After having suffered the worst May since 1940 (Dow), equities have continued their sell-off into early June, amidst concerns about spreading European debt crisis, Chinese tightening and fading US recovery. The rally off the March 2009 lows was driven by liquidity, stimulus and improving economic and earnings data, particularly in the US. Now that government stimulus starts to taper off the question is whether economic growth has become self sustaining or not.

A natural slowing in the second half of the year has been expected. However, concerns about a double dip recession now appear to be growing, given the sovereign debt crisis and contagion risks in the eurozone and Europe’s impact on the global economy as countries start implementing austerity measures. Add concerns about Chinese tightening to cool an overheating economy and rampant real estate speculation, plus a weakening recovery in the US… the picture is not pretty.

In the US leading economic indicators have started turning over. The Economic Cycle Research Institute’s (ECRI) Weekly Leading Index has gone negative for the first time in over a year, falling to 123.2 from 124 the week before – the lowest level since July 2009. The ECRI WLI has historically been a good predictor of US economic activity, so its downturn is pointing toward a significant slowing in economic growth in the coming months. The Conference Board’s LEI for the US peaked in March.

China has taken steps to cool growth. China’s LEI (leading economic index) peaked last fall, Chinese PMIs are weakening and property market activity has been declining in response to the authorities’ measures to curb speculation. The worry is how much the world’s growth engine will now slow down; so far the economy remains very resilient (exports jumped 48.5% in May). However, the Shanghai Composite index is off nearly 30%, indicating weaker global growth prospects.

May saw the largest slump in commodity prices since Lehman’s collapse, pointing to potentially disappointing global economic growth. The Journal of Commerce Industrial Price Commodity Smoothed Price Index plunged 57% last month, the most since October 2008. Copper price broke down to a new 7-month low, before a bounce this week.

For now the global business cycle expansion appears intact but growth is starting to soften. A mid-cycle slowdown is not so unusual; however, it’s not immediately clear whether we should expect a normal moderation or indeed a double dip recession.

According to the yield curve a recession is not likely. Having correctly called past recessions when it inverted (short rates higher than long rates), the yield curve presently sees the risk of a recession in the next 12 months or so as near zero.

Buy on dips? Maybe not this time …

So, has the recent panic in the financial markets been overdone? The global economy and financial system are still fragile and vulnerable to further shocks, and confidence is fast evaporating. This is no time for complacency – things could get very ugly very fast.

On top of everything else, policy shock (including US financial regulatory reform outcome) is an additional risk investors have to consider. As is often the case, the authorities have been adding to the uncertainty by increasingly erratic moves (chaotic ECB actions, Germany’s ban of naked short selling of some financial stocks and eurozone sovereign bonds and CDS – likely to be further extended, etc). Such actions are counterproductive; they only heighten volatility, increasing the cost of capital and reducing liquidity.

May proved catastrophic for most assets, including equities, commodities (except gold), the euro. The winners have been the US dollar and Treasuries, reflecting a flight to safety as well as a symptom of a deflationary trend. (Money supply is falling at a pace not seen since the early 1930s!)

Markets went into June very oversold, so the relief rally currently underway was expected, and indeed could last a little longer. However it is unlikely to be more than a short term bounce. The S&P has now closed below its 200 day moving average for 16 consecutive sessions – a clear sign of trend change. Although we can’t yet be 100% certain that this is indeed something far more worrisome than a standard correction, there are signs that the trend has turned negative. Until there is more clarity it may be wise not to buy this market – you will likely be able to pick up most assets at much lower valuations late in the year.

It is true that the market has already priced in plenty of bad news – assuming the global recovery remains intact and there is no contagion from Europe; however, that scenario is increasingly looking too optimistic. Considered there is still a great deal of complacency, the bulls could be in for a nasty shock in the coming weeks and months.

Credit crunch is back!

Furthermore, there is good reason to believe this sell-off is different from the previous ones we have seen since March 2009 – the action in the credit markets. We have not witnessed significant deterioration and widening of credit spreads since the start of the rally – until several weeks ago. This is a fundamental change and a sign that the credit crisis is returning.

Credit is the early warning sign; equities lag deterioration in credit conditions. Decline in commodity and equity prices, and ultimately in economic growth, are a result of weakness in the credit markets. It would be foolish to overlook that the current correction has indeed a differentiating characteristics to it; do pay attention to the funding markets.

The European sovereign debt crisis is not going anywhere, and global credit conditions have been worsening. Cost of credit is rising and credit availability declining, which is affecting the funding needs of corporations worldwide. The economic fallout is only just starting to become apparent.

And it’s not only Europe. Higher cost of capital is also noticeable in the US and emerging markets where corporate debt spreads have been rising and debt issuance slowing. Funding markets are seizing up and capital is becoming more expensive, a consequence of which will be a squeeze in profits and slowdown in global growth.

Credit clearly continues to point to further stress ahead. Some disturbing signs that we may be witnessing the beginning of credit crisis 2.0:

Widening eurozone government bond spreads: yield spreads between German bunds and Club Med bonds have resumed their widening trend in recent weeks and in some cases became wider than before Europe’s mega bailout package was announced (although they tightened somewhat this week). And it’s not just the PIGS’s creditworthiness that has been deteriorating; we have seen huge spikes in CDS spreads on Eastern European sovereign debt and even that of France, Austria, UK and Germany over the last month.

European bank CDS have surged, indicating rising stress in the banking system, loss of confidence and growing risk aversion. It means sharply higher borrowing costs for banks. (European banks have raised less from the capital markets in the past six weeks than in any year since 1995.) Some smaller banks have been reported to be completely shut out of the credit markets. Even more troubling is that some of the world’s largest banks in Spain, Germany and France are now becoming infected. The Markit iTraxx Financial Index of CDS on 25 European banks and insurers soared to the highest level since March 2009 (before improving somewhat this week).

The LIBOR-OIS spread has widened significantly in recent weeks (now standing at 32.4bps). Equally, the TED spread has been deteriorating and is now at 47, up more than 300% in the last three months.

LIBOR-OIS and TED reflect the health of (and perceived credit risk in) the interbank lending markets. They are gauges of financial strength or weakness of banks. A rising spread shows that banks are unsure of the creditworthiness of other banks, hence charging higher interest rates to compensate for greater risk. Due to the European debt crisis counterparty risk is increasing and banks are reluctant to lend to each other once again.

Eurozone banks have been parking record sums in the European Central Bank’s deposit facility. Use of the facility, which pays an interest rate of just 0.25%, reached a new high of 364.6 billion euros (higher level than after the Lehman collapse) – a further sign that banks don’t trust each other’s creditworthiness, opting to instead deposit funds with the ECB.

The uncertainty is also rocking the corporate debt markets. May was the worst month for corporate bond sales for over a decade. Issuance of high-yield company debt nearly halted amid new signs that Europe’s sovereign debt crisis may be spreading; investment grade companies are also finding it more difficult to issue bonds. Both High Yield and Investment Grade spreads have soared in recent weeks.

There has also been substantial deterioration in the US Commercial Paper market (short-term IOUs), which contracted to its lowest level since 1999. Debt outstanding dropped, after six straight weeks of decline, to the lowest level on record as companies pared back on tapping short-term funding.

The European contagion impact and lack of liquidity is being felt in the emerging markets as well. New bond issuance of Brazilian companies halted for a sixth straight week, the longest stretch in 14 months, as Europe’s debt crisis drove up borrowing costs and caused a surge in volatility.

This worrying credit contraction is eerily reminiscent of the situation in summer 2007. Investors are fleeing all but the safest government securities. Poor liquidity and vanishing risk tolerance could see consumers contract, businesses stop hiring and investing and economic activity coming to a halt.

The prospects aren’t so good. A recent ECB forecast (Financial Stability Review, May 2010) that eurozone’s financial institutions may have to write off 195 billion euros of bad debts by 2011 – on top of the 238 billion already accounted for – confirmed fears about the fragility of the financial system.

Deflation and double-dip recession?

Meanwhile, the economic picture in Europe is not encouraging.

On the positive side, European core has been surprising with strong economic data; German manufacturing and exports are booming – exports to non-euro area have now surpassed the pre-Lehman bankruptcy peak (a weaker euro will only supercharge this growth), Germany’s PMIs are at a four year high; IFO Expectations Index is at its highest level since mid 2007.

On the other hand, Greece is insolvent and will unlikely avoid debt restructuring/default, which poses a massive risk for the European banking system. (Could Spain and Portugal also turn out to be insolvent in the end?) The hope is that Europe has bought sufficient time to stabilize the rest of the eurozone before a Greek debt restructuring.

The question is whether the European sovereign debt crisis could bring down Europe’s banking system, causing a collapse in confidence and economic activity similar to the fallout of Lehman in September 2008. It’s too early to tell, but a bank run (and a capital strike against eurozone investments) is looking increasingly more plausible.

(Of course European banks are already in a precarious shape, having made much less progress on writedowns and rebuilding of equity than US banks. They will also have to refinance some 800 billion euros in long-term debt by the end of 2012, and bank borrowing has already suffered a major blow because of sovereign risks – see notes above on deterioration in the credit markets.)

It’s not just the ultimate value of their government bond holdings the banks have to worry about. The deficit reduction and austerity programs much of Europe is embarking on are a step in the right direction but will inevitably kill consumption, investment and growth in the short to medium term. A long and painful deflation and severe recession in the periphery would appear unavoidable. (Defaults down the road are still a likely scenario.)

The fiscal retrenchment under way will see incomes in a number of eurozone countries beginning to fall in nominal terms; this will undermine the ability of households and businesses to service their debts, leading to a surge in private sector loan losses at European banks. Credit growth will also further contract as banks – already burdened with the until recently thought safe government bond holdings – will become even more reluctant to lend to riskier private sector borrowers.

