02.01.2010 - market commentary

8/8/2019 02.01.2010 - Market Commentary

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Dr. Marc Faber Market Commentary February 1, 2010

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The Inescapable Debt Trap

Marc Faber

The Monthly Market Commentary Report

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The Inescapable Debt Trap

Great nations are never impoverished by private,

though they sometimes are by public prodigalityand misconduct. The whole, or almost the wholepublic revenue, is in most countries employed inmaintaining unproductive hands thoseunproductive hands may consume so great ashare of the whole revenue, and thereby oblige sogreat a number to encroach upon their capitals,upon the funds destined for the maintenance ofproductive labour, that all the frugality and goodconduct of individuals may not be able tocompensate the waste and degradation of produceoccasioned by this violent and forcedencroachment.

Adam Smith

"Experience shows that the most dangerousmoment for a bad government is usually just as itsstarting on reform."

Alexis de Tocqueville

The nearest thing to eternal life we will ever seeon this earth is a government program.

Ronald Reagan

Government is like a baby: An alimentary canalwith a big appetite at one end and no sense ofresponsibility at the other.

Ronald Reagan

I was recently taken by surprise when at a conference, following mynegative comments about the US governments economic interventionsand highly expansionary monetary policies, somebody exclaimed that USmonetary polices had led to strong growth in the US over the last 10 to 20years and that without interventions the current crisis would have been farworse.

To show that expansionary monetary policies did not lead to stronggrowth is easy to prove (see Figure 1).
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Figure 1: Last Ten Years: No Growth in Employment

Source: Dr. Alex Cowie,www.agorafinancial.com

I concede that an economy can grow while employment stagnatesbecause of large productivity improvements. But the myth of the greatUS productivity miracle has been sufficiently exposed by othereconomists, and when I travel around the world it is not my impression

that the US is particularly productive. Otherwise how could one explainthe colossal increase in the US trade and current account deficit after1998? Moreover, one productivity miracle I am very familiar with isthe US government sector (in particular immigration when you enter theUS) where employment and compensation has continued to increasewhile the rest of the labour force has stagnated (see Figure 2).
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Figure 2: Shrinking Jobs in Manufacturing and ExpandingGovernment Employees

Source: Clusterstock, ([email protected]).

As far as the governments interventions having prevented the currentcrisis getting out of hand, I should like to mention that the governmentrepeatedly intervened into the free market in recent times and that theseinterventions were largely responsible for the current economic mess.Had LTCM not been bailed out in 1998, the financial sector would never

have continued to increase its leverage as it did prior to the 2008meltdown. Moreover, had interest rates not been slashed to 1% afterJanuary 2001 (the US economy began to expand again in November2001) no or surely a smaller credit and housing bubble would havefollowed. As David Stockman observed recently in a Wall Street Journalarticle (see WSJ of January 20, 2010), the banking system has becomean agent of destruction for gross domestic product and of impoverishmentfor the middle class. To be sure, it was lured into these unsavourymissions by a truly insane monetary policy under which, most

recently, the Federal Reserve purchased $1.5 trillion of longer-datedTreasury bonds and housing securities in less than a year. It was an
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unprecedented exercise in market-rigging with printing-press money,and it gave a sharp boost to the price of bonds and other securitiesheld by banks, permitting them to book huge revenue from tradingand bookkeeping gains.

Meanwhile, by fixing short-term interest rates at near zero, the Fedplanted its heavy boot squarely in the face of depositors, as it shrank thebanks cost of production their interest expense on depositor funds toa vanishing point. The resulting yield curve for banks is heralded, by acertain breed of Wall Street tout, as a financial miracle cure. Soon, it isclaimed, a prodigious upwelling of profitability will repair bank balancesheets and bury toxic waste from the last bubbles collapse. But will it? Insupplying the banks with free deposit money (effectively, zero-interestloans), the savers of America are taking a $250 billion annual haircut inlost interest income. And the banks, after reaping this ill-deservedwindfall, are pleased to pronounce themselves solvent, ignoring the badloans still on their books. This kind of Robin Hood redistribution inreverse is not sustainable. It requires permanently flooding world marketswith cheap dollars a recipe for the next bubble and financialcrisis..The baleful reality is that big banks, the freakish offspring ofthe Feds easy money, are dangerous institutions, deeply embeddedin a bull market culture of entitlement and greed..During recentquarter, for instance, the preponderance of Goldman Sachs revenuescame from trading in bonds, currencies and commodities. But these

