A Warning To Western Governments And Investors

By Karl Denninger, The Market Ticker

The equity markets are ignoring this… for now…..

The American investment group said it will be a net seller of UK Government bonds this year, at the very point when the Bank of England brings its £200bn programme of purchases to and end and the Treasury attempts to raise unprecedented sums through the capital markets.

The move is doubly embarrassing for the Government because the head of Pimco’s European investment team is Andrew Balls, brother of Schools Secretary Ed Balls, who is mastering the Government’s re-election strategy. The move will be seen as a financial vote of no-confidence in the Government’s handling of the economy.

PIMCO has also said it is reducing its holdings of American Treasury debt.

This is, indeed, a "no confidence" vote on government fiscal and monetary policy.  It is an expression of belief that the budget situations in both nations are both unsustainable and will not be dealt with, and more importantly that the central banks of both nations will lose control of their attempt to monetize the debt – that is, inflate it away.

I wondered how long PIMCO would continue to parrot the line that "everything is under control and Bernanke has this situation well in hand."  I guess I got my answer.

Nobody cares in the equity markets – for now.  The move yesterday and then again this morning – where there was no reaction to this at all – either means that PIMCO is wrong or the equity market traders, egged on by the likes of CNBS and the rest of Tout Journalism, are stupid.

Note that PIMCO’s decision was not reported in the American media to the best of my ability to determine.  You don’t think that might have something to do with their bias and attempt to drive Americans into the equity markets and cause them to (again) wind up on the losing end of these trades, do you?

I am reminded of the early days of the 2000 tech wreck when there was a literal every day barrage of crooners on the television and in the "business pages" telling you how CISCO was a great buy at 60, because it was "fairly priced" at 80 and at $60 you were buying at 25% off.

It ultimately fell to $13, and today trades at $24.67, or less than ONE THIRD of its $82 high reached on 3/27/2000.

Folks, PIMCO has a record of being not only right but privvy to "analysis" that you and I simply never, ever have or will get access to.  How that happens is the matter of some conjecture – there are many, myself included, who believe that they’re privvy to information sources that "ordinary peons" never will be given access to and in the debt markets insider trading is (for the most part) legal.

As a result when an announcement like this is made you’re a rank idiot to ignore it or believe "it doesn’t matter."  It most certainly does matter and the odds are that they’re right – and if you go against them you will be proved in the fullness of time to not only be wrong but poor on top of it.

There’s a call this morning out of Stephen Roach (Morgan Stanley Asia) to either put up or shut up:

Jan. 5 (Bloomberg) — Morgan Stanley Asia Ltd. Chairman Stephen Roach said U.S. policy makers should start to exit emergency stimulus measures now if the economic recovery is as strong as they say it is.

“There is never an easy time to do it,” Roach said on Bloomberg Television today. “The longer they wait, the greater the chance they sow the seeds for the next bubble. So I’m in favor of an early exit strategy.”

The problem is that there is no real strength in the economy.  Housing has been propped up by The Fed buying more MBS than were issued in the last year, not "supporting" the market but rather being the market.  Likewise, ex-"quantitative easing" the entire US debt issue was under $200 billion last year – but this year between corporate and government we need to issue far more than ten times as much. 

Tout TV will not tell you that the impact this has had on the markets – both stock and bond – is mathematically impossible to sustain on a permanently basis and as a consequence we are re-living 1999 in the Nasdaq.

For those who forgot this is what happened in the Nasdaq:

Remember this?  Remember Cramer’s "10 stocks you must buy for the new paradigm?"  Remember "The titans of Tech?"

What came next?

Hmmm….

And today?

It’s different this time.  I’m sure of it.

This, of course, is why Bernanke still has interest rates at zero, why he’s buying MBS hand-over-fist and has not disclosed how he intends to "exit" from his tampering and why the government has not pulled back on its so-called "stimulus" plans.

The economy is really strong, these valuations are entirely reasonable and based on very strong economic growth, and we have prosperity to look forward to, right?

Once again I want you to look at this graph:

In the 2000s we roughly doubled the outstanding debt in the system.  $25 trillion dollars, approximately.

