Here’s the news of the week – and how we see it here at McAlvany Wealth Management:

1. Feeling Deflated … GDP, That Is. Increasing public concern is being expressed over the slowing economy and US debt situation. We’ve discussed our view of the debt ceiling issue elsewhere, so will not belabor the point here. Instead, we’ll focus on the numbers this week.

Second quarter GDP announcements reinforced popular concerns with a 1.3% announced growth rate that fell short of the expected 1.8%. This shortfall was not taken well. In fact, since the beginning of the year, we’ve seen a series of either lowered or unmet expectations from various Wall Street firms – firms that were confident 2011 would be a banner year for the economy. They’ve had to revise their numbers lower as poor job and income growth have continued to paralyze the consumer. This week’s lower consumer confidence numbers reflect this, in part.

You should consider two relevant inputs before accepting the proffered GDP figures as gospel. First: the deflator. The deflator is a variable that accounts for inflation in the determination of GDP; to apply it, they subtract it from GDP. In theory, the lower the deflator, the higher the GDP growth figure – and vice versa. 1.8% is the current assumed inflation number, or the deflator. Your imagination doesn’t have to be too vivid to see that a 3% inflation rate – or, dare we suggest, a 6-10% rate – would cause real public concerns over GDP. It would signal a desperate decline in the economy, reflected in a negative number. Yes, GDP would be contracting in that event (or, should we say, this event, as our “hypothetical” numbers above are a more accurate representation of present conditions than government numbers). As you can see, this material inaccuracy is similar to negative real rates, where inflation is the elephant in the room. The Fed thus faces the dual dilemma of too much inflation and not enough growth. What will it do?

It gets better. Here is the second relevant issue: Under normal circumstances, the consumer would be busy keeping up with the Joneses, not just busy keeping up with the bills. At present, though, the consumer has moved in the other direction and begun deleveraging. His debt-to-income level has dropped from a peak of 130% to the current 117%. This trend will continue until we reach last decade’s levels of 90% debt-to-income. Unfortunately, this will entail an additional $3-4 trillion in deleveraging – in part from personal bankruptcies and in part from paying down debts. Paying down debts does not increase GDP. In short, the consumer won’t be shouldering the GDP burden anytime soon.

In the absence of the consumer as economic engine, the government has stepped in to prop up the economy and spend cash to keep things functioning at a high level. In truth, they don’t have the money for this, so we are adding considerably to our debt levels in an attempt to keep a real contraction from occurring. Deficit spending at nearly $1.5 trillion is roughly 10-11% of our total GDP figure, which is near $14 trillion. If the government doesn’t continue to dole out cash (that it doesn’t have), we will immediately revisit the 1930s and see a total collapse in aggregate demand. Very few people care to recognize this, but we are on life support. Take away deficit spending, and our GDP figure is deeply negative. The wrangling over the debt ceiling is, needless to say, not well-timed.

2. When Theater Threatens Reality. I’m not for raising the debt limit, but neither am I for selective self righteousness among the political elite. The time to take a principled stand was decades ago, when nothing was really at stake except the principle of the matter. Now we have to be concerned with an implosion in our system and structure of debt. The stand being taken is purely political. This really is Ponzi finance, where the money is running out and the fraud is on the cusp of being revealed.

What must happen? If the debt ceiling isn’t raised, prioritized payments must be the order of the day. August debt maturities total $500 billion, with $90 billion maturing August 4th and a $30 billion interest payment due on the 15th. This competes directly with the August payment of Social Security, which is $49.2 billion, of which $23 billion is payable on the 3rd. Medicare and Medicaid payments of $50 billion are due (miss these, and more than a few doctors will be less than inspired to practice medicine … early retirement, anyone?). Also due in August are unemployment benefits of $12.8 billion and federal employees’ salaries and benefits to the tune of $14.2 billion.

Wow, I’m glad I don’t have that kind of monthly overhead! You can see how politically charged this is. Someone will not be pleased to receive late payments, and many of those “someones” may take their gripes to the polls in 2012 (barring a mass distribution of soma in the interim). The GAO has already determined that the Treasury has the authority, according to a 1985 legal opinion, to prioritize payments … and we wonder if that will be in consultation with the White House.

Overseas rancor is growing, with the Chinese stating, “We understand politics, but your government’s continued recklessness is astonishing.” Pause and think about that. Creditor número uno doesn’t like what we are doing to destabilize the dollar and the US debt markets … allowing politics to trump financial stability … and yet we still expect that creditor to eagerly refinance our debt this month, this year, next year, and on into the future? Are we mad?

Fans of decoupling, we hope you’re not thinking that just because the US is up against hard times, you’ve at least positioned your assets with the rising star (China). Chinese PMI declined again, and is a mere three points above signaling an official economic contraction. China may be our creditor, but China is no one’s savior – perhaps not even their own. The world financial system is more frail than it’s ever been.

To sum things up: As inflation is recognized as a primary factor in real GDP growth or contraction, just as it is in real rates of return, and is ultimately appreciated as the driver of both bond yields and equity valuations, we will see a massive move out of assets that are deemed vulnerable to inflation and into the few assets considered an inflation hedge. There is growing vexation overseas with our fiscal and monetary policies. We are already witnessing inflation-aware reallocations in the overseas markets. The US will follow suit – but will it do so in 2012, or will the Ponzi scheme be perpetuated beyond that? Only time will tell.

Best Regards,

David Burgess
VP Investment Management

David McAlvany
President and CEO