Lack of credit will further reduce investment, job creation and economic growth. Slower growth and lower tax receipts will make it even more difficult for the periphery to get their debts under control. And, slower economic growth will create further problems for the banks, causing higher loan losses as highly indebted eurozone households and companies default on their loans. A vicious feedback loop.

A double dip recession in parts of the eurozone should, on itself, not have a disastrous impact on US and Asian economies, although some industries are companies will be more heavily exposed to diminishing European revenues (Europe is China’s largest export market). However, a potential collapse of the European banking system would undoubtedly have catastrophic consequences for the global financial markets, plunging the world back into recession.

And this time policy makers and central bankers would have little ammunition left to support the economy; interest rates are already at or near zero and there is (for now) little appetite for several more trillions worth of stimuli. That might change, of course, after a severe deflationary period, financial collapse, recession/depression; the Fed, ECB and other central banks and governments would then undoubtedly embark on quantitative easing and stimuli on a never before seen scale.

Deflation followed by hyperinflation, anyone?

After months of optimism and growing complacency last week brought a sudden reversal of market sentiment. Optimism was replaced by worry and fear. Confidence was erased, despite a 110 billion euro EU/IMF bailout package for Greece and good US economic data; fear of a sovereign debt meltdown in Europe contributed to Tuesday’s and Wednesday’s sell-off, culminating in Thursday’s bloodbath. The Dow plunged nearly 1,000 points – the largest intraday decline on record – only to recover much of the loss minutes later. Even so, equities suffered their worst session since February 2009, with all major US indices ending the day down by more than 3%.

Escalating concerns of spreading European sovereign debt crisis, aided by images of murderous riots in Greece (casting further doubt of Greece’s ability to implement proposed austerity measures), provided the catalyst for the panic sell-off. Although some believe a trading error or technical glitch may have helped on the downside, the fact is the market was already very weak before the mid-afternoon plunge. The sell-off was, it appears, driven by good old fear.

More selling on Friday – despite better than expected US nonfarm payrolls report – reinforced the growing sense of panic. Both the Dow and the S&P 500 posted the largest weekly losses since March 2009 (DJIA fell by 5.7%, S&P was down 6.4% and the Nasdaq 8%), erasing all gains for the year. As fear spiked, so did the VIX (Chicago Board Options Exchange Volatility Index); it jumped by 86% – the largest weekly increase ever in its 20 year history. In a flight from risky assets the yen, dollar and gold were the best performers.

The EU/IMF providing just a short-term patch for Greece and no solution for other peripherals, financial markets remained unimpressed. Spreads in European sovereigns continued to blow out; the euro sliding further. There have also been increased concerns about European banks, which (as of end of 2009) hold claims of $193 billion on Greece and more than $1 trillion on Portugal, Ireland and Spain. Libor (the interbank lending rate) rose sharply as banks became increasingly suspicious of each other’s exposure to European peripheral sovereign debt.

The slide in the euro, soaring bond yields and global markets’ reaction to the crisis finally led eurozone governments to lay out a set of measures to safeguard the financial stability of the euro area. Last weekend they vaguely committed to additional fiscal consolidation and reform of the Stability and Growth Pact to ensure fiscal sustainability in the region.

As of Monday morning European leaders agreed on providing a massive rescue package of 750 billion euros ($960 billion) to eurozone countries in an effort to stop the sovereign debt crisis and contagion. Eurozone governments pledged 440 billion euros in new loans and guarantees and 60 billion under an existing lending program, with an additional 250 billion to come from the IMF.

The most dramatic intervention came with the announcement that the ECB (European Central Bank) would buy euro area public and private debt. The dollar swap line with the Fed has also been reactivated.

Yesterday’s rescue package averted an immediate crisis and will likely buy Europe some time to allow real fiscal adjustments to take place. However, while it helps eurozone sovereigns with near term financing, it does not fix the longer term debt and solvency problems.

Ultimately, Greece’s problem is not just one of liquidity but also solvency, so the country will still likely have to resort to debt restructuring (which has now been postponed). Without the option of currency devaluation, Greece must go through severe debt deflation. Incomes and tax revenues will plunge. The vicious circle of falling nominal GDP and rising debt/GDP ratio can only be stopped when growth resumes – which will be difficult without devaluation. Solvency risks will not go away anytime soon.

The euro currency downtrend will most likely continue. We may not be far away from a point when the ECB starts printing and effectively monetizing eurozone debt. Concerns of longer term viability of the single currency will also stay as peripheral economies sink deeper into debt deflation.

European periphery facing severe austerity programs and prolonged recessions will not only kill EU’s growth for the foreseeable future but also impact global demand that will go down just as the cyclical recovery is starting to face headwinds.

Where next for the markets?

Peripheral spreads have rallied spectacularly, retracing 50-75% of their widening since the end of March within just a few hours. However, this extreme narrowing is unlikely to be sustained unless the ECB continues buying peripheral debt. European, US and global equity markets also responded positively with a huge rally yesterday.

Last week’s Greek debt fallout provided a perfect trigger for corrective action – we were certainly due for one after the steep rally off the March 2009 lows. Bullish sentiment had reached levels consistent with short term tops (Investors Intelligence survey of investment advisers – a measure of the crowd’s sentiment – reported last Wednesday that 56% of advisers were bullish – the highest level since the 2007 market peak); equities and commodities were overbought. The amount of cash as a percentage of total assets at equity mutual funds was at a record low. Insider sales were at extremely high levels compared to insider buying.

At the moment it’s premature to say whether the sell-off is over; we could be seeing a relief rally, the correction could reassert itself and last for a few weeks. However, given the strong momentum from the March 2009 lows, decent valuations and good upside breadth the cyclical bull market certainly appears to be intact. The markets are bound to remain volatile for a while though.

The following chart shows the spike and subsequent decline in the VIX – also known as Wall Street’s ‘fear index’. A few weeks ago it was at 18 month lows, indicating high investor confidence (and complacency). As we’ve moved from optimism to fear and dread last week volatility rocketed, only to fall back after Monday’s eurozone bailout news.

(The VIX is a measure of the implied volatility of S&P 500 Index options. A low value indicates expected stability in the markets; a high value means expected turmoil. So the VIX tends to exhibit a strong negative correlation with equity prices.)

Another sentiment indicator, the equity put/call ratio, was also very stretched by the end of April, indicating extreme bullish sentiment. As optimism turned into fear the put/call ratio spiked up.

A look at April breadth measures also signaled an imminent correction as over 90% of S&P500 stocks traded above 50 day moving average. We dropped to oversold territory last week, before bouncing back somewhat.

As risk aversion grows US equities could benefit from a flight of capital from Europe; though it will more likely continue to flow into bonds. Importantly, the US economy is improving on all metrics.

We are now seeing a starting recovery in the labor market, based on the payrolls numbers as well as Household Survey employment data. Last Friday’s US nonfarm payrolls surprised to the upside with 290,000 jobs added in April – much better than the anticipated 180,000, with the March number revised upward to 230,000. However, the unemployment rate increased to 9.9% from 9.7% due to a surge in the workforce. (Also, census hiring added 66,000 jobs to the April number.)

There is no doubt about the strong recovery in US manufacturing, as witnessed by ISM data (at 60.4% as of April). The manufacturing sector expanded for the eighth consecutive month to its highest level since July 2004. The pace of new orders was very strong and employment within the sector continued to grow.

Consumer spending has been rising (albeit at the expense of the savings rate). Retail sales rose above expectations in April, for the fifth time in the last six months.

Despite positive US data investors remain skeptical about the health of the economic expansion. At present the consensus is for subdued economic growth; that might end up proving to be too conservative.

Short term interest rates are at their multi-decade lows. Even if rates were to start rising faster than expected, the environment will stay very stimulative for a long time. Low interest rates provide a subsidy to income, profits and economic growth.

Whereas liquidity has been the main driver of the stock market rally until now, the next phase will likely be spurred by growth and profits, with performance depending on expanding economy. Low rates, strengthening business activity and strong balance sheet conditions will drive earnings growth. (Earnings have been very positive, beating expectations in most cases. Expectations of S&P 500 operating earnings are in the region of $80-84 by the end of 2010.)

If economic growth is decent and rates stay low, profits will likely keep surprising on the upside. Of course better economic growth, employment growth and improving corporate profitability will eventually see a rise in interest rates. That alone is, however, not automatically negative for stocks. It is generally only when interest rates start to exceed the nominal GDP growth that the economy slows down. The yield curve also has to become inverted for a cyclical equity bear market to be triggered. Historically, cyclical bear markets were triggered when the yield curve became inverted at a level that was higher than the nominal GDP growth. We are nowhere near that point.

The cyclical bull market has further to go, although the pace of price gains is likely to be much slower, given the steep rally off the March 2009 lows. Most retail investors have not yet moved into equities and are sitting on the sidelines. Yet there is little reason to believe that they will not do so again once confidence in the rally becomes more widespread. Optimism should increase as evidence accumulates on the strength and durability of the economic expansion.

US fundamentals look good for now: leading indicators of growth remain strong, rates are extremely low, earnings are beating expectations, valuations are reasonable.

Equities are relatively cheap on 1-2 year forward valuations (PE of 14 and 12, respectively). Global equities valuations are also attractive at 12M forward consensus earnings multiple of 13. Emerging markets trade on a 12M forward P/E of 12, although they have, over the last two decades, grown earnings at an annual rate of 22% vs. 12% in developed markets, as well as having lower leverage and higher economic growth. Equities are also cheap relative to bonds (as per dividend yield/bond yield ratio).

