US Debt Situation, Investment and More

Recently, I have been harping on the vulnerability of the UK currency to a sharp decline or even collapse. But what about the US? Isn't the US vulnerable to some of the same issues facing the UK? Indeed this may very well be, although I think that there are two major differences. One is the the US holds the world's reserve currency and can therefore, pretty much write our own ticket. Secondly, the US does not have debt levels of the UK, although they may be fast approaching those of our English speaking cousins.

According the same source used for the estimate of 396% external debt/GDP the US ratio is only about 100%. Good news! Now, I believe that the total is higher, especially due to FRE/FNM bailouts, AIG bailout, Citi and BAC bailouts and such recent "financial innovations" which have undoubtably increased total indebtedness, albeit with much of it "off the balance sheet" and not accurately and forthrightly disclosed, thus the "Audit the Fed" movement, which I whole-heartedly support. Reasonalby, the debt/GDP ratio is probably 50-100% higher, but even at double the level, 200% would be relatively good compared to other Western financial economies, which have levels of debt more similar to Iceland than ours. For these reasons, I believe that it will be a few more years before we have to pay the piper. But when we do, it will be painful. The graph below may indicate why.


Not surprisingly, the net investment position of the US has been declining for twenty years. And it has really been accelerating for the last ten! We have almost $4T negative net equity. In other words, others own more of us than we do of them. So when the time comes to get paid, there will likely be some unhappy international creditors looking to collect from the US.


The SP 500 has had a run lately, but I wanted to look at the longer term picture for a moment.
The attached chart of the Quarterly SP500, shows the last 50 years. This shows a double bottom around the 700 level on the S&P, both this year and 2002. This has a similar pattern to the 74 bottom in the market. But are we in a similar position today? From the chart it would appear so, but considering the debt structure today in America, this may not be the case. In other words, we still had the borrowing capacity to leverage up some more and keep the system expanding back in the '70's. I am not so sure that we are in that position today. So it is no wonder why many are worried about inflation given the similarities with that decade, but history and the markets do not repeat so obviously. A more bearish possibility exists. That is one which views the current rally as just that: a rally in a bear market. And given the size of the boom the size of the bust may be accordingly large, resulting in a bottom on the S&P 500 around 300, or even as low as 100. More detailed analysis will be forthcoming in the weeks ahead, but to start the dialog here is a raw chart of the last 50 years of quarterly action in the S&P 500.

More Pounding Ahead

Above is the weekly action of the British Pound. There is some short term support just below the area we are in so I would expect some higher bounces off these levels in the next few weeks.


On the daily chart, it appears that we may be in for a bit of back and forth as it bounces around between the 1.55 and 1.64 levels. I am looking for any rallies to sell. A solid break below 1.54 would mean global trouble is imminent. I don't expect this dead ahead, but believe that this may take a few months to unfold, although it is best to be prepared and limit any exposure to British stocks, gilts or the economy immediately. There is room for a rally to the 1.67 - 1.70 area, but I do not expect to see it. If it occurs over the next few weeks, it could be the selling opportunity of 2010.



I believe that the British Pound is the next accident waiting to happen. There is a possibility that one of the Scandinavian currencies could fall first, but I am not sure that would have that serious an impact. There are Eastern European countries, like Poland, Hungary, Ukraine, Baltic states, etc. that could also fail first. If so, those would likely feedback to affect the Swiss Franc or Euro. While these possibilities should not be discounted, I am betting that the Pound will be the major currency that gets hit first.

Pound in for a Pounding?

For the last few years there has been a lot of hand wringing about the US Dollar. "The USD is a flawed currency", "we are printing money as fast as we can", "the Fed is monetizing the debt" and "Helicopter Ben has been working overtime lately" have been some popular sentiments toward the US Dollar of late. I don't disagree with these comments, but I don't think that the USD can be viewed in a vacuum since we live in a world of fiat currencies. So the correct question is what is the best currency? My answer: "I'll be darned if I know. They are all pretty bad, with the possible exception of the NZD, maybe... And that is not a major currency." So then the next question is which is the worst. Here I have a stronger opinion. The British Pound is probably the weakest major currency at the moment. Even though the British are a relatively small country with a second-rate economy, they still exert a significant influence in financial circles. Largely, because of their past position as a reserve currency, their relative wealth and experience in finance. But that is all about to change. As mentioned in a earlier posting, the UK has the highest debt/GDP ratio in the developed world. If it wasn't for Zimbabwe, it might win that dubious honor for the entire world.

