At A Crossroads, Facing Another Financial Abyss

by: Ramy Saadeh

The financial markets are on the brink of a cataclysmic spiral that could make the Greek crisis look like a walk in the park. Interestingly, markets still seem very hushed about the emerging risks ahead. Once the siren echo is heard it will escort fear, panic and major selloffs to become “the mother of all dreads.”

The trigger of the dreadful events could come as soon as the 23rd of November 2011 when the “Super Committee” is scheduled to set forth a plan to cut government spending by $1.2 Trillion over the next 10 years. The “Super Deal” is that no agreement has been reached yet and no plan will be delivered by the deadline. Quoting Jon Stewart in his show, the “Super Committee” did act on one thing “pushing forward with a bill to allow the sauce on pizza to be considered a vegetable in school lunches;” this is the closest thing they’ve reached to an agreement.

The amount of the US total public debt outstanding has breached $15 Trillions, to be more specific it reached $15,033,607,255,920.32. The height of a stack of 1,000,000,000,000 (one trillion) one dollar bills measures 67,866 miles. Stacking the US debt is equivalent to two times back and forth to the moon.

The US Debt to GDP ratio hit 98.9% and it’s still on its way up; a study lead by Carmen Reinhart and Kenneth Rogoff reviewing 200 years of economic data from 44 nations has reached a warning conclusion for the US: “Almost without exception, countries that are as highly indebted as the United States grow at sub-par rates.” When that ratio exceeds 90 percent, the nations' economies barely grow, and can even contract (for an average of -0.1%). Briefly, the US has reached a level where it has limited its ability to grow its way out of the debt problem, and can no longer continue debt-financing its growth.

With limited ability for the US to further boost growth, a failure of the “Super Committee” will only exacerbate the situation since the White House has agreed in August to forgo an automatic tax increase and spending cuts if no debt-reduction law is enacted; very likely the tax cuts enacted under George W. Bush will be allowed to expire. The consequences of those cuts and tax hikes would result in contraction of the GDP by 1.7 percent in 2012, according to JPMorgan chief U.S. economist Michael Feroli, razing the US growth into downturn.

A slump in the US is the last thing needed; the Euro-zone is already flirting with recession as stressed by the new head of the ECB Mario Draghi, “Europe might be entering Mild recession by year end.” We are witnessing a meltdown in Europe, and as long as no treaty changes for the role of the ECB comes to light, things will not get any better. The previous nibbling of the ECB to purchase the troubled countries' debt has only shown that the central bank’s actions were more toxic than tonic for the financial markets.

A deeper look in the Euro zone problems is more alarming:

  • Italy is struggling under a serious yoke of external debt without the ability of rolling it over in the private market.
  • The EFSF had spent more than €100 Million buying up its own debt.
  • Until lately, an increase in Spanish and Italian yields coupled a decrease in German yields; but currently, a surge in the distressed countries' yields was coupled with stabilization in German yields, signaling a complete avoidance of EUR-denominated assets.
  • European banks (mainly the French ones) are becoming more hesitant to lend to each other, forcing the ECB to announce additional US dollar liquidity; this is quietly developing a liquidity crisis that could blow at any time. If French banks took a hit, the AAA rating of France will not be spared; consequently the whole EFSF and rescue efforts will be deserted.

Conclusion: We have an environment of panic and fear, and if the prevailing problems came to light, things would deteriorate dramatically. The big sell off and market turmoil triggered by a political impasse in August is an example. In this respect, we find ourselves at a crossroads; either the US congress reaches an agreement and EU nations agree upon an alternative treaty that gives the ECB more autonomy and power, or we delve back into another financial abyss, only this time deeper.

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