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Referencing Kyle Bass' work in a
December 18 video, we
noted numerous countries have an unstable combination of debt and revenue
relative to the size of their banking system. Another excellent source for
debt sustainability analysis comes from Jeffery Gundlach,
manager of the 2011 top-performing U.S. bond fund. Mr. Gundlach
was recently interviewed by the Financial Times. He does not subscribe to the
theory European leaders can "put a Band Aid on a system which didn't
break a week ago, or a month ago, or a year ago. It's been in the process for
years." His analysis came to the same conclusion as Mr. Bass';
default on unpayable obligations will occur. He
also believes growing the way out of the problem is not an option since the debt
is "obviously unserviceable". Mr. Gundlach
summarized the gravity of the situation as follows (Financial Times,
12/21/2011):
"The 2008
problem was a private economy problem and businesses - the business owners -
do try, and are incentivized by laws and penalties, to tell the truth when
they have earnings calls every quarter. The difference here is it is not
company-based. This is a government-based problem and a public economy,
public sector problem and the issue that's so problematic is that the
politicians won't tell you the truth."
The challenge for investors is
getting a handle on the next outcome; is it inflationary or deflationary? In
the end, "solutions" will most likely include defaults, writedowns, and money printing. Writedowns
and defaults point to deflationary/bearish outcomes for risk and
inflation-protection assets. Money printing eventually sparks inflation.
We can understand what the markets
are anticipating by examining the intermediate-term outlook for silver, the
U.S. dollar, and euro. Silver was a big beneficiary of the Fed's quantitative
easing programs, which captured the market's concerns about future inflation.
The situation in Europe became more
concerning to the markets the weekend of April 29, 2011. Some signs of
weakness in China also surfaced; something we may see more of in 2012. From
the Associated Press
(4/29/2011):
Investors are
concerned about a pair of recent announcements that point to weaker demand
and even lower energy prices this year. Greece, at the center of the European
debt crisis, said over the weekend that it will miss its lower spending
targets despite severe cost-cutting. And China's manufacturing sector
appeared to cool off in September.
With concerns escalating about
unsustainable debt in Europe, silver took on a deflationary/bearish look.
While it is almost comical when you
consider the unsustainable debt in the United States, the U.S. Dollar (UUP)
is still considered to be a "safe haven" currency. Since Europe
became the primary driver of the financial markets, concerns about the health
of the euro (FXE) have escalated as shown by the performance of the U.S. dollar
relative to the euro. If the strong correlation between the euro and stocks
remains in place, the chart below points to renewed equity weakness in early
2012.
While the S&P 500 could rally
above 1,300 and the euro could experience a short-covering rally, the trends
point to deflationary and bearish outcomes in the first half of 2012. All
trends are subject to change, but presently they align with both Mr. Bass and
Mr. Gundlach. It is doubtful many market
participants understand the numbers in Europe better than these two men.
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