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Housing: New Bubble or More Trouble?


Posted by John Rubino

on Tuesday, 17 April 2012 17:50

By John Rubino on April 17, 2012

The in-laws own a gas station in Miami that they’ve wanted to sell for years. But they dithered when the market was hot and ended up being stuck with it when interest evaporated in 2009.

Lately, though, the phone has begun to ring again. It’s not exactly a feeding frenzy but real offers are coming from legitimate buyers for the first time in three years.

That’s actually a pretty good description of real estate in general, where low interest rates have convinced a growing number of people that it’s time to buy. See this upbeat story on the home builders:

    Pulte, Lennar jump as survey shows housing rebound
    NEW YORK (MarketWatch) — Shares of U.S. homebuilders rallied on Wednesday after a Wells Fargo analyst’s research report said data from 20 select markets nationwide are showing strength across the board.

    “For the third consecutive month, our survey points to an improvement in orders suggesting 2012 may be the long-awaited recovery year for housing,” the note said.

    PulteGroup PHM -1.39% added more than 8%, Lennar Corp. LEN -1.47% gained 5%, D.R. Horton DHI -2.44% rose 4.2% and Toll Bros. TOL -0.86% gained 3.8%.

    The bellwether industry ETF, the iShares Dow Jones U.S. Home Construction Index Fund ITB rose 3.4%.

    Wells Fargo’s monthly Neighborhood Watch Survey, which tracks 150 sales managers at housing tracts in 20 markets, showed that March results were strong across all measured metrics. In particular, the survey noted that March’s numbers surpassed poll       participants’ expectations by the widest margin since the survey started, in 2001.

    Wells said that pricing in the 20 markets also improved, both month-to-month and over year-ago figures. Sales managers’ commentary on market activity indicated that buyer confidence seems to be improving as inventory shrinks.

    “Sales managers suggested there is a sense of urgency in the marketplace as buyers anticipate higher home prices and/or mortgage rates,” the report said.

Bidding wars are even returning to some markets:

    Market squeezing homebuyers
    Home shopper Dian Schneider was four houses in on a whirlwind tour of local homes for sale Friday when her real estate agent issued her a warning.

    “Now if you like this one you’ll need to move today because there are already two offers on it, and they’re both above list price,” said Anna Hernandez of McKinzie Nielsen Real Estate. “They’re not crazy high, but you’ll have to go in high, too, if you’re serious about it.”

    Schneider nodded knowingly as she peeked inside closets, flushed toilets and opened cabinet doors.

    The 50-year-old single mom had already missed out on two homes she’d made offers on. She was outbid on one, and pulled out of a second over concerns about its dated electrical system.

    “In hindsight, I probably should have taken that one,” Schneider said.

    Almost all the available inventory in her price range is badly in need of repairs, and upgrading the electrical on the home she passed up wouldn’t have cost as much as she’d assumed, she later learned. But back then, she didn’t fully appreciate how lucky she’d been to find something.

    The Bakersfield area had only 583 single-family homes for sale in March, about a third fewer than in March of last year.

    Bidding war return
    The result has been fierce bidding wars and almost immediate turnover for anything of quality that’s priced reasonably, whether it’s a modest starter home or a mansion.

    “Everybody’s pretty much in the same boat right now, regardless of price,” said Robert Morris, who sells for Watson Realty ERA. “The supply keeps dropping and dropping and there’s nothing replacing it.”

    Broker Nancy Harper of Nancy Harper Realty recalled listing a home the day before Easter. By Easter Sunday, it had six offers on it, and when she called the losing agents to tell them their offers had been rejected, two of them burst into tears.

    “They told me they’d written something like 14 offers for clients and just couldn’t get one accepted,” Harper said. “When you have agents bursting into tears, boy, that’s low inventory.”

So is the housing bubble back?

To Read More CLICK HERE

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Gold & Precious Metals

Tap Profits in the Growing Graphite Market: Simon Moores


Posted by Brian Sylvester of The Critical Metals Report

on Tuesday, 17 April 2012 17:45

Source: Brian Sylvester of The Critical Metals Report

Simon Moores Graphite is the Next Big Thing for resource investors, but as in any sector, due diligence is a prerequisite for success. Enter Simon Moores, graphite market specialist with Industrial Minerals in London. In this exclusive interview with The Critical Metals Report, he explains why graphite is "the perfect mineral," why we're still going to be talking about it years from now and which companies to watch in this emerging industry.

Companies Mentioned: Archer Exploration Ltd. - Focus Metals Inc. - Imerys - Northern Graphite Corporation - Strategic Energy Resources Ltd. - Zimtu Capital Corp.

The Critical Metals Report: You once called graphite the perfect mineral. Why?

