Tuesday, December 27, 2011

Karl Denninger, "2012: The Big Suck (2011 Review, 2012 Outlook)"

"2012: The Big Suck (2011 Review, 2012 Outlook)"
by Karl Denninger

"As is my usual practice it's that time of year when I score my "best guesses" from the previous year, and look forward with my next set.  If you're not inclined to bother with long-winded explanations the title is probably sufficient.  But for everyone else, let's look at the 2011 list and see how I did.

    * We're not going to get away with spending another $450 billion in deficits on top of the $1.6 trillion we blew last year.  $2 trillion in deficits?  Not a prayer.

Well that "more or less" worked out.  I don't have the final numbers yet and won't for a bit as I'm writing this before the end of the year, but we most-certainly did not run a $2 trillion deficit.  As of 12/21 it's right near $1.1 trillion.  This is a bad number though as the most-recent data isn't in and neither are the cash adjustments that Treasury usually makes. Nonetheless there's no way we're going to see another trillion "magically appear", so that's a point.

    * Europe will not get their debt situation under control.  I give us a 50/50 chance that Ireland repudiates it's "deal" immediately following their elections, and the cancer there will spread.  I won't call a breakup of the Euro - yet - but the possibility exists that one or more nations will leave the common currency next year.  I only see the odds as something around 50% though, so it doesn't go on the "prediction" board for this year. Nothing but net on this one.

    * The Dollar remains the hooker with crabs while many other currencies have AIDS.  The wildcard is the Pound.  Britain may actually have their act under reasonable control.  We'll see.  For the Euro, no such luck.  I expect a wide trading range with lots of both euphoria and tears, perhaps as much as 40% or more.  That means we'll get plenty of whipsaws in the /DX as well.  Nonetheless, the doomers call of a dollar collapse and gold at $3,000+/oz will be wrong. Nothing but net again.

    * Oil is going to $100, and maybe considerably higher - but not on demand, rather on a "safe haven" and speculative play.  Go look at 07/08 for how this plays out.  And get ready for the bad effect on your wallet from higher gas prices.  I expect the $4 line to be breached in high-cost areas by the summer, and we may see $5 gas this year.  But - by the end of the year oil will be on the decline.  Again.  And again, it will be because the economy is in fact going down the crapper. Again, score.

    * Commodities will continue to ramp right up until oil tops as the economic reality that "charge it" can't fix what's broken sinks in.  Recognition will come hard and fast, and metals will not be exempt.  When oil starts to roll over beware.  Everyone loves commodities.  When everyone's on the same side of the boat it usually tips over and there are sharks in the water below. How's that gold trade working out for 'yall?  Topped nicely and sliding now.  Point.

    * Fannie and Freddie will get some sort of "resolution" path - and it won't be positive for them. Miss.

    * "Someone" will pry open the REMICs in MBS-land for at least private-label deals and fun will ensue. Miss, but I think only on time.  The lawsuits are coming - California and Nevada are leading this charge but I said 2011 and it didn't happen.  No score when the timing is wrong.

    * China will roll over as their attempts to tighten policy have come too small and too late.  Score.  Shanghai market is down about 25% on the year.  They're not done either.

    * Housing is and will "double-dip."  There's no bottom.  Those who bought the gamed reflex bounce on the tax credits and faux "stabilization" are in big trouble.  My projection is for a mid-single-digit to 1x% decline in prices nationally in 2011, and even then it won't be over. Half-point; we got a massive restatement on sales but the 1x decline in prices didn't happen.  No bottom though - that's agreed by pretty-much everyone.

    * States will try to tax their way out of pension trouble, and fail.  The Whitney call will be wrong but only because of how she phrased it.  States and municipal governments will be increasingly recognized as insolvent but they will continue to play games to try to stretch cash flow rather than defaulting outright. Score.  No defaults en-masse but the games and the problem were spot-on.