Retail investors have been net sellers of equities since March 2009. The total allocation to equities by the US household sector is well below long term average. Global bond funds posted inflows of $83.5 billion this year, equity funds saw inflows of only $7 billion. Since the trough of March 2009 US equity funds inflows came to $40 billion compared to bond funds inflows of $360 billion. Retail investors have so far not participated in the rally – retail equity funds saw net outflows of $82 billion since March 2009 (though in March 2010 retail have been modest net buyers). Institutional equity funds have seen modest net inflows since March 2009. (Data from EPFR Global and Credit Suisse.)

Central banks will likely continue to flood the system with liquidity whenever deemed necessary, and the Fed will keep short term rates in real terms (inflation adjusted) below zero for a very long period of time – all of which is positive for equities. And, as noted, there is plenty of cash available from investors who have missed the rally and are still sitting on the sidelines.

I believe the cyclical bull market (i.e. rally within the secular bear that started in 2000) will go on for a while, so any 10-20% corrections may be seen as a buying opportunity for select equities.

There are of course a number of medium to long term concerns.

The situation in parts of the eurozone will remain precarious. Austerity measures will plunge the periphery into a deep and prolonged recession, while bailouts will come at the expense of the productive European economies, all dragging down demand. Europe will buy less US goods, and with the euro likely close to or at parity to the dollar US companies won’t be able to compete with European exporters. This could well slow down US growth by late 2010 and 2011. (Tax hikes will also kick in next year.)

China is tightening in an attempt to slow down its economy, amidst concerns of overheating and housing bubbles. (The Shanghai Composite Index has broken below its key 200-day moving average – a possible precursor of what’s to come in other markets?) Brazil and India (and much of the rest of the developing world) are raising interest rates to fight inflation.

Concerns also remain about US regulatory changes, including financial reform.

The US housing market is a weak spot that needs monitoring. Although prices are stabilizing, the overall picture remains worrying, in particular due to the massive amount of unsold overhang remaining in the system. On the positive side, house price to income ratio is now close to a 40-year low and yields on low-end properties are, according to Credit Suisse research, over 8% – the highest on record relative to 30-year mortgage rate.

And there are still some $6.5 trillion of excess leverage in the developed economies, which will end up reducing growth. Government bond funding will also become more of a problem in the next few years, and not just in Europe. Economies won’t be able to simply grow their way out of fiscal indebtedness. In order to stabilize government debt to GDP fiscal policy will have to be tightened significantly (in the US, UK, Japan, much of the eurozone), which will be extremely challenging both politically and economically. We are still heading toward sovereign defaults a few years from now.

If we are lucky, we may have another 12-18 months before things start getting ugly again.

I think most Americans would agree taxes are heading higher. Yet, curiously, most may not care. (A Gallup survey shows 45% of Americans are happy with their tax rates and 3% believe them to be too low.) In fact, I suspect a significant portion of the population may welcome the tax increases with hardly concealed joy.

How is that possible, you ask?

The explanation is as simple as it is disturbing. For nearly half of US households taxes are simply somebody else’s problem. Approximately 47% pay no federal income taxes at all! (Data from Tax Policy Center for 2009.)

That’s right: nearly half of Americans qualified for enough credits and deductions to fully eliminate their tax liability, or had too low incomes to start with. (According to Deloitte, credits for low- and middle-income families have risen so much that a family with two children making $50,000 a year will owe no federal income tax.)

Half the country is happy with tax policies… well, they should be if they pay no taxes in the first place! These are the people who, more often than not, support higher marginal tax rates, for that simply means someone else will have to pay for their ever growing entitlements.

It is a sign of our hypocritical era that the cry of making taxes more ‘fair’ – meaning of course robbing higher earners blind so that lower earners need to pay nothing – has now been almost universally accepted.

But how on earth can one talk of fairness?

Consider this: the top 1% of Americans pay 40% of federal income taxes, the top 5% pay over 60%… while the bottom 50% pay less than 3%! (Data from the Congressional Budget Office, latest available tax burden release, 2006.)

Half the population is getting something for nothing, and they call this fairness?

As is always the case with expanding welfare states, generous entitlements are paid for by everyone except the actual beneficiaries.

There is nothing fair about redistributing incomes, much less on such a massive scale. There is no fairness in the government penalizing someone for working harder than others. (Not to mention it is unsustainable over a longer term – you will run out of wealthy people to tax.)

Now can you see the fundamental problem here? 40% of American households paid 86% of total federal tax liabilities. However, when it comes to deciding how the government should spend that money, they are outnumbered by the 60% who paid just 14% of taxes.

Is it any wonder that government spending is out of control and the US is coming close to fully adopting European-style socialism? The majority of voters decide on how to use other people’s money – why would they want any spending cuts?

The Congressional Budget Office data also shows that higher earners are paying a larger share of total federal taxes than ever before (as far back as tax burden data goes, to 1979).  

According to the IRS, in 1987 the top 5% of earners paid 43.26% of all federal income taxes; today, that group pays more than 60% of the tax burden – despite bringing in just 37% of the income. By contrast, the share of taxes paid by the bottom 50% of taxpayers – who bring home 12% of the income – has gradually fallen to less than 3%.

Higher earners have, over time, been forced to fund an increasing share of the federal government and fast growing entitlement programs. Meanwhile, according to the Tax Foundation, 60% of Americans consume more in government services than they pay in taxes, and the benefits extended to this group have been steadily increasing.

And yet the likes of Mr. Obama continue to tell us the wealthy aren’t paying their ‘fair share’!

Hence the $650 billion or so in tax hikes and new taxes that will be imposed on higher earners over the next decade will hardly be of concern to the vast majority of Americans. This is a short-sighted view, but then most people aren’t programmed to think of long term consequences. Given the immediate benefits for oneself, who will spare any thought on the negative impact on the economy and future job creation?

Which of course explains the shift toward statism and socialism at a certain stage of mass democracy. (Not for nothing did John Adams, the 2nd President of the USA, say that “there never was a democracy yet that did not commit suicide”, and did James Madison and other Founding Fathers believe that individual rights must be protected from the “tyranny of the majority”. They understood that without checks and balances the propertyless majority would tyrannically tax away the property of the minority.)

The state has clearly become far too big and in the process has made the majority of the electorate dependent on hand-outs, with the result that voting for the necessary medicine will now be virtually impossible.

The massive deficits, unprecedented debts and out of control entitlement programs (as well as demographic trends) leave few options – drastic spending cuts or significant tax hikes (or a combination of the two).

According to a recent Goldman Sachs study (based on budgetary data for 24 OECD economies covering 35 years from 1975), there is only one effective way to reduce debt and sustain future economic growth: imposing budget expenditure cuts across the board. On the other hand, increasing taxes to compensate for a higher budget has proved very damaging to future growth.

While cutting spending would be of most benefit to the country’s prosperity and future, it simply won’t happen on any meaningful scale. When the majority of the electorate has no interest in giving up their entitlements, political leaders will always take the path of least resistance and penalize those voters who, being a minority, don’t present a sufficient threat to their political careers.

And so, on top of all the existing, technically bankrupt federal programs, the Obama administration created a new health care entitlement, to be paid for, as usual, by everyone except those who will benefit. (Detailed overview of associated taxes further below.)

The problem is the US – along with much of Europe – is on a wholly unsustainable budget path, with unprecedented public spending (largely paid for by borrowing and money printing). In the absence of Americans rejecting the expanding welfare and entitlement state, taxes will have to rise much beyond the scheduled increases. Unless, that is, the administration finds some other – miraculous – way to reduce the enormous amounts of debt it continues to pile up.

A recent study by the nonpartisan Tax Policy Center calculated that to reduce the federal budget deficit to a sustainable 3% of GDP, the government would have to find some $500 billion each year – in new revenue (or spending cuts). To get that amount via tax increases on the top two brackets (families with over $209,000 in taxable income) the rates would have to go from the current 33% and 35% to 72.4% and 76.8%.

You didn’t think socialism comes cheaply, did you?

The truth is, no matter how much marginal income tax rates will rise, they cannot realistically be taken high enough to fill the fiscal hole. A broader based tax or a consumption tax is therefore likely to be on the horizon in the coming years.

Speculation about a value-added-tax (VAT) is already ripe. Former Fed Chairman Paul Volcker, among others, has called for VAT to be considered in light of the massive deficits. VAT is a national sales tax applied at each stage of production and collected by businesses (meaning additional bookkeeping and costs). It’s difficult for anyone to escape the tax since it’s included in the price of products and services you buy. (In Europe VAT rates range from 15-22%.)

VAT, apart from being a convenient way to pay for ObamaCare, has other advantages as well. It would allow (via increasing rates) for funding of a continued expansion of government, and as such would undoubtedly permanently open up the floodgates of public spending.

But while VAT is (for now) just a speculation, the tax increases starting next year are very real. Below you’ll find an overview of tax hikes and new taxes to be imposed on (better-off) Americans in 2011-2018.

2011 – tax hikes (tax cuts expiry) on higher income and capital income

First there is the expiry of the Bush tax cuts at the beginning of next year. The highest tax bracket will move from 35% to 39.6% and the 33% bracket will rise to 36%. The estate tax will also revert to 55%, with an exemption of $1 million (unless Congress reinstates the 2009 rules of 45% federal rate and $3.5 million exemption).

Importantly for investors, the capital gains rate is set to rise to 20%, up from 15% now. Dividends, currently taxed at 15%, will be taxed as ordinary income, with the top rate scheduled to rise to 39.6% (unless Congress enacts a proposal for a top dividend tax rate of 20%).

While most of these increases appear to only target wealthier Americans, they are also damaging to small businesses. (According to IRS data, some 26 million small business employers file under the individual income tax code and so will be subjected to much higher taxation.) This, along with the onerous new health care burdens, will certainly not help small businesses hire more people.

