Doom, gloom or boom? (Part 2)

2. Is the US moribund?

Despite the long term demise of the US (in relative terms – not to talk about Europe that is in a worse situation), the leash effect of the country on the word economy and markets is still present.

We are told by Nouriel Roubini , the IMF (note: with its 2,500+ economists it went from “it will be ok” in 2007 to “oh! My God!” 2 months ago – a useless organization that found a new “raison d’être” after the G20 summit in London) and some other that, depending on sources, the finance industry has USD1.3 – 2.5 trillion of forthcoming losses to absorb in addition to the $1 trillion that already hit their balance sheets, due to a near zero GDP growth, a continuing deteriorating real estate market (residential and commercial, the latter having more bad surprises to come with many shopping mall in bad shape for example and too many office space available – have a look at Manhattan -, as well as an increased delinquency for credit cards). That may be true or probable (making the banking sector insolvent at least in the US), I do not know; what I know is that helicopter Bernanke and pilot Tim will throw whatever money is necessary to avoid a collapse, even at the price of high inflation in the years to come, despite all the rhetoric of denial. Next year you get Senate and US House of Representatives elections, so do not expect any tightening (beyond a token one) for a good 12 months.

Debt and deficits are however a real problem. I posted a must see video on the sheer size of the problem the US is facing. Obama, Geithner, Bernanke and the lot are well aware of this and talk about it, but no real measures are taken to tackle it. The Chinese are becoming impatient but have no real alternative (but buying real assets, like natural resources; the West will, with reason, resist it however – see Rio Tinto as the most recent example – beyond Africa, the Chinese eye Australian and Canadian resources); it will be interesting to follow the results of Obama's forthcoming trip to China.

The latest revised deficit projection (May) brings the expected US budget deficit to $1.84 trillion (4 times the previous year), from a February projection of $1.75 trillion. For the 2010 fiscal year, the new estimate is $1.26 trillion, up from $1.17 trillion. Since optimism usually reigns in the blind kingdom of politics, just round the numbers to $2 trillion and $1.5 to get closer to the truth. On the official numbers, this represents a shortfall of 12.9% of GDP for 2009 and 8.5% for 2010.

We are back to the end of World War II! In February, in his 10-year budget outline, Obama projected the US would fall back just below the 3% level in the last months of his term, in the 2013 fiscal year: by “chance”? Who can believe a politician making such an assumption at time of his re-election time?

Annual deficits would never dip below $500 billion and would total $7.1 trillion over 2010-2019. And those dismal figures rely on economic projections that are significantly more optimistic (1.2% decline in GDP in 2009 and a 3.2% growth rate for 2010) than those forecast by private sector economists and the Congressional Budget Office.
And do not forget the +/- 41 trillions more in Social Security, Medicare and Medicaid obligations as baby boomers retire (If significant reforms are not undertaken, benefits under entitlement programs will exceed government income by over $40 trillion over the next 75 years according to the Governement Accountability Office).This would cause debt ratios relative to GDP to double by 2040 and double again by 2060, reaching 600 percent by 2080). Some argue that the total US Government current and future liabilities amount today to an astonishing $65.5 trillion and counting. Whatever the number, it is huge, enormous, unthinkable.

This leads to a ballooning debt standing at $11.4 trillion early June due to increase to $20 trillion in 2015.

Consequences are threefold:

• Issuance of Government debt will be huge during 2008-2009 fiscal year [link to part 1]

• The yield curve is steepening very quickly over the past few weeks (the difference between 2 and 10 year Treasury notes has reached 2.75% surpassing the previous record of 2.74 % set on Aug. 13, 2003).

• Either(1) markets anticipate a recovery, or (2) anticipate a quick deterioration of the US fiscal outlook or (3) Chinese are refocusing their portfolio on short dated maturities or (4) investors anticipate the huge increase in supply. It is probably a combination of the four factors, but I would put a 90% probability on the latest three that are linked anyway. The consequence would be for the FED to buy more US Treasuries to keep long rate down in order to limit/stop any hike in mortgage rates.
  

• Increase taxes, increase inflation or a combination of the two, leading to lower standard of living of American citizens and a continued debasing of the USD.
  

Whether the US will be moribund and in a secular decline will depend on policies adopted to fix the debt/deficit problem. On sure thing, the American people will have to pay for having lived on steroid for too long; using the $ dollar devaluation tool to have other countries paying for the US financial and economic sins will not longer work with foreign savings needed more than ever to pay for the US historical deficits and debt burden.

The leash effect of the US economy will diminish over time. During the current crisis, it is the Chinese market that led the rally: for investments, look at East and South not West.

For the US, gloom, not yet doom.

In part 3 , I will review one of my favorite investment theme: commodities.

Doom, gloom or boom? (Part 1)

1. Where are we?

GM is dead after several years of agony and Chrysler is Italian. Ford is the only surviving automaker (pending what the new GM will become).

Citicorp and GM are no longer constituents of the Dow Jones.

This must look like a revolution for our American friends.

Since its low on March 9, equity markets have sharply rallied, with the financial sector leading the charge. The MSCI world index is up 47% and emerging markets display an even better performance: +64% for the MSCI emerging markets index (interestingly, the low was posted in October and in March the low was a couple of days earlier than in developed countries)

In the meantime, the USD index has rapidly fallen at -14%. The safe haven status of the USD (which I have difficulties to see) has disappeared as fast as the perceived meltdown has receded.

The commodity and energy complex has also bottomed out, posting steep increases:



Interest rates are on the increase and artificially low yielding government debt is the last bubble (the mother of all bubbles?) to explode.



10 yr US Treasuries yield increased over 80% (or 101 basis points) from 2.05% at the end of 2008 to 3.06% on June 2. And this move applies to all government debt around the world, to a lesser magnitude however (30%-35% in the UK, Japan, Canada and somewhat less in the eurozone – from 7% for Italy to 28% for Germany).

This sharp increase is due to (1) to the receding market fear that benefited the US Treasuries and (2) investors demanding more remuneration to compensate for their perceived risk of holding US Treasuries.

At the end of April 2009 the total marketable US Treasuries was $5.8 trillion (ex TIPS). In 2008, the flight to safety helped US debt to rally 14%. We are now at juncture where the US:

• is perceived to have its economy bottoming out
• has huge fiscal deficits to finance ($1.85 trillion in 2009 and $1.38 in 2010 projected according to the Congressional Budget Office)
• needs to raise $3.25 trillion in 2009 (less than $1 trillion in 2008) according to Goldman Sachs
• faces the largest foreign buyer, China ($ 768 billion invested), getting nervous about its ability to control the situation and reign in fiscal deficits
• sow the seeds of inflation with its 12. 8 trillions of government and Fed spending and commitment to unfreeze the credit market
  

This year, the Treasuries have lost 5.1% in value i.e. $295 billion and we are jut at the beginning of a long, very long downward trail; the bull market for treasuries lasted 28 years (thank you Mr. Volker). The bear market is just starting. Assuming a loss equivalent to 18 % 2008 gains spread over 2 years (quite a conservative assumption) losses will reach more than $1 trillion; bond investors have a good reason to be nervous...

Still gloom.

The next article will review whether the US is moribund.