    * Between forced State austerity and semi-forced Federal austerity the rug will get pulled of the master "credit card spending" support chart up above.  The disruption that will become evident, especially in the back half of the year, will be material.  But the worst of it won't be in 2011 - it will be in 2012 and beyond. Nope.  Early - this one gets repeated for 2012 though.

    * Fed Index price paid/received divergences along with inventory build say we're going to double-dip in the general economy.  I believe it.  The Fed has of course tried to stop this with their QE games but they're not getting the effect they claimed they were after.  The Hopium runs out in 2011 and the addict will go through withdrawal. Eh, no point.  But the earnings flow-through on the PPI is here but I can't take the point yet.  This one gets repeated for this coming year and I might have only been off by three months.  Nonetheless, early is wrong.

    * Margin compression will become realized.  I'm just about the only one who's been talking about it in the back half of 2010 based on the PPI/CPI reports and regional Fed indices, but that won't last.  We'll start to see it in the Q4 earnings and by Q1 people will be talking about it.  This will put a cork into the "multiple expansion" crap that a whole lot of "pundits" have been running over the last year. Miss on time, will repeat this one too. It got talked about but didn't hit earnings until the start of 4Q. 

    * The inventory build we've experienced will prove to have been unwise.  Expect a cycle of write-downs which will further damage earnings.  Unsold inventory is a millstone around your neck.  I've been talking about the warnings evident in the data on this for six months or so - the bet the market has made is that this will be sold through.  Nope. Ditto.  No point.

    * The Fed will get neutered, but it won't be due to Ron Paul.  He'll huff and he'll puff and then blow a fart instead of blowing down their house.  It won't matter.  Bernanke's credibility will be severely trashed by the end of the second quarter as his monetization will be increasingly seen by The Republicans as nothing more than a way to pander to the profligacy of Congress (which they'll try to pin in the Democrats, despite their fully-complicit role in it.)  The end result (albeit through the typical partisan BS) will be that QE2 is the last time that happens, period.  I expect an all-on attempt to change The Fed mandate to remove "employment" and possibly define "stable prices."  These two things, incidentally, would be tremendously positive, and the first might actually succeed.  The second?  Don't hold your breath.  Dennis Kucinich's bill would be even better, and it will be reintroduced - and fail to gain any material sponsorship including from the Pauls.  Somewhere around the middle of the year this entire dynamic starts to become interesting in the 2012 Presidential sense. I'll take that point.  NO QE3, despite everyone who called for it.

    * The TNX will hit 4%, likely in the first quarter. Clean miss.

    * We won't get bond auction "fails" per-se (that's impossible given the Primary Dealer setup) but there will be plenty of "D"s and "F"s in terms of grades, with lots of tail showing.  Again, I expect this mostly in the first half of the year. Clean miss.

    * The market will roll over this year.  And not in a small way either.  We may finish the year over 1,000 on the SPX, but we're going Helium-style diving at some point first.  Since timing is everything in this game I'll stick my neck out - there will be a sucker sell-down early this year, the market will bounce, and then Hell will rain on earth later in the year and into 2012. Half credit - big sell-offs but the ending point is definitely wrong. We got a lot of it but not enough. 

    * Expect extreme volatility. Uh, yeah.  Point.

    * The potential for a regional war to break out is extremely high. Nope.

    * Civil unrest will spread beyond a few demonstrators in Europe.  This includes the possibility of unrest in the United States. Miss.  "Occupy" doesn't count and while there has been some over in Europe in particular what we've seen is not what I had in mind.  No point.

Looks like 10 out of 21.  Remember that to be right you have to hit both the event and the time, so I consider this a pretty good score.  You can judge it however you want.

Now let's look at how things are today. As this goes to press The ECB has tried to "put out" the Euro debt zone fire for about the 10th time this year.  None of the others have worked and this one won't either.  There's simply no "there" there.  The EU banks are ridiculously over-levered, there is no real attempt to force them to cut that crap out and in fact at this point they probably can't since they've geared up on sovereign debt - if they sell it down rates will spike to the moon and the entire EU comes apart.  If they don't and something goes wrong (anything!) then they blow up, rates spike to the moon and the EU comes apart.

