Tuesday, July 26, 2011

Mussolini Revisited

by Rick Davis

(In a number of recent articles we have explored potential "unthinkable" solutions to both the U.S. sovereign debt problem and the fiscal consequences of a suddenly balanced U.S. Federal budget -- given that a balanced budget would suck about 14% out of the country's GDP, meeting the clinical definition of a depression. These articles are listed at the end of this one under Related Articles)

As we consider the "unthinkable" paths out of our current economic mess, some are clearly more nightmarish than others. Full fledged episodes of either deflationary depression or runaway hyper-inflation certainly fall into that category. A couple of decades of anemic and stagnating growth while "kicking the can down the road" (e.g., Japan since 1990) probably also qualifies as a nightmare -- at least for those currently not enjoying life near the top of the food chain. But there are other possible nightmares, particularly if governments conclude that past interventions in the economy failed merely because they were not intrusive enough.

Follow up:

When reflecting back on the U.S. Treasury's and the Federal Reserve's repeated interventions on behalf of the financial industry after September 2008, we are reminded of the following quote:

"... a capitalist enterprise, when difficulties arise, throws itself like a dead weight into the state's arms. It is then that state intervention begins and becomes more necessary. It is then that those who once ignored the state now seek it out anxiously."

A reasonable comment on the situation, had it been uttered then. It was actually spoken, however, on November 14, 1933 by Benito Mussolini during his address to the Italian National Corporative Council.

U.S. Interventionism

However ingrained the cultural vision of the United States as the bastion of unfettered capitalism may be, it (like every other economy on the planet) has always floated somewhere in the grey zone between utter laissez-faire and total state control -- at least since the "Whiskey Excise Act" of 1791. Despite the best efforts of Andrew Jackson and Martin Van Buren in the 1830's, there has been an inexorable drift towards increased governmental intervention and economic statism since then. That drift accelerated sharply in several phases during the 20th Century -- particularly during the "Great Depression," World War II and the continued growth of the "military/industrial complex" during the Cold War. It arguably surged again after Paul Volcker allegedly demonstrated the power of the Federal Reserve to control inflation, and yet again when Alan Greenspan was widely perceived to have at last learned how to tame the U.S. business cycle. Since then Ben Bernanke and Timothy Geithner have once more expanded the monetary interventions to unprecedented levels, although in fairness a major portion of the recent interventions have actually been in defense of the Federal Reserve's original 1913 mandate as the liquidity source of last resort.

Throughout all of this movement towards increased governmental intervention in the economy, the members of the S&P 500 peerage (and their predecessors) have prospered. As noted Austrian School economist Murray Rothbard observed in his 1978 "For a New Liberty"

"Big businessmen tend to be admirers of statism ... because a good thing has thereby been coming their way. Ever since the acceleration of statism at the turn of the twentieth century, big businessmen have been using the great powers of State contracts, subsidies and cartelization to carve out privileges for themselves at the expense of the rest of the society ... that the vast network of government regulatory agencies is being used to cartelize each industry on behalf of the large firms and at the expense of the public."In reality, all of these reforms, on the national and local levels alike, were conceived, written, and lobbied for by these very privileged groups themselves. The liberal reforms of the Progressive-New Deal-Welfare State were designed to create what they did in fact create: a world of centralized statism, of "partnership" between government and industry, a world which subsists in granting subsidies and monopoly privileges to business and other favored groups."


The "partnership" that Mr. Rothbard describes is an early form of the more extensive "corporatism" that was familiar to the people sitting for Mussolini's 1933 address. It was the means by which Mussolini and his friends in Germany controlled their economies -- just as it is the means by which the nominally communistic leaders of China now control their economy.

And in 1936 Gaetano Salvemini, a first-hand observer of the Italian economy during the 1930's, wrote in his book "Under the Axe of Facism" an eerily prescient description of the moral hazards so vividly seen in the U.S. financial industry some 70 years later:

"In actual fact it is the State, that is, the taxpayer who has become responsible to private enterprise. In Fascist Italy the State pays for the blunders of private enterprise ... Profit is private and individual. Loss is public and social."

To understand how corporatism works one only need look at the likely workings of the post Dodd-Frank financial industry (or indeed, the Health Care Industry after the eventual full implementation of the Patient Protection and Affordable Care Act of 2010), and extrapolate those nominally capitalistic industries to the entire economy: private ownership of production capacity, but with the actual operations largely regulated and controlled by industry specific ministries, councils and commissions according to the political designs of the State.

Cynics will note that Mr. Rothbard's "big businessmen" will be fully represented in those ministries, councils and commissions. In Japan there is a name for the cross-employment collusion between big business and the governmental agencies entrusted to regulate them: "amaagari," the ascent to heaven. Here we simply call it the "Treasury/Federal Reserve/Goldman Sachs" revolving door. While the "Keiretsu" in Japan and the S&P 500 peerage in the U.S. will be able to safeguard their interests in a corporatist world, the businessmen on "Main Street" will be expected to scramble for whatever crumbs may fall from the table.

Formula for Growth

The economic track record of corporatism in 1930's Italy and Germany is difficult to disentangle from the "Military Keynesianism" prominent in Italy during the early 1930's and in Germany after 1936 (for that matter, the Roosevelt Administration's track record post-1939 suffers from the same problem). But the economic growth track record of China is impressive by any standard, and the duration of that growth far out-strips anything seen in Europe 70-80 years ago and lays to rest charges that such growth is necessarily transitory:


(Chart Courtesy of www.TradingEconomics.com)
How can "corporatism" achieve such spectacular results? The answer is simple: if the State determines that the primary political priority is employment-generating growth, then all conflicting social niceties are merely obstacles that must be eliminated. The eliminated obstacles might initially include environmental protection, collective bargaining, domestic wage growth, domestic consumption, cartel-free markets and unrestricted international trade. Eventually the casualties will include political opposition and civil rights (although during China's unique and pragmatically serendipitous evolution from a purely communistic state into a defacto pseudo-fascist state, exo-Party political opposition was already a distant memory).

