Stock markets, unsurprisingly, have not reacted well to the recent decision by Moody’s to downgrade, by between 1 and 3 notches, the ratings of 15 major global banks or financial firms including Bank of America, Barclays, Citigroup, Credit Suisse, Goldman Sachs, HSBC, J.P. Morgan Chase, Morgan Stanley, Royal Bank of Scotland, Credit Agricole, BNP Paribas, Deutsche Bank, Royal Bank of Canada, Societe Generale and UBS.
Whilst the news headlines have been occupied by Greece, Ireland, Spain and the US fiscal cliff, it is interesting to investigate investment growth opportunities as uncorrelated from the Western world as possible.
We have battened down the hatches from a tactical asset allocation perspective over the past few weeks. In a crisis, we have learnt that if you need to panic, it is best to have panicked first! Those asset allocators who have issued statements over the last few weeks that they are sitting out this volatility are generally overweight global equity and do not have much choice. But are we nearing the end of the secular bear market in developed world equities?
For its neighbours, the main problem with a unified Germany is the giant shadow cast across Europe by its increased economic might and strategic importance, relatively diminishing the status and economic competitiveness of all other European countries.
From a German perspective, a unified Germany has enormous, unleashed, latent potential; the gap between what the rest of Europe sees and what Germany sees as its rightful place. In Imperial times, this was expressed in terms of territorial ambitions, nationalistic fervour and military strength. More recently, it led to World Wars I and II.
The historian, A. J. P. Taylor, explained this better than anyone to my generation, which quickly learned the diplomatic lessons. Other than local conflicts (notwithstanding that some of these have caused appalling loss of life), peace in Europe has mostly prevailed since 1945. Less clear is whether we have taken to heart the lessons of inter-war economic policies which did so much to exacerbate the casus belli inherent in the Versailles Treaty.
The post-1918 global landscape abounded with economic imbalances. The ‘war to end all wars’ concluded with a Soviet regime presiding over what had been the Russian Empire, Germany coming perilously close to a similar outcome following, the Austro-Hungarian and Ottoman Empires being sliced and diced into volatile nascent nations, while both France and Britain were, like Germany, heavily indebted to America. The US was the global provider of capital, whose main achievement until the latter part of the war had been accumulation of enormous quantities of global gold reserves, allowing the US Dollar to become the global reserve currency - something that has not changed for nearly a hundred years.
While more serious students should absorb Rogoff and Reinhart’s, This Time is Different : Eight Centuries of Financial Folly, a McKinsey study concludes there are only four ways of dealing with enormous build-ups of debt:
Inflation - The current US strategy, based on the monetarist shibboleth that increasing money supply ultimately creates inflation, has demonstrably failed universally in practice (other than possibly one questionable instance in Chile). Chief apologist Milton Friedman and his dangerous devotees, headed by Fed Chairman Ben Bernanke, have excused monetarist policy failures saying that all previous attempts failed because they did not do enough of it (!). In other words, when something is not working you need to do it more.
In fact, markets have previously imposed limits to the pursuit of monetarist solutions. America’s close to these limits now - every injection of stimulus has a smaller and shorter-lived effect than its predecessor. Some estimates now indicate that each $1.00 stimulatory input results in only 12 cents of additional output. The current monetarist ideologues are not yet ready to abandon their strategy (the only one they have) but will ultimately find themselves with no choice.
This is similar to President Hoover, in 1932, who even considered having to pass legislation preventing ‘money hoarding’. Hoover’s successor, Roosevelt, even tried adding the firepower of unlimited leverage by abandoning the gold standard. This appeared to work for half a decade but the term ‘double-dip’ was coined to describe the situation where recession/depression recurs because the law of diminishing returns inhibits the inability of central banks to maintain effective stimulatory output.
In the inter-war period, in Germany, the Weimar Republic famously experimented with pursuing currency expansion to the ultimate extreme so as to try to repay its war debts and the Versailles reparations. This led to hyperinflation where wheelbarrows full of Marks became worth less than the actual cost of printing them. Mr. Bernanke’s complacent claims to be able to easily create inflation by harnessing the twin technologies of printing presses and helicopters could well become his epitaph.
Austerity - This is the UK coalition’s self-prescribed foul-tasting medicine and the current German/ECB/EZ Core prescription for Greece and its fellow GIPSIs. There are huge scars on the German psyche following the Weimar period but, like the monetarist inflationary theories, the tail chasing the dog on an ever downward spiral of debt reduction and GDP destruction has rarely, if ever, proven successful in major debt episodes.
Inevitably, it too cannot be pursued to its logical conclusion; people prove unwilling or unable to put up with it to that point. The Financial Times reminded us last year that while hyper-inflation destroyed Germany’s last shreds of self-esteem, it was the austerity Germany’s creditors imposed through the mechanisms of the BIS that led to Hitler’s election.