Simon Moores: It's conductive; it's a lubricant; it's resistant to high temperatures and it's a strong mineral. This means it doesn't have just one major market; it has an abundance of markets and uses. It's key to existing technologies that have been around for 100 years as well as new technologies, like lithium-ion batteries.

But despite what many think, it's not a niche industry. Rare earths and lithium are niche industries. Each year, 1.1 million tons (Mt) of graphite is produced. It's bigger by volume than molybdenum, vanadium, cobalt, tungsten, rare earths and lithium combined.

Graphite miners operate all around the world in Canada, Brazil, Europe, India and, of course, China, which accounts for 80% of production. That's a new figure that our research at Industrial Minerals has just uncovered for the new Natural Graphite Report 2012. China's grip on graphite production is greater than people thought previously.

TCMR: What is China's next move in the graphite market? Do you think there will be more quotas and export restrictions?

SM: There are no rare-earth style quotas at the moment. China doesn't say, "We are only allowing 400,000 tons (t) of graphite to be exported every year." But the country is doing things that could restrict the raw materials supply. The government doesn't like exporting raw materials that other people make money from. It is trying to build a value chain to unlock the value in its natural resources.

For example, China exports flake graphite to Japan. Japan turns it into battery-grade graphite, which is then used to make anodes, which is then used to make batteries, which Japan then ships for a much higher cost than the raw graphite. Now China is trying to build those finished products domestically. As a result, less raw material will come out of the country. In addition, China is trying to control its sprawling mining industry by forcing consolidation. Graphite is a perfect example of a sprawling Chinese mining industry.

TCMR: China is already encouraging foreign companies who depend on rare earth elements (REEs) to set up shop in the country. Do you see the same story unfolding in the graphite industry?

SM: The difference with rare earths is that China is the only place you can get good supply. It operates the world's only mine in Inner Mongolia until Molycorp and Lynas truly get underway.

China is aware that companies can get graphite elsewhere. It is also aware that at the moment it makes good business sense to sell quality raw material at high prices for the short term. Longer term, the story is different.

TCMR: China's had environmental problems with some of its rare earth operations. You visited some graphite mines in China. Are the graphite mines environmentally problematic?

SM: No, it's basic mining that has been around for centuries—extracting from the ground, crushing and grinding. You then put it in a floatation tank with reagents. This part of the process requires chemicals, but these are well known chemicals used in many other industries. Finally, graphite processors dry it and bag it. Graphite is an inert mineral, so it's not harmful. There are no underlying environmental problems in graphite mining.

The only area that holds some controversy is processing into spherical graphite, which requires additional chemical and physical treatment. Acid treatment is quite intensive and there could be future controversy surrounding the disposal of acids used.

TCMR: Are the Chinese mines primarily producing large-flake graphite or a lower-end product?

SM: It's almost a 50-50 split. Flake graphite mining exists all the way down the country's spine. This is good-quality material suitable for both domestic and international refractory and battery markets.

The Hunan province, in the south, is home to amorphous graphite, the old-style graphite people first started mining around the world. Amorphous is more common because the graphitization is lower and closer to coal, whereas flake graphite is closer to diamonds. Amorphous graphite supplies lower-end markets that produce products like pencils and lubricants.

TCMR: You describe the graphite market as having "layers" of demand. What does that mean?

SM: When graphite first came into use, it was mainly employed in lubricants and pencils. Those were the primary demands until after World War II, when the steel industry, driven by construction, became an additional end user, forming a second layer that boosted demand by about 30%. In the 1960s, the auto boom and car construction, especially in North America and Europe, formed yet another layer. Throughout graphite's industrial history, new technologies keep emerging while demand from traditional industries hasn't dropped off. This has built graphite into the 1.1 Mt industry it is today.

TCMR: Are there any graphite substitutes for these new technologies?

SM: Synthetic graphite is a substitute. Cost is still prohibitive, and people prefer flake graphite's properties. Batteries, for example, require a good porosity and surface area so the lithium ions can flow through the anode and generate the charge. Man-made graphite doesn't really provide that.

TCMR: What are some characteristics of an economic graphite deposit?

SM: The carbon content throughout the deposit is very important. A lot of companies are reporting the top range of carbon content, but because mining needs to stretch over many years, carbon content needs to be consistent throughout and not just good for three months.

The type of graphite is critical—flake and vein graphite are the best. Flake is the good stuff. Vein graphite is even better—it is found in lumps in the ground and is "cooked" by long geological processes. It is the form closest to diamond mineralization, and for this reason is much rarer, only found in Sri Lanka today.

A third key factor is infrastructure. Transportation makes up a large portion of the costs of large-scale graphite production. Currently, graphite is going through a high price peak, so existing producers are enjoying themselves. Producers have to prepare for the worst: If the price comes back down to perhaps half of its current market value, a producer's logistics are critical because that's where it either spends a lot of money or saves a lot of money.

