In October 2008, we considered that the credit crunch is the solution, not the problem, or to be more specific, that the current, "Credit Crisis" is:
The source (the world's commercial banks) of the problem (massive and consistently understated inflation) correcting itself through market forces (banks limiting credit due to good old-fashioned concerns about the value of collateral and borrowers ability to repay).
Since then we've heard pundits explain how our free markets have failed, regulation was insufficient, and that 'speculators' threaten us all. I'll punt on the question of the regulatory regime and focus on how (if at all), market forces have failed and if so, how we're to go about 'fixing' the solution to our inflationary problem (I know, you say we don't have an inflationary problem anymore, but that's the point).
First, let's revisit the base case for today's market environment. In October we put forward some expectations:
- Long US Dollar (USDX/UUP) - As deflationary pressures continue.
- Long Volatility (VIX) - Until the global unwinding is complete.
- Short Commodities (NYSE:DBC) - As the economy dampens global demand and the purchase of these assets with borrowed funds slows.
- Long US Equities (NYSEARCA:SPY)/Short World Equities (VGTSX/VT) - As US companies outperform their global peers, enhanced by the stronger dollar and 'flight to quality' appeal.
Then, and now, these capture the underlying trend in the markets, rising 7.6% since then (nearly 23% annualized). Until the structural drivers of this trend change we can expect more of the same, but what would those structural changes look like - what is the fix for the solution?
First, let's briefly look at some charts that illustrate again the unreal growth in US consumer credit, juxtaposed against savings (from the NY Times Debt Trap series):
Here's a dramatic post from Reuters, courtesy of FT Alphaville, that shows how private sector debt has risen three times faster than the economy since 1975.
John Kemp notes,
This created a dangerous interdependence between GDP growth (which could only be sustained by massive borrowing and rapid increases in the volume of debt) and the debt stock (which could only be serviced if the economy continued its swift and uninterrupted expansion).
We're left with a "Balance Sheet Recession", and (again, courtesy of FT Alphaville), Nomura's economist Richard Koo draws comparisons with Japan's, "lost decade", concluding that in balance sheet recessions monetary policy is largely useless:
So stimulus is our fix for the solution - but certainly easier said than done if it is to be both politically palatable and efficient/effective/timely enough to boost GDP, facilitate the service of existing debt and establish a floor on asset prices.
Free markets haven't failed, they're correcting a dangerous and unsustainable debt driven inflation. They're doing so despite the strong political, commercial and central bank opposition and real human costs. Stimulus plans on the table may hold the answer to restoring real growth, but for now the underlying market trend continues, and we can continue to expect:
- US Dollar strength
- Panic Level Volatility
- Weak Commodities
- US Equities to outperform Global Equities
Disclosure: Long positions in DBC and VGTSX.