A Debt Crisis in Cold Storage

Chronic decay – rather than dramatic collapse – may become the theme of 2012...

GLOBAL MARKETS are sure to carry over the fear of 2011 into the new year, writes Gregor Macdonald.

The last 18 months have supplied historians with every reason to believe that a replay of the 2008 financial crisis was about to unfold. The difference being that the private sector debt crisis which triggered 2008's terrible domino event has now been transposed into a similar risk in sovereign debt. Especially the sovereign debt of peripheral Europe. 

As a student of macroeconomics, and as one who observes the procession of market psychology — when markets slowly move from the comfort of sleep to the Ker-Pow! of recognition — I am strangely in the position of thinking the following, mildly heretical thought: tail risk in global markets is now much, much lower than most anticipate. If that's true, certain asset classes are going to make very large, very surprising moves in 2012.

My personal reputation as hugely negative editorialist on developed world economies is fortunately not in jeopardy. For the past three years on my blog, I have articulated the intractable dilemma of debt and resource scarcity that will plague the EU, US, and Japan for the balance of the decade. In short, oil prices are never going to come down again — not for any length of time. And US house prices and US wages are not likely to ever go up again — not for any length of time. The dream of higher wages and lower oil prices is just that. And the utopia of 1999, when purchasing power was flipped (compared to now) and the US Dollar stood like a giant against food and energy, will eventually be accepted as a lost era. Never to be regained.

While enormous advantages can be lost in absolute terms, however, in relative terms the developed world still has some advantages. The US, while not often thought of in this regard, is a veritable titan of natural resources. Not in oil, so much, but along with North America more generally the US sits on a tremendous cache of timber, natural gas, coal, and arable land. 

Meanwhile, Europe and Japan remain epicenters of the highly technical manufacturing bases the world will need as it transitions away from liquid fossil fuels to the powergrid, and transport globally becomes increasingly electrified. I have written endlessly about the failure of Western economists to sufficiently account for the influence over natural resources now held by the 5 billion people in the developing world. However, the pressure that their gargantuan demand places on oil, coal, copper, and food is still offset by the crucial advantages still offered by the West, from our engineering traditions. This makes for ironic portraits. 

For example, the United States, with its political dysfunction, is unable to do the correct thing and choose rail over automobile transport, which itself is now a low to negative ROI economic proposition. Meanwhile, China correctly embraces rail transport but there is a problem: many of the large engineering projects in Asia and in China — and I'm sorry to say this — are not constructed very well. The economic might of Germany, therefore, is not a fluke: that country continues to make, along with other parts of Europe, the finest infrastructure equipment the world can buy. If you think this tradition can be replicated easily, you are wrong.

This does not change the fact, however, that the West — particularly Washington and London — has messed up big time in allowing private and public sector debt levels to reach a terrifying escape velocity that now extends way, way beyond any reasonable growth prospects (in industrial terms) that we could achieve in our future. If you want to be calmed about debt and find yourself turning to the whispers of the Keynesians and MMT-ers for comfort, at least recognize that included in every scolding article from Paul Krugman about debt fear-mongering is an admission that growth, yes, economic growth, will still be necessary to escape our current debt levels. 

Unfortunately, I must remind you that the entire economic policy and business complex is still operating with the assumption that economic growth is inevitable and will resume. There remains a lot of market risk embedded in that belief.

But there is another market risk as we move into 2012 that fascinates me more. And that is the strong possibility that no discontinuity, no Lehman Event, no cataclysm is forthcoming. You see, while the private sector is especially good at producing such meltdowns the public sector has a few tools to handle such events, converting them from something quite acute, to something rather chronic.

Normally, at this point in the post, I would run a chart of the balance sheet expansion of the European Central Bank, showing that despite their failure to but up billboards with the letters "QE" on every European motorway, that a grand panic-neutralization operation has been underway for some weeks now. I could also show that the Eurostoxx 50 Index actually bottomed 4 months ago, or display a chart of the slumping Volatility Index. And how about the ratio of gold to the S&P 500 —  showing that the face of lion, a Blakean fearful symmetry, actually peeked out in late August? 

Instead, I am going chartless today. And linkless, too. You market addicts can see these images in your mind already. I want to make my case with words, because, what's happened is that the three main central banks of the OECD are methodically placing tranche after tranche of our unpayable debt into cold storage. With the solemn and purposeful laboring of an undertaker, their embalming fluid is released each day through the veins of the system, dampening the urge for radical simplification (collapse).

For 2012, therefore, I am planning not on rupture (or rapture) but on decay. The market will go through the year with a persistent desire for drama. But at this point, after psychologically anticipating a rupture in our tightly coupled financial system, the exit of a country from the Eurozone would more likely be greeted with relief. The Euro is not going away, neither is the Dollar, nor the Yen. Instead, like the system itself, they will simply continue their chronic declines against food prices, energy prices, and yes, gold. 

What's frankly the most terrible outcome for young people in the West is that the placing of our unpayable debt into cold storage prevents the explosive reset of the system, which, although terrible, would trigger the blossoming of wildflowers. Let young people be not confused: the policies which crush your opportunities are designed to save the retirement of the aging class.

Our current moment in the markets, therefore, aside from the chronic structural problems I've described, reminds me most of the twin crises phase of 1997-1998. There is much that doesn't work in this analogy, but in terms of price action alone it might be worthwhile to pay attention to that sequence. Asia crumbled in 1997, and the rest of the emerging markets crumbled in 1998. The problem, once again, was debt. And the Federal Reserve's bailout of LTCM and a double rate cut in the autumn of 1998, allowed global asset prices to recover. 

But remember, global markets today are not focused so much on industrial growth but nominal prices. In the same way it would be a mistake to think an S&P 500 at 1250 is the same level as S&P 500 at 1250 ten years ago, it would also be a huge mistake to think S&P 500 at 1500 is impossible simply because OECD countries are hopeless. 

We are now in the domain of asset switching, and capital oscillation. And that is all. The S&P 500 at 1250 today buys less of just about everything, than its same level 10 years ago. So despite however much you agree with the dissertations of Russel Napier, Albert Edwards, and Kyle Bass (and I do), "higher" price levels are not hard to achieve. After all, they don't mean much.

If markets come to understand, therefore, that tail risk is much lower than the current short position the Euro indicates, or that current yields on US Treasuries indicate, then there is a fairly large move ahead in stocks and bonds before markets turn their attention back to fundamentals. This is the risk that was underpriced coming out of the spider hole in March 2009. 

Zooming to a larger view, if you read the scholarly work on collapse from Joseph Tainter and Jared Diamond, and also study the myriad ways in which resource scarcity halts the growth of large systems, you will come to understand better that fast collapse is the anomaly and decline is the norm. Moreover, I would also point out that systems in ascent experience short, sharp pullbacks. But systems in decline will experience speed bumps of a different kind: sharp advances.

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