An Imminent Downturn: Whom Will Our Leaders Defend? (Hussman)

Tuesday, September 6th, 2011

An Imminent Downturn: Whom Will Our Leaders Defend?

John P. Hussman, Ph.D., Hussman Funds

The global economy is at a crossroad that demands a decision – whom will our leaders defend? One choice is to defend bondholders – existing owners of mismanaged banks, unserviceable peripheral European debt, and lenders who misallocated capital by reaching for yield and fees by making mortgage loans to anyone with a pulse. Defending bondholders will require forced austerity in government spending of already depressed economies, continued monetary distortions, and the use of public funds to recapitalize poor stewards of capital. It will do nothing for job creation, foreclosure reduction, or economic recovery.

The alternative is to defend the public by focusing on the reduction of unserviceable debt burdens by restructuring mortgages and peripheral sovereign debt, recognizing that most financial institutions have more than enough shareholder capital and debt to their own bondholders to absorb losses without hurting customers or counterparties – but also recognizing that properly restructuring debt will wipe out many existing holders of mismanaged financials and will require a transfer of ownership and recapitalization by better stewards. That alternative also requires fiscal policy that couples the willingness to accept larger deficits in the near term with significant changes in the trajectory of long-term spending.

In game theory, there is a concept known as “Nash equilibrium” (following the work of John Nash). The key feature is that the strategy of each player is optimal, given the strategy chosen by the other players. For example, “I drive on the right / you drive on the right” is a Nash equilibrium, and so is “I drive on the left / you drive on the left.” Other choices are fatal.

Presently, the global economy is in a low-level Nash equilibrium where consumers are reluctant to spend because corporations are reluctant to hire; while corporations are reluctant to hire because consumers are reluctant to spend. Unfortunately, simply offering consumers some tax relief, or trying to create hiring incentives in a vacuum, will not change this equilibrium because it does not address the underlying problem. Consumers are reluctant to spend because they continue to be overburdened by debt, with a significant proportion of mortgages underwater, fiscal policy that leans toward austerity, and monetary policy that distorts financial markets in a way that encourages further misallocation of capital while at the same time starving savers of any interest earnings at all.

We cannot simply shift to a high-level equilibrium (consumers spend because employers hire, employers hire because consumers spend) until the balance sheet problem is addressed. This requires debt restructuring and mortgage restructuring (see Recession Warning and the Proper Policy Response ). While there are certainly strategies (such as property appreciation rights) that can coordinate restructuring without public subsidies, large-scale restructuring will not be painless, and may result in market turbulence and self-serving cries from the financial sector about “global financial meltdown.” But keep in mind that the global equity markets can lose $4-8 trillion of market value during a normal bear market. To believe that bondholders simply cannot be allowed to sustain losses is an absurdity. Debt restructuring is the best remaining option to treat a spreading cancer. Other choices are fatal.

Greek debt races toward default

On Friday, the yield on one-year Greek debt soared to 67%. Europe is demanding greater and greater austerity as a condition for additional bailouts, but austerity has already resulted in a depression for the people of Greece, and a loss of tax revenues that has paradoxically but very predictably resulted in even larger budget deficits. As I noted more than a year ago (see Violating the No-Ponzi Condition ), “The basic problem is that Greece has insufficient economic growth, enormous deficits (nearly 14% of GDP), a heavy existing debt burden as a proportion of GDP (over 120%), accruing at high interest rates (about 8%), payable in a currency that it is unable to devalue… I suspect that budget discipline to the extent required will not be easily implemented, and may be so hostile to GDP and tax revenues as to make default inevitable in any event.”

Presently, the Greek debt/GDP ratio is 144%, and is likely to reach 180% by year-end. It was only in June that we observed (see Greek Yields – Certain Default But Not Yet ), “At the point that a near-term default becomes likely, we would expect to see one-year yields spiking toward 40% and 3-month yields pushing past 100% at an annual rate (essentially pricing near-term bills toward the anticipated recovery rate).” To see the one-year yield leaping suddenly to 67% is an indication that we should brace for a very serious turn of events almost immediately.

One problem appears to be that European banks are eagerly volunteering for a 21% haircut on the debt (which is trading far less than that on the open market), but only in exchange for shifting the debt covenants from Greek law to more binding international law. This would be a bad deal for Greece, because it would essentially impose further severe austerity on the Greek people in return for a debt reduction that would still leave the debt/GDP ratio well above 100% and growing. Greece should reject this, because a larger default is inevitable, and it would serve the country best to maintain as much control over the size of the default as possible. Ultimately, my impression is that it would serve Greece best to exit the Euro, but it appears too late for this to be graceful.

