This Time is Different

The Most Expensive Words in the English Language

Wishful thinking! Unfortunately this time is definitely not different. The business cycle will not be denied; it can be altered, it can be delayed, but it cannot be stopped. As in all cycles from recession to boom and back to recession, the excesses that become built up need to be resolved so the system can cleanse itself and recover. Inefficient industries and/or companies and mismanaged entities (public or private), and the accompanying debt will need to be re-structured or bankrupted. As mentioned in other articles, much of the global debt has been shifted from private debt to sovereign, federal, state, or municipal ledgers. Currently ultra-low, repressed, and manipulated interest rates allow for budgets to re-pay the interest carry, but certainly not the principal of global debt. New loans are created by central banks in a round robin of “borrowing to pay”. Eventually, the ultimate arbiter, the global currency and global bond market will demand either repayment in full or a much higher interest rate to justify increasing credit risk. This applies to even the most credit worthy stalwarts like Japan, the United Kingdom, Germany and the United States. Conservative investors may not appreciate the degree of real risk in the bond markets; I suggest even a small rate rise of just 1.0% could result in catastrophic losses as investors exit positions.

The current fiscal leadership including from the Federal Reserve, IMF, ECB, Bank of Japan and the rest of the G20 nations is attempting to liquidate the global banking system to inflate and hopefully grow the global economy. Fresh debt is added to the old debt and needy governments (Greece, Spain, Portugal, and perhaps Italy, France, Hungary, Cyprus etc.) accept the loans with the dimming hope of growing their economies. Programs of higher taxes and reduced spending through austerity programs are proving to be highly ineffective and have worsened already desperate situations. The policy of adding new debt to the old debt is adding to the burden. Resolution to the debt problem and the natural progression of the cycle are only delayed and the ultimate outcome made worse. I propose that a cyclical tidal wave is overdue as a result.

The bond markets have provided consistent income with growth of principal over the last 10 years or so. However, the winter season is rapidly approaching for bonds, and it is time to harvest assets and profits to prepare for the cold, dark nights and much shorter days, and to prepare for the spring that should just as surely come. There are many potential seismic triggers cocked: a Middle-East War, euro-zone breakup, rising rates in Japan, or my personal favorite, global recession; each is capable of causing enormous turmoil. There has been a shift in the financial world, a change of trends that may require a shift in investments. Two definite scenarios are possible: defaulting on the debt or inflating against the debt.

Government and corporate budgets are much the same as in a personal household. A boiling point of manageable debt and repayment costs is reached which extends beyond the household’s capability. There is only so much revenue, and when the outflows exceed the inflows, a breaking point is reached. This is an excess that needs to be resolved, perhaps by very radical means, because the problem spreads like a vicious cancer.

Nations such as Greece have had very difficult decisions to make. They can honor the debt and suffer for a decade or more with rising social unrest and higher unemployment. Somehow, perhaps miraculously, with reduced spending and austerity, the economy might improve. A more radical, but more immediate decision would be to default on the debt. The repayment burden would be removed with a return to the national currency. Local revenues would be curtailed somewhat, but even reduced revenues could be used to stimulate services and restart the economy. There would be turmoil, but measured in months to a couple of years instead of by decades.

Should such a solution spread to other burdened nations, it could become acceptable to default and a global rebalancing could occur. The result would be a severe mistrust of all fiat currencies and all sovereign debt, including U.S. debt. This mistrust would result in higher rates, significantly higher rates. This mistrust would also result in a shift of capital allocation to hard assets such as oil, gold, silver, farm land and agricultural commodities. It also would offer opportunity to all investors through investment in REITS and Real Estate. My personal favorite is the single family home in stable neighborhoods.

The inflation scenario is problematic for the bond market. Trillions of dollars have flooded into it throughout the world. The large multinational banks including the likes of Citigroup (NYSE: C), Goldman Sachs (NYSE: GS), J.P. Morgan Chase (NYSE: JPM), Morgan Stanley (NYSE: MS), Barclay’s (NYSE: BCS), Credit Agricole (OTC: CRARY.PK), Deutsche Bank (NYSE: DB), UBS (NYSE: UBS), Credit Suisse (NYSE: CS) and many of the world’s largest corporations are hoarding reserves, reluctant to deploy capital.

In addition to the reserves, the losses to the housing bubble collapse are diminishing as the U.S. real estate market recovers. The black hole of foreclosures and short sales, which have destroyed immense capital, is closing and may be completely closed within 24 months should the economy skirt a recession. There exists a tremendous potential for pent-up demand to propel the real estate markets higher as former homeowners become eligible to purchase. This demand could provide one of the catalysts to spark the velocity of money and unleash a torrent of capital seeking a return. This flood of capital would drive prices higher and perhaps ignite inflation and overwhelm deflationary trends. Hard assets would be the destination of capital looking for a return, and my favorite, real estate prices, would trend higher. However, rising interest rates accompany inflation.

Rising rates have the potential to decimate a bond portfolio, particularly a long-term bond portfolio where many investors have parked conservative money. It has the potential to be catastrophic. Real estate can provide an income stream that grows and often mimics the rate of inflation. Yet, there are many alternatives to help balance a portfolio. Please check with your advisor and review investments, as a rebalancing may be in order.

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