profits were no evidence of Mr. Market doing Gods work, greasing thewheels of commerce and trade by facilitating productive financialtransactions. In fact, they represented the fruits of hyperactive gamblingin the Feds monetary casino a place where the inside players obtaintheir chips at no cost from the Fed-controlled money markets, and arewarned well in advance, by obscure wording changes in the Feds policystatements, about any pending shift in the gambling odds. To be sure, themost direct way to cure the banking systems ills would be to return to arational monetary policy based on sensible interest rates, and an end

to frantic monetization of federal debt and a stable exchange valuefor the dollar (emphasis added).

Stockman has a point when he talks about big banks having becomethe freakish offspring of the Feds easy money, and that the bankingsystem has become an agent of destruction for gross domestic productand of impoverishment for the middle class, which is taking a $250billion annual haircut in lost interest income through artificially lowinterests rates. In addition, the middle class was badly hurt byexpansionary monetary policies in the first half of 2008 despite the Feds

decision to slash interest rates in September 2007 because of soaringcommodity prices (see Figure 3).


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Figure 3: Were the Fed Fund Rate Cuts After September 2007Beneficial?

Source: Ed Yardeni,www.yardeni.com

The oil price, which had been hovering around $75 per barrel prior to theSeptember 2007 rate cuts, after they had peaked at $79 in July 2006,soared to $147 in July 2008, at a time when global demand was alreadyslowing down. As a result, crude oil outlays in the US increased on anannual basis from $500 billion to almost $1 trillion in mid 2008 (seeFigure 4). In other words, the US consumer was burdened by an

additional tax of almost $500 billion (please also note that on anannualized base US oil outlays increased from $75 billion in 1998 tocurrently approximately $500 billion).
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Figure 4: US Crude Oil Outlays, 1987 - 2009


In addition, the price of soybeans, corn, and wheat almost doubledbetween September 2007 and the summer of 2008, lifting food prices. Inturn this depressed discretionary consumption further. Now, I am notsuggesting that the spike in commodity prices were only due to the fedfund rate cuts which followed September 2007. But it should beunderstood that had fed funds remained at 5 % after September 2007,commodity prices including oil and food prices would not have soaredthat much. After all, artificially low interest rates encourage speculation.Also, the increase in oil outlays in the fist half of 2008 were not the only

reason for the collapse of the global economy after September 2008.However, rising commodity prices in the first half of 2008 were animportant contributing factor in curtailing consumption globally, whichsubsequently aggravated the recession.

But aside from intervening into the free market mechanism withmonetary policies, which as I have shown brought about numerousunintended and negative consequences (a credit and housing bubble,rising commodity prices resulting in an additional tax on consumption),governments also embarked on an unprecedented fiscal stimulus, which is

going to increase the governments debt burden significantly (see Figure5).


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Figure 5: Cumulative Increase in Real Public Debt Since 2007

Source: Carmen Reinhart and Kenneth Rogoff

I am bringing this up for several reasons. Carmen Reinhart and KennethRogoff, both accomplished economists, recently published a sobering butactually very logical study entitled Growth in a Time of Debt.

