Funds Flowing, But For How Long?

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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.

Growth of Domestic Nonfinancial Debt
Click here to enlarge

 

–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:

USA Private Debt to GDP
Click here to enlarge

 

–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…

Chart of the ASX200
Click here to enlarge

–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.

Greg Canavan
Greg Canavan is the Managing Editor of The Daily Reckoning and is the foremost authority for retail investors on value investing in Australia. He is a former head of Australasian Research for an Australian asset-management group and has been a regular guest on CNBC, Sky Business’s The Perrett Report and Lateline Business. Greg is also the editor of Crisis & Opportunity, an investment publication designed to help investors profit from companies and stocks that are undervalued on the market. To follow Greg's financial world view more closely you can subscribe to The Daily Reckoning for free here. If you’re already a Daily Reckoning subscriber, then we recommend you also join him on Google+. It's where he shares investment research, commentary and ideas that he can't always fit into his regular Daily Reckoning emails. For more on Greg go here.
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43 Comments on "Funds Flowing, But For How Long?"

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Stillgotshoeson
Guest

Had to do a double take.. thought I had been linked to the Ned and Biker MSN Chat by mistake..

Anyway an article in the Age.com.au…

Who’d of thunked this….

http://www.theage.com.au/business/treasury-brief-reveals-household-debt-concern-20100924-15qnn.html

Ned S
Guest

“the Ned and Biker MSN Chat” – It was a quiet Friday night with DRA’s two most loyal fans just feeling to do our bit to fill in their dead air time maybe Shoes? ;)

Following is worth a look though regardless, if it got rolled by because of my general BS. I’d certainly recommend it to Steve if he isn’t already using it:

http://www.refindhouseprices.com/

Your link sums things up quite well I’d say.

Stillgotshoeson
Guest

Was already aware of that site.

Ned S
Guest

Then why hadn’t you, as a giving and caring type, shared it with all your long suffering fellow bears, might I ask mate? :D

Ned S
Guest

I got half a mill that says Biker ain’t Ned … Any takers? ROFLMFMO!!! :D

Stillgotshoeson
Guest

Someone else did sometime ago.

Biker
Guest

Back from a quick trip north, Ned. Steve giving you a bit of lip, I see. ;)

Ned S
Guest

“Someone else did sometime ago” – Damn, I’ve been reading every comment for years and missed the single most useful one. Guess that investing is all about being lucky rather than doing one’s research and due diligence stuff after all. Never mind, the link still might be handy for Steve if he missed it too.

Biker
Guest

No, something tells me ‘Steve’ knows that comment very well, Ned.

Gotta laugh. This bloke never misses any opportunity to blog bad news about property. If we did the same in regard to his pet projects, he wouldn’t even acknowledge our presence here. Truth is, he _loves_ the attention. ;)

Enjoyed his comment about my trollmanship.

For some interesting fun, type stillgotshoeson into Google sometime, to see what bloggers on other sites think of this little leprechaun…!!~ :D

Ned S
Guest

What’s a bloke to say Biker? – Here’s silly ole buggers like us wasted our entire lifetimes actually working for a living … Damn, how disappointing! :D

Biker
Guest

I have a good excuse, Ned. I came from a broken home*.

* Broke most of it myself… . ;)

Ned S
Guest

“I have a good excuse, Ned” – I understand fully mate … My favourite chook died when I was only seven. Scarred me emotionally I reckon. Not so much the bit where I had to catch her. More the bit where I had to pluck ‘n gut her after me ole man chopped her head off. But I console myself with the fact that ‘Honey’ tasted bloody good! :D

Biker
Guest

Cheer up, Ned!~ The Colonel would have been proud… .

And to cheer Steve up:

http://www.perthnow.com.au/business/news/a-rise-may-prevent-interest-rate-rises/story-e6frg2qu-1225928975992?from=public_rss

8:52 pm… and I’ve just been told it’s time for bed!
Crikey… . :)

Ned S
Guest

Thanks Biker. Yes, you are correct. All the world needs is a tiny little 70% correction in Oz housing prices and all its woes will be fixed. So I’ll tune in to DRA again tomorrow too as they keep assuring me that this IS gunna happen soon! :)

Ned S
Guest

Life’s tough alright. But I live in the best country in the world. And have the best Ma ‘n Pa in the world. And the best lady in the world. (For me anyway.) And the best bro in the world. And the best younger family members in the world. And the best mate or two in the world. So yeah, I figure I’ll hang in and continue doing it tough here for a while yet … :D

nv
Guest

Comment by Stillgotshoeson on 25 September 2010:

“Who’d of thunked this….”