And before you say "oh that didn’t matter" I want you to pay close attention to that table on the right again.  Specifically, the percent of GDP that was actually more debt being added to the system during the last decade.  It stands at 21.57%.

Therefore, if we simply flat-line debt in the system – that is, we add nothing – and all other things remain as good as they were in the 2000s, we would record GDP growth that is 21.57% lower than the last decade.

GDP growth from 2000-2009 was an annualized 5.2%.  This means we could achieve (with no debt increase) a maximum of 4.08% GDP growth assuming business conditions are otherwise as favorable as they were in the 2000s.

But debt addition has a multiplicative effect, because the people you hire with the debt acquisition spend money too.  So the compounding effect is in fact much higher than it first appears.

What’s dramatically worse is the civilian employment picture.  We’ve literally regressed some 30 years (some would argue all the way back to the 1970s!) in this regard, with a smaller and smaller percentage of the population being the "working class."

Yet the non-working not only do not contribute to output they actively deplete it through various "social programs" (e.g. unemployment insurance, food stamps, etc.)  As such there is a multiplier effect there as well, and both of these run the wrong way.

I find it ludicrous that we will achieve 4% GDP growth for the next ten years, or even the next five years.  The spending plans of government, ensconced in health care legislation, tax increases and the like will prevent it, along with the carrying costs of all that government borrowing.

Yet the stock market’s price increases are in fact pricing in GDP growth closer to 6% for the next decade!

This is exactly the same "error" that the market made in 1999.  It was precisely the same argument that I heard on BubbleTV for roughly the year prior to the implosion.  I scoffed at it then and I scoff at it now – those numbers were not achievable then even with the insane debt increases.

NOW such a prediction is beyond ludicrous – it’s the product of certifiable insanity.  To even get within 20% of that prediction – 5% GDP growth – we would have to be able to expand debt outstanding from $53 trillion to approximately $90 trillion by 2019.

Explain how that both can and will happen in an environment where the largest bond fund in the world is shunning both UK and US sovereign debt issues, while both governments remain committed to "pump priming" (putting the lie to the belief that a recovery has in fact taken hold) and I’m on board with the predictions.

Until you do I remain in the camp that we’re looking at a repeat of 1999, complete with sentiment indicators that are at levels higher than 1999 and last reached in 1987 just before the market crashed.

How far does the collectivity insanity go before we play Wile-E-Coyote?  I have no idea.  I didn’t know when it would "crack" in 1999 either – only that it would happen, with certainty, and I said so at the time in multiple interviews, some of which you can still find on the net.

I’ll gladly go on record with that same viewpoint once again – the rubber band is again being stretched by those who are willfully blind to the mathematical realities that underlie all economic growth and production, and they are leading you, the consumer and "retail" investor, straight toward the cliff.

The longer this charade goes on the worse the inevitable reaction.

Note that we have just recorded the first ever negative decade in the S&P 500.  That’s right – never before in history has the S&P had a negative return over a full decade.  It has now.

I will leave you with the following – the last time we played this game we lost everything from December of 1996 to spring of 2000 in less than three years.  If we do not stop being stupid – soon - I fully expect we will trade under 500 on the NDX and under 600 on the S&P.

And if you prefer the S&P 500….

I know, I know, everyone is looking at 2003 on the S&P and saying that we should have a 2004-like year, the more acceleration. 

But in 2003 credit was rapidly expanding, as it was in 2004.  This is why the S&P expanded back to (and slightly beyond) it’s previous high – that was all financial leverage.  The Nasdaq, made up of companies that made "things" (and services) for the most part, did not recover because it was not able to play financial engineering.

Now credit is contracting strongly ex-government, and even with the government’s borrow-and-spend policies total outstanding credit is not expanding at any meaningful pace.

So if the S&P’s recovery in the 2000s was based on financial leverage (it was) while the Nasdaq’s "recovery" was what you get minus that leverage what happens to the broader indices that are polluted with the "leverage required" firms when the market figures out that the leverage is not coming back?

I argue in reply that without the expansion of credit a durable recovery in asset prices is not just unlikely it is mathematically impossible, and that in fact current asset prices are both predicated and dependent on credit expansion that is in fact not happening now and mathematically CANNOT happen on a forward basis.

We’ll see who’s right.

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