The worst case scenarios keep getting worse and worse. The depth of pessimism in today’s markets is exemplified by a widely-circulated strategy document that makes the case for a cascade of sovereign defaults and a shutdown of global finance, leading to “the biggest economic shock the world has ever seen.”
How much time have we got left? About six months, according to the author, who is not some obscure newsletter writer, but Raoul Pal, a respected former hedge-fund manager at GLG.
Once upon a time such doom-mongering could have been dismissed as financial science fiction. No longer. After the Lehman Brothers debacle of 2008 and the slow-motion trainwreck in the Eurozone, financial apocalypse has come to have a queasy plausibility.
Like many uber-bears, Mr. Pal bases his pessimism on the scale of the world’s debt burden, which could lead to a prolonged period of deleveraging. Yet, as we know from the Japanese experience, deleveraging creates enormous appetite for risk-free assets, meaning government bonds, which makes the kind of market rebellion that leads to defaults less, rather than more likely. Government bonds will only be sold off when deleveraging no longer seems such a good idea and risk assets recover their appeal – ie. when investors believe that reflation is gaining traction.
The exception of course is the Eurozone, where countries lack monetary sovereignty and capital has fled from the periphery as the scale of the imbalances has become apparent.
There the situation looks bleak. Even so, it is possible that the contamination from a Eurozone exit is being exaggerated. Countries that have abandoned exchange rate targets and pegs – such as the UK in 1992, crisis-hit Asian countries in 1998 & Argentina in 2001 – have often devalued their way back to growth, despite a chorus of dire warnings to the contrary. Exit from a currency union is a great deal more complex, but if well prepared – with bank recapitalizations, speedy exchange of old for new currency and legal changes to re-define contracts – there is no reason why it should end in disaster.
Greece, for example, has an exports-to-GDP ratio similar to that of the UK in 1992. If devaluation were to generate a rapid increase in exports and tourist receipts, its funding gap might disappear surprisingly quickly. Better still, the Greeks could carry on being Greek in the time-honoured way, rather than attempting the impossibility of becoming German.
The problem is a successful Greek exit would make it tempting for other uncompetitive peripheral countries to follow suit. This prospect is anathema to the Eurozone’s powers-that-be, which is why they are incentivized to make the process look so traumatic. It would, however, be extremely reassuring to markets.
The Greeks could do us all a favour by voting Trotskyite and neo-pagan and thereby bringing an end to a saga that could otherwise stretch out for decades.
Meanwhile the cost of insuring against financial apocalypse has become exceptionally high. Thirty year bond yields in Germany, Sweden and Denmark have already converged with their Japanese equivalents. But while Japan remains in deflation, consumer prices are rising elsewhere. Even at microscopic nominal yields, JGBs are better value than , for example, US treasuries and UK gilts.
Furthermore, most Western countries are likely to be less tolerant of deflation than Japan, where immigration is negligible and wages have adjusted downwards – two factors which help to keep unemployment low amongst young males. Whatever their mandates may say, central banks have to respond to these social and political realities.
The other “risk-off” asset of choice, gold bullion, is within spitting distance of the real all-time high it touched in 1981. What came next was a twenty year bear market which delivered a capital loss of 80% in real terms. The idea that gold protects against inflation at no matter what price is demonstrably false.
The reality is that gold lost its status as touchstone of value in the 1970s and is now a financial asset like any other. Thanks to the creation of Exchange Traded Funds specializing in gold – the world’s biggest ETF is in gold, not equities – anyone can buy and sell the yellow metal twenty five times before breakfast.
So where is the safe haven which enables you to protect your wealth from the machinations of politicians and all the other risks the world is generating? Guess what – there isn’t one. Everything has become somebody’s idea of an asset class, from junky modern art to the copper that burglars strip from church roofs. Everything carries the risk of loss and some things – cash, for example – do not even offer any return to compensate.
The poor performance of stock market indices has caused commentators to announce the “death of equities.” But historically the greater part of equity market returns has come from dividends, not capital gain. Capital gain may well be deader than Elvis, but a case can be made for selected equities purely on the basis of income.
Admittedly, not all stock markets are good value – the US in particular still looks pricey in terms of the Shiller PER and other long-term measures and the BRICs bubble has yet to deflate entirely. Value is emerging in beaten-up European markets, but for investors not willing to take the macro risk the logical choice is Japan, where the Topix index has fallen to a 28 year low even as corporate profits reach all-time highs.
So the advice is buy what’s cheap and beaten-up and go to sleep for a few years. As the example of Japan shows, de-bubbling can be a long and dreary process, more Ingmar Bergman than Apocalypse Now.
In the words of one famous banker –
This is the way the world ends
This is the way the world ends
This is the way the world ends
Not with a bang but a whimper
The Hollow Men, T. S. Eliot