The rhetoric of a "corporatist" regime change is always wrapped in nationalistic jingoism, as it was in Italy, Germany and China. Steps were taken to devalue the currency and prioritize exports, while promoting self-sufficiency ("autarky") as a matter of vital national interest. Personal consumption was discouraged, while personal savings were encouraged. Barriers to imports were constructed, including appeals to patriotic consumption of only domestic product. Private enterprises were allowed to raid public "commons," appropriating via eminent domain critical real and intellectual resources required by the State's goals. Unfunded regulatory mandates were created, designed to channel private investment and consumption into industries that had political favor. And interest rates were kept artificially low, to encourage the expansion of private sector commercial credit and to keep the costs of State borrowing minimized. Every step of the way the changes were wrapped in the cloak of some necessary social good -- even paradoxically in the guise of protecting the very economic obstacles that were being trampled.

(And the early signs of corporatism need not be glaringly obvious: just regulations that on the surface defy economic common sense but are rationalized on the premise of some greater social good. Recent U.S. examples might include the regulatory obsolescence of incandescent lighting or analog broadcast TV when market conditions alone (i.e., consumer preferences) would never have fully accomplished the same transitions in the State desired time frames. In the latter case the domestic corporatist beneficiaries (the telecommunications giants) are far easier to identify in retrospect than the rationalized social good -- or even the economic good given the bonanza afforded to off-shore flat-screen TV manufacturers and the subsequent pressure on trade balances.)

The Temptation

The clear and present danger for the U.S. is that the fully entrenched Keynesian bureaucrats in Washington will defend their power, prestige, influence, careers and lucrative future gigs by insisting that the only thing wrong with their past efforts was that they given neither sufficient time nor the coercive tools necessary to do the job right -- not unlike the proponents of the "Flat Earth Society" insisting that the only reason we haven't yet found the edge of the earth is that we simply haven't sailed far enough in sufficiently speedy ships.

By any standard the American based "Too Big To Fail" Primary Dealers have already achieved corporatism. They have already reached the point previously observed by Gaetano Salvemini in Mussolini's Italy: "Profit is private and individual. Loss is public and social."

The danger is that an "unthinkable" expansion of corporatism will be seen as the lessor of evils necessary to forestall either a deflationary depression or a crushing episode of hyper-inflation. In fact, the growth record experienced by the Chinese over the past two decades may prove to be an irresistible prescription for how to prevent a Simpson-Bowles induced depression -- fully justified by a national economic emergency.

It is likely that the American public will prove less submissively docile than their Italian, German or Chinese predecessors were when corporate predation became State sponsored and their rights (and the environment) were trampled. Prudent investors understand that turbulent economics inevitably lead to turbulent politics. There's almost certainly a populist Andrew Jackson somewhere out there ready to wrap himself in his version of the American flag and do battle with the central bankers and their minions in the corporatist oligarchy.

Rick Davis is founder and CEO of the Consumer Metric Institute. The Consumer Metrics Institute (CMI) provides timely and quality information about the consumer economy in the United States. Background information on CMI is available at http://www.consumerindexes.com/Overview.pdf .

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Economists: Causes of High Commodity Prices

Growing demand for corn to use in biofuels and for soybeans to help feed a booming Chinese economy are among key forces driving commodity prices higher this year, according to a report by three Purdue agricultural economists.
A weak U.S. dollar, high oil prices, declining grain supplies and poor harvests in 2010 also contributed, they wrote in the report, which predicts that high prices will continue beyond the 2011 crop year.
The economists - Phil Abbott, Chris Hurt and Wally Tyner - detailed their findings in "What's Driving Food Prices in 2011," commissioned by Farm Foundation, NFP, and released Tuesday (July 19). Costs of commodities influence retail food prices as do general inflationary pressures such as transportation, packaging and food processing.
The report follows their analyses for Farm Foundation, NFP, in 2008 and 2009, when retail food prices also peaked.
For commodities prices in 2011, it comes down to world food and fuel demands exceeding supply in recent years.
"In the United States, we've typically had more grain and soybeans than we could use here," said Hurt, who specializes in grain and livestock markets. "Now we have to ask ourselves, can the U.S. and the other major suppliers meet all these world demands?"
Corn use for ethanol represented 27 percent of the 2010-11 crop usage, compared with 10 percent of the 2005-06 crop. The growing demand for corn to make ethanol and China's increasing desire for soybeans have been two big "demand shocks" for agriculture, the report states.
"When you put them on top of each other, the price impacts are a lot bigger than either one separately," Hurt said.
The amount of U.S. farmland needed to meet those two surging demands has increased from 16.1 million acres in 2005 to 45.6 million acres in 2010, an increase of 189 percent, according to the report. U.S. agriculture met these demands in two ways, the economists said:
  • First, U.S. farmers shifted land into producing corn and soybeans and out of other crops such as cotton, wheat and sorghum. As a result, prices for most other crops also rose.
  • Second, U.S. stocks were used to the point where there is a minimum inventory of grains today to meet any production shortage. As a result, any weather threats to normal yields in 2011 will mean higher prices.
China's rapid economic growth is resulting in more demand as their consumers both buy more food and shift their food mix toward more animal products such as meat, milk and eggs, which require corn and soybeans to produce, said Abbott, whose work focuses on international trade and agricultural development.
"However, we also found that about 40 percent of the increase in Chinese soybean imports in recent years was due to increasing their inventories - building stocks," Abbott said. "We believe they now have sufficient stocks levels, and that could slow their overall rate of growth of purchases in coming years."
That economic growth contributes to China's demand for soybeans, crude oil and other commodities, Abbott said.
"The movement of agriculture into biofuels has now linked the oil market to the corn market and to agricultural markets in general," he said. "If oil is high-priced, this will tend to mean agricultural markets are high-priced as well. All of that is contributing to higher commodity prices in general."
The authors also noted that agricultural markets have become less responsive to price changes, leading to both high prices and greater volatility in prices. Most of the U.S. corn used for ethanol is mandated by the government. The mandate requires that 12.6 billion gallons be blended into gasoline in 2011. It will increase to 15 billion by 2015.
That requirement creates what economists call an "inelastic" market.
"The amount of corn that it takes to produce that will be used in the U.S. whether corn is $2 a bushel or $10 a bushel," Tyner said. "That's pretty inflexible."
Other inflexibilities are coming from foreign buyers who want basic food commodities - almost regardless of price - and from the livestock sector, which now can afford to pay much higher prices for feed than just a few years ago.
High corn, soybean and fuel prices eventually make their way into higher retail meat prices, the economists noted. The animal industries suffered heavy financial losses in 2008-09 when producers began to reduce herds and flocks after feed costs escalated and a world recession set in. That reduction in meat supplies forced retail prices up in 2010 and now to record-high retail prices for beef and pork in 2011.
Ethanol production has grown rapidly the past five years, but the rate of growth in mandated levels is beginning to slow, the authors said. This means that the demand base that has built up will persist but will not grow as quickly in the next few years.
Looking to the future, they say a slowing rate of growth in both corn use for ethanol and in soybean purchases by China could provide a better chance for world grain supplies to catch up to slowing demand surges.
"But it's unlikely that we will go back to having huge surpluses because that demand base remains so strong," Hurt said.
The full report is available at http://www.farmfoundation.org, where previous reports also are posted.

