Sunday, August 14, 2011

What Next?

Can the stock market do well if the real economy is likely to stagnate? That is the question.

The European debt crisis will ultimately lead to sovereign defaults that may leave no country unscathed. The US will probably use inflation as its default method of choice. So might Europe. But, Europe will witness a rolling pattern of workouts, country by country. The Euro itself should survive. The survival of the Euro, to me, was never in question. After all, if California defaults which is very likely, such a default would not threaten the US dollar.

There will be sovereign defaults within the US among cities and states.

Eventually, all the bad sovereign debt will be written off. It is just a matter of time and place.

What will equity markets do during that time? Some debt default is already priced-in; priced-in both in the debt market itself and presumably in equity markets as well.

The Asian crisis of 1997, which was largely a (private) debt crisis was overcome within three to five years. But, then Asia had no one to bail them out (and hence to prolong the process). They were lucky.

Unfortunately, Western countries are obsessed with the idea that bailouts actually work. Most Westerners think, incorrectly, that the bailouts in the Fall of 2008 saved the US economy. There is no reason to believe this, but most people do believe it. As a result, bailouts have become the policy of choice, both in the US and in Europe.

So long as bailouts are seen as the way out of the Western nations' debt problems, economic growth will be elusive. Equity markets could still improve in that environment, but probably won't run away on the upside.