Simple question: how do you invest during an inflationary boom? Today, some concrete ideas. And the simplest idea of them all-when you consider soaring government deficits-is to sell government bonds and buy beaten down, world-class equity.

Mind you, this is if you want to be in the equity market at all. There is a very good case to be made for NOT being in the equity market this year, or only being in those asset classes and single stocks you think will appreciate (or grow earnings) faster than the rate of inflation.

But let’s be more direct and say that this is still a bear market. The bear market began in 2000 with the popping of the tech bubble. The Fed fought back in 2003, setting a low-interest rate policy the rest of the dollar-pegged world followed. This kicked of leveraged booms in residential housing, credit derivatives, and stocks, bonds and commodities.

All those bubbles are popping. You do not wipe out twenty-five years of credit and leverage excess in a mere eighteen months. We are barely halfway through the liquidation/loss realisation phase. The essential question is which assets are going to perform the best as governments inflate and create a new bubble in government debt? And by the way, it’s going to be very large bubble.

Forget the $1.8 trillion deficit the Obama White House admitted to. The true scope of government borrowing is breathtaking, and rather sickening. More importantly, you have to wonder where the money is going to come from, and what will happen when it’s not forthcoming from private investors.

Consider the chart below, courtesy of Niels Jensen, writing in John Mauldin’s “Outside the Box” e-letter. Niels shows that according to IMF estimates, twelve governments around the world (the ‘Dirty Dozen’) will have to issue $10.2 trillion in bonds to cover future banking losses and funding requirements in the credit markets as a result of the ongoing financial crisis.

The ‘Dirty Dozen’ and $10.2 Trillion in New Bonds

Ten trillion is a huge number. But there’s every chance the number is, in fact, a conservative estimate of government borrowing requirements. It is based on smaller than expected losses in the banking sector (the bogus scenarios modeled in the U.S. Treasury’s ‘stress tests’) and a lower-than-average increase in public borrowing to deal with a financial crisis.

The IMF estimate is that public sector borrowing will grow to an average of 27% of GDP in Western or industrialised countries. But according to a study by economists Carmen Reinhart and Kenneth Rogoff published last year, governments almost always underestimate the amount of public borrowing that takes place in the wake of a banking crisis.

They do because—as the government here in Australia has done—they underestimate the blow to tax takings that comes from lower bank lending and lower economic growth. Tax takings fall while spending generally increases, especially borrowing to subsidise lending in key sectors like say, high-risk mortgage lending and property development. Think of the AOFM’s role in buying securitised residential mortgage backed securities and Ruddbank.

So how big could government bond borrowing needs get? Under the ‘best case’ scenario (lower loan losses, quicker economic recovery) Rogoff and Reinhart say public sector debt would grow to an average of 40% of GDP, leading to global borrowing needs of $15 trillion-50% higher than the IMF’s estimate. But that’s just the best case scenario.

Using the chart below, Reinhart and Rogoff suggest that in previous banking crises, government borrowing as a percentage of GDP has risen to an average of 86%. Under that scenario, now you’re talking $33 trillion in global government bond issuance in the coming five years to deal with the rest of the losses in the banking system.

The Mother of All Bubbles in Government Debt

You can see why we think all this talk of recovery and rally is a bunch of hokum. Maybe it won’t be quite 86%. Or maybe it will be more. But we know for a fact that global governments are going to flood with world with bonds in the coming years. But will investors buy them? If they don’t, you can expect much higher bond yields and much more money printing. That means inflation.

What does an investor do? Well it’s worth noting that Microsoft appears to be preparing for massive inflation by borrowing. The company is selling $3.75 billion in debt in order to buy back some of its own shares. Obviously Microsoft reckons the real value of the debt will diminish with inflation while the current purchasing power of the borrowed money allows it to buy back its own shares.

It’s a nifty trade and provides the example of buying equity in world-class businesses at cheap prices. There have to be a lot of investors in the world out there who see the endgame of this explosion in government debt and would much rather buy equity. That alone means the “weight of money” argument for equities could send shares higher.

We have to admit we are extremely dubious of this strategy because it says nothing about how these businesses will perform in a world saddled with so much debt. But we suppose if you are a truly a long-term investors and have decades to wait, buying equities at these lows is, a) a much better idea than buying government bonds, and b) about the only sensible investment strategy if you’re going to stay in the equity markets.

What does an investor do? Well it’s worth noting that Microsoft appears to be preparing for massive inflation by borrowing. The company is selling $3.75 billion in debt in order to buy back some of its own shares. Obviously Microsoft reckons the real value of the debt will diminish with inflation while the current purchasing power of the borrowed money allows it to buy back its own shares.

It’s a nifty trade and provides the example of buying equity in world-class businesses at cheap prices. There have to be a lot of investors in the world out there who see the endgame of this explosion in government debt and would much rather buy equity. That alone means the “weight of money” argument for equities could send shares higher.

We have to admit we are extremely dubious of this strategy because it says nothing about how these businesses will perform in a world saddled with so much debt. But we suppose if you are a truly a long-term investors and have decades to wait, buying equities at these lows is, a) a much better idea than buying government bonds, and b) about the only sensible investment strategy if you’re going to stay in the equity markets.

But let’s say you don’t want to buy-and-hold blue chip stocks. And let’s say you want to be in the market and not just in gold, vodka [or bourbon—Ed.], bullets, and canned goods. If you’re a “financial survivalist” what else can you do?

Try uranium and lithium (as investments, not meals). We reckon the government WILL decide that because energy is an industry that’s going to survive the credit crisis. China is building twenty one-gigawatt nuclear reactors at the moment. China will not be able to supply its own uranium needs. Australia, with over 30% of the worlds proven uranium reserves, is in position to capitalise, should it so choose.

According to Scotia Capital Inc. China strategist Na Liu, China’s nuclear industry will consume 15,700 tonnes of uranium per year by 2020. “At this rate,” she writes, “China’s currently known uranium resources can only last for five to 10 years. Clearly, in our opinion, it is imperative for China to secure long-term supply through imports or investment.”

So you see, for the resource speculator, an inflationary boom can be the best of times. It is a high-risk exercise. But junior resource stocks are one of the asset classes that CAN go up faster than the rate of inflation. And if, as we believe, the explosion in government bond issuance is going to lead to an inflationary rally in stocks, then dabbling the junior resource stocks and small caps is like hitching a front seat on a rocket.

Remember, this is pure speculation. You only hope your rocket is like Richard Branson’s new Virgin Galactic space plane, and not the nuclear missile Slim Pickens rides in Dr. Strangelove.

And what about red wine? The bottle shop across the street from the Old Hat Factory is closed for renovations. In its clearance sale, we were able to pick up a few bargain bottles of Penfolds Bin 389 Cabernet Shiraz. That is wealth you can either drink or store. We’ve done a little of both.

But you can also sell it! There appears to be a roaring trade in Penfolds wines on e-Bay. There are certainly worse things you could spend depreciating paper money on. We’re also hearing that the 2004 vintage of the Penfolds Grange is the best ever. Can’t wait to find out.

Regards,
Dan Denning
Australian Daily Reckoning

May 13, 2009