I can’t believe that! said Alice.

Can’t you? the Queen said in a pitying tone. Try again: draw a long breath, and shut your eyes.

Alice laughed. There’s no use trying, she said  one can’t believe impossible things.

I daresay you haven’t had much practice, said the Queen. When I was your age, I always did it for half-an-hour a day. Why, sometimes I’ve believed as many as six impossible things before breakfast.

Wow!! What a Week! What a Month! What a Year so far!

The plethora of unexpected events witnessed in the last few months has been nothing short of remarkable. These include spiraling revolutions in the Middle East, Natural Disasters and Nuclear leaks in Japan, NATO airborne assaults on behalf of Libyan rebels and the still slow burning fuses attached to public finance debt bombs in the US, Japan and Europe.

Through it all, global currency, equity and fixed interest markets have remained remarkably placid and well-supported. The VIX index is in fact not registering fear of any kind.

Shouldn’t we be asking ourselves whether the markets’ faith in the future reflects far too rosy an interpretation of the developments and probable outcomes in key economies? Could the markets be setting themselves up for another big dump? To this end we present our Top Six hit parade of impossible beliefs held by the markets currently. Let’s take a closer look:

The Top Six Impossible Beliefs

1. The Chinese Economy is not in a Bubble
2. The Japanese Disasters will not threaten Global or US Economic Prospects
3. Large Banks in Europe and the US are solvent
4. The Sovereign Debt Crisis in Europe is under control
5. The US Fiscal situation is under control
6. There will be no more QE after QE2

We are not optimistic that today’s lawmakers and policymakers have the skill, inclination or fortitude to handle the pressing issues that require due care and attention. Expect coordinated QE, know that we are already on the path to high inflation, and expect at least another one or two of these situations to go sideways and precipitate another financial crisis within the event horizons shown below.

The Sorry Details Start Here

(1) There is remarkable complacency over the stability of the Chinese economy. According to an economic outlook report from an Asia Pacific Economic Cooperation (APEC) business advisory body, China’s economy is expected to remain strong in 2011 and 2012, but inflationary pressures are likely to rise further due to rising food prices.

Most commentators do not look behind the numbers. If they did then what they might find as regards the sustainability and quality of Chinese economic growth might give them some pause. We only consider two issues: significant mal-investment; and the cost to China’s economy of GDP growth in terms of externalities such as pollution and desertification.

Can people with bad haircuts and clad in cheap suits (ie: government bureaucrats) make better decisions than the market? Apparently this is what Chinese central planners think. Maybe this is why they have set out plans to build millions of new housing units, and yes even entire cities, in the absence of market demand . Perhaps that is why at last count there were 64 million unoccupied housing units in China with more under construction. Entire cities have been built that now stand completely empty. Why the empty units? Consider the fact that many experts believe that Chinese property prices may have outstripped purchasing power by up to 70%.

Now consider that adjusted for population, relative housing prices and the size of the economy, that the Chinese housing overhang described above is about 2-3 times larger than the deplorable residential housing market situation in the US. This does not take into account the mal-investments in infrastructure and coimmercial real estate that have accompanied the housing developments. Is it not probable that there are some serious non-performing loan problems at Chinese banks as a consequence? Is it also not surprising that in recent days that Jiang Jianqing, the Chairman of ICBC, one of China’s four main lenders was protesting that the $100 Bn of lending to local authorities that his bank undertook does not represent a threat to his bank’s stability?

This is only one example of egregious mal-investment by the Chinese government and the state-owned banks. There is an ample supply of others.

Then consider this report, which reveals the fact that Chinese desertification may take over three hundred years to reverse Another study conducted by the OECD also spells out the scale and severity of the ecological crisis now engulfing the country, poisoning its people and holding it back economically. Over 400 million people drink contaminated water every day. Seventy five per cent of lakes rivers and the near oceans are polluted and toxic. Taken together, the externalities of desertification and pollution effectively negate China’s 10% economic growth rate, leaving it no better off each year, facing a large and growing clean up bill, a sickened population  and in urgent need of new sources of clean water.

