Debt Problem Has Not Gone Away

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Last year’s stock market rally was impressive. But what if it was merely a case of investors taking on more risk, having been encouraged by low interest rates and all the liquidity sloshing around in the stock market, taking it higher? How would that be substantially different from banks taking advantage of low rates and liquidity to make epically bad lending decisions? We’ll get back that in a second. First…to the newswires!

The futures were down overnight by 72 points. Like it or not, the Aussie share market still takes its marching orders from the U.S. action. It hasn’t decoupled yet – even though what drives the respective economies of Australia and America is somewhat different. Australia has resource demand for its raw materials from emerging markets. America does not. But both countries have debt (especially household debt), and plenty of it.

Here in Australia, what will investors think of the new powers being sought by the Federal government on behalf the corporate regulator, ASIC? ASIC would have the power to tap phone lines, impose fines of $500,000 on insider traders, and double jail terms for insider traders from five to ten years. Hmmn.

Better yet, what will corporate insiders think? We’ve seen some strange share price activity since moving to Australia four years ago. Shares move on no news and volume spikes. Then a few days or weeks later some important announcement comes out. And frankly, the disclosure rules for insider buying (or selling), or at least the enforcement of those rules, seem fairly voluntary.

Not that it’s any better in America or anywhere else. But perhaps because of the smaller financial community and the under powered regulator, the insiders have a better time of it here than they might other places. Ahem.

But the power to tap telephones? Yikes. That sounds draconian. But it’s fully in line with the encroachment of government power into private life, so it’s no big surprise.

Outside Australia, more trouble is piling up for the world’s most debt-addled nations. “We no longer classify the United Kingdom (AAA/Negative/A-1+) among the most stable and low-risk banking systems globally,” said ratings agency Standard and Poor’s. The FTSE finished lower on that cheery note.

This is the big back story to today’s financial markets. The debt problem has not gone away. Banks have recapitalised, making up for some of their losses from 2008 and 2009. But you still have a financial system addicted to debt and leverage. Investors have bought into the recovery story, though, and taken a punt on shares at just the time they ought to be reducing their allocation to shares (in our estimate). Why?

The deleveraging that kicked off in 2008 still had a long way to run. The banks know this, which is why they’ve decreased risk by being stingier with lending. Shareholders, on the other hand, have done the opposite. And that could cost them.

“Any discussion about the response to the crisis,” reports Peter Larsen at Reuters “must acknowledge the need to reduce the levels of debt that have been built up. A study by McKinsey, the consultancy, found that previous deleveraging episodes have generally taken four forms: a period of belt-tightening, in which credit growth lags behind economic growth for many years; massive defaults; high inflation; or a period of rapid GDP growth as a result of a war effort or an oil boom.”

So which will it be? The RBA releases its report today on financial aggregates. We’ll see if credit growth is lagging the economy. Not likely, we reckon. Massive defaults? High inflation (higher than the RBA is comfortable with)? Or war and an oil boom?

None of them are particularly attractive. But none have really happened yet either. That’s why we think 2010 will have more fireworks. Perhaps a debt default by a sovereign government or two. And then you have fewer and fewer surviving financial firms all deemed too-big-to-fail by the government. Not good.

This just in…the U.S. Senate has voted to raise America’s statutory debt ceiling to $14.3 trillion. This will allow the Treasury to borrow more money to both service existing debt and pay for this year’s $1.3 trillion annual deficit. Ben Bernanke was also confirmed for another for another four-year term as destroyer in chief of the U.S. dollar by a 70-30 vote.

Prediction: at some point the American people are going to turn on the clowns ruining their money and their financial future, piling up debt that will take decades to pay off, if it’s ever paid off at all. The Congressional Budget Office reckons that interest on that debt will more than double as a percentage of GDP. It nominal terms, it will triple from $202 billion to $723 billion.

That’s just interest. That is the price of living above your means as a nation. That is the price (really just part of the price) for making promises you can’t keep. It’s a big price. And in the meantime, we’d take U.S. dollar rallies with a lick of salt. And though we read this morning that George Soros thinks everything is in a bubble – including gold – we’d keep an eye on old yeller and look to buy more on dollar strength.

Finally, we got a fair bit of mail in response to Murray Dawes’ short-selling primer. We can’t reprint all the questions. But we asked Murray to have a look and answer the most common ones. That he did.

He writes, that “One question that came up a few times in response to the shorting article was how long a short could last for. The simple answer to this question is that it is indefinite. There is no time limit on how long you can be short for, but in saying that you have to be aware that the lender can call back their stock at any time.”

“In practice this rarely happens, but the lender may want their stock back so that they can vote with their shares at a meeting of the shareholders. In such a case the investor who was short the stock would be required to buy their stock back and return it to the lender. This could really throw a spanner into the trading plan of an investor who is short and is one of those unforseen risks that we are exposed to in trading the markets.

“Another issue that is constantly in the press is whether or not trading short is ethical. I think it is ridiculous that people turn to scapegoats and start pointing fingers whenever things don’t go their way. I didn’t hear anyone screaming for the heads of people who short while the market was in a huge bull market for years.

“But the situation was exactly as it is now in regards to shorting. People took on risk to go short a stock and in fact take on more risk than someone who is long because markets do rise over time. When the shorts were getting killed, people were happy for them to be short. Now that they are making money everyone is crying in their beer.”

