Dancing Into the Abyss, Against All Reason

"Financial markets are not yet pricing in US over-indebtedness. If they did, the world would be heading towards a 'blood-red abyss'."

~ Professor Laurence J. Kotlikoff

Over the past few months, the economies of industrial nations have continued to shrink. The economic data is generally bleak at best. Yet, stock markets have continued shooting up higher. Hmmm.

It is interesting how against all reason – and despite the current fundamental and REAL economic facts – we have reached a new peak of positive investor sentiments.

As long as central bankers keep promising to keep intending to keep pushing that monetary accelerator, with that arguably simple and effective money multiplying toolkit of theirs, investors around the world remain optimistic. Even the fiscal austerity talks in America which have reached the front pages of the news have not made a difference. Possibly, they are taken for what they are – talks to no end. The general conclusion: We might as well keep dancing.

As I write this update, the latest news on US stock markets sounds something like this: US stocks rose, sending the Dow Jones Industrial Average to its highest level since 2007, as speculation the Federal Reserve will continue stimulus measures trumped concerns over US spending cuts and China's economy.

Facing Multiple and Problematic "Gaps"

From a big picture perspective, as we bravely and optimistically head into the spring of 2013, we face a variety of increasingly precarious "gaps":

Debt gap. In the Special Report I co-wrote in April of last year, on the " Implications of the Debt Crisis ," in the context of our Big Picture Review, the issues and possible economic scenarios were discussed in great depth. That report was right on target when we published it, and it is still very much valid, as it should be since it looks at the "big, i.e., long-term, picture." What has evolved since then is precisely what we described: More monetary inflation , more financial repression, more austerity, but not more growth. The fiscal gap – the growing financial obligations that are being transferred to future generations – has taken root and now grows on its upward trajectory, irrespective of all the austerity talks and the posturing.

In this context, it is important to realize that the official debt numbers published in Washington have little to do with the true present value of future obligations. In his interview with Notenstein Private Bank, Prof. Laurence Kotlikoff said it loud and clear: "The US is broke. It's not broke in 30 years or 15 years or 5 years. It's broke today. Moreover, it's in worse fiscal shape than any developed country, including Greece. You wouldn't know this by looking at the conventional measure of fiscal problems, namely a country's debt-to-GDP ratio. But by carefully choosing its fiscal labels, administrations and Congresses going back to Eisenhower have succeeded in keeping the vast majority of our country's fiscal obligations off the books."

"With the American public and global financial markets focused for decades almost exclusively on official debt, Uncle Sam has rung up an incredible set of off-the-book obligations. Based on the Congressional Budget Office's (CBO) most recent long-term fiscal projections, there is a USD 222 trillion gap separating all of Uncle Sam's projected future expenditures, including debt service, and all his projected future taxes."

Risk gap. In view of the gigantic debt gap, the logical reaction of worried investors would be to demand a risk premium on interest rates. However, while a growing number of financial experts and economists like Prof. Kotlikoff have pointed out the growing risk of fiscal and monetary imbalances – and the fragility of the global financial system overall – this has not yet been priced into markets.

Current interest rates – the price of lending government issued fiat currency – in no way reflects true credit risk. Central banks have gone all out to artificially suppress interest rates. The result is a significant and growing gap between the current "risk-free rate" and the "true price for risk" that would exist in a free market. In other words, long-term bond yields have not yet priced in the impending insolvency of America, the UK or Japan.

Why is that? The answer: It's how markets function. As long as Wall Street believes the soothing promises of Ben Bernanke and Mario Draghi , expansionary monetary policies will continue to keep financial markets afloat. As soon as official inflation rates or inflation expectations pick up, as soon as enough herds of investors look up and see the warning signs, possibly when they read Prof. Kotlikoff's interview, they will start dumping bonds. Interest rates will rise to the level of equilibrium. When that happens, the central bankers will again print money and buy Treasury debt to keep rates low.

This applies in particular to the US. Due to the dollar's reserve currency status, the US is still able to borrow easily in US dollars. One would expect investors to sell the dollar and seek shelter in other currencies, real assets, etc., but it currently isn't happening. In fact, based on the current circumstances and the perceived relative strength of the dollar, the Greenback may in fact be expected to rise in the short-term future.

However, at some point, the fiscal gap problems will be reflected in the financial markets. If politicians do not tackle the debt problem out of free will, market pressure will ultimately force the hand on them.

Birth gap. According to Jonathan V. Last, who wrote an excellent article in the Wall Street Journal , for more than three decades, Chinese women have been subjected to their country's brutal one-child policy. Those who try to have more children have been subjected to fines and forced abortions. Their houses have been razed and their husbands fired from their jobs. As a result, Chinese women have a fertility rate of 1.54.

In America, white, college-educated women – a good proxy for the middle class – have a fertility rate of 1.6. The rates are even lower in Japan and some European countries. The Western world has its very own one-child policy. And we have chosen it for ourselves.

