EXCESS GLOBAL DEBT IS STILL THE PROBLEM

By Comstock Partners:

The impact of the Greek debt crisis on the stock market does not come as a surprise to us.  It is one part of the chain of reaction from the excess global debt problem and the related “cycle of deflation” that we have been warning about since the late 1990s.   At that time we wrote about the large amount of debt being used to finance the dot-com boom that collapsed in the early 2000s.  From 2003 to 2007 we continually pointed out that the housing boom and related debt buildup sparked by the Fed’s extended low-interest rate policy would inevitably have a bad ending.

Since that time we have been insistent that without the reduction of both global and domestic debt any economic recovery would not be sustainable. However, rather than reducing overall debt, most nations, including the U.S., have shifted debt from private to sovereign hands.  These actions were virtually certain to result in sovereign debt problems, and these have now begun to show up in spades.  As usual the weaker entities have been hit first (Dubai and Greece) and the debts are now in the process of being transferred to the stronger nations.  The key problem is that the stronger nations have only limited capacity, at best, to take on a significant amount of additional debt, and they run the danger of being dragged down as well in a continuation of the chain reaction.  Without a major deleveraging of debt the economy cannot return to its historical long-term growth rate.  But the process of deleveraging will result in below-average growth with recurring recessions until the process of reducing debt to manageable levels is completed.  The process of deleveraging almost always results in deflation, and a series of “beggar thy neighbor” policies, although inflation can eventually follow as nations attempt to print money in an effort to avert defaulting on their debt. (Please see Comstock’s cycle of deflation chart below

The Greek debt problem, therefore, is not an isolated event, but part of a chain reaction in response to decades of debt expansion that must now be unwound.  As soon as the Dubai crisis emerged late last year we have seen it as just the first in a series of sovereign debt crises that would emerge over time.  Even if the EU and IMF together provide Greece with enough money to kick the problem down the road, they would have little ammunition left to bail out Portugal, Spain or any other nation that runs into trouble.

Since the late 1990s we have done numerous comments and special reports on the cycle of deflation.  The following is an excerpt from our latest one on Feb. 25, 2010:

“.due to the debt related problems many countries worldwide are struggling to help their own economies at the expense of their trading partners.  In the past this has been accomplished by debasing their currencies in order to export their goods and services.  Because of currency pegs and one currency used by 22 countries (Euro Zone), this means of debt relief is not as easily accomplished.  The next stage of the Cycle of Deflation is the much more onerous “beggar-thy-neighbor” policies in order to support the economies of debt burdened countries.  This is not good news and could have the same effect for the global economies as Smoot Hawley did (a bill in 1929 that became law in 1930 which raised the tariffs on the U.S’s. major trading partners).   The Therefore, the main problem of reducing the debt of major economies throughout the world is even more complicated and makes us even more convinced that the secular bear market that started in 2000 is still intact.”

Upon the emergence of the Dubai crisis we recognized it would be followed by other sovereign crises, and wrote the following on December 10, 2009″

“Another ominous development is the recent emergence of sovereign debt problems.  The revelation of Dubai World’s inability to pay its debts on time resulted in a one-day market drop that was soon easily dismissed as one-off event.  After the initial blithe dismissal of the emergence of subprime mortgage problems, the world should have learned that such events never occur in a vacuum.  After a world-wide debt binge based on the theory that assets can only rise in value, an unexpected severe decline in asset values leaves debtors with too little cash flow to service their debts.  It was therefore naïve to think that Dubai would be the only nation impacted, and, sure enough, the other shoes have started to fall.  Fitch lowered their rating on Greece to BBB and S&P followed with a change in Spain’s outlook to negative on its current AA+ rating.  The firm had already downgraded Portuguese bonds a few days earlier.  The distress in Greece, Portugal and Spain place the ECB in a tough position.  The central bank has to do what is best for all 16 member nations as a whole, and when they tighten monetary policy the stresses on the weak members gets even worse.  We would not be surprised to see other nations in debt trouble as well, both in the ECB and any where else on the globe.”

