The anatomy of Stagflation and its victim US Dollar. CS

With latest report about anemic GDP growth in 1st quoter 2007 of just 1.3% annualised, we should carefully examine the situation of US economy and stock market health. Stagflation is a word you should know about at the moment. It is defined as: " Condition of slow economic growth and relatively high unemployment - a time of stagnation - accompanied by a rise in prices, or inflation. Stagflation occurs when the economy isn't growing but prices are, which is not a good situation for a country to be in. This happened to a great extent during the 1970s, when world oil prices rose dramatically, fueling sharp inflation in developed countries. For these countries, including the U.S., stagnation increased the inflationary effects." Should I remind you the price of gold in the end of seventies early eighties? Stagnation is becoming apparent with growth below 2%: if you subtract inflation, Real Output is already negative, inverted yield curve has been showing it for months signaling recession. The only way out of recession and to prevent slowing economy out of spiralling into deflation, which has put Japan on hold from nineties, is printing press which has taken many exotic forms now, but they are all the same in one: increasing amount of credit available to consumers and other market participants. Easy credit on domestic scale allowed people to consume without normal boundaries of financial health, liars' loans made it available to become homeowners to those who can never afford it (and should not for their own good). New artificial demand has put pressure on house prices and we had first bubble in housing which is bursting right now. People made their home ATM machines and supported economy by taking equity out of housing "perceived" value to cover real cash outflow - interest payments on credit cards. Everybody became property tycoons. Least prepared people has taken most possible leverage. Go and try to borrow against your gold mining stock portfolio, what discount you will receive if anyone will grant you a loan, but with housing you could get it without any down payment and with interest payment only or even negative amortisation loan. But the most devastating I believe will be financial bubble bursting in the derivatives market. Money creation by FED became multiplied without any control by derivative market in which you can get economic exposure for a fraction of a real cost of asset. In this way using the same capital you can actually take risk on more positions, "academically" it is believed that it will reduce risk, spreading it among market participants. But first it will create "artificial" demand for assets and will drive their prices up. And second risk will be "spreaded" to those who are least prepared. This flood of liquidity chasing all assets classes created bubbles all across US economy, which became financial in its nature and GM was making more money in different financial services then by making cars. But now when liquidity is drying up in form of tightening credit supply bubbles start bursting and consumer becomes squeezed without any more easy credit available: two thirds of economy is without engine for growth now. So in the best case scenario growth will be anemic and we have stagnation. But interestingly enough it will not mean automatically that inflation will come down. The trick is that USA is a net importer of oil and other commodities and is competing for supply on the world markets. Commodities are priced in USD and foreigners are ready to pay more in USD with their own currency rising in order to secure the supply. So USA effectively importing inflation back home with rising oil and other commodities prices which are underlining for all other prices. The problem here is that USA has huge budget and foreign account trade deficit. In order to finance deficit USA is selling IOU - Treasuries and will find buyers only if interest will be attractive. You have to keep "perceived" value of dollar high if you would like to play this game. How long foreigners will be accepting effectively IOU for their oil and commodities? US Dollar is reserve currency of choice and nothing else. You need to tighten credit supply and rise rates in order to protect value of your currency, but your hands are tight: economy is melting and waiting for cut - more money supply. What will be the choice - another war? Economy will not handle it, keep it on hold and we have our scenario: economy is stagnating without stimulus, housing market in painful down slope for years, markets are flat (best dream) accounting for inflation and eroding value in real terms accounted in gold, milk or egg prices. Inflation is rising: you are chasing reluctant foreigners to buy your IOU to finance deficit but they are demanding more and more discount. USD is falling against other currencies and all real assets: foreigners start to diversify from "reserve" currency further eroding its value. US Dollar becomes chosen victim because the only way to pay less on your debts in real terms is to inflate them out and repay in depreciated currency. How can you preserve your wealth? Look for real value: growing population, rising emerging markets creating industrial infrastructure and demanding commodities for its growth, rising new powers and their wealth which they will protect from falling dollar. Commodity hunger will bring spotlight for companies like Tenke mining and Lundin mining which have secured huge deposits of basic metals like copper and zinc with demand for years to come. Falling US Dollar will ignite investment interest to companies leveraged to price of Gold and Silver like Tanzanian Royalty Exploration and Silver Wheaton. It is important to mention that these markets are relatively small and even fraction of money coming out of general market will lift sector in the next bull leg up from its consolidation phase. Sector is very volatile and you need to apply all proper due diligence and asset allocation rules, but until you can buy companies with trustworthy management with copper at 10 cents, gold at 50 dollars and silver at 1 dollar in the ground pay day will be worth the risk.