Dr.

Marc Faber

Market Commentary February 1, 2010

The Inescapable Debt Trap Marc Faber

The Monthly Market Commentary Report

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Dr. Marc Faber

Market Commentary February 1, 2010

The Inescapable Debt Trap

“Great nations are never impoverished by private, though they sometimes are by public prodigality and misconduct. The whole, or almost the whole public revenue, is in most countries employed in maintaining unproductive hands… those unproductive hands… may consume so great a share of the whole revenue, and thereby oblige so great a number to encroach upon their capitals, upon the funds destined for the maintenance of productive labour, that all the frugality and good conduct of individuals may not be able to compensate the waste and degradation of produce occasioned by this violent and forced encroachment.” Adam Smith "Experience shows that the most dangerous moment for a bad government is usually just as its starting on reform." Alexis de Tocqueville “The nearest thing to eternal life we will ever see on this earth is a government program.” Ronald Reagan “Government is like a baby: An alimentary canal with a big appetite at one end and no sense of responsibility at the other.” Ronald Reagan

I was recently taken by surprise when at a conference, following my negative comments about the US government’s economic interventions and highly expansionary monetary policies, somebody exclaimed that US monetary polices had led to strong growth in the US over the last 10 to 20 years and that without interventions the current crisis would have been far worse. To show that expansionary monetary policies did not lead to strong growth is easy to prove (see Figure 1).
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gloomboomdoom. Marc Faber Market Commentary February 1. and when I travel around the world it is not my impression that the US is particularly productive. 2010 Figure 1: Last Ten Years: No Growth in Employment Source: Dr. www. Otherwise how could one explain the colossal increase in the US trade and current account deficit after 1998? Moreover.com I concede that an economy can grow while employment stagnates because of large productivity improvements.All rights reserved Page 3 of 24 . www.Dr.agorafinancial.com © Copyright 2010 by Marc Faber Limited . But the myth of “the great US productivity miracle” has been sufficiently exposed by other economists. one “productivity miracle” I am very familiar with is the US government sector (in particular immigration when you enter the US) where employment and compensation has continued to increase while the rest of the labour force has stagnated (see Figure 2). Alex Cowie.

com).All rights reserved Page 4 of 24 .Dr.gloomboomdoom. I should like to mention that the government repeatedly intervened into the free market in recent times and that these interventions were largely responsible for the current economic mess. Had LTCM not been bailed out in 1998. the Federal Reserve purchased $1. “the banking system has become an agent of destruction for gross domestic product and of impoverishment for the middle class.com © Copyright 2010 by Marc Faber Limited . Marc Faber Market Commentary February 1. it was lured into these unsavoury missions by a truly insane monetary policy under which. 2010 Figure 2: Shrinking Jobs in Manufacturing and Expanding Government Employees Source: Clusterstock. Moreover. had interest rates not been slashed to 1% after January 2001 (the US economy began to expand again in November 2001) no or surely a smaller credit and housing bubble would have followed. As David Stockman observed recently in a Wall Street Journal article (see WSJ of January 20. the financial sector would never have continued to increase its leverage as it did prior to the 2008 meltdown. As far as the government’s interventions having prevented the current crisis getting out of hand.5 trillion of longer-dated Treasury bonds and housing securities in less than a year. (newsletter@businessinsider. most recently. To be sure. 2010). It was an www.

