The Coming Global Restructuring - Harvesting Alpha
August 25, 2010
· When one examines developed country revenues on a historical basis they are generally linear (moving sequentially higher, yet still experiencing cyclicality), however their expenses have grown exponentially. Additionally, as government debt went parabolic private incomes stagnated.
· Simulative policies in OECD have helped avoid the pain of this mismatch only temporarily, the need to restructure has only been postponed.
· Japan's public debt to GDP is approximately 190%, Greece is 113% in the United States 53% or substantially higher depending on how you analyze the numbers; either way you examine the US debt to GDP it is unsustainably high.
· 50% of US debt roles every year, meaning that if short rates move up at all they will have an immediate and exponential effect on funding costs. Therefore the US cannot allow rates to go up until some sort of realignment/restructuring has taken place.
· Taking a global view; new sovereign debt to fund this year is $4.5 trillion dollars, this assumes all existing debt was rolled over. Total global debt is $188 trillion; the global population is 6.5 billion people, resulting in a global debt per person of $30,000.
· The question is, where will this $4.5 trillion, come from. In the United States, bank security portfolios are up 26% as a result of their buying treasuries and not lending. Last year 2009 OECD countries printed 40% of GDP.
· The US cannot allow rates to start rising, causing a cascade of sequentially higher rates as the cost to fund the debt accelerates. The US will eventually be forced to restructure.
· In our lifetimes we have known cycles and are familiar with the premise of buying low and selling high, counting and investing on the basis that at some point growth will return and the next up cycle will begin. The world is an ongoing entity after all.
· However, the new normal we are facing is one of secular change, which takes place about every 100 years. A significant component of this secular change involves massive structural headwinds, which are in part demographic, having profound implications on savings/spending and government revenues/expenses.
· As to European sovereign debt issues; the European banking system is 3.5 times the United States banking system given their GDP-they are substantially more leveraged than US banks. The European Bank stress test was overseen by 28 separate regulatory bodies and required only €3 billion to be raised; to be blunt the test was not credible. Yes, the Spanish auctions have been a success but the securities are bought by the three largest banks and then repoed out to the ECB. There will be sovereign defaults/restructurings in Europe’s peripheral countries; it is only a matter of time.
· Japan is currently hitting a fiscal/funding inflection point as government revenues are ¥40 trillion (unchanged from 1985) while government expenses are ¥97 trillion, 200% of 1985 expenses. When debt service outstrips revenue receipts in a down trending secular environment, eventually something must give. Japan’s special funding circumstances result from massive corporate and personal savings due to its export oriented economy; however personal savings rates are now zero and headed lower, corporate savings rates are currently 4% and under stress as the economy weakens. In fact, the largest two holders of the Japanese Government Bonds announced that they would be net sellers this year.
· The population decline in Japan has now reached its secular point; the working age population peaked in 2009. Like any Ponzi scheme the only way to keep going you must have new buyers of bonds or new births-if not the house of cards comes crashing down.
· When JGB rates start to rise, every 100 basis points increase will increase government interest expense by an additional 25% of revenues.
· For developed economies, growth in China (specifically) and Asia overall is where the future of global growth lies. If for some reason China were to stumble, in any number of areas putting into question short to medium term growth rates, projections of global growth would be revised downward significantly. We know from history that any country's growth is not linear. Take Japan for example; if in 1850 someone had said Japan would be the second-largest economy in the world in the next 125 years, they would've been correct. However we all know that in that 125 year period Japan’s growth was anything but linear, to expect a similar linearity from China's growth ignores history.
· If investors make the assumption that China will be able to manage: its growth, its continued dependence on exports, misallocation of capital, local/provincial government indebtedness, resource dependability (water, raw materials, etc.)… they are putting at risk a significant portion of their portfolio. Investors who ignore the fact that global markets are more correlated than ever, have short memories indeed.
· Currently almost 25% to 30% of private commercial and housing stock in China is vacant. Entire cities such as Ordos in inner Mongolia, erected literally from scratch, stand empty. Beijing is in a dilemma (different but in some ways similar to the OECD) of wanting to cut spending and rein in its voluntary monetary expansion allowing more capital to seek more productive endeavors. This move however would mean slower growth, lower house prices rising unemployment and potential civil unrest. On the other hand, it could continue to prop up real estate markets and like the developed world, and keep kicking the can down the road until the eventual reckoning proves much more damaging. One has to ask themselves how nine Chinese Party officials will be able to successfully manage the Chinese economy, when the Federal Reserve that has so much more experience has still mismanaged our ours.
· It is my opinion that the ability of global economies to continue to grow at 2 1/2 to 3% rates on balance will come into question as developed economies struggle with the secular headwinds of: demographics, personal/sovereign debt and stagnating incomes/government revenues. As events unfold, the realization that we are entering a secular global change in developed economies (forcing restructurings) the global financial landscape will be radically altered. Additionally, we must never forget that policymakers are reactive not proactive, only responding when there is a full-blown crisis in process. Compounding this problem is the reality that policymakers globally, both in developed countries and in Asia have limited playbooks to go by - most of which have reached the outer limits of effectiveness. Increasingly (certainly the case in the US) the effectiveness of advertised stimulus measures and transfer payments are dwindling rapidly.
· As global growth slows (revenues continue to decline) in the developed economies and liquidity to European banking system/quantitative easing/ zero interest rates… fail to deliver additional growth/stability, business/consumer confidence will become profoundly pessimistic. Governments will be forced to shrink budgets during a time of extreme balance sheet stress and rebuilding. Interest rate expense as a percent of government budgets will increase as growth stagnates, developed governments and local entities will be greatly challenged by the needs of their citizens.
· Those that succeed in the New Normal will not be the smartest, nor the hardest working, but those most able to adapt to the new realities.
Investing in the New Normal
<>Confusion reigns, rules of thumb and historical correlations prove irrelevant, or worse, (this is the new normal), they are misleading guides to positioning your portfolio. Breached guideposts and guard rails abound: V-shaped recoveries may not inevitably follow deep recessions (as the incoming U.S. data are now confirming); tripling the monetary base may not inevitably lead to double-digit inflation (as the Treasury Inflation-Protected Securities [TIPS] market is telling us); and half-trillion-dollar official sector rescue packages may not inevitably be sufficient to address sovereign liquidity disruptions (as is reflected in Greek government bond prices).
<>The New Normal world is likely to be one with frequent flips between “risk on” and “risk off” days. With so much profit and loss riding on tail events and so little profit and loss tied to the cluster of outcomes near ex ante means, repositioning will likely be more frequent. This is because many investors lack conviction in their understanding of the true distribution, so that each passing day provides an opportunity to learn or unlearn how likely the relevant tail events are. Positioning for mean reversion will be a less compelling investment theme in a world where realized returns cluster nearer the tails and away from the mean.
<> Harvesting alpha in the New Normal will require getting the tails right.
<> In a New Normal world, the cost of debt financing to fund speculative trades must go up. The lender does not benefit from the fatter right tail of borrower profits if that right tail is symmetrically matched by a fatter left tail of borrower losses.
Disclosure: Long GLD Long Treasuries Short financials Short consumer discretionary Short equities