On top of the tax cuts reversal, Obama’s health care ‘reform’ brings a number of new taxes and tax increases (2011-18) aimed at financing part of the new spending. For obvious reasons most of the tax hikes will start in 2013, after the election year. (Some ObamaCare related taxes go into effect in 2011, however, these will affect drug makers and importers.)

2013 – increase in payroll tax + new tax on investment income

From the beginning of 2013 higher-income taxpayers will be hit with a tax increase on wages as well as an entirely new levy on investments.

Medicare payroll tax will rise by 0.9% from 1.45% to 2.35% – a gigantic 62% increase – on wages above $200,000 for individuals and $250,000 for married couples filing jointly.

In addition to that, and for the first time ever, Medicare taxes will be extended to investment income. A brand new 3.8% tax will be imposed on the falsely called ‘unearned’ income – dividends, capital gains, interest, rents and other investment income – for individuals making more than $200,000 a year and couples making more than $250,000.

(A 2.3% excise tax on sale of medical devices also goes into effect in 2013.)

2014 – penalties for lack of insurance

2014 is when the health coverage goes into effect, and the requirement begins for everyone to have health insurance. (The government will provide subsidies for lower and middle income groups.) If you don’t want health insurance, tough; you’ll pay penalties – $695/p.a., further rising in 2016.

Medicaid (the federal-state program for the poor) will expand to all Americans with incomes of up to 133% of federal poverty level; since this could bankrupt the states they might start electing out of Medicaid. (More than a dozen states have already filed lawsuits over the constitutionality of the burden imposed by Obama’s bill.)

Subsidies (tax credits of up to 50% of employer’s contribution) for small businesses (up to 10 employees) will provide for coverage increase. Penalties will be imposed on employers with over 50 employees who don’t provide ‘affordable’ coverage (note – affordable as deemed by government bureaucrats); they will be fined $2,000 a year per employee, excluding the first 30.

(The health insurance industry will also start paying annual fees; $8 billion in 2014, rising in subsequent years.)

2016 – steep rise in penalties for uninsured

Penalties for those who don’t carry coverage will rise to 2.5% of their taxable income or $695/p.a. – whichever is higher.

Not to mention, a mammoth bureaucracy will be created thanks to ObamaCare (see here the astonishing list of all the new boards, commissions and agencies the bill gave birth to). The government will also hire an estimated 16,000 IRS agents to harass and audit individuals and individual businesses to check for compliance. (I suppose Mr. Obama would expect us to applaud this convenient new job creation scheme?!)

2018 – tax on high value plans

An excise tax of 40% will be imposed on health care plans with premiums exceeding $10,200 (individual coverage) and $27,500 (family coverage).

Investors hardest hit

Apart from higher-income taxpayers being disproportionately targeted as a revenue source, policy is now clearly taking the path of increased taxation of passive income. In fact investors and higher earners will bear all the burden of ObamaCare (without getting any of the benefits).

Let’s look again at the massive new taxes Obama assaulted investors with, as well as the likely impact.

Those with income from stocks, real estate or other investments are expected to contribute a giant share of the costs of health care expansion. (I suppose we’re seeing a theme here… from the continuing witch-hunt on the financial sector to the increasingly investor-hostile environment.)

Aside of the income tax and payroll tax hikes detailed above, there are three specific developments penalizing investors: increase in capital gains tax from 15% to 20% (2011), increase in dividend tax (to either 20% or as high as 39.6% – see further below; 2011), and the new additional 3.8% tax on all ‘unearned’ income (2013).

What exactly will be subject to the 3.8% tax? Dividends, interest, annuities, royalties, rents, as well as capital gains (minus deductions properly allocatable to such income). Basically, all income and gains derived from a ‘passive activity’ count as investment income. (Note that income and gains from an investment fund, even if the fund is classified as a ‘trader’ for tax purposes, will be subject to the tax.) Tax-exempt interest income and distributions from tax-qualified retirement plans, including IRAs and Roth IRAs, are not to be included in investment income.

Capital gains, currently taxed at 15%, will therefore be subject to a 23.8% tax (20% after expiry of the Bush tax cuts + 3.8% in new tax).

Dividend income (currently taxed at 15%) will be particularly hard hit. In 2011 dividends will be taxed as ordinary income, with the top rate scheduled to rise to 39.6% from 35%. With the additional 3.8% Medicare tax dividend tax will go as high as 43.4% in 2013. Obama has proposed a top dividend tax rate of 20%; if Congress enacts the proposal, the top tax rate for dividends would rise to ‘only’ 23.8% at the beginning of 2013.

Impact on investment and investors’ behavior

Overall, some $409 billion in additional taxes will be snatched from investors in order to pay for big government socialism. What will be the likely impact on investment?

Essentially, investment income (capital gains, dividends) will be worth less to investors once the tax hikes/new taxes go into force than it is today. It is feasible that it could revalue the entire stock market lower.

Credit Suisse in a recent (April 2010) report estimates that a 10% rise in dividend and capital gains tax in the US would take about 7% off the fair value of the equity markets (assuming that 30% of the market is owned by tax-exempt funds and foreigners and the higher tax rates will apply for 15 years).

The 2011 capital gains tax increase could also prompt investors to liquidate holdings this year, ahead of the increase.

In addition, we may see shifts in investors’ behavior, in particular if dividend tax goes up by nearly 200%. Investors will certainly take that into consideration when making decisions; as a result they could shy away from dividend stocks and focus on those they perceive as having greater potential to appreciate.

More generally, the new taxes will discourage investment, making it more difficult for companies to bounce back after the recession. On top of that, as noted earlier, most small businesses pay the individual income tax, and the rate hike will have a negative impact on expansion and hiring. (Mr. Obama of course sees small business owners not as job and wealth creators but as rich exploiters who must pay yet more onerous taxes so that those who don’t pay any can enjoy still further entitlements.)

Add higher income taxes for the most productive Americans and higher payroll taxes, and it becomes clear that the Obama administration is penalizing those who have worked hard, saved, and invested, while rewarding and indulging the less able, unproductive and lazy. Classic Marxist class warfare… blaming the productive and enterprising for all of society’s ills, which can naturally only be ‘fixed’ by redistribution of unprecedented scale.

We will not need to wait too long to see the outcome. Significant tax increases can only reduce economic growth, for they take away people’s incentives to work, save, and invest. (They also encourage tax avoidance, thereby defeating the purpose of the tax increases.) Capital will be allocated to where it can avoid (some of) the taxes instead of where it would be most productive for the economy.

“When people who earn more than the average have their ‘surplus’ or the greater part of it seized from them in taxes, and when people who earn less than the average have the deficiency, or the greater part of it, turned over to them in hand-outs and doles, the production of all must sharply decline, for the energetic and able lose their incentive to produce more than the average and the slothful and unskilled lose their incentive to improve their condition.”

(Henry Hazlitt)

I will not even take into consideration increases in other taxes at federal, state and city levels, including corporate tax hike proposals, a likely consumption tax on energy (as part of climate change legislation) and possibly a value added tax.

And in the unlikely case you still believe Mr. Obama’s socialist propaganda on how the ‘rich’ aren’t paying their ‘fair share’, please review the statistical data at the beginning of this article. Not only do higher-earners pay a fair share, they are being robbed blind. (Brief recap – the top 5% earn 37% of income yet pay nearly 61% of all federal income taxes, while the lower 50% earn 12% of income and pay less than 3% of taxes. And that is before any of the coming tax hikes on the better-off!)

How did we get to this sorry state?

Consider that in 1913 the top rate of income tax was just 7%! Not only have taxes gotten more progressive and excessive, there has also been a staggering increase in related bureaucracy. The number of pages in the tax code has increased by 16,775% in the past century.

Taxes are, however, only a side issue. What should really concern us is how, within a relatively short period of time, the US went from a limited government, free enterprise, individual liberty valuing regime (of the Founders) to big government statism and finally the progressive socialism of today. The people, once freedom loving and self-reliant, have carelessly traded their liberties and responsibilities for entitlements and handouts.

Government programs and welfare only make people less reliant on themselves and more dependent on the state, which in turn prompts an ever increasing size of government, until one inevitably ends up with socialism.

The dependency mindset is now almost as prevalent among Americans as has long been the case in much of Europe. The productive sector that adds value to society is sucked dry by the parasitic state bureaucracy, the able and hard working are penalized for their success; as a result the whole society ends up much poorer. (Not to mention the terrifying and impoverishing public debt burden left to the next generations.)

Of course all this happens in the name of ‘fairness’ and ‘equality’.

Yet redistribution has nothing to do with fairness and everything to do with envy and theft. Such action gains, thanks to majority rule, a seal of legitimacy, but it really is no better than common robbery.

The fact is today the vast majority of people feel entitled to the property of others. They demand that it be taken away from them through taxation, so that (some of) it can be given to those they deem to be ‘in need’ – i.e. those who have less but of course feel entitled to have more.

Forcibly taking other people’s money would in other circumstances be considered criminal, yet this mass criminality is rationalized on the grounds of democracy, will of the people, political mandates, etc. Progressive taxation appeals to the masses who, more often than not, have a desire to pull down the minority of the most productive, talented, enterprising (and as a result more successful). Progressive policies in general are just a mean to an end; the end being an envy-based redistribution.

Unfortunately once a certain stage of statism or progressive socialism is reached it is nearly impossible to reverse. Once a voting majority pays no income tax and benefits from entitlements, the productive and enterprising minority is doomed. The majority will continue to vote away the rights of others, and call it the will of the people.

This is the tyranny of democracy the Founding Fathers had warned against. They did not intend for the state to guarantee everyone’s well-being and provide support against every possible obstacle. They would be horrified at the idea of divesting some people of their properties for the advancement of others in society. And yet today that is exactly what much of the population expects – to be taken care of by the government, be given something for nothing – all at the expense of those who stand on their own two feet and attain things by hard work.

