Are the U.S. and Russia capable of waging a financial war?

As the Ukrainian crisis unfolded threats of financial war came from Russia and to a lesser extent from the E.U. and the U.S. They were not carried out except a few sanctions targeting key personnel in Russia. These were shrugged off and the crisis appears to have dropped to a series of posturing by both sides. A sigh of relief crossed the developed world and investment life went back to normal. In the past we have had similar events that were defused in a similar way. But history teaches us that that the world can suppurate easily and quickly in tense situation like this. The First World War started because of one shot from a pistol. He Second World War were preceded by trumpeting of ‘peace in our time’ as mistaken politicians thought they had made peace with Germany.

For the investors, these are signals that should be taken seriously, if his portfolio is not to be taken by surprise. After all, when such situations are ignited, events move too fast to prevent an assault on investments. Most of us tend to feel that if we can’t actually see the storm clouds and hear the thunder then the storm isn’t coming. It’s a certain lemming-like quality where if we see the man in front of us moving forward then we do too. In this case an investor shouldn’t do this he should take preventative action even when he doesn’t see the storm.  To start with, we should ask if both sides are capable of carrying out the threats.

Threats from the U.S. & the E.U.

The overall threat of financial war was accompanied by invidious pressure on global investors to reduce their sizeable holdings in Russia. For more than a decade Russia has sought more trade and investment with and into Russia. Trillions of dollars have flowed into companies controlled by the state. If these were to exit, the economy would be severely damaged. Over the last four years, western investors have sunk $325 billion into stocks and bonds issued by Russian companies and the country’s government, according to the research firm Thomson Reuters. Of that, $235 billion has been directed toward corporate borrowings by the likes of Gazprom and state-owned banks like Sberbank. Demand has been so strong that Pimco, the world’s largest bond manager, introduced a socially responsible emerging market bond fund in 2010. According to its prospectus, the fund looks to invest in companies that are reducing governance risks. It also reserves the right to steer clear of the bonds of countries that are listed at the bottom of the World Bank’s corruption indicator or are subject to sanctions by the United Nations. Now that Russia looks like one of these, can we expect some heavy handed action to disinvest? As of the end of 2013, Russian corporate and government bonds accounted for 31% of the fund’s $292 million in assets, nearly three times the weight in its benchmark, a JPMorgan emerging-market bond index.

Pimco has declined to comment.

Gazprom, the Russian energy giant supplies so much gas to Europe it has to be a possible target of the E.U. or a weapon in Russia’s hands. It has the American mutual fund giants Pimco and BlackRock among its largest investors and creditors. While the last year has seen the fortunes of the company alongside its share price sag, an attempt to sell the entire U.S. share ownership of theirs would hurt the company and the Russian stock exchange, very badly.

Will the U.S. & the E.U. be allowed to strangle inflows of capital or remove it from Russia without resistance? In the event of the start of a financial war, we believe that Russia would not allow that capital to exit and would take measure to insulate themselves against capital flows from the country. This implies that Exchange Controls would be imposed to encourage inflows and prevent outflows. With China as an alternative investor and on neither sides of the potential conflict, they would likely come in to pick up the pieces cheaply.

This is the most potentially visible of the weapons that would be used. The weapons to be used would extend from the financial to the economic. For instance, Russian companies selling to Europe and the U.S. would switch to buyers in China, the largest consumer of nickel. This was the opinion of eight out of 12 nickel producers, traders and analysts in the Asia-Pacific region. Punitive measures would increase global prices at least in the short-term. This is one aspect of the confrontation.

A second is the sale of gas by Russia to Europe. Europe is heavily dependent on Russian gas and would be badly hurt in the event of either higher prices or a cutback in supplies. In such a war, the weapons such as these extend across a wide spectrum. For sure the investment climate in both Europe and Russia would deteriorate drastically.

The biggest danger would be the attitude in such a confrontation because this justifies punitive actions that hurt the wielder of such weapons as much as it does the victim. What do we mean? The German Finance minister’s words that, “The objective is to uphold international law. It is of secondary importance whether there is an economic or financial cost.” This is a typical posture that precedes war-like situations.