Low-fertility societies don't innovate because their incentives for consumption tilt overwhelmingly toward health care. They don't invest aggressively because, with the average age skewing higher, capital shifts to preserving and extending life and then begins drawing down. They cannot sustain social-security programs because they don't have enough workers to pay for the retirees. They cannot project power because they lack the money to pay for defense and the military-age manpower to serve in their armed forces.

The demographics do not speak for economic growth rates that are comparable to the last 50 years. The statistics indicate stagnation or very low growth. So, while central banks around the world try to stimulate economic growth via monetary and fiscal expansion, the demographics are working against them.

Wealth gap. There is a growing gap between the "haves" and "have-nots" of the world. The middle class is shrinking. In America, as the Federal Reserve pumps more and more money into the financial system, that money has led to rising asset prices and financial gains for those able to benefit. However, it has not trickled down to the real brick-and-mortar economy. This wealth gap is growing in Europe, too. It results in growing social tensions, most easily and recently observed in Greece, France and Spain. It also leads to increased pressures to transfer wealth. Socialism is on the rise. Governments are increasingly intrusive, and voters support that trend in hopes of the state solving their problems.

Reality gap. The reality gap is the gap I find most amazing. We live in a world where information has become highly accessible. Yet, there appears to be a huge information and reality gap.

For instance, in regards to gold: The entire world seems to be pursuing a devaluation policy for their respective currencies. Japan, the UK, the euro zone...all the major currency areas have recently staged competitive currency devaluations and the headlines openly proclaim currency wars. Central banks are buying more and more gold. Yet Credit Suisse, Goldman Sachs , UBS, Morgan Stanley and the rest of the Wall Street gang are calling for the end of the gold bull market. As we head closer to the "blood-red abyss," as Prof. Kotlikoff calls it, the chances are that we will enter high- (if not hyper-) inflation territory. Gold should provide an excellent hedge in that situation.

While the general belief, at least according to most reports, appears to be that the EU economy is close to recovery, auto sales in Europe are down almost 15% in January from a year ago. They have slumped below the lows of 2009. As portrayed in the following figure, sovereign spreads (10yr sovereign spreads vs. German bunds) in peripheral Europe are rising again. That, too, does not support the recovery storyline.

Spreads in Spain and Italy – average 10yr spread to bunds

Political gap. Governments, politicians, administrators, bureaucrats – they increasingly rule the world. As they work toward more harmonization, more centralization, more unification, the gap between their intentions and actions grows apart from what the man on the street wants. Presumed democracies are becoming increasingly un-democratic.

This political gap was best portrayed by last week's elections in Italy. The world was quick to mock the Italians. The Economist 's cover story was titled "Send in the Clowns." In several German newspapers, it was questioned whether the Italians were "mature enough" to deserve a democracy. I was estranged by these comments. In fact, I considered the vote a strong democratic signal. The Italian people are no longer happy with their government, with their choice of politicians, with their leaders. They are no longer prepared to accept a puppet minister from Brussels, irrespective of Mr. Monti's technocrat qualities. They want to run their own show. Italy's vote was a clear slap in the face to the EU and all it stands for.

While we don't expect the Italian election to immediately trigger another Euro crisis, it clearly signals that debtor nations like Italy, Spain, France, et al. will not accept EU dictatorship. What we can expect in Europe, in this context, is a growing political gap between the bureaucrats in Brussels and the national governments, elected by national voters. This does not bode well for the Euro in the long term.

Short-Term Investment Implications

I generally don't like to give short-term investment advice in these updates. There are so many if's and/or but's and nuances of implementation that such advice might not be helpful. In fact, it might be counter-productive. However, I do want to point out that in order to make profits in the short term, you will unfortunately have to join the dance toward the abyss, at least for a little longer.

I am alerting you to the fact that there are considerable fundamental issues. Fundamentally, nothing has changed and the recovery story is, in my view, nothing but a fairytale. Therefore, the key point to remember for your investing is that you stay active and use prudent risk management measures. This is not a buy-and-hold-while-you-snooze kind of market.

Yes, I too expect things to go along nicely, well into the second quarter. Despite the above "precautionary notes," the immediate and short-term implications for investing are mixed and not at all pessimistic. There are a number of profit opportunities that deserve consideration. In the realm of "currency wars," we are witnessing a bit of a see-saw pattern between the USD, the Euro and the Yen – taking turns to the downside. Currently, the depreciation of the Yen offers itself to shorts. Equally, the Japanese stock market can be expected to rise further, which in combination with a Yen short makes for an interesting trade.

The "kick the can down the road" scenario has already gone on for a long time. And, it will potentially continue to go on for quite a while. Investment sentiment is very positive. Technically, there is still room for more upside movement in stocks. If the price patterns of the last two years have any significance this year, then we might expect more positive price moves to around May. And the brave amongst us are right to consider holding on. However, be sure to have the stops in place.