Credit Crisis

Back in the 1930's, Irving Fisher introduced a concept called the 'debt supercycle.' Simply put, it posits that when there is a buildup of too much debt within an economy, there reaches a point where there simply is no other available solution but to let it rewind. We are at that point in our economy, as are most other major economies around the world, claims John Maudlin, author of the popular Thoughts from the Frontline newsletter and the recent bestselling book Endgame: The End of the Debt Supercycle and How It Changes Everything. For the past several decades, excessive and increasing amounts of credit in the system have allowed us to live above our means as both individuals and nations. We've been able to have our cake and eat it, too. Now that the supercycle has ended and the inevitable de-leveraging cycle is staring us in the face, we will be forced to set priorities in a way that has been foreign to our society for over a generation.

All you need to read.

Presented with little comment except to note that Bloomberg's Chart-of-the-Day highlights specifically what we have been discussing for weeks as in this earnings season, only 47% of companies in the S&P 500 have so far exceeded analyst expectations - the lowest since before the credit crisis. S&P 1300 FTW.

One of the more useful Wall Street fictions is the naive notion that big players and small-fry equity owners alike love low-volatility "melt-up" markets that slowly creep higher on low volume. The less attractive reality is that big trading desks find low-volatility "melt-up" markets useful for one thing: to sucker retail buyers and less-adept fund managers into an increasingly vulnerable market. Beyond that utility, low-volatility "melt-up" markets are of little value to big trading desks for the simple reason that there is no way to outperform in markets that lack volatility. The retail crowd may love a market that slowly gains 4% for the year, barely budging for months, but such a market is anathema to big traders. It's always useful to ask cui bono--to whose benefit? In this case, highly volatile markets don't benefit clueless retail equities owners, as they are constantly whipsawed out of "sure-thing" positions. From the big trading desk point of view, this whipsawing provides essential liquidity, as retail traders and inept fund managers trying to follow the wild swings up and down provide buyers. I have a funny feeling the "smart money" has built up a nice short position here and as a result the market is about to "unexpectedly" decline sharply. The ideal scenario for big trading desks here is a sudden decline that panics complacent retail traders and managers into selling (or leaving their stops in to get hit).

The Sovereign Ponzi

Last week the Federal Reserve and the Bank of England announced plans to tighten the control over the balance sheet management and the risk-taking of private banks. This is just the beginning, believe me. The nationalization of money and credit will intensify in 2012 and beyond. More regulation, more restriction, more control. Not only in defence of the bankrupt banks but also the bankrupt state. We will see curbs on trading, short-selling restrictions and various forms of capital controls. A system of state fiat money is incompatible with capitalism. As the end of the present fiat money system is fast approaching the political class and the policy bureaucracy will try and defend it with everything at their disposal. For the foreseeable future, capitalism will, sadly, be the loser. The conclusion from everything we have seen in 2011 is unquestionably that the global monetary system is on thin ice. Whether the house of cards will come tumbling down in 2012 nobody can say. When concerns about the fundability of the state and the soundness of fiat money, fully justified albeit still strangely subdued, finally lead to demands for higher risk premiums, upward pressure on interest rates will build. This will threaten the overextended credit edifice and will probably be countered with more aggressive central bank intervention. That is when it will get really interesting. We live in dangerous times. Stay safe and enjoy the holidays. In the meantime, the debasement of paper money continues.

One of the problems with economic crises is that mainstream economists and financial advisors either don’t see them coming or simply won’t admit to them. That’s exactly what happened in the fall of 2008, when the financial crisis kicked off in the United States. Since that time, governments have continued to spend, all while production has slowed and unemployment has skyrocketed. As we enter the fourth year of the post-crisis environment, there is no sign of growth that is impressive enough to get us out of the negative feedback loop in which governments have continued to operate. A negative feedback loop takes hold when massive government debt loads, a weakening financial system and a slowing economy feed off each other, interrupted by Federal Reserve and other central bank reflationary attempts. As shown in the chart below, rising debts become unsustainable and trigger austerity measures designed to reduce spending and/or increase taxes or other revenue sources to try and reduce debt. The more production and employment falter, the more lending contracts, causing further harm to the economy, missed budgets and higher bond yields. The result is a downward spiral of business and financial activity and a banking crisis usually ensues. Under pressure to stimulate the market, the Federal Reserve and other central banks carryout band aid fixes by printing money and governments implement additional austerity measures which starts the vicious cycle of the feedback loop all over again.  The fix needs to come from a unified front, not just a single country or continent. When we look at the three global pillars of the world economy — the United States, Europe and China — sure, each has its own problems, but each one’s fiscal choices impact the globe as a whole. And really, it’s four pillars when we add the Federal Reserve. We are a four-legged intertwined economic and financial system that relies heavily on each other for banking resources, government debt issuance, investments and exports. The feedback loops are never ending. And when economic growth stalls, debt accumulation increases. Without taking tough, systemic and coordinated economic measures including fiscal consolidation and a commitment by governments to cut rising deficits and reduce what are, in some cases, dangerous levels of national indebtedness, a second crisis may indeed be inevitable. The world is trying to recover from the worst financial crisis in 70-years and is suffering from debts levels not seen in decades and the crisis continues to intensify. And, as the graph below shows, with the exception of Ireland, countries need just as much, if not more, financing to cover debts in 2011 compared to 2010. Nothing has changed.

