“I believe that banking institutions are more
dangerous to our liberties than standing
armies. If the American people ever allow
private banks to control the issue of their
currency, first by inflation and then by
deflation, the banks and the corporations
that will grow up around them will deprive
the people of all property until their
children wake up homeless on the continent
their fathers conquered.”
Thomas Jefferson – 1802
The current protestors on Wall Street may not have Jefferson’s exhortations in mind, nor may they amount to anything much, but it has raised an eyebrow……
The structural issues that caused us to write to you on August 8th have not gone away. Indeed risk remains elevated both to the upside and the downside as witnessed by the extraordinary volatility that we are experiencing in financial markets at present.
The two structural issues the world faces, namely; Europe’s sovereign debt and America’s budget deficit, until resolved, will likely continue to see markets as macro driven with a reasonably high degree of correlation between stocks both when the market rises and when it declines.
Somewhat perversely, a solution to these structural issues is more likely to occur during periods of market weakness. Strong or even stable markets are unhelpful as politicians feel they can defer the hard decisions and policy inaction will likely rule the day until speculators have cause to short the market anew.
It is well recognised that Greece’s debt position is untenable. Default or compromise with creditors is coming. This is nothing new. In fact it has been going on for at least 2,400 years.
In the fourth century BC, the Temple of Delos in Greece learned that several City States to whom they had lent money were reneging on their debt causing the first credit default in recorded history.
The Temple itself went into decline but Greece went on to enjoy a golden era that included Plato, Aristophanes and Aristotle amongst others.
Perhaps it is instructive that all of the aforementioned made their fame in the city state of Athens which steadfastly refused to debase their currency whilst almost everyone else was shaving metal from their coins. There is some irony in the fact that the Athenian Drachma retained its reputation as a reserve currency and a reliable store of value well into the Roman period.
The modern parallel to shaving coins is devaluing one’s currency or permitting inflation to deflate the real value of ones debts.
This is however not an option for Greece. That the Greeks will default or compromise with their creditors is almost a certain thing. Credit Default Swap (CDS) spreads for Greek debt (the cost of insuring a Greek bond from default) reached a new peak in September and the probability of a default, implied by CDS pricing, is well above 90%. Unlike the UK as an example, Greece is currency constrained and hence devaluation, except at the margin, cannot provide the assistance Greece needs to get back on its feet again.
For investors in Greek debt, (largely European banks) it is quantifying the extent of losses that is important. Once a loss is known or quantified, investors also know what they have left. Fear of the unknown is replaced by a known quantum of loss.
It is then that the healing process can begin. We have used many times the example of the crash of 1907 to illustrate this point. After the collapse of the Knickerbocker Trust company and amidst an ensuing run on the banks in New York, John Pierpont Morgan (JP Morgan) held an all night session at his library with the financial elite of the City and decided there and then which of the banks and trust companies would survive and which ones would be left to compromise with their creditors. By dawn, everyone knew what their losses were and the run on the banks was over.
Whilst we remain of the view that fear of a Greek default or compromise will be worse than the actual event, this is predicated on an orderly default. The Europeans need to recognise this and prepare for it. There are ways to solving Europe’s debt problems and as markets continue to corner politicians and bring increasing pressure on central banks and agencies to act, we are starting to hear some talk about solutions rather than papering over the cracks. A US style TARP (Troubled Asset Relief Program) like facility (where sovereign bonds could be used as collateral) or issuing Eurobonds as a substitute for sovereign bonds have both been canvassed in September.
These sorts of strategies have by and large worked for the American banking sector. They did not help the economy or the man in the street. They bought the banking system time, ensured adequate liquidity and enabled the banks to make huge profits in the meantime which in turn bolstered bank balance sheets.