What will be the catalyst which brings down the pound? I don't know. But I believe that fundamentally, the UK is in the same position Iceland was in about 12 months ago. Technically, the chart of the Pound shows the longer term downtrend is about to exert itself after a significant rally. See for yourself.



The Point and Figure chart above clearly indicates that a potential reversal is at hand. A break below the 1.60 level would confirm.



The weekly chart shows that momentum (upper graph on chart) is turning negative. A break of 160 would likely lead to support at 1.55, with a break of that level leaving the next support at 1.36. If that level was broken, all bets would be off. But going out on a limb, 1.10 is a reasonable guess. In a crisis environment, it could even break dollar parity. With the debt load so astounding in Britain's banks, I think a crisis is likely.

This would likely start a European conflagration, where either the Swiss Franc or the Euro would be attacked after the Pound fell. Technically, the Euro looks more vulnerable, but fundamentally the Swiss also have a huge exposure to bad loans in Eastern Europe. Also, the French and the Germans still have a large capacity to support the Euro. But by no means is it a sure thing that they would feel it necessary to support their profligate neighbors. Also, certain members like Italy have already made noises about wanting to abandon the Euro due to the stringency it imposes on their economic policies. Same thing for Spain with an unemployment rate of 18.5% and GDP likely shrinking over 4% in 2009, their is a large incentive to devalue the local currency. Of course they can't, since they are committed to the Euro.

$100 Billion in counterfeit bonds

Spain struggles with common currency

As the above article points out, if they pulled out of the Euro, Spain would most likely have to default on its debt, since it is denominated in Euros. But this is what Great Britain did in the 30's and also what Argentina did only a few years ago. And in both cases, after a few bad months these economies started to stabilize. At some point, faced with watching their economies sink nearly 5% a year with unemployment at or above 20%, default will seem like a better option. The ironic part is that these two countries have relatively low debt loads, at least compared with their European neighbors. So what would this mean for the rest of Europe? At some point, it will be every country for themselves. And that will be the end of the Euro. And I believe that we are about to witness the beginning of the end with the failure of the British Pound in the months ahead, probably in the first half of 2010, but assuredly by the end of 2010.

On a final note for the Pound, the short term action may produce a bounce as the daily chart has a significant gap at the 163.5 level. Filling this gap before heading lower may serve to confound as many people as possible.

So what about the dollar then? Bob Prechter recently stated that only 3% of advisors are bullish on the USD. This was similar sentiment to the bottom of the US stock market in March. The weekly chart looks ugly, but then things always look bleakest at the bottom. I am bullish on the USD. It may be a flawed currency. But the competition may have even bigger problems.

Monaco Credit Crisis

So you are wondering "Who cares about Monaco?" and what does this have to do with the economy or financial markets? I bring it up because according to Wikipedia, Monaco has the highest debt to GDP ratio in the world. With a GDP of $1 billion and external debt of $18 billion, this is an astounding figure, higher than even Zimbabwe, which has external debt of only at 220% of GDP (probably because no one is silly enough to loan them money). Now I know that these numbers are unreliable, like much of the information on Wikipedia. And I don't think that if I told you that these figures are actually taken from the CIA World Factbook that you should feel any more confident in the accuracy of these numbers, maybe less so. The World Factbook even states that their figures are rough estimates. Even if both of the figures were off by 100%, that would still paint a bad picture with debt/GDP ration of over 400%. I don't actually think that there is going to be a default on Monaco's debt anytime soon, but it does serve to illustrate some interesting points.

First, some of the oldest and most wealthy states in the world are grossly overleveraged. The debt/GDP ratios of some of the most stable, civilized countries in the world far exceed 100%. Ireland leads the list at 960%, followed by Switzerland at 441%, the UK at 375%, Belgium 349% (a staggering $1.3 T for a small country), the Netherlands 353% (an astounding $2.2T), Denmark 242%, Austria 233%, France 211%, Germany 160% and finally the US at an almost respectable 95% (but gaining rapidly).

