Will Sovereign Debt Overcome the World’s Economies?
Lance Spicer, Editor - Trident Confidential, 9 Nov 2011, 12:37 PM
What has happened in Greece?
For the last decade the Greek Government has borrowed too much money and spent all of it on stuff that doesn’t make money or create tax revenue. The other problem the Greeks had is they did not collect enough tax revenue. Greeks just don’t pay tax. Of 11 million people just 5000 declared they had earned more than $100K. That is just one example of tax- avoidance in that country.
Part of the solution to European debt and US debt for that matter will be to sell assets and pay down debt. Greece doesn’t have much of any value and their debt is way above what they could raise by selling stuff, so the write-down was probably always on the cards. Italy is not like that at all. They could pay down their debt to almost zero if they wanted to by selling assets. However, they don’t like doing this and would rather “kick the can down the road”.
Now you may have heard of the expression “kick the can down the road” in the media and you may be wondering what exactly do they mean? Well, it means delay the problem and move it to sometime in the future. Now, you may think this might make the problem worse but it actually is a solution, believe it or not.
The two solutions to debt
The first is what we all do, which is to pay it off. We pay it off, corporations pay it off (sometimes by converting debt to equity by issuing more shares, as we saw in the GFC) but governments rarely do, unless they sell something. This brings me to the second way to reduce debt and that is by “kicking that can down the road”. By delaying facing up to the debt immediately you allow the forces of inflation and growth to erode the value of existing debt. An analogy being that a $200,000 mortgage 30 years ago (1981) was a lot of money and would have bought you a home in Sydney, but now a mortgage of that size is small and would buy almost nothing within 50kms of Sydney. See what I mean? Time erodes the value of money – and it erodes the value of debt, as long as you don’t increase it with ever growing amounts of new debt. Time and inflation will erode debt at around 3%pa or whatever the inflation rate is. Moderate inflation is good as it works for all of us in this way. Now, if a government prints more money it also erodes the value of money in that way too. If a government wanted to “erode” 10% of all the debt it owes it would print 10% more money – this is simplistic, but that’s how it works. Now, if a central bank increases it’s inflation target to 4% from 3%, it will print money and lower interest rates to achieve that end. “Kicking the can down the road” will achieve this end as debt value erodes through inflation and GDP growth that appears naturally through population growth, standards of living and through government stimulus or economic manipulation.
Now to our current problem
Many countries have endured governments who for the most part have been more interested in getting re-elected and keeping their jobs than they have been interested in fiscal responsibility. The governments of Greece and to a lesser extent Portugal, Spain and of course, Italy, have been somewhat “naughty” and are now in a bind where they have to come clean and admit to fiscal stupidity, where they have spent more than they earned and the debt problem isn’t being eroded, but being added to by poor taxation systems and overspending by politicians trying to be popular rather than sensible. It’s crunch time for them. The austerity measures being imposed upon them is all about achieving balanced budgets and letting time erode their debt through inflation and GDP growth. If you balance your budget, then debt is just maintained and the government bonds maturing are simply replaced by new ones for the same value, and hopefully at lower and lower rates.
This has worked superbly for the US, as it’s bond yields are at record lows, but it is currently a big problem for Italy, as it has to replace 4% bonds with 6% bonds and this makes it hard for them, as they don’t have the combination of GDP growth and inflation adding up to over 6%, the number at which debt erodes. In response, the ECB and the Eurozone bailout fund will aggressively buy Italian bonds to drive down their yield and thus make it cheaper for Italy to refinance their loans. If this is unsuccessful, it raises the prospect of Italy needing a bailout – not good, obviously. This is why there is pressure on Italian PM Silvio Berlusconi to put budget cuts in place, increase taxes and sell off assets to reduce this burden, but of course he wouldn’t be as popular anymore and he might lose his job – see the problem?
However, I think Italy will be coerced into doing the right thing (eventually), as the EU recognises the problem and has a solution, but Berlusconi wants to remain in power, so a compromise has to be met, and I suspect it will, as Berlusconi can’t afford the chaos that Greece has endured, as he would be kicked out anyway.
Italy is NOT the basket case Greece is.
Italy is a very wealthy nation, unlike Greece. The Italian central bank has stated that household debt in Italy is 78% of disposable income, whereas equivalent household debt in the US is 130% and in Germany 100%. So, this is very low by comparison and while Italy’s sovereign debt is 1.9 trillion Euros, Italian households have over 8.6 trillion Euros in net wealth, which converts to wealth per household of 350k Euros – a figure which means Italians are 10% richer than Australians on average. Money is not a problem in Italy at all – they are amongst the world’s richest people. The problem is the tax system and the government’s love of “collecting” assets. They need to simply increase tax collections – problem solved. If they do this and make a few budget cuts, the yield on Italian bonds will sink and the problem’s gone!
So what happened last night? First Papandreou – Now Berlusconi! Italian PM Resigns!
Italian PM Silvio Berlusconi last night lost his parliamentary majority in a minor vote. He realised it was time to go because it was his own party that brought him down as the opposition abstained from voting, so it doesn’t get much worse than that. He will step down after the EU austerity requirements have passed the parliament. This obviously excited the markets in a good way and the indices went from a loss to a gain.