Investors, after the event, would see the heightened risk and either withhold funds, or demand significant premiums on good investments. Sovereign risks on the E.U. and Russia would elevate borrowing costs and slow the flow of funds where they continue to exist.

It is likely that additional collateral would be required that is outside the pledges of either side.  These would be extreme times and so require commensurately non-national assets like gold to be used. We would see gold/currency swaps routed through the B.I.S. to facilitate the continuation of the monetary system as we know it now. Gold would move to a pivotal position internationally in such an event. Nations would scramble to get it, to be able to get international liquidity. Where would they get it from?

The EU agreed on a framework for its first sanctions on Russia since the Cold War. This places the E.U. in step with the U.S.A. The determination we are seeing from the E.U. is more than expected and sets the tone for more action and retaliation. The big question is just how far will the two sides go?

Certainly the dollar and the euro are threatened as are all their ‘dependent’ currencies’. The damage that Russia could do to Europe is far more direct because they are neighbours.

All global financial markets will feel at least a ripple from the Tsunami that will happen, once matters go too far. The least vulnerable and the bloc most likely to gain whatever advantages may come amongst the rubble of the financial system would go to China.

Threats to ‘crash’ the monetary system from Russia

A senior adviser to Putin said last week that if the United States were to impose sanctions on Russia over Ukraine, Moscow might be forced to drop the dollar as a reserve currency and refuse to pay off loans to U.S. banks. These remarks were purported to have come from a senior aide to President Vladimir Putin’s, Glazyev. While his remarks were later refuted by Russia, the possibility of such action remains. What harm would such moves do?

Glazyev also said that Russia could reduce to zero its economic dependency on the United States if Washington agreed sanctions against Moscow over Ukraine, warning that the American financial system faced a “crash” if this happened.

He said that if Washington froze the accounts of Russian businesses and individuals, Moscow will recommend to all holders of U.S. treasuries to sell their U.S. government debt. Do his remarks have credibility? Apparently, Glazyev is often used by the authorities to stake out a hard line stance. He does not make policy but has the ear of Putin and would be aligned with the more hawkish elements in the Russian government and military. He further threatened that Russia could stop using dollars for international transactions and create its own payment system. Russian firms and banks would also not return loans from American financial institutions. “An attempt to announce sanctions would end in a crash for the financial system of the United States, which would cause the end of the domination of the United States in the global financial system,” he added. Glasyev’s comments were likely sanctioned by the Kremlin and by Putin himself. They would appear to be a warning to the U.S. regarding isolating Russia politically and imposing economic sanctions. So far they have not been carried out, so will they. Are your investments vulnerable?

Do these threats pose a real and present danger to the West? Should Russian foreign exchange reserves and bank assets be frozen as is being suggested, then Russia would likely respond by wholesale dumping of their dollar reserves and bonds. That will set off a destruction of the financial system that we know now. It takes far less than most expect to cause such damage. Yes, it would border on insanity!

In the state the global financial system is in at the moment such threats followed by any sort of action will produce ripple effects that in themselves will produce turbulence and collateral damage in global financial markets that go far beyond the borders of Europe and the U.S.A.

The hegemony of the dollar will be threatened if not mortally wounded, for sure. Simply the loss of stability in financial markets will rupture many markets. Russia would turn once again to China after trying to sell the dollar. Again, such actions would be cutting of its nose to spite its face. But that’s what war is.

The dollar is so entrenched as the globe’s reserve currency, that even a small action against it would cause disproportionate damage to its exchange rate. A strong seller of the dollar would hurt it badly. If that seller were known to be a central bank, then the damage would be considerably heavier.

We could go on far more describing the damage that could be done to both sides but we think the point is well made already.

Unlikely – Because of the consequences!

The consequences of even starting down this road are so dramatic that we deem the likelihood of a financial war as most unlikely. The Crimea and the Ukraine were part of the U.S.S.R. Hence we do not believe that either the U.S. or the E.U. will stake so much for so little potential gain. The results would be too horrible to contemplate.