TCMR: We didn't hear much about graphite even a year ago, certainly not from publicly listed companies. Are we still going to be talking about graphite in three years?

SM: We will. Lithium is a perfect comparison, because, in 2009, it had the same boom graphite is now having. In 2010, it reached a peak. Lots of juniors entered the industry. Everyone got excited about it. In 2011, nearly all of the juniors fell away, and the remaining players were focusing on their projects and not making as much noise. This year, we're seeing consolidation in the industry. Graphite will follow the same pattern.

TCMR: Has the boom in the price of high-quality graphite over the last year or so surprised you?

SM: Not really, because you have to look at the fundamentals. Graphite supply has been neglected for a generation yet it's still used in a lot of growing markets. Graphite's demand security is in its diversity: when one market drops off, another steps up.

When you only have this situation with a handful of active mines and no new operations planned, then there's only really one outcome: Eventually prices are going to rise, because there's going to be a supply squeeze. China adds a huge element of future supply uncertainty as well.

TCMR: The last graphite boom was in the 1990s. But then prices fell, and a number of mines were mothballed. Who's to say that won't happen again?

SM: It could happen again. That's always the risk, when you have so many potential mines coming online.

China caused the bust in the 1990s. New producers flooded the world market and put a lot of people out of business with low-cost production. Today, in a twist of fate, China could now be the cause for making these mines viable again. We have to look at how much production China controls, and its long-term goals, what it wants to do with its economy and its raw materials. Any new bust, however, is not going to be as drastic as the one in the early 1990s.

TCMR: One of the graphite derivatives that is very misunderstood is graphene, which is a single layer of graphite that is created in labs. How close is the industry to commercial-scale graphene production?

SM: The industry is some way off. A Google search will throw up many companies claiming they can produce graphene. But I wouldn't call it graphene—I'd call it nano-graphite. There may be three, four, five layers of graphene in their products.

Graphene is used in intelligent inks, for example, which are used for security systems on bank cards. That's its first market, and others may emerge in the next few years. But I believe the production of true graphene is many years away—commercially producing true graphene one-molecule thick—is extremely challenging, one of the biggest materials scientists will face. But if they crack it, the possibilities for its use are almost endless and it would revolutionize they way we live our lives. But to get graphene's super properties we all read about, you need to peel away and isolate a one-molecule layer. It's almost impossible to do that on a commercial scale. In terms of serious large-scale commercial use, it's at least 15 years away, and predicting 15 years into the future is like trying to predict 1,500 years into the future.

TCMR: Will the steel and battery industry end users drive another layer of graphite's growth?

SM: Yes. The steel industry uses refractories, which are protective layers for vessels that hold molten steel. If you pour molten steel into metal, it's going to melt through. So refractories are lined with bricks that can handle extreme temperatures. A big component of brick is graphite—up to 15% per brick. The steel, cement, petrochemical, glass and ceramics industries all use graphite in this way.

TCMR: What about lithium-ion batteries for electric cars—that's a significant amount of graphite in those products, too, correct?

SM: Electric vehicles are not a big demand driver today. But that's where the potential lies. In an electric car battery 1.8 kilograms (kg) graphite is used per kilowatt hour (KWh). Then take a battery pack equating to 24 KWh (like Nissan's LEAF), that's 38kg natural graphite per battery. It's a long way off, but if a manufacturer were to sell a million of these cars, that amounts to 3.8 Mt natural graphite. The natural graphite market is 1.1 Mt a year at the moment. So you can see why people are excited about it.

TCMR: What are some companies with graphite projects that could fill the supply gap for natural graphite, especially large-flake graphite?

SM: I'd look first at the companies that are actually producing graphite now. There's Timcal Ltd., which is publicly traded by Imerys (NK:PA), based in Paris. Imerys is a big minerals company; graphite is just one small area of its business. But its mine in Quebec is the only major active mine in North America. In December, Imerys announced plans for three new mines in the area, which shows that existing companies have the ability to do it straightaway.

TCMR: Canada in general seems to have a lot of potential for economic graphite deposits.

SM: Exactly. It's got a handful of leading juniors: Focus Metals Inc. (FMS:TSX.V), Northern Graphite Corporation (NGC:TSX; NGPHF:OTCQX), Ontario Graphite Ltd. (private) and Mega Graphite Inc. (IPO expected by the end of Q112).

Focus Metals' primary graphite operation is the Lac Knife deposit in Quebec. The deposit is famous and has been on our radar for more than 20 years. It's a large, high-quality graphite deposit with about 8.1 Mt flake at 16% average carbon content, which is strong. And the company is investing in technology to make graphene, which sets it apart.