If you're wondering why there's been no solution that's the reason - there isn't one that doesn't involve taking these wealth-destroying institutions out back, shooting them, paying off depositors as best you can and then either charging their executives under the law or simply turning them over to the now-very-pissed-off citizens who just saw their pensions and social benefits go "poof" (never mind that it's really the politicians fault that it all happened in the first place!)

Speaking of that I want to go into a bit of detail, because it seems that people just don't "get it" in this regard.  It's convenient to blame the big banksters, and they're certainly a big part of it.  But the primary blame has to rest with the political class for two reasons: They make the laws under which the banks operate and they love making political promises to spend money they both don't have and are unwilling to tax someone to acquire.

What Congress spends but doesn't have Treasury must borrow.  When Treasury borrows it creates the capability for banks (including The Fed) to create monetary inflation and bubbles. There are three sorts of "money" - actual surplus capital from past economic activity, self-liquidating credit and non-liquidating credit.  All three spend exactly the same but they are not the same.

The first is earned by someone's efforts and it is what's left after you pay your costs (including taxes, if any.)  That's actual wealth - and is the only sort of "money" that one can call "real."  At least in theory it is supposed to be durable and able to be saved, invested, or spent as you choose. The second is credit money that is created to liquify an asset.  An example of this is a letter of credit guaranteeing payment for a shipment from Japan to the United States.  It's hard to sue someone in the US from Japan, so this is very useful to commerce.  But this credit money goes away when the bill is either paid or defaulted.  The same model exists with a credit card that you pay off every month.  This has no inflationary impact because it disappears when the transaction is closed. The third is credit money that is created based on nothing other than a promise to produce something tomorrow.  In the case of government that "something" is of only one form - taxes.  In the case of an unsecured private loan it could be anything from a revolving credit card to an OTC derivative trade.  The problem with such a loan is that it does not self-liquidate as it's never closed - instead, it's rolled over again and again.  Since this sort of loan permanently expands the number of monetary units in circulation it is a pure act of monetary inflation.  It is important to note that all government deficit spending has been of this form in the modern era - we have never actually run a budget surplus save one year - a tiny one in calendar 2000 (but not fiscal 2000.)

Why is this understanding so important, you might ask?  That's simple - it is the explicit and intentional acts of the government in their overspending that lends cover to virtually all of the other ills with capital misallocation, trade imbalance and other games.

Let's take a simple example: Nation "A" and "B" both have floating fiat currencies.  Nation "A" runs a trade deficit with Nation "B".  What happens?  Capital drains from Nation "A" to "B" since the funds to buy the goods move and never come home.  This makes Nation "B" more wealthy and "A" poorer; that in turn makes the goods "B" is exporting more expensive in "A"s terms and almost-immediately cuts off the imbalance. So how do you prevent that?  Oh that's easy - get the government to run a $600 billion budget deficit!  Now you can "replace" $600 billion of capital with $600 billion of non-liquidating (that is, permanent) credit money.  Heh maw, look - my trade deficit didn't self-extinguish! But notice what's going on under the surface: Capital and credit aren't the same thing.  One is wealth, the other is a promise to labor tomorrow.  In other words one is the product of free men and women, the other is a demand that others submit to slavery - a promise that others will pay taxes in the future!

If you're wondering where our jobs went, that's how it happened.  The actual capital flowed out of the country and was replaced by credit which spends the same but isn't the same at all.  What disappeared was wealth and freedom, and what replaced it was bondage, unemployment and McJobs.  If you're wondering why despite Congress saying they don't want to see all of our jobs go to China and Mexico it keeps happening, it is happening precisely because Congress will not stop spending more than they tax!