The problem for China is that if it stops growing increased social unrest will result. If it addresses the issues of mal-investment and economic externalities it must stop growing. However if it does not stop the externalities from accumulating and stop investing in redundant plant, equipment and real estate development, then the bubble will pop anyways, resulting in social unrest.

Catch-22 ?

Event Horizon : Chinese Bubble Pops. Zero to three years.

(2) According to the Washington Times and most other news outlets, the Japanese Earthquake is unlikely to threaten Global growth or affect the US. In fact, in recent days more than two thirds of the news reporting out of Japan has focused on the nuclear situation at the Fukushima reactor site. The bulk of the remainder of the reporting has focused on the plight of the locals. These reports stress that the worst thing to fear from the Japanese natural disaster is the threat of nuclear contamination. Nothing could be further from the truth. In fact this misplaced focus by the amusement park media completely ignores all of the science on nuclear radiation that has been accumulated since the Chernobyl disaster.

To be sure, there are several stories here which bear mentioning here. As per the foregoing, the first is that the nuke contamination fears are completely overblown. The second is that the Japanese have done a remarkable job of getting control of a huge disaster in a very short span of time and with little outside help. Compare and contrast to Hurricane Katrina and the more recent BP oil spill in the Gulf of Mexico. Both instances featured an abdication of responsibility at the Presidential level, a failure to identify the problem and apply solutions in a timely manner and almost zero accountability among the officials involved. Countless billions were wasted through mismanagement and corruption in the USA. Not so in Japan.

The real problem issues with the Japan disaster is that it has severely hurt that economy and the ability of many of its top companies to contribute specialized goods into the global supply chain and to meet growth and earnings targets. What many folks do not know is that most large factories in Japan have thousands of Mom and Pop suppliers who sometimes work out of garages and improvised workshops in residential areas. It is too early to tell how many of these suppliers are even still in existence, and the effect that their disappearance might have on the likes of Sony, Mitsubishi and Toyota.

In addition, the disaster places even more stress on the public finances of Japan as tax revenues will be lower than forecast, support costs for the public relief effort are going to be enormous along with an estimated $250-300 billion price tag for the reconstruction. The other issue of course is how this reconstruction is to be financed. Japan has almost $3.0 Trillion of net foreign assets but it is unlikely that it will liquidate these to support reconstruction. US and European political pressure will more probably dictate that Japan finance this through a QE merry go round which will see the yen Money Supply pumped up in order to accommodate JGB issuance from the Ministry of Finance.

The bottom line is that Global Growth will suffer and Japan’s balance sheet will be further stressed by additional dollops of Zombie Finance.

Event Horizon: Weak Japanese growth. Deterioration in public finances. Zero to three years

(3) Banks in Europe and the US are solvent. This past Friday the Federal Reserve announced that certain banks among the 19 tested were allowed to increase their dividends only if they passed “stress tests” conducted by the Federal Reserve to see if their balance sheets were strong enough to weather another recession. The Fed said it had completed those tests and expects that “some” banks will increase or resume dividend payments, buy back shares or repay government capital. The Fed did not reveal the names or number of banks that are expected to do so. Notable for their absence from the list were Citigroup Inc. and Bank of America Corp., the nation’s largest bank.

The Fed singled out the two “Too Big To Fail” institutions and whacked them on the wrist. Big Deal.

The elephant in the room in all of this is the absence of any discussion of mark-to-market accounting treatment for ANY bank portfolios. Recall that mark-to-market accounting was abolished by the Fed and US regulators in April 2009. The latest wheeze by the US regulators and central bank is thus nothing more than a scheme to lure more investors to put money into bank shares and for banks to pay out money to institutional investors hungry for cash such as pension funds, insurers and mutual funds by pretending that all is well. Of course, bank executives also get to line their pockets as a result of this decision. The money to pay the dividends is, of course, freshly minted by Dr Bernanke acting as agent for the US Treasury and his member bank shareholders.

Similarly, the European regulators have announced another round of stress tests upcoming in order to achieve the same result with the markets ie: Nothing to see here. Move along. Move along. Here again the methodology leaves us more than a little short of endorsing the robustness of the entire procedure. Some stresses such as interest rate and equity market stresses, look a little light. But the killer is that again regulators are not permitting any consideration of sovereign default or restructuring.

