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?

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.

The past week had the unmistakable feeling of an inflection point. Such moments of transition are the coming into awareness of potential realities and possible futures that had been slowly percolating in the collective unconscious. Per Clausewitz, “ it is always out of a mere inkling and foreboding of the truth that a man acts”… if anything, this has been a week of inklings and forebodings. There has been a general sense of expectations coming unglued, coupled with the anxiety that we’re not looking at a V shaped recovery, nor a U shaped recovery, but a long dreary slog through a slough of despond.

Not that we’re exactly shocked. The political class in the United States appears to have succumbed to the corrosive temptations of empires, rather like a primordial tarpit that slowly suffocates anything so unfortunate as to walk into said tarpit.

We also believe that Obama made a cardinal miscalculation by attempting to shift the agenda to health care reform dreadfully prematurely, long before the endemic problems in the financial and manufacturing sectors (and the attendant severe issues of unemployment) were adequately repaired. To have thrown the weight of his political capital into the infinite labyrinth of the health care industry so soon after the market collapse was pure folly.

This brief analysis based on the Fed’s data gives us a rather amazing insight into how extensive, consistent, and programmatic the collapse of the industrial sector in the United States has truly been. More incredible is that this chart showing the true nature of the decline, and the length of the decline, hasn’t made it into the financial media as far as we know. Quelle Surprise.

The first chart is the raw number, dating from 1939, when the average house cost $3,800, the last man was guillotined in France, Hitler invaded Poland, and Tina Turner was born, of people employed in the manufacture of durable goods.

This next chart shows the percentage of the entire US workforce employed in durable goods manufacture. As late as 1969 it consisted of 15% of the workforce, by 1990 it was 10% of the workforce, by December 2009 it was about 5% of the workforce. If it continues in this pattern, by 2030 it will cease to exist altogether.

We predict this has put many Americans in such an economically untenable position that we will see the inevitable return to protectionism, nativism, and paranoia that is part and parcel of American history when fear and loathing of displacement enters the national discussion. These phases are rarely a pretty sight.

State budgets are in absolutely horrible shape. Unlike their federal counterpart, states can’t print money and they are required to run balanced budgets, which has become a technical and practical impossibility. When Montana and North Dakota are the fiscally healthiest states in the nation, you really have to wonder.

The difficulties are hardly limited to the United States. We’ve been wondering mightily about the real significance of the price of gold. Our attention has been drawn to the idea that China is a major purchaser of gold, which we interpret as being motivated by one of two reasons, neither are comforting. One is that there is no currency alternative to dollar based holdings, and at a ministerial level their confidence in the dollar, and perhaps the country that prints dollars, is coming undone.

Interestingly, Robert Prechter at Elliott Wave International has suggested that precious metals may be at a major top, based on a Fibonacci ratio analysis of other historical highs.

Is this time different, and if so, what might be different this time?

We tend to believe that a second scenario might be worth considering, that gold is not only being accumulated at the state treasury level, but also as a hedge by wealthy Chinese in case the Great Expansion doesn’t work out exactly as planned.

When we looked at the Global Integrity Index for 2008 for “practical implementation” of their legal framework, they were graded in the lowest quartile, below say, Serbia, Azerbaijan, and Ecuador. This suggests that, despite enormous strides, there is weak confidence that everything is as stable as it may seem.

In addition, we did a small study of the Consumer Price Index dating from 1914, taking through economics in its Classical, Keynsian, Neo-Classical, and Wherever We Are Now phases. This is very instructive, as it allows us to see American history unfolding in terms of price stability.

This becomes clearer when we convert this data into year-over-year changes and see that we never have dipped into negative territory since the economy stabilized and got moving around 1955. Until last year that is. Clearly deflation is perceived as a danger to be avoided at all costs. Whether it CAN be avoided is another question.

The world is in a most precarious condition when China must figure out a way to contain a potential runaway inflation and we must contrive to do the opposite. Should either zone lose control of the process, the opposing zone may also be thrown into a chaotic condition.

