Worldwide Debt Crisis Unravels: Doomsday Scenario for the Markets

 |  Includes: DIA, SPY
by: Erik Wright

Long gone are the days when people would save all their cash to buy large purchases without using debt. By looking at the following chart from the BusinessInsider's "Chart of the Day", US household debt has evidently grown to frightening levels in comparison to median household income (click on images to enlarge).

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Over time, credit card use and heavy debt has become normalized in our culture. It is practically a drug to society and it seems that even the governments of major countries are addicts of this drug; like any drug, the consequences will be severe if it is not recognized and resolved.

It is not feasible to solve a drug abuse problem by giving a patient more drugs; therefore, it is not rational to solve a debt problem by offering a larger debt limit to use. The US government has now raised the debt ceiling 103 times since 1917, 8 times under George W. Bush alone.

The chart below portrays the increases; the debt chart is beginning to look like an exponential function, which does not bode well for the future, and the rate the debt is increasing.

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Chart 5, from the U.S. government's Accountability Office's Citizen's Guide to the 2008 Financial Report, tells quite a scary story.

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Entitlement spending, such as Medicaid, Medicare, and Social Security, as well as mandatory spending such as the interest on the national debt, are creating the problem. It is predicted that sometime between 2030 and 2040, this entitlement and mandatory spending will exceed government revenues. All discretionary spending, such as defense, law enforcement, education, and other spending, will require borrowing.

By 2060, total government expenditures are projected to be 45% of GDP, levels unseen since WWII. By 2080, expenditures could exceed 60% of GDP, more than 3 times predicted revenues.

The increase in borrowing will thus create much more interest costs making the government operations increasingly unsustainable and the ability to borrow from the public could become increasingly diminished. It also doesn't help that federal revenues have been dropping. This year, federal revenues are expected to drop to 14.8% of GDP. With the current US debt downgrade by Standard & Poors, interest payments could rise even more to reflect the riskier rating of US debt, making the future situation look even dimmer.

But the debt situation as we know it is not only affecting the US; many other countries are addicts of debt use. Currently the European debt worries are some of the largest debt concerns. It seems that countries in Europe are being sucked into this crisis one after the other. Starting with Greece, then Portugal and Ireland. Now even Italy and Spain, the third and fourth largest economies in the European Union, are being hit with debt problems.

The European countries have mostly benefited from a very socialist regimen, which has forced the government to overspend - on social benefits, pensions as well as bailouts - to keep their economies growing.

Although a 48-billion euro austerity package passed last month in hopes of getting the government on track to bring the budget into balance by 2014, Italy’s huge public debt has failed to calm market fears because the fear of such a large economy in Europe also having debt problems could potentially be devastating. The following graph demonstrates the high levels of debt to GDP in 2010 of some of the countries currently dealing with debt concerns.

It becomes quite frightening when a country's debt level is reaching or surpassing its GDP. The whole world is becoming increasingly more in debt. Global debt levels have increased by $24.6 trillion over the last decade, reaching 69% of worldwide GDP.

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We could potentially be on the crossroads of an imminent long term crisis where our debt-ridden society finally realizes and suffers the consequences of playing with fire and being in debt over their heads.

The first wake up call of this crisis was the subprime mortgage crisis, the main cause of the 2008-2009 recession. Society has become overcome by greed and living beyond its means. The mortgage crisis, mainly caused by the greed of individuals and investment banks, has taught society many lessons about over-leveraging but it has not put a stop to household borrowing and, most importantly, government borrowing.

We are now in a dilemma and a balancing act as governments, especially in the US, have to cut costs and spend within their means while still stimulating their economies to create jobs and GDP growth. Gary Shelling, one of the world's foremost economic forecasters and Forbes columnist, has predicted that we will be experiencing a no-growth decade:

The American economy is facing a huge shortfall in the 2011-2020 decade. We need real gross domestic product growth of at least 3.3% just to keep unemployment stable. But that's impossible, says Shilling; America will be lucky to get an average 2% real growth.

He further explains that the United States faces the possibility of 10 years of slow - even less than zero - growth. Plus high-stress and chronic unemployment. Plus accelerating global unrest, regional conflicts and increasing Pentagon budgets. He expresses that a 2012 recession is likely because much of the excesses and financial leverage built up in past decades, especially in the financial sector globally and among US consumers, remain to be worked off.

The markets are due for this pullback and emotions and fear are now driving this market. Investors and traders will take every news release to heart, creating a very volatile market. This decade will be a very tough one for equity markets - not only will this debt crisis have to work itself out, but baby boomers will be retiring and liquidating out very large portions of assets from the equity markets, dampening the markets further.

For the time being, the market downtrend seems to have started. The S&P 500 (SPY) and the Dow Jones (DIA) are all trading below their 50,100,and 200 day moving average. In the short term, markets are looking oversold but with the recent US downgrade market, emotions are likely to run high and markets may continue to plunge lower before bouncing slightly upwards. The S&P is currently sitting slightly above the next support line of 1190 (indicated below). If the markets fall past that level, analysts are expecting that a head and shoulders top pattern is expected to be realized with a target price of 1140.

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Although a no-growth decade seems quite far fetched, it is quite possible - the global situation is likely to get much worse unless something extremely drastic takes place.

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