So says Michael Mandel, chief economic strategist at the Progressive Policy Institute, in an article* posted at www.theatlantic.com which Lorimer Wilson, editor of www.munKNEE.com (Your Key to Making Money!), has further edited ([ ]), abridged (…) and reformatted below for the sake of clarity and brevity to ensure a fast and easy read. The author’s views and conclusions are unaltered and no personal comments have been included to maintain the integrity of the original article. Please note that this paragraph must be included in any article re-posting to avoid copyright infringement.

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Looking across the world, the underlying problem is that borrowers–households and governments–have taken on debt that they can’t afford to pay back, given the current rate of income and economic growth.  In the U.S,  too many homeowners are struggling with mortgages that far exceed the value of their homes and cannot be repaid from their current incomes. In Europe, Greece and perhaps other countries have issued bonds that they cannot pay back unless growth unexpectedly skyrockets.

Down the road  the same principle of matching growth to debt allows us to perceive potential financial crises to come.  College graduates, for example, have seen their real earnings plunge by  19% since 2000… Meanwhile education borrowing has soared,  suggesting that we are on the verge of a student loan crisis, where young grads simply cannot pay back their mountain of debt.

It’s not easy to explain why lenders overestimated the ability of debtors to pay or, rather, there are too many explanations:

• complicated financial instruments obscured the true amount of debt, as in the case of the U.S. financial crisis…
• greedy financiers expected to be bailed out, or worse, simply didn’t care…
• excess optimism about future growth… In the case of student loans, the conventional wisdom is that education is always a good investment, suggesting to both students and lenders that borrowing for college is always a good idea. In the case of housing, many economists subscribed to the belief that national home prices never go down…
• the unexpected innovation shortfall of recent years, which,…particularly in biosciences, has led to a slowing of growth in the developed countries. What’s more, the true extent of the growth slowdown has been masked by flaws in the economic statistics.

No matter which explanation you favor, [however,] the essential mismatch between growth and debt has only two possible solutions:

1. increase the growth rate or
2. reduce the debt.

For a country like the U.S.,  increasing the growth rate requires innovation, and innovation requires a devotion to investment – in physical capital, investment in human capital, investment in knowledge capital.  That increased investment, in turn, should result in higher rates of productivity growth and increased innovation. In other words, we have to shift from a consumer economy to a production economy. This is partly about a change in spending patterns, but also about a change in attitude. For example, we need to boost R&D and other investment in knowledge capital,  but we also need federal regulatory agencies to  encourage rather than discourage innovation. We need more infrastructure spending and other investment in physical capital, but it should be directed towards supporting exports and production in the U.S., rather than clearing up bottlenecks of imported consumer goods. This profound shift in policy and behavior is essential over the long run, but it won’t be easy or quick.

The alternative to increasing growth is reducing the outstanding debt.

In theory governments can organize a orderly write-down for unpayable debt, getting lenders to accept a deal that acknowledges reality. In practice, however,  an orderly write-down is not so easy to organize in today’s multi-layered financial system.   Much of the Greek debt, for example, is held by European banks, but those banks in turn fund themselves by borrowing abroad.  Given that both the U.S. and the European Union are net borrowers, it’s clear that the ultimate source of funds is likely to be the big creditor nations such as China and Saudi Arabia.   It’s difficult to see China–still a poor country–accepting a write-down in the value of its loans to richer countries.

Inflation is an undesirable but feasible mechanism for reducing the burden of debt.  By inflation I mean a sustained increase in both wages and prices.  For example,  an inflation rate of 4% would raise the nominal level of wages by 50% over ten years, making debt much less onerous. Ben Bernanke addressed exactly this point in a 2000 paper, where he suggested that the Bank of Japan could have targeted an inflation rate of 3-4% to combat the Japanese stagnation of the 1990s.  Just this week, Chicago Fed President Charles Evans suggested that the Federal Reserve should target 3% inflation. The Federal Reserve has the authority to execute such a policy, although it would have a lot of critics. One way is for the Fed simply announce that it will keep rates near-zero until inflation expectations are above 3%.  Another way is to target some level of nominal gross domestic product that rises over time. In either case, the expected results would be a reduction in the real value of dollar-denominated debts, a rise in long-term interest rates,  and most likely a depreciation of the dollar.

However, to be truly effective, a policy of reinflation would have to be followed by all of the major central banks around the world. Such a synchronized monetary policy would not eliminate the debt overhang right away, but over time would have the effect of balancing the scales between borrowers and lenders.

In adopting a reflationary policy, central banks would have to be very wary of letting inflation get out of control. It’s all too easy to keep pumping money into the economy, eventually leading to hyperinflation and a general loss of faith in the financial system.  Investors can lose faith and be unwilling to lend.