Assuming we are dealing with a country that has low total creditmarket debts compared to GDP (say 30%) and this country doublessubsequently its debts compared to GDP, growth will temporaryaccelerate because aggregate demand will increase. However, since debtscannot double as a percentage of GDP indefinitely, some of the demandwill so to speak be borrowed from the future. Also, additional borrowings

for productive capital investments are obviously more desirable and willbe long-term growth-enhancing whereas borrowing for consumption will


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lead to slower future growth. Therefore, one of the conclusions of theReinhart/Rogoff study is that the relationship between government debtand real GDP is weak for debt/GDP ratios below a threshold of 90% ofGDP. Above 90%, median growth rates fall by one percent, and average

growth falls considerably more (see Figure 6).

Figure 6: US Government Debt, Growth, and Inflation, 1790 -2009

Source: Carmen Reinhart and Kenneth Rogoff

As can be seen from Figure 6, when government debt increases, GDPgrowth slows down and inflation tends to accelerate (I should add thateconomic growth slows down irrespective whether an economy is

increasing its private or public debts above a certain level). I need to pointout that if in our example of an economy with a 30% debt-to-GDP ratio


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debt growth accelerates from say 15% per annum to 30%, growth willtemporary also accelerate. So, much of the GDP increase between 2000and 2008 (or more precisely since 1982) can be explained by the increasein household debts as well as by a further decline in the saving rate (see

Figure 7).

Figure 7: Rising US Household Debts and a Declining Saving RateBoosted GDP Growth Between 1982 And 2008

Source: John Hussman,www.hussmanfunds.com

However, the day debt growth slows down, economic growth will alsodiminish or come to an abrupt end altogether (see Figure 8).
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Figure 8: Total Debt Growth and Nominal GDP Growth, 1954 2009

Source: Barry Bannister, Stifel Nicholaus

In addition, as Reinhart and Rogoff show and as Barry Bannister hasdemonstrated before, there is a time when additional debt growth does notlead to any GDP growth the so called zero hour, which, in myopinion, has now been reached (see Figure 9).


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Figure 9: Counterproductive Debt Growth Has Now Been Reached


I need to add that I have so far not touched on the dire conditions ofAmerican states financial conditions and their over $2 trillion unfundedpension fund liabilities. A states budget gap is the difference between astates expenditures and revenues expressed as a percentage of thegeneral fund expenditures for that state (see Figure 10 for clearerviewing please enlarge).


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Figure 10: State Budget Deficits Another Looming FinancialDisaster

Source: Michael Panzner, Financial Armageddon

Reinhart and Rogoff (see above) conclude that the sharp run-up inpublic sector debt will likely prove one of the most enduring legacies ofthe 2007-2009 financial crises in the United States and elsewhere. Weexamine the experience of forty four countries spanning up to twocenturies of data on central government debt, inflation and growth. Our

main finding is that across both advanced countries and emergingmarkets, high debt/GDP levels (90 percent and above) are associatedwith notably lower growth outcomes..Seldom do countries simplygrow their way out of deep debt burdens..Why are there thresholdsin debt, and why 90 percent? This is an important question that meritsfurther research, but we would speculate that the phenomenon is closelylinked to logic underlying our earlier analysis of debt intolerance.A general result of our debt intolerance analysis, however, highlightsthat as debt levels rise towards historical limits, risk premia begin to risesharply, facing highly indebted governments with difficulttradeoffs.Even countries that are committed to fully repaying


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their debts are forced to dramatically tighten fiscal policy in order toappear credible to investors and thereby reduce risk premiaOfcourse, there are other vulnerabilities associated with debt buildups thatdepend on the composition of the debt itself countries that choose to

rely excessively on short term borrowing to fund growing debt levels areparticularly vulnerable to crises in confidence that can provoke verysudden and unexpected financial crises (emphasis added).

The problem for the US is that real government debt-to-GDP is not84% as indicated by Reinhart and Rogoff (see Figure 5) but around 600%(see Figure 11).

