‘How did You Go Bankrupt?’

‘Gradually ....then suddenly’

 

 

Global View

Working off the accumulated debt of the past two decades weighs on wealth, as assets are written down, and diverts a larger share of lower incomes to debt repayment, slowing economic growth for years to come. The reluctance of businesses and households to borrow, and bankers to lend, makes growth more volatile because rather than borrow to smooth the path of investment and consumption, when income declines, investment and consumption fall too.

 

American businesses and households are now net savers. If government cuts spending too quickly, and becomes a saver year after year, the US will be forced into a terrible recession unless it can promptly run a surplus with the rest of the world. The rest of the world is not likely to let this happen. The US should act now to cut dramatically its future spending while not cutting spending in the next two years while the economy needs support.

 

China faces the awkward task of switching from investment to consumption as the engine of growth. Even if well managed, this will be difficult. Almost half of Chinese economic activity is now investment. This means that when investment stops increasing year after year, the rate of growth of the Chinese economy could be cut in half. It is highly unlikely that consumption can grow quickly enough to fill this hole.

 

Europe

The privatisation programme in Greece has more than 20 deals which are supposed to have been completed by January, according to the latest EU-IMF agreement. With only E5bn of privatisation revenues in the bag so far, this year’s target of E390bn appears elusive.

 

Europe has a fragmented sovereign debt market. At the end of 2010, Italy had E1,500bn of bonds outstanding; Germany E1,400bn; France E1300bn and  the UK E1,100bn. By comparison, US government securities outstanding were E6,600bn and Japan E7,900bn. Investors can abandon much smaller markets more easily than they can US or Japanese bonds. In other words, a given size of investor outflow from one European country’s bonds will be far more disruptive than from bigger markets. Replacing all national sovereign bonds with common Eurobonds would create a market worth E5,500bn. It would be backed by governments that together owe less debt, run a lower combined deficit and have greater tax-raising capacity than the US and Japan. It would almost certainly lead to lower yields than the current euro zone average. German yields would be higher and their public is allergic to anything like a ‘transfer union’ .

 

 A potential solution would be for Germany and its most like minded partners – the Netherlands, Austria, Finland and Slovakia – to leave the euro zone. Also, exclude Greece and the remaining 11 countries can create a E3500bn bond market with macroeconomic figures only marginally worse than those for the euro zone as a whole.  They would be more powerful than Germany alone and once they realise this they should perhaps use it.

 

The size of the most recent ECB injection of E22bn and of the European Financial Stability Facility (E440bn) that is yet to be ratified, is tiny compared to the overall level of debt that needs refinancing.

 

According to The Economist, the countries with worse debt dynamics than Italy in descending order are Japan, Ireland, Britain, Greece, Portugal, Spain, United States, France and Belgium. Each of these countries should therefore suffer the same fate as Italy with lower credit ratings and higher bond yields and thus borrowing costs. Total debt as a percentage of GDP is 471% in Japan and 447% in the UK, compared to 71% in Russia.  

 

United States

The astonishing feature of the US federal fiscal, position is that revenues are forecast to be a mere 14.4% of GDP in 2011, far below their post war average of 18%. Individual income tax is forecast to be a mere 6.3% of GDP in 2011. In 1988, at the end of Ronald Reagan’s term, receipts were 18.2% of GDP. Tax revenue has to rise substantially if the deficit is to close.

 

Government Debt

Falling rich world public deficits lead to lower corporate profits, all else being equal. For example, Smithers & Co calculates that the fall in US retained profits as the government hacks at the deficit between now and 2016 could be up to 7% of output. Similar falls are needed in Europe and Japan. Perversely, Equity investors should be feeling nervous every time governments agree on a way to reduce its debts.

