What Happens When the Money Runs Out?

In the markets, all the really interesting action is happening behind the scenes. On the surface, things appeared to get better on Friday. In the U.S., Ford told investors that it lost $1.4 billion in the first quarter. Apparently this was less than analysts expected. The Dow closed up 1.48% and climbed back over 8,000.

What a battler that Dow is. It’s got nothing on the S&P 500 though. The S&P is up 28% in the last thirty-three trading days. It hasn’t done anything like that since the 1930s. However the index did close down for the week. That broke a six-week run of gains.

One more note about that. Four-week winning streaks of ten percent are more are generally followed by much smaller gains or losses over the next four weeks, according to the analysts at Bespoke Investment Group. Their research shows that in the four weeks following a four-week rally of 10% or more on the S&P, the index followed up with average gains of 1.87%.

How about one more note about that. There were two four-week rallies of more than twenty percent, according to the same research. The S&P 500 surged 54.2% in just four weeks by early August of 1932. Over the next four weeks in went up another 30%. Then, in April of 1933, the index provided an encore to one four-week surge of 33.8% with another surge of 19.2%.

So there you go. What we do we make of all that? Well, it shows you that even in the middle of the Great Depression, the market was capable of staging mammoth rallies that would tempt investors back in. No doubt those were extremely tradable rallies. But they were followed by lower lows once the forces of economic and earnings reality reasserted themselves on the collective mind of the market.

This time will be different because it’s always different. But if you’re wondering if the stock market is flashing a recovery sign for the economy, you might want to take a look at insider selling. The insiders are selling this rally, according to Data by Maryland-based Washington Service. That outfit says the during the S&P’s 28% climb from twelve-year lows on March 9th, CEOs, directors, and senior officers of U.S. corporations sold 8.3 times more stock than they bought.

Not that there won’t be others. But behind the scenes, other things are happening which are going to drag on stocks.

One of those things is that many of the world’s sovereign governments are in the process of going broke. Spain, Ireland, Greece, and Portugal have all had their sovereign credit ratings downgraded by the ratings agencies. These countries face different challenges like burst property bubbles, declining government tax revenues, and banking sectors hobbled by massive bad loans. But what they have in common is that their respective governments have responded to the crisis by ramping up borrowing to credit-rating ruinous levels.

The scale of global borrowing plans is pretty breathtaking. And what you begin to wonder is a simple question: where is all the money going to come from? Or, to quote David Gray in “Nightblindness”, “What we gonna do when the money runs out?”

For example, the UK’s Debt Management office, which issues bonds on behalf of the British government, says that British bond sales between now and 2013 will exceed £696 billion. The Guardian reports that it will be more like £815 billion, according to figures from Deutsche Bank.

Do you think private investors are super excited to loan the British government money when the British economy is expected to contract by 3.5% this year? Under the budget revealed last week by Chancellor of the Exchequer Alistair Darling, the UK will borrow £175 billion this year alone, or about 12.5% of British GDP. Over the next five years, public sector debt would rise to 76% of British GDP from its current level of 46%.

Gee. That is a lot of borrowing. Britain is a country drowning in debt. Adding more millstones around its neck would not seem to improve its chances of paying that debt down. You could pay it down by, say, generating national income from exports.

S&P’s ratings agency keeps track of the sovereign debt to income ratio. If a country exports a lot of finished goods or raw materials, the government benefits from tax and royalty revenues. These monies are used to service the sovereign debt.

But if you’re not generating large export revenues, then you find a big gaping hole in your budget where royalty and tax revenue should be. Maybe that’s one reason Britain’s new budget raises tax rates on high-income earnings from 40-50%. What you gonna do when the money runs out?

If Britain’s government thinks it can make up for disastrous public finances by raising taxes, it’s probably making another in a long line of stupid mistakes. The high-income earners who would face the big tax increase are exactly the same people getting fired from their jobs in the City. This shows, once again, that building an entire national economy around high finance puts you in all sorts of trouble.

But wait. Maybe the high-saving nations of the world will bridge the gap between British expectations and financial reality. We wouldn’t count on it though. Remember the big hoopla from the G20 meeting in London when it was announced that the International Monetary Fund’s funding would be tripled to $750 billion?

That funding is desperately needed. The IMF itself reckons it will have to dole out some $187 billion in new loans to national governments just to ride the current phase of the global financial crisis. But a key piece of information was left missing in London. How would the IMF be funded?

The G20 finance ministers met in Washington to sort that out. And the early indications are that the IMF will be funded by issuing bonds sold to high-saving nations. If this is true, it’s a victory for the developing world and a defeat for the U.S. and Europe. The U.S. and Europe were both pushing for a direct cash injection funding method. In other words, they wanted China, Russia, Brazil, and India to use their foreign currency reserves to fund the IMF.

But the BRICs batted that proposal away. So now the IMF plans to sell around $500 billion in bonds. They will be denominated in the quasi-currency the fund uses internally (the special drawing rights, or SDRs that both Russia and China have floated as a possible new global reserve currency).

How the bonds actually work still has to be sorted out. But the internal logic of the whole arrangement is now clear: creditors hold the whip hand. Debtors are going to get whipped. The balance of power in the global economy is clearly shifting from the borrowers and spenders towards the savers and producers. Advantage BRICs.

Disadvantage Gordon Brown and Barack Obama and probably Kevin Rudd too. With the existing debt-to-GDP ratios in Britain and the U.K., we reckon it is going to be impossible to fund further expansions of financial bailout programs and welfare state programs without much higher interest rates (borrowing costs).

You can avoid the borrowing problem for a while by soaking the rich with higher taxes. You might also use climate change hysteria to tax carbon (really an indirect tax on consumers). If both happen this year and the result will be even more rapid economic contraction. They will be this Depression’s equivalent of Smoot-Hawley: exactly the wrong thing to do, done at the worst possible time.

Of course the easy out, we feel obliged to point out, is not to borrow the money at all or tax it from your citizens. You could just print it instead. But this tends to unleash hyperinflationary pressures which also tend to destabilize civil society. It’s better to avoid this if you can.

Either way, there is no avoiding the reckoning. Right now, you could make a compelling argument that the value of credit-backed assets is falling so fast that government steps to prop them up simply won’t (or can’t) work. Credit deflation rules the day. The formidable fiscal and monetary stimulus measures are disappearing in the maw of asset deflation while the world goes broke trying to prevent it.

If this is right, and it’s something investors take the time to notice, stocks are going to make lower lows again. A lot lower.


Dan Denning
for The Daily Reckoning

The Daily Reckoning