“It would be lovely if markets only ever went up, but as we learnt during the tulip frenzy hundreds of years ago, a bubble will always pop in the end. It’s not the fault of the ‘evil’ people who dared to realise that the market was overvalued. If there is any finger pointing to be done it should be at the people who allowed the bubble to form in the first place. And we all know who that was (see also Greenspan and Bernanke).”

For the record, Murray has a few short trades open in Slipstream Trader. A few weeks ago, in a forecast to Slipstream readers, he called for a decline to 4,600 on the ASX/200. The index trades at 4,619 as we write. Stay tuned next week for a fuller introduction to what Murray’s been up to. We admit we’ve kept his trading method under wraps. We’ll explain why next week. Until then.

Dan Denning
for The Daily Reckoning Australia

Dan Denning
Dan Denning examines the geopolitical and economic events that can affect your investments domestically. He raises the questions you need to answer, in order to survive financially in these turbulent times.
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12 Comments on "Debt Problem Has Not Gone Away"

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Ross
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I find several points of difference I have had for some time have built into conflict with positions taken by Dan D and Bill B. Can resource and energy producing states take a decision to demand something other than a USD? My answer is no. Bill and Dan seem to believe there is an alternate answer but in my opinion they don’t look sufficiently through the eyes of those that are selling. Can Australia or Canada or Denmark do it politically? No. Resource and energy developments are capital intensive, and after you extinguish the USD you also extinguish the largely… Read more »
Dan
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Pirates, contrary to fairy tales, are not rogue sailors without backing – nation states are usually behind them in some way. After all, without pirates or other bogeymen, what excuse would there be to park the navy in this or that ocean? Agreed, US is self-destructing (thanks to its leaders who are probably acting deliberately – as I cannot assume they are imbeciles), yet the contrived scenario of a weakened (ie: critically overstretched) US military is not out of the question. If that arises, then a believable crisis could result – probably to convince the world to unite and defeat… Read more »
Ross
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I am reminded that I meant Norway rather than Denmark, but something being amiss might have distracted me.

I do realise too that the US wants to devalue, especially Volcker because that and public debt are the two black parts of his 1980’s three card trick. But devalue to ticket clip compensating funny money powered USD commodity/resource gains is also a trick that has run its course because consumers can’t pay … anywhere in the world. So they can’t export their inflation down that road either. Witness liberal fascism’s IPCC failure.

Ned S
Guest

Ross is correct (IMO) – USD hegemony isn’t going away anytime soon – Too much an entrenched part of global financial systems. A bit like dividend imputation and negative gearing in Oz I guess? But way MORE fundamental!

Move gradually away from it by all means. And prepare for coping with the response from the Yanks when they figure such movements are beginning to disadvantage them rather than advantage them.

Ned S
Guest

Wonder what some have against rabbit stew? It’s definitely not my favourite tucker … Not like prawns or pig – But it fills the guts quite adequately regardless.

Ned S
Guest

Been giving it some thought and Oz really could use some more PIs – In these somewhat difficult days. So that Krudd and Co don’t reckon there’s such a huge need to take our tax dollars off us to pump out socialized rentals. Hey, that HAS been tried before ya know Kev?

Pete
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Some advantages of rabbit casserole? 1.) It’s free; 2.) Only use the back legs (why bother with the rest?) 3.) Create a bed of rosemary (also free); 4.) Place eight hind legs in the crockpot; 5.) Sprinkle with finely chopped garlic, port, a little salt and pepper… and chopped onions; 6.) Cover with rosemary; 7.) Slow cook for 5 – 6 hours. Serve with cool climate Shiraz and a nice salad. Creme caramel for dessert.

Serves four. Cheap. Half a dozen airgun pellets… . Gawd, I love Stralia, he mumbled… .

Ross
Guest

Rabbit stew forces some to revisit poverty and social embarrassment. Even worse when it is a neighbours or friends frequent invitation you couldn’t refuse without blowing the hell out of immediate society. Not even the french or all day in a kooka can fix it for me but I’m proof that if you are hungry or pressured enough you will eat it and you won’t be choosy or leave chewy morsels.

Biker Pete
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Well, there you are, Ross. Nice to see a good friend ordering rabbit at an expensive restaurant the other night. He must be trying to impress me. ;) Plague of bunnies on our place, all healthy. Even my missus, who used to hate the smell of cooking rabbit (eats only seafood, anyway) pays no mind to the rosemary/garlic scent emanating from our crockpot. Good lean meat that falls right off the bone. Low in cholesterol, low in calories, and fairly high in protein. Yes, it helped a lot of Aussie families through the Depression… and perhaps revisiting that may refresh… Read more »
Ned S
Guest

The meat out of a pig’s head is real good too! But unlike me ole granny, I never took to their trotters at all – As I knew where they’d bin! Us younger generations get SO pampered! :)

Ned S
Guest

Me granny also liked “tripe” – That’s fancy talk for guts with the contents quizzed outa them and onion gravy added. Hmmm … Reckon if it was good enough for me ole granny then it’s good enough for me!

Biker Pete
Guest

Snapper head soup was a regular treat for the Grans. Great old bump-head snapper-head in a pot, with chives, spring onions and the works. Kids these days can’t really imagine it all I suppose. Remember lambs fry?

Wonder what happened to the foxes while we were away? Bunnies everywhere. I can lean out the window and zap ’em now. Thinking of putting a ‘tree stand’ (shooting platform) up on the windmill and taking a few with my compound bow… . Jeez I’m gonna hate retirement…!! ;)

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