Which is all quite speculative. However, our friends at Petroleum Intelligence Weekly have somewhat ominously noted, American refineries are running at only 80% of capacity, and Japanese refineries are running at about 70% capacity, suggesting very weak demand for energy. China on the other hand is trying to get hands on all available energy sources, with very large refinery runs.

We took the CPI yoy data from 1914 and ran a Fourier transform to see if it might give us some hints about the future. Obviously this is only one possible model based on past economic cycles, so consider it one scenario out of many possibilities.

If there are long term cycles that became ironed out to a degree with the emerging US-China relationship, they may be reasserting themselves in this era.

It may also be worthy of note that a recent Supreme Court ruling on campaign finance reform was poorly received, to put it mildly. President Obama lashed out in language rarely heard directed by a President toward the court.

The intensely populist language points to a growing culture of populist resentment and radicalism in the American electorate, which makes for interesting times and impulsive legislation, typically leading to a reduced appetite for risk, at exactly the time that risk aversion may be leading us into a liquidity trap.

Public debate lurches from the timid to mediocre to the bizarre to the incoherent, a symptom of the intellectual incoherence of our age.

Which leaves us where? The political process appears to be slowly coming unglued, the media incapable of communicating anything like a clear understanding of the realities and perils we face, and the financial system uncertain as to whether there is another boot left to drop.

Although we are in no wise where we were in 1932, history, as Mark Twain said, doesn’t repeat but it rhymes. The core problem of the 1930s was incoherence. Established models such as the gold standard had broken down, the finance ministers and governors were products of an earlier era with no maps to guide them, and the world had entered a procedural vacuum.

Once again a generation of free market philosophers is having to improvise an interventionist strategy with inadequate models from a vastly different set of circumstances.

“A man may be sharper than another, but not all others”

-La Rouchefoucauld

“Nothing on earth consumes a man more completely than the passion of resentment”

-Nietzsche

“People who bite the hand that feeds them, usually lick the boot that kicks them”

-Eric Hoffer

We are well to hold in mind that every political moment is an economic moment is a social moment. Long periods of prosperity create formulaic thinking, banal entertainment culture, speculative energy distracting from a general ennui, a certain nostalgie de la boue, an indifference to corruption, a fondness for idiocy, a displacement of common sense and common courtesy by trivial rules and regulations, by tinpot “outrage” in place of penetrating insight. This won’t be the first time we’ve been in these parts.

So far the Venture Capital Association reports that ventures are still getting funded. That’s a good sign, because it means that there is still great confidence in the long term for America to creatively respond and sophisticated investors do see the long term payoff as deserving of the risk. If venture money had dried up altogether, that would have been a far more ominous long term sign. Assuming that the VCs are better informed and more intelligent than the average investor, and have longer time lines with fewer constituencies to placate, we will take this as a positive sign of confidence in the deeper future.

However, for the moment, VCs don’t seem to be doing IPOs, we assume that their view of the current market is that now is not the time. We take that as a medium term negative. Perhaps a strong negative.

Or a large change in direction.

According to Ari Levy and Dakin Campbell in their January 19 blurb on Bloomberg:

Veteran venture capitalist Dixon Doll predicts that more U.S. technology companies will start holding initial public offerings in other countries as economic growth in Asia outpaces domestic expansion.

“In the next 10 years, I expect more portfolio companies to list on foreign exchanges,” said Doll, founder of Menlo Park, California-based firm DCM, in an interview last week. China “will become a big deal.”

The U.S. venture-capital industry is coming off its slowest two-year stretch for IPOs since the mid-1970s, with only 19 in 2008 and 2009, according to the National Venture Capital Association. Doll said that while U.S. companies may not flock to China in the next year or two, the world’s third-largest economy will be increasingly attractive for technology start-ups as its capital markets mature.

China’s gross domestic product will expand 8.5 percent this year and 9.3 percent next year, according to Bloomberg surveys of economists. That compares with average predictions for U.S. growth of 2.7 percent in 2010 and 3 percent in 2011, according to Bloomberg.