Social tensions are everywhere - from Jasmine Riots to Arab Springs, from Tottenham Court Road to the EZ elections, which at least provide the glimmers of hope that some pressures can be released before austerity inevitably results in more self-appointed extreme dictatorships or military regimes.
War event/subsequent peace dividend - Ultimately WW II did lead to the resolution of the 1929-1949 debt crises. In that sense, austerity did lead to the solution of the problem. Not only is Angela Merkel reminiscent of Alaric, the Goth leader who overthrew both Athens and Rome by siege and starvation, but globally, tensions between nations are on the rise again. The Middle East remains tense, the Filipino and Chinese navies stand-off over a tiny Pacific outcrop of islands, Iran has raised stakes in the Straits of Hormuz over nuclear aspirations, Vladimir Putin’s rhetoric and actions tend to be inflammatory, roguish nations continue to develop nuclear programmes and the US has increased its military presence in Asia Pacific. Global nuclear conflagration ought to be totally unthinkable, but sadly it is not.
Default - Nations default when they cannot pay. This happened in the 1930s and has started happening again today. Default, whether outright (through debt repudiation) or de facto (currency/debt debasement) is rarely orderly although Greece has managed to live in default for over 50% of the last 2 centuries! It tends to happen when all other choices have been exhausted. Whatever form it takes, if the conditions which led to the situation that caused it are changed, then it can be a base from which to achieve sustainable growth, cure dysfunctional banking and liquidate malinvestment, restoring social order at the same time. This is what happened in South East Asia following the crises of 1997 and in Iceland after 2007.
What can we learn from our parents and grandparents? Answer given below in an economic formula:
Santayana’s comments [“those who cannot remember the past are condemned to repeat it”] + Mark Twain’s [“history doesn’t repeat, it rhymes”} + Einstein’s definition of madness [“doing the same thing over and over again and expecting different results”] + Hyman Minsky’s observations that trying to cure debt bubbles with more debt only ends in eventual catastrophe) = [I’ve said many times before that Liaquat Ali’s “Lords of Finance” should be compulsory in schools everywhere] If we do not learn the lessons from the 1930s parallels, there is a very good chance that the outcomes of this decade may not be something to look forward to.
So, are we in a Depression? I am now!
Three highly respected investment gurus were recently asked their opinions of what will happen to Emerging Markets in the near future. Christian Menegatti, MD and Head of Global Economic Research at Roubini Global Economics, says that, “China is one of the largest contributors to global growth, although subsidized by its government. We cannot predict if the Chinese slowdown will have a soft or hard landing, but the effects will be global.”
As things stand now, it might seem that there is no light at the end of the tunnel - in investment terms at any rate. American government debt has been downgraded, the euro zone is about to go into its second recession in five years, the US’s fragile recovery is in serious danger of stalling and China’s transition to a more balanced, consumption-led economy is more than challenging its double-digit growth history. Given this environment, why would anybody want to buy equities? After all, globally equities lost 40% in 2008, and whilst this has been recovered to a large degree, it has taken five years to do so! Japan has never even come close to revisiting the heady heights of the Nikkei in 1989. This option does not really seem like a great source of stable, inflation beating returns does it?
For those of us from a Judeo-Christian heritage, it is sometimes possible to believe that suffering is worthwhile; a way of paying for past sins. In this light, the age of austerity in which we supposedly live has a sort of redemptive quality. Grit our teeth, and we will come out the other side, purified and ready for robust economic recovery.
As many readers will know, MitonOptimal are our preferred fund house. Their common sense approach beats all others as far as we are concerned. For example, their strategic inflation forecasts are based on the long term Kondratieff inflation / deflation / disinflation cycles. The developed world has been in the disinflationary and deflationary cycle since 1980 and is about to change to a vastly different long inflationary period. Most Emerging Markets are earlier in this cycle with some Asian countries ahead of the process.
Anyone who had listened to what the Bank for International Settlements was saying since 2005 would have been well prepared for the shocks that began towards the end of 2007 and then blew up in 2008. They issued a new warning in their September 2011 report, The Real Effects of Debt. We should heed this warning. They conclude, “Our examination of debt and economic activity in industrial countries leads us to conclude that there is a clear linkage: high debt is bad for growth. When public debt is in a range of 85% of GDP, further increases in debt may begin to have a significant impact on growth (in 1st qtr 2010 USA’s debt: GDP ratio was 117%)… A clear implication of these results is that debt problems facing advanced economies are even worse than we thought. Given the benefits that governments have promised to their populations, ageing will sharply raise public debt to much higher levels in the next few decades. At the same time, ageing may reduce future growth and may raise interest rates, further undermining debt sustainability.
The Bank of International Settlements (BIS) analyses a country’s debt by three categories - corporate, government and household. The BIS did a report in September which showed that there were thirteen countries in the developed world whose debt was beyond the threshold in at least two of the aforementioned categories. Time was when markets could just worry about one or two countries. Unfortunately, with the world edging towards a financial precipice, those markets are now going to have to concentrate on many more nations than usual as the numbers are just too large to contemplate.