Insights from the Street: A New Hope

French President Nicolas Sarkozy spoke at a press conference just days after Standard & Poor's stripped
his nation of its AAA-rating, which also resulted in a ratings cut for the European Financial Stability Facility

"We enter 2012 with a great deal of hope, but our hopes are not for more bailouts, or money printing, or any of the myriad policies that investors seem to hope will save bad investments and sustain elevated valuations. Instead, our hope is that in 2012, the market will finally "clear," in the sense that bad debt around the world will be recognized as bad and restructured; that overleveraged financials will be taken into receivership instead of forcing austerity on every corner of the global economy in order to make them flush again; that rates of return will rise enough to compensate and encourage saving – and high enough to encourage borrowers and other users of capital to allocate the funds productively. Of course, in order to restructure bad debt, someone has to accept a loss. In order for rates of return to rise, valuations must decline. In short, our hope is for events that will unchain the global economy from an irresponsible past and open the gates toward a prosperous future. Maybe that is too hopeful, but we are not entirely convinced that bailouts and 'big bazooka' will be as easily procured in the year ahead as a confused public has allowed in recent years."

– John P. Hussman, Ph.D. (hussmanfunds.com)

I read the article above a few days ago and it occurred to me that it really captured my thoughts regarding the year(s) ahead. Unfortunately, I have a hard time believing that some of the past poor decisions made by many won’t rear their ugly heads in the coming months. I have several points that I’d like to cover, so let’s dive right in. Warning- this Insights is a bit longer than usual. I think it is rather important though; so bear with me…

First off, many countries are now facing a couple of choices, which differ according to their own specifics, but all revolve around the necessity to deleverage, in both the private and public sectors. Theoretically, when a financial system ceases to find outlets for the credit it “creates”, then it delevers. This should be understood from a credit and yield risk point of view. When both yield and credit are at risk, the mix can be toxic. The behavior of savers and investors in certain struggling European countries emphasizes the concept, and a recent example would be the meltdown of MF Global. If a saver/investor has money on deposit with a bank/investment broker that not only is perceived to be at risk, but also returns nothing due to the current interest rate environment, then why would they maintain the deposit? If and when this occurs, delevering takes place throughout the system, as opposed to the credit expansion that has largely fueled our economic growth since the end of the gold standard in 1971.

Unfortunately, many developed economies have not, in fact, de-levered since 2008. Certain portions of them – yes: U.S. and European households; southern peripheral Euroland countries. Credit as a whole, however, has not changed very much. This is due to massive quantitative easings (QEs) in the U.S., the U.K., and Japan. Additionally, the issues simmering in Europe will generate another huge QE tidal wave (cleverly disguised as a LTRO – 3-year long term refinancing operation). This EU circus act is causing financial “innovation” which results in QE by any definition and very close to Ponzi by another. ¹

The end of a 40-year global credit expansion is a shift of gigantic global economic proportions, unlike anything we have seen for close to 80 years.² While each country must carefully make their own choices, the consequences of said choices will have a substantially larger effect upon the world. While globalization has been a noble aspiration in past years, now our interconnectedness has landed us in a world where isolating the impact of a “problem-child” country is no longer possible (and unfortunately, there are numerous problem-children). Sadly, the need for global cooperation is vital at a time when politicians will be increasingly restrained by the exigency of their local problems and palpable voter angst.

So, the essential question is whether the efforts of the Fed, Bank of England, and European Central Bank will work. Can they bolster animal spirits in the face of significant sovereign credit concerns and interest rates at the zero-bound? Will the credit-engine-that-could continue on or are we in the final chapters? We shall see. It seems prudent to me that an investor should hedge his/her bets until the outcome becomes more obvious.

I realize that the view above is somewhat gloomy. Longer term however, I am much more in the bullish camp. Fortunately, history teaches us that that these ugly periods are finite. After some pruning, new growth and prosperity “buds” can begin to surface. While we could have some stressful times ahead, I think the trick for individuals will be to make the best possible choices, given the situation, with a vision towards the future when risk is no longer a four-letter word. At some point, smart, calculated risk will be embraced; not avoided like the plague. For countries, it will be advantageous to make the choices that will enable a new equilibrium. It will not be without pain, but the longer we wait; the more and more difficult the choices will be when they are made or forced upon us.

Your busy trying to figure it all out analyst,
Justin Deruy
justin@wallastreet.com

Monthly Riddle: My role is moderation. My goal is consistency. If I clash, I will flare up to an intolerable degree. What am I?

Last month’s riddle:  I am the center of gravity, and part of every victory. I am clearly seen in the middle of a river. Three are in love with me and I have three associates in vice. What am I?

Last month’s answer: The letter V.

P.S. – Congratulations to Mike Roe, the winner of last month’s riddle drawing! Good work, Mike! Keep the riddle answers, questions, and comments coming in…we really enjoy hearing from all of you! Another $25 gift card will be up for grabs this month. Good luck!

Citations.
1 - http://www.pimco.com/EN/Insights/Pages/Towards-the-Paranormal-Jan-2012.aspx [1/10/12]
2 - http://www.johnmauldin.com/frontlinethoughts/2012-a-year-of-choices [1/10/12]