January 1, 2012

2012 Initial Outlook

Given the macro-economic backdrop, it is hard to be anything but pessimistic for 2012.  The West is drowning in debt and our politicians don't have the will or the smarts to do what is right.  Is it any wonder that they are dreading the upcoming elections of 2012?  There's a reason why several viable political candidates are retiring and others are avoiding going for a "higher" office.  Their natural tendency of "kicking the can down the road" is failing. 

Total debt-to-GDP levels in the 18 core countries of the Organisation for Economic Co-operation and Development (OECD) rose from 160 percent in 1980 to 321 percent in 2010.  These numbers mean that the debt of nonfinancial corporations increased by 300 percent, the debt of governments increased by 425 percent, and the debt of private households increased by 600 percent.  The costs of the West's aging populations are hidden in the official reporting. If we included the mounting costs of providing for the elderly, the debt level of most governments would be significantly higher.

Add to this picture the fact that the financial system is running at unprecedented leverage levels and it’s apparent that the 30-year credit boom has run its course. The debt problem simply has to be addressed but we are short of political backbone.  There are four approaches to dealing with too much debt: saving and paying back, growing faster, debt restructuring and write-offs, and creating inflation.

Saving and Paying Back. For the private sector and government to reduce debt simultaneously would require running a trade surplus. So long as surplus countries (China, Japan, and Germany) pursue export-led growth, it will be impossible for debtor countries to deleverage. The lack of international cooperation to rebalance trade flows is a key reason for continued economic difficulties.  Saving and paying back cannot work for 41 percent of the world economy at the same time. The emerging markets would have to import significantly more, which is unlikely to happen.

Growing Faster. The best option for improving woeful debt-to-GDP ratios is to grow GDP fast. Historically, this has rarely been achieved, although it can be done. 

Companies can afford to invest significantly more, as they are highly profitable. The share of U.S. corporate profits in relation to U.S. GDP is at an all-time high of 13 percent, yet corporate real net investment  in capital stock in the third quarter of 2011 was back to 1975 levels.  Lost on our politicians is the fact that companies are reluctant to invest while the outlook for the world economy, taxes and new regulations is understandably high

The inability to grow out of the problem is bad news for debtors. When investors start doubting the ability of the debtor to serve its obligations, interest rates rise even further, leading to a vicious circle of austerity, lower growth, and rising interest rates.

Debt in itself makes it more difficult to grow out of debt.  Once government debt reaches 90 percent of GDP, the real rate of economic growth is reduced. This also applies to the debt of nonfinancial corporations and private households. 

[Note:  The flags represent the US, Japan, Germany, France, Britain, Portugal, Italy, Ireland, Greece, and Spain, in order.]

Assuming a combined sustainable debt level of 180 percent of GDP for private households, nonfinancial corporations, and governments, the debt overhang is estimated to be €6 trillion for the euro zone and $11 trillion for the U.S.

The target level of 180 percent can be debated but a level of 220 percent would still imply a debt restructuring of $4 trillion in the U.S. and €2.6 trillion in the euro zone.  Given the unpopularity of a “wealth trax”, this means that politicians must resort to the last option: inflation.

Inflation. In spite of today's low-interest-rate environment, interest rates are higher than economic growth rates. As risk aversion in financial markets increases and a new recession in 2012 looms large, the problem could get even worse.

So the only way to achieve higher nominal growth will be to generate higher inflation. Aggressive monetary easing has barely moved the inflation needle in the U.S. and most of Europe. Inflation is not being generated, because the expectation of inflation remains low and because there is still overcapacity and overindebtedness in the private and public sectors. Continued monetary easing will lead to a substantial monetary overhang that could, if the public loses trust in money, lead to an inflationary bubble.  Additionally, many believe that the inflation indicators do not give a true reading of the underlying rates of inflation already.  Some inflation is probably attractive to those seeking to reduce debt levels. The problem is stopping the inflation genie once it has left the bottle.

There are no easy solutions to the debt problem. At best, we expect a sustained period of low growth in the West. Even this would require the following:

-        -  A coordinated effort to rebalance global trade flows, which would require the emerging markets, Germany, and Japan to import more, thereby allowing the debtor countries to earn the funds necessary to deleverage

-         - Stabilizing the overstretched financial sector through recapitalization and slow de-risking and deleveraging

-         - Reducing excessive debt levels, ideally through an orderly restructuring or higher inflation

Current policies fall short against all these criteria. The coordinated intervention of several global central banks on November 30 could be construed as a positive sign of global cooperation, given that the whole world fears the implications of a (disorderly) breakup of the euro zone. In reality, it was once again merely a case of printing money and so did not address the one fundamental problem facing the world economy. Even China's participation reflected its worries about its biggest export market (Europe) and the risk of another  recession more than a true willingness to support the West by rebalancing trade flows. 

December's EU summit was supposed to restore confidence in the future of the euro zone.   It remains to be seen if it will even be feasible in legal terms. Even more important, it is not yet certain that the individual governments will commit to the rules as decided at the summit or that they will be followed.

Thus far, it appears that steps taken are not sufficient, because they do not address the core issues of the debt overhang and diverging competitiveness. The plan that emerged from the summit is unlikely to be enough to stabilize financial markets. With the U.K. opting out and the uncertainty about legal enforcement, there is valid reason to question the plan's credibility.  The new agreements essentially put in place some additional improvements to the existing stability and growth pact, which has not been successful to date. The politicians did not do anything of substance to address the sovereign-debt risk; there was no progress on debt mutualization through the issuance of common Eurobonds; there was no forceful monetary easing plan for the ECB; there were no tough calls made on how to address the problems of diverging competitiveness; and no strategy was articulated for reigniting growth in the euro zone. 

For some commentators, it is not a question of whether the euro zone will break up but of how and when it will break up. There is undoubtedly an increased risk of at least some (potentially disorderly) fracture in the euro zone. And some governments are rumored to be preparing just in case.
Any breakup would lead to significant turbulence in financial markets, including a worldwide recession. The OECD has warned that a breakup of the euro zone would lead to "massive wealth destruction, bankruptcies and a collapse in confidence in European integration and cooperation, leading to a deep depression in both the existing and remaining euro area countries as well as in the world economy.
As we go into 2012, it is shaping up to be a difficult year, and perhaps several difficult years. 

Many thanks to John Mauldin for much of the economic content in this post.

In later posts, I will try to come up with some concrete ideas on where to best put your investment and retirement monies to minimize exposure to what could be some nasty occurrences.  But first, I need to get more data and better understand where it looks like the major economies are headed.  For the time being, I remain almost 100% in short-term U.S. government money market funds.  Given the tendency of the stock market to trade almost exclusively on the "headlines of the day", I think that is the safest place to be right now.

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