The Debt Problem Has Not Gone Away

Last year’s stock market rally was impressive. But what if it was merely a case of investors taking on more risk, having been encouraged by low interest rates and all the liquidity sloshing around in the stock market, taking it higher? How would that be substantially different from banks taking advantage of low rates and liquidity to make epically bad lending decisions? We’ll get back that in a second.

Like it or not, the Aussie share market still takes its marching orders from the U.S. action. It hasn’t decoupled yet – even though what drives the respective economies of Australia and America is somewhat different. Australia has resource demand for its raw materials from emerging markets. America does not. But both countries have debt (especially household debt), and plenty of it.

Here in Australia, what will investors think of the new powers being sought by the Federal government on behalf the corporate regulator, ASIC? ASIC would have the power to tap phone lines, impose fines of $500,000 on insider traders, and double jail terms for insider traders from five to ten years. Hmmn.

Better yet, what will corporate insiders think? We’ve seen some strange share price activity since moving to Australia four years ago. Shares move on no news and volume spikes. Then a few days or weeks later some important announcement comes out. And frankly, the disclosure rules for insider buying (or selling), or at least the enforcement of those rules, seem fairly voluntary.

Not that it’s any better in America or anywhere else. But perhaps because of the smaller financial community and the underpowered regulator, the insiders have a better time of it here than they might other places. Ahem.

But the power to tap telephones? Yikes. That sounds draconian. But it’s fully in line with the encroachment of government power into private life, so it’s no big surprise.

Outside Australia, more trouble is piling up for the world’s most debt-addled nations. “We no longer classify the United Kingdom (AAA/Negative/A-1+) among the most stable and low-risk banking systems globally,” said ratings agency Standard and Poor’s. The FTSE finished lower on that cheery note.

This is the big back story to today’s financial markets. The debt problem has not gone away. Banks have recapitalised, making up for some of their losses from 2008 and 2009. But you still have a financial system addicted to debt and leverage. Investors have bought into the recovery story, though, and taken a punt on shares at just the time they ought to be reducing their allocation to shares (in our estimate). Why?

The deleveraging that kicked off in 2008 still had a long way to run. The banks know this, which is why they’ve decreased risk by being stingier with lending. Shareholders, on the other hand, have done the opposite. And that could cost them.

“Any discussion about the response to the crisis,” reports Peter Larsen at Reuters “must acknowledge the need to reduce the levels of debt that have been built up. A study by McKinsey, the consultancy, found that previous deleveraging episodes have generally taken four forms: a period of belt-tightening, in which credit growth lags behind economic growth for many years; massive defaults; high inflation; or a period of rapid GDP growth as a result of a war effort or an oil boom.”

So which will it be? The RBA releases its report today on financial aggregates. We’ll see if credit growth is lagging the economy. Not likely, we reckon. Massive defaults? High inflation (higher than the RBA is comfortable with)? Or war and an oil boom?

None of them are particularly attractive. But none have really happened yet either. That’s why we think 2010 will have more fireworks. Perhaps a debt default by a sovereign government or two. And then you have fewer and fewer surviving financial firms all deemed too-big-to-fail by the government. Not good.

This just in…the U.S. Senate has voted to raise America’s statutory debt ceiling to $14.3 trillion. This will allow the Treasury to borrow more money to both service existing debt and pay for this year’s $1.3 trillion annual deficit. Ben Bernanke was also confirmed for another for another four-year term as destroyer in chief of the U.S. dollar by a 70-30 vote.

Prediction: at some point the American people are going to turn on the clowns ruining their money and their financial future, piling up debt that will take decades to pay off, if it’s ever paid off at all. The Congressional Budget Office reckons that interest on that debt will more than double as a percentage of GDP. In nominal terms, it will triple from $202 billion to $723 billion.

That’s just interest. That is the price of living above your means as a nation. That is the price (really just part of the price) for making promises you can’t keep. It’s a big price. And in the meantime, we’d take U.S. dollar rallies with a lick of salt. And though we read this morning that George Soros thinks everything is in a bubble – including gold – we’d keep an eye on old yeller and look to buy more on dollar strength.

Dan Denning
The Daily Reckoning, Australia

February 1, 2010

The Daily Reckoning