www.. zero-interest loans). But will it? In supplying the banks with free deposit money (effectively.During recent quarter. But these profits were no evidence of Mr. ignoring the bad loans still on their books. as it shrank the bank’s cost of production – their interest expense on depositor funds – to a vanishing point.” which is “taking a $250 billion annual haircut in lost interest income” through artificially low interests rates. are dangerous institutions. permitting them to book huge revenue from trading and bookkeeping gains. and are warned well in advance.The baleful reality is that big banks. To be sure. and an end to frantic monetization of federal debt and a stable exchange value for the dollar” (emphasis added). by obscure wording changes in the Fed’s policy statements. Market doing God’s work. they represented the fruits of hyperactive gambling in the Fed’s monetary casino – a place where the inside players obtain their chips at no cost from the Fed-controlled money markets. The resulting yield curve for banks is heralded.” and that “the banking system has become an agent of destruction for gross domestic product and of impoverishment for the middle class. by fixing short-term interest rates at near zero. for instance. This kind of Robin Hood redistribution in reverse is not sustainable. And the banks.All rights reserved Page 5 of 24 . by a certain breed of Wall Street tout. the most direct way to cure the banking systems’ ills would be to return to a rational monetary policy based on sensible interest rates. are pleased to pronounce themselves solvent. the Fed planted its heavy boot squarely in the face of depositors. the preponderance of Goldman Sachs’ revenues came from trading in bonds. after reaping this ill-deserved windfall. about any pending shift in the gambling odds.Dr. In fact. In addition.gloomboomdoom. as a financial miracle cure. Soon.. 2010 unprecedented exercise in market-rigging with printing-press money. and it gave a sharp boost to the price of bonds and other securities held by banks. Marc Faber Market Commentary February 1. it is claimed. Meanwhile. Stockman has a point when he talks about big banks having become the “freakish offspring of the Fed’s easy money. the middle class was badly hurt by expansionary monetary policies in the first half of 2008 despite the Fed’s decision to slash interest rates in September 2007 because of soaring commodity prices (see Figure 3). the savers of America are taking a $250 billion annual haircut in lost interest income. the freakish offspring of the Fed’s easy money. deeply embedded in a bull market culture of entitlement and greed…. currencies and commodities. It requires permanently flooding world markets with cheap dollars – a recipe for the next bubble and financial crisis…. greasing the wheels of commerce and trade by facilitating productive financial transactions. a prodigious upwelling of profitability will repair bank balance sheets and bury toxic waste from the last bubble’s collapse.com © Copyright 2010 by Marc Faber Limited .

Dr. As a result. soared to $147 in July 2008. the US consumer was burdened by an additional “tax” of almost $500 billion (please also note that on an annualized base US oil outlays increased from $75 billion in 1998 to currently approximately $500 billion). www.com The oil price.yardeni. which had been hovering around $75 per barrel prior to the September 2007 rate cuts. crude oil outlays in the US increased on an annual basis from $500 billion to almost $1 trillion in mid 2008 (see Figure 4). www. 2010 Figure 3: Were the Fed Fund Rate Cuts After September 2007 Beneficial? Source: Ed Yardeni. Marc Faber Market Commentary February 1.gloomboomdoom. In other words. at a time when global demand was already slowing down. after they had peaked at $79 in July 2006.All rights reserved Page 6 of 24 .com © Copyright 2010 by Marc Faber Limited .

com © Copyright 2010 by Marc Faber Limited . rising commodity prices in the first half of 2008 were an important contributing factor in curtailing consumption globally.All rights reserved Page 7 of 24 . www. which is going to increase the governments’ debt burden significantly (see Figure 5). www.com In addition. 2010 Figure 4: US Crude Oil Outlays. the increase in oil outlays in the fist half of 2008 were not the only reason for the collapse of the global economy after September 2008.yardeni. Also.gloomboomdoom.Dr. But it should be understood that had fed funds remained at 5 ¼% after September 2007. artificially low interest rates encourage speculation. I am not suggesting that the spike in commodity prices were only due to the fed fund rate cuts which followed September 2007. and wheat almost doubled between September 2007 and the summer of 2008. 1987 . However. which as I have shown brought about numerous unintended and negative consequences (a credit and housing bubble. commodity prices including oil and food prices would not have soared that much. In turn this depressed discretionary consumption further. the price of soybeans. governments also embarked on an unprecedented fiscal stimulus. Marc Faber Market Commentary February 1. corn. rising commodity prices resulting in an additional “tax” on consumption). After all. But aside from intervening into the free market mechanism with monetary policies. which subsequently aggravated the recession.2009 Source: Ed Yardeni. lifting food prices. Now.