Two Big Contrarian Indicators Point To Downside Risk

As the first half of the year ends, we are in an up-phase. After the recent sell-off in May and early June, the market internals have started to look better. The S&P 500 bounced smartly off the 200-day moving average and has turned upward.
Yet, if you look at sentiment indicators, a contrarian view would say the pain is not over. Andy Lees writes today:

The first chart overlays the net AAII bull/bear sentiment index, which has rebounded heavily, against the US macro surprise index which remains towards rock bottom at -93.6. As you can see the divergence is the worst since December 2008. (The G10 surprise index is -52.5, Latin America -46.4, Europe -9.30, Japan -62.10, Britain -50.80, APAC, Australia -36.8, although APAC is still +6.70 and China 27.3)

The surprise index measures the divergence between actual data and economists forecasts, and is therefore another form of sentiment or expectations index. Economists are at a near record divergence against the reality of the data, and as the overlay chart shows net bullish market sentiment is also at a near record divergence to how the data is coming out vs expectations.

Perhaps they are right and the economic weakness is just a blip that will pass and the data will rise to meet expectations, but if not there is a big hole between the level of bullishness and the existing reality of the macro data. The second chart shows the VIX index, reflecting “a market estimate of future volatility based on the weighted average of the implied volatilities for a wide range of strikes”. The low VIX level suggests a level of complacency totally out of kilter with this level of risk, and at a time when QE2 has come to a conclusion.
Basically, just as the fundamentals are diverging enormously from actual data, bullish sentiment is increasing. That is a seriously bearish contrarian indicator. As for the positive 200-day moving average data I mentioned, Andy writes:

The S&P bounced heavily off its 200 day moving average but the Nasdaq has not yet been able to break back above its 40 year trend line – (trend level today is 2825) – suggesting this is still just a technical bounce and not yet to be trusted, which in the context of near record divergence between data and sentiment & expectations is not a good sign.

The mitigating factors are the recent manufacturing data and the pickup in small business credit. I especially like to see small business with access to and take up of credit because that could mean renewed hiring. The jobless claims numbers are not moving yet though.

Overall, the data are still soft and the surprise index is still saying that earnings estimates will be cut. In my view that means the risk is still to the downside.

Highest weekly close for the Nasdaq 100

by Kimble Charting Solutions

Are the "Forces" against the U.S. Dollar?

by Kimble Charting Solutions

Safe-Haven Currencies: If You Want to Flee the U.S. Dollar, Here Are Four Places to Hide

By Martin Hutchinson

As a young British banker in the inflation-ridden 1970s, I got used to carrying large amounts of German deutsche marks, Swiss francs and Japanese yen in my wallet - to have some security against the lousy performance of the British pound sterling.

While paying for a pizza in London with this foreign cash was difficult, having those "safe-haven" currencies in hand helped me sleep at night.

We've reached that point again. In light of the escalating debt-ceiling debacle that's unfolded in Washington, the potential for a U.S. credit-rating downgrade no matter the outcome, and the likelihood that a long stretch of dollar-killing stagflation is headed our way, it's time to take refuge in today's safe-haven currencies.

And I'm going to show you the safest of those safe havens.

The Battle-Damaged Greenback

I know that many of you are extremely worried about what will happen if Standard & Poor's downgrades U.S. Treasury debt from its top-tier AAA credit rating.

But I'm telling you that there's a much bigger cause for concern. While I concede that having our federal debt lose its top-tier credit rating wouldn't be good, the bigger cause for concern is what happens to us if the U.S. dollar stops being regarded as AAA - meaning it's no longer good for settlement of all international transactions.

If that happens, you have to ask yourself two questions:

  • What would be the impact on the U.S. and world economies?
  • And, even more importantly, what would investors like us need to do?
The answer to the first question is clear: The fallout will be worse than you imagine. And that means that, even now, you need to be searching for refuge in the very best of the world's safe-haven currencies.

With the Aug. 2 deadline for raising the debt ceiling approaching fast, the U.S. dollar took another beating and fell against safe-haven currencies yesterday (Monday), after Washington failed to reach agreement on the nation's $14.3 trillion debt ceiling. The Swiss franc actually reached an all-time high against the dollar, which has slipped 25% against that currency in just the last 12 months.

