Can the U.S. Grow its Way Out of Debt?

February 28, 2010

The S&P500 slipped about 0.4% last week, the final week in February.  Once again, the volume seemed to confirm the slide in prices: volumes rose last week, above the levels from the prior week when prices rose.  The VIX (or fear) index rose slightly, infusing the week’s activity with a sense of complacency.

The economic data were weak and starting to point to further erosion.  Consumer confidence tumbled to levels far below consensus estimates.  New home sales not only fell (when they were expected to rise), but also reached depths not reached in the history of the survey (since 1963).  Existing home sales also sorely disappointed; they fell when they were expected to rise (because of the government home buying incentives).  Jobless claims spiked to 496,000, well above estimates and almost above the ominous 500,000 level.  Although GDP revisions for Q409 were strong, many economists are starting to worry that the inventory restocking force that drove this growth will soon disappear.

Technically, the weekly downtrend is still in effect.  However, the uptrend on the daily charts has also not been broken.  Over the next two weeks one of these two trends will get broken. 

Over the last year, Paul Krugman, the Nobel winning economist, has argued that the U.S. government should have implemented a larger fiscal stimulus program than the $787 billion package that actually passed.  He also argued that the additional borrowing that the government would require to fund the larger stimulus will not overly burden the total debt load because the resulting growth in GDP will more than compensate for the debt growth.  In other words, Krugman argued that the long-term GDP growth rate will exceed the debt growth rate; this would cause the ratio of debt to GDP to come down and avert a sovereign debt crisis.

It sounds perfectly logical.  In theory.

In reality, things may not actually work that way.  Carmen Reinhart and Ken Rogoff (professor of economics at Harvard University), in their new book, This Time is Different, identified 22 countries that lowered their external debt to GDP by at least 25% between 1970 and 2000.  Their goal was to determine whether the ratio fell because debt fell (through paydown or some form of default ) or because GDP grew, as Krugman predicts would happen in the U.S.

15 of the debt reversals occurred because of some sort of debt default.  Six debt reversals occurred because of simple debt repayment.  And only one reversal (Swaziland, 1985) occurred because the country grew out of its debts.

Rogoff and Reinhart concluded that “countries typically do not grow out of their debt burden”.

That’s not a good sign for Paul Krugman.  Experts in almost all countries with high external debt levels will argue that their debt levels are sustainable and manageable simply because they will outgrow them.  Historical evidence suggests they’re wrong.

This evidence is currently most relevant to the impending debt crises in Greece, Iceland and perhaps Spain and Portugal.  Soon, it may express itself in Italy, the U.K. and Japan.

And finally, history could repeat itself in the U.S.  The evidence is clear–the odds are high that the U.S. will someday default on its debts.

After 28 Years, is the Bull Market in Bonds Over?

February 21, 2010

The S&P500 climbed 3.1% last week, in a continuation of the rebound from the late January lows.  But the volume pattern was still bearish–in weeks when equity prices fell this year, volumes spiked; in the last two weeks when prices rose, volume dried up.  The VIX (or fear) index fell, but stayed well above its lows from early January.

The economic data were mixed.  The Empire State Mfg survey was better than expected.  Housing starts rose more than expected.  Producer prices were higher than estimated; consumer prices were lower.  But the downside risk of dropping consumer prices is the threat of deflation;  so lower consumer price appreciation is good, but the markets would fear negative price trends.  Initial claims jumped more than expected.  Leading indicators rose, but less than economists had projected.  And the Philly Fed survey came in slightly better than forecast.

Technically, the S&P’s multi-month uptrend is still broken on the weekly charts.  The daily charts show that the strong bounce from the February 5 lows could be nearing its completion, especially when the paltry volumes do not validate the price rise.

Since 1982, when the Fed chairman, Paul Volcker, shoved interest rates up to break the back of inflation, the U.S. Treasury bonds have enjoyed a secular bull market–rates have trended down, as bond prices have trended up. 

After 30 bond rates dropped to 2.5% in December 2008, they have been crawling up, reaching 4.7% last week.  Over the last 28 years, one or even two percentage point variations–within a year or two–have been perfectly normal because the rate rises never broke the long-term downtrend.

Until now.  The 28 year old trendline is about to be tested.  If 30 year Treasury rates rise above 4.8% to 4.9%, then most technical analysts will begin to call for the end of this monster rally.  And traders could respond to such analysis by selling long-term Treasuries, pushing rates up even higher, thereby making the rate increase more decisive.

Fundamentally, the long-term rates are in a major tug-of-war.  On the higher rate side, concerns about rising inflation, enormous debt supply and even growing credit risk (credit default swaps on U.S. sovereign debt have risen in price over the last several months) will tend to push prices down and rates up.

On the lower rate side, the risks of deflation and a double-dip recession will tend to apply downward pressure on rates and upward pressure on prices.  Also, the strong possibility of an international (non-U.S.) financial crisis, in Greece, other European nations or even Japan, would shove rates lower as capital from the affected regions would rush into the relative safety of U.S. Treasuries.

In the end, the actual rates will tell us which side will win this battle.  And chances are high, as in an actual tug-of-war, that one side could take control for a while, and later the other side could take control also for a while.  In this scenario, we’d enter a long-term trading range (as we did from 1890-1910 and 1940-1950) where rates oscillate in a narrow horizontal band.  The long-term downtrend would still be broken, but a new uptrend need not begin right away.

Either way, we are at a major testing point for the 28 year old downtrend.  Very soon, perhaps within one or two months, we will know if it has finally ended.