” Assuming we are dealing with a country that has low total credit market debts compared to GDP (say 30%) and this country doubles subsequently its debts compared to GDP.All rights reserved Page 8 of 24 . growth will temporary accelerate because aggregate demand will increase. recently published a sobering but actually very logical study entitled “Growth in a Time of Debt. some of the demand will so to speak be borrowed from the future. Also. additional borrowings for productive capital investments are obviously more desirable and will be long-term growth-enhancing whereas borrowing for consumption will www.com © Copyright 2010 by Marc Faber Limited . 2010 Figure 5: Cumulative Increase in Real Public Debt Since 2007 Source: Carmen Reinhart and Kenneth Rogoff I am bringing this up for several reasons. Marc Faber Market Commentary February 1. since debts cannot double as a percentage of GDP indefinitely. both accomplished economists. Carmen Reinhart and Kenneth Rogoff.Dr.gloomboomdoom. However.

gloomboomdoom. Growth. GDP growth slows down and inflation tends to accelerate (I should add that economic growth slows down irrespective whether an economy is increasing its private or public debts above a certain level). Above 90%.Dr. when government debt increases. median growth rates fall by one percent. and average growth falls considerably more” (see Figure 6). Therefore. 1790 -2009 Source: Carmen Reinhart and Kenneth Rogoff As can be seen from Figure 6.All rights reserved Page 9 of 24 . 2010 lead to slower future growth. and Inflation.com © Copyright 2010 by Marc Faber Limited . one of the conclusions of the Reinhart/Rogoff study is that “the relationship between government debt and real GDP is weak for debt/GDP ratios below a threshold of 90% of GDP. I need to point out that if in our example of an economy with a 30% debt-to-GDP ratio www. Marc Faber Market Commentary February 1. Figure 6: US Government Debt.

2010 debt growth accelerates from say 15% per annum to 30%. www. growth will temporary also accelerate. Marc Faber Market Commentary February 1. Figure 7: Rising US Household Debts and a Declining Saving Rate Boosted GDP Growth Between 1982 And 2008 Source: John Hussman. So. the day debt growth slows down.All rights reserved Page 10 of 24 . economic growth will also diminish or come to an abrupt end altogether (see Figure 8).hussmanfunds. much of the GDP increase between 2000 and 2008 (or more precisely since 1982) can be explained by the increase in household debts as well as by a further decline in the saving rate (see Figure 7).com © Copyright 2010 by Marc Faber Limited . www.gloomboomdoom.com However.Dr.

Marc Faber Market Commentary February 1. 1954 – 2009 Source: Barry Bannister. there is a time when additional debt growth does not lead to any GDP growth – the so called “zero hour.” which. in my opinion.All rights reserved Page 11 of 24 .Dr.com © Copyright 2010 by Marc Faber Limited . has now been reached (see Figure 9). as Reinhart and Rogoff show and as Barry Bannister has demonstrated before. Stifel Nicholaus In addition. 2010 Figure 8: Total Debt Growth and Nominal GDP Growth.gloomboomdoom. www.

2010 Figure 9: Counterproductive Debt Growth Has Now Been Reached Source: Barry Bannister.gloomboomdoom. Marc Faber Market Commentary February 1. www. Stifel Nicholaus I need to add that I have so far not touched on the dire conditions of American states’ financial conditions and their over $2 trillion unfunded pension fund liabilities.All rights reserved Page 12 of 24 .Dr.com © Copyright 2010 by Marc Faber Limited . A state’s budget gap is the difference between a state’s expenditures and revenues expressed as a percentage of the general fund expenditures for that state (see Figure 10 – for clearer viewing please enlarge).