TCMR: How close is that project to production?

SM: It's at least two years from production, the same as any other new junior. Building a new mine anywhere in the world is never a quick process.

TCMR: Let's move on to Northern Graphite, the darling of the industry. It was publicly listed last year, and the trajectory has been steadily upward.

SM: Its Bissett Creek project in Ontario is great. Northern Graphite has been around for a while, under different names. Bissett Creek has also been on our radar for a long time – before others were interested in graphite, work was being conducted on the deposit which says a lot for its quality even in down times. The company has ramped up drilling and marketing activities in the last two years.

Northern Graphite's selling points with its project are the size of the flake and the purity of the carbon content. The company, like many others, still needs the funding to build the mine. That's the challenge for all these juniors in Canada. Bissett Creek is still a very good project. You can't deny that.

TCMR: Northern Graphite is also doing some research on graphene—what do you make of that?

SM: It's a new battleground for some of these juniors. They're battling not only for funding but for share of the headlines. Any company with a high-quality graphite deposit naturally lends itself to mechanical exfoliation production of graphene.

TCMR: The other junior you mentioned is Ontario Graphite, which has a project not far from Bissett Creek.

SM: Ontario Graphite is a bit different, because it's a mine-reactivation project. For that reason, I would think that it will be quicker to bring production onstream. The company will need a new plant and new equipment, which is relatively straightforward to install. It is scheduled for commissioning in September this year. I could see Ontario Graphite processing product within 2012. The resource is also a good size—43.5 Mt Measured and Indicated resources, 12.3 Mt Inferred resources.

TCMR: Are there enough metallurgists available to create the end product?

SM: Yes. It's not like the rare earth industry, in which North America lost all its intelligence and skilled workers. Graphite has been a consistent, worldwide mainstay, which means the knowledge base has been retained thanks mainly to U.S.-based companies like Asbury Carbons and Superior Graphite. The challenge may lay with higher-value graphite grades for the battery market. Spherical graphite is a key raw material for battery anodes and this is still a new process for everyone.

TCMR: You also mentioned Mega Graphite.

SM: Mega Graphite bought an Australian company called Strategic Energy Resources Ltd. (SER:ASX) and that gave it a fast track route into the graphite industry. Its Uley Mine is actually a big stockpile of processed and unprocessed material because, similar to Ontario Graphite, back in the early 1990s the mine was closed. It wasn't economical enough to compete with cheaper products from China.

Mega Graphite has upgraded the plant with modern equipment and is reprocessing the stockpiled material to make the various grades of graphite. It has the potential to produce about 20,000 tons good-quality graphite from that stockpile over the next three years. But it will need to start mining to replenish these stocks.

TCMR: Is there a significant mining industry in Australia? Will Mega Graphite and Strategic Energy face some competition?

SM: At the moment Australia has no graphite mining industry. Zimtu Capital Corp. (ZC:TSX.V) is buying up a lot of deposits there and has an impressive portfolio of assets around the world. Archer Exploration Ltd. (AXE:ASX) is another company that has a project as part of a larger portfolio of mineral assets. But Mega Graphite is far more focused on producing graphite so the company shouldn't encounter much production competition in the near term.

TCMR: What's the infrastructure like at Uley?

SM: It's fine. Australia is mining friendly. It is used to this kind of industry.

TCMR: It's not going to face any mining royalties there? Australia has implemented one on iron ore and coal.

SM: Australia will try to target its big businesses like iron ore and coal. Graphite is never going to be a comparatively big business there. If Australia heavily taxes the smaller mining companies, then it won't have much of a mining industry left. It needs to encourage these. Mining is the sole reason Australia didn't slip into recession.

TCMR: What advice would you give to investors who are interested in the graphite story?

SM: The resource is everything. The larger the flake and the higher the purity of carbon the more critical it will be to high-tech applications. Also look at what the company's plans are for selling this material and if it is targeting specific markets—co-operation with Japan and South Korea will be key here. Traders from these countries are usually the most savvy of long-term investors.

The most interesting graphite plays are those that are focused on technology end uses. Producing high-tech-compatible materials for emerging markets, like spherical graphite for batteries, will add the serious value.

Industrial Minerals is working on the Natural Graphite Report 2012, which should be out in the next two months. It's an extensive world overview of production, prices and demand and should answer any more questions readers may have.

TCMR: Thank you for speaking with us today.

SM: My pleasure.

Simon Moores has been reporting on, researching and analyzing the non-metallic minerals sector since 2006, when he joined London-based publishing and research house Industrial Minerals. He has specialist knowledge in critical and strategic minerals including graphite, lithium, rare earths and titanium.

