Many investors continue to overlook the profound ramifications of having the largest economy on the planet fall into a steep recession. EU 27, which has a GDP north of $16 trillion, is the largest export destination of some of the world's fastest growing economies. Bloomberg reported last week that Chinese exports rose at the slowest pace in almost two years in the month of October as the deepening debt crisis crimped demand. A sharp decline in the European economy means slower growth in emerging markets, which has implications for U.S. corporate earnings and bond prices as well. Remember how the fall of 2008 so very clearly illustrated the interconnectivity of the global economy. Can there really be any safe haven country when the GDP of the developed world is on the precipice of a sharp decline? The truth is that Europe, and quite possibly Japan and the U.S., face a recession in 2012 due to a full-blown bond market crisis.

 But the mechanics behind what is occurring is actually very simple to understand. And once you grasp the fundamental dynamics behind what causes a sovereign default, investors can reach a very clear conclusion as to what action they need to take. History is replete with examples that indicate once a nation reaches a debt to GDP ratio of between 90-100%, two pernicious conditions begin to appear. First, International bond investors start to become concerned that the tax base cannot support the amount of debt outstanding. This concern is precisely because economic growth rates screech to a halt, as most of the available capital is diverted from the private sector to the government. And secondly, it is at this point that interest rates begin to climb inexorably....

Two recent examples of this can be found in Greece and in Italy. Neither country is growing and their debt to GDP ratios have soared well above 100%, and their bond markets are now in full revolt. The sad fact is that their debt levels have become so intractable that both bond markets have now been placed on the life support of the European Central Bank. However, regardless of central bank intervention, interest rates eventually rise to a level in which most of the country's tax revenue must be used to service the interest payments on the debt. It is at this point where investors fears become a mathematical reality and the country finds paying down the principal of the debt an impossibility.

Sadly, at this juncture only two default options exist. The country can admit their insolvency and default on the debt outright-which is the smartest route to take. The other option-and the one that all fiat currencies take-is to monetize the debt. However, this default by means of inflation doesn't solve the problem, it only extends and exacerbates the default process.

It is very likely that an inflation-led default will be deployed first in Europe and then later in this decade in the U.S. Therefore, it makes sense to avail yourself of the best protection against the ravages of a crumbling currency. That is why gold and gold equities are a buy, especially when you are fortunate enough to get a pullback.

Michael Pento

President: Pento Portfolio Strategies
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M (732) 213-1295