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Sleepwalking Toward a Precipice
ObservatiOns & OutlOOk
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WHat We Will COver...
Its structural: Te credit crisis and Great Recession revealed
structural problems in the United States, Europe and China which m
hinder their uture growth prospects.
PolItIcal DysfunctIon: Political leadership has been unwilli
unable to address these structural issues eectively, resulting in tempo
expedient solutions that oten make problems worse.
fourth Branch solutIons: With the ailure o political lead
central planning has been ceded to central banks to reate markets
reliquiy insolvent banking systems and insolvent sovereign nations.
the unknowns: Given the ragile nature o global economies co
out o crisis, a variety o uncertainties could also negatively impact gr
Market Matters: Over the next decade, we see double-wide
possibilities or economic growth translating into double-wide
possibilities or U.S. and global markets. We hope you enjoy.
Jason B. Leach, CFA
Director of Research/Portfolio Management
Cravens Brothers Wealth Advisors
PROPRIETARY AND CONFIDENTIAL | Cravens Brothers Wealth Advisors is a branch o and Securities oered through WFG Investments, Inc. (WFG), member
FINRA/SIPC. John Cravens, Jason Leach & Miguel Kremenliev are Registered Representatives o WFG Investments, Inc. | COPYRIGHT Cravens Brothers 2012
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eurO ZOne: the failed experiment
euro Zone InsolVency MIX: Te European Monetary Union
(EMU) is a 17-member subset o the larger 27-member European Un
In 1999, this Euro Zone adopted both a single currency and singlemonetary policy administered by the European Central Bank (ECB).
frst decade o its existence, use o the Euro across countries with di
in competitiveness, tax collection, wages and entitlements, inevitably
led to wide trade imbalances, high defcits and rising debt in weaker
periphery Euro Zone countries. Te 2008-2009 fnancial and econom
shocks catalyzed this mix o structural problems, raised borrowing co
signifcantly or periphery countries, and in 2010, set o periphery E
Zone nation solvency crises.
enrIcheD crIsIs-InIuM: Euro Zone, EU, and IMF leaders (
troika) umbled over numerous liquidity and austerity measures to f
sovereign debt crisis, but their actions served only to enrich it. In 2
2011, troika leaders secured over 1/2 trillion dollars to bail out Portu
Ireland, and Greece (twice), and orced adoption o strict budget cuts
tax increases, and labor reorms. In 2012, leaders orced a $132B priv
sector haircut on Greek bonds, approved enhanced bailout unds to
Spain and Italy, and orced all countries to adopt a fscal compact to
defcits. Te fxes let Greece with more debt, eliminated uture privbuyers o distressed sovereign debt, provided insuffi cient capacity or
outs (~$650 billion), and reduced growth through austerity.
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eurO ZOne: the change bank, thats what we
sInGle worD scores: As European leaders administered m
acronym fxes, world markets shuddered with every new hal-baked
solution. Te European Central Bank vigorously resisted becoming o last resort or distressed countries and banks, but relented in late
2011 and early 2012, lending trillions to Euro Zone banks via Long
Refnancing Operations (LRO) as Spanish and Italian yields (the ra
which they borrow) spiked, and normal channels o bank unding dri
Te ECB became the single word score that could calm ears o ano
fnancial crisis. As in the U.S., ailure o political leadership ceded pow
the central bankers to reliquiy insolvent banking systems, and in the
Zones case, insolvent sovereign nations.
fonZI fInance: In a scheme too cool to be called Ponzi, the
provided insolvent banks $1.3 trillion in 3-year, cheap loans (LRO)
the banks in turn bought hundreds o billions in distressed Euro Zon
sovereign bonds, and then deposited the risky sovereign bonds back a
ECB as collateral or the original loans. Tis game o pass the parc
may have prevented a second fnancial crisis in late 2011/early 2012,
also made the sovereign debt crisis bigger (allowing or hundreds o b
in immediately impaired sovereign debt to be issued), will weigh on l
term growth by misallocating capital to insolvent banks and insolvennations, and let taxpayers o the Euro Zone on the hook or the baili
banks and countries indefnitely.
