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Most
investors and market pundits continue to misdiagnose the reason behind the
worldwide economic malaise. The underlying problem isn't
"uncertainty" or any other platitudes Wall Street and politicians
like to offer. The truth is that massive sovereign debt defaults (if central
banks allow them to be written down honestly) are very deflationary in
nature.
Debt defaults
destroy the assets of non-bank investors and also wipe out the capital of
financial institutions. Without adequate capital, these banks are unable to
make new loans and expand the money supply, causing bubbles to burst.
For a good
while Wall Street was holding on to the ridiculous idea that the U.S. and
China would be spared from a meltdown of the second largest economy on the
planet. However, last week's data should have put a dagger through the heart
of that notion....
The Non-farm
Payroll report showed that the U.S. produced just 69k jobs in May, while the
unemployment rate rose to 8.2%. However, the most alarming part of the report
was that America lost 15k jobs in the all-important goods-producing sector.
GDP posted an anemic 1.9% growth rate and home prices continue to fall--down
2% YOY. China's PMI fell sharply in May, dropping to 50.4, down from 53.3 in
the prior month. And Eurozone PMI came out at an alarming 45.1 in the same
month, which is well below the line of economic expansion.
Global
markets are sounding the alarm of rapidly intensifying deflation. Commodity
prices such as oil and copper are in free fall, while equity prices are
hurting as well. Japan's Nikkei Dow lost 10% in May alone, which was its worst
monthly loss in two years? But Japan isn't alone. The Chinese Shanghai
composite is down nearly 20%, Spain's IBEX is down nearly 50%, Italian stocks
fell 45% and Greece is down over 60% from the year ago period.
The only
market yet to succumb to the carnage is the U.S., whose averages are roughly
unchanged for the year. However, the S&P 500 has lost nearly 10% over the
last 30 days, and is now in full catch up mode with the rest of the world.
It is simply
undeniable that the global economy is closely interconnected. Emerging
markets depend on Europe to support their export driven economies and the
U.S. depends on foreign economies to support the earnings of S&P 500
companies -- forty percent of S&P revenue and earnings are derived from
overseas.
In truth, the
real reason why global markets are melting down is because the recession in
the Eurozone is quickly turning into a deflationary depression.
For example,
take a look at the direction Portugal is headed. This country had negative
GDP growth and a 10% unemployment rate in 2010. At that time their 5 year
note was just 3%. Now their unemployment rate is 15% and GDP has been down
for 6 straight quarters. Their economy cannot possibly survive now that the 5
year note has been in the 15% range for the last year!
The carnage
all began when Irish and Southern European banks became insolvent due to
non-performing real estate assets. Then the sovereigns borrowed so much
money, in order to bail out the banks, that their economies have become
insolvent. Now banks find themselves insolvent once again ... this time
because they own the debt of bankrupt countries that were shoved down their
throat by the ECB's LTROs.
So we now
have a situation where insolvent nations are trying to bail out insolvent
banks by proposing to borrow more money, which will cause the countries to
become even more insolvent. Then, of course, banks are asked to lower their
country's borrowing costs by buying more of the debt issued from insolvent
nations. Doesn't that sound like it will work out well?
If you can
believe it, that is the proposed magic bullet to save Europe.
It's simply a
game of counterfeiting chicken. Central Bankers have been on a money printing
hiatus, pretending and hoping that the global economic bubbles didn't need
their money printing to keep them inflated. However, each and every worsening
piece of economic data brings us closer to the eventuality of more central
bank intervention. That is the reason why gold soared $65 per ounce on
Friday. Gold is now signaling the helicopters may be just over the horizon.
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