Using More Debt To Solve a Debt Crisis Has Failed

The US market posted a 200-plus point gain overnight, so the ASX should start the day well.

All the talk about the Fed possibly raising rates a whole 0.25% in June or July obviously did not dampen trader enthusiasm.

The prospect of a higher US cash rate has strengthened the US dollar.

A month ago the Aussie dollar was nudging 78 US cents; today we’re under 72 US cents…an 8% fall.

Gold too has suffered from a stronger US dollar. Earlier this month the precious metal was nudging US$1,300; last night it was trading at US$1,227.

For Australian gold investors it’s not all bad news. The 6% fall in the USD gold price has been offset by the weakening Aussie dollar.

My view, in the short term, is that the US dollar will continue to flex its muscles, and our dollar is destined to once again fall below the 70 US cent mark.

In the longer term I still expect our dollar to fall nearer the 50 US cent level. The next major economic crisis that’s bubbling below the surface is promising to be one for the record books.

If history is a guide, money (valued in the billions of dollars) will flood into US Treasuries for perceived safety — which, in turn, will supercharge the US dollar.

A couple of recent articles have again highlighted just how fragile our economic and financial system is:

I predict that the current level of household net worth is not sustainable. I believe that some unforeseeable event will prick the bubble, perhaps this year. The result will be recession which will, unfortunately, be accompanied by more misguided monetary and fiscal policies. I call this monetary and fiscal policy insanity: Keep doing the same thing and expect a different result! I would love to be wrong, but I doubt I will be.

— Dr Daniel Thornton, 12 May 2016

It is neither possible nor necessary to force economic growing by levering up…

Trees cannot grow to the sky. High leverage will inevitably bring about high risks, which could lead to a systemic financial crisis, negative economic growth and even wipe out ordinary people’s savings…  

China’s economic performance will not be U-shaped and definitely not V-shaped. It will be L-shaped…’

— China’s official newspaper, The People’s Daily, 12 May 2016

A year ago, on 19 May 2015, the Dow Jones Index hit a record high of 18,312 points. Since then, it’s been a case of down dale and uphill. The US market has twice fallen into the 15,600 point range (August 2105 and February 2016), only to recover and flirt with the 18,000 point level.

Overall the US market is down around 3% over the past 12 months.

The market is trying to make up its mind…where do we go from here?

US corporate earnings are fatiguing. The smoke and mirrors trick of using cheap debt to finance buybacks to boost earnings has all but run its course.

According to FactSet (20 May 2016):

Earnings Growth: For Q1 2016, the blended earnings decline is -6.8%. The first quarter marked the first time the index has recorded four consecutive quarters of year-over-year declines in earnings since Q4 2008 through Q3 2009.

Earnings Guidance: For Q2 2016, 73 companies have issued negative EPS guidance and 30 companies have issued positive EPS guidance.

The world’s largest market appears to be in a period of suspended animation. Surely the good times can’t be over?

Yes, they are…but no one is willing to call it quits just yet.

The experiment in using more debt to solve a debt crisis has proven to be an abject failure.

That in itself is a sad indictment on the central planners’ abilities…and society’s misplaced faith in these economic witch doctors. But what’s worse is that policymakers have placed us in a far more dangerous situation then the one that existed in 2008.

The bells of common sense are beginning to peal, but I dare say the bell ringers have left it a little late to sound the warning.

Dr Daniel Thornton was employed by the US Federal Reserve Bank of St Louis for 33 years. In 2014, he retired from the position of Vice President and Economic Adviser.

Since receiving his gold watch, Dr Thornton has been providing independent economic commentary.

In his now-independent opinion, the economic and financial bubble (the Fed largely created) is destined to meet with a very sharp needle. Personally I think it will be more of a porcupine than a single needle.

Take your pick (or, prick): Japan doubling down on the currency war; Europe’s refugee crisis intensifying during its summer; a European banking crisis; Trump winning the US election; wholesale credit defaults…and the sharpest needle of all — China’s seemingly uncontrollable appetite for debt hitting a brick wall.

Since 2008, China has been on a spending spree that’s without any historical precedence. Japan’s credit binge of the 1980s, and the debt propulsion behind the US housing bubble, both pale into insignificance when compared to China’s post-2008 splurge.

As the UK Daily Telegraph recently stated:

China’s debt is approaching $30 trillion. The fresh credit alone created since 2007 is greater than the outstanding liabilities of the US, Japanese, German, and Indian commercial banking systems combined.

On 5 April 2016, Fitch Ratings issued a warning about China’s rising debt, labelling it as ‘a mounting source of systemic vulnerability.’ Now there’s an understatement.

