Lather, Rinse & Repeat

Lather, Rinse & Repeat

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For the third year running the markets have run out of steam about the same time as the latest central bank intervention efforts expire. As we mentioned in our recent article The Long March, central banks have managed to avoid an outright depression at the expense of rapidly increasing debt levels. Herein is the primary problem. It appears that policy makers have no other options that they are comfortable with. That is to say other options exist, but are not deemed acceptable at this time. Thus more debt is created in an attempt to pay off the old debt. To compound the predicament, for the first time since the 1930s, much of the industrialized world’s employment, industrial production and private sector GDP did not regain their pre-recessionary highs while global debt levels have continued to skyrocket.

PMI Manufacturing Status

Moreover, it is probable that performance of equity markets have become beholden to the ‘flow’ of new central bank intervention efforts rather than the stock (the size) of their balance sheets. The following two charts show that as central bank balance sheets expand, equity markets have tended to increase in value. Unfortunately, when merely the rate of balance sheet expansion ebbs, equity markets have contracted.

Global Markets and The S&P 500

Another reason for the interventions has been to provide psychological support to economies and investment markets. The psychological support emanates from a belief that something productive is under pursuit. The problem is that once the intervention abates there appears to be no other choice than to do what so many shampoo bottles recommend: Lather (new intervention), rinse (distribute funds from intervention) and repeat.

As the inevitable next round of intervention arrives, we will be keenly watching for more direct application of money to local economies. It is one thing for central banks to provide funding that mostly remains stuck in the paper trading markets for debt, equity and commodities. It is quite something different, namely highly inflationary, for funds to be directly injected into the economy via such routes as public works projects, mortgage balance/payment reductions, ‘cash for clunker’ programs or more creative efforts. The former has resulted from the past few years of interventions, while the latter may become increasingly necessary – and thus could stoke inflation.

These new effects on developed market economies are in stark contrast to emerging and developing market economies that have experienced real recoveries over the past three years. Renewed easing and stimulus will likely continue to leak into the emerging and developing shores with the traditional expected effects of an economic booster shot. For economies that remain mired in debt, deleveraging and deflation, it seems that paper asset inflation is the best that can be hoped for until a new direction is chosen by the populace.

If the present approach is not adjusted then fear will likely build that governments will go bankrupt, or ‘simply’ default through inflation. An old Ernest Hemingway conversation quote comes to mind:

“Question: ‘How did you go bankrupt?’”

“Answer: ‘Two ways. Gradually, then suddenly.’”

This is how it has begun to play out with Spain. Italy and Cyprus may not be far behind. Even the UK and France are in a perilous washing cycle. As shown above in the first bar chart, sovereign defaults generally occur in clumps of fifteen to twenty over a span of a decade. We sincerely hope that this time it is different. However, history is a strong advocate that the more things appear to change, the more they remain the same.

As a parting thought, we note that precious metals have traditionally tracked the pace of money creation, whether in the form of fiscal deficit spending or monetary intervention. Further, it is notable that when debt cannot be paid back the effect of issuing debt is no better than printing money. Deficit spending is already firmly in place for many years into the future. Various rounds of global monetary intervention are anticipated later this year. The USA debt limit is also set to be increased again this fall. The following chart shows a very interesting relationship since the year 2000. How high will the debt limit be raised to? Will gold continue to track the increase?

U.S. Debt & Debt Limit vs Gold