What a lot of folks don't realize is that the fate of the U.S. dollar is closely tied to that of U.S. Treasury bonds. If U.S. inflation takes off to serious levels - as I'm almost certain it will - both Treasuries (except Treasury Inflation Protected Securities, or TIPS, which are inflation-protected) and the dollar will tank simultaneously.

After all, the United States has been running balance-of-payments deficits of $500 billion or more for almost a decade now - much longer than the country has been running $500 billion budget deficits. 

The dollar is also almost certain to drop if the vast U.S. budget deficit causes a crisis in the Treasury bond market. Finally, the advent of modern communications technology has made global manufacturing much easier, lowering the market premium of U.S. wage levels above emerging-market-wage levels (that's one reason unemployment has been so stubbornly high this time around). The easiest way for these wage levels to be equalized again, necessary for U.S. unemployment to fall, is for the dollar to decline sharply against emerging-market currencies.

For these reasons, we can expect the dollar to be generally weak against other currencies. That will unsettle international traders who receive payments in dollars. They will look to get paid for their goods and services in other "safe-haven" currencies.

The challenge, of course, is to determine exactly which safe-haven currencies we're talking about ...

The answers will surprise you.

The Four Real "Safe-Haven" Currencies

So if we're searching for safe-haven currencies, which ones should we look at?

The European euro? That won't do - there's too much of a chance of it splitting in two. That would be either good or bad - good if the weak-sister PIIGS of Portugal, Ireland, Italy, Greece and Spain split off to form their own weak bloc (leaving the euro strong), or bad if Germany and a few stronger countries split off (leaving only the weaker currencies in the euro). Either way, the euro is a risk, and a big one: After a split, the currencies would probably shift by 20% to 30% against each other, to give the weaker countries a chance of exporting their way out of problems.

The British pound sterling? What a very sweet, old-fashioned idea. If this were 1911 - or, better still, 1821 - this would be the ideal safe haven. But it's 2011, and Britain has all the same problems as the United States - only to a greater degree.

The Japanese yen? Japan has a much worse debt problem than the United States, and only the fact that Japan owes all that money to itself is keeping the Japan Government Bond (JGB) market stable.

The Chinese renminbi? A fashionable solution, but the reality is that China still won't let its own citizens get their money out freely. What's more, there is a huge glop of bad debts in the Chinese banking system that at some stage will cause big problems - so big, in fact, that the 2008 financial-system crash and collapse of Lehman Brothers Holdings (PINK: LEHMQ) will seem like a springtime stroll.

Such afterthoughts as the Brazilian real, Australian dollar or Canadian dollar? While I'll grant you that Canada is much-better run than the United States, the ugly truth is that Brazil and Australia are no better run than any other country. In fact, all three of these countries had the great fortune to be heavily dependent on commodities at a time when commodity prices happened to soar.

If commodity prices decline, the innate problems facing each of these currencies' problems will become painfully apparent.

As our trip around the world

There are thus very few safe-haven currencies for you to invest in.

There are actually four clear winners:

  • The Swiss franc: Switzerland is the ideal European country - chiefly because it has a large-but-safe banking system. The Swiss National Bank made UBS AG (NYSE: UBS) and Credit Suisse Group AG (NYSE ADR: CS) recapitalize themselves properly and have forced the two to do more wealth management and less investment banking.
  • The Norwegian crown: Norway has oil, a large trust fund and no European Union membership. That trust fund (actually a very-well-managed, $570 billion sovereign wealth fund) makes this one ideal - even if oil prices collapse.
  • The Singapore dollar: This is a beautifully run country - the least corrupt in the world, in fact - and is a banking-and-trading entrepĂ´t, to boot.
  • The Chilean peso: Yes, I'm recommending a South American currency as a safe-haven currency - my 1970s global-merchant banking colleagues would recoil in horror. All the same, Chile is less corrupt than the United States. It has a commodity economy, but is better run than Australia (and less likely to be under cut by cheaper labor, since Chilean labor is still quite cheap). And it has a trust fund (sovereign wealth fund) to guard against a return of low commodity prices.

Moves to Make Now

Even when you know what currencies you want to be in, buying them is not all that easy. Generally, the currencies themselves can be bought at any major commercial bank, although you may get killed on the rate. However, this will give you a pile of paper money with no yield and a danger of being eaten by mice.

A better alternative is to buy bank deposits. Here our friends EverBank can help you; it offers a bank-deposit service in a wide range of foreign currencies. Three of our four currencies are on EverBank's list; you can open accounts in Norwegian crowns, Singapore dollars and Swiss francs - but not in Chilean pesos.

Foreign-currency bonds are another alternative, although not all brokerages allow you to buy them. The difficulty here is the minimum amounts are generally large, and there is a substantial bid-offer spread. Still, this is probably your best alternative for Chilean pesos, where the government is currently rated AA for Chilean-peso obligations and 10-year peso government bonds yield about 2.4%.

Safe-haven currencies gave me such a sense of security when I turned to them during the economically tumultuous 1970s that I still can recall the feeling today - nearly 40 years later; now it's time for you to seek out that kind of security.

See the original article >>

Brace for the Worst as Debt Ceiling Crisis Deadline Nears

By David Zeiler

If Washington lawmakers don't beat the debt ceiling crisis deadline, we'll see plummeting stocks, soaring interest rates, a slumping dollar and a severe shock to the weak economy.

All of which will hit you in the wallet - and hard.

Most investors are not prepared for the consequences of the failure of U.S. lawmakers to agree on a plan that will raise the federal debt ceiling before the Aug. 2 deadline.

Few believed it even possible, but with only a week to go Congressional leaders and U.S. President Barack Obama are no closer to a deal than they were several months ago.

"We may have a few stressful days coming up - stressful for the markets of the world and the American people," William M. Daley, President Obama's chief of staff, admitted on the CBS program Face the Nation on Sunday.

Until recently, the markets have kept a cool head - most analysts have assumed government officials would reach a compromise in time.

