Forget the flotsam and jetsam of the great financial crisis for a few minutes. Yes, that’s right; ignore the millions of unemployed people around Group of 20 nations; the debt piling up for taxpayers to see off in perpetuity; the hundreds of idling ships in the world’s ports and the hundreds of thousands of forever vacant plaster-board houses dotting the landscape. Instead, as behoves a time of the year when people traditionally look back and ahead, consider the winners of the year.
When I wrote We are all Japanese now (Asia Times Online, September 5, 2009), even I hadn’t realized quite how completely the transformation had taken hold of world markets. Recent events such as the bailout of Dubai World and the goings-on in the world of sovereign debt signify a dramatic shift in world financial markets, favoring asset-rich borrowers with strong cash flows over ideas-rich entrepreneurs.
Disclaimers for asset managers and funds typically state something on the lines of “past performance is no indication of future returns”; but that pertains to the laws of probability – in other words, just because a fund manager does well under a particular scenario is no indication that the strategies would work in a different environment.
Bank the buck
The lack of such a disclaimer is what defines this year’s winners. For they did not get to be successful by having any special talents, any significant factor advantages or indeed even a fortuitous turn of fate. They have been, to the last one, those who have had the right connections and played them out for whatever they were worth.
Whether it was the big American and European banks that used their government connections to secure (often illegal) bailouts at the expense of taxpayers in 2008 only to quickly hand them back when the “financial component of the crisis” ended earlier this year; the big asset managers who have been appointed to chaperone troubled assets purchased by the government in their rescue of the above-mentioned banks; the insurers who managed to selectively tear up inconvenient insurance contracts even as they benefited from government largesse on the other hand; the increased costs of doing business as a borrower or investor that has been facilitated by the government bailouts of select financial institutions; the self-serving financial restructuring plans for individuals and businesses that ended up benefiting financial institutions instead; every step that has been taken by the US and European governments this year has been to the benefit of their large financial institutions.
Comically, at the end of the year, various governments decided to take a stand on the bonuses being paid to bankers; as always the Keynesians seek the wrong remedial actions after first applying the wrong medicine to the wrong diagnosis. Nothing will come of it, for bankers are now emboldened beyond mere problems with moral hazard, a curious result of what was essentially an avoidable crisis.
Banks have become more risky, more leveraged and pose greater risks to the world economy now than at any time in history. Encouraged by their new owners in government, banks have piled on more dubious assets to their books during this year, with a view to propping up secondary prices of these instruments, in turn benefiting their own holdings of hard-to-value assets.
Bring on big government
The second major development of the year is the increase in government debt around the world. With a decline in consumer and investment spending as a natural fallout to the credit crisis, governments around the world embarked on expansion of their spending; with a view to dull the impact of the recession.
Higher spending has been the norm, rather than lower taxes. As a proportion of gross domestic product, it was China that opened up government purse strings the most, although this was disguised as increased lending from the banks. Other governments soon followed suit, ranging from other Asian countries such as Japan and India to the United States and European countries.
Somewhere along the way, it would have been a good time for investors to stand back and ask “exactly who is going to pay for all this?”, because on a gross basis, the world has run out of savings with which to fund rising government debts.
That is the reason the biggest buyer of US government debt this year wasn’t China or Japan, but rather the US Federal Reserve itself. In other words, US dollars are being printed at a record rate in order to fund the US federal deficit. In an ideal world, Keynesians wouldn’t have been allowed to get away with such nonsense. Interest rates would have increased massively and confidence in the US financial system would have diminished considerably.
Instead, thanks mainly to the sheer volume of global excess capacity, that is, deflationary forces, the volume of money printed by the US Federal Reserve has basically helped to offset normal market logic. Plenty of cracks showed through – such as the little fact of inverse correlation between US stocks and the US dollar (that is, as the dollar fell, stocks rose) and more importantly, the rising price of gold.
The big debt machine chugged along nicely through the second and third quarters of the year as ample liquidity from various central bank programs, money printed to purchase government debt and excess savings from Asia helped provide demand for the vast supply from around the world.
