The sovereign debt crisis has been the main headache of global financial markets for the past two years and hardly a week passed by without more news regarding the financial problems of Greece, Portugal, Spain or the U.S., just to name a few. Still today, many fear that a debt related financial and economic collapse is on the horizon. The popular argument is always the same: Too much debt.
We remain concerned about the debt problems of many nations and believe that it will take several years to improve this situation. However, in our view, the current discussion is too much focused on the debt side of the equation. Yes, too much debt is not good, but what makes it even worse is when there are no assets and income to cover and support the debt. In that sense, looking at a country is not much different from reviewing a company and analyzing its financials; just what financial analysts do the whole day. Interestingly, in the discussion about sovereign debt the comparison between nations is often done based on an overly simplistic view. There is one aspect of the comparison that is a lot different when reviewing the financial standings of a nation. Unlike a private company, a nation with its own central bank can determine the value of its currency by "printing" more money if needed. This is for example the case in the U.S. where the Federal Reserve has been engaging in a large scale asset purchase plan (quantitative easing). Skeptics often refer to this as "printing money out of thin air" and they see this as a first step towards high inflation, possibly even hyper-inflation. This is not wrong, but also not fully correct. It depends what the newly created liquidity does and if it finds its way into the real economy. What we are seeing in today's situation is that most of that new liquidity isn't doing much at all, the main effect has been that the banks deposit more money back at the central banks. This in turn is helping the banks to earn risk-free profits so they don't have to actually lend money to somebody which would actually increase the risk for the banks. Since the actual money flow is not increased, the risk for inflation is well contained and as long as there is not a real pick up for credit from households and businesses, it is very unlikely that we see a sharp spike in yields in most major economies. Despite some encouraging signs in recent weeks the actual velocity of the money flow remains very slow. Velocity is an indication of the speed at which money is flowing in the financial system. Increasing velocity is an indication of improving economic activity, something that has not really happened so far. Also, given the fact that commodity prices have fallen sharply in the past months (see chart "Commodity prices" below), the risk of seeing a sharp increase in inflation is almost zero.
The chart above clearly shows the slowing growth momentum that is currently seen in most major economies. Slower growth has direct implications on the commodity market where prices have moved sharply lower in the recent past. Charts from BIS
Actually, the risk of seeing negative inflation rates in many economies is significantly higher. Central banks see this and since most of them fear deflationary tendencies, they will all keep loose monetary policies. In a global context it does not even make much of a difference if the U.S. Federal Reserve is going to reduce its asset purchase program eventually. Other central banks, especially the Bank of Japan, have already started to make up for that. "QQE", quantitative and qualitative monetary easing as the Japanese program is called is even more aggressive than the Fed's program. It aims to almost double the monetary base within the next two years (!!) and buy back bonds and other securities on a very large scale. The goal is to reduce yields across the whole yield curve, especially at the longer end and by doing so to encourage consumption and investments. What is different with the program in Japan is that the government is also planning to increase investments, this in sharp contrast to the U.S. and Europe where governments are actually cutting back their spending.
The charts above show the effects of central bank intervention and how this impacts interest rates, despite a small increase in the last couple of weeks, interest rates in many markets are still near record lows, with expected increases not coming before mid 2014
It remains to be seen which is the better way and for different countries different strategies might be right. Japan has very high levels of debt but it also has a high level of domestic savings, so it looks like this is sustainable. In the U.S. the situation is slightly different due to the lower savings rate. Just cutting spending is not going to solve the problem. What is needed are public investments that make sense and that have real economic returns. So the discussion should be which strategy is appropriate for a given country. With regards to Japan and the U.S. there needs to be a more forward thinking strategy. For the European countries, this is a slightly more challenging issue. Countries such as Italy, Spain or Greece are not poor countries, actually these governments own some very valuable assets, the problem is that those countries need to make more reforms and increase privatization of state owned assets and this is something that is much harder to do in Europe. Reforms take time and they are usually only done under pressure; the liberalization of the job market in Europe is a good example of that. However, the current economic situation is creating the pressure needed to jump start reforms.
Monetary and fiscal policies are also impacting financial markets, especially stock markets. Lower yields typically increase the present value of stock investments, but this is only one influence. Equity prices also react to interest rates because the lower these rates are the less attractive the bond market is and the more attractive equities are on a relative basis. The chart below illustrates this very clearly. Stocks have been doing much better than other investments (such as bonds and commodities). We expect interest rates are going to remain supportive for stocks for quite some time to come. Yields might go up slightly but on a relative basis they still remain exceptionally low.
Low interest rates are making equity investments more attractive on a relative basis again. With yields remaining low for longer, the chances for a continuing outperformance of stocks versus bonds and precious metals seems very likely
We regard the current discussion and speculation about when the Federal Reserve is going to stop its asset purchase program as a non event. In our view it makes no difference and it is not changing the fact that rates are going to remain at very low levels. A sudden and sharp increase in yields would put the current, already fragile, recovery at risk. Also other markets are going to see very low interest rates for probably years to come. For many central banks price stability is not a very important goal anymore as other measures such as GDP growth or employment numbers are the main focus.