But when negotiations between President Obama and Speaker of the House John Boehner, R-OH, broke down over the weekend, the possibility of a U.S. default suddenly grew frighteningly real.

"There has been this expectation that at some point, they'd come up with a deal, but given the failure this weekend, I think market confidence is eroding," John Canavan, a market analyst at Stone & McCarthy Research, told The New York Times.

The impact of the endless political dithering is already being felt in the equity markets, which will become increasingly sensitive to developments in Washington as the clock ticks ever closer to the debt ceiling crisis deadline.

The Dow Jones Industrial Average dropped 145 points early yesterday (Monday) in reaction to the lack of progress over the weekend, although it recovered about half of the losses later in the session.

"The stock market is where a lot of the volatility will occur," Bernie Williams, vice president of discretionary money management at USAA, told USA Today.

Bonds Threatened

Perhaps more vulnerable, however, will be the bond markets.

All three major credit rating agencies - Moody's Investors Service (NYSE: MCO), Standard & Poor's and Fitch - have threatened to downgrade U.S. credit, which could cause a selloff in U.S. Treasurys, particularly the 30-year notes.

Ominously, the credit agencies have warned of a ratings downgrade not just in the case of a default, but also if Congress fails to address the amount of debt as well as the yawning budget deficits that feed it.

"When this started, the focus was the debt ceiling. Now the issue is that the ratings agencies have said they need to have a credible deficit-reduction program in place for them to take away the threat of a downgrade," Steven Englander, head of G10 FX Strategy at Citigroup told Reuters.

Many pension and money market funds could be forced to sell bond holding because of requirements that they hold AAA-rated investments. Few fund managers have taken any action to prepare for a default scenario.

"I don't think investors are prepared. It's hard to prepare for such a tail risk," Alessandro Bee, fixed income strategist at Sarasin, told Reuters. "It's like preparing for nuclear fallout."

In addition to roiling the bond markets, a downgrade would drive up interest rates, which would slam the struggling housing market and hurt businesses and consumers by raising the cost of borrowing.

"Playing Russian roulette with the bond market is a zero sum game," Christian Cooper, head of U.S. dollar rates derivatives at Jefferies & Co., told Reuters. "It is history's rule rather than the exception that the outcome of a default will be dramatically higher interest rates for all Americans and a generation-defining shift that will make job creation significantly more difficult."

In the world currency markets, a default will cause a slide in the U.S. dollar, driving up the cost of many imported products and commodities.

Beyond the credit issues, failure to raise the debt ceiling by Aug. 2 would force the government to immediately cut federal spending by about 40%, which could hurt companies reliant on government contracts.

"You have a number of sectors that can be getting hit from the credit downgrade and hit from the austerity," Dan Clifton, Head of Policy Research at Strategas, told Yahoo! Finance's Breakout. "There's a discretionary spending cap that would go into place."

Go for Gold

Given that a U.S. default would severely harm equities, bonds and the dollar, what should you do?

If the worst happens, one haven will be precious metals like gold and silver. In fact, gold hit a record high of $1,624.30 an ounce yesterday before falling back slightly. Silver was up 0.6% to $40.361 an ounce on the Comex.

"Gold is feeding off the uncertainty of the debt negotiations,"Matthew Zeman, a strategist at Kingsview Financial in Chicago, told Bloomberg News. "Gold is in a ‘can't lose' situation with the debt negotiations because regardless of the outcome, the dollar is going to suffer."

Oddly enough, short-dated Treasurys may also rally, simply because few liquid investments can match the size of the U.S. market - a lot of money will have nowhere else to go.

Of course, a major breakthrough deal before the debt ceiling crisis deadline would reverse all of this, sparking a big rally on Wall Street. That means you'll need to keep a close eye on Washington until all this is resolved.

"We believe Winston Churchill characterized the U.S. well when he said, 'You can always count on Americans to do the right thing after they've tried everything else,'" David Kotok, chairman and chief investment officer at Cumberland Advisors told Reuters. If not, "the markets will experience a horrible shock. The unthinkable will have occurred."

USA Debt Crisis: Is There Any Truth?

by Steven Hansen and John Lounsbury

This morning the NY Times covered the division within the economic community over the way out of the USA’s overspending / balance budgeting.
“Reasonable people can sit down and, apart from any political or policy motivations, come up with different answers,” said Robert S. Chirinko, a finance professor at the University of Illinois at Chicago who studies corporate taxation.
No doubt this is true. The economic community’s solutions range from more deficit spending stimulus (on the theory that boosting the economy will boost tax revenues to balance the budget) to out-and-out cutting spending (on the theory that re-balancing, while causing short-term pain, will spur long-term growth). Both extremes have some basis in main stream economic studies.

The economic objective is to find the best path through this crisis causing the least disruption and unintended consequences. These headline economists are macroeconomists who specialize in studying and modeling the economy as a whole – studying the forest, not the individual trees.

The unanswered question in macroeconomics is whether the past economic responses to economic management will work in the current situation. There are many forces which effect an economy – and no two situations are the same.

Much work published in Econintersect analysis looks at the trees, and not the forest. On the issue of USA debt – it seems like most macroeconomic models are ignoring many trees. Some of the trees ignored are:
  • There is no way to balance the budget much before 2050 without touching entitlements (see analysis here). In fiscal year 2011 – USA tax income is less than the money being spend on entitlements. On the other hand, shotgun cutting entitlement spending reduces support to the weakest elements of the population.
  • The current deficit in f/y 2011 is $1.6 trillion. How much of this money effects GDP of over $14 trillion is unknown – but a contracting government sector and a stagnant private sector spell “recession”. Budget balancers are ignoring negative spirals (less spending resulting in reduced taxes resulting in less spending…..). Is a balanced budget necessary? (analysis here)
  • The NY Times states in their article that a tax increase of 1% reduces economic activity by 1.3%. Shotgun tax increases appear to do more harm than good.
  • The USA’s current system requires deficit spending to be financed with treasury bonds / bills. The additional stimulus advocates ignore that the economy at some point will engage, and that the debt itself will begin to starve the economy (from higher interest payments).
Econintersect endeavors in its analysis articles to provide facts for readers to form their own opinions – and not accept the soundbites from dogmatic groups. Economies are complex, and, at this point, no good solutions exist where you can have your cake and eat it too.