He led the research and publication of the market study, The Natural Graphite Report 2012: data, analysis and forecast for the next five years. One of the study's key findings was China's dominance of production was significantly higher than previously thought, accounting for 80% of supply. He has chaired conferences and given keynote presentations around the world. He has also been interviewed by international press including London's The Times regarding Chinese control on world graphite production, and The New York Times with regard to rare earths after breaking the story that China blocked exports to Japan in 2009.

SimonMoores



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Currency

Of Debt, Gold and Okun’s Law


Posted by Rick Mills via Resource Investor

on Tuesday, 17 April 2012 11:19

Is gold’s run over? Let’s look at some facts.

The amount of money the federal government owes to its creditors, combined with IOUs to government retirement and other programs, now tops $15.23 trillion. That's roughly equal to the value of all goods and services the US economy produces in one year: $15.17 trillion as of September, 2011.

Among advanced economies, only Greece, Iceland, Ireland, Italy, Japan and Portugal have debts larger than their economies.

The US government spent over $454 billion just on interest on the national debt during fiscal 2011.

The debt ceiling stands at nearly $16.4 trillion. Some predict the US will run out of money by September 2012. The next increase to the debt ceiling could be as high as $2 trillion.

4-16-12-aoth-1-image001

zerohedge.com

Since Barack Obama was elected, the US government has added $5 trillion more to the national debt.

The United States government is responsible for more than a third of all the government debt in the entire world.

Mandatory federal spending surpassed total federal revenue for the first time ever in fiscal 2011.

 


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Personal Finance

To Tame Toronto’s Housing ‘Bubble’, Ban Foreign Buying


Posted by Diane Francis at Financial Post

on Tuesday, 17 April 2012 09:30

Diane Francis at the Financial Post

Conventional wisdom is that this is the market at work. This is not the market at work. This is manipulation of a government system of open-ended mortgage insurance that is poorly supervised.

Nearly three times’ more condo high-rises are being built in Toronto than are being built in New York City and nearly seven times’ more than in Chicago, according to Bloomberg News.

This development boom, and accompanying price increases, is not about housing to meet a sudden surge in population. It is not about an economic boom. If it was, Calgary and Edmonton would have 128 cranes, like Toronto does, building housing and pushing up all prices. Instead, this is taking place in Toronto and Vancouver where economies are moribund.

What is going on here is a deluge of hot money from abroad that is creating an artificial and potentially dangerous real estate bubble

Conventional wisdom is that this is the market at work. This is not the market at work. This is manipulation of a government system of open-ended mortgage insurance that is poorly supervised. What is going on here is a deluge of hot money from abroad that is creating an artificial and potentially dangerous real estate bubble. This mania happened in several other countries — where it was shut down — and has spread to Canada. Officials here have been urging restraint but that is not the solution. A ban on foreign buying of residences is the only solution.

This is what is happening. For example, a modest bungalow in Toronto sold last month for $1,180,800, $400,000 more than the asking price of $759,000. Canadian bidders were furious and deserved to be. The winning bid was made by a university student whose parents have a business in the United States but who live in China. I don’t know if there was a mortgage involved, but student housing — even for foreign students — is now liberally insured by CMHC, in other words, by the Canadian taxpayer.

To Read Full Article CLICK HERE

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Bonds & Interest Rates

Hoisington First-Quarter Review and Outlook


Posted by John Mauldin

on Tuesday, 17 April 2012 09:16

John Mauldin | April 16, 2012

Lacy Hunt kicks things off with a bang in Hoisington's Quarterly Review and Outlook, this week's Outside the Box:

"The standard of living of the average American continues to fall."

The reason, in a word: debt. Lacy explains what happens:

"Efforts by fiscal and monetary authorities to sustain growth by further debt accumulation may produce some short-term benefit. Sadly, these interludes fade quickly as the debt becomes more destabilizing. The net result of increased indebtedness then becomes the opposite of what policymakers intend when they promote economic growth by either borrowing funds for increased government expenditures or encourage consumers to borrow with artificial and temporary incentives."

In other words, you can't get to real, sustained growth of an economy by growing debt after a certain point –one that, sadly, we have already reached.

It gets worse, because, since 2009, private debt-to-GDP has fallen while government debt-to-GDP has surged. And, as Lacy notes, "United States government spending carries a zero expenditure multiplier, as do operating expenditures of state and local governments. Thus, each dollar spent by the federal government creates no sustainable income, yet the interest payment incurred with each borrowed dollar creates a subtraction from future revenue streams of the private sector."

That is, unproductive government debt is killing us. So what gives? It's simple: we either make some big, tough collective decisions, and make them soon; or we come to the "bang point" documented by Reinhart and Rogoff, where the bond market no longer believes the US will pay its bills. Europe and Japan will get there before we do, but the writing is on the wall: we must get our national-deficit act together.