One can work and produce goods or services that others want to pay for, or one can steal (or give the government a mandate to loot on their behalf). It is human nature to take the path of least resistance, which explains why most believe it is perfectly acceptable to plunder others rather than obtain what they desire by their own efforts and sweat. Naturally they will always find a justification for such action; hence it is deemed a matter of fairness for a minority to subsidize the majority who are perceived as disadvantaged in one way or the other (never less apt, less willing or simply lazy).

This socialist disease has now infected much of the fabric of the society. And it’s not just the liberals who prefer the state to make life-governing decisions for them. According to information from the 2008 American National Election Study about spending priorities, the majority of self-identified conservatives isn’t really in favor of cutting spending on most government programs either.

Of course anyone who disagrees with this entitlement mentality is labeled uncaring, uncharitable, lacking social conscience, or worse. The notion that unless we let the state do everything for us we are ‘bad’ persons is now so prevalent that few dare to mention the choices that must be made. How many in public office take up the cause for limited government and hence severe cuts to welfare and the public sector (including eliminating millions of counterproductive public jobs, bureaucracies, regulations, entitlement programs, etc)?

And yet far from unfair or uncaring, that is the only viable path to safeguarding America’s economic future.

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Here we are again, back to the disturbing – but entirely unsurprising – war on the ‘free market’ (or whatever is left of it after decades of government interventionism).

The pattern of governments creating a mess and promptly laying the blame at the feet of the private sector is not at all new, so EU’s and Washington’s attacks on the markets and George Papandreou’s continuing threats against ‘evil speculators’ should not have caught anyone by surprise. In much the same manner, the coming (politically motivated) clampdowns and regulations of various market activities are being designed with the sole purpose of shifting blame – for excessive borrowing, overspending, harmful interventions and defective regulation – away from the policy makers.

Of course diversion of blame and responsibility is not a behavior exclusive to governments. It has come to characterize much of today’s society, and is largely responsible for the economic, social and moral decline we’re at present witnessing all around us. (More on that in an upcoming post.)

Let’s start with Greece. Prime Minister Papandreou has stepped up his rhetoric about his country being victimized and having problems servicing its debt, not as a result of irresponsible and fraudulent behavior over many years, but because of speculators’ bets to bring it down.

“Despite the deep reforms we are making, traders and speculators have forced interest rates on Greek bonds to record highs. Many believe there have been malicious rumors, endlessly repeated and tactically amplified, that have been used to manipulate normal market terms for our bonds.” He went on to say that as a result Greece was forced to borrow at rates almost twice as high as Germany, and that such ‘prohibitive’ interest rates would swallow all gains from the planned austerity measures.

Manipulate ‘normal’ market terms? ‘Prohibitive’ rates? Someone please show Mr. Papandreou the spread between Greek and German bonds pre-Maastricht Treaty – at multiples of what it is today! See for yourself in this astonishing chart: Club Med spreads (1992-2010).

Let’s not forget that the Greeks (and other fiscally shaky Southern European states) have only enjoyed – undeservedly – low rates thanks to the EMU. And, had Greece not lied about its finances, it would never have been admitted into the monetary union in the first place (it has never complied with the required fiscal discipline, preferring to falsify data). The current rates on Greek borrowing are more than appropriate (in fact, quite benevolent) for a country that carelessly jeopardized its own future by decades-long irresponsibility.

For a decade the markets have ignored the vast differences in fiscal policies between eurozone members; risk premiums on sovereign bonds were barely discernible. After the financial crisis investors started awakening to sovereign risk and spreads became far more aligned with reality. The bond markets are once again reflecting fiscal policies, as they should. Far from ‘market manipulation’, it’s simply a return of country risk.

Indeed the financial markets are now doing the job that politicians have failed at so miserably – forcing the countries to take measures that will lead to a return to fiscal sanity (or else face the consequences). It should also be obvious that any country’s funding costs will now increasingly reflect its own fundamentals, rather than those of say Germany, as investors are unlikely to be blinded by any implicit EMU guarantees again, at least for the foreseeable future.

The Greeks, who have over decades borrowed and squandered too much money, won’t admit that their 12.7% budget deficit (that being the official figure; the true deficit is estimated at 16%), 120% debt/GDP (135% estimate for 2011), out of control government spending (at over 50% of GDP), rampant tax evasion, among other problems, are the root-cause of their troubles and consequent risk pricing by the markets. (For an analysis of the Greek situation and possible solutions see recent article here.)

Given that Greece has defaulted on its debt 108 times in the last 200 years, showing no sign that it has learned fiscal responsibility, it is rather astonishing that the Greeks should be surprised at rising interest costs. Would any responsible lender extend credit to an over-leveraged borrower on the verge of bankruptcy, at extremely low rates?

Yet the Greeks appear to believe that threats and regulation will force the capital markets to supply them with unreasonably cheap credit. During a recent Washington visit to win President Obama’s support for the war against evil speculators, Mr. Papandreou said: “Europe and America must say ‘enough is enough’ to those speculators who only place value on immediate returns, with utter disregard for the consequences on the larger economic system not to mention the human consequences of lost jobs, foreclosed homes and decimated pensions.”

Therefore, investors should lend to Greece at ultra low rates, ignoring any default risk, in order to allow the Greek government and population to carry on with a spending binge, delaying the day of reckoning indefinitely. (Much like banks had been coerced by the US government into lending to unworthy borrowers with no deposits and insufficient income; and we know how that ended. But more on that later.)

The Greeks’ sense of entitlement to other people’s wealth, their perceived ‘right’ to borrow at low rates, is indeed quite disturbing. Though rather than being solely a Greek issue it appears to be a sign of our times.

But why the widespread hatred of market participants, be it speculators, traders or investors?

After all, it wasn’t speculators who had run up massive debts and a 13% deficit, but the Greek politicians (and population). Investors and traders have merely exposed the truth the Greeks, as well as EU authorities, would have preferred to keep hidden. It should be obvious that Greece only has itself to blame for not being able to borrow at the same rates as fiscally prudent Germany.

The much vilified short sellers, as well as CDS (credit default swap) buyers, perform a vital function by pointing to problems and deficiencies (whether in companies, industries or countries) and backing their opinion with their money. When they believe an entity may go bust, shouldn’t they be allowed to protect themselves and/or profit accordingly? When it comes to sovereign debt, if it wasn’t for the markets, politicians would never take the necessary action to put their house in order.

Papandreou’s argument that “unprincipled speculators are making billions every day by betting on a Greek default” misses the point entirely. If Greece’s fundamentals were less disastrous, anyone betting on a default would be losing billions. No speculators can bring down a healthy company, currency or country. In any case, there are always two sides to each trade. For everyone shorting Greek debt there is also someone on the long side.

As for the fallacy of speculators destabilizing the Greek bond market via CDS use: Germany’s financial regulator (BaFin) has found no evidence that CDS were used for large scale speculation against Greek government bonds, reporting (earlier this month) that the net volume of outstanding CDS contracts has barely changed since the beginning of the year. Some of the most active CDS traders are German and French banks, who happen to hold significant amount of Greek debt. If there were no CDS (essentially, insurance against default), who would take on the risk of financing Greek debt?

Ironically, it has just been uncovered that the biggest CDS speculator, holding 15% ($1.2 billion) of the total $8 billion of Greek CDS, has been the Greek state-owned Hellenic Post Bank! (Article here.)

And yet, despite his obvious delusion, Mr. Papandreou has been finding an attentive audience in other European leaders as well as President Obama. After all, Greece’s is not the only government that views the markets as a welcome scapegoat for their own mismanagement and incompetency.

Given bureaucrats’ readiness never to waste an opportunity to further restrict economic freedom, it isn’t particularly surprising that the European Commission is discussing regulation of the sovereign CDS market, and the US Justice Department has reportedly been looking into hedge funds’ short positions against the euro, to determine whether they colluded to drive down the value of the single currency.

European politicians, who have a long tradition of anti free market beliefs, have blamed speculators for the recent decline of the euro in the wake of the Greek crisis. They, much like the Greeks, feel entitled to low borrowing costs for EMU members and a stable euro, irrespective of the fiscal and economic mess of the EU.

Germany’s finance minister, Wolfgang Schaeuble, went as far as suggesting the use of anti-terrorism methods against financial speculators in order to protect the euro. He said the government might “set up surveillance of who is getting together with whom for which kinds of speculative processes, and where.”

What’s next? Will they start arresting traders for threatening ‘economic stability’ if they happen to dislike the fundamentals of a certain country or currency and vote against it with their money?

It would seem there is no better sign that an entity is in severe trouble than authorities starting to crack down on short bets against it. The truth is, if the euro was fundamentally sound, it would not have been ‘attacked’. (Not to mention that those who believe speculators have caused the euro to drop to unfairly low levels can always back their opinion by taking action in the forex market.)

What Greece and other nations need to learn is that one cannot go on indefinitely increasing government spending and borrowing without consequences. There comes a point when markets lose confidence in the country’s ability to pay and refuse to lend the money (at acceptable rates). That moment appears to be fast approaching for a number of countries.     

Of course when it comes to short term political gain, shifting the blame onto the private sector is an entirely valid strategy. We have seen its success in the aftermath of the 2008 crisis; the people have, without much questioning, accepted the official line: the crisis was caused by insufficient state intervention and regulation of the ‘free market’. Therefore, we have been told, a massive increase in government bureaucracy and regulation was necessary.

The threats against speculators in (Greek) sovereign debt are reminiscent of the attacks on banks, hedge funds and financial markets in general, over the last two years. Of course there was much that went wrong in the financial sector, but the blame game has been indicative of the failure of governments to admit their own mistakes.

