The Jumbo 747, since the early 1970's, became the icon of mass transport over long
distance. In a similar vein, and over a similar timeframe, the American economy, via
the consumer, became the mass driver of global economic growth.
At cruising height the Jumbo can, and has stalled, at which point it loses significant
altitude in a matter of seconds. If the flight crew panics and tries to start all 4
engines simultaneously the plane will crash as there is insufficient in-board battery
power to execute such an attempt. It is possible to start each engine in sequence,
however, thereby using the power from engine 1 to start engine 2 and so on.
Last week the Jumbo stalled mid-flight and most financial assets lost significant
altitude in a gut wrenching hurry. To determine what will happen from here we
must make a judgement call as to whether the flight crew, namely Messrs Bernanke,
Trichet, Lagarde, Merkel, Sarkozy, Cameron and Kan, react in the correct manner.
Mr Obama is not on the flight crew as he failed the application test before take-off
when he allowed political brinkmanship to usurp policy leadership.
Continuing our stalled Jumbo analogy let us assume:
Engine 1 is the European debt debacle
Engine 2 is the US fiscal fiasco
Engine 3 is Currency wars (using the Japanese Yen as a proxy) and,
Engine 4 is Global Investor Sentiment
Engine 1 - European Debt Debacle
Whilst, for a variety of reasons, Italy is not Greece, it was inevitable that speculators
would at some time test the EU’s resolve by switching their attention to Italy and
Spain’s debt markets. This started in earnest last week.
Italy has the 3rd largest bond market globally and the largest in Europe at Euro 1.9
trillion. The situation in Italy, in conjunction with that in Spain, Greece, Portugal
and Ireland, is a present and tangible danger that cannot be "deferred" to a super
committee to present a solution at some later date. Many of Italy and Spain’s
leading banks have exposure to their own sovereign debt well in excess of their tier 1
The European Financial Stability Facility has been proven to be a sham even in its
extended form as Italy and Spain are guarantors for 30% of the facility's backing. It
is not a viable solution to have the creditor and debtor being one and the same.
Desperate times require clear policy and concrete action - the issuance of long dated
EU bonds, backed by the collective might of EU member countries will place a peg
in the ground to enable member countries to present realistic and plausible solutions
to their individual economic trauma.
Has Italy's announcement on Friday to bring forward a balanced budget to 2013
done enough to scare the bond vigilantes into short covering or will the
downgrading of Americas debt give them renewed vim and vigour? Either way it
does not fix the underlying problem and at best just kicks the can a little further
down the road. A line in the sand needs to be drawn soon with a clear and
comprehensive response to Europe’s debt issues that markets find credible.
Engine 2 - US Fiscal Fiasco
It is not the level of US debt that is the concern - it is the lack of attention to the
current budget deficit (running at >10% of GDP) which has raised the ire of the
international investor and rating agencies alike.
The US administration needs to be as bold as their European counterparts need to
be in addressing, in America’s case, the level of taxes and the degree of entitlements.
The former rate is too low and too narrow and the latter is unaffordable. Change
that seems impossible today will become necessary tomorrow as financial markets
drive politicians in the US to make the hard decisions.
The rating downgrade of America’s AAA status will likely only have a short term
impact. There simply is no other market alternative with the depth of liquidity of US
Treasuries. One would expect that it will be short term in that it may just be the
catalyst for US politicians to come up with something sensible by the 23rd of
November (the self-imposed cut-off date for agreeing further cuts) that addresses
the long term issues and is sufficient to restore the AAA rating.
But November 23rd is a long way away and financial markets are impatient. A
positive shift in investor sentiment will be needed before then. We do expect a pick
up in the US economy in the second half, and, whilst helpful over the medium term,
it is not likely to send short sellers scrambling for cover in the near term.
There are some quick fixes that Bernanke and co. could wheel out (again) but these
treat symptoms not underlying causes. Nevertheless it would not be surprising to
see QE3 or banning short selling enacted again and no doubt these would be a fillip
for investor sentiment and buy more time.
Engine 3 - Currency wars (using the Japanese Yen as a proxy)
The competitive devaluation of the US dollar has now reached a choke point as
evidenced by the currency interventions of both the Bank of Japan and the Swiss
National Bank on the same day late last week.
If the dreadful impact of Japan's tsunami was not enough, the move of the Yen close
to a post WWII high is now choking off what little life there is left in Japan's
manufacturing sector. Whilst Japan has long faded as an economic super power, it is
the chronic government debt overhang, now worsened further by the tsunami
reconstruction costs, which is the threat. There are insufficient Japanese private
savings to buy yet more Japanese government bonds. The most sustainable way
forward for Japan is to enable the economy to export its way out of a debt deflation
spiral. Let's hope Messrs Bernanke and Obama are listening.
Engine 4 - Global Investor Sentiment
We are firm believers that it is the market that makes the news not the news that
makes the market. That Italy and Spain have debt problems is not new news, they
have simply come into the cross hairs of speculators now as information released
made it apparent that the US economy is at stall speed. The pessimism that this has
in turn engendered has been sufficient for the bond vigilantes to attack the next
weakest link in the global financial chain – Italian and Spanish bonds.
Behavioural psychology is a key element in financial markets. When markets lurch
towards risk aversion, speculators immediately go after what they see as most
vulnerable. We saw it in the GFC with over geared business models in the Property
and Infrastructure sectors. Speculators never dared attack these unsustainable
funding models during the boom times but they were relentless during the GFC.
The point is that market psychology is the critical element to market direction and it
can change quickly. The US debt ceiling resolution, (and why Obama is not on the
flight), is a massive missed opportunity to shift market psychology. Hence it is likely
we will have to look elsewhere for a fix to the current aversion to risk assets.
Conclusions (and what it means for your portfolio)
The good news is that a Jumbo can fly on one engine, albeit with a great deal of
Engine 4 needs to fire, even if only through temporary measures, to regain some
positive momentum in global financial markets. But it will stall again unless engines
1, 2 and 3 are started.
Speculators are pushing politicians into a corner. The window for short term fixes
to lift investor sentiment is becoming more and more narrow. With each new
episode of global risk aversion, credit default swap rates on Greek debt reach new
highs. It is time for the EU and US Governments to make the hard decisions that
address the long term structural issues that have periodically plagued markets since
In the crash of 1907, John Pierpont Morgan famously summoned the cream of New
York’s financial community to his house, locked them in all night and, raking over
bank and trust company balance sheets, drew the line in the sand which determined
who would survive and who would not. This is the sort of leadership that is required
now. As it was in 1907, confidence will improve once a credible line in the sand has
been drawn and the losses that the financial system needs to absorb have been
We think there is good buying now in selective Australian shares that are offering
excellent fundamental value on a long term basis. Cautious buying today may not
provide instant rewards but acquiring quality assets on cheap fundamentals makes
money in the end.
Australian shares remain cheap on a variety of measures which is positive for the
medium term but valuations alone will not be supportive in the short term in the
absence of clear cut policy responses. Australia’s ability to respond to further risk
aversion is better than most of the developed world. We are in a position to cut
interest rates significantly should the need arise. Our banks rely considerably less on
wholesale funding than in the GFC, the budget surplus could be deferred and bank
deposits could again be guaranteed. All of these measures are defensive in nature
and in our view limit the downside.
Addressing the structural issues that have given rise to the Jumbo’s engines stalling
however would likely see a powerful rally and the base line set for the next bull
market. Even some of the short term solutions we have discussed would in all
likelihood see markets spike upwards but at some point in the future the US and EU
will need to tackle their long term issues.
All we need now is a JP Morgan to step up and do what needs to be done.