Dr.com © Copyright 2010 by Marc Faber Limited . Our main finding is that across both advanced countries and emerging markets.Seldom do countries simply ‘grow’ their way out of deep debt burdens….gloomboomdoom. but we would speculate that the phenomenon is closely linked to logic underlying our earlier analysis of ‘debt intolerance……. Financial Armageddon Reinhart and Rogoff (see above) conclude that “the sharp run-up in public sector debt will likely prove one of the most enduring legacies of the 2007-2009 financial crises in the United States and elsewhere. high debt/GDP levels (90 percent and above) are associated with notably lower growth outcomes…. inflation and growth.. We examine the experience of forty four countries spanning up to two centuries of data on central government debt.. 2010 Figure 10: State Budget Deficits – Another Looming Financial Disaster Source: Michael Panzner.Why are there thresholds in debt. and why 90 percent? This is an important question that merits further research.All rights reserved Page 13 of 24 . risk premia begin to rise sharply. Marc Faber Market Commentary February 1. highlights that as debt levels rise towards historical limits. however.’ A general result of our ‘debt intolerance’ analysis.Even countries that are committed to fully repaying www. facing highly indebted governments with difficult tradeoffs…….

Marc Faber Market Commentary February 1. 2001 .Dr.All rights reserved Page 14 of 24 . The problem for the US is that “real” government debt-to-GDP is not 84% as indicated by Reinhart and Rogoff (see Figure 5) but around 600% (see Figure 11). But is this a realistic assumption for the US? Hardly. With GAAP and Accruals. 2010 their debts are forced to dramatically tighten fiscal policy in order to appear credible to investors and thereby reduce risk premia……Of course.nowandfutures.gloomboomdoom. there are other vulnerabilities associated with debt buildups that depend on the composition of the debt itself…… countries that choose to rely excessively on short term borrowing to fund growing debt levels are particularly vulnerable to crises in confidence that can provoke very sudden and ‘unexpected’ financial crises” (emphasis added). Figure 11: Total Federal Government Debt. Reinhart and Rogoff note that “even countries that are committed to fully repaying their debts are forced to dramatically tighten fiscal policy in order to appear credible to investors and thereby reduce risk premia” (to tighten fiscal policies implies large spending cuts or significant tax increases or a combination thereof).2009 Source: www. in my opinion! There is neither the www.com Above.com © Copyright 2010 by Marc Faber Limited .

Moreover.All rights reserved Page 15 of 24 . What about radical spending cuts.8% from December 2008 (a symptom of a still shrinking economy). which would be the most desirable way to address the budget problems? Under the Obama administration and given the view by several “leading” US economists that more fiscal stimulus is needed I just can’t see this happening in the next few years.gloomboomdoom.2009 Source: Ed Yardeni. Marc Faber Market Commentary February 1.com © Copyright 2010 by Marc Faber Limited . if Reinhart and Rogoff are right about “high debt/GDP levels” that “are associated with notably lower growth outcomes” and that “seldom do countries simply ‘grow’ their way out of deep debt burdens.Dr. 1995 . Figure 12: US Federal Government Receipts. municipal and federal government www. www.yardeni. So.” then US tax receipts will continue to remain disappointing and make it difficult for the fiscal deficit to decline (see Figure 12). 2010 political will to face the problem of excessive debt nor the recognition among Fed officials that excessive debts caused the crisis in the first place (see also enclosed report by Steve Keen entitled “The Economic Case Against Bernanke”).com As an aside I should mention that December 2009 tax receipts were down 7. how will the US get out of its “debt trap?” There are two ways: default on obligations (default on state.

