Tuesday, September 13, 2011

The Gathering Storm

After posting Saturday's blog, found two more very knowledgeable market sources with timely information about the coming economic storms: John Mauldin and John Hussman of Hussman Funds. I want to show a few of the charts I found in their reports:

First, from John Mauldin's most recent Frontline report:

Next, from John Hussman:

Hot (frightened) European money seeking safe haven at the US Fed for next to no return. A high probability of a second (double-dip) recession in the US. Wage income as a percent of GDP falling strongly. Unsustainable transfer payments supporting (for now) consumer demand. Add this to the fact that 45% of US Households are either underwater or within 5% of being underwater. The US consumer is completely out of gas, and will retrench for a long time to come. Consumers: we're broke, so no extra spending. Business: no orders and no new demand, so no new investment. Conservative economists who think business investment is held back by tax, regulation and other government-sourced uncertainty concerns, are just plain wrong. If consumers were spending, business would start coming to the table with new investment. Without that new consumer spending, they will remain on the sidelines.

And all of this is happening at a time when Europe is literally on the edge of an economic precipice. We are looking at a textbook case of debt deflation: debt fears have pushed a number of countries into fierce austerity programs - cutting public budgets to try to eliminate deficits and thus reduce the debt burden. But cutting government spending reduces demand, which reduces GDP, and then drops tax revenues more than what the budget was cut. Then the country must borrow more to keep current on debt payments, which raises debt service costs, which increases deficits, and the negative, self-reinforcing circle continues.

In a "normal" economic situation, the debtor would go into "bankruptcy", or some form of debt restructuring (for a sovereign). But for countries like Greece, Ireland and Portugal in the European Union, this is not an option unless the other members of the EU agree. And in this case, this means Angela Merkel and Germany. I am not perfectly sure of this, but I think Merkel and Germany could stop this potential train wreck, not by imposing more and more onerous conditions on Greece, but by agreeing to a full restructuring of the Greek debt. This would entail  40-60% haircuts taken by all the banks (which would then have to be recapitalized, probably taken over by their sovereigns).

Possible. But it might just be a bridge too far. And if Greece goes, the European banking system will unravel in unpredictable ways. The contagion will find our shores soon thereafter. Our Fed is very good at liquidity rescues, but markets for financials will be hammered, and with no appetite for TARP II, we could be looking at restructuring one or more banks.

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