And the disagreement between economists goes beyond political bias, at least in some cases. One example is the Great Debate© between Casey Mulligan (University of Chicago), who argued for lower taxes and less government spending and Menzie Chinn (University of Wisconsin), who took the other side.

In the NYT article it is pointed out that there are also a variety of opinions about the relative magnitudes of tax change impacts on GDP. And, to go further, not all taxes are created equal when the effects on growth are estimated. From a GEI Analysis article published last fall, the following graphic shows just how widely different various tax rate impact estimates can be.

It depends where the taxes come from just how much the effect may be. And then the discussion can swing back to the Mulligan/Chinn debate.

Finally, that brings us to the excruciating grind that is the debt ceiling negotiation in Washington. From a GEI News article about the Gang of Six plan:
Which of the proposals will be the hardest to reach agreement on in the broader Capitol Hill community? The opinions vary. The Christian Post suggested it might be the repeal of the AMT (Alternative Minimum Tax). The Huffington Post said it might be a standoff between the right and the left over tax increases and benefits cuts, respectively. TheWall Street Journal editorial of July 23 gives two impediments: (1) Deeper cuts are needed to pass the House; and (2) The president is grandstanding.
GEI Editor’s note: We find it curious that no other grandstanding was mentioned.
The bottom line is given by the NYT: “The lack of definitive answers reflects the reality that economics is not a hard science.” That means that any policy implementation is entirely an experiment, in spite of what any proponents or opponents proclaim. And, of course, just who is experimenting (or grandstanding) and who knows what they are doing is often entirely in the eyes of the beholder. With all deference to the wisdom of Prof. Chirinko, the final decisions may not be made by reasonable people, apart from any political or policy motivations, who compromise between different answers.

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Graham Summers’ Weekly Market Forecast

by Graham Summers

Given the ridiculous number of rumors (and ridiculousness of some of the rumors) related to the US and EU debt talks that are circling the financial community, I thought it best that we confront the realities these two economies face. Today we’re focusing on Europe.

Regarding Europe, we still don’t have any details regarding the Greek bailout, nor do we have any real sense of how the mega-bailout fund will really work in terms of solving any of the EU’s problems.

However, the fact remains that everything related to EU bailouts hinges on Germany. Germany is the most solvent member of the EU. And without its backing, NO EU bailout scheme will work in any way.

With that in mind, we need to consider that the majority of Germans now want out of the Euro. As I have noted in previous articles, politics is the name of the game in the EU, so the next round of German elections in September could dampen Germany’s interest in backstopping more bailouts (current Chancellor Angela Merkel’s party took a serious beating in the March elections already).

A second element that needs to be focused on is Germany’s economy. Any threat to the German economy could quickly hinder the debt talks/ bailouts in the EU for the following reason:

1) Germany is the largest, strongest, most solvent, member of the EU, so if it’s in trouble, the less solvent members will be in major trouble.
2) A weak German economy will fuel the political fires for those Germans who see little benefit in remaining in the EU (subsequently the heat will turn up on those politicians pushing for continued bailouts).

In simple terms, if the German economy breaks down, then the EU and the Euro are in big trouble. With that in mind, Germany has recently seen three economic releases that show the “recovery” is slowing (the IFO Business Climate, Manufacturing and Services, and the ZEW Economic Sentiment).

If any of the negative issues mentioned above become worse, the EU experiment would fast approach its end. This would result in the Euro taking a hit, which would push the US Dollar higher.

On that note, the Euro broke out of the triangle pattern I mentioned a few weeks ago to the downside. It’s now rallying to retest the lower trendline for this pattern (fitting the classic, break-down, test, then REAL move pattern I’ve been telling readers about for years).

The ultimate downside target for the triangle patterns breakdown is 136 or so. So unless the Euro stays above 44, we’re going there relatively quickly. Given that Italy has just joined Austria in cancelling a bond auction, I’d say this downside target is on its way.

However, the bigger picture here is the 125-level which has been a line of massive importance for the Euro since its creation:

As the above monthly chart of the Euro reveals, 125 has served both as important resistance and important support over the last 20 years. The Euro just broke below this level during the 2010 Crisis. The next time it breaks below this line we’ll be in the midst of the final End Game for the Euro experiment.

A Tale of Two Debt Crises

On Thursday, Euro-area leaders stepped up their efforts to resolve the ongoing Greek debt crisis, announcing €159Bn ($229Bn) in new aid for Greece. They arranged for bondholders to foot part of the bill and expanded the power of the €440Bn Euro rescue fund to buy debt across stressed European nations - “after a market rout last week sparked concern the crisis was spreading.

The fund can also aid troubled banks and offer credit-lines to repel speculators.” The Euroland leaders hope to construct a financial “firewall” around struggling countries like Spain and Italy, while assuaging fears that the debt crisis is spreading. French President Sarkozy compared the transformation of the bailout fund to the creation of a “European Monetary Fund.”

Hopes for saving the Eurozone from multiple defaults by weaker EU members strengthened the Euro against the Dollar. We view the solution as another attempt to kick the can down the road. It was, however, a substantial kick and probably good for at least a few months. It whacked the Dollar, and conversely rallied the equity market.

As Bruce Krasting wrote,
“The Council of the European Union statement makes it pretty clear that the Euro folks are going to do everything they can (including direct intervention in the bond market) to stop the spread of contagion. I think they will succeed in maintaining market peace for a few months. But sometime this fall the issue of default by some Euro members will rise up again. It has to. I think the leaders in Europe are dreaming.”
U.S. Debt Ceiling Deadlock

In the United States, a fierce battle over raising the debt ceiling raged on, with both sides refusing to negotiate a settlement.

