. But as foreign consumers and businesses enjoy the benefits of additional goods and credit previously provided to Americans, overseas economies will grow faster, extending the lives of what are very powerful bull markets.
On a similar note, the recent global rout in stocks produced similar declines in both gold and gold stocks. Here again I feel that we are witnessing liquidity events that will likely reverse as the true nature of our problems becomes apparent. As Fed officials continue to talk tough on inflation and deny the obvious threats to our economy from the growing credit crunch and collapsing real-estate market, gold is being sold in favor of Treasuries. Soon, however, the markets will see through this charade and gold will shine more brightly than it did in 1980. The key for those of us holding the yellow metal or other non-dollar assets in anticipation of a major economic crisis in the U.S. is not to be panicked out of our positions. I am confident that we hold the winning hand; all we need do is not throw it away.
Regards,
Peter Schiff