When the Greek crisis emerged we recognized the potential stock market impact, and issued the following comment on January 11, 2010:

“The Greek problem may end up having even more market impact than any of the above.  The Greek government’s fiscal deficit has reached 12.7% of GDP and Greek bonds have recently tumbled.  Since Greece is an EU member it cannot use an easy monetary policy to offset any dire economic consequences of cutting back its deficit, and any move by the EU to tighten its own monetary policy would drag Greece down with it.  Furthermore if Greece were to leave the EU in order to conduct its own policy, the EU and the Euro currency would be destroyed.  All in all there doesn’t appear to be any good options. The Greek problem has led to a flight to safety toward the dollar and away from the Euro and concurrently out of commodities.  In addition to Greece other EU members have serious fiscal problems as well.  The fiscal deficit-to-GDP ratio is 12.2% in Ireland, 9.6% in Spain, 6.7% in Portugal and 5.5% in Italy.  EU rules call for a maximum deficit of 3%, and it is difficult to see how this goal can be met without economic havoc that would spread globally.”

On February 4, 2010 we compared the emergence of the Greek crisis to the first indications of a problem at Bear Stearns:

“The emergence of the crisis is reminiscent of the first indications that Bear Stearns was facing financial difficulty, and could be the proverbial “canary in the coal mine” indicating the potential contagion to a slew of other sovereign nations.  Moreover, it’s an indication that the severe global debt problems we have been talking about for so long are still with us and getting worse rather than better.  (For more detail see our most recent special report, entitled “The Total Debt Relative to GDP Trumps Everything Else”.)  The lesson the world never seems to learn is that whenever and wherever we get an explosion of debt we also get a series of asset bubbles that are sure to implode.  When that happens assets disappear, but the debt remains and there is not enough income to service the interest payments or to pay off the debt at maturity”

On February 11, 2010 we related the Greek crisis to the overall global debt”

“The Greek fiscal crisis is just a symptom of world-wide credit problems that was signaled by the emergence of subprime loan disclosures as early as August 2006.  The importance of subprime lending was not recognized until much later, but nevertheless evolved into a continuing series of economic and financial crises that continue until this day.  The problem has now extended to sovereign debt, and, as usual, the weakest links are exposed first (Dubai and Greece) only to spread to stronger entities later.  Not far behind are Portugal and Spain, then perhaps Italy and Britain.  It’s not just a localized minor problem to be solved by some sleight-of-hand by the EU, but a debt crisis that could envelop the globe.”

On March 4, 2010 we related the sovereign debt problems to the stock market”

“Some may wonder why we continue to emphasize the global financial and economic problems and what this has to do with the stock market.  In our view this has everything to do with the stock market.  The entire rally has been based on the belief that we can undergo a V-shaped recovery and that modern governments just will not allow the kind of unraveling that has followed all other major credit crises.  However, governments can only try to halt the malaise by increasing their own debt and running up huge budget deficits that cannot be sustained.  In the U.S. we are already seeing the backlash as the public, while still demanding that the government somehow create more jobs, is also rebelling against the prospect of ever-increasing deficits.

“Therefore  if the market, as we believe, is discounting events that will not happen, the disappointment will be severe—and in a market increasingly dominated by trend players, the rush for the exits can be something to behold.”

Today, the impact of the Greek crisis on both the EU and the global financial system finally registered with the stock market.  Although the day’s action was apparently affected by mechanical problems, the market was already down sharply before the glitch.  After a dot-com bubble, a housing bubble and two 50% market declines in the same decade, it makes us wonder how many wake-up calls the market needs before it reacts.  Although there was once a time when stocks were able to discount the significance of events ahead of time, those days are long gone.  It reminds us of the old story about the mule who wouldn’t move until the farmer it hit it in the back a two-by-four. Although we’ll probably see a lot of wild swings in the days ahead, it is likely that a major market decline is now underway.