 

Stock Markets and Property

Financial crises occur when debt levels are excessive and asset prices fall. The severity of the recession that ensues can then be mitigated by large increases in government deficits and large cuts in interest rates. Today the conditions for the next financial crisis are already in place. Debt remains at pre-crisis levels and US equities and UK property are seriously overpriced. But the ability to reduce the impact of the next recession with large increases in government deficits and sharp falls in interest rates has vanished. In the US, private sector debt today is 2.6 times gross domestic product, and nearly twice the level reached after the 1929 crash, having fallen to only 31% by 1945. Much of the debt is secured against real assets and, when asset prices fall, lenders worry about being repaid. But borrowers are not off the hook. They still have to repay their debts.

 

The Cyclically Adjusted Price Earnings Ratio show the US stock market to be about 60% overpriced. This is a long way below the peaks of 1929 and 2000, but similar to the peaks of 1906, 1937 and 1968 – which were followed by falling markets and recessions. Official data from the Federal Reserve and the US Bureau of Economic Analysis show that US companies have near-record levels of debt, whether measured gross or net of cash, and whether compared with net worth or output.

The corporate profit cycle has probably shortened. This is due to the lack of both private sector investment and confidence in the sustainability of end demand. This has been a trend in Japan, where economic rebounds over the last twenty years have typically lasted two to three years. Discussions with both banks and companies continue to reveal that loan demand is not being fuelled by long term investment decisions. Instead it is being used to fund short term working capital as customers orders rebound. By its very nature, this type of credit demand is much more volatile. If orders slow, so will credit growth. Thus the result is a corporate profit cycle that is not only shorter than has historically been the norm but inherently more volatile.

 

The supply chain of the hardware technology industry is a classic example of the problem facing companies. The demand shock created by the Lehman crisis resulted in technology companies cutting inventories to the bone. When demand for hardware (computers, mobile phones etc.) rebounded sharply, inventories proved insufficient to meet demand. This forced manufacturers to ramp up production, pushing up the prices of key components due to their limited supply. This in turn squeezed manufacturer’s margins. To ensure against a similar problem, the industry has been aggressively building up inventories, in many cases at double the rate of sales. If as we expect, demand slows then the result will be a glut of supply.

 

 Companies are still making profits, not losses. Profit margins coming out of the Lehman recession, when companies took the opportunity to impose sharp cost cuts, always looked unsustainable. The world does seem to be out of kilter in a way that makes it difficult for companies to raise profits, or for investors to raise their returns from stocks.

 

Since 1900 there have previously been thirteen cyclical bull markets in secular bear markets. The average duration of these cyclical bull markets is 26 months and this one has lasted 26 months. The average gain was 85% and this one was 102%. The following bear market duration was at least 6 months, the average 19 months and the longest 41months. This new bear market has lasted 3 months. The average subsequent bear market fall was 39% and the worst 57%. The current bear market fall has been 18%.  

 

Half of all commercial property debt is due to mature within the next three years.

 

Emerging Markets

Output per person in emerging markets is still less than a fifth of the US. As Smithers & Co notes, the ratio for Japan was higher than that as far back as 1950, and its GDP. Based upon inflation, GDP growth, unemployment, credit growth, real interest rates and changes in current-account balances the most overheated emerging markets are Argentina, Brazil, Hong Kong  and India.  Many countries such as Brazil have failed to invest in infrastructure. Cities are becoming gridlocked and this will affect long term efficiency. Together with the currency information below, this suggests that investors should become more discriminating about emerging markets economies in which they choose to invest.

 

Currencies

Adjusted for GDP per person, the countries with the weakest currencies are India, United States and China. The strongest currencies are Brazil, Argentina, Sweden and Switzerland.

 

China

China should now learn a lesson from the US debt deal – it should end its dependency on the US Dollar. The risk remains that US debt will continue to grow to a point where its government is left with no option but to inflate the burden away. The Chinese government has admitted that its foreign exchange reserves have already exceeded its needs. It has tried various measures to slow down the growth of these reserves and protect the value of its existing reserves.. This has included demand stimulation, allowing the remnibi to appreciate gradually and creating sovereign wealth funds. It has also promoted reform of international monetary systems and the internationalisation of the remnibi. None of these has worked. With large capital flows and a current account surplus, China’s foreign exchange reserves have continued to rise.