Nooo not ‘ere son, it’s different down ‘ere to be sure to be sure.

Stillgotshoeson
Guest

Comment by Ned S on 25 September 2010:

“Someone else did sometime ago” – Damn, I’ve been reading every comment for years and missed the single most useful one.

Had a quick look through the archives, could not find it.. It was probably on the Barefoot Investors Blog.. via the Heraldsun that it was brought to my attention.

Biker
Guest

Oh, those archives store some gems, to be sure, to be sure!!~ ;)

Ned S
Guest

Yes Biker, you will notice that I don’t release too many details on my lady that could get any sicko going … To be sure, to be sure! ;)

Hope Steve has that link though. As you and Shoes and I have all agreed, it is a useful one:

http://www.refindhouseprices.com/

Biker
Guest
The refind site is a very useful addition, Ned. We currently get daily information (emails) from: * realestatealert * viewalert * realestateview …and * domain In all cases we’ve specified both ‘rent’ and ‘buy’ for our two locations of interest, with a specific range of prices for both. In addition, I have two realtors who provide me with the actual sale price of anything we have/had expressed interest in. Despite this immense volume of information, we still don’t have the very finite picture of realty we had between ’77 and ’90, when we had every single lot mapped for purchase… Read more »
Ned S
Guest

Darn, who’d have ever thought he’d pick up a useful RE link off DRA hey? ;) Ta mate. The ‘viewalert’ one didn’t love me but I’ve bookmarked the others! :D

Biker Pete
Guest

“…who’d have ever thought he’d pick up a useful RE link off DRA hey?”

Hope that within two weeks, I’ll be able to brief you on our findings re. some kind of retirement mix’n’match plan, Ned. Quite a list of key questions.

Latest question is: “Does money (already) taken out as a TTR count towards the maximum $160K one can take out tax-free if retiring after 55, but before 60?”

Doesn’t apply to me, but the missus will pull-the-pin mid-2011, to allow us six months’ NH travel next year.

Ned S
Guest

DRA was advertising for a superannuation specialist a while back Biker. Once you’ve got the answers to these questions you just might be their man hey? ;) But despite that being a half smart arse comment, I would add that I place way more faith in the thoughts of someone with lots of practical and personal experience than some university theory. Thanks again. I’ll very much look forward to it.

Biker Pete
Guest
The missus would be the ideal person, Ned!~ :D Walked to our favourite winery this afternoon, for a few samples (and coffee & cake) and during the trek we went back over facets of The Plan. I’m still amazed by her ability to discern issues where I’d seen none. You know, there’s a chance I’ll need to pressure our Super company to provide a lot of this info free of charge. The b*stards want to charge us $5K minimum for essential information which ought to be provided to their members free, considering how long they’ve been taking a cut from… Read more »
Ned S
Guest

The FAs are what they are mate. Three years ago when I set up my SMSF the advice was that the tax return and accounting I couldn’t readily do myself would cost $800 pa. It seems that is now $1,800 pa. Yep, scumbags; No question! :)

Biker Pete
Guest

The last independent FA we talked to wanted $10K+ per YEAR, Ned.
(Same fella knew very little when we put a series of questions to him! :( )
Eventually, he talked himself down to $5K per annum, but we were already walking… . :)

With our Super company we’ll take the line that they have a duty of disclosure; then apply for the information we want through Freedom of Information, if they decline to provide the advice we need… !~

Stillgotshoeson
Guest
Comment by Biker on 26 September 2010: Oh, those archives store some gems, to be sure, to be sure!!~ ;) Yep SURE are… Comment by Biker Pete, Digby, NS, Canada on 30 August 2009: Claytonator, I guess you figure rents will fall, too(?) I’m sure you can also create an argument for this outcome! We’ve been hearing this ‘simple’ (your word) logic for a couple of years now. It is just that, simplistic… . and the Pantene economy in Australia… It won’t happen overnight but it will happen…. http://www.homepriceguide.com.au/media_release/APM_Rental_Market_Report_June2010_Quarter.pdf Key Findings… Rental growth flat in most capitals in June quarter… Read more »
Stillgotshoeson
Guest
Comment by Ned S on 3 February 2010: Sambo and Mike sound legit to me too. As is CA of course! And Steve/Steven. Hmmm … Who’s been missed? Oh yeh, Biker – But that’s obvious. Reckon that bloke who’s still got his shoes on is crook though. As is SBD or whatever he calls himself. Like I’ve said, there’s been so many PB morphs lately, with my interest levels being way too low to bother trying to follow them, that there isn’t any real chance of me naming too many names accurately. But if my little contribution should be of… Read more »
Stillgotshoeson
Guest
Comment by SteveG on 28 January 2010: When I was working in retail, there was this guy who came in pretty much every day. Now this guy who reckoned he was a federal cop. Among other wonderful stories, he also reckoned that he won second divison in the lottery (for the second time, apparently). Ran into him one day at his work. Turns out he was actually a security guard. To his credit, he was able to spin this wonderful story about how he had to leave the force because he was a corruption whistleblower, but he got a packet… Read more »
Biker Pete
Guest

“…Annual rental growth remains under 5% nationally for both houses and units…”

And my comment a few days ago, re rent growth over six years here?
30%… or 5% per year.

