The oldest privat Bank of Switzerkand is facing a year of decision:

What will come in 2010?

Wegelin & Co., the reputable swiss bank - the oldest private bank of Switzerland - only can see conflicting signals in the financial markets. So they decided to present three different scenarios about what may happen in 2010. One model exclude the other. You will realise that Wegelin & Co. gives a fair warning.

It is the second reputable bank which give the warning that a global collapse may come. The first was the french bank Société Générale in november.

Following the extract of Wegelins Investment Commentary No. 267:

Scenario: the blood-red abyss

The rising price of gold and the rapid increase in credit risk premiums for national finances in the wake of the Dubai crisis are the first signs of an inexorable spiral that will end in the downfall of the Western industrial nations, in the abandonment of their function of ensuring order internally and externally, in a chaos of increasingly illusionary promises made to the various social groups without the capital to honour them, in greater protectionism and an inclination towards expropriation, and ultimately in violence. Abyssus ruber, a blood-red abyss brought about by the radical increase in the already almost hopelessly excessive level of debt in the USA, Japan, the United Kingdom, Germany and other European countries, in the wake of the financial crisis.

The additional debt turns out to be essentially unproductive, as it only serves to maintain the notoriously inefficient structures in the financial system, to cement in place the sinecures provided for the big financial conglomerates by the implicit state guarantee, and to perpetuate the distortions in the real estate sector and the short-term saving of face in industrial policy (car manufacturers!).

Political errors, particularly on the part of the USA, aggravate the situation in that, on top of the already existing reservations about America’s debt situation, measures are taken that increasingly deter foreign capital from financing US debt. The Foreign Account Tax Compliance Act of 2009, on top of the already extremely offputting plans to reform the Qualified Intermediary system, and together with the inclusion under American inheritance law of tax liability for foreign holders of American securities, with high rates of progression, begin, slowly but surely, to erode the basis on which America is financed. The US dollar comes under increasing pressure, not least as powerful voices in the country, such as the bond expert Bill Gross and the stocks guru Warren Buffett recommend greater diversification. At a certain point in the erosion of the currency,and under the impact of a crash on the bond markets – the creditworthiness of state debtors is no longer accepted globally – the Americans are obliged to raise interest rates at the worst possible moment.

Meanwhile, the world as a whole is seriously disappointed by the way the economy develops. What had been described as stabilization at a low level turns out to be merely a plateau on the edge of the next abyss. The stimulation packages for car manufacturers and home owners turn out to be expensive flashes in the pan – in fact, mistaken investments. The US real estate market falls by a further 20 percent, and General Motors finally ceases production.

In Europe, the medium-sized companies, which had managed so well during the first phase of the crisis, are seriously wrongfooted, as they had just started to ramp up production. Given their already stretched financial situation, bankruptcies are inevitable. Politicians behave erratically, pressure from the street on business grows, and results in many cases in outbreaks of violence.

The guiding light of 2009, the Peoples’ Republic of China, experiences in 2010 one of its most dangerous internal crises. As American imports dry up, large, labour-intensive enterprises have to be shut down; it proves impossible to absorb the hordes of unemployed workers elsewhere in China. The result is social unrest, which increasingly

threatens the tender shoots of an emerging middle class. Uncertainty settles like a leaden

cloud over the Chinese colossus.

And so on. There’s not much fun in outlining the future Armageddon in the style of a pulp novelist. But seriously: can all this, and even worse, really be dismissed out of hand?

A Russian futurologist recently forecast the collapse of the USA and the possibility that Russia might get Alaska back. Apart from the notion that Sarah Palin might then one day become President of Russia, such scenarios often appear to be little more than irrational

fantasies.

The thing is, the history of the world is full of such irrational courses of events.

So, in our view, it would be unwise to devote too little attention to the consequences of such “blood-red abysses”. They do exist; indeed, historically speaking, there is little else.

And there is this: Abyssus abyssum invocat – one mistake leads to another. Proverbs, too, belong to the treasury of mankind, along with myths and legends.

Scenario: the East is golden

This story too starts with the rising price of gold. This rise is due to continuous, secret purchases of gold by the central banks of India and China. In part, the banks are nterested in diversifying the excessive currency reserves held in dollars, but this is not all; they are also preparing for the launch of an Asian alternative to the US dollar as the monopolistic reserve currency. Backing such a currency with as much gold as possible is one aspect; another is the preparation of a market for Chinese treasury bills issued via the financial centre of Hong Kong. For the Chinese, crassly underestimated in the West as mere copyists, have, as accurate observers and excellent economists, realized why the euro has never been able to win a position as a serious reserve currency:

because it lacks a liquid market for risk-free paper.

In Hong Kong, they have a versatile platform, oriented both inwards, in the interest of

investments in mainland China, and also outwards, towards the global financial universe,

which is well known to be thirsting after diversification possibilities – for zero-interest Treasury bills have only a limited appeal.