Notice that any economic boom is always a result of ‘wise government policies’. When the inevitable collapse comes, a culprit must be found, fast, before anyone starts looking at possible policy makers’ faults. And so all crises are quickly declared to be a problem of the ‘free market’.

Such denunciations look particularly misplaced given the disastrous track record of public management, including the crucial role of the Fed and US policy makers in creating the recent crisis. It was the Fed’s loose monetary policy that had encouraged speculation and inflated a massive housing bubble, aided by vote grabbing policy makers’ interventions in the housing market (incl. coercing financial institutions into lending to unqualified, low income borrowers under such monstrosities as the Community Reinvestment Act).

And of course the government sponsored Fannie Mae and Freddie Mac were by far the worst offenders, likely to end up costing the US taxpayer some $400 billion. (They remain an ‘off-balance sheet’ – or so the politically convenient fiction goes – dumping ground for the debris of the housing crisis.) But don’t hold your breath waiting for Obama et al. to acknowledge any of this; they’re too busy pounding on the banks.

Bizarrely, our political elites appear to fully ignore the fact that highly expansionary monetary policies – and resulting unprecedented indebtedness – have been largely responsible for the current mess. It’s nothing new; interventions into (what was once) the free market have always brought unintended negative consequences. And yet the link between low interest rates, excessive credit growth and asset bubbles appears to evade policy makers’ understanding.

The slashing of interest rates in 2001, and keeping them at record low levels for several years, has led to the credit and housing bubble. Spiraling debt contributed, in a large part, to the apparent prosperity of the last 15-20 years (much as it had in the 1920s, ending, equally disastrously, in the Great Depression). Greenspan and Bernanke acted as cheerleaders of debt, while policy makers were busy identifying new targets for lending, in the name of democratization of access to credit.

And let’s not forget the essential role of greedy housing market participants, millions of whom have knowingly taken on mortgages and loans they couldn’t afford to pay back, in order to satisfy their irresponsible craving for a lifestyle beyond their means. (In the past 25 years the amount owed by US families has risen more than sevenfold, from less than $2 trillion in 1984 to nearly $14 trillion, according to the Fed.) Inevitably, cheap credit has also created huge imbalances and fueled speculation in the financial sector.

And yet, shockingly, no lessons seem to have been learned. Central banks and governments – in particular in the US and UK, considering a painful period of readjustment (perhaps a short depression) to be politically unacceptable, have embarked on massive quantitative easing (in other words money printing) and huge stimuli to restore economic growth. In the process they have loaded their countries with an unprecedented mountain of debt.

Indeed, blind to the fact that easy credit and excessive debt created the crisis in the first place, the Fed and the Obama administration are happily running up higher and higher debts. In an unprecedented printing press exercise the Fed has purchased over $1.2 trillion of toxic agency (Fannie, Freddie, Ginnie Mae) mortgage backed securities (MBS), creating a floor for housing prices and so delaying necessary corrections. Hence the massive burden of toxic assets now weighs down not only the private financial markets but also the Fed itself.

Numerous other government support measures have been masking the fundamental sickness of the housing market, including tax breaks for home buyers and government-mandated loan modifications (the majority of which end up in default again within six months). The Federal Housing Administration (FHA), with its aim to make homes more affordable, has underwritten hundreds of billions of dollars of mortgages in the last two years alone. Its support for the housing market is expected to double again – growing to $1.5 trillion – over the next five years. FHA foolishly continues to require down payments as low as 3.5%, when it should be obvious that a 15-20% deposit would allow home owners to better withstand any future crisis. (Unsurprisingly, a record number of FHA-insured loans are delinquent.)

Speaking of loose monetary policy… rates have been fixed at near zero. The resulting boost to the price of securities held by banks, as well as what are, in effect, zero interest loans from depositors, have translated into strong revenues for the sector, allowing banks to ignore the bad loans still on their books. It is clear that the irrational monetary policy with artificially low interest rates, plus monetization of debt, will continue for quite some time. A certain recipe for the next bubble and crisis.

And of course the government has also embarked on an unprecedented fiscal stimulus, a consequence of which is a massive increase in public sector debt. (The US national debt now stands at over $12 trillion. But add the ‘off-balance sheet’ unfunded liabilities and the total public debt comes to an estimated $60 trillion – an amount that can clearly never be paid off. We’ve discussed the impact of extreme debt levels in a recent post here.)

Despite the shocking debt and deficit we’re unlikely to see any serious attempt at spending cuts any time soon; quite the opposite, there seems to be a new US spending bill proposed almost every week. Crucially, at a time when existing entitlement programs are bankrupt, the Obama administration saw it fit to create a monstrous new $2 trillion health care entitlement.

In spite of the alleged temporary nature of the public spending boom, the expansion of government will likely be permanent. The price to pay is obvious – high deficit, high taxes, slower economic growth and less wealth. Unless, that is, you agree with Mr. Obama and the ‘leading’ economists that government spending creates wealth.

The belief we can cure a debt crisis with even more debt would also be rather comical, if the situation, and consequences, weren’t so tragic.

So what then is the solution?

Instead of the government attempting to micromanage the financial markets (and any other private industries) via further interventions, regulation, punitive taxation, bans and growing bureaucracy, we should simply allow the free market to work. The finance industry as well as borrowers should be let to suffer the consequences of their actions (be it bad lending or irresponsible borrowing). They also need to be allowed to make commercial decisions without coercion or interference from policy makers. In the absence of government intervention – that only creates distortions and moral hazard – the markets would curb bad behavior via defaults and bankruptcies, resulting in suitable risk adjustment by other participants.

US home owners should also be liable for any outstanding mortgage balances (as is common in virtually every other country), instead of simply being allowed to walk away from underwater mortgages. Naturally such policies would mean fewer home buyers taking on mortgages they can’t afford to repay, and that goes against the government’s idea of home ownership being a near universal ‘right’ – a notion which, bizarrely, still appears to be alive and well in Washington. But until people return to a suitably affordable lifestyle (whether that be renting instead of home ownership, or a more modest home) we are only kicking the problems down the road for a little longer.

It is natural that in a crisis, recession or period of high unemployment people are angry; they need to externalize the enemy. The markets, speculators, or Wall Street are a highly convenient (and sometimes justified) target when it comes to diverting blame away from policy makers, central banks and general population. They also provide a welcome opportunity for governments to expand and to regulate more, tax more and interfere more in private sector activities.

However, if any lessons are to be learned at all, we must acknowledge that it was the culture of living on (cheap) credit and spending beyond our means – spurred by disastrous monetary policies and interventions - that led to record indebtedness, housing bubble and collapse, and resulting financial and economic hardship. Only then will we be able to recognize that the current policies are simply setting the stage for a much larger crisis a few years from now.

UK still in recession

The UK today confirmed its position as the only G20 country still mired in recession. While revised upward from an earlier estimate of 0.3%, the economy contracted by 0.2% in the third quarter of 2009.

In recent weeks analysts predicted that today’s figure would show the country has already exited the recession. Instead Britain has now seen six successive quarters of contraction – its longest downturn since the 1930s. The loss of output since early 2008 now stands at 6.03%.

In a new blow to Chancellor Darling’s optimistic forecasts, the economy was dragged down by declining services and industrial production output. This was partially offset by a rebound in construction, according to data from the Office for National Statistics.

Darling’s forecasts of 1-1.5% GDP growth in 2010 and 3.5% in 2011 are seen by analysts as overly optimistic. Many suggest the UK may struggle to grow at all next year. The OECD estimates the UK economy will expand by 1.2% in 2010 and 2.2% in 2011.

If the Treasury’s forecasts prove wrong, the government will have to find yet more money to cover its spending. Borrowing has reached a record £20.3 billion in November alone, and the 2009 budget deficit is expected to come to a staggering £178-185 billion.

That represents more than 13% of GDP; the 2010 deficit is also likely to reach 13-14% of GDP. (Which is higher than Greece’s 12.7%. Yet, while Greece is expected to cut its deficit by nearly 4% of GDP next year, the UK government has opted to do nothing to reduce Britain’s deficit in 2010.)

Today’s data also showed the UK household saving ratio to have reached 8.6%, the highest level since 1998. Just before the start of the recession in early 2008 it stood at a record low of -0.7%.

US GDP growth at 2.2% in QIII

In the US third quarter GDP growth has been revised down to 2.2%, from an earlier estimate of 2.8%. It was the first quarter of economic growth after four quarters of contraction.

Analysts are revising upward their forecasts for 2010 GDP growth. The latest predictions expect the US economy to expand by 2 to 5% (depending on forecaster), signaling possibly a stronger snap back from the most severe recession in three decades.

The National Association of Business Economists raised its forecast of 2010 growth to 3.2%, which coincides with the figure the White House used in its latest economic outlook. OECD, on the other hand, expects a 2.5% growth in the US next year. Michael Mussa, a former IMF economist, now with the Peterson Institute for International Studies, expects the economy to grow at a rate of 5% in 2010, predicting a strong recovery in both growth and jobs.

The big question marks that will influence next year’s growth are the consumers and the housing sector. Although analysts expect to see job growth next spring, unemployment will remain high (likely around the 9-10% mark).

With historically high levels of household debt, consumer spending growth may remain weak for much of next year. Households are likely to prioritize paying down debt at the expense of personal spending. While house prices seem to have bottomed out, housing will also unlikely be the engine of growth it has been in recent years.

Eurozone set for weak 2010 growth

After five quarters of falling output the 16-nation eurozone exited the recession in the third quarter, posting a 0.4% GDP growth. (The 27-member EU saw GDP up by 0.3% in QIII.)

According to Eurostat, a jump in inventories and exports were the main drivers of economic growth in QIII, while household consumption remained weak amidst high unemployment (near 10%).