 

These policies failed because they did not address the real cause of the rapid increase in foreign exchange stocks, namely state intervention aimed at controlling the pace of remnibi appreciation. The People’s Bank of China must stop buying US dollars and allow the remnibi exchange rate to be decided by market forces as soon as possible. 

 

China has reiterated its pledge to diversify its foreign exchange reserves, but also repeated comments about the difficulty of investing in precious metals and industrial commodities. Using official reserves to acquire such assets would push up their price, and so hurt the Chinese individuals and companies that are already buying large amounts of gold, oil and other commodities, it said.

 

Argentina

Before Argentina’s 2001 default on $100bn of sovereign debt, the idea had appeared unthinkable. As one international rescue package followed another , the debt burden only grew. At the same time, social protests increased as the country’s fixed exchange rate system forced deflation upon an increasingly uncompetitive economy.

 

The recovery has been impressive – the economy expanded 65% from 2002 until the world financial crisis broke in 2008; its 2011 growth forecast has just been lifted to 8.2%. But the government has still not been able to lift the stain of default from Argentina’s reputation.

 

The ‘model’ as President Christina Fernandez calls the country’s policy mix. Has worked for longer and far better than many thought possible. Because the country remains cut off from international capital markets , it fights to run twin trade and fiscal surpluses. Keeping the exchange rate competitive is central to this approach as it helps generate a balance of payments surplus while also boosting exporters. That option is not open to Greek policymakers as long as their currency remains in the euro zone.

 

Another critical feature was the rigid commitment to fiscal discipline from 2003 to 2007 by keeping an eagle eye on tax revenues.  But since 2007 that discipline has relaxed and inflation has risen as the government has turned to the printing press to meet some of its financial needs. Private estimates suggest that Argentina is heading for an inflation rate of 25% or more this year, the fifth straight year in double digits.

 

Argentina’s foreign debt to GDP ratio is an enviable 35%, but Claudio Loser, the most senior IMF official for Latin American at the time of the default, reckons it still owes as much as $16bn (4.3% of GDP) to holders of defaulted bonds when interest is included. That is despite two tough bond swaps that restructured 92.4% of the defaulted debt. Argentina also owes $7bn to western governments; and, though widely seen as willing to pay, it is generally perceived to be willing to do so on any terms but its own.

 

Gold

We have been long term buyers of the BlackRock Gold & General Fund which invests mainly in gold mining shares, rather than the gold price because of the gearing effect of buying shares. From trough to peak the BlackRock Gold & General Fund gained 1263.8% (15/10/2000 to 30/12/2010 – source www.blackrock.co.uk) whereas the price of gold gained 642.7% (02/04/2001 to 22/08/2011 – source – ww.kitco.com).

 

More recently, over 200 days gold is up 38% and gold mining shares are up only 3%. The last time gold exceeded the returns available from gold mining shares, it preceded a fall of 28% in gold and 68% in gold mining shares in the Autumn of 2008.

 

Summary

We are spending a lot of time analysing the implications of the debt crisis in the developed world but there are a number of simple conclusions that can be drawn. They being to avoid any form of developed market credit risk including government fixed interest bonds and other assets supported by and not yet reflecting the high levels of debt supporting them i.e. property and stock markets; and to invest in safe havens or areas that are not exposed to this credit risk.

 

The detailed analysis that we are carrying out is necessary to establish likely conclusions and the total and inflation adjusted return impact that this will have on all asset classes. The conclusions could be deflation, stagnation or inflation depending upon the actions of Central banks all around the world.

 

 

 

The views reflected herein are those of Mitchell Neale Investment Services and should not be regarded as a recommendation to invest in any one product or service; before investing you should always consider personal investment advice.

 

Mitchell Neale Investment Services does not accept any liability whatsoever for any direct or consequential loss arising from any use of this report or its contents. Investors should be aware that the value and income from investments can rise and fall and that past performance should not be considered as a guide to the future.

 

Mitchell Neale Investment Services

22nd August 2011