Macro
Children of the Debt-Addicted Revolution
Welcome back. Going to keep it short today but the theme this week will be DEBT and why it can be a bad thing for everybody.
On a personal level we know how bad debt is – nobody likes to owe anybody else any money. Debt is asymmetric, it’s one-sided, in itself it’s unrewarding. There is often little praise for one who has repaid his or her debt; after all, that is what is expected of you. But if you default on your debt just once, well, then your life becomes a complete misery. It is this one-sidedness which is the root cause of all debtors’ woes. But borrowing individuals (i.e. consumer debt) are not the only entities that incur debt, companies often borrow money to invest or expand, as do governments – and, yes, when governments cannot keep up with payments they must default too and are usually bailed out by a consortium of other economies (under extremely stringent terms and covenants, of course). It gets pretty ugly at that stage. We should bear in mind that even Britain had to grovel to the IMF for a bailout in the 1970’s – that was a low point in Britain’s economic history, but it does not mean it will never happen again. Remember it was only a few weeks ago that S&P the ratings agency put the UK economy’s sovereign debt rating on “negative watch”.
Now, back to monetary policy: typically, central banks can inject money into the system by inflating the monetary base (best illustrated by “base rates”) and thus forcing it into money supply in the greater economy. By tinkering with the supply of money in the system inflation can hence be tamed, it can be increased or decreased; it can be monitored and controlled by the central banks – in fact this is their primary role. As inflation affects us directly as citizens, taxpayers and consumers, our delicate and fragile future is indeed in their hands. However, back in Japan, debt accumulation by banks and corporations was so high that when asset prices collapsed in the 1990’s the deflation was so violent that it did not matter how much the Central Bank cut interest rates or even how much fiscal stimulus was injected into the economy, people, companies, organizations refused to take advantage of easier borrowing conditions to spend. Why? Because they were in a “debt corner”; when things got so bad, the priority was not growth, it was survival. So companies, banks and individuals alike concentrated all their efforts into repairing their balance sheets (cutting debt and putting aside cash reserves) to insulate them against further deterioration in the economy. Less spending and consumption meant prices in the real economy kept getting lower and the cycle began to feed on itself in a death-spiral, as expectant deflation encouraged people to repair (pay down debt and save cash) yet more – which caused yet more deflation. As we know, indebtedness becomes a real issue in a deflationary environment and this reveals another asymmetric attribute of debt: interest rates cannot go below zero. So, simplistically speaking, if prices keep going down this is a good thing, if you have CASH because your purchasing power goes up – after all everybody likes cheaper goods! However, if you have DEBT then the wealth effect is reversed because the principle value of your debt goes up, relatively speaking. Looking at it another way, it may take you 100 loaves of bread to pay a $100 debt, but if, in a deflationary environment, whereloaf goes from $1 to 50cents, it now takes you 200 loaves to pay the same debt. Not only that, because the bread is decreasing in value the baker is being paid less per loaf, his wages are going down. And because deflation is everywhere, everybody is experiencing wage deflation. So while prices are going down, so too are wages to match the effect – net-net there we could say that we are no better or worse off. Except for the guy who is in DEBT, because while wages and prices are decreasing synchronously, the debt value is stuck at the same high value, it does not decrease with deflation and thus the principal amount of that loan gets further and further out of reach and the debt/mortgage/loan/borrowing gets harder to pay off. While many people have enjoyed low interest rates for nearly two decades now and many people still enjoy low mortgage rates and interest rates now, it’s worth bearing in mind one thing: they are low for a reason.
Many mistakes were made by Japanese policy-makers and many mistakes will be made by our leaders and policy makers today in the aftermath of the recent financial crisis, but let’s be clear: this all started with DEBT.
The banks were over-leveraged but, given the highest levels of consumer debt ever recorded, we as individuals are part of the problem too. This is the reason why the Fed, the BoE and the related government administrations are doing everything in their power to avoid deflation – to the extent that they are even willing to risk severe inflation and a currency devaluation. As a society, we have corned ourselves with debt and are now reliant on inflation of both consumer prices and asset prices to keep our asymmetric, imbalanced system afloat. This is why extreme monetary policy is being pursued – deflation is simply not an option for a society riddled with a paralyzing debt addiction.
Macro Data to Watch:
- CPI out in South Korea
- Hong Kong Retail Sales
- US ISM numbers
Markets
October is history and November is here. Really there are only 6 trading weeks left in the year, as we all know the last two weeks of the year is basically a non-event for trading volumes. Did the year really go that quickly?
Wow, the US stock markets down big on Wednesday, then they reversed all their losses and spiked on Thursday and finally, on Friday, the last day of the month, they got hammered even lower than Wednesday lows – now that’s some volatility! CIT filed for bankruptcy and then indices were led lower by the banking sector (BoA down 7%, JPM down nearly 6%) but the sell-off seemed to feed into even more industrial companies like Siemens and resource stocks.
The next couple of days will be important because we need to see if this sell-off is for real of whether it was just profit-taking into the month-end for investors.
Volatility indices, a measure of uncertainty, hit their highest level in 4 months. Those who bought volatility positions when the VIX was in the low 20’s are probably looking at some attractive marks for their positions now!
Global Stocks to Watch:
- Banks – what are the follow thru effects of CIT bankruptcy. Britain announces that it is to break up RBS and Lloyds which will likely result in three new retail banks by 2013. How will this be received by shareholders?
- Earnings:
- Suzuki
- RyanAir
- AngloGold Ashanti
- Loews
- Ford
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