We, uh, needed to keep these highly expert people in their seats.
- AIG spokeswoman Christina Pretto to Matt Taibi of Rolling Stone.
Politicians must be hugely grateful that the electorate and the media can be so easily manipulated. Which figure, for example, is the bigger, and more worthy of investigation: the $165 million (now known, like all their other figures, to be a lie) given in bonuses to staff at AIG, or the $173 billion that has been given to the firm as a bailout by taxpayers? Both figures illustrate why governments shouldn't run financial companies. The witch-hunt is all very enjoyable as a spectator sport*, but it is grossly distracting from the weightier issues of the day. But then governments in deficit are financial companies, essentially, of the worst sort, and the supposed cure to the current economic malaise – government spending, and lots of it – may end up being worse than the disease.
Sovereign entities, goes the conventional thinking that led to the then worst US financial crisis in history in the early 1980s, don't default. The table below, courtesy of Bedlam Asset Management, would suggest otherwise:
But we are not yet in default territory as regards the larger government bond markets. Merely, perhaps, at the point where hysterically overbought government bonds represent particularly poor long term investments, as “return-free risk”, or as certificates of confiscation. Michael Pollaro takes up the debate in his recent analysis, "Obama says short US Treasuries", posted on the Mises website. Pretty soon, the figures start to become incalculably large. The US federal deficit this year will be, according to Goldman Sachs, a business that probably only exists now because of its close political affiliations, as high as $2.5 trillion. That is 5.5 times the 2007 federal deficit. Fourth quarter federal debt was $10,700 billion, which amounts to almost 7 times US gross savings. So why, asks Pollaro, are US Treasury yields so low? We have to thank the generosity of strangers, since foreigners and central banks now own more than half of publicly held federal debt.
Notwithstanding the Treasury purchases of foreigners, the Federal Reserve is in the process of expanding its balance sheet:
That balance sheet expansion is likely to continue. But imagine, asks Pollaro,
what the Federal Reserve's balance sheet – and inflation – will look like when the Federal Reserve has to step in and monetize the federal debt too. Now if that doesn't put an inflation premium into US Treasury rates, nothing will.
So much for the US government bond market. US Treasury (and for that matter, UK Gilt) purchases will still make sense if we are truly destined for a long, deflationary crisis. Not all commentators share that view. As strategist Russell Napier suggests, a combination of deposit insurance, a fiat monetary system, and the lessons of history mean that real deflation in the west is unlikely. With people like "Helicopter Ben‟ Bernanke at the controls of the printing presses, you have to ask yourself if it is really worth fighting a Fed that is determined to recreate inflation. And inflation, at heart – this is a purist economic observation – is not the rise in general prices, but the explosion in the money supply that precedes it. The US, the UK, Switzerland and Japan are all now pursuing quantitative easing, namely expansion of the money supply. The economic war may not have been won yet, but the intellectual war has been won without firing a shot.
Napier believes there are reasons for optimism, from a tactical perspective at least. He cites three markets that typically turn before an equity market recovery: TIPS (US Treasury inflation-protected securities, the equivalent of UK inflation-linked Gilts); commodities, most notably copper; and corporate bonds.
Of the above, possibly the most reliable indicator of a turn for the better in the fortunes of the stock market is the corporate bond market. Napier – who has published this research in the book Anatomy of the Bear: lessons from Wall Street's four great bottoms (CLSA Books, 2005) – points out that corporate bonds have a superb track record of anticipating recovery.
- US corporate bonds bottomed in June 1921. US equities bottomed in August 1921.
- US corporate bonds bottomed in May 1932. US equities bottomed in July 1932.
- US corporate bonds bottomed in February 1982. US equities bottomed in August 1982.
Bond market investors aren't stupid. There is good evidence that the bond market is altogether shrewder than the stock market. So if Napier is right (and we suspect he is), a) the corporate bond market will prove a good leading or at worst coincident indicator for a recovery in stocks; and b) the corporate bond market is now one of the most attractive asset classes in investments. There has been much chatter of late about a supposed bubble in corporate bonds. A peculiar bubble when the price of an asset is at its lowest levels, in relative terms (relative to government bonds, at least) for over 70 years.
You can see the correlation between corporate bonds and stocks in the following of Russell Napier's charts. Baa-rated bonds have been chosen because unlike AAA bonds, Baa issues are a fairer representation of the credit risk inherent in the corporate bond market. The first chart shows the 1974 experience:
The second shows the example of 1981-1982:
And the third, that of 1990-1991:
As an ironic aside, the Lehman bond index has now become a Barclays bond index. Who will sponsor it in future? One attendee at a Napier presentation recently suggested it would morph into a Her Majesty's Government bond index, and in turn to an IMF bond index.
In conclusion, the colossal money creation process and the complete absence of any kind of monetary brake (the gold standard, for example) in a fiat currency world, is likely to lead to a bear market for government debt in the near future. Inflation-linked bonds will mark the turn. As will the corporate bond market, which will anticipate any form of meaningful recovery in both the economy and the stock market by some months, certainly well ahead of any improvement in corporate earnings. Commodities, most obviously "Doctor Copper‟ (so-called because of its apparent ability to forecast economic and equity market changes in trend), should also be closely monitored.
From an investment perspective, we see obvious value in high quality corporate bonds, together with important hedging characteristics in the form of gold. It will inevitably be difficult to commit wholesale to the stock market given the likely duration and severity of the recession. But rather than debate whether stock markets have bottomed or not (we have had myriad false dawns already), it makes more sense to focus on high quality companies that will do a better job of delivering income by way of dividends and of weathering current storms, hence our ongoing focus on measures such as the Altman Z Score.
*Matt Taibi of Rolling Stone does a particularly fine job of dissecting the AIG debacle and its broader symbolism. Be advised of some rather colourful language. Amongst the best paragraphs:
In the final three months of last year, the company lost more than $27 million every hour. That's $465,000 a minute, a yearly income for a median American household every six seconds, roughly $7,750 a second. And all this happened at the end of eight straight years that America devoted to frantically chasing the shadow of a terrorist threat to no avail, eight years spent stopping every citizen at every airport to search every purse, bag, crotch and briefcase for juice boxes and explosive tubes of toothpaste. Yet in the end, our government had no mechanism for searching the balance sheets of companies that held life-or-death power over our society and was unable to spot holes in the national economy the size of Libya (whose entire GDP last year was smaller than AIG's 2008 losses).