But having said that, prudent investors, as we warned at the beginning of the article, won’t wait for these events to happen! They will not only be protecting themselves from the consequences, if these events took place, they would be positioning themselves to benefit from them. And they would do this now, well ahead of such possibilities, or go the way of lemmings.

With gold the clear benefactor in such situations we expect that if markets perceived the bigger danger to be imminent the gold price would surge.

For gold investors, the fact that such rhetoric is taking place is a salutary reminder that gold will rise in extreme times like these and that to buy that gold ahead of the slide down into the abyss is the wise course!

Hold your gold in such a way that governments and banks can’t seize it!

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In recent years a good part of the monetary debate has become a simple war of words, with much of the conflict focused on the definition for the word “inflation.” Whereas economists up until the 1960’s or 1970’s mostly defined inflation as an expansion of the money supply, the vast majority now see it as simply rising prices. Since then the “experts” have gone further and devised variations on the word “inflation” (such as “deflation,” “disinflation,” and “stagflation”). And while past central banking policy usually focused on “inflation fighting,” now bankers talk about “inflation ceilings” and more recently “inflation targets”. The latest front in this campaign came this week when Bloomberg News unveiled a brand new word: “lowflation” which it defines as a situation where prices are rising, but not fast enough to offer the economic benefits that are apparently delivered by higher inflation. Although the article was printed on April Fool’s Day, sadly I do not believe it was meant as a joke.

Up until now, the inflation advocates have focused their arguments almost exclusively on the apparent dangers of “deflation,” which they define as falling prices. Despite reams of evidence that show how an economy can thrive when prices fall, there is now a nearly universal belief that deflation is an economic poison that works its mischief by convincing consumers to delay purchases. For example, in a scenario of 1% deflation, a consumer who wants a $1,000 refrigerator will postpone her purchase if she expects it will cost only $990 in a year. Presumably she will just make do with her old fridge, or simply refrain from buying perishable items for a year to lock in that $10 savings. If she expects the cost of the refrigerator to decline another 1% in the following year, the purchase will be again put off. If deflation persists indefinitely they argue that she will put off the purchase indefinitely, perhaps living exclusively on dried foods while waiting for refrigerator prices to hit zero.

Economists extrapolate this to conclude that deflation will destroy aggregate demand and force the economy into recession. Despite the absurdity of this argument (people actually tend to buy more when prices fall), at least there is a phantom bogeyman for which to conjure phony terror. Low inflation (below 2%) is even harder to demonize. Few have argued that it has the same demand killing dynamics as deflation, but many say that it should be avoided simply because it is too close to deflation. Given their feeling that even a brief bout of minor deflation could lead to a catastrophic negative spiral, they argue for a prudent buffer of 2% inflation or more. But the writer of the Bloomberg piece, the London-based Simon Kennedy, quotes people in high positions in the financial establishment who offer new arguments as to why “lowflation” (as he calls it) is a “threat” in and of itself. And although the article was primarily concerned with Europe, you can be sure that these arguments will be applied soon to the situation in the United States.

The piece correctly notes that those struggling with high debt tend to welcome high rates of inflation. The math is simple. By diminishing the value of money, inflation benefits borrowers at the expense of lenders. By repaying with money of lesser value, the borrowers partially default, even when paying in full. The biggest borrowers in Europe (and the United States for that matter) are heavily indebted governments and the overly leveraged financial sector. Should it come as a surprise that they are the leading advocates for inflation? The writer admits that higher inflation will help these interests manage their debt burdens and in the case of the financial sector, profit from the increased lending that low interest rates and quantitative easing encourage.

On the other side of the ledger are the consumers, the savers, and the retirees. These groups want lower prices and higher rates of interest on their accumulated capital. Such a combination will lead to higher living standards for those who have worked and saved for many years in order to enjoy the fruits of their efforts. But these types of people are simply not on the “must call” list for our best and brightest economic journalists. As a result, we only get one side of the story.

