10 Reasons to Be Cautious Right Now

The national budget must be balanced. The public debt must be reduced; the arrogance of the authorities must be moderated and controlled. Payments to foreign governments must be reduced if the nation doesn’t want to go bankrupt. People must again learn to work instead of living on public assistance.

~ Cicero, 55 B.C.

DANGER: Submerged Obstacles

It’s hard to believe the above quote is from 55 B.C.. It seems like it could just as easily apply to the last couple of years, or even today. In my 2010 What Ifs post I identified debt (sovereign, consumer, and corporate) as my biggest economic concern. Where do we stand just one month into this young year?

Well, debt has indeed become a common theme, and not just in the financial pages where you would expect to find it. It’s gradually turning up more in the mainstream media. Still, I think that most people are largely unaware of the fact that global debt levels are reaching alarming levels. After all, aren’t stock markets up 60%-70% worldwide? Aren’t we at the beginning of a standard cyclical recovery?

The economic statistics and the markets have definitely improved since we flirted with the abyss last March. What turned things around? In my humble opinion 3 main factors have contributed to recent improvements:

• Global government stimulus, particularly from China and the U.S., has boosted confidence and spending.
• Ridiculously depleted inventories needed restocking.
• Central banks worldwide have held interest rates at historically low levels so that banks could heal their balance sheets by borrowing money at very low rates and hopefully lending it to us at higher rates.

So, great. Depression averted. All systems go, right? Well, maybe not. The trouble with the “solutions” outlined above is that they have not ameliorated the problems that caused the crisis in the first place and may have even left us vulnerable to more trouble. Here are 10 reasons to be cautious with your finances right now:

1. Real Estate Bubbles: China, Canada, and other countries may have stimulated themselves right back into another bubble. Low interest rates and government stimulus have led people like Jim Chanos (a respected investor and short seller) and Jim Rogers (a notorious China bull) to voice concerns over the Chinese real estate market. In fact, the Chinese government has recently moved to cool bank lending, which was at least one factor that triggered the recent stock market correction.

Inflated prices in the Canadian housing market have also been in the news, with many warning Canadians to be careful about mortgage and consumer debt levels.

2. U.S. Option ARM Resets: Many U.S. homeowners still face problems as a lot of mortgages known as Option ARMs are due to reset at higher rates this year and next. This could trigger another wave of foreclosures and possibly another leg down in the U.S. housing market. There is also evidence that many of the mortgage modifications undertaken in the States are not working, and many people are re-defaulting.

3. Commercial Real Estate: I will refer you to An Insider’s View of the Real Estate Train Wreck, which is an article written by David Galland of Casey Research. I came across this via John Mauldin’s Outside the Box column. I think the title speaks for itself and it’s a good read, with lots of information I haven’t read elsewhere.

4. Sovereign Debt Outside the U.S.: Greece has been much in the news lately because of market fears that the country may default on its debt. John Mauldin’s most recent newsletter addresses that topic (see the section entitled Greeks Bearing Gifts) and much more. Portugal, Ireland, Italy, Spain and Dubai are also major subjects of concern in the area of sovereign debt. Since many of these countries are in the Euro Zone, their problems weigh on the stability of the European union and the Euro currency. Japan is another country to watch. John Mauldin often refers to that country as “a bug in search of a windshield”. If you’re thinking that doesn’t sound too positive, you’re right.

As I was writing this, a new edition of Outside the Box hit my inbox and it gives a thorough treatment of the sovereign debt issue by Mohamed El-Erian and Niels Jenson. It’s definitely worth your time.

5. U.S. Sovereign Debt: I’ve placed the U.S. sovereign debt issue on its own here because of the the size and influence of the American economy and currency on the global macroeconomic picture. I hate to mention Mr. Mauldin yet again, but he has written about this a lot as well, particularly as he has been reading a much-discussed book called This Time is Different: Eight Centuries of Financial Follyby Carmen Reinhart and Kenneth Rogoff. This book examines the history of financial crises and warns that debt-induced financial crises do not resolve themselves in the way that normal recessions do.

Those who contend that we are experiencing a normal recovery may be missing the fact that there is still a significant (and increasing) amount of debt in the global economic system at all levels, and that the inevitable deleveraging that must occur will not be pleasant. When it will happen is a question to which no one has the answer. If you want to attempt to wrap your head around the scope of the U.S. fiscal situation, you can take a look at the U.S. Debt Clock (12.36 trillion and counting!). It is truly dizzying. In case you’re interested, there’s a Canadian debt clock too.

6. Unemployment: Unemployment has leveled off in both Canada and the U.S., but we have yet to see any significant improvement. In fact unemployment insurance benefits are running out and it looks like some of these people may not be able to find new jobs before they do. I know unemployment is supposed to be a lagging indicator, but I believe that applies more to recessions caused by the normal business cycle and not to those triggered by debt-induced financial crises.

7. Problems in the Banking System: Back in September of 2009, Nobel Prize winning economist Joseph Stiglitz warned that banking problems are now bigger than before the Lehman Brothers collapse. More recently, S&P downgraded the credit ratings of U.K banks. This came less than a year after the ratings agency announced that Britain itself could lose its AAA credit rating. Further, recent earnings results from U.S. banks did not match the optimism built into their stock prices.

Just yesterday, Neil Barofsky (TARP’s special inspector general) and his team released a report that warned that the U.S. could be headed for another bubble and crash. That’s because the bank reforms that have been proposed do not address the problems presented by financial institutions that are too big to fail, the excessive compensation issues, or a host of other issues that contributed to the recent financial crisis.

8. Consumer Debt: With many banks tightening lending standards to more realistic levels, the well for already over-leveraged consumers is running a bit dry. Some consumers are getting some religion on debt as well and choosing to pay it down rather than adding to it. If only our governments would catch on to that idea! Still, many other consumers are still digging deeper holes. As Tara Perkins points out in The Globe and Mail, Consumer Debt Loads Are the New Concern.

9. Retirement Savings: How are debt-laden consumers going to save enough money to service their debts, pay them off, and save for a decent retirement? Many people have not saved enough for retirement, especially in light of the fact that many corporate pensions are struggling and in some cases, heading toward extinction altogether. Even in Australia, a country which has weathered the downturn relatively well, pensions are facing a shortfall. This is a scenario that is playing out worldwide and is not likely to improve in the near term.

10. Trust: Many consumers and investors have lost trust in financial and government authorities to do the right thing. They see wealthy bankers being paid large bonuses immediately after having received their tax dollars to avert the dissolution of said institutions. Like it or not, the optics do not sit well with main street workers who may have lost their jobs due to the crisis. Many of them are struggling to keep a roof over their heads, and buy food for their children. They are not concerned with maintaining a country club membership or a yacht slip at the local marina. Danielle Park recently addressed the issue of trust, among others, in a post that wrapped up key stories early in January.

Sorry for being such a wet blanket. I know that I have concentrated exclusively on negative issues in this post. I’m not saying that nothing good is happening and I’m certainly not advocating stocking up on canned goods and buying a gun. I just think we get enough of the positive side of the story everyday and I wanted to show that there is (unfortunately) another side to this whole thing. We need to be aware of these issues if we are to navigate our way through them. I perceive elevated risks in the market at the moment, and so I choose not to participate. Your choice may be entirely different.

What do you think? Is all of this going to blow over before another crisis hits, or are we wise to be cautious?