Conclusion

There’s no doubt that innovation is a far superior solution to our problems than inflation.  Innovation creates new wealth, raises the living standard of future generations, and potentially solves some of the real problems of our time. Inflation creates no new wealth, but merely pares down the mountain of debt to reasonable levels. However, inflation is something we know how to achieve, while using public and private investment to deliver innovation is a complicated process.

We want innovation, we need innovation.  If we can’t have innovation, [however,] we may have to accept inflation as the less-desirable but feasible way out. [Regardless of which way we go,] we have to match growth to debt. If we can’t create miracles from growth, we have to consider inflation to reduce the value of our debt.

*http://www.theatlantic.com/business/archive/2011/10/there-are-only-2-ways-to-save-the-economy-innovation-or-inflation/247168/

1. Job market indicators continued to deteriorate, anticipating very weak job creation and a higher unemployment rate.
2. Capital spending plans and inventory investment plans all weakened and remain at recession levels.
3. Inflation continues to rise [which is] a notable business concern for owners who are raising their own prices at the fastest pace seen in years.

Knowing where we are within the business cycle can help investors better position themselves for superior returns [because, as we all know,] during economic expansions equities typically outperform fixed income investments while the converse is typically the case during economic downturns.  Current analysis of the business cycle suggests a period of slower growth ahead, not just in the U.S., but also globally, [but no signs of an impending recession. Let me explain.] Words: 834

So says an article* by www.financialsense.com which Lorimer Wilson, editor of  www.munKNEE.com , has further edited ([  ]), abridged (…) and reformatted below  for the sake of clarity and brevity to ensure a fast and easy read. Please note that this paragraph must be included in any article re-posting to avoid copyright infringement. The article goes on to say:

Additionally, equity returns among various sectors such as early cyclicals (financials, consumer discretionary), late-stage cyclicals (energy, basic materials), and non-cyclicals (consumer staples, health care) fluctuate depending on where we are, which is often referred to as sector rotation. 

ECRI’s “Leading Indicator of Industrial Growth” Forecasts Global Downturn

Lakshman Achuthan of the Economic Cycle Research Institute (ECRI) is calling for a slowdown in global economic growth by this summer…[based on] the ECRI’s Leading Indicator of Industrial Growth (top line of figure below) which provides a long lead time to global industrial production and commodity inflation. It peaked late in 2010 and is forecasting a slowdown in industrial growth by this summer and weakness persisting through much of the rest of the year.

Source: ECRI

The good news as the slowdown quickly approaches is that Achuthan does not believe another recession is headed our way. The bad news is he says “the U.S. economy will not escape” the downturn, but will “participate in it … and in one way, shape or form, it is going to impact this recovery.”

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“OECD Global CLI Diffusion Index” is Turning Down

My own analysis lines up with Achuthan as my OECD CLI Diffusion Index (orange line below) has peaked and has been turning down now for several months, as fewer and fewer OECD nations are experiencing accelerating growth. While many global economies are already beginning to decelerate, more than 90% of OECD countries are experiencing positive economic growth as can be seen by the blue line below, which shows the percentage of OECD nations with expanding economies. We had growth slowdowns in late 2004 and again in 2010 that did not lead to a global recession…although more than 50% of OECD economies expanded than contracted[during that time period].

Source: Bloomberg

Both [the 2004 and 2010] global slowdowns witnessed flat-to-negative one-year returns in the S&P 500 but no bear market…as was the case in 2008 when the global slowdown turned into an outright recession going from 86% of OECD countries experiencing expanding growth heading into 2008 [down] to 0% by the fall…producing the first bear market in the U.S. since 2000 [and,] according to the ECRI, there is clear evidence that the global economy, including the U.S., will experience a growth relapse ahead.

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Regional Federal Reserve Surveys Suggest Continuing Slow GrowthThe three U.S. regional Federal Reserve surveys below are rolling over and the prices paid component suggests U.S. growth may continue to slow throughout the rest of the year.

Source: Bloomberg

No Evidence of a Recession

While the case for a growth slowdown ahead is easily made [as per the above indicators], there is not enough evidence to make a recession call. Our recession model [see chart below] typically provides several months’ warning before a recession begins [with] the 20% mark…[being] the line in the sand with only one false signal (1987) over the last 30 years. Given [that] the current reading rests at a 3% probability of a recession beginning over the next six months, I am in agreement with the ECRI’s Achuthan that a recession is not in the cards as of yet.