Naturally, China hit back, telling the ratings agency to ‘have a drink and calm down’.

‘China is different’. ‘China has delivered on economic growth’. ‘The naysayers have never understood China’. ‘Don’t judge China by Western standards’.

To date, these retorts have been enough to create doubt about whether China really is different, and whether its economy really is bullet proof against the side effects of continuous debt accumulation.

Which is why the recent article in the People’s Daily (the Chinese Communist Party’s official propaganda newspaper) caught so many by surprise.

The officially sanctioned front page story questioned the wisdom of pursuing economic growth based purely on increased debt levels. Now, if that’s a genuine reflection of the Party’s thinking, then China really is different to the Western economies.

The Western world — come Hell or high water — is not going to move an inch from its predetermined course of re-fuelling another consumer credit binge.

If China is genuinely concerned about not wanting to add to the heightened risk of a systemic financial crisis, then this is a real game changer for the global economy…and has serious ramifications for the Australian economy.

Since 2008, every central banker has been singing from the same Fed-orchestrated hymn sheet. If China breaks ranks and does a solo act, then we have a completely different tune being played.

China easing back in credit growth and moving into an L-shaped (down, followed by a flat line) period of performance, could be the tipping point for the anticipated GFC Mk II.

Without China’s US$23 trillion (not billion, but trillion) injection into the global economy over the past eight years, there’s no way there would’ve been a V-shaped recovery in asset prices.

Dr Thornton — while conceding he might be wrong — thinks we could see the economic sparks fly sometime this year. China putting the brakes on debt accumulation would certainly unleash a whole host of unintended consequences.

For instance, what impact would a clampdown on Chinese debt have on our fragile resources sector and capital city property markets? You can bet it wouldn’t be positive. And the dominos would keep falling.

The report in the People’s Daily may have been a smokescreen for an internal political agenda.

Which would be a shame, because the article was full of good old fashioned common sense on the perils of using unrestricted debt to pursue a growth at all costs policy.

So whether it’s China, or one of the other ‘needles’ that pricks the bubble, it appears almost certain an ‘event’ is in our future.

In the bigger picture, it’s somewhat irrelevant trying to guess which needle is going to burst the bubble.

The fact remains that the ramifications of the bubble bursting are likely to be devastating…far worse than 2008/09.

But the equally scary part of all this is (emphasis mine): ‘The result will be recession which will, unfortunately, be accompanied by more misguided monetary and fiscal policies.

Dr Thornton, after 33 years in the employ of the Fed, must know how these guys and gals are wired.

More misguided monetary and fiscal policies. Hmm…

How on Earth can they get any more misguided then what we’ve witnessed over the past eight years?

Perhaps we ain’t seen nothing yet from Janet and her band of Desperados!!!

That’s what’s really worrying for those of us who’ve mentally and financially prepared for the bubble meeting the pin.

What is the Fed’s ‘insane’ response going to be?

What does Dr Thornton know that he’s not telling us?

Rates going even deeper into the negative? More QE? Helicopter money? Underwriting government budget expenses for infrastructure spending? Confiscation of gold?

Seriously, who knows?

The Fed will have a broad plan, but, by and large, they’ll make it up as they go. Why? Because every action they take will have a reaction…a reaction they probably haven’t factored into their modelling.

So they’ll scamper and scurry about to come up with another strategy to nullify the previous failed strategy, and on and on it’ll go.

The Dow is marking time…for now.

During this period of calm before the storm, my advice is to take the opportunity to reduce your market exposure to a level that allows you to sleep at night. There is plenty of volatility headed our way.


Vern Gowdie,
For Markets and Money

Vern Gowdie has been involved in financial planning since 1986. In 1999, Personal Investor magazine ranked Vern as one of Australia’s Top 50 financial planners. His previous firm, Gowdie Financial Planning was recognized in 2004, 2005, 2006 & 2007, by Independent Financial Adviser (IFA) magazine as one of the top five financial planning firms in Australia. He has been writing his 'Big Picture' column for regional newspapers since 2005 and has been a commentator on financial matters for Prime Radio talkback. His contrarian views often place him at odds with the financial planning profession. Vern is is Founder and Chairman of the Gowdie Family Wealth advisory service, a monthly newsletter with a clear aim: to help you build and protect wealth for future generations of your family. He is also editor of The Gowdie Letter, which aims to help you protect and grow your wealth during the great credit contraction. To have Vern’s enlightening market critique and commentary delivered straight to your inbox, take out a free subscription to Markets and Money here. Official websites and financial eletters Vern writes for:

To read more insights by Vern check out the articles below.

Leave a Reply

Your email address will not be published. Required fields are marked *

Markets & Money