Undoubtedly, a Greek default comes with a significant risk of contagion to other countries. On that front, the most worrisome targets of contagion – Italy and Spain – both have high debt-to-GDP ratios, but there is really no credible risk of outright default in those countries. As such, the ECB should certainly be willing to extend its purchases of Spanish and Italian debt. But note that the objective would not be “quantitative easing,” nor would it represent a subsidy to those countries. Rather, an ECB backstop for larger European countries would represent market stabilization of what are likely to be good credits. And provided that the ECB only purchases the debt at reasonably high interest rates (rather than depressed rates as the Fed seems eager to do here), the intervention would simply be an application of the century-old Bagehot’s Rule (“very large loans at very high rates are the best remedy for the worst malady of the money market when a foreign drain is added to a domestic drain.”) Importantly, Bagehot also accompanied this rule with an admonition to impose costs, capital requirements, and other safeguards where public funds are concerned. As for any public funds approved for use by various European governments to stabilize the financial system, IMF chief Christine LaGarde is right – those funds would be better used to recapitalize banks (ideally, restructured banks) rather than using those funds as a transfer to Greece in hopes of making bad debt good.

What is particularly unfortunate is that all of this is unfolding in a very predictable way, but the constant attempts to ignore reality and defer the inevitable restructuring is imposing enormous costs on the public. As Ken Rogoff and Carmen Reinhart wrote two years ago in their book This Time It’s Different, “As of this writing, it remains to be seen whether the global surge in financial sector turbulence of the late 2000s will lead to a similar outcome in the sovereign debt cycle. The precedent [a close historical overlap between banking crises and external debt crises in data from 1900-2008] however, appears discouraging on that score. A sharp rise in sovereign defaults in the current global financial environment would hardly be surprising.”

Measuring the probability of oncoming recession

A wide variety of data continues to corroborate the high risk of an oncoming recession, including plunging consumer confidence, weak payroll employment, and various indices of economic activity. The following chart updates the U.S. economic activity composite that I presented in early August (see More than Meets the Eye ). Note that new orders, in particular, have deteriorated to a point that is rarely observed outside of U.S. recessions. The deterioration is also clearly more severe than we observed in 2010.

In that August 1, 2011 comment, I reviewed the components of our Recession Warning Composite , noting “From the standpoint of this composite, we would require only modest deterioration in stock prices and the ISM index to produce serious recession concerns.” Within a few hours of publishing that comment, the August ISM figures were released, coupled with a drop in the S&P 500 sufficient to complete the elements of that recession warning. I should note that while the September ISM figure for manufacturing came in slightly above 50, the primary source of strength was inventory accumulation, while new orders slumped. This is not a favorable profile, and as the graph above indicates, a much broader set of evidence is consistent with economic contraction.

Tags: Austerity, Bondholders, Bonds, Counterparties, Crossroad, Debt Burdens, Economic Recovery, Financial Institutions, Fiscal Policy, Game Theory, Global Economy, government spending, Hussman Funds, Infrastructure, Job Creation, John Nash, Mortgage Loans, Nash Equilibrium, Outlook, Recapitalization, Sovereign Debt, Stewards, Transfer Of Ownership
Posted in Bonds, Brazil, ETFs, Infrastructure, Markets, Outlook | Comments Off

Crude Oil at a Crossroad of Inventory and Fed’s QE2

Sunday, October 17th, 2010

By Dian L. Chu, Economic Forecasts & Opinions
Oil prices have continued to soften at $82.51 a barrel for November delivery on the NYMEX Friday after Federal Reserve Chairman Ben Bernanke’s speech sparked some uncertainty as to how far the central bank will support the economy.

Crude was also weighed down by the weekly inventory report from the U.S. EIA. Despite a week-on-week draw of product and crude inventory, and supply interruptions from Canada due to Enbridge Inc 670,000 b/d crude pipeline shut-in since Sep. 9, and the Houston Ship Channel after a barge knocked down a power line, the overall stocks are still well above the 5-year average with a year-over-year increase (Fig. 1)

Decoupled from Equities and Metals

Crude oil prices had generally correlated with the base metals and equities on U.S. dollar weakness and strong Asian demand. However, due to the abundance of inventory and supply, crude has remained range-bound, despite improved market sentiment, and started to decouple and underperformed other commodities with tighter supply conditions, such as copper, as well as equities. (Fig. 2)

According to Barclays, over the past month, the average price increase of base metals has been 11%, compared to only 3% for WTI crude. While this has surprised some traders, it is nevertheless a reflection of diverging market fundamentals, particularly in terms of supply.

Transparency Kills the Mystery

Crude oil prices are also at a “disadvantage” due to the lack of a cross-sector transparency. As one of the most widely traded and liquid commodity, oil has relatively better transparency in the form of weekly inventory / demand detail reporting and various widely available forecasts and analyses, while other commodities remain more “shrouded in mystery.”

Tags: Base Metals, Canadian Market, China, Commodities, Commodity Oil, Crossroad, Crude Oil Prices, Crude Pipeline, Dian, Dollar Weakness, Economic Forecasts, Eia, Enbridge Inc, Federal Reserve Chairman, Federal Reserve Chairman Ben Bernanke, Houston Ship Channel, Inventory Report, Market Fundamentals, Market Sentiment, Nymex, oil, Qe2, Silver, Supply Interruptions, Wti Crude
Posted in Canadian Market, China, Energy & Natural Resources, Gold, Markets, Oil and Gas, Silver | Comments Off