An August break from the fray which, for many of us, began in 2008 with the Lehmann collapse, allowed me valuable breathing space to reflect upon the turbulent events reshaping our world at a distance from the weekly deluge of analysis and reports. The result was Clarity.
Although I study analysis from many global sources much if it from unconventional thinkers or mavericks I’ve no special gift for insight myself. Instead throughout this latest crisis I’ve done my best to concisely interpret and report vastly conflicting analyses, giving you my best professional opinion. What follows is my conclusion as we enter the fourth year of the crisis on Sept 19th. It's a conclusion I’ve come to after a long travelled road and after the benefit of seeing quantitative easing in action for three years. It is one also shared by analysts and writers I rate.
You mightn’t like the conclusion but it has compelled me to issue this alert and suggest you take important action. You should talk to your advisor about what defensive steps you can take, otherwise you can talk to us. It may involve no new products, nothing arcane or complex just tactical switches within fund ranges;
Step 1 Defensive Switches to more protected funds and, later
Step 2 Opportunistic Switches back when perhaps all about are terrified to do so later in the cycle like in 2012 or 2013. But first the rationale;
The underlying disease is too much debt and not enough lifting power from growth in developed economies in the grip of a rebalancing of global economic growth towards the newly industrialised countries (NICs). That means there appears to be insufficient growth to lift out of the debt trap in many economies. The destination is smaller Government, a widening of the tax net to include all citizens other than those in genuine poverty and a huge thinning of the welfare state – aka austerity against a backdrop of debt restructuring relief in large parts of the global economy.
Think about it - isn’t that what creditors are telling sovereigns and politicians? Those already on the long road like Ireland and The Baltic economies are being rewarded with falling bond yields and those moribund from political ineptitude to grasp the nettle, are being punished. Take the lead economy, the USA which recently lost its AAA status from a leading rating agency;
Uncle Sam - the World’s Largest Debtor
The annual US deficit is $1.6 trillion and the total deficit of $14.3 trillion is to be allowed swell further to $16.4 trillion shortly, on a path to $20 trillion by 2020. But add in the off balance sheet liabilities for healthcare and pensions and include the fact that the US Government guarantees half its home mortgages (nearly six million of which are in arrears) and, the economy that produces the world’s reserve currency, faces liabilities many times higher. That's why the risk that the USA is facing bankruptcy is now at an extremely high level despite its huge strengths in R&D, it's ownership of the dollar, the prevailing view that it's Treasuries are the world’s safest and it's military strength.
All these can be overwhelmed if markets come to the conclusion that the US is tottering on the edge of insolvency. There’s a thousand billion in a trillion and the big global bet is that the US can be financed by taxes on future economic growth. If that view changes, the impact will be severe.
Ireland has off balance sheet liabilities, just for the public sector pension liabilities alone, of over €100bn. You scratch any developed economy and you’ll find the same thing while, underneath, most developed societies are ageing rapidly. The biggest single risk, the event that dwarfs all other risks is that the USA becomes insolvent somewhere along the road as creditors desert US treasuries. That, I feel may be a lot closer than convention thinks.
Quantitative Easing - a Cure or Infection?
The policy response to sharp global economic downturn has been two rounds of massive quantitative easing, cutting interest rates and printing money. But has it worked? Signs are that growth is reversing in key economies. Inevitably there will be a third round as central banks and Governments will be forced to follow the same path to avoid the growing threat again of a double dip in the global economy. But even with economic contraction, inflation will be the legacy, not just because of flooding money into economies thus debasing currencies but also because of predicted shortages of oil on world markets caused by vociferous demand growth from NICs.
Is this being overly pessimistic? It’s not really in my nature to be pessimistic. In Feb 2009 I reckoned that a rebound in stock markets was imminent and would be led by commodities. Markets, forever forward looking are an accurate bellwether of the next economic cycle and were always going to love low interest rates and quantitative easing. The result was a run up of over 100% from the lowest points. But the steam appears to be running out again. It’s not a new story. From 1934 to 1937 the lead market index, the Dow Jones added 106% but fell heavily and didn’t fully recover for seven years.
So far the policy response, when you boil it down, is to borrow more money and print more money, adding further debt, thus weakening confidence in currencies that aren’t heavily backed by commodities like the dollar and pushing up gold prices even more. The pattern has also engulfed the Euro and is likely to lead to another period of extreme turbulence shortly for the nascent currency as European political leaders freeze in the headlights, fearful of jumping forward into deeper fiscal union or backwards into Eurozone downsizing.
The big bet globally is that muddling through with summits and half- baked action distilled from political compromise will buy more time for economic growth to kick in and for balance sheets to be repaired from a borrowing splurge which, arguably lasted twenty years. I'm no longer optimistic that it's going to work because the evidence so far is unconvincing.
Temporary Feel Good
These days, markets are, perversely, rallying on bad news because it increases the expectation of a third round of quantitative easing. Europe is likely to follow the US this time with vast money printing and recent ECB rate hikes look like they will reverse. That may boost stock markets for a spell but inevitably gravity is likely to take hold except that, next time, policymakers will be out of silver bullets. If markets, eventually, read the tea leaves the same way the result will be a severe stock market rout testing the lows following the Lehmann collapse.
Thereafter it could take several years for a sustained rally because it would rely upon politicians in developed countries finally swallowing the bitter pill Ireland has been forced to ingest and tackling the underlying causes of poor competitiveness to stimulate economic growth. That would require root and branch restructuring of economies, reform of uncompetitive practices and a gastric band around the fat in spending and welfare.
So when could such a precipitous fall happen?
Another severe downturn in equity markets is probably months if not weeks away which will force further global quantitative easing and interest rates cuts in Europe. Markets are likely to rally on the expectation of a boost from new programmes but as soon as weaker than expected economic data filters through after the next round, the game will be up and markets will reset expecting much lower corporate earnings from higher unemployment and spending cuts, meanwhile commodities, ever sensitive to a downturn in demand, will fall, hitting mining and energy companies.
This time things could get nasty last because of recession fatigue and the realisation that there isn’t a way out except a prolonged period of grinding austerity and poorer lifestyles.
What can you do?
Throughout this crisis and previous down cycles for the past twenty years, I’ve continuously advised playing the long game and not trying to trade cycles. This lessens the risk of miscalling not just the time to get out, but far more importantly when to get back in. During the latest crisis only a tiny handful of our clients bailed out to cash and missed out on the rapid recovery from the lowest point in March 2009, seven months after Lehmann’s.
You can continue to play the long game for pension investmentwhere the money is locked up for the next ten years and longer. A prolonged bear market is an opportunity for the long pension investor to buy good value through regular monthly and yearly contributions during bear markets.
But for everyone else my conclusion is that this time it is different. There will be no quick recovery after a few quarters of economic contraction. It’s going to be slow and painful.
It is a big call.
Holdings in equity funds and commodity funds should now fully or partially switch to defensive funds within fund ranges. You should exercise extreme caution in bailing to cash. Cash in banks will be unsafe until the next crisis reveals who remains. Despite the headlines, remember government bonds are a proxy for underlying banking weakness. The ability next time for a weak sovereign to bail out a bank of systemic importance will be compromised. That German banks have taken a hammering in recent weeks is telling you all you need to know about the continuation of the banking crisis and the cross linkages beneath the surface.
Strong sovereign bond funds and especially those offering inflation protection are much safer than bank deposits and come the next crisis; there will be a flight to their guarantees. In the large fund ranges used by Irish investors there are a range of defensive funds. You should be moving to these now. If your normal advisors have been largely silent for the past three years get in touch with us through the website to talk about switch options and other tactics.
- Eddie Hobbs