Secondly, the economic model of Monaco (if it can be called that) of no income tax and revenue generated by tourism and gambling actually seems to fit the modern economy pretty well. The UK economy is 75% services! The Brits produce some oil and gas (and this is now declining) and tea and scones to generate some cash and the rest of it is exchanged among themselves. Well not really just themselves, but actually the rest of the world, since London is still an important financial centre (as they would spell it). But probably not for long. The US economy is 70% dependent upon the consumer. These are not healthy numbers.

The $13T of external debt the US faces is staggering, but we are still a highly productive people, with companies like Intel, Microsoft, Apple, Cisco, Amgen, Coke and more which produce goods that people all over the world need and want. Of course, that doesn't mean that they won't buy less of them or that they can't find substitues. They actually are with AMD, Linux, Samsung and others providing fierce competition. How much longer before Chinese companies learn to duplicate advanced American technologies? Probably at least a decade or two. So we had better get our house in order by then. But what about the more immediate implications of these debt levels?

It seems unlikely that Britain will be able to maintain its level of debt for much longer for even at an extremely modest level of 3%, the service cost would amount to 11% of GDP! This doesn't account for the assets that were purchased with this debt, but simple arithmetic would imply that these assets would need to provide an income of 11%, just to keep British GDP stagnant. What if the value of these assets dropped 13% or so? That would deliver a hit of 50% against British GDP! It is no wonder that central bankers the world over are scrambling to keep assets prices inflating. With this kind of leverage on such a massive scale, even modest single digit percentage drops in asset values can have monstrous consequences. In Britain's case, there most assuredly will be massive negative consequences. Because their external debt is approximately 1/4 of the entire worlds outstanding debt, it will spill over and affect virtually every part of the world. The countries mentioned above account for 80% of the $54T world total. So they will take the biggest hit. Maybe if everyone cooperates fully, the world can muddle through, but it seems highly unlikely that such perfection can be achieved in human endeavor. It will only take a relatively small actor acting in its own self-interest to start a waterfall of financial destruction the world has never seen before. China and Japan are not big enough to stop it. Besides they have their own problems. With actual costs of carrying this debt likely above 5%, it does not seem plausible that what is basically a global Ponzi scheme can carry on much longer.

When it breaks, the British Pound will likely fall 30-50%. This will have a contagion effect which will make the credit crisis of 2008 look like a stiff breeze. Due to the high leverage of the other Eurozone countries, a rolling currency crisis could develop where the Swiss Franc drops after the Pound, then the Danish Kroner, then the Swedish Kronor, then possibly the Euro itself, leaving only the Yen and the US Dollar to face the storm. At that point, the entire global financial structure could unravel. Because after all, these are just bits and pieces of paper. The Chinese are buying Oil, Gold, Copper, Molybdenum, virtually any hard asset they can get their hands on. And the prices they are paying do not look attractive. But in the case of a global currency meltdown, prices in fiat paper currencies would become dangerously fluid, almost meaningless if confidence is lost. Because without confidence, then a piece of paper is just a piece of paper. And eventually all asset prices return to their true value. It doesn't matter whether it is called a Pound, Euro or a Dollar. Ultimately, a piece of paper is just a piece of paper.

Deflation anyone?

Is this what deflation looks like? It sure seems like Procter and Gamble is preparing for lower pricing power in the year ahead. Either they are making a big mistake or more likely, as one of the prime movers in consumer goods, they are getting ready for reality by adjusting to market forces. This chart doesn't imply that a bottom has been reached. Does it really make sense to bet on a V-shaped recovery?

To read the entire WSJ article, which includes such tidbits as "P&G also is testing Tide Basic, a version that costs about 20% less than regular Tide. Meanwhile, P&G plans to reposition Cheer as a value brand, cutting its price by about 13%." :

P&G Plots Course to Turn Lackluster Tide

Real Estate Downturn

Attached is a link to a fascinating graph posted at Mark Wadsworth's blog, comparing today's real estate downturn to that of 1989. The figures are from HBOS, a British banking outfit (I use the term banking very loosely here). Bottom line, we are in for about another two years of hard times. This agrees with a number of other measures. First, there is the approximate eight year cycle in real estate prices. Next, is the schedule for ARM resets, due to peak in 2011. And now this chart. All in all, we are nearing the top of this section of the roller coaster ride. Hold on! Because the next stretch is even rougher than the first!

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