But, if you like, I’ll put up some of _your_ classic comments for consideration, son!~ I know you’ll appreciate that.
Last time, you sulked for weeks… . ;)

Biker Pete
Guest

“…quite possibly by the same author….”

Sums Shoes up very well. He’s a punter of first order.
Guesswork is his hallmark, Ned. :D

Ned S
Guest

Maybe Shoes had a rider somewhere on any of his comments about you and I being the same bloke along the lines “Like I’ve said, there’s been so many PB morphs lately, with my interest levels being way too low to bother trying to follow them, that there isn’t any real chance of me naming too many names accurately” Biker? Or maybe he didn’t? But it is good of him to quote mine anyway! :)

Biker Pete
Guest

“But it is good of him to quote mine anyway! :) ”

Ah, but he has to, Ned.

In a particularly Shoesian piece of craftsmanship, he has painted himself right into a corner. The Big Sulk means he can’t respond to anything I say directly, so he can only take his shot off someone else’s quote.

Classic Catch 22. :D

Lachlan
Guest

Reflation seems to rule so far with a short cover rally last Friday.
Bought some SAR today Shoes and kept a long posi on the index. I’m not sure Bens going to let these markets fall any further after watching things last few weeks. The money just keeps a rolin’ on in. Of course Im not saying I agree on any of these things but just trying to trade the market as is. As they say, place ya bets gentlemen ;)

Ned S
Guest

Making predictions about markets strikes me as a potentially disappointing pastime. This has got to be one of the more impressive Whoops, did I say that calls of this century at least:

“All that said, given the fundamental factors in place that should support the demand for housing, we believe the effect of the troubles in the subprime sector on the broader housing market will likely be limited, and we do not expect significant spillovers from the subprime market to the rest of the economy or to the financial system.”

Ben S. Bernanke
May 17, 2007

http://www.federalreserve.gov/newsevents/speech/bernanke20070517a.htm

Biker
Guest

Well… Bernanke… ! Just as Obama has to deal with the Sins of the Fathers, so too does Bernanke… .

Each inherited a bloody mess. Both have attempted to pour oil on troubled waters, but even rocket fuel could not have got them out of trouble… .

Padley reminds us to reread the Zurich Axioms… . :D

Stillgotshoeson
Guest
Comment by Lachlan on 27 September 2010: Reflation seems to rule so far with a short cover rally last Friday. Bought some SAR today Shoes and kept a long posi on the index. I’m not sure Bens going to let these markets fall any further after watching things last few weeks. The money just keeps a rolin’ on in. Of course Im not saying I agree on any of these things but just trying to trade the market as is. As they say, place ya bets gentlemen Had a look at SAR.. Looks a promising play.. Financials seem good, Production… Read more »
Stillgotshoeson
Guest

oops.. Left out OZL as well in that sell off…
OZL
AGO
GPT
TTS
PLA

Lachlan
Guest
Well done Shoes. I only took notice of SAR recently while combing through Gold Nerds list of companies. I’ve noted your trading plan which obviously works well. I have done poorly on stocks in past after jumping ship on deflation fears (not gold stocks)…however well founded they may be..I dont know the mind of BB. This time round Shoes I’m just taking small gold miner positions but more interested for holding for longer periods of the gold bull market. Crumbs I’m sounding like a buy and hold doofus. Maybe I’m im a contrarian then. Now I know what your tinkin… Read more »
Lachlan
Guest

I posted back Shoes but comment in moderation. Heading away a few days now but let us know if you find any gold miners worth a few bob.

Stillgotshoeson
Guest

Comment by Lachlan on 27 September 2010:

I posted back Shoes but comment in moderation. Heading away a few days now but let us know if you find any gold miners worth a few bob.

Hill End Gold HEG and Beacon Gold BCN are two cheapies if your in to the speculative game

HEG is around 10 cents
Beacon less than 2 cents
I don’t have HEG but I have some BCN…

Lachlan
Guest

Ta Shoes…I’ll check them out on the weekend. Yep its specs for now but some bigger blokes later when some more dough comes my way.

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