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eurO ZOne: moles follow the gold
the new BarBarous relIc: Te root cause o the seeming
never ending Euro Zone debt crisis is the core structural problem o th
and related adjustment processes. Te use o a single currency across meconomies is much like the mis-priced gold standard o the 1920s and
1930s (Keynes barbarous relic). Te Euro orces uncompetitive, high
indebted countries to adjust internally (pushing down wages and prices
as opposed to externally (devaluing currency to improve competitivene
increase growth, and pay down debt). ied to the new barbarous relic
no means o external adjustment, weak periphery countries ace years o
deationary depression and debt deault/restructuring.
euro Zone whack-a-Mole 2012:
Debt crisis contagion inthe Euro Zone is the inevitable post-economic crisis outcome o high
indebted countries beholden to a single currency union and thus hard
math limits. Changes in sovereign debt levels depend on: (i) growth,
borrowing rates, and (iii) budget surpluses/defcits beore interest pay
When there is doubt that growth will challenge borrowing rates, and/
that budgets will worsen, perception that debt levels will perpetually
causes new borrowing rates to spike. At borrowing rates above 7% (w
Greece and Portugal reside and where Spain and Italy are going), high
indebted countries without control over their currency cant ever pay their debt - moles go up.
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eurOPe: straightjackets, walks, & transmiss
fIscal straIGhtJackets & walkInG stIcks: Te surviv
scenario or the Euro Zone eatures: (i) years o transition to a United
o Europe with centralized budget and Eurobonds, (ii) the ECB bridggap via LRO and direct sovereign bond purchases, (iii) core countries
their AAA ratings, (iv) sovereign debt deault or restructuring o multip
Euro Zone members, (v) multiple large bank ailures/nationalizations,
exibility on austerity limits (fscal straightjackets), (vii) slow growth
recession in the core, (viii) depression in the periphery, (ix) ever increas
social unrest and political swings to ringe parties, and (x) possibly on
more members leaving (e.g., Greece, Portugal).
euroPean transMIssIon: Te degree to which the Euro Zo
resolution transmits to the rest o the world relies on how orderly it
and whether there are Euro Zone exits. Te orderly deault o Greec
2012 had a minor eect on the global economy. Alternatively, disor
deaults and/or orderly and disorderly exits could cause a collapse o
the European economy and banking system, fnancial and economi
contagion around the world, and global depression. It is not a ques
o i or when, but rather, how bad. Te major structural prob
o the Euro Zone cannot easily be fxed by politicians or, in turn,
central bankers, and thus Europe is sleepwalking toward a precipiceunortunately, dragging the rest o the world with it.
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CHina: what in the whirl?
the structural Junk: Te dramatic slowdown in global grow
and trade in the fnancial crisis and Great Recession shone a light on
structural issues in Chinas state-capitalist economy.
Chinas economy has an extreme over-reliance on public investment a
exports (70% o GDP growth over 10 years), with domestic consump
(30% o growth) hindered by violent ination swings, misaligned tax
policies (middle/lower classes 50% o taxes vs. 3% in the U.S.), artifc
high savings rates (inadequate social saety nets, limited investment
opportunities), a rapidly growing wealth divide, aging population, an
distortions rom the one child policy.
Small and medium-sized enterprises (SMEs) are handicapped by Chin
preerence or monopolistic, ineffi cient state-owned enterprises (SOE
wasteul state-directed banking system that lends predominately to SO
widespread corruption, random enorcement o rule o law, and overa
tension between which orm o capitalism should drive growth, state
capitalism or ree market capitalism.
Local governments are over-reliant on continuous local real estate
speculation (land sales 20%-40% o gross revenues) and overburdene
state emphasis on continuous investment in public works (no long-tepublic bond markets).
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CHina: middling kingdom of growth
steroID econoMy: China targets GDP growth at the state leve
to onboard millions o new workers every year. Consensus is that 8%
annual GDP growth is the minimum to achieve Chinas aims, below is, in eect, a China-cession, and well below 8% may have consider
negative eects (large scale social unrest). Since Chinas economy is
precariously dependent on its distorted investment-led growth model
investment were to atten (build the same amount o projects as the y
beore), GDP growth could all by more than 50%. Te second majo
contributor to GDP growth, exports, is subject to at to alling Euro
and American demand due to post-crisis deleveraging.
traDe wInDs a slowIn: In response to a all in exports and G
growth during the fnancial crisis, the central government authorized
$580 billion stimulus package and the Peoples Bank o China (PBO
allowed banks to issue $2.7 trillion in new loans (~45% o GDP) or
investment projects. Te massive stimulus allowed China to weather
slowing trade winds and maintain above 8% GDP growth, but it
exacerbated Chinas structural issues as investment increased rom 40
50% o GDP at the expense o consumption, SOEs became a larger p
o the economy, real estate bubbled and is busting, ination skyrocke
and banks lent and local governments borrowed to virtual insolvency.the U.S. and Euro Zone, actions taken ater crisis only served to enha
existing structural problems the same dierence.
