The coming global debt-driven depression

Reality begins to set in, which inspires panic. Frantic selling across various speculative assets brings prices drastically lower. Retirements and pensions wiped out. Paper investments made effectively worthless. Sound like a repeat of 2008-2009?

The American Nightmare

This horrifying scenario is coming to fruition not because the economy is dipping back in to recession — the fact is without the bailouts, deficit spending and stick saves by the Fed, we’ve been in a depression since late 2008. All of the papering over fraud was about kicking the can down the road rather than fixing the underlying economic, fiscal and monetary imbalances.

Zero interest rate policy combined with reckless fiscal measures have sealed the fate of the US markets and the greater global economy. By implementing such a robust framework without fixing any of the underlying problems on bank balance sheets, in various governments forward debt loads or in household debt we are now looking at repeating the kind of volatility we saw in late 2008 to early 2009, but worse yet there are far greater consequences to a significant economic dislocation. Consequences that were entirely avoidable had the authorities, corporate leaders, banking executives and individual households of the world looked at deleveraging more aggressively and taking the bitter pill that is a brief, but sharp depression so that the excess could be cleared out in favor of rebuilding a more stable and sustainable economy.

Past the Point of No Returns

Now we’re nearing the cliff. The drop-off that is a near mathematical certainty given that many countries governments are reaching their upward debt limit (that is to say no party but their respective central banks are willing to buy their debt). This includes the US, Japan and much of Europe — countries that were once economic superpowers are being reduced to beggar thy neighbor debtors, hat in hand, begging for handouts.

The demographic issues in these areas may differ, but the fundamental economic, monetary and fiscal problems are all too similar. Persistent high unemployment, a highly leveraged financial sector, households that are swimming in debt (with the exception of perhaps Japan) and stock markets that are losing a decade+ in any form of gains.

Worse yet, the forecasts being foisted upon the public are overly optimistic, full of fluffy economic growth predictions that are impossible to achieve. That means that the growth which was necessary to service debt burdens and keep the overly extended economies of the world lurching forward will not occur and thus leaves a much more dire scenario. One of sovereign debt defaults, crashing stock markets, currency crises and an atmosphere of higher unemployment and more civil unrest.

Caution: Debt-Driven Depression Ahead

Let’s look towards the possible future by examining one country that’s already where many will be in the coming months and years ahead. Greece’s stock market is down 85% from its peak, their 1 year government bonds are trading at an absurd yield of about 97% and there is talk of a full scale default as early as this weekend. The Greek people have been protesting, rioting and the unemployment rate by modest measures is 16%. This is a depression, not a recession. While the media is largely ignoring the severity of the crisis, those within Greece are all too familiar with the situation. One that has the potential to become significantly worse before any improvements may happen.

All of the bailouts for Greece have only managed to make the situation worse, because they piled on debt Greece could not pay off while forcing Greece to sell off the few productive assets it has to foreign parties. The combination of these factors ensure a severe economic contraction.

Much of the rest of Europe, with perhaps the exception of Germany, Norway, Finland, Switzerland and Sweden, face the same dilemma: too much debt, too little economic growth. In the United States we face the same crisis, which has only been temporarily offset by the dollar’s reserve currency status — a privilege we may not enjoy for much longer here given the incompetent and dangerous monetary policies of the Federal Reserve. By Bill Gross’ measurement the United States has $75 trillion in unfunded liabilities. That is approximately a 500% debt-to-GDP ratio (over twice that of Japan). Some even say Gross’ measurement is too conservative and the number could be closer to $100 trillion in unfunded liabilities. The fact remains that there is no mathematical or economic scenario where this debt becomes serviceable or sustainable.

The problem is simple, though the solution has been muddled by short-sighted piecemeal bailout attempts. A debt crisis cannot be solved by piling on more debt. It is impossible to achieve economic equilibrium by bailing out corporations that do not know how to manage risk properly. Consumers, who account for 70% of US GDP, are being largely ignored and yet are experiencing significant harm from this crisis. Instead these insolvent banks need to be unwound, brought through bankruptcy and their speculative subsidiaries and divisions need to be completely separated and spun off from their depository and lending functions. We learned this lesson from the Great Depression, but somehow forgot it in the last decade as banks were once again allowed to recklessly speculate with money they did not have.

Modern Banking Is Anything But

Let us remember that banks should really only function as a basic utility for depositing funds and matching those that wish to lend money with those that are seeking interest on savings. That is the vary essential function of a bank. The speculative gambling that occurs on Wall Street has no place in conventional banking and it should never have been allowed to re-join the conventional banking industry.

