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Page 6 of 10
Serial debt creation and lax monetary policy snatched us from the abyss in 1998. Easy money and an unregulated shadow banking system prevented a bursting of the debt bubble after the equity/credit implosion in 2000-2002. The bubble was doomed in 2005. This was when our incomes could no longer carry our load. In the past, nations have leveraged private debts until they were paid, defaulted on or were assumed by the government.
Since the mid-19th century, the U.S. has owned a no-default option. Uncle Sam can transfer private debt to the government's balance sheet via asset purchases, bailouts, backstops, etc. He can print money to monetize some or all of the transfer. As he does, the risk of an inflation bust rises. In this grand poker game, the U.S. has played with a loaded deck and held the right cards. Our current hand is weak.
Foreign players now own the casino, and the house always wins. Players win some hands but they lose a lot more. The house is beginning to fear the U.S. is a compulsive gambler that will eventually ask for more than the house is willing to credit. This condition is rare. The last time foreigners owned so much U.S. debt was in the mid-19th century, when Europeans bought bonds for the construction of railroads, canals and highways. We may be near our house limit. Foreigners can see that their loans are not financing infrastructure assets (and other future income generators) that enhance the value of their investments. Self-interest rules.
Foreigners see us wasting their loans on saving an insolvent financial system, which might be why foreign debt purchases fell sharply in January 2009. Offshore banking centers sold Treasuries. Central banks sold U. S. agency bonds, resulting in a $43 billion decline in foreign net investment in January 2009 compared to January 2008's $35 billion surplus.[1]
Our Not-So-Brave New World
All participants define the markets-traders and MPT adherents alike. One of the best ideological dichotomies is "Brave New World or Bust" by Marc Faber of Marc Faber Ltd. published in welling@weeden on January 20, 2006.[ii] In this article, Mr. Faber gives his perspective on Louis-Vincent Gave's market views derived from GaveKal Research's economic theories.[iii] We will turn our attention back to Reflexive Asset Allocation (Figure 2) after we have disputed the foundation of the GaveKal thesis that deficits are not an issue because globalization and great platform companies (their concept) have moderated our economic cycles.
The Not-So Great Moderation Disguised Risk
Figure 7 originated in 1997. It is important for it to predate GaveKal's book, "Brave New World," published in 2005, because there is nothing worse than a backseat driver critical of a recent wrong turn. We all make a wrong turn from time to time. A 1997 origin adds weight to our dispute.
Quite often, bad investments stem from an untested theory of how the world works. Investors who followed the advice given in GaveKal's book since its release are by now quite likely timid. Back then, GaveKal proposed: "It is truly different this time!" with religious zeal and, called nonbelievers blind.
GaveKal preached that we lived in a brave new world transfigured by platform companies into a permanent state of economic moderation and robust corporate profits. They envisioned a heaven of persistently higher equity valuations sustained by high leverage. In this new age, developed countries had closer ties to the cyclicality inherent to labor and inventory-intensive production.
Developing nations were feeding the developed world their manna of consumption products. In doing so, the developing nations inherited the severity of our past economic and profit cycles while we inherited our great economic moderation and huge trade deficits. Deficits were of little concern. They were simply a sign of a manageable symbiotic relationship. This view was wrong and egocentric.
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