The proof of whether this is the end of debt crisis will be whether Italian bond yields will begin to fall from their 6%+ rates. If these bond rates fall significantly, we’re “off to the races” so to speak.
This brings me to the next problem – the United Sates
Yes, they have massive debt if you look at the number, but not so bad if you look at the percentage to GDP and the source of the debt, particularly the net debt situation. The US government debt can be eroded effectively over the next 10 to 15 years if Bernanke keeps rates low, keeps printing money at a rate that will keep inflation under 3% or 4%. You see the US is replacing debt expiring with 4% yields with debt with 2% and 3% yields. Their payments are going down, as GDP growth and inflation rise. The problem however is this….
They are still increasing their borrowing because they can’t balance their budget. They need to get to a balanced budget fairly soon (next couple of years) otherwise they could find that it becomes even more difficult to reel it in. There are many proposals on how this can be done coming from both sides, the big one is to scrap “Obamacare”, the “socialized” medicine plan he has proposed. This would save billions. Others ways proposed are tax increases, stopping foreign wars and cutting defence spending, trimming “big” government etc. I’m sure they’ll get there or he will lose his job next year. The opposition Republicans have their own plans on how to get to a balanced budget and it’s very different to what Obama’s Democrats are offering. The US people will decide that issue. One thing is for certain, the next President will have to tackle this issue and solve the problem of budget deficits and it will be the primary focus of the next presidency. The next President will have to have very solid economic credentials, something Obama lacks. The problem is solvable, it just won’t be popular with many people – but it has to be done.
The last problem country I see – Japan, is in a rather unique situation.
It has the highest debt load of any country on earth and is getting worse – worse than Greece. However, Japan has almost no yield on bonds and cash – yet people keep investing there. Bond yields are between 0% and 1.7%. Why? Because they don’t have any inflation and often go into deflation where the value of goods goes down and the Yen increases in value as a result. The Japanese central bank just recently moved to deflate the value of the Yen, as it’s causing some issues with exports and competitiveness. However, their debt load as a percentage of GDP keeps rising and this is due to the GDP more than the debt. Actual GDP in Japan has peaked and is slowly falling, as the Japanese population not only ages but shrinks. The Japanese are slowly disappearing as their population shrinks. This means less people working, and less people paying tax, and therefore debt to GDP percentages rising.
The property market and stock market have been falling for years after a peak in the 1980’s and I expect that while the Japanese population keeps shrinking and the people keep aging it will continue to do so. I would not be an investor in Japanese stocks as a rule, although there are a few exceptions that have expanding operations in emerging markets, but generally the trend is down. The bottom line here is that at some stage, this debt will need to be paid back or be “restructured”. Could they default at some stage in the future – almost certainly yes, and the damage will almost be 100% confined to Japan as the Japanese banks and people are the major investors in their own debt. The global problem will come from a contraction of Japanese spending as a result of debt chaos and their trading partners will be hurt the most. Number one of the “hurt” list will be Australia, as they are our 3rd largest consumer of commodities. Be careful being exposed to non-essential commodities sold to Japan where consumers in Japan are the customers. Companies involved in electronics and motor vehicles will be less affected as most of their products are sold into other markets.
So What Is Next? The World Going Forward
We find ourselves in a different world than the one we lived in prior to 2007. We are less willing to spend without good cause and we like to reduce our debt rather than increase it. Most corporations have balance sheets that have so little debt on them, even though interest rates are at record low levels and borrowing is cheap. Banks although are not in as a good a condition as they were in 2007, having had to take massive write-downs on subprime debt and now dealing with write-downs on sovereign debt, and possibly more to come.
However, there will be no cataclysm, no end of the world scenarios playing out – this will not happen. It will not be allowed to happen.
Before anything like that would happen, we would see central banks cranking up printing presses and producing more money and more accompanying inflation to go with it. The result would be devaluation of currencies, higher inflation and interest rates that will remain stunningly low – for years. Citizens around the world will demand balanced budgets from their governments and that will come at a cost. Generally, the developed world will in some ways have lower standards of living, particularly in the areas of government services – a fact that we will have to accept. The developed world will cede some of our wealth to emerging countries who can produce faster and cheaper than we can – another fact we will have to accept. We have had it too good for too long.
The downside is cash and bond returns will remain miserable for years and inflation will increase, but the inflation will be controlled by central banks to erode debt (it’s already happening). Those holding government bonds will be the big losers as their assets are eroded in an effort to reduce debt. If you are invested in bonds for safety, then you also have to accept you’ll be going backwards slowly. We are already seeing capital requirements being lifted for banks as central banks understand that depreciating (in real terms) assets such as bonds are inadequate to keep banks stable and adequately funded at present levels.
How will stocks do?
Stocks will always do better in a higher inflation, low interest rate environment, than fixed interest and bond investments. Property will also do well in this environment, although we are still debt shy after the GFC, so leveraging up is not something we are comfortable with yet, so house prices will be contained somewhat.