The key eastern countries are currently enjoying a robust upturn. India, always characterized by a strong domestic economy, is successfully dismantling significant internal trade barriers. With its Anglo-Saxon legacy, it is increasingly coming to represent a significantly more youthful clone of Europe. The low level of debt enables Indian companies not only to keep pace with the current wave of innovation, but at times to play a leading role in it.

After many years as the last bastion of real socialism, bleeding its labour force dry and flooding the world, and the USA in particular, with the cheap goods they produced, China began in 2005 to distribute the national assets that had accumulated at the highest level of the state, by means of enormously ambitious and extremely rapidly executed infrastructure projects. The millions of engineers, craftsmen and other workers are achieving a degree of private prosperity, and moving upwards to form a sort of middle class. This middle class corresponds in size roughly to the population of the USA or Europe. At the same time, the Chinese are cautiously beginning to spin the strands of a social security network. The Chinese savings rate falls in parallel with these developments: the Chinese have become consumers. Growth, the only determinant of political stability in China, enables the regime, nominally communist, but de facto an oligarchy with monarchical characteristics, to retain control without significant problems.

Both neighbouring countries (Hong Kong, Taiwan, South Korea) and those further away (Indonesia, the Philippines, Australia, New Zealand) benefit greatly from the Chinese upturn and stability in the east. The whole region orients itself on the new reality of the shift in the global balance of power. To what extent changes in security policy occur, to reduce the dominance of America in this part of the world, remains, however, uncertain.

Europe and the USA are battling with an economic “double dip”. The economy collapses for a second time in 2010, as the disadvantages to the western industrial nations of excessive state debt and overindebted social security systems become manifest. The forces of reform have not yet managed to regroup, however. Thus the new coalition

in Germany completely drops the ball played them by the electorate, and tries to force through tax increases, instead of freeing the country and its citizens at last from the burden of excessive solidarity.

The President of America’s halo has long faded; the hoped-for leader has become a mere cheerleader, no longer taken seriously by his weary and shrinking public. The only companies benefitting from the Asian boom are those that still had sufficient financial room for manoeuvre after the first phase of the recession, and that were able to get sufficient finance for their investments from the banks.

For one thing has become clear. Not only has the economic geography of the world changed; the recession of 2008/2009 has also unleashed a further technological revolution. There is no sector and no market in which the same products can still be manufactured or distributed with the same structures. From car manufacture to energy generation, the media and financial services; it is the flexible, quick-acting market players that have gained ground, while the old dinosaurs at best suffer and decline.

Scenario: the comfortable “lazy L”

It is evident that not only has the financial crisis seen the implosion of a banking system based on excessive debt and hyperactivism, but the lengthy period of entirely unproblematic financing has also created distortions in the real economy, which will now be corrected in the global recession.

This phenomenon of distortions with real consequences and the necessity for real corrections is most obvious in the case of Dubai. The results of an excessively low threshold for project finance are plain to see. In a place in which it is only possible to be outside for six months of the year at most, and in which everything is literally artificial, who in the world was supposed to fill the thousands of offices, hotel suites and penthouses, and pay vast sums of money for the privilege? Vacant properties were a foregone conclusion. It is said that credit buys time. But too much credit generates too many ill-considered projects in too short a time. That is the problem with excessive debt. It was the case in the American real estate sector, it was the case in Dubai, and it is also the case in the balance sheets of various, mainly European, banks, that have been happily stuffed with Dubai risk. (According to an estimate by Morgan Stanley, of the current 113 billion dollars of Dubai risk, 87 billion is held by European institutions, 50 billion of which by British ones. What was that about lightning never striking in the same place twice?)

The financial hype was – and still is, in some parts of the world – reflected in the exuberance of the real economy. This perspective also explains the partial paralysis of the global economy, made manifest in the collapse in cargo rates towards the end of 2008. The financial crisis provided an occasion for releasing the excessive pressure in the global economy, and because this happened abruptly, a significant amount of collateral damage was unavoidable. Overall however, apart from this tectonic shift downwards, little has changed in the basic structures of the global economy, which means that from about 2010, business can continue unhindered, if at a lower level. The development of the economy would thus resemble a slanted, “lazy L”: sharp drop, gentle recovery.

The roles of the individual economic blocks have also changed little, and without any additional signs of real crisis. American consumers will tendentially become less important, but they will remain the dominant source of demand for goods from the Far East. This is reflected in the still significant balance-of-trade surpluses that the Asiatic countries have vis-à-vis the USA.

Europe will be able to resume its lucrative export of capital goods. Any company in this sector that has improved its productivity through cost reductions will be able to continue to exist with this lower level of sales; greater demand will improve margins in due course. To this extent, the profit improvements already anticipated in stock prices seem not unrealistic.