Then suddenly in the fourth quarter, the cycle juddered to a halt as a number of previously tethered naval mines came undone from their anchors and started bobbing into the shipping lanes of global debt finance.
The goings-on in Dubai appeared merely a test case as a number of smaller European countries received adverse attention from rating agencies as well as debt markets. Some, like Greece and even Ireland, appear destined for a gut-wrenching series of debt workouts, perhaps with the tender loving care of the International Monetary Fund. Other European states like Portugal, Spain and Italy may take a while to get to their days of reckoning, although from purely a fundamental debt perspective, I am hard-put to recognize how these countries could ever evade a painful restructuring.
The key benefit of being in Europe is that countries get to send their collective bills to stronger economies, such as Germany and France. In particular, Germany has been the model of a strong partner, in effect bailing out smaller debt-ridden European nations through the refinancing window at the European Central Bank (ECB).
However, when it emerged that a bunch of Greek banks had been misusing the refinancing facility in order to bump up their returns, buying a boatload of local government debt at 4%, refinancing with the ECB at 1% and pocketing the difference, this was a bit too much for the staid ECB to tolerate; and when the Greek banks were put on notice, it became apparent to the still-clueless people at rating agencies that without the “captive” purchases of Greek banks it would be virtually impossible for the government to refinance itself.
What makes the Greece story really interesting is the very obvious evidence that the rating agencies and bond investors have learned precisely nothing from the travails of the market from 2007 to now. The Greater Fool theory of investing remains at the forefront of market movements, and woe betide anyone who decides to play outside the sandbox.
All that said, the most painful case of debt restructuring in the developed world would likely be the United Kingdom. Here is a country that has lived far beyond its means by borrowing heavily during the period of economic surplus for the past 10 years. It was hit very hard (and early) during the financial crisis, as I wrote two years ago (see Rocking the land of Poppins, Asia Times Online, September 22, 2007), and appears to have compounded the errors made prior to the crisis on financial supervision with measures subsequently designed to expand government stimulus but also to cut back on “excesses” in the financial system.
The net result is a country that appears not just delusional but positively suicidal. With a freely floating currency that has been weighed down by low interest rates of late and a significant quantitative easing program, the United Kingdom represents the broadest test case for government responses to the financial crisis.
A reduction of confidence has already been signaled by the debt markets as 10-year UK Gilt yields have risen from less than 3% in March this year to just over 3.85% now. In contrast, Germany, with much the same economic conditions as the UK, has seen its 10-year (“Bund”) yields go from around 3.1% to 3.19% over the same period. Importantly, there are no measures to support German bond issuance, ie no central bank is buying them outright as the Bank of England has with UK Gilts; therefore the difference in performance is that much more indicative of a failed approach to the crisis.
It would be fitting after all if Keynes’ theories were finally buried in the very country where he wrote them.
I do not seek to write investment commentary for readers. Indeed, my personal disclaimer to readers has always been to not follow the advice of a pseudonymous writer such as myself but instead secure appropriate advice for a reader’s specific situations.
With that said, here are a few things I am looking toward for 2010:
a. US dollar volatility continues well apace as investors square off between the longer-term uses of the currency versus the short-term demand on their liabilities side.
b. Inflation starts peeping out as the sheer volume of monetary expansion catches up in the prices of goods; expect to see some jarring prints for negative real interest rates by the third quarter of next year.
c. Markets lose confidence in a few more sovereign borrowers, with my least-favored sovereign for 2010 remaining the United Kingdom.
d. Gold prices oscillate around the US$1,000 per ounce level through the first quarter of next year, but then breaks out higher as mounting evidence of a regime shift in financial system metrics becomes apparent to more investors from the second quarter.
e. Stocks are currently overvalued significantly, which, combined with substantial easy money, suggests that the natural course from here is up, not down. Much like the death throes of the technology bust in the 1990s were only signaled with record stock prices in 1999, investors should expect further gains in the first quarter 2010. After that, stocks will probably fall by 50% or so.