Those who intentionally defrauded their clients, the government and employed criminal tactics to profit should be indicted, prosecuted and hopefully incarcerated for their crimes against society. Those reckless, greedy and immoral enough to bring down the entire world economy so that they can profit from its artificial rise and subsequent demise are the true threats to a prosperous future. So long as they remain in power we will not see any trust return to the markets nor shall we see any glimpse of true economic recovery. After all, if the rule of law breaks down, there is not much left to keep people from essentially avoiding the entire gulag casino that Wall Street has become.

We must unite around the world and demand that the crooks are prosecuted, the insolvent banks are unwound and that we, the people are not robbed blind to continue to fund these morally and financially bankrupt institutions. It is the only way that we can begin to move forward and start to rebuild our respective countries.

Risk off panic selling, Euro collapse and more

The world markets were roiled today by panic selling. The sell off was catalyzed by negative news on Italy’s solvency, accelerated further by margin calls on major institutions, forcing a major deleveraging across the board. Many are fearing a reemergence of recessionary declines across the globe.

Europe’s outlook has significantly weakened as of late after its been revealed that the fiscal problems of the sagging debtor states are growing more severe at a rapid rate. Headlines today included major exchanges shuttering temporarily, bond issuances being suspended and civil unrest growing. The Euro lost about 1.35% of its value in a single day, a significant sell-off — and one that is likely to continue.

The downside risks for speculative paper assets are intensifying. Growth stocks lost 5-8% or more of their value in a matter of minutes. Some posted double digit losses. The selling in the US continued in to the close without much sign of short covering, indicating that many are still bracing for a negative jobs report tomorrow.

Gold, silver and other precious metals were no exception, as margin calls forced traders and investors who were employing margin to deleverage their portfolio, selling their profitable positions to cover losses, presumably in equities.

The only green on the board was primarily in the US dollar and bonds, once again finding themselves as a safe haven asset during times of panic. One has to wonder, given the underlying uncertainty regarding the US debt, and the condition of global and local financial markets, how long such a phenomenon can last — especially given the tendency for investors to migrate in to hard assets when there’s a whisper of inflation.

The most likely scenario from this point forward is more quantitative easing, probably coordinated by the G7 countries, instead of a unilateral US effort, to prop up sagging markets. Such a liquidity infusion would likely spark a significant rally in commodities and equities, at the cost of the purchasing power of various fiat currencies. Such a powerful inflationary force could cause precious metals to stage vicious upward price discovery as more paper currency is created out of thin air.

In the short term and intermediate term we are looking at a very oversold market. By just about every measure possible we are in a very dangerous zone to be selling stocks. A violent bounce is highly likely, but how sustainable that bounce is depends entirely on what the ECB and Fed say in the coming weeks.

Technically on the S&P 500 there’s a good chance that we’ll see a retest of November, 2010’s lows around 1171 if economic data and news continue to build on the negative sentiment. The 1225 area has now become resistance. This could be the formation of a new trading range or the beginning of a significant downtrend.

Gold made new highs today, but margin calls forced liquidation and brought the price down over $40 from its highs. Silver tested the $42 level, but the same liquidation brought silver down by over 7% at the lows. There’s a good chance that the correction in precious metals could continue if the liquidity vacuum effect of souring debt markets in Europe continues. If instead central banks announce additional easing and credit expansion then we may see a significant rally.

Unfortunately today’s markets are no longer primarily powered by economic growth, but instead moreso from central bank money printing and artificially low interest rates. This is the main reason that more and more investors are turning to hard assets to hedge against, if not profit from, future inflation. If the sell-off continues, with gold, silver and other hard assets seeing discounts, I would consider it an opportunity to buy such assets as the longer term outlook is higher inflation and a resulting attraction towards precious metals.

Significant headwinds ahead for US economy

I feel we are facing significant headwinds moving forward because of the loose monetary policy of the Federal Reserve, the refusal to address the core problems in our financial system and the incredibly opaque derivatives market that has yet to be regulated or even cleared on open exchanges.

The root of the problem

To expand on the first point of loose monetary policy, from my own research I have gathered that the government has put at least $12T, possibly up to $30T worth of guarantees, backstops and other forms of insurance against the prospect of another meltdown. In addition the Federal Reserve has, in my opinion, illegally bailed out AIG through programs they are not authorized to participate in. These actions and other measures have transferred the risk of collapse from the private sector to the US government and to the Federal Reserve.

Interest rates remain below 1% in a range of 0.00% to 0.25%. Combine that with the infusion of US dollars the Federal Reserve has given to other central banks around the world and we have literally created a carry trade scenario. Not only are we repeating the mistakes of Japan, but we are going down a path where should a geopolitical event or other significant negative catalyst occur the repatriation of dollars could create a collapse across nearly every asset class.

