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(J.P. Moczulski/The Globe and Mail)
(J.P. Moczulski/The Globe and Mail)

David Rosenberg

Safeguard your capital: This debt crisis has not ended Add to ...

It was the Diner's Club card in the 1950s (one card per family!) that started it all.

And it's clear now, around fifty years later, that the credit expansion driven by a "buy-now-and-pay-later" society had reached the point where the financial system became so polluted that a bubble, fuelled by greed and ill-advised mortgages, began to form. And it spread - like bacteria.

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It was without question the biggest credit bubble in human history. And we are still in the early days of watching it collapse.

The problem of course was simply that there was not enough income to support the record debt load the world had taken on.

When asset prices succumbed to their own grotesque degree of overvalued excess, that compounded the problem and further fuelled the credit collapse and financial crisis.

These woes continued through 2008 despite the cries from the economic intelligentsia that all we were in for was a soft-landing during a wonderful period that would be labelled "The Great Moderation." What followed was all the king's horses and all the king's men, brandishing all their marvellous new tools, attempting, futilely, to put Humpty back together again.



What happens if the next recession begins, or the original contraction resumes, before organic growth has been renewed sufficiently and balance sheets have been repaired enough to weather the storm?


We then got a pause in the collapse and a spectacular bear market rally in the final eight months of 2009 and early 2010. But, as Mick Jagger put it in an oldie but goodie, "it's all over now."

We are now rolling back into a period of pronounced economic weakness, with contraction in gross domestic product likely to soon follow the stagnant economic conditions of the current quarter.

The rolling-over in the equity market, alongside the virtual meltdown in government bond yields, strongly suggests that, at the margin, investors are also belatedly, and begrudgingly, coming around to this view.

This then forces the question: What happens if the next recession begins, or the original contraction resumes, before organic growth has been renewed sufficiently and balance sheets have been repaired enough to weather the storm?

And, what are the policy options if the U.S. Fed can no longer reload the gun and society fully withdraws its political support for the extreme fiscal stimulus measures that we know the administration truly craves - even if the prior rounds of intervention appear to have been ineffective? (Hey, isn't the unemployment rate supposed to be 7 per cent by now?)



What the bulls still refuse to see is that we are in an entirely new paradigm. There is simply too much debt overhanging the U.S. household balance sheet; the largest balance sheet on the planet.




I often weave the legendary Bob Farrell into my work and I am reminded of his sage advice in a report he wrote in the twilight of his storied multidecade tenure at Merrill Lynch back in 2001:

"Change of a long term or secular nature is usually gradual enough that it is obscured by the noise caused by short-term volatility. By the time secular trends are even acknowledged by the majority, they are generally obvious and mature. In the early stages of a new secular paradigm, therefore, most are conditioned to hear only the short-term noise they have been conditioned to respond to by the prior existing secular condition. Moreover, in a shift of secular or long-term significance, the markets will be adapting to a new set of rules while most market participants will be still playing by the old rules."

What the bulls still refuse to see is that we are in an entirely new paradigm. There is simply too much debt overhanging the U.S. household balance sheet; the largest balance sheet on the planet.

The cumulative household debt-to-asset ratio in the U.S. is 20 per cent. At the peak, this ratio was almost 23 per cent, and the pre-bubble norm was 12.5 per cent (no wonder a quarter of Americans are considered high-risk borrowers). The process of balance sheet repair is still in its infancy.



We will see first hand what happens when policy stimulus and a mini-inventory cycle fade in a credit contraction: stagnation in the third quarter followed by renewed economic contraction in the fourth quarter.


We are a long way off this deleveraging phase from running its course, both in magnitude and duration. If history is any guide, these transition periods to the next sustainable bull market and economic expansion typically last seven years.

The U.S. government, along with the Federal Reserve, has expended tremendous resources to cushion the blow. But now we will see first hand what happens when policy stimulus and a mini-inventory cycle fade in a credit contraction: stagnation in the third quarter followed by renewed economic contraction in the fourth quarter.

So, play it safe. Look to capital preservation strategies, find hedge funds that hedge and make income a priority. Do so and you will be able to rule in the sort of environment we are in today - and we're likely to be in it for some time.

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