Demon Debt

It may appear a little rich for someone from a bank to write about debt concerns given that borrowing is a key part of the business. However, this article refers to the ballooning of easy money and debt creation in the English-speaking world, which may well mark the beginning of the end of America’s Superpower status. Even before 9/11, the United States was already heading for a recession following the bursting of the technology bubble. However, the terrorist attack created a mood of no surrender in which a slowdown was politically not an option and was deemed to be un-American.

There then followed three years of incredible stimulus to the economy through the use of ultra low interest rates, tax cuts and increased government spending. As ever, the road to Hell is lined with good intentions (hence the title) and the Law of unintended consequences has never been so apparent.

The attempt to stave off recession at any cost has created plenty of mini-bubbles in the economy such as those seen in property, shares and bonds. One symptom of an overbought condition is the very low level of yields on assets relative to inflation. This has been driven by too much debt-inspired money sloshing around the economy. Interestingly, in spite of the surge of liquidity in the US financial system, this has failed to push the stock market back to anything like its previous levels and is a sign that all is not well. Although equities have rallied nicely since 2003, even a brief look at long term charts will show that mainstream US markets have failed to regain levels which were first breached in 1998.

The indulgence in debt closely mimics the use of drugs by an addict. At first, the addict is in control and then steadily the drug begins to rule their life with greater doses required to achieve the same effect. Like any addiction, the longer it lasts; the worse is the torturous effect cold turkey effect. We only have to look at the Japanese example where the crazy lending of the 1980s saddled the economy with a millstone of debt. In a self-fulfilling inflationary spiral, the rise in Japanese collateral values was closely followed by further borrowing against those assets. One thing we know about assets is that they can easily fall in value while debt has a nasty habit of constancy when the inevitable downturn comes along. In 2004 the burned-out US consumer was encouraged to switch from stable long-term borrowing rates to the far more volatile short term rates known as ARMs or adjustable rate mortgages.

Though not openly discussed at the time, they appear to have been promoted to free-up consumer cash flows in order to keep the property pot bubbling. This encouragement to switch came just before US interest rates rose from a 50-year low of 1% to a level of 4 ½% in early 2006 leaving these badly-led borrowers to undergo severe cash flow difficulties. While the ex-Chairman of the US Federal Reserve retired in February 2006, many of his fellow citizens will not have the same luxury. He has presided over one of the biggest debt explosions ever, such that many Americans will have to work to their dying day just to pay off the mortgage. Since the beginning of the new millennia, George W. Bush’s Administration has created more debt than all the previous presidents combined since George Washington.

In previous economic cycles governments have quite rightly intervened in a downturn to stave off a Depression. However, the American cupboard is now bare as the spending has already happened during the boom times. This attempt to avoid any form of recession will have serious repercussions in future. Neither the government nor the public have any savings to act as a buffer in the event of a slowdown. There is an assumption that once consumers have spent their very last (borrowed) dollar then miraculously, the multinational cash-rich companies will come and fill the spending void to keep the economy bubbling away. These organisations are not charities, nor are they the 7th Cavalry coming over the hill to save the damsel in distress.

Corporations have instead dedicated themselves to reducing debt and outsourcing labour in the recent period of low interest rates. This sensible behaviour is exactly what logic would dictate i.e. when interest rates are low we should use the extra cash to reduce debts and when interest rates are at their peak we should be borrowing to snap up all those bargains that come along at the height of a recession. However, as consumers we are mere human beings who buy when prices peak and sell when prices trough. This applies to all kinds of assets and investments.

The Administration is now hemmed into a position where rising interest rates will cause a slump as the cost of holding debt goes up. The only alternative is to allow inflation to take a hold and burn off the massive government debt burden which is exactly what happened during the Vietnam War era. Either way, there is no comfortable middle ground. We will either have inflation which is bad for savers or deflation which will cripple the economy. As more and more central banks move away from holding US$ assets in their reserves, then a dollar devaluation is also becoming more likely. The end game of this scenario will be a round of international devaluations as rival trading blocs seek to stay competitive. This in turn will lead to a reversal of globalisation, greater trade tariffs and a move towards isolationism as countries try to minimise competition so as to reduce domestic unemployment. The other result of economic turmoil is a marked shift in politics from a crowded centre to the extremes of right and left. We have plenty of examples of this over hundreds of years to make the prospect of military conflict a reality in the years to come.

Just as the aligning planets were seen as a portent of doom in Greek Mythology, we now see a series of events for 2006 that paint a negative picture. First, the handover of the Federal Reserve chairmanship is often followed by a period of falling stock markets once the honeymoon period is over. Second, the US consumer and government are so sodden with debt and liabilities that any significant rise in interest rates will topple the property market which is underpinning the entire economy. Finally, the pressure on China to revalue their currency may well be the final push that sends the dollar into devaluation mode. This is because they will no longer be under any obligation to buy the mass produced debt of the US government, in the form Treasury bonds. Instead of exporting deflation to the USA, strengthening Asian currencies will mean that inflation is imported instead, given that so many goods are made there. A recent Federal Reserve announcement explained that they will no longer publish M3 money supply data; a figure that is scrutinised constantly by their European counterparts at the ECB. This is a very clever move because while the Fed appears to be conservative by raising interest rates, the opposite would appear to be the case given that they are swamping the economy with printed money below the surface. Some market participants understand that these factors are inflationary. This is why the gold price has broken above and beyond the $500 level and US bond yields are rising. It would also appear that gold is emerging as a currency in its own right because it is no longer a hostage to the fortune of the dollar. Gold should be looked on as an insurance policy for one’s paper assets: it should not be traded but left well alone.

From an investor’s point of view, we should make hay from the dollar’s decline as Gold and commodity prices surge. However, we should be looking to reduce our risk profile in the form of overall equity exposure. For bonds, top quality names with minimal risk of default should be chosen while hedge funds should only be used where the level of gearing is transparent and conservative. As borrowing costs rise, the fuel supply of many hedge funds will dry up at a time when investment risk is rising. Given that their number and value has surged in recent years you do not want to be heading for the exit when they scale back borrowing and risk. In the survival of the fittest, you will be trampled in the stampede out of risky assets should you choose to stay invested. In summary we should make no assumptions about the well-being of our finances or financial markets, especially where they involve a large dollop of debt. Most major recessions since the dawn of the industrial revolution are heralded by a similar theme of a debt bubble followed by a surge in commodity prices, usually during a War. Finally, mention was made in the first paragraph about an end to America’s Superpower status. This comes from the very simple premise that a country that consumes and goes into debt will eventually be overtaken by countries that manufacture and build up savings. It appears that the so-called BRIC alliance (Brazil, Russia, India and China) are doing just this so we may well be witnessing the start of a shift in polarity of world power. It just seems such a pity that for the sake of avoiding one recession, America is likely to lose its hundred year dominance which for the most part has been a force for unity and good.

Toby Birch
March 2006