Between a Rock and a Hard Place - November 2011

Economies around the world continue to struggle between out of control entitlements, debt obligations and the ability to make those payments. For all the countries in the developed world, the entitlements that were granted are now empty promises that are bankrupting the systems and causing havoc with people who expected to receive the benefits. At some time in the near future, things will come to a head. Either the beneficiaries give back benefits and increase tax payments or the countries will default on the payments because THERE IS NO MONEY!

EUROPE

Recently, many people and columnists have warned about Europe and the European contagion. One day, Greece is fixed and Italy is broke, the next day, they are both fixed. In no way did the removal of the Prime Minister of either country solve any problems. Both Greece and Italy have major problems and so does the rest of Europe. As Margaret Thatcher said, “the problem with socialism is that at some point you run out of other people’s money.” Well, Europe is broke and has no money. The key point is whether or not Germany will continue to bail out the European Nation States. Germany’s debt to GDP is now over 80%, fast approaching the danger point. Germany is not a bottomless pit of money. We think that eventually they will stop the bailouts.

We believe Greece is doomed. Greece is a land of fewer workers and even fewer customers. How do you grow GDP? With exports! What does Greece export, olive oil? When the government introduced austerity measures, the Greek tax collectors walked off the job.

Italy also has major problems. Recently, interest rates on Italian 5-year bonds rose to over 7%. On November 14th, the Italian Government had another auction of 10-year bonds. The value of 10-year bonds issued in October fell to 82.6% of face value. When interest rates increase, the value of the bonds falls. We believe that this is going to be an issue going forward for the developed countries of the world. The world is stating that Italy has a debt problem!

The difficulty in Europe is more than just too much debt and too many benefits. The problem is that Europe has decided not to reproduce. Greece has one of the lowest fertility rates in the world at 1.3 children per couple. How are they going to continue the entitlement state? The United Kingdom has a population growth rate of 0.2%, Germany is at 0.0% and France is at 0.4%. The European country with the highest population of childless women is Germany. Because of this, Germany’s working age population is expected to decline by 30% in the next few decades. There are not enough people being born in these countries or immigrants coming to the countries to pay into the system to support the entitlement programs. Eventually, as will happen later in the USA, the benefits must be reduced or stopped. This is simple mathematics. When you spend $4 trillion but only raise $2 trillion (the current model), you obviously have no intention of paying it off and the world knows it.

About half of the global economy is living not only beyond its means, but beyond its diminished children’s means. Instead of addressing the situation, countries with a debt to GDP of 125% are being “RESCUED” by countries with a debt to GDP of 80%.

INFLATION VS DEFLATION

It is imperative in the political overseer’s view that the economy return to the pre-crash policy of spend spend spend in order to save the economy. The FED wants to have inflation (modestly) and is very concerned about deflation. Let’s explore the differences.

In inflation, prices go up slowly and efficiently (hopefully), and people spend money to buy these items before the prices go higher. The rationale is that the more one waits, the more expensive the product becomes so one purchases it now. What we have now is a working class whose income has not gone higher so when they spend, it is with credit. This actually makes consumers poorer as debt is a wealth destroyer.

In deflation, prices go down because of less demand. People decide to wait before they buy because the price might be cheaper in the future. What do they do with the money while waiting? They save it, usually in banks. The banks then lend it out to businesses, which cause wealth creation and job creation. People start spending money, but they have less debt than they did previously and pay with dollars saved.

THE MARKETS

So what do investors do with the turmoil going on around the world? The first thing is to ignore the volatility. Turn off the news, don’t watch CNBC, and try not to look at the account balances often. The portfolios are managed for the long term. We have discussed the need for an investment plan to reach your goals. This plan should be reviewed with you to see if your goals are still the same or if changes need to be made to the plan.

No one knows what is going to happen with investments in the next minute, day, week or year. We remain optimistic in the long term and we can create a portfolio to reduce the volatility of your investments while still providing growth.

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