Editor’s note: In Dan Denning’s continued absence; today’s DR comes from Greg Canavan, editor of the Sound Money. Sound Investments report (go here for a free trial). This article is from Greg’s most recent report. Mr Canavan, you have the floor…
–We’ve made this point before, but we’ll make it again. Today’s modern financial system depends critically on continued debt growth to stop asset prices from collapsing. In modern economies dominated by governments and their agents, central banks, money is debt and debt is money.
–Grasp this truth and you understand modern financial markets better than 99% of the investment community. We raise this point again because the recently released ‘Fed Flow of Funds’ report makes it startlingly clear that global equity markets rely exclusively on debt creation in the US for their sustenance.
–To be more precise, they rely on debt creation by the US Federal Government. Take a look at the accompanying table from the Fed Flow of Funds report. It shows the growth of domestic non-financial debt since 2000 and was recently updated for the second quarter of 2010.
–As you can see, total annualised debt growth of 4.8% in the three months to 30 June was the strongest rate of growth in years. But it had nothing to do with a healthy economy.
–Households continue to pay down debt and business borrowing was flat. The private sector is paying down (or defaulting) on debt built up during the previous decades. Even state and local governments cut back during the quarter. Federal government borrowing accounted for all of the debt growth.
–This continues a trend that has been underway since the credit crisis began. Federal government debt expanded at a 20% plus rate in 2008, 2009, and is on track to do the same in 2010.
–The government is clearly trying to cushion the impact of private sector credit contraction. To date, they have been successful. But even with the Federal Reserve as the buyer of last resort, it is a war they cannot win. Consider this chart, sourced from Steve Keen’s debtwatch blog:
–It shows the ratio of US private sector debt to GDP. As you can see, the ratio reached a record high of nearly 300% in February 2009 but has since fallen back as the private sector begins the long-term process of lowering its debt burden.
–This is the sharpest rate of debt repayment/default since the Great Depression and if those tumultuous years are any guide (and they’re the best guide we have) the process has many years to run.
–So can the US government continue to offset private sector deleveraging for a decade or more? It can, and probably will, try. But market forces will at some point stop the madness by bringing about either a currency or bond market crisis. Let’s hope it happens sooner rather than later.
–We’re not talking hypothetical’s here. This is the path the US economy is headed down. When the market wakes up to this reality, there will be trouble.
–If you’re wondering why the world’s equity markets are so reliant on US government fiscal policy, it all boils down to the fact that the world is on a ‘US dollar standard’. But it’s no gold standard. Nor is it even a poor imitation of one.
–Under the classical gold standard, countries running deficits (like the US) would lose their gold reserves (to pay for the excess goods and services). As the gold flowed out of the banking system, it would contract the monetary base and push up interest rates. This process would stop the deficit from becoming too large and avoid distortions forming in the global economy. (Because gold was considered money and was an integral part of the banking system back then, a loss of gold meant a contraction in the monetary base).
–On the other side of the coin, the surplus nations would receive an influx of gold. This served to expand the monetary base and lower interest rates, which encouraged consumption and the running down of surpluses.
–But since 1971, when Nixon severed the US dollar’s link to gold, we have been on an international dollar standard. The problem with this monetary arrangement is that there is no in-built balancing mechanism.
–It has evolved into a system whereby the dollar is the primary provider of liquidity to the global economy. It fulfils this function via the US economy running persistent current account deficits. These deficits flow to the surplus producing countries, who build up their US dollar reserves in an apparent show of strength.
–Like gold, these reserves expand the domestic monetary base and provide the platform for robust domestic credit growth. Why do you think Asia has been such a powerhouse in the past decade? Increasingly large US trade deficits are helping to finance their domestic growth.
–Which brings us back to the flow of funds…
–If the US can’t maintain credit growth (which is what creates US current account deficits and US dollar flows to surplus nations) then global equity markets are in real trouble. The whole dollar standard, the experiment with paper money, call it what you will, is slowly coming to an end. The smart money has realised this and is moving into gold. The Federal Reserve has not realised this at all, or if they have they are just playing for time.
–The recently released FOMC statement (issued by the Federal Reserve) signaled that the Fed is ready to print more money to support the economy if it needs it. Apparently there are many people who still believe the Fed can create wealth and economic growth. More than likely though, it is only the speculators who hang on the Fed’s words, knowing that they have more paper money to play with while the dollar standard teeters on its last legs.
–Make no mistake, this is the big picture backdrop and you need to keep it in mind when managing your wealth. The dollar standard’s demise is assured. Only the timing is uncertain.
–In such an environment we would view the probability of sustained advances in markets as being very low. With stock prices having increased considerably in September (especially the prices of lower quality companies) we see no reason to get involved at this point and see risks increasing as the market rises.
–Consider the chart of the ASX200 below, which shows just the last two months performance. What we want to point out here is the dramatic drop off in volume in the past few days…
–Volume spiked in the last decent sell-off (16 Sept) but since then it has fallen away dramatically. This shows there is a major lack of conviction about the sustainability of the recent rally. Just as the index hit some critical technical levels, follow through buying dried up. This is bearish action as far as we are concerned.
–As Australian investors, you have the luxury of having your patience rewarded by sitting in cash. Cash rates are already attractive and if anything will get better in the months ahead. (We may have underestimated the RBA’s willingness to raise rates aggressively. The officials are sounding very hawkish and look to be preparing markets far a series of rate rises). Competition from cash is probably one of the things keeping a lid on share prices in the local market.
–Obviously gold will be the standout performer in an environment of currency turmoil. We are already seeing that now. Gold hit new highs following the Fed’s comments that it stands ready to print more money to support the economy. Every major nation is trying to debase their currency. The only winner in this will be gold.
–Given the strong performance of the Aussie dollar lately, the USD gold price strength is not translating into the same strong gains for AUD gold. But just give it time, it will.
–Since inception we have built up an exposure to gold, gold equities and silver bullion of nearly 20%. Combined with a healthy cash weighting and a focus on quality, good value companies, this will stand us in good stead for the numerous challenges that confront the Australian and global economies in the years ahead.