The article also points out that higher inflation gives businesses more flexibility to retain workers in periods of weak growth. The argument is that if sales revenue falls, companies will not be able to lower wages, and will instead resort to layoffs to maintain their profitability. However, this is only true in cases involving labor union contracts or minimum wage workers. In all other cases, business could reduce wages in lieu of layoffs. Plus, if prices for consumer goods are also falling, real wages may not even decline as a result of the cuts.

In circumstances where wages cannot be legally reduced, as is the case for unionized or minimum wage workers, layoffs are often the employer’s only option for keeping costs in line with revenue. However, inflation allows employers to do an end run around these obstacles. In an inflationary environment, rising prices compensate for falling sales. The added revenue allows employers to hold nominal wage costs steady, even when the raw amount of goods or services they sell declines. When inflation rages, higher skilled workers will often demand, and receive, pay raises. But low-skilled workers, who lack such leverage, are usually left holding the bag.

In other words, politicians can impose a high minimum wage to pander to voters, but then count on inflation to lower real labor costs, thereby limiting the unemployment that would otherwise result. So what the government openly gives with one hand, it secretly takes away with the other. Workers vote for politicians who promise higher wages, but those same politicians also create the inflation that negates the real value of the increase. But while government takes the credit for the former, it never assumes responsibility for the latter. The same analysis applies to labor unions. Based upon political protection offered by friendly officials, unions can secure unrealistic pay hikes for their members. But the same governments then work to reduce the real value of those increases to keep their employers in business.

Of course, what the Bloomberg writer was really arguing is that governments need inflation to bail themselves out of the policy mistakes they make to secure votes. But two wrongs never make a right. The correct policy would be to run balanced budgets rather than incur debts that can only be repaid with the help of inflation. On the labor front, the better policy would be to abolish the minimum wage and the special legal protections offered to labor unions, rather than papering over the adverse consequences of bad policies with inflation.

So be on the lookout for any more hand-wringing over the supposed dangers of lowflation. The noise will simply be an effort to convince you that what’s bad for you is actually good. And although it’s an audacious piece of propaganda to even attempt, the lack of critical awareness in the media gives it a fighting chance for success.

Peter Schiff is the CEO and Chief Global Strategist of Euro Pacific Capital, best-selling author and host of syndicated Peter Schiff Show.

Catch Peter’s latest thoughts on the U.S. and International markets in the Euro Pacific Capital Winter 2014 Global Investor Newsletter!

The world’s economic, financial, and geopolitical risks are shifting. Some risks now have a lower probability – even if they are not fully extinguished. Others are becoming more likely and important.

A year or two ago, six main risks stood at center stage:

• A eurozone breakup (including a Greek exit and loss of access to capital markets for Italy and/or Spain).
• A fiscal crisis in the United States (owing to further political fights over the debt ceiling and another government shutdown).
• A public-debt crisis in Japan (as the combination of recession, deflation, and high deficits drove up the debt/GDP ratio).
• Deflation in many advanced economies.
• War between Israel and Iran over alleged Iranian nuclear proliferation.
• A wider breakdown of regional order in the Middle East.

These risks have now been reduced.

….continue reading HERE

I sometimes get the feeling that somewhere across that huge puddle, in America, people sit in a lab and conduct experiments, as if with rats, without actually understanding the consequences of what they are doing.

We promised to explain how it ends. The world, that is. The world we live in now. The one in the middle of a rapidly inflating central bank bubble.

First, we need to understand that this is a very different world from the world of the 19th and early 20th centuries. It is a world where central bankers play a role somewhere between con artists, mad scientists and God Himself.

They deceive and cheat. They conduct their experiments without any real idea how they will affect people. And they move almost every price in the world – sending investors, householders and business people all running in one direction.

Their experiments change not only prices quoted on the Big Board and the supermarket. They also change the physical world. Jobs are lost to machines that – without such low interest rates – would not have been built.