I am doing a road show for Bloomberg in San Francisco, with 8 meetings today and a few more tomorrow. Bloomberg is marketing a very high-end new service called Mauldin Research Trades. My partners Gary Habib and Peter Mauthe have assembled an all-star team of technical trading analysts (who between them have written about 20 books on technical trading), who give us "conviction" trades each and every week. We publish the letter on Sunday evening. I am very pleased with the results so far. If you are interested, contact your Bloomberg Tradebook representative or drop me a note and we will get them in touch with you.

Tonight is dinner with real estate maven John Burns, where I am sure I will pick up a few new insights (I always do with John). Then I'm off to north of Denver for a day, then back home before I fly down to Austin over the weekend to be with Lacy Hunt at his long-delayed wedding reception where the iconic Texas band Asleep at the Wheel will be playing. Lots of friends there at a must-not-miss evening.

And Join me next Tuesday morning in Philadelphia at The 30th Annual Monetary & Trade Conference: Demographics, Politics, and Economic Growth, sponsored by the Global Interdependence Center (click on program title to register). It will be very informative.

Have a great week! I see some great food and conversation in my life in the next few hours.

Your worried about ever more debt analyst,

John Mauldin, Editor
Outside the Box
JohnMauldin@2000wave.com
Hoisington First-Quarter Review and Outlook

 

Lacy Hunt and Van Hoisington
Hoisington Investment Management Company
Debt/Income/Productivity

The standard of living of the average American continues to fall. Real median household income today is near the same level as it was fifteen years ago, a remarkable statistic since the debt to GDP ratio is 100 points higher (Chart 1). The cause of this deterioration in living standards can be traced to the excessive accumulation of debt, as well as the debt proportion that has turned increasingly unproductive, or even counterproductive. When debt is utilized to finance nonproductive assets, an economic process is initiated that undermines prosperity. Productivity gains must be generated in order to boost income, and thereby the standard of living. If debt enhances productivity, incomes will expand and the economic pie will be enlarged. Otherwise, the debt increase exercise is debilitating to economic growth.

The negative feedback loop arising from the unproductive nature of this debt accumulation is straightforward. First, United States government spending carries a zero expenditure multiplier, as do operating expenditures of state and local governments. Thus, each dollar spent by the federal government creates no sustainable income, yet the interest payment incurred with each borrowed dollar creates a subtraction from future revenue streams of the private sector. Second, much of the massive debt increase over the past decade has been in the form of mortgage debt. Jobs and income were created with the expansion of the housing stock. However, no productivity gains are evident in this housing stock increase, which means future incomes have not expanded. Nevertheless, the repayment of principal and interest weighs down the system, and the consequences of delinquency, foreclosure, default and bankruptcy compound the problem.

Third, debt that is utilized to finance consumers' daily needs obviously fails to generate any productivity or future income growth. Efforts by fiscal and monetary authorities to sustain growth by further debt accumulation may produce some short-term benefit. Sadly, these interludes fade quickly as the debt becomes more destabilizing. The net result of increased indebtedness then becomes the opposite of what policymakers intend when they promote economic growth by either borrowing funds for increased government expenditures or encourage consumers to borrow with artificial and temporary incentives.
Modern Example of Over-Indebtedness

Since 1989, Japan has provided an excellent but highly disturbing example of the debilitating effects of a prolonged period of taking on additional debt while shifting more of the debt into unproductive uses. In 1989, their public and private debt was just under 400% of GDP. After repeatedly trying all of the Keynesian and monetary school recommendations on a large scale, Japan's debt ratio stood at an all-time record 491% in 2011. Over this 23-year span, the portion of government debt to GDP ratio more than quadrupled, advancing from near 50% to over 200%. The government's financing needs were so great that the private debt to GDP ratio actually contracted nearly 55%, a strong indication that the composition of the debt increasingly financed unproductive activities. Since 1990, numerous episodes of seemingly better Japanese growth failed to establish a self-sustaining recovery as debt's negative feedback loops progressively worsened.

The trajectory of the Japanese experience is beginning to take shape in the United States. Since 2009, private debt to GDP has declined while government debt to GDP has surged. If we use the IMF projections for gross U.S. federal debt for this year and next, and assume that the private debt ratio is stable, the total debt to GDP ratio will rise sharply this year, and again in 2013, putting the U.S. in Japan's footsteps (Chart 2). Also, the U.S. economy has witnessed episodic improvement along with gains in business and consumer confidence. But, ephemeral positive shifts in psychology cannot match the negative elements of higher levels of unproductive debt.

