NEW YORK ( TheStreet) - Stock investors focused on corporate profitability might not spend too much time worrying about the multi-trillion dollar debt problem in the United States. But John Mauldin, financial expert and author, says investors should not dismiss the risk of default by big nations like the United States, remote as that possibility may be. Failure to address the debt issue now could leave the country with a permanent recession, he says, as the dollar would lose value and create financial market upheavals.
Mauldin is the president of Millenium Wave Advisors, an investment advisory firm. His free weekly e-newsletter, Thoughts from the Frontline, reaches an estimated 1 million readers. TheStreet spoke with Mauldin about his latest New York Times bestseller Endgame: The End of the Debt Supercycle and How It Changes Everything, his thoughts on the solution to America's debt problems and his views on the market. TheStreet: Your book, Endgame, talks about the sovereign debt crisis, which remains a major market headwind. The U.S. government is facing a possible shutdown over budget issues as we speak. What is the "Endgame" referred to in the book's title? John Mauldin: Governments everywhere are going to have to figure out how to live within their budgets or they will hit the wall. They will become Greece or Ireland. Greece hit the wall because they were a profligate, wasteful, "nobody pays any taxes" country. Ireland was the Celtic tiger. They could do no wrong. They were going at 7, 8, 10%. They built 300,000 too many homes in a country of 6 million people. Everybody was flipping homes. They made what happened in California and Nevada look like Sunday school picnic. And then their banks became multiples of the size of their economy just like Icelandic banks. And then their government wanted to nationalize and back their banks. But, no! They are too big to save. It is beyond too big to fail. They are too big to save. That is why the Irish government was thrown out. The new government coming in wants the bond holders to share the pain. Ok. What does that look like? Those bondholders are British, French and German banks. They, quite naturally, want the taxpayers to pay it. The taxpayer doesn't want to. That puts pressure on banks that are levered 40 to 1. If a German bank writes a credit default swap against a sovereign nation, that does not count against their Tier 1 capital. That's crazy. Because regulators say: Well, a government cannot default.
|John Mauldin, President, Millenium Wave Advisors|
Sure they can! And once they start to default, it becomes a problem all over the world just like subprime problems in Riverside, California infected the rest of the world. These things have consequences and it is going to change the abilities of government to respond to problems. The European debt crisis is just one of the many risks that are looming for the market. Is the market underestimating this risk? Of all the things in my worry closet, the European debt crisis is my number one risk. European banks scare me. They are heavily overleveraged. That is why I have been writing about Ireland. It is a brinksmanship game. Ireland could tip it over. What they are trying to do is kick the can down the road until the European banks are able to raise capital and get enough of sovereign debt off their books, so that when the time comes when the EU really can't underwrite Greece or Portugal or Spain anymore, the banks don't go bankrupt. They got enough to be able to weather the storm. As an American I am cheering them on. I don't want there to be a crisis that creates a problem here on this side of the Atlantic. But if I was a European taxpayer I won't be happy. Japan is a bug in search of a windshield. They are going to collapse in two, three years or the yen will collapse in a serious way -- go to 100 yen, 125 yen and then 150 yen and higher as the Japanese would be forced to print a great deal of money. And we will get to see what happens when a central bank prints money. If you are Mrs. Watanabe you are not going to be very happy as the buying power of the yen declines. What about in the U.S.? How do you get the average American investor and taxpayer to appreciate the urgency of fixing the deficit issue? What we have to understand is that there is no intrinsic reason that we can't be Greece. If we wait until a crisis, then the solutions and the choices that we have then will become much more limited and much more difficult. And we will start seeing permanent recessions and depressions depending on how long we wait.
If today Paul Ryan says he is introducing a budget that cuts $4 trillion in spending
over the next ten years , then I say...well, that's a good START! Because that is what it is, it is just a start. We have to cut $8-9 trillion over the next ten years. We have to get our deficit below the growth of nominal GDP. We can run a deficit every year so long as it is below the growth of nominal GDP because that means your income in national terms is growing faster than your debt. Now it might be a wise thing to run a surplus but it will not kill you. What we are doing today will kill you. It will destroy the economic body and you either have interest rates go through the roof or the Fed prints money which means the dollar really goes down against most currencies and it becomes a true ugly contest.In that case you can have all sorts of financial upheavals. Profits won't do well, the markets won't do well in a scenario like that. Everybody just seems to think we are the United States and we will solve it or we are too big. No we are not. Big nations can have financial crises..there are numerous cases in history. If you read the book "This Time is Different" Carmen Reinhart and Kenneth Rogoff ... what you will clearly see is that we are not any different from any small banana republic. If you don't manage your currency well, you are going to hit the wall. We are dealing with this issue during a recession when incomes are not growing, fixed income earns barely anything and now the retiree may have to accept major changes to their Medicare program. Should the solution be higher taxes? I don't want to cut Social Security and Medicare, but if we don't, we have to pay for it. In a true macro sense I don't care what we do, whether we cut deficits or raise taxes. I just want to get the deficit below nominal GDP, because it is a cancer. I want to survive. I want to get rid of the cancer. If you ask me my preference, I would like to do it with less spending, smaller government and recognizing that more taxes will reduce productivity and growth. In the government's desire to help the people they are hurting the economy and the people in the long run.
What about the bond market? We have seen yields tick back up but how can you tell what is driving the move? Is it inflationary expectations, recovery expectations or serious concerns about the country's deficit? We don't know, but we are going to find out by the end of June. .....I expect the dollar to get stronger after June going to the end of this year, which will surprise everybody. And it wouldn't surprise me to see rates go down because that is what happened last time
when QE1 ended . >>>How to Trade the End of 'QE2': Strategists I think the bond market, the world, responded to QE2 with higher rates. The problem is that we humans are hard wired for cause and effect. We literally get a chemical reaction in our brain that says A causes B and that gives us pleasure. We have to be very careful saying what is causing the rise in rates. As you laid out, there are three or four potential answers. All of them might be working together. A little bit of this and a little bit of that all add to make the cake. Last time when QE1 was completed, the economy looked like it was slipping back into recession. Do you think we could face something like that this time or is the country now on a better economic footing? I think the next recession will be some kind of exogenous shock rather than a business cycle recession. There is no reason, given the low levels that we are at, to expect that we will go that much lower. I don't expect a fast increase in growth, I expect to muddle through. Then there will be something...Japan imploding, China slowing down, an oil shock or something that could shove the United States down. We are at stall speed. When you are growing between 1-2% which I think will happen next year, it does not take a lot to shove you down. It takes something, I just don't know what. What should bond investors do? You should follow Bill Gross's advice. He said: "I am out of here." I wouldn't be buying treasuries at all. If I am buying bonds I am buying shorter term corporate. I am selling covered calls on dividend paying stocks and hedging it with VIX. I think that the next five to seven years will look like the seventies in terms of volatility. We will see more frequent recessions. The Congressional Budget Office projections of income assume no recessions in the next ten years and a benign interest rate environment. I cannot look back at any time and see a benign rate interest environment and no recessions. It is not a realistic assumption. I think investors need to be more cautious. Edited for length and clarity. --Written by Shanthi Bharatwaj in New York.