2010 debts or default on obligations to the US population through smaller entitlement payments or by increasing retirement age) or by massively monetizing US debts and reducing the debt through inflation.com I am highlighting the diminishing supply of gold in order to contrast it to the increased level of debts and money.Dr. Figure 13: Annual Gold Production from Main Producers. In my opinion.com © Copyright 2010 by Marc Faber Limited . which inevitably follows a period of excesses (excessive debt growth and excessive consumption in the case of the US) is postponed through monetization and “end loaded. if I was able to convince my readers that the explosion of debts on all levels of society (corporate. Ceteris paribus where supplies increase. www. additional massive monetization of debts is the most likely outcome. 1970 2009 Source: Jean Laherrere. prices increase. So.All rights reserved Page 16 of 24 . This is so because the economic pain. prices decline and where supplies diminish. and buy assets such as equities. household. and government) will lead to www.goldsheetlinks.” From an investor’s perspective the process of monetization has important implications: Avoid long term fixed interest securities (except for temporary rallies).gloomboomdoom. avoid cash. real estate and commodities – in particular precious metals (see Figure 13). Marc Faber Market Commentary February 1.

But if I am right about further monetization and further government debt growth. weakness in gold and other commodities as well as in emerging markets (see Figure 14). I am mentioning the temporary tightening of liquidity because there are a number of symptoms which seem to suggest that this process is now underway.Dr. platinum and palladium makes sense from a longer-term point of view. Marc Faber Market Commentary February 1. This is not to say that gold cannot correct further down to between $950 and $1050 per ounce if liquidity tightens temporarily (please note that even in a hyperinflationary environment.while still expanding .decisionpoint. www. the risk is really not to own any precious metals at all.com © Copyright 2010 by Marc Faber Limited . then holding gold. liquidity evaporates temporary). Figure 14: Chinese Shares No Higher Than in June 2009 Source: www. 2010 further monetization.All rights reserved Page 17 of 24 . These symptoms include a strengthening US dollar. money supply growth in China .com Indeed.gloomboomdoom. silver.is expanding at a moderating rate (see Figure 15).

P. 2001 2010 Source: CEIC. That something is not quite right in China is evident from the recent poor performance not only of Chinese and Hong Kong stocks (the latter are down by more than 12% from their November high) but also of industrial commodity prices and of the Baltic Dry Index. www. This lending stop could badly affect Chinese import orders for commodities and machinery and significantly tighten mortgage lending. J. banks have suspended new lending following an emergency meeting by the central bank’s monetary policy bureau. Apparently. This should come as no surprise since the country’s banks loaned last year $1.Dr. In other words.All rights reserved Page 18 of 24 . I should add that there are observers who believe that 25% or $355 billion of these loans will default. either bank lending slows down considerably now as a result of a decision by the central bank or later as bad loans escalate and lead to a tightening of lending standards. which is equivalent to about a quarter of China’s nominal GDP. which is now no higher than in June 2009 (see Figure 16). the sudden lending suspension has caught importers by surprise as letters of credit became unavailable. Morgan News out of China is that as of January 19th. In either case tighter monetary conditions and slower growth in China must be expected.com © Copyright 2010 by Marc Faber Limited . Marc Faber Market Commentary February 1. 2010 Figure 15: China: Declining M2 (Percent 3-Month Average).42 trillion.gloomboomdoom.

com I cannot emphasize enough the investment implications of a meaningful economic slowdown (or collapse as some observers think) of the Chinese economy. Hong Kong high end properties.All rights reserved Page 19 of 24 . The hardest hit assets would be industrial commodities. Freeport. and currencies of resource based economies. resource based economies.McMoRan etc.) are all down 20% from their highs and that stock markets such as Brazil have recently broken down decisively (see Figure 17).gloomboomdoom.com © Copyright 2010 by Marc Faber Limited .2010 Source: www. www. Marc Faber Market Commentary February 1. Noteworthy is that material stocks (US Steel. 2003 . POSCO. 2010 Figure 16: Baltic Dry Index.Dr.decisionpoint. for which China has become the largest export market.