Just as in nature, the economic world has its own bloodsucking vermin in the form of banking elites which are a wretched drain on the whole of the human race.  Without their vicious and predatory presence, I envision a world so rapturously above and beyond what we wallow in today that it is impossible to describe.  The disgust many feel when considering the virulent feeding habits of the common mosquito or the slithering leech does nothing to compare to the utter gut churning revulsion I feel when studying the financial habits of banks like the Federal Reserve and the “too big to fails”.  They are without a doubt the most malignant form of social cancer imaginable.  And yet, after nearly four years of ongoing fiscal exsanguination, a sizable portion of the American populace is still looking to these pests for economic comfort and reassurance, just like farm animals consistently grazing near the entrance of a vampire bat cave, as if it is a shelter from harm.  Worst of all is the willingness by which investors still, to this day, commit their savings and their livelihoods to the stock market meat grinder.  Let’s be honest; the typical American daytrading investor is a complete moron.  They have absolutely no sense of the fundamentals of our financial structure nor the eccentric rules by which it operates.  They only have the faintest inkling of the functions of the highly manipulated stock market.  They foolishly believe that what little money they make today riding the wave of an illegitimate liquidity driven rally they will actually get to keep.  For them, stock investment is no different from buying a scratch-off lotto ticket at a hillbilly gas station; it is a cheap and tawdry game rife with failure but exciting to play, if only for a fleeting guilt addled thrill. To be fair, they play because the game is indeed “rewarding”, at least, initially.  The first taste is so sweet that it soils the plasma; the very skin of the cellular membrane of the financial mind becomes saturated.  It swells within the weakening heart of a culture, and overrides its sense of logic.  It makes us do terrible and stupid things, and we clasp our hands together and pray that it will never end.  But, of course, an ending is painfully inevitable.  The more we indulge, the more it takes down the road to satisfy us.  We become an addict nation, riding the chemical wave of a pharmaceutical roller coaster fed by the opiates of fiat and fantasy. The bottom line; we are being drained of our lifeblood as a country.

The following release represents Moody's Investors Service's summary credit opinion on the United States of America and includes certain regulatory disclosures regarding its ratings. This release does not constitute any change in Moody's ratings or rating rationale for United States of America. "Despite high debt levels, the financeability of the US federal government debt remains high, in part due to the global role of the US dollar. This has been demonstrated during the course of 2011, with the yields on Treasury securities falling to near-record lows at times. Over the longer term, this role could be eroded, but Moody's sees no immediate threat to the US government's ability to continue to access financing at relatively low cost."

Since the 2012 Outlooks have now slowed to a drip, its appears retrospectives are the stocking-filler of choice for the week. Goldman's economist group reflects on their '10 Questions for 2011', released at the end of December 2010, and finds they were correct seven times. The tricky thing about judging the 'score' is the magnitude of the error - or more importantly the magnitude of the question's impact on trading views. Jan Hatzius and his team have had their moments this year, for better or worse, in economic sickness or health but they have largely been accurate at predicting Fed policy (or should we say 'directing/suggesting' Fed policy), but were significantly off (along with emajority of the Birinyi-ruler-based extrapolators from the sell-side) on growth (high) expectations and inflation (low) expectations. Nevertheless, the lessons learned from over-estimating the speed of healing from the credit crisis and the disin- / de-flationary effects of a large output gap (which BARCAP would argue is not as wide) when inflation is already low and inflation expectations well anchored are critical for not making the same overly-optimistic mistake into 2012.