In other words it is Congress that has drained the capital of our nation through their policies.  They have serially lied to us for thirty years in this regard with those lies really picking up steam in the last decade.  The so-called "Tea Party" along with the Democrats and "mainstream" Republicans are all liars in this regard - every one of them is complicit, as any of these groups could have shut this down at any time. Had the Congress refused to raise the debt ceiling in August it would have immediately forced a balanced budget - without the need for a Constitutional Amendment. Remember too that the House and Senate both have permitted "Continuing Resolutions" to run the government now for two years.  This was agreed to by both Houses, ergo, it's both of their fault and those claiming otherwise are liars.

This same dynamic has played out over in Europe.  Greece, Spain, Portugal, Italy and others have all made promises they can't keep with their current tax revenues. The same dynamic has led to the same outcome - they're just a bit ahead of us on the road to perdition.

Of course the political impetus to spend money you don't have is strong.  It's easy to buy votes for a while by promising people things you know you can't afford, and it is wildly unpopular for a politician to say "No."  Even the vaunted Ron Paul who claims to be "Dr. No" in his voting record in fact does not honor that when it comes to earmarks - he lambastes them on the floor but when it comes to vote he pushes for, votes for and accepts them for his own district! The reason of course is simple - he wants to keep his seat.

But overspending is a corrosive act no matter who is doing it.  It eventually bankrupts any entity that engages in this practice, but when governments get involved the results are particularly nasty, as it is the entirety of the nation that suffers.  The more attempts are made to cover up the effects of the stupidity, such as by financial repression of interest rates, the worse the harm and the more-widely that harm is spread across the population.

There's been no honest attempt to deal with any of these issues, including most-particularly in the United States.  You cannot solve a debt problem with more borrowing any more than you can drink yourself sober.  We continue to believe we can run trillion-dollar+ deficits without consequence and the 10 year Treasury yield seems to agree.  What must be kept in mind is that this is the same dynamic that played out in Europe - including in both Greece and Italy - right up until it didn't, and when the bond market came apart there it did so with extreme violence.  The same thing can and will happen here.

This, of course, leads to the obvious next question: when?   It is here that math provides a useful degree of guidance. In 2007 we had to shrink our Federal Government by about 20-25% in order to restore balance to the economy.  Those who have followed The Ticker for what is now approaching five years and 5,000 articles know that I've been calling for this realignment incessantly since that time.  Instead we grossly expanded the size of our vote-buying programs with more and more deficit spending.  This led us to today where the required shrinkage is now approaching 50% in size - four years later.

This is an important fact, because that is a geometric progression.  Now let's go back and see what we have four years previous and see if the progression holds up - to 2003. In 2003 we ran about a $600 billion deficit against a GDP of $11.5 trillion, which was about 6%.  That is, we tracked under the geometric expectations on a backtest (which were about 10-11%.) Can we survive a 50% reduction in the size of the Federal Government, a doubling in actual taxes received by the government, or some combination of the two?  I don't know, but it doesn't matter whether we can - one of the two or some combination adding to that point is going to happen whether we survive it or not!

The "outside window" on "when" is four years hence.  Of course that's the "100% reduction" line at which point we simply collapse into civil war and anarchy forced by mathematics, and in truth we'll blow sky high long before we get there.  You can reasonably expect that there will be attempts to push the line backward, but there is no actually stopping of the process until and unless we run a surplus in terms of economic growth - that is, growth in the economy must exceed growth in government spending (this, incidentally, means that if economic growth is negative the government must shrink at least as much.)

The members of the Simpson-Bowles deficit commission had their own private estimates of "how soon."  None believe we have more than two years left.  I think that's about right, and we may not get that far.  History says that these walls always are closer than they appear, just like the T-Rex was in the rear-view mirror in Jurassic Park.  Revulsion tends to come from a "moment of recognition" that precedes the actual hitting of the wall, just as it did in Greece and the rest of the European continent. Thus it will be here if we fail to address the issues facing our nation and defer to political expedience and vote-buying.

Now let's look at the current macro picture.  We have durables reports showing massive inventory levels - in fact, the December report had inventory at all-time highs.  This, standing alone, is bad - it "pulls forward" GDP numbers but the sustainability of that is predicated on sell-through.  If there is no sell-through you're in big trouble.

