Bill Gross is a bond guy. And in the bond world, the return of capital counts for a heck of a lot more than the return on capital. So, naturally, with debts being socialized from the private to the public sector, Gross has been asking himself and his investors first and foremost which countries will default. To wit, ever since the Dubai World crisis, almost all of his recent monthly newsletters have been about sovereign debt, rather than corporate debt.
Below are a few posts I wrote about his commentary – all of which are about government stimulus "exit strategies" and sovereign risk. Notice Gross’ newfound populist flair, which the titles reflect:
- Bill Gross opines on investing in a world of crony capitalism – Dec 2009
- Bill Gross and the deficit ring of fire – Jan 2010
- Can you get out of a debt crisis by piling on another layer of debt? – Mar 2010
- Gross: American-style capitalism has reached a dead end but buy T-bills anyway – Mar 2010
Only last month did Gross depart from the sovereign debt theme when writing about the ratings agencies. He still retained his populist meme though.
So what does that mean for investors? To my mind, it speaks to risk aversion. For bond investors, it certainly means that some developed economies like Greece will have sovereign debt that trades more like Emerging Market debt. Having emerging market characteristics necessarily means that in these countries some (internationally-oriented) corporates are going to have better ratings than the formerly risk-free sovereign.
But it also means that some of these countries will default. I certainly think this is true with Greece at a minimum (and one reason the Greeks should be pushing for a restructuring instead of only endless austerity and competitive currency devaluation). We have already seen comments from Gross that PIMCO won’t touch Greek sovereign debt for this very reason. But he again asks rhetorically whether it is "possible to get out of debt crisis by increasing debt." His answer: yes.
Yes – was the answer, but it was a qualified yes. Given that initial conditions were favorable – relative low debt as a % of GDP, with the ability to produce low/negative short-term policy rates and constructively direct fiscal deficit spending towards growth positive investments – a country could escape a debt deflation by creating more debt. But those countries are few – the U.S. among perhaps a handful that have that privilege, and investors, including PIMCO, have strong doubts about U.S. fiscal deficits leading to strong future growth rates.
My answer is no, but a qualified no.
In Europe, the eurozone has operational constraints given the single currency that limit how much debt governments can take on. Moreover, you have countries like Greece, which I have already mentioned has a tough road ahead. Their debt is incredibly high, as are the burdens in Italy and Belgium. With everyone in the eurozone about to embark on fiscal austerity, there’s no way the growth that allows one to ‘grow’ out of debt problems is coming. More likely you get depression and a worsening debt picture.
Granted, sovereign debtor nations are now saying all the right things and in some cases enacting legislation that promises to halt growing debt burdens. Not only Greece and the southern European peripherals, but France, the U.K., Japan, and even the U.S. are sounding alarms that might eventually move them towards less imbalanced budgets and lower deficits as a percentage of GDP. Still, credit and equity market vigilantes are wondering if in many cases sovereigns haven’t already gone too far and that the only way out might be via default or the more politely used phrase of “restructuring.” At the now restrictive yields of LIBOR+ 300-350 basis points being imposed by the EU and the IMF alike, there is no reasonable scenario which would allow Greece to “grow” its way out of its sixteen tons. Fiscal tightening, while conservative in intent, leads to lower and lower growth in the short run. Tougher sovereign budgets produce government worker layoffs, pay cuts, reduced pension benefits and a drag on consumption and the ability of the private sector to accept an attempted hand-off from fiscal authorities. Recession becomes the fait accompli, and the deficit/GDP ratio moves ever higher because of skyrocketing risk premiums and a plunging GDP denominator. In many cases therefore, it may not be possible for a country to escape a debt crisis by reducing deficits!
But Gross seems to suggest that the Germans could ostensibly grow their way out when he writes "constructively direct fiscal deficit spending towards growth positive investments." I am not so sure given the anaemic growth in Germany for the past decade. So, my answer is a firm no for Europe.
In contrast, the US could theoretically run up debts for quite a while because it is a sovereign issuing debt in its own currency. The promise to repay US Dollar denominated debt is merely a promise to repay with more of the same currency which the US government creates. Look at Japan. This is what they have done. The problem, of course, is the malinvestment and the currency revulsion that it creates.
For sovereigns with debt in their own fiat currency, there is not the operational constraint that you and I face. After all, they can go to the backyard and just pick some bills off their money tree – something we can’t do unless we want to go to jail.
Remember, many countries like the U.S. or the U.K. can just print money to meet creditor demands. After all, the only financial obligation of government in a fiat currency system is the payment of more fiat money. This is a confidence game then. Creditors will only accept more fiat money from the debtor if they believe that the money represents good relative future value (i.e. when debt repayment occurs and where value is relative to other currencies or real assets at that time).
So while there is no operational constraint on government because of the electronic printing presses, there is an effective constraint in the form of debt and currency revulsion and price instability (large measures of deflation or inflation). On countries like Greece or Portugal in the Eurozone, the operational constraint is a lot more real than it is on the U.K. because of currency union. The same is true for countries with a currency peg or large foreign currency debts like Latvia, Hungary or Dubai.
Think about Gross’ words; can the US or the UK "constructively direct fiscal deficit spending towards growth positive investments?" In my view, no. That has certainly been the case in Japan as they have tried to grow their way out of debt. Theoretically, you can bring the debt load down. But, in reality, the Predator State intercedes and shuffles the investment off to those poor stewards of capital which are being propped up by government. Meanwhile, government will print as much money as it can reasonably get away with, which could eventually lead to tax and currency revulsion. So I am not sanguine about the US or the UK either.
In any event, I am sure governments will try to grow their way out of this if and when the sovereign debt crisis abates. So, I will end with the chart buried in Gross’ post which points to the stumbling block to sustained growth: debt.
Three Will Get You Two (or) Two Will Get You Three – Bill Gross, PIMCO
Here is a video of Bill Gross on Bloomberg explaining his take on why a Greek debt restructuring is inevitable.