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Where are we Heading (and What to Do?)

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By washcomp
December 24, 2009

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Much has been said on METAR over the past couple of weeks, but on surprisingly few topics. There have been sparks of new information (such as Hohum77's periodic shipping data), but much of the discussions, now that we've become a bit bored talking about extreme PM's have revolved around a few macro topics. Most of these properly concern debt as, while equities provide fun and profit, our issues are more debt related than asset related.

We have the incredible destruction caused by mortgage debt (and its derivatives) last year which precipitated our problems. Interesting that, while bank debt is still on our minds, the credit default swap risks seem to have left our radar screens. They still exist and are as prevalent as ever and will, no doubt, cause systemic problems if the economic recovery becomes sidetracked.

The overwhelming debt taken on by the US consumer (X-mortgage) seems to be receding, but I wonder if this is through a conscious effort to draw it down or because of "reporting error". I find it hard to believe that people who were in hock up to their eyeballs during good times have the ability to satisfy their debts during the current recession.

Our government's debts are obviously growing. Congress's "health reform" plans, regardless of their efficacy as social programs, are going to increase our obligations (either/or through more governmental debt and/or higher taxation). Currently, through the "good offices" of the Fed, our debt service costs are currently being kept low, but once inflation reports no longer hide increased costs, interest rates will climb. While the Fed has deep pockets and many assorted levers it can pull, they cannot singlehandedly handle the entire debt issuance of our nation.

While 2009 was fairly benign from a real estate refinancing point of view, 2010 is not. While there were originally projections of $1T of ALT-A and ARM resets due in 2010-2011, I suspect the effects have been buffered by both previous issues and foreclosures. OTOH, there is an impressive pile of commercial real estate refinancing that is expected to take place during the same time frame and my impression (based on annual reports, etc.) is that these loans have not been marked to market. It is politically difficult to envision another congress approved bailout of the TBTF banks, so Treasury will be forced to either re-issue TARP funds (which will be received by the public at large like a ton of bricks after this year's bonus payoffs) or force the bondholders to turn their debt into equity in order to increase capital. There is already a precedent in a bank which received TARP, but was not on the TBTF list (Banco Popular did this about two months ago). (Prudence would dictate, if you hold bonds in financial institutions evaluating this risk going forward).

The situation in both the Eurozone (well publicized with Greece and Ireland, but also affecting Spain, Italy and Portugal) as well as the exposure of Eurozone banks (largely Austrian, but not limited to them) to Eastern Europe is causing concerns, in the aftermath of Dubai's near default, which is supporting the US dollar. We have succeeded in exporting much of the inflation pressure caused by the recent drop in the greenback to Asia where real estate bubbles are causing concern.

The value of the USD should not be underestimated in importance. With a low dollar, the reported earnings of our companies will be higher, increasing the presumed value of our equity market. If the dollar retraces its heights, either by the actions of the Fed or by external events, our equity market will become extremely vulnerable within a reporting quarter.

It is in the world's interest to hold oil prices moderate. This has been largely successful, despite the drop in the dollar, after the bubble pop of a year ago. The price of oil is apparently within the comfort zone of OPEC and supply/demand figures still are favorable to a reasonable price. Per Hohum77's observations, world commerce is still abated despite signs of life in portions of the emerging markets. The equity markets in some of the emerging market countries (such as China) have become casinos and the best results over the next year may lie in the secondary tiers (such as Israel, Chile, Viet Nam, Turkey, etc.).

Taking the above observations (subject of course to your heckling and sneers) into account, the valuation of debt and the US dollar will be far more important indicators of things to come than the equity market.

I believe that the Fed would actually want to inflate our economy once the employment figures pick up in order to make it easier to pay off debts (mortgages, etc.), but until employment is high enough for wages to increase accordingly, significantly higher interest rates are probably not in the cards. I feel that 2011-2012 will be years of higher than normal inflation followed by an increase in interest rates in 2013 (after the presidential election) to moderate it. This will spike the USD and cause a (hopefully controlled) recession of relatively short duration.

2010 will be a year likely to provide substandard returns in the absence of bubble scenarios because our current increases in both bond and equity prices are due to the flow of free cash into the banks. It is unlikely that they will altruistically lend this money out to small businesses unless either a large enough carrot or a large enough stick is offered to them.

Once the Fed removes the punchbowl from the banks, in the face of next year's challenges (especially if interest rates rise and the US dollar increases), we could have another equity market "event".

Treasury (Tim G) has indicated that they will not allow another "credit freeze" to take place (which is why I'm skittish about bank bonds). That said, sometimes events take on a life of their own. The US dollar has been the safe haven (rather than gold) and the yellow stuff has become more of a sidelined issue. Money can be made there, but don't confuse it with the main event.

I'm hoping some will show me the errors in the above logic (no politics please). If the premises are correct, the question is where to safely deploy funds where they won't be subject to loss and offer an opportunity to profit.

Ball's in your court now :-)

Jeff