Debt Fuelled Deflationary Death Spiral - Part 1

I figure with a title like "Debt Fuelled Deflationary Death Spiral" there would have to be more than one entry over time hence the Part 1. As each days passes I become more entrenched in the belief that this market is going to break to new lows this year as the economy does not turn the corner in 2009 and expectations of a better second half of the year are not met. The back drop for the "Debt Fuelled Deflationary Death Spiral" is not new news. Western economies have been accumulating debt at a staggering pace for roughly two decades. One just has to look at personal savings rates to realize our balance sheets need work (remember in 2007 when savings went negative). The Asian economies, namely China, have been happy to export all things manufactured to the consuming nations. With its large current acccount surplus the Chinese bought US debt and kept interest rates low. Sort of a wonderful relationship ... until it stops working. This is where we are today. Oh and just for fun throw in the fact that the global financial system is being nationalized in one form or another and that the availability of credit has fallen to depths not seen since the 1929 Depression. I guess systemic risk is real.

I can't help but cringe at analysts, portfolio managers, strategists and economists alike as they talk about how we are through the worst part of the cycle and are looking through trough earnings to better times in the second half of 2009. Essentially what they are doing betting Western spending culture returns. I hate to burst another bubble but this isn't going to happen. From 2002 - 2007 home equity withdrawals accounted for approximately 70% of consumer spending. If consumer spending is 2/3 of GDP then these home equity withdrawals accounted for a full 50% of GDP growth during this period. How much stuff did we really need? Whatever happened to saving for a car, vacation, rental property etc. With house prices rising and credit flowing no one waited. Presto instant gratification. All is well as long as asset prices continue to rise. Remember leverage works both ways. So now you are left with the debt (due to the use of leverage at unprecedented levels) and deflating assets - houses and cars. Since the 3rd quarter of 2007 the US consumer's household net worth has contracted $13 trillion dollars or 20%. I believe we are still nowhere near the bottom in housing prices and if the markets break down again this year there is still much more pain to come.

Credit is tight might be the understatement of 2009. I had a meeting with a junior mining company today. They are literally 6 weeks away from there first gold pour and the project is on time and on budget. The CEO was literally at wits end about how difficult it is to deal with Shell to get the oil needed to run the mill. It is a cash based system. Pay first then you get your supplies. Not a year ago they had 30 days from delivery to pay. I must emphasize that this management team is not new. This is the seventh time they have brought a mine into production. They have no bad debts outstanding. They are sitting on about 7 million ounces of gold and have about a 94% completed facility that will produce 200,000 ounces of gold when production is fully ramped. Oh did I mention they are pouring gold in 6 weeks. Even the group managing operations is paid in advance. Unbelievable. How quickly things have changed. The rate of change going on with the deterioration of credit is amazing. I think this is where the "so-called experts" have missed to boat.

Recessions have to do with inventory cycles and are solved with monetary policy (cutting interest rates). Well since treasury bill yields are basically at zero I guess this hasn't worked so well. This is due to the necessity of the consumer to repair its balance sheet. Remember all the stuff we have pre-bought between 2002 - 2007. As we work through this we will most likely hear more rhetoric about depression. Who cares about the title, this is what will continue to happen: 1)deleveraging will become the new leveraging 2) we will actually want to pay off our debt 3) in order to deleverage and pay down debt we will continue to liquidate assets and 4) we will increase our savings rate to the long term average of 8%. This process cannot happen in a year or two. It takes time and lots of it. Seem excessive. I would argue not! Excesses in one direction ALWAYS lead to excesses in the opposite direction - the financial equivalent of Newton's law.

The above new world order is based on both fear and the reality of this new world. It is a world where unemployment hits double digits and bankruptcies (both personal and small business)explode higher. Just look at mall vacancies if you don't want to believe me. U6 unemployment is 13.5% and going higher. The argument I get here is that fiscal stimulus will come to the rescue. Not so fast. I agree it might slow the pace of the decline but it will not stop the decline. It is a plug figure to step in as personal consumption and investment vacates the building. As unemployment continues higher protectionist banter will surely not be far behind - don't be surprised. Wait a minute didn't we see this with Geithner complaining about renminbi manipulation last week. In the Wall Street Journal today the headline on banks was "Nationalization Gets a New, Serious Look". Oh no the US wouldn't stoop to nationalizing!!!! Oh yes they would, they will and they already have (at least in part with Citigroup, Bank of America and AIG to name a few). This is just starting. Please don't get fooled in here.

Ok enough doom and gloom. There are still lots of opportunities to make money out there. We will eventually discuss them. But for now I'm off to bed. Looking forward to watching my son at his hockey practise tomorrow. Taking the afternoon of to do that.