Doll, 67, said he expects 40 to 50 venture-backed companies in the U.S. to go public this year, because the “system is so constipated” from two years of inactivity. The financial crisis wiped out investment banks such as Lehman Brothers Holdings Inc. and Bear Stearns Cos., and forced more than 850 hedge funds to shutter in the first nine months of 2009. That left fewer banks to lead IPOs and fewer investors to buy shares in them.

In the words of Jim Morrison, “the future’s uncertain and the end is always near.” We simply may have to go through a painful schooling in the next few years as we unlearn many of the lessons we took to heart as we moved from what appeared to be a Keynesian orthodoxy undone by a great inflation to a Chicago school era that began brilliantly and ended in chaos. Until the new synthesis of economic theory, social expectations, political frames, and a stable contract between economic stakeholders in in place, we should brace ourselves for a witches ride.

China may successfully break with a historical pattern and successfully manage its’ way through a period of hyper-expansion. It is our belief, however, that stable institutions require a long time to develop, and a longer time to become uniformly internalized beliefs about the nature of social and economic reality.

The great downturn beginning in 2007 forced China to re-imagine itself as a nation of internal markets. Wise policy level figures have long understood the need to gorge expanding social classes on tempting distractions lest they become overly curious about the mechanism of the state itself. Which requires a rapid expansion of credit so that this new class CAN indulge itself in new toys.

We made this error between the Clinton and Bush administrations when we made the political choice to buy off the electorate with a fantasy world of palatial homes and (imported) consumer goods, founded on the substrate of a corrupt and unstable credit allocation mechanism. Will China be capable of discovering another, less Minsky flavored path ?

Here is a brief add on study to complement the cycle analysis we did in the last post, where we looked at the Chicago Fed National Activity Index. Today we take a look at the broad money supply in the US, known as M2.

For very suspicious reasons nobody has been willing to articulate, M3, the most broad accounting for the money supply, has vanished. They’d been compiling the stuff since 1959, then suddenly, poof! All they’ll say is DISCONTINUED SERIES. We’re mightily curious as to what was driving that decision. We doubt it had anything to do with keeping the public well informed.

Luckily, a website called NowAndFutures.com compiles a proxy M3 on a consistent basis. A private undertaking can produce US government statistics when the US government won’t? That ought to set off an alarm or two.

We’ve included a sample of their work. Notice that despite the appearance of narrower gauges of money, the proxy M3 has been trending, well, not up for quite a while. Would that have tipped a careful observer off to the possibility that not all was well in leverage land? You be the judge.

Here is the more mundane, less revealing M2 money supply, expressed in percentage change year over year. As we can see, it has been plummeting lately. As in down. This suggests that the Fed is actively draining money out of the system, trying to cool a potentially disturbing inflationary spike before it gets out of the barn, or, alternatively, that the stimuli aren’t going exactly as planned. We’re not sure and they aren’t talking.

For our final observation, we performed a Fourier transform on the year over year M2 value to see which cyclic components would be visible.

We detect an important 4.6 year cycle in money growth that seems to sync up roughly with the 5 year cycle we saw in the CFNAI. However, there is also an 11 year cycle (10.8 years more accurately) that sometimes aligns with the 4.6 year cycle. Why there is an 11 year cycle in money and an 8 year cycle in basic economic activity is mysterious and fascinating to us. According to this measure, it appears we are a few months ahead of another cyclic turn in the 4.6 year money cycle. How that translates into human behavior is anyone’s guess.

We are decidedly in interesting times. Precisely which times those may be is highly dependent on what information one is considering at the moment.

Tacitus has dug into the Federal Reserve databases seeing what might rear its head. One the surface, the Fed’s economists are quite upbeat, predicting a robust recovery in several sectors. But then, their job is to function as official cheerleaders, as much as they can get away with.

Looking at the Fed’s own official background radiation detector for hints of inflation and deflation, the venerable CFNAI (Chicago Fed National Activity Index), we do see an energetic rebound from the recent low. However, the index remains in potentially deflationary territory, which means, cheerleading or not, the Fed definitely plans on erring on the inflationary side.