Will China Save the World Economy?

February 14, 2010

The S&P500 inched up 0.9% last week on very low volume.  The low volume is not very bullish because in each of the prior four weeks when the index fell, volume was strong.   It appears that more and more equity holders are looking for the exists, rushing out the door when prices start to slide.

There was very little macro data, but most of what was announced was weak.  U.S. trade figures were worse than expected; this means that the preliminary Q409 figure will almost surely be revised lower.  Retail sales came in as expected.  Initial claims were better than forecast, but the improvement probably had something to do with the massive snowstorms that crippled much of the eastern U.S. from Atlanta to New York City.  Business inventories were lower than consensus estimates, and consumer sentiment fell when it was expected to rise.

Technically, the S&P is still very overbought on the weekly charts.  The downtrend that began in January is fully in place.  On the daily charts, the short-term rally last week was not unexpected.  In fact, it was weaker than many bears had anticipated.  So another push higher would not be surprising before the weekly downtrend reasserts itself.

China has been touted as the savior of the global economy.  It’s amazingly consistent and impressively strong 9%-10% annual growth rates have been the envy of the world. 

Naturally, as the fiscal and monetary stimulus programs of the developed economies starts to fade away, many analysts have begun to look to China to provide a lift to everyone else.  And so far, it has been working.  China’s purchases of raw materials from suppliers such as Australia, Canada and Brazil has impressively boosted these respective economies. 

And now, the hope is that this engine of growth will spill over into other parts of the western world and work its magic.

But can China help the rest of the world?  More critically, is China itself at risk of a slowdown?

The evidence is not encouraging.  When the western world imploded (financially and economically), demand for Chinese manufactured goods plunged.  The Chinese government stepped into the void with a huge fiscal stimulus.  Much of this was invested in infrastructure and real estate.

But the problem is that this extra building is resulting in overcapacity.  Final demand has not returned from the West, and domestic consumer demand has not risen enough to replace the lost external demand.

Real estate prices are skyrocketing and industrial capacity is booming–all financed by government sponsored lending through the banking system.

If this sounds familiar, it’s because it is.  China is in the late stages of a bubble economy where the bubble was induced by government stimulus programs.  In the U.S. the bubble was induced by excessive consumer borrowing, enabled by excessive bank financing and Wall Street securitization. 

The U.S. bubble ended in disaster.  The Chinese bubble will end in disaster.

And when it does, not only will China not be able to lift the fortunes of the global economy, but China will more likely create a huge drag on the rest of the world. 

In fact, the impending Chinese implosion could be so severe, that it could blow another hole in the U.S. economy, a hole from which we may not recover so quickly again.

Will the Dam Burst?

February 7, 2010

The S&P500 dropped for the fourth consecutive week, slipping 0.7% last week.  The strong volume confirmed the selling, as did the VIX (or fear) index which rose 6%.  

The macro data were mixed.  Consumer spending rose, but less than expected.  Incomes were better than forecast.  ISM Manufacturing was better; ISM Non-Manufacturing was worse.  Construction spending fell more than consensus estimates, but factory orders were better.  Initial claims again disappointed, rising to 480,000 when they were expected to fall to 455,000.  Non-farm payrolls showed a loss of 20,000 jobs when most economists called for a slight rise.  The unemployment rate fell to 9.7%, but primarily because more people–who’ve lost their jobs–simply left the workforce and were thus not counted as unemployed.  And in a footnote, the government announced that in 2009, 1.2 million more jobs were lost than formerly reported in monthly payroll releases. 

Technically, the charts–daily and weekly–are broken.   The multi-month uptrend is now over.  This means that many traders will look at short-term rallies as opportunities to put on short positions with improved risk/reward profiles. 

The selling continued last week, in part, because of fears that government fiscal spending may spark funding crises.   This time, Greece and Portugal got most of the bond market’s attention.  Late last year, Dubai sparked a minor panic.  Going forward, the list of other countries, which have amassed enormous sovereign debt loads, is ominously long:  Spain, Italy, Ireland, Germany, the U.K., many Eastern European nations, Japan and the U.S.

Compounding the damage from these enormous debt loads, trillions of dollars of toxic assets–that are not marked to market–are infesting these nations’ financial sectors.  When one adds in the hundreds of trillions of interest rate and credit derivatives sitting on top of all the debt, it becomes clear that the world’s governments are trying to hold back a huge set of forces, forces that had swamped the private sector in 2008 and early 2009.

And so the question becomes, will the collective efforts of the world’s governments be able to contain these destructive forces?  This question is even more important because, while the private sector could always count on the public sector to bail it out should a crisis arise, there is obviously nobody left to bail out the world’s governments should they fail to contain the destructive forces.

The odds are not high that the dam will hold.  At first, the good news is that not all the dams will burst at once.  The dams in Dubai or Greece or Portugal will break first.  This will create a torrent of capital out of these states to their savior states and the U.S.

Later, perhaps several years  from now, the dams of the larger, savior, states will start to break.  Think the U.K., Japan and even Germany.  Even more capital will then rush to the U.S. and the dollar, temporarily making the U.S. seem like it’s a safe harbor from all the destruction.

But finally, the U.S. and China will follow.  Like the largest ships in a naval fleet, these two aircraft carriers will take aboard the frantic capital from all the other sunken states, only to ultimately suffer the same fate–they will both sink as well. 

Only then can the rebuilding begin.  The looting by the fiat-controlling elites will end.  There will emerge a new order, where the productive sector of the economy will dominate and restrain the financial sector, at least for a while, a very long while.