Monetary Fantasy

Those in the 1% are only as rich as they are today thanks to the Fed’s manipulations. America’s super-sized houses also are largely the result of the Fed’s 2002-07 real estate bubble. And many a mansion has been built in Aspen or the Hamptons with money from Wall Street bonuses, which wouldn’t have been possible without central bankers’ grand designs.

And China is the way it is today – with its gleaming towers, its mega-factories, its empty cities and clogged roads – largely because US officials made it easy for Americans to buy things they didn’t need with money they didn’t have.

Central bankers – along with central governments – have created a kind of monetary fantasy… which depends on ever increasing amounts of credit.

But where can all this new money go? Real output can’t keep up with it. So prices must adjust. In the event, they bubble up… first one market, then another… first one sector, then another…

And after the bubble, what?

The bust!

That’s what we’re waiting for. A bust in the biggest debt bubble of all time.

When the credit inflation ball bounces off the ceiling, it produces an equal and opposite reaction in the other direction. Asset prices fall. This is deflation. It begins with asset prices… and then makes its way into consumer prices.

Making Volatility Your Friend

Most investors think they need to protect themselves from this kind of volatility.

Academic studies show that more volatile stocks under-perform less volatile stocks – they call it the “volatility anomaly.” And it is obvious that if your stock goes down 50% you need 100% on the upside to get back to where you started. Losses and gains have “asymmetric” effects on your portfolio.

But at our small family wealth advisory, Bonner & Partners Family Office, one of our principles is that you need to “make volatility your friend.” Because volatility is not the problem. The real problem is risk. There is risk that you will buy the wrong investment at the wrong price. Then you’ll get whacked.

EZ money policies – low rates, QE, paper money – produce an apparent stability. As long as the money flows freely, even some of the worst businesses and the worst speculators can borrow to cover their losses.

Stocks go up and up and up. It looks good. But it masks real risk. As the bubble in credit increases the risk of a major blow-up increases… until it becomes a certainty.

This is where volatility can be your enemy and your friend. Just as Fed policies have made stocks too expensive… the equal and opposite reaction of the financial markets will be to make them too cheap. (Stay tuned.)

So, there you have it. The first stage of “the end” will be a major selloff of stocks. At present prices, of course, they’ve got it coming anyway.

But the implosion of the debt bubble and the collapse of asset prices are not likely to be the end of the story. Not as long as we have delusional activists running central banks and central governments.

Tune in tomorrow for the second stage of the end.

Regards,

Bill

Market Insight:

From the desk of Chris Hunter, Editor-in-Chief, Bonner & Partners

Investors continue to hang on the words of central bankers.

They are focused on the doctor (central bankers), not the patient (the economy).

Further evidence of this came on Friday, when the S&P 500 plunged following Janet Yellen’s comment, made during her post-FOMC press conference, that the Fed would consider raising short-term interest rates “something on the order of around six months” after the end of QE.

This was sooner than the roughly one-year gap the market had anticipated. Investors reacted by hitting the “SELL” button.

Here’s a look at the effect Yellen’s “six month” comment had on the S&P 500.

A market that reprices stocks so quickly based on the utterances of a Ph.D. is a highly distorted one in our view. And highly distorted markets tend to be highly dangerous markets, too.

That’s because they are based on a fiction: that central bankers can perform miracles.

This fiction may explain why investors have been so sanguine about rising geopolitical tensions around the world: in Ukraine… Thailand… Venezuela… Turkey… Syria… Iran… and North Korea.

The logic goes that, sure, geopolitical tension may be on the rise. But central bankers “have investors’ backs.” If something major goes wrong, investors can expect even more dramatic credit easing from central banks… and a resumption of the uptrend in stock prices.

This is a dangerous fallacy.

Ignoring rising geopolitical tensions has been profitable of late. But nothing is more dangerous to your wealth than extrapolating past trends into the future.

Unhedged portfolios will suffer greatly if this trend reverses and underlying geopolitical tensions trigger a major selloff.

We recommend you hold plenty of cash and gold in your portfolio to offset potential stock market losses.