Marc Faber Market Commentary February 1. a symptom of tightening liquidity) “a reasonable assumption would be for the S&P 500 to outperform emerging markets” (see Figure 18).Dr. 2010 Figure 17: Further Downside Risk for Resource-Based Economies Source: www.All rights reserved Page 20 of 24 .decisionpoint.com © Copyright 2010 by Marc Faber Limited . I concluded that if the US dollar were to strengthen in the first half of 2010 (as explained before.gloomboomdoom. www. but when I see so many assets markets breaking down simultaneously I believe it is better to err on the side of caution and to postpone the purchase of equities.com We do not know how serious and long lasting the Chinese economic slowdown or possibly the economic slump will be. Last month I mentioned that over the last few years a weak dollar had led to an outperformance of emerging markets compared to the US whereas a strong dollar led to an outperformance of the US versus emerging markets (see also Figure 12 of the January 2010 report).

com © Copyright 2010 by Marc Faber Limited . 2009 – 2010 Source: www. www.Dr.gloomboomdoom.All rights reserved Page 21 of 24 . 2010 Figure 18: S&P 500 Compared to Emerging Market ETF.com This is not to argue that the S&P will go up and emerging markets decline. One reason for my caution is that money supply growth has not only slowed down in China but also in the US (see Figure 19). Marc Faber Market Commentary February 1. Both could move down whereby I would expect the S&P 500 to decline less than emerging stock markets (a market neutral strategy would involve being long the S&P 500 and short emerging markets).decisionpoint.

A correction has begun with many stocks already down 20% from their highs. At some point in 2010. The way I see asset markets move in 2010 is as follows. 2010 Figure 19: US M2 Money Supply Growth Slowing Down Source: Barry Bannister.com © Copyright 2010 by Marc Faber Limited .gloomboomdoom. The correction is likely to continue (interrupted by a technical rally in the next few days) whereby I would look for a bottom in the second half of February.Dr. Thereafter we should have a recovery rally but I doubt that the January 19th high at 1150 for the S&P 500 will be exceeded (and if exceeded only moderately so). Marc Faber Market Commentary February 1.All rights reserved Page 22 of 24 . stocks will likely be down between 20% and 40% from their recent highs (emerging www. Stifel Nicholaus A reader recently asked me – following my conclusion in last month’s report that 2010 would be a rather difficult year and that “capital preservation” would be “of paramount importance” – how best to preserve capital.

During this decline the US dollar and US government bonds should continue to strengthen (see Figure 20). In this rebound precious metals and mining companies should outperform the S&P 500.gloomboomdoom.Dr.All rights reserved Page 23 of 24 . 2010 markets with a large China exposure would seem to be particularly vulnerable). Whether stocks and industrial commodities will then manage to exceed their recent highs will depend on the size of the additional monetary stimulus. Marc Faber Market Commentary February 1. policy makers and central banks around the world will implement additional coordinated fiscal stimuli and more money printing. Beneficiaries from www. Precious metals and mining stocks are likely to benefit the most from additional fiscal and monetary stimulus and should be accumulated on weakness.decisionpoint.com © Copyright 2010 by Marc Faber Limited .com But as soon as the S&P drops to around 950 and as soon as the Chinese economy weakens visibly. This will lead to a tradable rally (and renewed US dollar weakness). Figure 20: Twenty+ Year Treasury Bond Fund ETF Source: www.

Marc Faber Market Commentary February 1. www. In short.com © Copyright 2010 by Marc Faber Limited . And if stocks now fail to decline and continue to rally right away I would use strength to lighten up positions. 2010 zero interest rates are also financials including Japanese banks such as Mitsubishi UFJ (MTU).following a brief rebound in the first few days of February . I expect a choppy year for equities in 2010. Zions Bancorporation (ZION). Mizuho Financial (MFG). should stock markets . and Synovus (SNV).Dr.gloomboomdoom. I would buy some stocks for a rebound.All rights reserved Page 24 of 24 . In the near term. and regional banks in the US such as KeyCorp (KEY).decline into the second half of February.

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