We’ve done a little deeper analysis of CFNAI, this time taking the entire data series going back to 1967 and applying a Fourier Transform to see if there are any internal cycles that might help us anticipate the comings and goings of the economy. Indeed, we did find two cycles, roughly a 5 year cycle that coexists with roughly an 8 year cycle. This did a nice job of picking up the last major cycle and seems to suggest a moderate rebound as the 5 and 8 year cycles are out of sync this time.

Contemplating the year over year percentage change in retail sales (which can be unpredictable) it looks like business has snapped back to normal levels. This may have been a relief rally of holiday buying though, as it suspiciously coincided with the Christmas shopping season.

Under the circumstances, it would not be surprising if government economists were cooking the books as a confidence sustaining measure. They have been known to do such things. The “financial media” are often surprisingly gullible, taking statistical releases at face value. We’re not so sure. It’s a little TOO pretty for our comfort.

On the other hand, when we look at housing starts, as opposed to toaster ovens, the picture doesn’t communicate the same brio. As a matter of fact it looks downright miserable. The Chicago Fed insists we’re do for a nice springy real estate rebound in 2010. Judging from the data, anything will be able to qualify as a rebound off of this base!

And for the grand finale, we have a chart of the federal Surplus/Deficit going all the way back to 1895. Right. That’s not a typo. Not 1995 (ancient history by most standards) but no, 1895, when Grover Cleveland was president. Many people never heard of Grover Cleveland. He probably was responsible for this statistical series. A toast to President Cleveland!

You may notice that the gross federal deficit looks, well, downright bizarre compared to its entire history. As in absolutely, breathtakingly monstrous. In case you were wondering just how much it cost to, ummmm, underwrite this magnificent recovery we are currently enjoying, you might begin with this.

For some final thoughts… in the following video Marc Faber discusses his perspective on the medium term investment environment and the concern that the market may be fully priced for now.

Central banks are faced with a dangerous paradox. Economies at the state level have become de-linked and sectors within economies have become de-linked as well. At the top level, coordinating a policy response means both finding a mechanism to cool off China’s rapidly overheating economy and continuing to pump oxygen into the western system.

Even within the United States, as we are starting to see a healthy rebound in certain sectors, there are disturbing signs of a second possible real estate collapse – this time in the commercial sector. The Federal Reserve system will be forced to choose between averting an imminent disaster today and tolerating an overheated economy later OR letting the chips fall where they may, the market clearing brutally and efficiently, which brings the risk of entering a deflation spiral, but the possible benefit of a stable, less intervention prone future.

This chart is a proprietary index which I’ve found does a nice job of picking up on economic inflection points. It combines industrial factors and money supply, tracking the rhythms as economic cycles gain strength, then gradually lose steam. According to this metric, we ought to be shifting solidly into recovery mode and clearing out the debris of bad investment decisions from the last cycle. That supports the optimistic scenario.

(Note: This chart is sensitive to flows of activity in the real economy of manufacturing and large orders and changes in money supply around those orders, so it will show strong surges leading out of recessions as well as softenings in order flow leading into recessions.)

However, the International Monetary Fund remains quite pessimistic about the financial condition of the US consumer, with the assumption that consumer loans will be charged off for an extensive period, and not reach 2007 levels until possibly 2013. This strongly suggests an extended period of workout with tightened credit conditions, more stringent collections activities, and a general loss of desire to take on yet more debt. This alone will probably keep the consumer bottled up through the next cycle.

If the picture on the consumer credit side is less than wildly energetic, the commercial real estate market appears to be downright implosive. Nobody seems to really know how bad it could get or how much direct intervention may be required in case a major player decides to pull a Lehman.

No doubt the Treasury and the Fed are wondering, should they have to go back to Congress, and ultimately the US taxpayer, how much sympathy would be left for another massive bailout program. The public may have become so disgusted by the last round of emergency measures that they’ll vote to let the chips fall where they may this time around.

Surely Geithner and Bernanke understand the political dimension, and will be working overtime, in advance, to stave off a commercial real estate collapse with every means at their disposal that can be kept reasonably hidden from public view. Which may mean that they are willing  to stuff the goose in advance and pray that they can drain excesses from the system before a potential inflationary surge gets back into the public mentality.