Add to that the earnings misses coming from various companies.  We are now into the maw of the profit impact from the PPI ramps of a year to 18 months back, which I've been pounding the table on now since August of 2010.  The PPI has slacked off on the rate of advance, but the damage is done.  That's in the pipe and can't be avoided.  In addition the organic profit cycle has almost-certainly peaked in terms of percentages of profit from gross sales.  Those two factors plus the inventory situation are all the ingredients for a severe inventory (conventional) recession while The Fed has already backed itself into a corner with ZIRP and The Federal Government continued to overspend!  In other words the policy tools to "help" are slim and none and Slim is in the bar getting drunk.

Politically we have a huge problem - the premise is "tax cuts good, anything that raises taxes bad."  At the same time "spend more" remains the mantra of both political parties.  The "Pay For" on the recent FICA deal was spread over 10 years but the impact on the deficit - some $200 billion - is all right now.  Of course in a year nobody will be willing to "raise taxes" either, so the $200 billion over 10 years will be $2 trillion.  To those on the right who argue that "we can't give more to the government; they'll squander it" you're free to run that line when the budget is balanced - until it is you're just arguing for jamming the accelerator as we approach the brick wall at 100mph, exactly as are those on the left.  "Blow up in one year or blow up in two" still is "blow up."  Both are stupid and indefensible and we should call them what they are - calls for anarchy - because that's exactly what we're going to get on this path.

Now let's look east - specifically at Japan.  The most-recent budget, accepted by their government, calls for an astounding near-50% deficit - that is, they intend to borrow half of what they spend!  The willingness of the bond market to swallow whatever the Japanese government emits has led them to believe they can continue that sort of game forever.  They're wrong.  And while I'm at it may I remind everyone that the Japanese stock market remains down more than 75% from its all-time highs - 20 years ago?  How's that "earnings growth" and "economic progress" thing working out over there?

Finally, China.  The most-recent news is that of large minimum-wage hikes.  Nice idea.  Can they successfully navigate from a mercantile jackbooted exporter that steals anything that isn't nailed down (and some things that are) to a consumer-led, consumption-based economy that generates actual economic surplus?  I'm not sold, especially when you add to that the need to stop treating the land, air and water like open sewers.

Returning back home we have one final area of contention to consider - it's an election year.  If you think either major political party is going to do anything that might be perceived as "helping the other guy", you're nuts.  They most-certainly will not.  This will lead to some very interesting times in the next few months, given that the second half of the debt increase is subject to vote and as of the 22nd of December we're a grand total of $113 billion from hitting the wall - again.  January is usually a month that Treasury runs a surplus due to tax payments, but you can still expect the clamoring - and games - to start up pretty much with the drop of the ball in Times Square.

Will the so-called "Tea Party" fold their claims of fiscal prudence once again?  You bet.  After all, they just did vote to blow a $200 billion hole in the deficit with the payroll tax cut extension - a vote that was taken by "unanimous consent" because not one Representative out of 435 thought it was more important to stand on principle and demand a recorded vote than it was to drink eggnog with those providing their bribes - er, "family and friends."  You got that right folks - not one man or woman stood on principle.

Not one.

So we are consigned to the same sort of cock-n-bull game now that we were back in 2007, and 2008, and last year.  But Mr. Market doesn't care.  He's going to do what he's going to do, and he's issued his warnings - which were ignored. So with that, here's your 2012 Outrage List, and we'll see how many I get right.

    * We're going down - and this time it's not "buy the dip."  The can-kicking will be attempted, of course, but we're pretty-much out of policy tools - we used them.  Add in a peak in the profit cycle and the PPI pass-through and you've got trouble.  Formally, this is "market ends lower than it began."  (The next four are verbatim repeats, as I said I would; these are marked with asterisks)  Note that there's no place to hide overseas in equities either (see below.)