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CHina: the orient of debt
the orIent of DeBt: Chinas state-led growth model is heading
towards a debt crisis. Te state-owned banking system is the largest in
world history with over $17 trillion in assets, but it misallocates capitto fxed proft margins, exible accounting standards, and politicized
directed lending to local governments, SOEs, high profle political pr
and over 100 countries. Publicly, Chinas debt/GDP ratio is around 2
30%, but it is around 100%-200% when inevitable bailouts o banks
other SOEs are included (on par with the U.S and Euro Zone). Te r
path to remediation would be state asset sales, but it is more likely Ch
will socialize bad debts. Again - the same dierence.
the Great reBalance: Chinas investment-led growth mode
unsustainable. In order to rebalance toward more consumption, Ch
needs to: (i) privatize SOEs (sell them), (ii) remove its currency peg
benefts exporters at the expense o consumption (high ination), (i
remove capital controls (allow consumers to earn inve stment incom
(iv) marketize the fnancial system so banks compete or consume
deposits (consumers earn more interest) and lend to proftable SME
(SMEs increase wages more than SOEs), (v) allow lo cal governmen
issue bonds and not be as dependent on land sales or revenues (det
real estate speculation by consumers), (vi) reorm the tax system (rmiddle class spending power), and (vii) institute a viable social secu
program (lowering savings rates and increasing consumption).
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CHina: an 800 lb panda named Status Qu
status Quo : Ultimately, i China doesnt rebalance eectively, it
lead to unsustainable debt levels, prolong Chinas growth downturn
be a drag on growth not only in China, but in the U.S., Europe, anemerging economies due to delayed Chinese consumption o oreig
goods. Te grip on power and money by the communist party, asso
elites and avored state-owned champion enterprises is the major
obstacle to rebalancing. Te 800 pound panda in the room is that n
believes the status quo is sustainable long term, but then again, no
power is incented to change it. For all the admiration o Chinas me
rise to a global economic powerhouse, its structural aws are just as
inspiring, they have been exacerbated by political ailure and centra
excess as in the West, and i they are not rectifed, China is sleepwaltoward a precipice along with the West.
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unkOWns: white pigeons & black swans
Mena In fluX: Egypt, the largest Arab country, is poised or rule
radical Muslim Brotherhood and Saudi Arabias royal rule may be rep
by extremists within a decade. Tere is growing enmity between Iran
Israel with heightened risk that the U.S. and/or Israel will use militar
to stop Irans nuclear development. An oil price shock due to conict
Middle East North Arica (MENA) could roil global markets and cau
global growth to slow dramatically (90% o post-WWII U.S. recessio
have been preceeded by oil price shocks).
PanDoras cyBer BoX: In 2010, the U.S. or Israel unleashed
Stuxnet, a virus that successully took control o nuclear acilities in I
the frst ever use o a computer virus to cause physical damage. Postin
the source code on the Internet made advanced cyber terrorism availato anyone, and in 2011 American hackers demonstrated how to blow
plant or open doors at a correctional acility. Cybercrime is growing r
with over 90% o U.S. companies hacked at least once per year, and o
trillion worth o intellectual property stolen annually.
Bull Market In BaD: In 2011, total global economic cost rom
natural disasters was $380 billion, 70% above the 2005 record o $22
billion. In the next 10 years, the number o natural disasters could do
with population growth in dangerous coastal areas (21 o 25 megaciticlose to coasts). 2011 was the costliest disaster year ever in the U.S. w
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unkOWns: continued
record 14 separate billion dollar disasters, including 400-year drough
wildfres, 1000-year de luges and ooding, the 2nd highest tornado co
U.S. history, and soaring heat (26,500 records and 4th warmest wint
the new Markets - return free rIsk: U.S. stock exchan
have become server arms or high requency trading with 80% o tra
just 2% o participants, 90% o orders cancelled, and ash crashes
market manipulation becoming the norm. Commodity fnancializatio
time high asset correlations, rising volatility, and a shrinking AAA co
world (7 o 19 AAA countries have lost ratings) all increase ri sk in m
and economies. Te $700+ trillion over the counter derivatives mark
(10X the size o global GDP) daisy chains enormous risk across instit
and billions o new structured notes tying bonds and CDs to derivaon stocks and commodities may be brewing a Subprime II.
aMerIcan reVolutIons: Energy demand met by domestic so
rose to 81% in 2011 (the highest in 20 years), and the U.S. is on cou
to be the worlds top energy producer by 2020. Advances in sotware
robotics, materials and processes could lead to a manuacturing revol
in the U.S. with exible actories relocating near cheap energy and
consumers (up to 30% o goods imported rom China could be made
the U.S. by 2020). Tese positive disruptions could boost jobs, incom
government revenues, cut the U.S. trade defcit, and provide greater
exibility in dealing with the Middle East and China.