Risk grows as stability wanes

This environment that has been created to engender a recovery is not only unsustainable, but it has created more risks than had existed beforehand:

#1 Should another market panic occur where AIG’s credit default swaps are due, the US Treasury and Federal Reserve must cough up the difference. This would lead to another series of bailouts and funneling cash to foreign and domestic banks at the tax payer’s expense on bets that never should have been made and were downright idiotic.

#2 Big banks are BIGGER now than before: JPM, BAC, WFC, USB and others are now larger and present a much more significant risk to the system should, say for example, one of their mark to make believe off balance sheet assets implode — potentially bringing down the entire world financial system, again.

#3 The stress tests were fraudulent and did not expose the off balance sheet asset liquidity vacuum these banks are suffering from. Papering over fraud never leads to a sustainable rebound.

#4 Tax receipts are down across the board – how can counties, cities, states and the Federal government hope to control deficit spending if they are not collecting as much in taxes? They can’t sell bonds forever, bringing me to my next point.

#5 Commercial real estate and corporate bonds are headed towards a potential implosion in the next few years, with major mall holders filing bankruptcy and many occupants of office and retail space vacating as they downsize. Corporations also must refinance their debtload which is ever growing while the global appetite for these bonds is diminishing.

#6 We in the United States are very seriously facing the risk of a sovereign debt default in the future. This prospect is made even more serious by continued bail outs, war spending, entitlements and other programs that are completely unsustainable with our country’s $14T debt burden.

#7 Such a sovereign debt default would lead to a currency collapse and that could engender either an environment of hyperinflation or heavy deflation — all depending on where the chips fall at the end of the day.

Inflation or deflation?

While speculators are now hedging for inflation and shorting the dollar in any way possible, there is another market we must pay close attention to. A market that significantly dwarfs the size of the commodities markets as a whole. That is the US Treasury Bond Market. Last I checked it was $33.5 trillion dollars. I find it interesting that gold is touching $1111.00 an ounce while 10 year bonds are at only 3.625% — who is wrong in this gigantic game of chicken?

Either the folks buying gold are insane to believe inflation is the bogeyman to fear or the much larger, much more influential and liquid bond market is crazy because they obviously fear deflation. Why else would a rational human being buy a bond at 3.625% that they must hold for 10 years? Such an instrument would be less than worthless in an inflationary environment.

First the principle value of the bond erodes as interest rates rise, and secondly the yield would not make up for the rate of inflation. So we are experiencing a financial conundrum right now. Either we are on the verge of a deflationary collapse or a hyperinflationary currency crisis. Which way we’re going to go has not yet been made clear to me because I feel the markets are being propped up, even manipulated.

The most dangerous bubble

Why would I pose such an idea? Let’s start with the P/E of the S&P 500 which is now well over 25 (and was at one point over 100). How can anyone feel that these stocks are reasonably valued with such an absurd P/E? Most of the decrease in P/E from over 100 to over 25 has been from companies downsizing, firing employees, hiding bad assets and not organic growth. In the current global macroeconomic environment there’s no feasible way earnings can catch up, so in my opinion we’re already in a bubble.

Bubbles of the past were not as dangerous because the US government never had such a large stake in the market. Now we’re talking about a situation where if the credit, bond, currency and/or stock markets implode, so does our sovereign debt and currency potentially.

Investing is now speculation

Investing in this environment is difficult at best. During the March panic I was a buyer in the high S&P 600s of just about any material, technology, financial and energy stock I could find, but once we got to the 900s and I saw P/Es jump beyond levels I felt were fair valuations I became a seller of my holdings. I also invested some in to silver, foreign currencies and other commodities during the March lows, but also have since taken a lot of those profits off the table.

We are in a very risky area for people to be entering the market. I don’t feel these lofty levels are sustainable nor do I think the valuations are rational. I don’t know when the rally will end, but I do know that any parabolic move usually ends very badly and any time there has been a carry trade in the history of money it has ended painfully for all the speculators who did not exit in time.

Another collapse coming?

In closing I will say that before Rome’s collapse the government was shaving gold and silver coins down to create more currency. They also had a severe debt crisis. The shaving and continued spending led to awful inflation that eventually catalyzed the empire’s downfall.

History is being made every day and the decisions are going to shape the face of America’s future. It is imperative that we start to take our medicine (meaning we must face the financial problems instead of ignoring them) and deal with the overwhelming burden of debt before it swallows up everything left.