Market Outlook: July 08, 2011

TACTICAL REMEDIES AND STRATEGIC PROBLEMS

The most important problem facing the global economy today is the increasing likelihood of a prolonged slowing in aggregate demand. Should this slowing occur, it will be driven by the deleveraging process in the developed economies and by anti-inflationary policies in the emerging countries.

First, let’s examine the issue of deleveraging. The debt build-up in the developed countries began a long time ago. With respect to the U.S., perhaps the best way to gain perspective is to track the rise in consumer and government debt as a percentage of GDP. Figure 1 shows this data from 1980 to the present day.

Figure 1: U.S. Consumer and Government Debt as a Percentage of GDP

Source: Federal Reserve, Epoch Investment Partners, Inc.

The most recent acceleration in our country’s debt build-up was precipitated by the global financial crisis of 2007/08. The demise of Lehman and AIG caused a collapse in private sector demand and widespread employee layoffs. In response, the government stepped in with a fiscal stimulus program – about $1.2 trillion since President Obama took office – and the Fed endorsed a very expansionary monetary policy, cutting interest rates to nearly zero and then, in two rounds of QE, buying $2.3 trillion of government- and mortgage-backed bonds. These tactical actions, while necessary at the time to stave off a calamity, failed to deal with the big strategic issue at hand: the developed world’s staggering over-indebtedness.

The best empirical evidence presented on the topic of excessive debt appears in the book This Time Is Different by Ken Rogoffand Carmen Reinhart. The takeaway of their analysis, which encompasses 800 years of financial data, is quite simple: excessive debt can be corrected only by a long period of deleveraging. Fiscal stimuli, which replace private debt with increased public borrowing, merely postpone the inevitable and necessary deleveraging process. Specifically, the “cash for clunkers” program, incentives for new home purchases, and temporary tax cut extensions and accelerated depreciation rules have provided the U.S. economy with a temporary boost, but have not offered any real solutions for decreasing our debt, which, as Figure 2 shows, has reached very high proportions at the household level alone.

Figure 2: U.S. Household Debt as Percentage of Disposable Income.

Source: Federal Reserve, Epoch Investment Partners, Inc.

And the situation doesn’t look much better across the pond. The plight of the PIIGS (Portugal, Ireland, Italy, Greece, and Spain) is now well-known and is placing many European countries on the verge of sovereign debt crises. Governments everywhere have been forcefully reminded that heavy public debt risks much more than just crowding out private investments. It can, and ultimately will in the case of Greece, bring on insolvency. The recent Greek deal is another example of a tactical solution to a structural problem. Restructuring for Greece is inevitable, which will slash the value of their debt by half. Although European banks will bear most of the cost, U.S. institutions are not immune. According to the Bank for International Settlements, the U.S. has less institutional exposure than Germany, but more than France. U.S. financial institutions have written most of the credit default swaps on Greek debt, and nearly half of U.S. money market fund investments are European bank paper credit instruments. According to Wolfgang Müchchau of the Financial Times, this exposure to the Greek economy is comparable to an investment in a toxic CDO. Müchchau explains,

“…if you own a Greek bond that matures by June 2014, you keep 30 per cent of the redemption as cash and roll over 70 per cent into a 30-year Greek government bond. The Greeks will have to pay an annual coupon, or interest rate, of between 5.5 per cent and 8 per cent…Of the money received; Greece will lend 30 per cent to a special purpose vehicle. The SPV then invests into AAA-rated government or agency bonds and issues a 30-year zero coupon bonds. The purpose of this action is to guarantee the principal of the 30-year Greek government bond that you just bought…The complexity of the scheme is because of the need to persuade the rating agencies not to attach a default rating to Greek bonds. The rollover agreement represents, from an economic point of view, nothing but a collateralized bond. It subordinates all other bondholders¹.”

Despite what Euro authorities would have us believe, “private sector participation” is a misnomer here. Rather, this rollover agreement is a private sector bail-out. For the Greek economy to stay afloat, it must be able to pay the interest on its debt, which means the interest rate needs to be below the growth rate of nominal GDP. Nominal GDP, however, will decline this year and probably next year as well which makes it inevitable that Greece will eventually go broke. Greece, then, is the “canary in the coal mine” with respect to deleveraging. There is a long list of countries that will have to deal with their debt issues, as outlined in Figure 3. Deleveraging will be a drag on these economies for years, and will probably cost the world 100 to 150 basis points of GDP growth.

Figure 3: General Government Net Debt to GDP (2011)

Source: International Monetary Fund, World Economic Outlook Database

As for the effect of Greece on the rest of the Euro zone, the fear of contagion is real. Irish and Portuguese debt spreads hit all-time highs in the past week, and Spain and Italy can’t be too far behind. The Spanish and Italian economies carry four times the debt load of Greece, Ireland, and Portugal combined. For perspective, if the entire periphery were to default, it would be the equivalent of the 1994 Mexican crisis, the 1998 Russian crisis and the 2002 Argentina crisis occurring five times over. In light of this fact, why has the ECB elected on three occasions to contract the monetary base? This monetary policy has sabotaged the fiscal austerity policy, leading to a dramatic conflict in strategy. In our view, the ECB is quite likely to do a 180-degree turn as Euroland’s outlook becomes more and more grim. The emerging markets are also in flux, but for very different reasons. Given that the Chinese peg their currency to the U.S. dollar, the Chinese effectively “import” our monetary policy, which is very inflationary in its intent. Since China will not allow its currency to float, it has turned to clumsier instruments in its battle against U.S.-derived inflation. Reserve requirements ratios have been lifted 12 times since 2010 and now stand at 21.5%; growth in M2 has decelerated sharply (see Figure 4); EMBI spreads have widened; and CDS spreads on the Bank of China have soared.

Figure 4: China Monthly Money Supply M2 YOY %

Source: The People's Bank of China, Bloomberg

As a result, China’s growth rate is slowing. Unit labor costs are increasing faster than prices, which has hurt margins. Labor costs are rising 15% per year according to Charles Dumas of Lombard Research. By contrast, unit labor costs in the U.S. are falling, with labor costs remaining flat. All of this suggestscontinued pressure on China’s growth, with demand falling in its end-markets and its costs rising relative to prices at home. From a global perspective, the big picture is remarkably consistent: austere policies are “in” at the fiscal level and most monetary policies are tighter than they were a year ago. Needless to say, this does not bode well for real growth expectations in 2012. From the investor’s standpoint, though, it is not all gloom and doom. Investors buy companies, not countries; and even though national economies are flailing, company balance sheets are in excellent shape, boasting lots of cash and little leverage. Earnings yields are nearly triple government bond yields, and large numbers of companies have cash dividend yields well above “safe” bond yields. Remember: these equity yields have growth rates attached to them, which makes them significantly more attractive than bond yields. The world is a troubled place at present and 2012 will likely prove no different. But there is reason for hope: global firms with growing dividends, growth footprints in the developing economies, and managements that have proven to be wise capital allocators sell at reasonable valuations. The road is bumpy, but opportunities exist.

¹"The Greek rollover pact is like a toxic CDO,” Wolfgang Münchau, Financial Times, July 4, 2011.