Unlike other, more humorous instances, such as Byron Wein and his 10 endlessly entertaining year end forecasts, some banks take the smarter approach not of predicting what will happen, because only idiots think they have any clue what tomorrow may bring with any sense of certainty, especially under global central planning - a regime that is by definition irrational, but instead of stating what would be a surprise to a base case forecast. And with "surprise" now the new normal, it would be prudent to anticipate what to the status quo may represent as fat tails in the coming year. Especially since even UBS now mocks the Wall Street consensus, and the traditional upside biad: "Let’s face it: Bottom-up consensus earnings forecasts have a miserable track record. The traditional bias is well known. And even when analysts, as a group, rein in their enthusiasm, they are typically the last ones to anticipate swings in margins." Which is why, with that advance mea culpa in hand, we bring to readers the Ten Surprises for 2012 from UBS' Larry Hatheway: "At the end of each year, in our final strategy note, the global asset allocation and global equity strategy teams join up to consider possible surprises for investors in the year ahead. Inside, we briefly describe ten such outcomes, and also provide a review of how last year’s surprise candidates fared." For those pressed for time, here is the full list: i) The consensus of bottom-up earnings estimates is right; ii) Financials outperform; iii) The euro rallies; iv) Oil prices fall below $70/barrel; v) Sovereign default outside the Eurozone; vi) Rising Treasury yields; vii) An Italian sovereign upgrade; viii) EU or EMU disintegration; ix) Fewer than five governments switch hands and, last but not least, x) Britain does Great at next summer’s Olympics. Let's dig in.

Jim Reid and his team from Deutsche have produced another magnificent compendium of information and prognostication in their 2012 Credit Outlook and while their up-in-quality preference (non-financial) may not be earth-shattering strategically, their timing view is of note. Instead of viewing the looming refi-ganza among European sovereigns and financials in H1 2012 as a reason for doom and gloom, they see it as the necessary evil to drive the ECB into the markets in size only for the latter half of the year to disappoint significantly as the reality of the underlying problems rear their ugly head once more. The down-then-up-then-worse-down perspective on markets for next year hardly sounds optimistic but it is the following six scenarios away from European woes that keep them up at night. From the positivity of a US housing rebound or Election year cycle to much more extreme downside risks such as geo-political concerns and non-European sovereign risks, their views on China, QE-evolution and Inflation concerns are noteworthy.

What is there to be so optimistic about (in resource investing)?

1. We are going to face an awful lot of volatility. And I should start by saying that volatility can be good news for you if you are prepared for it. It gives you frequent sales. Why the volatility? In the first instance, there are seven or eight trillion dollars sitting on the sidelines just in the United States looking to be invested. That has some upward bias.

2. We are in a secular bull market in 'stuff'. The bottom of the [global] demographic pyramid as it gets richer, and it is getting a bit richer, uses a lot more stuff than the top of the pyramid. So per capita consumption of stuff is growing, spread over lots and lots and lots of capitas.

3. Resource stocks have not kept pace with commodity prices. So resource stocks for the first time in several years are attractively priced.

4. The senior resource companies, including the mining companies that have been real under-performers for the last decade, are starting to make an awful lot of money. And one of the themes I think that you are going to see in the resource space is mergers and acquisitions.

All you need to read.

China cut rates yesterday potentially as part of a globally co-ordinated central bank plan or co-incidentally because their economy was losing steam or both. I would bet there was communication and that may have impacted timing but with the weak PMI number China did what was necessary for China - as they always do. Much was made of the globally co-ordinated rate cut on USD swap lines. Any swap requires a minimum of 2 counter parties and since this plan had been globally "re-instated" or "re-affirmed" in September the market may be making too big of a deal of this global coordination.  This was largely cutting the cost of an existing series of global swap lines by 50 bps. It did not change the liquidity available to banks, just the cost. Currently it seems that only $2.4 billion is being used. It is not a bad step but no new liquidity is added (through I work under the assumption they will increase availability if needed) and it is impossible to cut unilaterally and would be pointless since as recently as September there was global agreement. Rumors that a bank was on the verge of failure seems overdone and changing this fee by 50 bps does nothing for that. Sadly, since the Fed is both independent and unaccountable there may be additional activities behind the scenes that we don't know about that may be supporting strong price action. More people feel forced to follow market moves based on the assumption that some people may actually KNOW something about future policy moves or existing but undisclosed actions. It is a rational reaction but does tend to exaggerate the moves and lead to quick reversals when no one actually KNEW anything.