Source: Bloomberg

Investment Implications

In a nutshell, [a defensive position] is likely to outperform over the next six months, which would mean that in terms of asset classes, bonds will likely outperform stocks. In terms of sectors, the non-cyclical sectors such as healthcare and consumer staples will benefit from sector rotation as investors decrease their allocation to cyclical sectors like consumer discretionary and financials and lower their portfolio’s risk profile.

Conclusion

Monitoring incoming data will be the key to gauging whether economic growth will reaccelerate like it did at the end of last summer, or if the coming growth slowdown will morph into another recession.

*http://seekingalpha.com/article/271331-global-slowdown-ahead-recession-not-likely

Editor’s Note:

• The above article consists of reformatted edited excerpts from the original for the sake of brevity, clarity and to ensure a fast and easy read. The author’s views and conclusions are unaltered.
• Permission to reprint in whole or in part is gladly granted, provided full credit is given as per paragraph 2 above.
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Economic Growth

[A look below at the trend in the U.S.'s share] of world GDP (data here) from 1969 to 2010… [shows an] amazingly stable share of world output which has remained [constant at 26.3%] for more than forty years…[and] is a testament to how America’s dynamism, resiliency, and culture of innovation and entrepreneurship have enabled us to be productive in a tough world. [Let me expand on this further.] Words: 730

So says Mark J. Perry (http://mjperry.blogspot.com/) in an article*which Lorimer Wilson, editor of  www.munKNEE.com , has further edited ([  ]), abridged (…) and reformatted below  for the sake of clarity and brevity to ensure a fast and easy read. Please note that this paragraph must be included in any article re-posting to avoid copyright infringement. Perry goes on to say:

[As a result of] slowing economic growth around the world, stock markets are at the “tipping point” of a correction. Here are 15 global signs that supports that thesis. Words: 678

So says Bret Jensen (www.samstrategy.com) in an article* which Lorimer Wilson, editor of  www.munKNEE.com , has further edited ([  ]), abridged (…) and reformatted below  for the sake of clarity and brevity to ensure a fast and easy read. Please note that this paragraph must be included in any article re-posting to avoid copyright infringement. Jensen goes on to say:

1. Chinese manufacturing is expanding at the slowest pace in 10 months
2. Utilities are unable to pass on fuel increases to their customers causing several large cities to be  without power 1 day in 3
3. Coal plants (up to 25%) could go out of business in the next couple of years
4. Annual growth of 8% is impossible due to structural elements according to Stratfor…[who] compares the current Chinese economy to a giant ponzi scheme.

1.  Further austerity measures for Greece have not been agreed upon with Greek leaders. Without these additional measures, the latest tranche of IMF loans is imperiled. The ECB has already stated it will not step in if the IMF fails to provide these loans. Given escalating protests, it is hard to see the Greek ruling coalition agreeing to further pain. This has the potential for triggering cascading events that could throw the credit and currency markets into chaos. Greek bonds are already pricing in a huge default risk.
2. Spain’s unemployment is at 21%
3. Protests are escalating across the indebted countries of Europe [and] the political will of the creditor countries, mainly Germany, make further largesse unlikely.

1. Japan remains a basket case. The capital stock taken out by the earthquake and tsunami was twice that of the 1995 Kobe disaster. This does not take into consideration the power outages caused by the nuclear crisis at several reactors. Given [that] Japan is already over indebted, its policy choices are limited and it is hard to see it contributing to the world’s economy in any meaningful way in the near future.

1. Global economic growth has been reduced to 4.3% from the 4.8% prediction made by Goldman Sachs in mid-April while UBS has reduced its forecast from 3.9% to 3.6%.

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These are worrying signs and I think we are due for a significant pullback over this summer. I would stick to stocks of multinationals that have pricing power and low valuations… [and] blue chips with good dividend yields… I would also have a good portion of funds in cash to take advantage of the coming selloff.

Be careful out there.

Further Articles Related to the Above:

1. “U.S. Debt Default Risk is Up Dramatically YTD” http://www.munknee.com/2011/05/sovereign-debt-default-risk-has-risen-dramatically-in-u-s/
2. “ Be Forewarned: Worldwide Systemic Financial Risk is Rising Rapidly – Again” http://www.munknee.com/2011/05/be-forewarned-worldwide-systemic-financial-risk-is-rising-rapidly-again/

 *http://seekingalpha.com/article/272426-10-global-signs-that-the-market-is-at-a-tipping-point?source=email_macro_view

Editor’s Note:

• The above article consists of reformatted edited excerpts from the original for the sake of brevity, clarity and to ensure a fast and easy read. The author’s views and conclusions are unaltered.
• Permission to reprint in whole or in part is gladly granted, provided full credit is given as per paragraph 2 above.
• Sign up to receive every article posted via Twitter, Facebook, RSS Feed or our FREE Weekly Newsletter.

Economy