Figure 11: Total Federal Government Debt, With GAAP andAccruals, 2001 - 2009

Source:www.nowandfutures.com

Above, Reinhart and Rogoff note that even countries that are committedto fully repaying their debts are forced to dramatically tighten fiscalpolicy in order to appear credible to investors and thereby reduce riskpremia (to tighten fiscal policies implies large spending cuts orsignificant tax increases or a combination thereof). But is this a realistic

assumption for the US? Hardly, in my opinion! There is neither the
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political will to face the problem of excessive debt nor the recognitionamong Fed officials that excessive debts caused the crisis in the firstplace (see also enclosed report by Steve Keen entitled The EconomicCase Against Bernanke).

Moreover, if Reinhart and Rogoff are right about high debt/GDPlevels that are associated with notably lower growth outcomes and thatseldom do countries simply grow their way out of deep debt burdens,then US tax receipts will continue to remain disappointing and make itdifficult for the fiscal deficit to decline (see Figure 12).

Figure 12: US Federal Government Receipts, 1995 - 2009


As an aside I should mention that December 2009 tax receipts were down7.8% from December 2008 (a symptom of a still shrinking economy).What about radical spending cuts, which would be the most desirable wayto address the budget problems? Under the Obama administration andgiven the view by several leading US economists that more fiscalstimulus is needed I just cant see this happening in the next few years.So, how will the US get out of its debt trap? There are two ways:

default on obligations (default on state, municipal and federal government


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debts or default on obligations to the US population through smallerentitlement payments or by increasing retirement age) or by massivelymonetizing US debts and reducing the debt through inflation. In myopinion, additional massive monetization of debts is the most likely

outcome. This is so because the economic pain, which inevitably followsa period of excesses (excessive debt growth and excessive consumptionin the case of the US) is postponed through monetization and endloaded. From an investors perspective the process of monetization hasimportant implications: Avoid long term fixed interest securities (exceptfor temporary rallies), avoid cash, and buy assets such as equities, realestate and commodities in particular precious metals (see Figure 13).

Figure 13: Annual Gold Production from Main Producers, 1970 -2009

Source: Jean Laherrere,www.goldsheetlinks.com

I am highlighting the diminishing supply of gold in order to contrast it tothe increased level of debts and money. Ceteris paribus where suppliesincrease, prices decline and where supplies diminish, prices increase. So,if I was able to convince my readers that the explosion of debts on alllevels of society (corporate, household, and government) will lead to
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further monetization, then holding gold, silver, platinum and palladiummakes sense from a longer-term point of view. This is not to say that goldcannot correct further down to between $950 and $1050 per ounce ifliquidity tightens temporarily (please note that even in a hyper-

inflationary environment, liquidity evaporates temporary). But if I amright about further monetization and further government debt growth, therisk is really not to own any precious metals at all. I am mentioning thetemporary tightening of liquidity because there are a number ofsymptoms which seem to suggest that this process is now underway.These symptoms include a strengthening US dollar, weakness in gold andother commodities as well as in emerging markets (see Figure 14).

Figure 14: Chinese Shares No Higher Than in June 2009

Source:www.decisionpoint.com

Indeed, money supply growth in China - while still expanding - isexpanding at a moderating rate (see Figure 15).
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Figure 15: China: Declining M2 (Percent 3-Month Average), 2001 -2010

Source: CEIC, J. P. Morgan

News out of China is that as of January 19th, banks have suspended new

lending following an emergency meeting by the central banks monetarypolicy bureau. Apparently, the sudden lending suspension has caughtimporters by surprise as letters of credit became unavailable. This lendingstop could badly affect Chinese import orders for commodities andmachinery and significantly tighten mortgage lending. This should comeas no surprise since the countrys banks loaned last year $1.42 trillion,which is equivalent to about a quarter of Chinas nominal GDP. I shouldadd that there are observers who believe that 25% or $355 billion of theseloans will default. In other words, either bank lending slows down

considerably now as a result of a decision by the central bank or later asbad loans escalate and lead to a tightening of lending standards. In eithercase tighter monetary conditions and slower growth in China must beexpected.

