Thursday, January 22, 2009

Through the Looking Glass

Consumer confidence is so important for the Real Estate market and it has many asking what is the portent for our economy in the near future?

The US financial crisis has now spread across the globe. Years of easy credit created massive asset bubbles in the housing and financial services sectors. There has been too much exuberant leverage, not enough regulation; too strong a belief in asset-based prosperity, too little common sense that prices could go down as well as up; excessive “me first” greed, and too little concern for the burden of future generations.

There have been four bad bear markets in the last 100 years and while conventional wisdome suggests that investors “ride out the storm”, this may prove to be a poor strategy for everyone but the youngest of investors.

Bull and bear markets tend to move in cycles lasting for about 20 years. The Dow's 1929 peak was not surpassed until 1953 (24 years later), the Dow's 1968 peak was not surpassed until 1982 (14 years later) and the Japanese NIKKEI is down 80% from its peak of 44,000 in 1989. As of this writing, the Dow is at the same level that it was at the beginning of 1999 and the storm has only just begun.

And the greatest fear is that at the back end of this current crisis is a scenario that will send inflation soaring, wreaking havoc on even the most conservative investor's portfolio.

As defaults and foreclosures intensify and house prices continue to decline, the recession will get worse and the credit crisis will be amplified by the $1.2 quadrillion of derivatives that have been created. This will require increasingly larger government rescue and bailout attempts. What's worse, this influx of money is certain to have unintended consequences that are both long-term and very damaging. Although trillions of dollars in bailouts have already been issued, they will take time to work through the system, and lawmakers and economists admit there is no guarantee that they will work.

Currently, we are in the midst of a liquidity crisis brought on by the bursting of two asset bubbles. But the real danger is that the liquidity issue could become a full-blown insolvency crisis if credit is not made available in time to re-liquefy the system.

As a result of this crisis, we are entering a phase in the easing of monetary policy that has already taken real interest rates below zero when the real inflation rate is taken into account.

Most economists agree that inflation arises when the central banks increase the money supply in excess of the rate of GDP growth. For many years, the world's central banks have been doing just that. The fact is, global expansion in money supply has been depreciating all currencies, not just US dollars. The law of supply and demand is inescapable. If too many dollars chase too few goods, those goods must rise in price. Inflation always decreases real wealth by eroding purchasing power.

In the US, the Fed and Treasury are already pumping out vast amounts of public money to “liquefy” the banking system, and US money growth is now running at close to 14%, well above the official GDP rate of 3-4%. This year alone the total money supply, as measured by M3, has already increased by over $1 trillion. This doesn't include the announced bailouts.

Another $1.6 trillion was potentially added to the government's exposure when the Fed recently announced they would begin buying secured and unsecured commercial paper (short-term loans for business). This is a historic first; it did not occur even in the midst of the Great Depression.

After a big run-up, commodity prices have pulled back as recession fears begin to spread. While no one can call the bottom or knows if we are heading for a mild or a deep recession, the consensus is for a global slowdown with rising unemployment.

When we start to come out of this mess, longer term, inflationary pressures will start to rise as the newly printed money works its way into the system. In addition, due to the decline in global oil production coupled with rising demand from China, India, Russia and Brazil, oil prices will resume their surge. As oil is used in the manufacturing of most products as well as agriculture, mining and transportation, rising oil prices will lead to increases in most commodities and finished products.

Meanwhile, all the money that was printed and borrowed to try and liquefy the system will escalate prices, leading to an inflationary recession. The worst of all possible worlds is declining purchasing power combined with high unemployment and rising prices.

This is 1970s-style stagflation.

But because inflation numbers have been understated for years, and money supply is set to increase at unprecedented rates, this time it could intensify into a hyperinflationary depression.

In the early 1980s, the actual interest rates for Lower Mainland families was 22% (prime was 19.5%).

A return to inflation will result in sky high mortgage interest rates once again. Even if interest rates ONLY soared to 15%, the result will devestate housing prices.

Consider... in order to have the same monthly payment on a $650,000 dollar mortgage at todays five year fixed rate of 4.79%, the mortgage amount at 15% would have to drop to $250,000.

As we come out of this recession, virtually every economist insists that rapid inflation is unavoidable.

And that $650,000 house will HAVE to fall to at least $250,000 if anyone can even hope to afford to buy it.

If you knew that the $650,000 house you were thinking of buying today would only be able to fetch you $250,000 5-7 years from now, would you buy it?

Not a chance in hell.

And that's why Real Estate sales will plummet and fall off the charts this year.

Only a fool would assume such a large mortgage with these economic storm clouds on the horizon.


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