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Central bank rule:one big monetary experimone BIG Monetary eXPerIMent: Ater crisis, central banks
printed money to buy bad bank assets and inate markets, doublin
size o their balance sheets in the process. When balance sheet expans
stops, it may quickly deate asset prices and reverse the 10%+ boostto GDPs rom the stimulus. Unwinding the unprecedented monetary
experiment without damaging global growth will require uncanny
judgment and timing on the part o central bankers.
the DIstorter: Te market eects o expansionary monetary po
are evident in the strong moves up ater the beginning o QE program
and the anticipatory alls toward the end o stimulus. Market depend
on Fed stimulus is distortionary. Future rollercoaster rides depend on
Feds view o ination expectations, employment and economic data,movements in the Euro and Chinese Yuan versus the U.S. dollar.
PaPer, BoXes & steel: In times o economic stress, nations de
their currencies or growth and debt reduction. But, all countries can
devalue at once, and competitive currency devaluations (currency wa
have arisen between both developed and developing nations. On the
ront, tensions have escalated rom attempts to label China a currenc
manipulator to trade duties on American SUVs and enormous tari
on Chinese solar panels. Currency and trade wars weigh on growth an
sometimes worse.
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tO reCaP
Te Euro Zone experiment, with its numerous structural aws, was
destined to encounter major diffi culties ater crisis and economic
slowdown. How the Euro Zone experiment is resolved has largeimplications or global growth. Te decisions Chinese leaders make
address myriad structural aws and change or maintain the status q
will determine that countrys economic uture and aect global grow
as well. A variety o unknowns ace global economies and markets
in coming years with wide ranging po tential eects. Central banker
acting as central planners or economies ace an unwinding o a ma
monetary experiment, which may harm growth. Existing currency w
and potential trade wars loom large over global economies.
In Part III o this work, we discuss our ideas or navigating these unc
times, protecting and growing wealth. Well see you there.
Jason B. Leach, CFA
Cravens Brothers Wealth Advisors is a branch o and Securities oered through WFG Investments, Inc. (WFG), member FINRA &
SIPC. Jason B. Leach is a Registered Representative o WFG. The above commentary is the opinion o Jason Leach and not nec-
essarily those o Will iams Financia l Group or its a liate, WFG Investments Inc. PAST PERFORMANCE IS NOT A GUARANTEE
OF FUTURE RESULTS. This market commentary is provided or inormatio nal and education al purposes only. It is not intended
as and should not be used to provide investment advice and does not address or account or individu al investor circumstances.
Investment decision s should always be made based on the clients specifc fnancial needs and objectives, goals, time horizon and
risk tolerance. All opinions and views constitute our judgments as o the date o writing and are subject to change at any time without
notice. Inormation was obtained rom third party sources, which we believe to be reliable but not guaranteed. An index is an unmanaged
weighted basket o securities generally representative o a certain market or asset class. An investment cannot be made directly in an index.
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Liei, Zheng. China Risks 4-Point Growth-Rate Cut in Case o Europe Worsening: Economy. Bloomberg. Web.
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Pages 16-19
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Pages 20-21
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Durden, Tyler. $707,568,901,000,000: How (And Why) Banks Increased Total Outstanding Derivatives By$107 Trillion In 6 Months. Zero Hedge. 26 Nov. 2011. Web.
Gave, Louis. Weeks When Decades Happen. Outside the Box. 14 Mar. 2012. Web.
Global Natural Disasters May Double in next Decade - WWF. Web log post. Ria Novosti. 13 Oct. 2011. We
Goldman, Russell. Recession Turns IT Workers Into Hackers. ABC News. 06 Mar. 2009. Web.
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Reynolds, Brian. The Upcoming Sub-Priming o Stocks And Commodities. WJB Capital Group, Inc. 22 Web.
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Texas Sets Record or Hottest Summer on Record in U.S. GlobalPost. 8 Sept. 2011. Web.
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Pages 22-23
Brusuelas, Joseph. Sluggish Economies Show Central Banks Work Unfnished.Bloomberg Brie (4 Apr. 2
Durden, Tyler. The Fed Is Losing The Ra ce To Debase Zero Hedge. 25 Mar. 2012. Web.
Hubauer, Gary Clyde, and Martin Vieiro. US Anti-Dumping Duties on Chinese Solar Cells: A Costly Step. 21 May 2012.
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Pages 4-5
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Pages 6-9
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Pages 10-11
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Pages 12-13
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Pages 14-15
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