This YouTube video (posted about a month ago) will help explain this leg of the predicament we find ourselves in.

Meanwhile, China appears to have used every tool and mechanism at its disposal to avert a global meltdown by a radical program of internal investment to create internal markets to buffer the loss of external market capacity. The result seem to have been to unleash an astounding amount of real estate development and speculation. How much is too much?

What happens if it breaks down? Who is left holding the bag? Does the Chinese Communist Party have the administrative smarts to structure a bailout program above and beyond furiously reflating their economy? Or was the Chinese approach to combating a potential worldwide deflationary spiral that of slamming their economy into the opposite gear of a potentially extreme inflation or bubble scenario?

A year ago, with the world on the brink of a total economic collapse, we were told buy & hold investing was dead, earnings would take years to recover and the economy would languish for years to come. Of course the experts were wrong, and anyone who didn’t listen and bought stocks is sitting on exceptional gains.

The rebound has indeed been stellar. The Dow Jones Industrial Average ended 2009 up 19% (having gained 60% from March lows), S&P 500 is up 24% and the Nasdaq up 43% – the best year for the US markets since 2003.

In the UK the FTSE 100 gained 22% last year (54% since the year’s lows) – its best annual performance since 1997.

Lost decade… for some

Of course, as positive as that is, it’s only half the story. When we look at the performance over the last decade, the picture is quite different. Little wonder the last decade has been labeled the ‘lost decade’. Instead of holding stocks over the last 10 years investors could as well have stuffed the money under a mattress. Or so it seems.

From the end of 1999 through 2009 the Dow has seen its second worst performance on record (down by 9%). The 1930s and the 00’s were also the only decades during which the Dow ended lower than where it started. The S&P has fallen by 24% in the 10 years since the end of 1999 and the Nasdaq by about 44%.

The UK and Europe haven’t fared any better. Investors in the FTSE 100 would have lost 23% over the last decade; the German Dax has fallen by 14% and the French CAC-40 by 34% over the same period. Even accounting for dividends investors would still have lost out. Naturally, when we take into consideration inflation and falling currencies, the decline in asset values has been even sharper.

The awful performance over the decade is of course somewhat skewed as 2000 saw the peak of the dotcom bubble with stock markets at historic highs. The past decade saw not just one but two market crashes. It’s therefore my belief this was an abnormally bad period for equities and the next decade will be much more in line with historic performance.

Great decade for others…

More importantly, when we talk about a ‘lost decade’, we’re forgetting the other parts of the world, outside the US and Europe. Investors in emerging markets have seen rather extraordinary gains over the last 10 years – despite the sharp declines in 2008.

While emerging markets were hit hard by the flight to safety (the Shanghai Composite slumped by 65% in 2008, Russia’s Micex by 67% and Brazil’s Bovespa by 41%), they rebounded just as fast. The Micex index gained 121% in 2009, the Shanghai Composite index rose 80% (and Shenzhen Composite 117%), Bovespa added 83% and India’s Sensex 80%.

Compare the 10-year losses in the main developed markets with the emerging markets performance over the same period. The Shanghai Composite gained 140%, Sensex 30 went up by 249%, Bovespa by 301% and Russia’s Micex has surged a staggering 802% since the end of 1999.

Here’s a chart comparing 10-year returns in emerging vs. developed markets:  See chart.

Emerging markets in 2010 and beyond

I believe the emerging markets will continue to outperform in the long term. Yes, they are highly volatile and there will be plenty of bumps, but the long term trend has been up and I see few reasons to doubt it will continue.

Much of the developing world’s growth in the last decade has been fueled by a reduction in poverty rates, fast expansion of the middle classes and resulting consumption. These trends will continue and support robust economic growth for years to come. While China heavily depends on exports and is therefore linked to the strength of western economies (for now), that is less the case for the likes of Brazil and India.

That’s not to say that the strong rebound of 2009 wasn’t partly due to the massive fiscal stimulus (particularly in China) and speculative money inflows. Just like the cheap money supported the rally in the US and Europe.

According to IMF predictions, in 2010 the developed economies will see a 1.3% GDP growth vs. 5.1% in the emerging markets. In 2011-2014, the IMF estimates average annual growth of 2.5% and 6.4%, respectively.