Are all of the big banks solvent? Unlikely!!

Event Horizon: Large US or European Bank Fails. Zero to 18 months (see below)

(4) The Sovereign Debt Crisis is Europe is under control. March has featured a summit marathon for the EU and euro area. Since the version of the Treaty on the Functioning of the European Union (TFEU) currently in force does not admit a permanent anti-crisis mechanism, the EU Member States must agree on a Treaty amendment. Two sentences are to be added to Article 136 TFEU with effect from January 1, 2013. As of that date euro area countries will be allowed to install a permanent stabilisation mechanism granting financial assistance with conditions attached. The other issues that were discussed include amendment of the European Financial Stability Facility (EFSF) as part of the existing crisis mechanism; how the European Stabilisation Mechanism (ESM) is to be fleshed out as successor to the EFSF and financial aid from the Commission; and an economic governance package.

Consequently, for the past month European leaders have been meeting in order to address these amendments to the EU governance matters and concerns regarding the stability of heavily indebted member nations. The process is designed to allay concerns that the Euro is under threat and that certain EU countries may default and walk away from the obligations. The concerns of the politicians are well founded. Look at the chart below. This is what has been giving Cameron, Merkel, Sarkozy, King and Trichet sleepless nights. If any one of the European Sovereign borrowers defaults and walks away, then the banks that have lent all that money will face significant capital issues.

For this and other reasons the entire EU restructuring process has been conceived and is being managed in order to AVOID ANY HAIRCUTS and to pass the cost of lending excesses on to taxpayers of the various countries involved. This process involves the imposition of austerity measures, the requirement that countries accept bailout monies, the requirement that they must cede a portion of their sovereignty and agree that there are no reductions in the amounts owing.

The unravelling of this scheme is only just beginning. The EFSF is inadequate, ill-conceived; and has been  ill-managed. This week saw renewed riots in the UK prompted by austerity measures, strikes against user fees in Greece and the fall of the government in Portugal. Moreover the escalation in market rates for the debt of the various Zombie Nations is in most cases already at levels that will not permit the continued economic rollover of obligations as they come due.

The fuse on this debt bomb has long been lit and there is still no competent UXB team in sight.

Event Horizon: EU area debtor country defaults and demands haircuts. Zero to 18 months

(5) US Fiscal prospects are being capably managed. As the US military was launching over 100 Tomahawk cruise missiles at pro-Quadaffi targets in Libya, Obama was to be found on his way to South America for a five day junket through the region, in part to secure jobs for Americans. Obama couldn’t have gone to better place. Both Brazil and Chile, two of the countries on his itinerary, sport lower unemployment rates than does the US; and better economic prospects. Perhaps Obama plans to subsidize the emigration of the US unemployed to South America: Fly to Rio courtesy of Uncle Sam. Enjoy the Beach. The Feds will pick up the tab of moving you and your family as long as you never come back. We are sure that all of this could be done for less than $50,000 per household. This figure is about one tenth the cost of the last big stimulus program launched by this Administration. A bargain at the price.

All kidding aside; the fiscal crisis that is engulfing US Government finances shows every sign of accelerating, not in the least because Democrats at every level of Government are refusing to acknowledge the need for fiscal restraint of any kind. Red ink is also killing Municipal and State finances. The latest monthly Government deficit number for the Feds at over $220 Billion is in nosebleed territory. Not only does Obama not even want to secure agreement of a symbolic $100 Billion of budget cuts; the US Government is no longer even pretending to have any sort of fiscal discipline in place at all. The Federal Government is operating with no official budget and is coming up fast against the debt ceiling. (As a line item, Obama had no fiscal authority to order military units to support the operation in Libya. Under the continuing resolution which is in place until April 8^th, the only funded war-fighting operations are in Iraq, Afghanistan and Central Asia.)

It appears that under any circumstances forecasted by the CBO, the CEA or the US Treasury that Trillion plus dollar deficits will continue indefinitely; in combination with the $50 Trillion or so in unfunded but known liabilities, this makes any discussion of imposing fiscal discipline a round table on Fantasy Finance.