    * Between forced State austerity and semi-forced Federal austerity the rug will get pulled of the master "credit card spending" support chart up above.  The disruption that will become evident, especially in the back half of the year, will be material.  But the worst of it won't be in 2011 - it will be in 2012 and beyond.  (Ed: Repeat from last year.)

    * Fed Index price paid/received divergences along with inventory build say we're going to double-dip in the general economy.  I believe it.  The Fed has of course tried to stop this with their QE games but they're not getting the effect they claimed they were after.  The Hopium runs out in 2012 and the addict will go through withdrawal. (Ed: Yes, this is an actual "official" recession call.  Q2-Q4 timeframe.)

    * Margin compression will become realized.  I'm just about the only one who's been talking about it in the back half of 2010 based on the PPI/CPI reports and regional Fed indices, but that won't last.  We'll start to see it in the Q4 earnings and by Q1 people will be talking about it.  This will put a cork into the "multiple expansion" crap that a whole lot of "pundits" have been running over the last year.  (Ed: The reports on this have already started.)

    * The inventory build we've experienced will prove to have been unwise.  Expect a cycle of write-downs which will further damage earnings.  Unsold inventory is a millstone around your neck.  I've been talking about the warnings evident in the data on this for six months or so - the bet the market has made is that this will be sold through.  Nope.  (Ed: Inventory levels are at record highs - not smart!)

    * The fissures - if not outright failure - in the Euro Zone become realized.  I fully expect one or more nations to leave the Euro and there is a non-zero chance of an outright collapse.  Timing is the problem - I'll go ahead and stick this in 2012 but may be early a year.  We'll see.  Incidentally because of how I worded this Greece leaving is a "score" but I'm not thinking Greece here - try Spain or Italy on for size.

    * A viable third-party candidate emerges and runs for President in 2012.  Viable is defined by votes.  1% doesn't do it.  Double-digits does.  There's the marker.

    * Serious changes - and charges - will come out of the MF Global disaster.  I don't know if Corzine will get indicted or not, but the light will go on within the regulatory and Congressional offices and a "burnt offering" will be made.  Maybe more than one or two.  The issue is the risk of a lockup in the commodity forward markets, which would be disastrous for the global economy (consider that such an event would make impossible buying an airline ticket for more than a month or so in advance, as just one example.)  In short this is prediction that we will see actual handcuffs.

    * The Dollar will be flat to materially stronger.  Once again those calling for a sub-60 (or worse) dollar index will be wrong.  In short cash will be King.

    * Housing will not recover.  That won't stop government from continuing to try to hold prices up of course. Doesn't matter - there's no recovery in the offing on housing.

    * There will be severe issues with subgroups who don't get their "cheese."  Whether this reaches the formal level of "riots" is open to some question but the impact won't be.  It will be real and ongoing; the political season will definitely play into this as well.

    * Lots of noise will be made about deficits and debt but real, effective moves toward addressing the problem will not be made.  The reason of course is that admitting that we're addicted means cutting of the games - and that's unacceptable to both sides of the political aisle.  As such actual effective movement will require the market to act.

    * A real shooting conflict breaks out in the Middle East. I've got my suspicions on who starts it and why, but the story told in the papers has a less-than-50% chance of being the truth so I'll leave that out.  Any large-scale shooting conflict counts (not a couple of cruise missiles or similar.)

    * The Fed will back off and rates will rise.  The pressure will simply get too be too high; they're aware of, I'm convinced, serious gaming and risk in the financial system and interconnection (e.g. MF Global) problems but will deduce they'll never get away with another large-scale bailout.

    * The squeeze in state and local funding will get materially worse.  This is going to be an interesting development to watch; the first real cracks of realization that big pension obligations to police, fire, teachers and similar will not be paid is odds-on to show up this year.  The wild card is how everyone involved deals with it; the blast radius is likely to be pretty wide.

Here 'ya are - 15 for the New Year.  As always I reserve the right to revise and extend until 12/31 at 11:59 PM."

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