A team of six senator, three Republicans and three Democrats, the “Gang of Six,” put together a decade-long, $3.7 Tn deficit reduction plan. President Obama remarked to reporters before the Tuesday White House press briefing that the Senate “Gang of Six” proposal was a “very significant step” towards resolving the impasse, representing a “potential for bipartisan consensus.”

The proposal, however, drew considerable opposition. House members of both parties feel their side had given away too much. “We don’t have to increase the debt ceiling,” says three-term Rep. Paul Broun (R) of Georgia, who voted against the bill. “There are other ways to raise revenue without going into receivership,” he added, suggesting that the government could increase federal revenues by opening up energy reserves or selling unused federal buildings.

Robert Borosage of Politico was also displeased:
“[T]his isn’t a New Deal or a Fair Deal. It’s a Raw Deal — one that every citizen concerned about rebuilding the middle class should oppose. It would add to unemployment in the short term, increase Gilded Age inequality, leave seniors more vulnerable and shackle any possibility of rebuilding America. It puts the burden of deficit reduction on the elderly, the poor and the vulnerable; endangers jobs and growth; and lards even more tax breaks on the rich."
But, in the end, Boehner said on Sunday evening the path forward does not include an agreement between him & the President. If last-ditch talks fail, they will have to take responsibility if the unimaginable — a government default — happens in 10 days and the checks stop going out.”

Debt Ceiling & the Markets

One fear regarding a U.S. default is that creditors will demand higher interest in return for issuing new debt. Considering how enormous the U.S. debt load currently is (roughly $14.5Tn), higher interest rates would add a crippling burden to an already high burden. This leads to the question of how the markets would react if the U.S. defaults on its debt obligations.

Discussing the market on Friday, Russ Winter observed,
".....the best comment I’ve spotted on the causa proxima of all this was made in the public feedback section of another site. Someone who goes by the name ‘sbernard’ used the term ‘hubris obliviana.’ It’s such an apt descriptor that I’m going to adopt it as a Winterism. Wrote sbernard:
‘The truth is that Wall St suffers from a serious disease called hubris obliviana, fueled by endless government interventions, bailouts, stimulus, and Fed money expansion. One of the ‘unexpected’ consequences of this monetary heroin in that Wall St has lost all perception of risk. They reflexively have too much unending faith in the power of government to fix all their troubles. Thus, they are setting us all up for even more risk — risk the government cannot avert because it is the (weak link)!’”

Copper On The Rebound?

Copper slightly disappointed investors, ending the first half of the year with a decline of 3.50 percent. Worries about global inflation and, more specifically, the potential slowing of China’s economy weighed on copper’s price. The red metal rose 5 percent quickly in the new year, but similar to zinc, lead, palladium and platinum prices, declined sharply at the beginning of May.

Copper on the Rebound?

Since the end of June, copper has been slowly inching its way up, with the past three weeks having produced positive results. Part of this rise is due to reduced supply issues. Chile, the world’s largest copper producer, has been plagued by power outages, strikes, accidents and heavy rains.

Reuters recently reported that a “once in a half century winter storm” caused more than 12 mines to slow or stop operations after the open pit roads became too slippery in the South American country that mines about one-fifth of the world’s copper.

The election of Ollanta Humala in Peru–the second-largest producer of copper–has also been a drag on copper prices as investors debate the probability of Humala electing a mining friendly cabinet. As I discussed in “Is Peru’s Humala Jekyll or Hyde for Mining?,” investors have worried the president-elect could retract policies that encourage mining investment and help grow their economy.

The announcement came this week that Humala will appoint Luis Miguel Castilla, Peru’s former deputy finance minister, as the new finance minister. Carlos Herrera will lead the mines and energy ministry. However, according to the Financial Times, it is still not clear whether Humala will increase the corporate tax rate paid by miners and enforce tighter state controls. The actions of this leader will have an influence on the direction of copper prices for the remainder of the year.

In terms of demand, copper is a necessary ingredient for numerous building projects. Electrical power cables, electrical equipment, automobile radiators, cooling and refrigeration tubing, heat exchangers and water pipes all require copper. With all the construction and infrastructure building in China over the past several years, it’s not surprising that this country is the No. 1 world consumer of copper. It’s estimated that China accounted for nearly 40 percent of global copper consumption last year.

Because of this large demand, similar to our outlook for oil, copper prices hinge on China’s ongoing development. While some have begun to wonder about the health of the country’s continuing growth and development, Macquarie Research believes that “real demand in the country remains robust.”

Take developer activity, for example, which Macquarie says has been a huge driver of construction growth in 2011. The media has focused its attention on ghost cities and lagging sales of property in China. Yet Macquarie thinks it’s important to consider the property sales across all different sizes of cities. In its Commodities Comment, subtitled “Chinese social house – another reason to buy copper and iron ore,” Macquarie acknowledges a weakness in property transactions in China’s larger cities. This was due to the government restricting investment demand to slow growth. However, these larger cities only account for 20 percent of the total market, says Macquarie.

Conversely, many smaller cities, such as Anquing, Guizhou, Luzhou, Mudanjiang, and Shijiazhuang, have had double-digit year-over-year growth in unit sales so far this year. In the case of Hohhot, the capital city of Inner Mongolia, sales growth has tripled. Government investment has led to urban space increasing from 80 square kilometers in 2000 to 150 square kilometers last year, according to the city’s government website. Hohhot, which means “green city” in Mongolian, has grown to more than 2 million people and has become a hub for agriculture and manufacturing.

Property Sales Strong in Smaller Cities

Most importantly, Macquarie says the tremendous sales activity in these smaller cities indicates “there has been enough cash to keep construction activity going.”