Event Horizon: US fiscal problems cause investor revolt and downgrade. Zero to 36 months

(6) Widespread market expectations point to no renewal of QE after the current round (QE2) ends in June. In fact several Fed Governors have gone on record saying that QE2 is the last QE. We have explained the real reasons for QE in a previous post. Although advertised as stimulus for the economy, the reality behind QE has in fact little to do with stimulus and much,  much more to do with the gaping deficits at the Fed, an insolvent Banking system and Washington’s fiscal deficit which can no longer be properly funded in the open market. Nothing has changed since the time of that analysis to cause us to alter our opinion. In fact, recent events in Japan and Europe now argue even more strongly for a continuation of this program.

Even before the disaster that struck Japan, she and other foreign investors were quietly paring back on their purchases of Treasury Bonds and Notes. The entire volume of new supply has in fact been entirely taken up by the Fed through its QE operations. At this point the Feds have two alternatives: they can stop QE and bet that markets will continue to absorb Treasuries at yields that are quite arguably far below actual (rather than reported) inflation. Or the Feds can continue with QE and try to continue to maintain the fiction that everything is fine: the recovery is on track, jobs are being created and inflation is under control.

These choices amount to the following: choice (1) means that the Feds  admit to the problems, stop the fantasy finance of QE, clean up insolvent banks, implement swingeing cuts in public expenditures; and then take the associated economic pain which would be followed by renewed, durable growth. Or under choice (2) the politicians avoid the hard alternatives, continue promising bread and circuses to the public and hope that they (the politicians) can retire with an inflation-indexed pension before the economic firestorm starts.

The stark reality is that there is no politician of any stripe that would opt for choice (1) at the present time. This would be political suicide.

The path of least resistance therefore is to continue kicking the can down the road. US leaders, like the Europeans, Chinese and Japanese don’t have the courage to promote AND implement painful, but necessary adjustments. QE will continue because the default position for not only the US but for Europe, China and Japan is that the solution to the solvency issues amongst banks and sovereigns lies in inflating away the value of the debts and bad assets. The alternative of making good on debts and paying them off in full in a low-growth, low-inflation world is simply not a credible prospect when one looks at the finances of Ireland, Portugal, Greece, Japan the United States and other countries.

In the case of the United States we calculate that an increase of between 8 and 12 times the current price level is required to bring Government debt ratios and debt servicing capacities  back into balance. This means that we are likely looking at an inflationist program that lasts at least until QE6 (assuming that the size and duration of the operations match QE2). The path of least resistance for other central banks is to accomodate. Thus,  US inflation will be exported worldwide and will likely be the last hurrah for the USD as the principle reserve currency.

Clearly, the central, glaring risk of this strategy is that the money printing and increases in bond supply will result in pressure on term rates and a subsequent financial meltdown in many countries due to debt servicing shortfalls and balky issuance markets. While the authorities will make every effort to forestall this development, rising interest rates are inevitable and will be the final nail in the coffin for those countries burdened with aging populations; extravagant entitlements programs, shrinking tax revenues, high unemployment, a sluggish economy and a political class unwilling or unable to make the correct choices. Savers, retirees and other owners of capital will be decimated by persistent and elevated levels of inflation unless they take protective actions soon.

Event Horizon: QE3-QE6+. QE3 starts in 3-5 months

End Notes

We are not optimistic that today’s lawmakers and policymakers have the skill, inclination or fortitude to handle the pressing issues that require due care and attention. Expect co-ordinated QE, know that we are already on the path to high inflation, and expect at least another one or two of these situations to go sideways and precipitate another financial crisis within the event horizons shown.

[Courtesy of Leonard Cohen, follow this link to a track that will make our communal descent into inflationary dystopia a little easier to bear.]

This entry was posted on Tuesday, March 29th, 2011 at 10:30 am and is filed under Bank Loans, Bankruptcy, Banks, Crisis, EU, Fed Policy, Loan Losses, Middle East, Sovereign Debt. You can follow any responses to this entry through the RSS 2.0 feed. You can leave a response, or trackback from your own site.