The solutions are there but nothing in Europe is easy. Consider the following:
Pythagoream Theorum: 24 words
Lord’s Prayer: 66 words
Archimedes’ Principle: 67 words
Ten Commandments: 179 words
Gettysburg address: 286 words
US Declaration of Independence: 1,300 words
US Constitution with all 27 Amendments: 7,818 words
EU regulations on the sale of cabbage: 26,911 words
The structural problem facing America is its budget deficit, not debt. Compared to Europe’s problem, the US should, on paper be easy to fix.
The problem is the complete lack of dialogue between the Democrats and Republicans. It is disappointing to see politicians more interested in promoting ideology than addressing America’s national interest. November 23rd is when the Super Committee, from both sides of the house, is required to report on long term deficit reduction targets and failure to agree will result in automatic cuts to expenditures with healthcare and defence amongst the largest cuts. This gives us some hope of a compromise as cuts to defence will alarm Republicans whilst healthcare is an area of great sensitivity for Democrats.
For Australia, the story remains largely unchanged. Household thrift is being driven by the desire to deleverage against a backdrop of a dysfunctional government and uncertainty surrounding global growth. Australia’s starting point though is well ahead of most other developed nations. Our government debts remain comparatively low, interest rates are relatively high, with scope to be reduced and Australia is still long what the world wants; be it energy, proteins or metal ores.
Recent jitters in commodities, reflecting fear of a renewed slump in global demand coupled with concern about a slowdown in China’s growth rate, have put significant pressure on resource shares.
Whilst we remain believers in the long term prospects for the sector, speed bumps along the way can be quite savage. Copper for example, could fall to $2.00 per pound and still be above its long term bull market trend. Key to the short term outlook for resources is China’s inflation trend with the next data point due mid-October.
An old Japanese proverb states that the reverse side of a coin also has a reverse side. In the midst of the prevailing gloom pervading both hard and soft commodities, the reverse side of the coin is that input price declines will lead to margin improvement for industry and/or relief in the form of lower prices to households. Perhaps most importantly, the pressure on inflation, felt most keenly in the developing world, is likely to abate. This is bullish for future growth.
The market is cheap at present with forecast PE ratios for the Australian market forecast clustered around 10x earnings for 2012. We believe that there are still further downgrades to occur in the industrial sector but even allowing for this, shares are fundamentally cheap.
However, until the two structural issues are resolved, markets are likely to remain range bound and volatile, reacting savagely to new information as it is released.
If a Greek default occurs in an orderly fashion and European banks are able to withstand marking to market their holdings of Greek sovereign debts, shares are likely to rise substantially. If a Greek default is disorderly and fears of bank solvency and contagion re-emerge, there is scope for significant further falls in risk assets globally and a western world recession is likely to follow.
There are many historical examples of default and compromise at the sovereign level and our reading suggests that most of the pain is suffered going into the default and recoveries are surprisingly robust and quick.
The Economist publishes every week a list of financial metrics for a range of nations and from a quick scan of the global GDP growth data, it is quite clear that aggregate global growth remains robust, at least so far, despite the growth relapse currently being experienced in much of Europe, the US and UK.
In the economic cycles witnessed up until the recession induced by the GFC, a downturn in demand in the major Western world economies caused magnified pain in the world’s developing nations. The developing world’s economies relied primarily on exports to OECD nations for their prosperity and when America sneezed, the rest of the world caught a cold. Yet in the GFC it was clear that a different dynamic was at work. The chart below shows that the US and European recession that followed the GFC was cushioned by growth in the developing world. The usual transmission of weak growth in the developed world to amplified pain in the developing world did not occur.
It may be difficult for us in the developed western world to acknowledge that we are no longer the engine of global growth. It may be anathema to us to think that the world can continue to grow while we are mired in a mess of our own making with too much debt, too little growth to meaningfully cut into deficits and a consumption hangover from years of over indulgence. Yet for all our profligate ways, someone was supplying and profiting from our excesses and those economies that did so generally have high savings rates, trade surpluses, ambitious middle classes and considerable pent up demand.
Our somewhat myopic view of our own importance to the health of the global economy may well be about to be tested and we may very well be surprised by the outcome.