Previous Debt Episodes

The U.S. accumulated a massive amount of unproductive debt in the 1920s. The ultimate solution to that episode was a period of austerity in which the saving rate soared. Significantly, the Japanese personal saving rate from 1989 to 2010 exhibits a completely contradictory pattern to the U.S. experience from 1929 to 1950. During that period in the United States, the excessive debt of the 1920s was dramatically reduced and created the basis for post WWII U.S. prosperity (Chart 3). From 1989 until the early 1990s, the Japanese saving rate was consistently above 25%, but in recent years it has fluctuated around zero as the debilitating effects of ever high debt levels have accumulated. The mandatory rationing in the United States during World War II, combined with the income generated gains in exports of virtually everything we could produce from U.S. farms, mines and factories pushed the U.S. personal saving to a peak of more than 25%. This permitted the excessive debt of the 1920s to be paid down. The current low level of U.S. saving precludes the same resolution to the debt problem seen in the 1920s case, but is similar to the current Japanese situation.

Bang Point

There is a longer-term negative feedback loop that has been referred to as the "bang point" by economists Reinhart and Rogoff, and it occurs when government or private borrowers are denied access to further credit because the marketplace has no confidence that new or existing debt can be repaid. At this point interest rates soar and debt issuance becomes impractical; therefore, the government or private borrower is forced to live on current revenues. As recent cases in Europe have documented, this is painfully disruptive, with high social costs. We do not believe this point is at hand for the United States, but it has occurred many times historically, including in contemporary Europe. If it were to happen in the U.S. now, the consequences would be traumatic since 42 cents of every dollar spent by the federal government in the first six months of the current fiscal year was borrowed. The chaos that would be created by a reduction in federal government spending of 42% is unimaginable.
Disequilibrium

Economic models, regardless of whether from micro or macroeconomics have two conditions: equilibrium and transition. In the simplest micro model like the market for soft drinks, equilibrium is reached when the supply and demand curves intersect and determine the price of the item and the quantity demanded and supplied. When either the demand or supply curves shift, this transition leads to a new equilibrium. Equilibrium occurs at a specific point in time. This simple model also yields total dollar sales or the quantity supplied or demanded, multiplied by the selling price. When aggregate demand and supply curves intersect, the aggregate price level, real GDP and nominal GDP are determined at a specific point in time.

The economics profession has almost universally taught that equilibrium is the main condition and that transition is short and largely trivial. Little effort is made to trace the critical role of the transition process. However, the sweep of economic data over the last hundred years suggests that transition is a much longer phase than equilibrium. Economies only attain equilibrium briefly, if at all, before moving on to another period of transition.
Tracking Debt Disequilibrium

The distinction between equilibrium and transition is well illustrated by the private debt statistics available since 1916. Over this 96-year span, private debt to GDP averaged close to 160%, or 130% below the level for 2011. The private debt to GDP ratio moved into close proximity or crossed its mean no more than ten times (Chart 4). Obviously much more time has been spent in transition than at equilibrium. A similar economic indicator, velocity of money, demonstrates the same pattern.

The velocity of M2 (V2) had only ten equilibrium points from 1900 to 1953 and from 1980 to the present. From 1953 to 1980, V2 was stable around the post 1900 mean of 1.68 (Chart 5). Periods of stability should not be surprising since debt and velocity are linked. When increases in debt are of the sound variety, such as the normal type of business and consumer lending in traditional banking, velocity should be stable. When debt to GDP accelerated very rapidly after 1980 along with a great increase in financial innovation, velocity surged until hitting a post 1900 peak of 2.12 in 1997. After 1997, velocity turned down, indicating the surge in debt was going into less productive uses. Such a pattern was exhibited in the 1920s when the debt to GDP ratio surged, but V2 fell. Other series with very long historical records, like the price earnings (P/E) ratio, the cyclically adjusted P/E ratio and the real 30-year Treasury bond yield, confirm that equilibrium is the rare condition. Transition is the norm, and that transition is extremely volatile and erratic.

In 2011, the U.S. private and public debt to GDP ratio was about 174 percentage points higher than the post 1870 average. Comparably measured debt to GDP ratios are substantially higher in the Euro zone, the UK, Japan and even Canada, indicating that the debt issue is a global depressant to growth. To remove this growth impediment, debt needs to decline dramatically relative to GDP for a prolonged period. Contrary to common wisdom, monetary and fiscal policy actions that spur growth by increasing debt may buy transitory gains in some measures of economic activity, but they perpetuate this disequilibrium. Increasing debt merely makes the economy more vulnerable to economic weakness and potential instability because income growth is stunted or, as previously stated, over-indebtedness cannot be cured by more debt. Periods of over-indebtedness change the sacrosanct rules of thumb of business cycles. The conventional wisdom of business cycle analysis that suggests five to seven good years followed by one to two bad years is broken. Normal risk taking is not rewarded.
Impact on Investment Returns

The current period of extreme indebtedness in the U.S. constitutes the third such episode since the Civil War. The two earlier cases include the 1860s and early 1870s, and the 1920s and 1930s. After these previous massive debt buildups, two twenty-year periods ensued where the total return on the S&P500 was less than the total return on long-term Treasury bonds, a condition referred to as a negative risk premium. The underperformance of stocks relative to bonds from 1928 to 1948 occurred even though WWII intervened. Extreme over-indebtedness created a different playing field from normal circumstances that did not reward risk for a very long time. Once the excessive indebtedness was corrected, a positive risk premium was reestablished. The risk premium was also negative from 1991 to 2011.