When it comes to stocks, I suppose you have to firstly ask the question who is involved in fixed interest and bond markets? Yep, banks and insurance companies will struggle, and their dividend yields may be affected as time goes on. Companies with debt loads will be less risky, as their debt loads become eroded and low interest rates prevail. This is a big departure on how we perceived these businesses and fundamental analysis will obviously change as we see manageable debt being somewhat more stable in reviewing balance sheets. Companies with skinny operating margins may also struggle as inflationary pressure increases input costs and competition and squeezes the revenue.
The businesses to do well will have wide operating margins, industry leadership or close to it in a growing market -technology comes to mind, obviously. In addition, exposure to market staples such as commodities, energy, agriculture and health will be advantageous and of course, the big one, exposure to emerging markets.
The Bottom Line
Italy is still an issue, yes, but not because they don’t have any money – they are rolling in it - the problem is purely political.
I get the feeling that we are very near the end of this mess.
There is plenty of speculation about what will happen with the world’s debt crisis, but it will turn out like most crises turn out. There will be a range of solutions offered, some will work just well enough for most countries to muddle through and allow time to erode the “worst scenario outcomes” and this is the whole point of “kicking the can down the road”. Economic growth will continue to improve and emerging markets will keep us “afloat”. There will be a significant transfer of wealth from west to east in the process. The emerging markets will do better - we’ll do a little worse as time goes on. Western societies have to expect that less government spending (as a percentage) is 100% inevitable and the losers will be people living with government assistance and the lower socio-economic groups. Higher taxes on the wealthy just won’t work very well, as governments realise these people will simply place assets and wealth out of reach and the yield on wealth taxes is very low. Taxes may be increased in the area of luxury goods and on Goods and Services (GST) to pick up revenues from the greater consumers. However, it will be budget cuts that will occur and we simply have to accept this outcome.
Obviously, what companies will be hit by widespread budget cuts? Anything, I suppose, that depends on government funding for most of their revenue - Defence and health care immediately spring to mind, as well as non-essential infrastructure. I don’t think companies like ISRG would be impacted due to the fact that these machines increase efficiency and profitability in hospitals, nor do I think pharmaceutical companies will suffer overly and companies involved in generic drugs could do better. However, consumer discretionary purchases could suffer, particularly if their market demographic is the lower to middle class families who will have government benefits removed. I’m not talking about Australia necessarily here, but generally across the EU and North America as well. I suppose we have to get used to the idea that the days of benevolent “socialist” style governments may be coming to an end in some respects and we may be made more responsible for our own lives. Some may see this is a good thing, many may not.
To those of you that have sent me emails, web-links to bearish forecasts etc. be careful listening to people who push bearish views because they often have a hidden agenda - that will benefit them - not you. You are interested in the stock market to make money, listening to these people will not make you a cracker.
Through the week a subscriber sent me an email asking about my opinion on another very doom-laden opinion (from December 2010) from a fund manager who was saying the debt issue in the EU, and the rest of the world, would overcome the world’s economies and recession would result. Well, I did some digging and found what this fund manager was investing in for his investors - and guess what? He is investing in US mortgages (35%), high yield bonds (23%), bank debt (25%) and “distressed” investments (17%). What?? This man is professing that the end is nigh and is investing his investor’s money in the very investments that will disappear first if his predictions come true!
Now, you figure it out, I can’t. Watch those hidden agendas and hypocrisy. Telling the crowd one thing, and doing the exact opposite is a neat trick and very contrarian.
Why Should You listen to Me?
Well, after that major explanation of all the machinations going on in the world, I hope you think I am talking sense. But most importantly, it comes down to results. What I (and my subscribers) have done with the Trident Confidential Portfolio this year is this:
Total Portfolio Return for 2011 is +43.90%
The Australian Market (All Ordinaries) has fallen –9.43% year to date
The US Market (S&P 500) has fallen –2.78% year to date
The TC Portfolio has soared +43.90% year to date
Earnings season is winding up and we are heading into one of the strongest earnings quarters of the year, which is good news, but I’m afraid all the good economic news and better unemployment data from the US may be overwhelmed by any news coming from Europe.
The dropping of rates in the EU was good and should help, but it will all be down to what the Italians do right now. I think Greece will fade from our concerns now, as they have little choice but accept the austerity plans proposed by the EU, ECB and IMF. They will fade, just like Iceland faded from our minds as time went on. Italy is the last major problem we face – let’s hope they can get their act together and do something worthwhile.
The market will be possessed by Italy – but nothing much will come of it. I think the market will probably move higher as it realises the real risks of an Italy default are very overblown.
The markets are looking a lot better as we head towards the end of 2011. The similarities with 2010 are quite stunning and as I said earlier in the year, the market would lift towards the end of the year. I know some of you had doubts that what I was saying would occur, but I had no doubts at all that this would be the outcome. Our profits from here will continue to rise. The EU dramas are coming to an end and the US economy is getting stronger at an increasing rate. China hasn’t weakened to the extent that people expected. So, I expect that our good results will continue at a higher rate from here on.
We have added 2 great Australian stocks last week and 2 new stocks this week that have Price Appreciation Potential of up to 60+% in the next year. All 4 are in buying range right now, if you want to join us.
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