July 25, 2011
In the day-to-day flood of news reports about debt problems of Greece, Ireland, Portugal, Italy, and even the U.S., it's easy to get lost in a sea of opinions about the effects of a given bailout measure. The best tool to cut through this confusion is simple arithmetic.
As my friend John Mauldin wrote last week, "No country save Britain at the height of its empire has ever recovered from a debt-to-GDP ratio of over 150% without a default. None. And the reason is simple arithmetic. Even a nominal interest rate of 6% means that it takes 10% of your national income just to pay the interest. Not 10% of tax revenues, mind you; 10% of your total domestic production."
For most countries in Europe, government revenues typically run between near 40% of GDP, while government spending presently runs several percent ahead of that. In Greece, government debt now represents about 150% of GDP at interest rates between about 10% for very short and very long-maturity debt, to about 25% annually on 2-year debt (reflecting a high expectation of default). The overall average yield on Greek debt is close to 15%. The problem is that 15% interest on 150% of GDP works out to 22.5% of GDP in interest costs if the debt actually has to be rolled-over without restructuring it. That would be more than half of the government revenues of Greece. The only way Greece can avoid default with that math is if investors quickly become willing to roll over the existing debt at an interest rate in the low single-digits.
While last week's extension of further bailout provisions for Greece certainly gave the markets a rousing "risk on" day on Thursday, the main effect on Greek debt was to extend the expected date of certain default (estimated based on interest rate spreads and credit default swaps) from about 1.5 years away, where the expectation was on Wednesday, to closer to 2 years away, which is where the expectation was by Friday.
Unlike countries with an independent monetary policy, Greece can't print its own currency, and can't devalue its obligations on the foreign exchange markets. So it is stuck with impossible math, save for the willingness of other European countries - mainly France and Germany - to pay the tab. It's still possible for Europe as a whole to summon the political will to do that, given that the GDP of Greece is only about 10% that of Germany. Still, Italy has a debt-to-GDP ratio of about 120%, and a GDP about two-thirds that of Germany, so the math becomes fairly daunting if contagion spreads past small countries such as Ireland and Portugal (which also have debt-to-GDP ratios near 100%).
As I've noted several times in recent months, bond market spreads imply very low near-term (3-6 month) probability of default in any Euro-area country. A sovereign default is much more likely to occur near the end of the next bear market, whenever it occurs, than at the start. As Ken Rogoff and Carmen Reinhart noted in their book This Time It's Different , "Overt domestic default tends to occur only in times of severe macroeconomic distress." The most likely window for a Greek (or other Euro-nation) default will be at a point when France and Germany are experiencing economic downturns sufficient to douse the political will to bail out their neighbors at a cost to their own citizens.
Here in the U.S., total Federal debt to GDP is also approaching 100%, but the debt held by the public (outside of that held by Social Security and the Federal Reserve) amounts to about 60% of GDP and rising, due to recent budget deficits of about 10% of GDP annually. This is presently manageable since so much of that debt is of short-maturity and is being financed at very low interest rates. And though U.S. Federal tax revenues have historically run near 19% of GDP (they're presently only about 16% due to the sluggish economy), those depressed interest rates mean that debt service doesn't consume a huge chunk of revenues just yet.
Still, it's precisely that short average maturity that makes the debt problematic from a long-run perspective, because it can't be inflated away easily. In the event of sustained inflation, the debt would have to be constantly refinanced at higher and higher yields. Contrary to the assertion that the U.S. can easily inflate its debts away, it is clear that sustained inflation would create enormous risks to our long-run fiscal condition by driving interest costs to an intolerable share of revenues. At that point, any shortfall in GDP growth or government revenues would result in a rapid spike in debt-to-GDP (as Greece and other peripheral European nations are experiencing now). Prior to embarking on an inflationary course, the first thing a government would want to do is dramatically lengthen the maturity of its debts.
For Greece, and increasingly for Portugal and Ireland, our view continues to be "certain default, but not yet." For the U.S., our view is that, barring significant restructuring of mortgage obligations, our debt problems are more likely to take the form of sluggish economic growth for an extended period of time. I continue to believe that the main window of inflation risk will begin in the back-half of this decade - not yet. Even so, we are already observing a sustained shift away from fiat currencies toward alternatives like gold (though there will certainly be fits and starts to that trend). Meanwhile, bond yields continue to offer very low yields-to-maturity, while credit spreads on corporate debt (even the riskiest types) have been squeezed as thin as they were in 2007. In stocks, on the basis of a wide variety of fundamentals, we expect the total return on the S&P 500 to average about 3.6% annually over the coming decade.