Thus, if the U.S. economy is unable to deleverage, then the already long cycle of an abnormal, or negative, risk premium will be extended. A negatively correlated asset, such as long-term Treasury bonds, will continue to generate positive returns, while serving to minimize the volatility in a diversified portfolio.
The Pathway Out of Excessive Indebtedness

From both economic theory and historical experience the answer is clear; austerity is the solution to too much debt. McKinsey Global Institute examined 32 cases where extreme leverage caused financial crises since the 1930s. In 24, or 75% of these cases austerity was required, which McKinsey defines as a multi-year and sustained increase in the saving rate. Public and/or private borrowers took on too much debt because they lived beyond their means, or they consumed more than they earned. Thus, to reverse the problem spending had to be held below income, increasing the saving rate. In eight, or 25% of these McKinsey cases the problem was solved by high inflation, but none were major global economies and all were emerging markets with either no central bank or a very weak one. It should be noted that some of these cases involved massive currency devaluations, an option that is not open to the United States or the other major highly indebted economic powers.

Devaluations were tried repeatedly from the late 1920s until World War II during an episode referred to as "beggar thy nation" policies. These devaluations only produced temporary gains for individual countries because retaliatory devaluations ensued. In those days, the world was on the gold standard, so it was possible to devalue, whereas today all major currencies except the Chinese Yuan float freely, or relatively so. That period was before the world understood the Nash Equilibrium, named for the Nobel Prize winning economist John Forbes Nash. Nash's equations demonstrate that if one party takes an action unilaterally for its own benefit then the overall benefit to all parties will decline.

Many people, including the majority in the political arena, consider austerity to be an unpalatable option. The Japanese policy makers have rejected this solution for more than two decades as their saving rate has declined from almost 25% to nearly zero. But, if the McKinsey data and economic theory are as valid as we believe, then the sooner the reality is accepted the sooner the economic norm can be restored. Taking on more debt, the current course of action, only serves to delay the restoration of prosperity. In other words, more debt can boost the GDP growth rate for a short period of time, but the GDP growth rate cannot remain elevated, and increased indebtedness serves to further undermine the standard of living.
Inflating Away Debt

Even though history demonstrates that inflating away debt has occurred only in small nations with unusual circumstances, this option remains a point of concern in the United States. We continue to believe that a deflationary environment is more likely to prevail than an inflationary one for several reasons. First, attempting to create higher inflation would mean that our debt to GDP ratio would only grow more onerous. In the U.S., debt is about four times the size of GDP. The increase in interest rates associated with higher inflation would be one for one according to well-tested empirical results and economic theory. However, GDP would lag because real incomes would fall short as the cost of living would rise faster than income for most Americans. Demand for higher wages might prevail in time but full relief would be lacking for a broad section of employees. In addition, a downward bias on wages would exist from import competition. Second, the rising rate structure would decimate discretionary expenditures at all levels of government. Deficits would increase as the interest on the debt would be increasing faster than revenues, and would replace all discretionary expenditures in a very short period. At the end of the day, more debt and increased interest payments would translate into lower productivity, lower income, and higher unemployment. To start down this road of inflation would be foolish, impractical, and improbable.
Bond Yield Developments

In early April the Fed announced that there were no plans to embark on a new round of quantitative easing. Initially, the announcement was greeted negatively in the Treasury bond market, as evidenced by rising yields. Our analysis indicates that the Fed's decision should be viewed ultimately as a constructive development. The ending of QE1 and QE2 caused investors to shift from inflationary sensitive assets into longer-dated Treasury securities as the economy slowed, and inflation quickly subsided once the Fed's balance sheet stabilized. This prior experience indicates that the current upturn in inflation and the related rise in bond yields is likewise transitory.

Since the end of last quarter, the 30 year Treasury bond yield has risen to a high of 3.5% in March. In most years economic optimism seems to flourish for the first four or five months of the year. Seasonally, interest rates are usually at their yearly highs between late February and mid May. In fact, in fourteen of the last twenty years the thirty-year Treasury bond yield has peaked in the first half of the year. Our view remains that while interest rates can rise for many transitory reasons, underlying economic fundamentals suggest long-term rates cannot remain elevated and will gradually move lower.

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