Economic growth is expected to be low at 0.9-1% in 2010, according to OECD and the European Commission.

As if we haven’t had enough of the insane ‘bash the banker’ game already… Today a senior Bank of England official – director for Financial Stability Andy Haldane – said the departure of financial institutions and bankers from the UK to avoid the super-tax on bonuses is a ‘price worth paying’ to achieve reform of the sector.

Given that BoE is supposed to be independent and non-political, this is a staggering comment in support of the government-led hostility against the City of London.

A new obsession sweeping the country

Banker bashing has, in the last 12 months, become the new national pastime, sweeping the country like the Spanish Flu. Depressingly, this rush to populism isn’t just confined to the government. Politicians of all parties are in fierce competition to show who is the toughest, the most vengeful on bankers, the modern day witches to be sacrificed and burnt at stake to satisfy the populist thirst for blood.

It’s a no brainer – attacking (‘rich & evil’) bankers is certain to prove popular with voters, who appear to take immense pleasure in castigating the generators of their recent prosperity.

The source of all evil?

Of course, bankers are a convenient scapegoat to divert attention from the government’s own role in the financial and economic meltdown. It wasn’t bankers’ greed and bonuses – as our ministers like to claim – that caused Britain to be on the verge of bankruptcy and having the largest budget deficit in history. For the past 12 years the government has been only too keen to get hands on the massive tax revenues from the finance industry, blowing them on pointless social engineering and ever growing state bureaucracy.

Not surprising then that Gordon Brown is only too happy to divert attention from his own ineptitude and recklessness by painting bankers as greedy little bastards responsible for UK’s economic collapse. Don’t get me wrong. I’m not saying they have nothing to answer for, just that they are no more to blame than the government, regulators, or, indeed, you and me.

Bonus envy? Let’s see…

And – at the risk of being lynched – I’d argue bankers may deserve to be paid more than many other professionals. You see, of all the people I have known, the bankers are some of the hardest working. 15+ hour days (often 7 days a week) in an extremely competitive, high stress environment, constant pressure to perform, barely any holidays, not to mention no time to spend with their families, not seeing the kids grow up…

So before we succumb to envy of bankers’ compensation, why not consider the sacrifices that go with it. How many of us would really want to trade in? And, who is more deserving of their large salaries and bonuses – the bankers, working 15 hour days in an onerous environment, or the politicians and bureaucrats in their cushy non-jobs with 90 days of holiday a year? And what about the country’s union barons, earning several hundreds of thousands a year for disrupting the economy with constant strikes?

Where do you think the money has come from?

Just a couple of days ago yet another case came alight of a £2.6 million, eight room mansion rented by a London council – at a rent of over £90,000 a year – to house a benefit claimant single mother of eight.  Thanks to our pathetically generous welfare state, not only does she live in a home beyond the wildest dreams of most hard working tax payers, she also receives over £15,000 a year in other benefits, tax free. And there are thousands like her who have not done a day’s work in their lives – and never will – yet live in luxury, courtesy of the tax payer.

Across the country there are over five million of such welfare-addicts, most of whom, having long realized work wouldn’t pay, have dedicated their lives to such favourite activities as drinking and watching TV. (The percentage of UK households where no one works is now a staggering 17%, according to the Office for National Statistics.)

If it wasn’t for the huge tax collected from the City (and its hundreds of thousands of highly paid bankers, traders and other staff) over the last two decades, how would the state have ever gotten its dirty hands on enough money to squander on all the undeserving?

Let’s not forget it’s the financial sector that can be credited for much of the unprecedented wealth that has been created in Britain in the last few decades. The UK – government and public – were profiting from the banking industry without complaint for nearly 20 years, yet didn’t hesitate to turn into a lynch mob overnight. Short memory, or just plain ingratitude?

And what about the role of the debt-addicted public? Most of us were eager to take on loans and credit card debt, remortgage our homes to fund a lifestyle we craved yet knew was beyond our means. Little wonder we’re casting blame while avoiding a look in the mirror – we are as guilty as anyone.

Drive them away and you’ll be sorry…

Like it or not, we need a profitable banking sector, and its billions in taxes – now more than ever. (Public borrowing hit an all-time record high of £20.3 billion in November alone, and yet our political elites act like we don’t need our biggest tax generator.)

Attempting to drive away its biggest cash cow is an act shockingly stupid even for this self-righteous, semi-socialist government. And it’s not just bankers either… Entrepreneurs and other wealth and job creators are equally being made to feel rather unwelcome and unappreciated in the UK these days (punitive taxation, class war & moronic labeling of the ‘bad rich’ aren’t exactly an incentive for anyone to invest their money and talent here).

Given that the 1% of top earners pay 24% of UK income tax and the top 10% pay 54%, and the City contributes 25% of UK corporation taxes, the stupidity of the current policies is mind blowing. And it’s not just about tax – the financial services industry accounts for 21.4% of total employment in the UK, over 6 million out of a total of 29 million workers (according to government statistics).

And yet the government propaganda and most of the masses are happily shouting we don’t need or want bankers in this country. The bad news for us is, there are plenty of countries that welcome enterprising people with open arms, appreciate their skills, and reward hard work with low taxes. Fact is, the UK needs such people far more than they need the UK.

In recent days New York, Frankfurt, Hong Kong, Singapore, Zurich have reportedly  been making an aggressive pitch to financial institutions to move their business from London. Labour’s populism is offering them an unprecedented opportunity to destroy the competitive advantage London has built over the last two decades.

With the country on the verge of bankruptcy and public borrowing out of control, who else is going to pay for the bloated, dysfunctional, inefficient public sector and the millions of welfare addicts? What is supposed to replace the City? Sheep farming, perhaps? Maybe the people now so keen to engage in banker-hatred will start to use their brain (that’s assuming there is any) once their welfare cheques stop coming.

The only thing certain is that the punitive tax raid (bonus tax, 50% income tax, etc) is a purely populist political measure that makes no economic sense (in fact, it comes as close to economic suicide as I’ve ever seen). Not only will it not provide any additional revenue for the taxman, it will cost Britain billions in investment – and taxes – diverted away from London, for many years to come.

I can only hope that at some point sanity will prevail, anger &  hypocrisy will fade, and we will acknowledge banks and bankers for what they are – a vital part of the economy. We should applaud them (and any other businesses) for making money, not demonize them or make them apologize for it.

I’m sure my opinion won’t be very popular… but I’d love to hear your comments! There’s nothing better than a good debate, as long as it’s kept civilized. And, if you enjoyed this post, please share it.

On Friday the House of Representatives passed the Wall Street Reform and Consumer Protection Act, a landmark legislation proposing sweeping changes to regulation of the financial system.

In a victory for the Obama administration, the 1,300-plus-page bill passed by a 223-202 margin (with all Republicans and 27 Democrats against). The Senate is working on its own measures to be debated early next year. Eventually, a final, compromise version will have to be negotiated between the two chambers.

The sprawling legislation will, in effect, regulate the financial services industry as well as most aspects of personal consumer banking. It covers everything from too-big-to-fail firms, banking regulation, hedge fund regulation, derivatives trading, executive compensation, to the simplest consumer financial products.

Republicans criticized the (Democratic) legislation, saying it could cause job losses, restrict the availability of credit and enable future bailouts of failing companies.

Let’s have a look at the main points of the reform bill.

Consumer protection

A central element of the bill is the creation of the Consumer Financial Protection Agency (CFPA), a new federal agency with far reaching powers to control all types of financial products offered to consumers (including a variety of loans, mortgages, credit cards, etc).

The bill also incorporates the mortgage reform and anti-predatory lending bill the House passed earlier this year. It prohibits lending to those consumers who shouldn’t be taking such financial risks and orders lenders to ensure that borrowers can repay the loans they are sold.

In a rare win for the banking industry, the House rejected an amendment that would have allowed bankruptcy judges to reduce mortgages of distressed borrowers. (A measure that, if adopted, would most likely have limited the willingness to lend.)

Financial Services Oversight Council

The inter-agency council, chaired by Treasury secretary, will identify and impose additional regulation on companies that are deemed ‘too big to fail’ and whose collapse would put the financial system at risk.

Dissolution of troubled companies

The bill aims to create a $200 billion ‘systemic dissolution fund’ (financed by fees to be levied on financial institutions) to cover the costs of dissolving firms that pose a threat to the economy. The government will have new powers to break up or dismantle large, failing financial institutions, in order to prevent a contagion to the rest of the system.

Fed audits

The bill will limit the power of the Federal Reserve, removing its consumer protection authority and limiting its ‘lender of last resort’ power.

It also includes a provision for Fed audits, subjecting its monetary policy and lending to financial firms to audits by congressional watchdogs. (The Fed argued this threatens its political independence, implies monetary policy will no longer be independent and decisions could be influenced by politics – all of which could unsettle the markets. Inflation and long term interest rates could also rise if investors believed the Fed to be under political pressure to keep growth going.)

Regulation of OTC derivatives

The legislation imposes, for the first time, regulation on the over-the-counter (OTC) derivatives market. It establishes a central clearing requirement for participants in the OTC derivatives market, aiming to increase transparency. Commercial end users, who use derivatives to hedge their price risk, will be exempt from the clearing requirement.

Regulators will also have powers to set capital and margin requirements, as well as position limits on financial and commodity-based derivatives.

Executive compensation

The bill takes on Wall Street compensation, giving shareholders a nonbinding vote on executive pay. It also requires financial firms to disclose any compensation structures that include incentive-based elements, and empowers regulators to ban inappropriate compensation practices.

Investor protection

SEC’s powers will be strengthened to allow for improved investor protection and regulation of the securities markets. A new study of the securities industry will identify necessary reforms, in response to the failure to detect the Madoff and Stanford Financial frauds.