In short, the present menu of investment options provides little basis to expect significant nominal or real returns from long-run, passively-held investments purchased at present levels. I strongly doubt that investors will be deprived of opportunities to accept risk at higher expected returns and lower prices in the coming years. With few exceptions, the markets presently offer all of the risk with weak prospects for long-term return.
As of last week, the Market Climate for stocks remained mixed, with rich valuations and a variety of measures of market action dabbling with support. Bullish sentiment increased to 46.2%, with bears at 21.5%. When you couple that spread with a Shiller P/E above 18 (it's presently over 23 and consistent with a broad range of other normalized valuation metrics), the S&P 500 has historically produced negative total returns - regardless of whether the S&P has been above or below its 200-day moving average (presently just under 1300 on the S&P 500).
Overall, the ensemble of present conditions implies a negative expected return/risk profile, but there are numerous factors that could shift that profile either modestly or significantly, ranging from an easing of present lopsided sentiment, modest weakness that clears overbought conditions without doing further internal damage, or significant weakness that improves valuations. Probably the most important near-term consideration is that present market conditions are similar to those often seen during extended multi-month bull market tops, where stocks essentially trade in a 5-7% band for 6-8 months and both advances and declines are highly prone to "whipsaws." Strategic Growth Fund is tightly hedged here, while Strategic International Equity has a modest net exposure of close to 20%, due to much more significant dispersion among international markets, many which have already experienced steep losses in recent months.
My impression is that the major risks are to the downside, but much like in 2000 and 2007, that impression is primarily based on "core" factors such as overvaluation and unresolved economic imbalances, as well as various syndromes that are more important for their extended market implications than they are for returns over a few months (see Extreme Conditions and Typical Outcomes ). We see a similar situation in the economy - despite the likelihood of an extended soft patch, we don't yet have evidence of an oncoming recession. Meanwhile, we continue to look for opportunities to accept even modest exposure to U.S. market fluctuations if the estimated return/risk profile peeks above zero.
Until those "core" factors surface to a greater extent, we can expect market action to occasionally be punctuated by bursts of investor excitement over agreements to increase government debt and bailouts at home and abroad. Thursday was one of those days, and featured strength in "risk-on" sectors like banks and lagging performance among more defensive sectors. Similarly, we can expect abrupt drops on the heels of low-volume, overbought short-squeezes, which produces the opposite profile of returns, particularly when debt concerns appear. Again, this sort of whipsaw behavior is characteristic of markets where the dominant "thesis" of investors is changing, but the evidence isn't conclusive.
The markets are an equilibrium where every share sold has to be matched with a share purchased. From an equilibrium standpoint, the worst market outcomes are always those associated with rich valuations, a deterioration in valuations from a fundamental standpoint (economic concerns, earnings disappointments, or weak guidance), and a break below widely-followed technical thresholds. The difficulty at those points is that you can get supply from both value-conscious and technically-driven investors, which is an incompatible combination because somebody has to be induced to buy. The only way to establish equilibrium in that case is for stocks to decline by enough to turn the value-conscious sellers into buyers, which essentially requires a free-fall. Importantly, that's not meant as a forecast. Rather, the point is to be alert for events that have the simultaneous effect of disappointing expectations from fundamental investors and also triggering breaks of technical "support."
In Strategic Total Return, we continue to carry a duration of about 2.5 years, mostly in intermediate-term Treasury securities, with an exposure to precious metals shares near 20% of assets being the primary source of day-to-day fluctuations in the Fund, driven by what we view as an unusually favorable ensemble of conditions in that sector.
Last week, a shareholder kindly forwarded an article that appeared in the New York Times Magazine: Sheila Bair's Exit Interview . Bair asked the writer, Joe Nocera, not to publish it until she left her position as head of the FDIC. It is essential reading. Opening line: "They should have let Bear Stearns fail."
The foregoing comments represent the general investment analysis and economic views of the Advisor, and are provided solely for the purpose of information, instruction and discourse.
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