Over the last two decades developed nations have seen a strong loss of economic influence. The US, Europe and Japan controlled approx 64% of the global economy in 1990; that is now down to 52%. The events of 2008/9 can only help to accelerate this process.

Furthermore, the four BRIC nations now hold approximately 42% of the world’s foreign exchange reserves. The G7 hold 17%, and if we take out Japan they come to a mere 4% of the world’s reserves. Over the last 10 years, while the BRICs accumulated reserves, the West went amassing debts.

For the UK, US and many EU economies ballooning fiscal deficits and spiraling public sector debt will present major problems in 2010 and beyond. Most Asian economies (excl. Japan) do not have the problems of government and household debt that the West has.

Where is the economy heading?

We won’t see a double dip recession, but economic growth in the US is likely to be subdued. Even that could be threatened should interest rates rise too much, too early (which, however, is unlikely to happen). Some analysts expect the US economy to heal more quickly and post stronger than the generally forecast 2.5-3% growth.

The budget deficit is an obvious problem. Huge amounts of private sector debt have been shifted to the government. The bill will eventually come due. The scale of the deficit will place an upward pressure on interest rates.

On top of that, high levels of consumer indebtedness, as well as unemployment, are likely to keep consumer spending weak. Higher taxes, which seem to be a certainty in the US and UK, will also inhibit growth.

The UK is in an even more precarious position. The obvious issue being its enormous deficit, as well as the 2010 general election, which could, in the worst case, see a hung parliament (and resulting uncertainty for the markets and economy). As in the US, recovery will also depend on improvement in employment and the property market.

Importantly, the withdrawal of the stimulus will have an impact on the markets and economy. If done too early it could cause a double dip recession, if too late it is likely to lead to a spike in inflation. Interest rates are likely to stay very low this year as the Bank of England won’t want to risk a relapse into recession.

2010 – A good year for equities?

Despite previous warnings, it seems the 2009 rebound in the markets wasn’t so unusual after all (once it became clear that Armageddon was no longer likely). The markets frequently recover before there is any sign of improvement in the economy or corporate earnings.

After last year’s surge in equity prices, 2010 performance will largely depend on earnings growth, fueled by productivity gains and maybe a return of the consumer. If the expected earnings don’t materialize, stocks could see a significant correction.

Coming out of recessions equities have traditionally performed quite well, and we could well see the markets end 10-15% higher in 2010. The large amount of cash still sitting on the sidelines and waiting to be invested is also likely to help prop up equity prices.

The exit from the monetary and fiscal stimulus that fueled last year’s rally may have a negative impact. A genuine recovery (with self-sustaining growth in jobs, earnings and spending) has to kick in before government stimulus is withdrawn. If private sector demand doesn’t step in by that time, we will see a reduction in output.

It is unlikely that we’ll see significantly higher interest rates in 2010. That’s good for the markets – low rates support earnings as well as steering yield seeking capital into equities. The concern is that if the Fed doesn’t move fast enough on rates, we are going to have excess demand for many goods and commodities, resulting in a rampant inflation. It would, in fact, be surprising if the trillion dollar stimulus didn’t trigger inflation down the road.

What seems certain is that 2010 will be a much more ordinary year for the stock markets, compared to the last two. Investors will have to earn their returns which will stem from individual investments rather than a general market momentum. Even if the markets stay largely flat or range bound, there will be opportunities to outperform.

Should US equities perform well next year, it is likely that many foreign markets (excl. Japan and Western Europe) will do even better amidst stronger economic growth. Given that many S&P (and FTSE) companies now derive a significant part of their revenues overseas, blue chips with strong foreign sales could also benefit from global economic growth.

Emerging markets, in particular Asia and Latin America, will, in my view, continue to outperform in 2010 and over the next decade. Just be prepared for the volatility and short term hiccups.

All that said… nobody knows what exactly will happen in the markets in 2010 (or any other year). The only thing certain is that there will be opportunities for proactive and selective investors to achieve healthy returns. And that’s where investment talent will come in.