In addition, China’s social housing project should drive incremental demand for copper. Macquarie indicated that China is “aiming for 10 million social housing units, up from 5.8 million in 2010.” The country has built only 3.4 million units so far this year, but based on China’s habit of exceeding its objectives, Macquarie thinks the target will be met.

Even if the naysayers think China’s growth will slow because of the government’s monetary policy restrictions, there’s consensus among research experts that the country’s inventory of copper is getting low. Goldman Sachs’ discussion of the copper market indicated that in the second half of 2011, the “winding down of destocking will lead to a stronger Chinese pull on global supply.” China seems to have no choice but to go back to the market for copper, if only to replenish its supply.

Tom Kendall, Credit Suisse’s vice president for commodities research, agrees. In a Mineweb interview on copper’s fundamentals and expectations of further growth, Kendall stated he has seen a “very sizeable drawdown” in Chinese copper inventories this year. He goes on to say, “some point in time, they will get to a point at which they have run down inventory levels to an uncomfortably low level and then there is no alternative to coming back to the international market.”

Portfolio Manager Evan Smith agrees that copper’s pricing looks promising. China is nearing the end of its tightening policies and has shown that its debt is under control based on released results of the country’s comprehensive debt audit. For the Global Resources Fund (PSPFX, he has been incorporating these macro thoughts into the team’s models to identify stocks with superior growth and value metrics that he believes could benefit the most.

Is Tech’s Rally for Real?

Technical indicators suggest that recent tech sector strength can continue, and buyers can now look for favorable entry points in a popular sector ETF and several strong tech stocks.

With two weeks of corporate earnings reports already behind us, the earnings for the technology stocks have gotten most of the attention, as there have been some very pleasant surprises, which contradict a June 24 USA Today article that suggested investors should lower their expectations for tech sector earnings.

The tech-heavy Nasdaq 100 made new highs for the year last week, as it completed its 200+ point trading range, which has been in effect all year. This gives upside targets in the 2600 area, or about 7% above Friday’s close. Those technology industry groups with the best charts include application software, data storage devices, and diversified computer services.

Still, given the market’s growing concern over the US debt ceiling, and even though there is a large amount of money on the sidelines, many are wary of venturing back into the technology sector. However, the technical outlook, including the relative performance, or RS analysis, indicates that recent tech sector strength can continue.
Click to Enlarge

Chart Analysis: The daily chart of the Select Sector SPDR – Technology (XLK) shows Friday’s close slightly above the chart resistance at line a.
  • The completion of the trading range has upside targets at $29.50-$30
  • RS analysis moved through short-term resistance at line c last week and then turned higher after a retest. The long-term downtrend, line b, has also just been overcome
  • Daily on-balance volume (OBV) broke through resistance (line d) in early July and held support last week. The weekly OBV has not yet confirmed the highs
  • XLK held the 50% support at $25.54 two weeks ago. That now becomes the key level to watch
Compuware Corp. (CPWR) is a $2.2 billion company that provides software along with Web performance and application services. The daily chart shows that CPWR retested the June lows in the $9.15-$9.40 area, line f, last week.
  • Volume was heavy on Friday’s strong close. The daily OBV has moved above its weighted moving average (WMA) and is now testing its downtrend. The weekly OBV has turned higher but is still negative
  • There is first resistance (38.2%) at $10.15 with the stronger 50% retracement resistance at $10.67
  • The daily downtrend, line e, is in the $11.00 area. The early-2011 highs were at $12.25
Click to Enlarge

NCR Corp. (NCR) is a $3.3 billion information technology company whose beginnings date all the way back to 1884. The company reported strong earnings last week that were up almost 13% over the prior year. In reaction to the numbers, NCR opened higher on Friday and closed on the day’s highs.
  • The trading range on the daily chart (lines a and b) was convincingly overcome Friday amid heavy volume
  • The 127.2% retracement resistance target is at $21.40 with the upside targets from the chart formation in the $22.50-$22.80 area
  • Daily OBV has turned up sharply and looks strong, but the weekly OBV (not shown) is still negative
  • Initial support is at $20.40-$20.65 with the breakout level at $19.70-$20
Oracle Corp (ORCL) was featured in a June article “2 Best Tech Sector Buys” and it subsequently dropped back to support at $31.20 last Monday.
  • The weekly chart has trend line support (line e) at $30 with the March lows at $29.60
  • Daily OBV is acting stronger that prices, as it has held above its weighted moving average despite last week’s drop. The weekly volume (not shown) has turned up but is still just below its WMA
  • Initial resistance is now at $33.20-$33.50 with further resistance at $34.05, line c. A move above this level will signal a rally to the stronger resistance at $35.50-$36
What It Means: The overall analysis of the technology sector suggests that the recent strength will continue. The primary negative is that the Advance/Decline (A/D) line on the Nasdaq 100 has not yet confirmed the new highs. It could easily confirm this week, but this is still an important item to watch.

Those not currently long the Select Sector SPDR – Technology (XLK), as recommended last week, or those with a low technology exposure in their portfolios, could consider buying Compuware Corp. (CPWR) and NCR Corp. (NCR), which look like interesting buys on a pullback.

How to Profit: I previously recommended buying XLK at $26.34, and that order was filled last Thursday (July 21) with the low of $26.20. Keep the stop on that position at $25.44. On a move above $27.10, raise the stop to $25.77.

For Compuware Corp. (CPWR), go long at $9.73 with a stop at $9.13 (risk of approx. 6.1%).

For NCR Corp. (NCR), go long at $19.88 with a stop at $18.44 (risk of approx. 7.2%).
Other previous tech stock recommendations include:

Oracle Corp (ORCL): Buyers should be long at $32.04 and using a stop at $30.76. On a move above $34.15, raise the stop to $31.44 and sell half the position at $35.66.

NetApp Inc. (NTAP): Buyers should be long at $50.22 and using a stop at $48.76. On a move above $55.76, raise the stop to $49.74 and sell half the position at $58.84.

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