July 24, 2013 Update

DJIA:15,568 S&P 500:1,692 NASDAQ:3,579 Gold:$1,342 Oil:$107.17 EURO:$1.32 YEN:99.99

On Detroit Default: Inflation is Not the Answer

Detroit is the largest city in the US to file for chapter 9 bankruptcy. Its crime rate is five times the US national average and half its population is illiterate. Detroit is the single most dangerous city to live in. As of April 2013 unemployment hit 16%, a significant improvement from 27.8% in July ‘09. Those unemployed still outnumber the working class, a consistent trend since 2009.  The population has declined by 63% since 1950 and has fallen 26% from 2000. Detroit’s citizens are leaving in flocks to escape the municipal burden that weights on households, but who can blame them? Detroit has estimated their total debt to be roughly $20B, which breaks down to $25,000 per citizen. The likelihood of repayment is slim, especially since income tax revenues have fallen 30% since 2002 as a result of unemployment. The city has no cash, so it has been forced to cutback on municipal services like electrical repairs, park upkeep, public education and police forces. To add to Detroit’s misery, property values are practically worthless. There are 78,000 abandoned structures (half of which have become gang headquarters) and 66,000 unkept vacant lots. As the mayor said, the city is going through “the Olympics of restructuring”. Sovereign default has historically been a staple in the financial system since its genesis. Even global powers like China, Japan, and the US have defaulted on debt obligations. But why does it have to be this way? Why do sovereigns even have the option to default? Unlike corporations, countries have central banks and, therefore, have the option of inflating its way out of debt when governments become strapped for cash. Although inflation may be bad news for bond holders, it does not make investors’ search for return impossible within country’s financial markets. I think default has remained a staple in the system because of the fact that debt creates value. The reason money holds any worth is because of the value people perceive it to have. Money is owed to laborers. Laborers  owe the fruits of their labor to the government because they use its services. We co-exist in a world intertwined in a system of systematic indebtedness in which one person’s asset is another person’s liability. If the US were to inflate Detroit’s way out of debt, not only would peoples’ perception of a dollar weaken, but the owners of the city’s liabilities would have contorted balance sheets due to the rapid increase of city’s devalued cash. Inflation for the sake of repayment would completely distort the credit multiplier effect. Think about it, the reason many of us decide we need something is usually because of the value someone else perceives it to have. If the US were to inflate Detroit’s way out of debt, people would perceived the city as worth even less than it is now. Many historians hold Germany’s hyperinflation responsible for Hitler’s rise to power since a crash in the financial system resulted in political and civilian unrest. Although default is clearly not the optimal choice for the owners of Detroit’s liabilities, I believe it is a necessary way to refinance, restore peace, and recreate value.

Domestic News

• Market Update Futures trading up ahead of a heavy earnings line up and positive sentiment lingering from yesterday’s better-than-expected results. 
• Data on new-home sales will be released 10:00, and are expected to have risen in June to an annual rate of 483,000 from 476,000 in May. 
• Markit will release its data on flash manufacturing PMI at 9:00, is it expected to increase to 52.8 for July from June’s 52.2
• Mortgage applications have decreased over the past few months as mortgage rates have increased. Purchase applications fell 2% in the July 19 week, despite rates falling substantially.

International Updates

Asia

• Market Update Most Asian markets fell from downbeat manufacturing data in China.

Europe

• Market Update Stocks rose with the upbeat and better-than-expected PMIs in the eurozone.

Corporate

• Caterpillar (CAT) Q2 EPS down to $1.45 from $2.54, profit $960mm vs. $1.7B