Governments Playing International Whack-a-Mole With Global Economy

by: Thomas J. Feeney

The tenor of the market has changed with the tragic events unfolding in Japan over the past two weeks. Not surprisingly, incidents as horrific as the earthquake and tsunami have introduced fear into securities markets, as they ushered death and destruction into Japan. As I write, experts are wrestling with the probabilities regarding ultimate outcomes and consequences for the damaged nuclear facilities. Evaluating matters little understood by the general public, investors’ first reaction has been to reduce portfolio risk by selling assets of many types. Stocks declined by about 650 Dow points off the March 9 close. They have since recovered just over half of those points as markets rebounded from highly oversold short-term levels. Recent buying was stimulated by coordinated international efforts to aid Japan materially and financially. Investor confidence was additionally boosted by organized efforts to implement a no-fly zone over Libya and by new measures agreed to by European leaders for solving the eurozone debt crisis.

With the best and brightest in the nuclear field highly uncertain about the outcomes in Japan, investors are left guessing about how extensive the financial consequences may become both in Japan and, in sequence, among Japan’s trading partners. In the short run the uncertainty can’t be helpful, but estimates of the knock-on effects span a considerable range.

Whatever the result of this latest crisis, it has become increasingly clear that continued recovery in the global economy and world equity markets has become dependant on government intervention. Just two years ago the biggest government rescue program in history saved the United States from financial collapse and likely depression. Dubai was rescued by Abu Dhabi. Several peripheral European countries have escaped default through coordinated endeavors by the IMF, the EU and the ECB. At a time when the original quantitative easing was scheduled to be unwound, our Federal Reserve deemed it essential to implement a second massive salvage effort in the form of QE2. Now comes Japan and the coordinated effort by the G7 nations to stabilize an unstable situation. One gets the impression that it resembles a very serious game of international whack-a-mole.

For the past two years we have characterized U.S. investors’ dilemma as a matter of whether or not to trust that government will win its bet. Can it save the U.S. economy and, in turn, our equity market by throwing more money and debt at problems caused by excessive debt? Over the past year and a half we have witnessed government intervention as the solution of choice worldwide. It’s a high stakes game of poker, and each new hand sees the ante raised.

As has become tragically clear in the ongoing real estate collapse, the ability to withstand tough economic times diminishes markedly as leverage expands. Each new round of government intervention increases leverage in one form or another, thereby increasing risk. We are walking perilously close to a ledge with potentially catastrophic consequences for a miss-step. Whether governments and their central bankers can successfully lead us along the ledge is open to question. Their record through this century-to-date leaves me less than highly confident. Each investor has to evaluate his or her capacity to withstand a major financial collapse should excessively indebted countries, states, cities, institutions and individuals overwhelm the best rescue efforts of central planners. An inability to replace lost assets should prompt much greater liquidity and defensiveness than has been considered prudent over past decades.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.