Hedge funds & private equity regulation

Hedge funds, private equity firms and offshore funds will have to register with the SEC and will be subject to systemic risk regulation.

Federal Insurance Office

The Federal Insurance Office (FIO) will be set up to monitor, for the first time, the insurance industry, including identifying possible gaps in the regulation of insurers that could contribute to a systemic crisis.

Reform of credit rating agencies

The bill addresses the role rating agencies played in the economic crisis, aims to reduce conflicts of interest and impose a liability standard on the agencies.

Conclusion

Everyone agrees that some changes are necessary. But we have had plenty of government regulation, and it has failed in the past. Can new government agencies and more bureaucrats employed to oversee and regulate the industry stabilize the markets and avoid future crisis?

I fail to see how this (or any) regulation can really ‘prevent such crisis from ever happening again’ (as Obama stated). Unless the government bureaucracy manages to stifle competition and kill innovation in the financial markets, there will always be new products, risks and indeed, crisis.

After all, while the 2008 meltdown brought the world to the brink, it wasn’t the first time (remember how the Russian financial crisis and LTCM implosion led to near Armageddon in 1998?). And I suspect it won’t be the last.

Chancellor Alistair Darling unveiled his politically motivated pre-budget report today. Let’s look at the details.

Bonus super-tax and new higher earner taxes

A new temporary super-tax on bank bonuses comes into effect immediately. Banks (incl. UK subsidiaries of foreign banks) will pay 50% tax on bonuses over £25,000 (to include shares, options and temporary salary increases). The bankers will of course then still be hit with the new 50% income tax on earnings.

The bonus tax is estimated to raise just £550 million in revenue, so it’s clearly just a populist measure for Brown’s semi-socialist government to grab votes. Bankers are an easy target and the recent witch hunt has been entirely in tune with Labour’s politics of envy and class war.

Thousands more of higher earners will also be hit with the new 50% income tax rate as it is widened to include not only pay but also pensions. In essence it was extended to those earning £130,000 or more.

Middle class tax grab

But it’s not just higher earners who will suffer the consequences of Labour’s mismanagement of public finances and the economy.

The threshold for higher-rate (40%) income tax will be frozen. That means people earning just £43,000 will pay more tax, costing workers £400 million a year.

And, in an additional massive middle class tax grab, the announced National Insurance (NI; income tax in all but name) rise will hit anyone earning £20,000 a year or more.

At present 11% of workers’ wages go toward National Insurance. From 2011 NI contributions will go up to 12% for all workers earning more than £20,000 a year. Those on more than £44,000 also face a second hit, paying 2% rather than 1% on their pay above that threshold. The increase in NI is to raise £4.5 billion a year from 2011/12.

On top of the employee contributions, the employers pay 12.8% of their workers’ salaries in NI contributions. This will increase to 13.8%. The raise of NI is a tax on jobs, pure and simple. And it comes at the time when UK’s economic recovery is incredibly fragile.

Finally, the inheritance tax threshold will be frozen at £325,000, rather than raised to £350,000 as previously promised.

Balancing the budget?

Darling expects GDP to drop by 4.7% in 2009, the worst peacetime performance since 1921. (His last prediction earlier this year was of 3.5%.) He expects the economy to grow by 1-1.5% in 2010 and 3.75% in 2011 – extremely optimistic figures and likely to be proven wrong, as so many of his past forecasts.

The pre-budget report shows plans to borrow nearly £800 billion over 6 years, taking the 2014/15 national debt to just under £1.5 trillion. Of course the real number is far higher, as the government figures do not include the public sector pensions deficit estimated at £1.2 trillion.

In a further upward revision of earlier forecasts, the government will, in 2009/10, spend £178 billion more than it receives in tax – equal to 12.6% of GDP. Next year, the deficit is estimated at £176 billion.

The Chancellor aims to cut UK’s deficit to 5.5% of GDP by 2013-14. However, we’re yet to see any clear and viable plan for that to be achieved. Britain’s credibility and credit rating depend on that, so let’s see what Darling proposes to do to cut spending.

Where are the much needed public spending cuts?

While Ireland is slashing spending – by way of benefit and public sector pay cuts – to the tune of 4 billion euro, you would be hard pressed to find many meaningful measures in Darling’s pre-budget report. (Irish budget deficit of around 12% is comparable with that of the UK.)

The Chancellor plans to impose a 1% cap on public sector pay rises (as opposed to the Irish 6% cuts in public sector wages and up to 20% for highest earning public servants) for two years. Even that is postponed until 2011. From 2012, government contributions to public sector pensions will be frozen.

Worse still, the Chancellor insisted key services will be safe and ring fenced. NHS, schools, police are guaranteed to see their budgets rise at least in line with inflation.

VAT will return to 17.5% from 1 January 2010, as expected.

Cuts? It’s more spending instead!

While any sensible observer might have expected severe spending cuts in a country on the verge of bankruptcy, Darling has laid out Labour’s plans for 2010 and beyond: tax more and spend more.

To please the party’s core voters, child and disability benefits will be increased by 1.5% from next April. Basic state pension will be raised by 2.5%. And, bizarrely, bingo tax will be cut. In fact, Labour will be spending an extra £7.7 billion in 2011/12 and £6.9 billion the following year.

Conclusion

So there we have it. Instead of much needed spending cuts, more taxes. Instead of significantly paring back the gargantuan public sector (yes, including welfare and the bureaucratic, inefficient NHS), the government chooses to heavily penalize middle and higher rate tax payers.

The increase in NI contributions means it will be more expensive to keep and hire workers. Hardly a sensible move when economic recovery is closely tied with job creation.

The pointless and harmful bonus super-tax will not generate revenues, but, just as the previously announced, vengeful 50% income tax, is sending the wrong message. Uncertainty – and the notion that everything is up for grabs – will make businesses and enterprising individuals think twice before coming to (or staying in) London.

The top 10% of earners already pay 54% of income tax and the top 1% pay 24%. But, no matter how much they are milked, it’s never enough for a socialist wealth redistribution agenda. From 2010 the UK will have one of the highest tax rates in the world. The state grabbing more than half of what the wealth- and job-creators make is certainly not a motivation to be ambitious and successful. And the paltry £500 million revenue is hardly worth the billions in investments and taxes the UK and the City of London is likely to lose as a consequence.

UK’s economic success depends on entrepreneurs, highly skilled workers, as well as a profitable financial services industry. Yet the signal the government is sending, by labeling such people as elitist & (bad) “rich” and imposing punitive taxation, is that the country neither values nor wants them here. And they may well listen, choosing a more welcoming destination for their efforts and money.

Thursday’s surprise news of a possible default by Dubai World shocked the financial world and caused stock markets to tumble amid concerns about the effect on the stability of the global financial system.

Dubai government’s announcement it was seeking a six month delay on debt repayments of state-owned Dubai World – the flagship conglomerate behind Dubai’s rapid expansion and extravagant property developments – caught investors by surprise. Dubai World’s $60 billion debt represents a massive portion of Dubai’s total debt of $80 billion.

Speculation about a potential sovereign default sparked a sell-off in global equities, high-yield corporate bonds and commodities, while the US dollar and Japanese yen surged in a flight to safety move.

Credit rating agencies slashed ratings on Dubai’s government-related debt. UAE’s federal government in Abu Dhabi, having already bailed out Dubai with $10 billion earlier this year, may yet need to provide another bailout.

Dubai’s vastly ambitious, eye-catching building projects became the poster child of the emirate’s turbo-charged expansion in recent years. Concerns about a supply and demand imbalance started being raised in the last couple of years, and – adding the global financial crisis and the disappearance of international buyers – Dubai’s property prices have tumbled by around 50% since their 2008 peak.

While US banks’ exposure to the region is thought to be limited, UK lenders have the most to lose from a crisis in the Emirates, with a combined $49.5 billion of loans outstanding.  According to JPMorgan Chase, the Royal Bank of Scotland underwrote more Dubai World loans than any other institution, while HSBC has the largest capital exposure to the UAE.

While initial fears of the Dubai crisis sparking a new financial meltdown have faded, and European stock markets rebounded on Friday, the fallout has shown the continuing vulnerability of the global markets and economy.

Unlike the economy, which is at the early stages of its comeback, with a shaky path ahead, the stock markets have come roaring back. After the strong rally since March, cries of too much too fast have been multiplying. Trouble is, these are much the same voices who have been advising investors to be cautious and wait before returning to stock market investing. It seems very many have now missed the rally… in particular the retail investors, many of whom rushed to sell in the panic of late 2008 and early 2009.

So has the market gone too far and are we in for a big correction? Well, here are two reasons why I disagree:

1. The doom-mongers are forgetting that the (US) stock market has lost more than half of its value between October 2007 and March 2009. So while the market is more than 60% up from its March lows, it is still 30% below the late 2007 highs.

2. Prices are justified by fundamentals: the consensus earnings per share estimate (S&P 500) for 2010 is approx $77. That is less than 15 times valuations, which is lower than the 50 year average of 16.5 and 25 year average of 17.8. So, in my view, fundamentals fit in quite nicely with the price levels.

While it’s true that equities have come a long way in a fairly short time, and current valuations may not be as compelling as a few months ago, I remain bullish from a long term perspective.

Sure, we may – and probably will – see occasional pullbacks, 5% or so would be my guess, but that’s normal market behaviour. Anyone who’s been sitting on their hands waiting for a large correction is, it would seem, well on the way to miss on one of the best investment opportunities of the last few decades.

Of course, if you know what you’re doing, there are still plenty of good companies to be had at extremely attractive valuations. With zero return on cash and continuing uncertainty in global property markets, equities are at present easily the most attractive long term investment.