Economic development at this lower level will not, though, be sufficient to generate inflationary pressure, given the productivity improvements. On the contrary, there is still enormous global overcapacity, which will put a sharp stop to any upward pressure on prices. As in this moderate scenario there is little room for political pressure for protectionist moves, regional and sector rigidities will play only a secondary role. This also means that the central banks will be able to keep interest rates low for a long time. An end to “quantitative easing”, the radical provision of liquidity by means of a zero-interest policy and the inflation of the central banks’ balance sheets, remains some way off. And as all the important central banks in the system – the Fed, the ECB and the Bank of England – are following more or less the same policy, there will be no abrupt shifts in currency relationships.

The banking system benefits greatly from this monetary policy of the central banks. Essentially, the financial conglomerates can take on debt at no cost and, at minimal risk (!), deploy a quantitybased strategy to earn generous revenues effortlessly. Those who still have some clearing up to do can get on with it calmly, and everyone else can return to the habitual frivolities of excessive bonuses and political arrogance.

And what of Dubai? And the further billions of write-offs that Dominique Strauss-Kahn, the Director of the IMF, recently said would be required in the global banking system? We’ll muddle through, see-sawing between hope and fear; from time to time some institution with deep pockets, such as the Abu Dhabi Investment Authority, will step in to prevent a return to the acute phase of the financial crisis. The Western nations, heavily burdened by the consequences of the financial crisis, will begin to come to terms with their new levels of debt. As nominal interest rates will continue to be low, debt servicing will remain feasible.

The continued inflation of the central banks’ balance sheets will mean that the necessary treasury auctions will be able to be held relatively unproblematically.

No doubt about it: this “normal scenario” represents a continuation of the developments in 2009, in the direction of a somewhat better future. It does not seriously contradict the current development of stock market prices, and nor are the low returns on bonds unjustified with an “L” that is not heading upwards too sharply.

Undecided

Which story do you find most appealing?

a)

The last one? More or less everything is going as in 2009?

But:

We know that this is not what will happen.

It takes a great deal – too much, perhaps – till one reaches the point at which one is ready

to give up the comforting warmth of the familiar.

b)

The second story, because it oozes optimism and belief in progress? Hang on a minute – have you given any thought to your own personal situation in such a scenario?

1. Have your children already learnt Mandarin?
2. Have you come to terms with the relative – and indeed, absolute – reduction in Western economic activity?
3. And already said farewell to the prospect of benefitting from a social insurance system based on growth?
4. Have you adjusted your lifestyle to the foreseeable reduction in your assets?
5. And what about your financial investment portfolio?
6. Is the new world adequately represented in it?
7. Has your advisor taken account of the need for greater financial power in his stock
8. selection?
9. How do you intend to deal with the end of the US dollar as the only reserve currency?

c)

Abyssus ruber, the blood-red abyss – we none of us want that! But, because it is conceivable, should we not at least take some precautions, so as not to be entirely unprotected should the worst happen?

Not easy, for it might develop into either a deep depression or inflation – hyperinflation,

even. The responses in terms of investments are contradictory:

• in the one case, liquidity is the best remedy;
• in the other absolutely not.

Furthermore, the blood-red abyss scenario almost inevitably involves expropriation and possibly physical danger; the possibilities for individual precautions are seriously limited. 

Where to live will be a question of the utmost importance.

• Switzerland, with its citizen-based society (and the resulting limitations on politicians’ ability to take extreme actions) has been able to get through comparable historical abysses. But would it be able to do so this time?
• Would Dubai or Singapore be alternatives?
• Or rather, New Zealand?

And what to do with the assets?

It will be necessary to reflect this development in the investment of assets. In doing so, it will be important not to include the new markets indiscriminately in the portfolio, as they are mostly still fairly illiquid and particularly subject to waves of enthusiasm and disillusionment. Here in particular, it will be necessary to pay special attention to the question of sustainability.

Withdrawal from familiar, and often successful investments in the declining industries of the West will be harder. But it may often not be necessary – particularly with regard to the stocks of internationally well diversified companies. The geographic diversification effect of the stocks of BASF, Holcim, Nestlé or Royal Dutch Shell is considerable.

Things look different with fixedinterest securities, however. Bonds, often regarded as a “safety component”, are very often issued by semi-state enterprises whose business models may be questionable over the longer term:

Their economic performance is often poorly diversified geographically, and they are entirely dependent on their political environment.

They would seem to be threatened under all three scenarios. The “safety component” in the investment assets thus requires consideration, not least as interest rates are so low that capital gains on these positions are no longer really conceivable.

Gold?

Without at all wishing to give way to the temptation of “backtrading” – that is, making unfair reference to a successful past recommendation – we must come back to our position in 2006.

We then recommended holding a strategic position in gold, to the tune of 5 to 10 percent of the total assets, “for a rainy day”, so to speak. We suggested possibly keeping it in a separate portfolio, so as to ring-fence it from future investment decisions. We stand by this, despite the far higher current price of gold.

Gold is a form of insurance, and should be understood, and handled, as such.

It’s not their value that counts, but their presence.