That something is not quite right in China is evident from the recentpoor performance not only of Chinese and Hong Kong stocks (the latterare down by more than 12% from their November high) but also ofindustrial commodity prices and of the Baltic Dry Index, which is now nohigher than in June 2009 (see Figure 16).


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Figure 16: Baltic Dry Index, 2003 - 2010


I cannot emphasize enough the investment implications of a meaningfuleconomic slowdown (or collapse as some observers think) of the Chineseeconomy. The hardest hit assets would be industrial commodities, HongKong high end properties, resource based economies, for which China

has become the largest export market, and currencies of resource basedeconomies. Noteworthy is that material stocks (US Steel, POSCO,Freeport- McMoRan etc.) are all down 20% from their highs and thatstock markets such as Brazil have recently broken down decisively (seeFigure 17).


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Figure 17: Further Downside Risk for Resource-Based Economies


We do not know how serious and long lasting the Chinese economicslowdown or possibly the economic slump will be, but when I see somany assets markets breaking down simultaneously I believe it is betterto err on the side of caution and to postpone the purchase of equities. Last

month I mentioned that over the last few years a weak dollar had led to anoutperformance of emerging markets compared to the US whereas astrong dollar led to an outperformance of the US versus emergingmarkets (see alsoFigure 12 of the January 2010 report). I concluded that if the US dollarwere to strengthen in the first half of 2010 (as explained before, asymptom of tightening liquidity) a reasonable assumption would be forthe S&P 500 to outperform emerging markets (see Figure 18).


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Figure 18: S&P 500 Compared to Emerging Market ETF, 2009 2010


This is not to argue that the S&P will go up and emerging marketsdecline. Both could move down whereby I would expect the S&P 500 todecline less than emerging stock markets (a market neutral strategy would

involve being long the S&P 500 and short emerging markets). One reasonfor my caution is that money supply growth has not only slowed down inChina but also in the US (see Figure 19).


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Figure 19: US M2 Money Supply Growth Slowing Down


A reader recently asked me following my conclusion in last monthsreport that 2010 would be a rather difficult year and that capitalpreservation would be of paramount importance how best topreserve capital. The way I see asset markets move in 2010 is as follows.A correction has begun with many stocks already down 20% from theirhighs. The correction is likely to continue (interrupted by a technical rallyin the next few days) whereby I would look for a bottom in the secondhalf of February. Thereafter we should have a recovery rally but I doubtthat the January 19th high at 1150 for the S&P 500 will be exceeded (andif exceeded only moderately so). At some point in 2010, stocks will likelybe down between 20% and 40% from their recent highs (emerging


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markets with a large China exposure would seem to be particularlyvulnerable). During this decline the US dollar and US government bondsshould continue to strengthen (see Figure 20).

Figure 20: Twenty+ Year Treasury Bond Fund ETF


But as soon as the S&P drops to around 950 and as soon as the Chineseeconomy weakens visibly, policy makers and central banks around theworld will implement additional coordinated fiscal stimuli and moremoney printing. This will lead to a tradable rally (and renewed US dollarweakness). In this rebound precious metals and mining companies shouldoutperform the S&P 500. Whether stocks and industrial commodities willthen manage to exceed their recent highs will depend on the size of theadditional monetary stimulus. Precious metals and mining stocks are

likely to benefit the most from additional fiscal and monetarystimulusand should be accumulated on weakness. Beneficiaries from


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zero interest rates are also financials including Japanese banks such asMitsubishi UFJ (MTU), Mizuho Financial (MFG), and regional banks inthe US such as KeyCorp (KEY), Zions Bancorporation (ZION), andSynovus (SNV).

In short, I expect a choppy year for equities in 2010. In the near term,should stock markets - following a brief rebound in the first few days ofFebruary - decline into the second half of February, I would buy somestocks for a rebound. And if stocks now fail to decline and continue torally right away I would use strength to lighten up positions.

02.01.2010 - market commentary

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