Archive for July, 2011
For most of the last few weeks it was the Eurozone crisis. Now it’s the crisis in the US (debt or growth, take your pick). Whatever the reason, risk assets have been through panic after panic. And at the same time, certain assets, regarded as safe havens, have shot up.
The question is: how safe would these havens really prove in the face of a true financial catastrophe?
Government bonds are the classic escape for the risk averse. But in a world where the source of much of our panic is uncontrolled government debt – in other words, an embarrassment of such bonds – which ones to buy? The US has traditionally played the role of safest bond haven in the world, but a failure to raise the debt ceiling in a few days’ time, which would present the real prospect of an event of default, challenges this view. Likewise, the performance of the gilt market looks out of tune with an indebted, low-growth economy battling a deficit of 10% of GDP; and would those euro-denominated bunds really give investors such a smooth ride if the single currency were to collapse?
On the currency front, market behaviour is if anything more perplexing. One of the most notable beneficiaries of weak sentiment over the US has been the Japanese yen. The yen! Japan’s economy is contracting, its debt burden as a percentage of output is the highest in the world (it overtook Lebanon in 2008), it has terrible demographics and it has also experienced the worst nuclear accident for a generation and one of the worst earthquakes in living memory. Then there’s the Swiss franc – Switzerland’s fundamentals are enviable and it certainly has the benefit of a defensive location, but it would be far from immune to the effects of another financial crisis. Looking at the other top performers, Norway and Australia would surely be affected should a new recession provoke another slump in commodities – which leaves those economic superpowers, Canada and New Zealand.
We can write off equities while disaster has the upper hand; ditto, property.
Commodities too should suffer in a crisis, with the notable exception of gold and silver. Though even then, with precious metals prices where they are (in the case of gold, not much more than $200 off its all-time real terms high) and volatility high, the risk of sudden and painful capital loss should Armageddon fail to materialise takes the shine off them rather.
Which leaves cash. And with interest rates at record lows throughout the developed world, and inflation having picked up steam, investing in cash guarantees the erosion of your wealth in real terms.
In short, while there is the odd bond market, currency or commodity that might be expected to offer some upside in the event of another major crisis, investors need to tread carefully. What looks like a hedge at first can sometimes be the edge of a cliff.
Government debt is an issue that has been preoccupying minds in Europe and the US for some time now. Emergency debates, emergency summits, emergency measures and the prospect of default ever hanging in the air: the sense is of a serious and immediately pressing problem which requires committed action to resolve.
In Britain there is none of this sense of urgency. Indeed, some commentators have been positively revelling in the woes of the eurozone; it has become idiomatic in certain quarters that we wise British are to be congratulated on our decision to remain outside the single European currency, membership of which has caused such terrible difficulties for those callow Continental powers foolish enough to have joined.
There is only one problem: the UK has a debt problem which is every bit as serious as those of the eurozone and the US.
Data out yesterday on the public finances showed that government borrowing reached £14bn last month, £1.5bn above the median estimate and £0.3bn higher than in June last year. For the period April-June – the first quarter of the 2011-12 fiscal year – borrowing is roughly unchanged over the same quarter the previous year, having fallen by less than 1%.
As the OBR’s accompanying commentary on the data reveals, a fall of over 14% on last year’s deficit is required to meet the Chancellor’s goal of borrowing “only” £122bn this year (7.9% of GDP). After the disappointing performance of the last three months this entails a reduction of almost 20% over the rest of the period.
The OBR insists that this is perfectly manageable, but there is a major concern. The disappointment came from weak revenues (spending was roughly in line with expectations), and this despite an increase in VAT receipts of over 16%, reflecting the higher rate that kicked in at the start of the year. Income tax, NI and corporation tax all disappointed. And that reflects weak economic growth.
The government’s 7.9% deficit target relied on a March growth assumption of 1.7% for 2011, which looks toppy against more recent forecasts. Failure to meet the target – which represents a modest deficit reduction of under 2% of GDP in any case – would cast into doubt the UK’s ability to contain its burgeoning public debt.
In his Budget statement, Mr Osborne had the following to say:
We have a higher deficit than Portugal, Greece and Spain, but we have virtually the same interest rates as Germany.
In other words, Britain’s creditworthiness has been receiving the benefit of the doubt from the bond markets. If it emerges that our fiscal consolidation plans have gone agley, that may cease to be the case. Our credit ratings and our low bond yields could be jeopardised – and that could mean trouble.
Just ask the Europeans.
There is widespread recognition that the UK economy faces problems. Our growth is stagnant, prices are rising – and there are those cuts to contend with too. So the British MPs, journalists, economists and so on who argue that Greece and its peers must be allowed to default without further outside assistance from anyone (and certainly not from us) take an understandable line.
Understandable, but wrong.
Moody’s, fresh from junking Portugal the week before, turned its guns on the Irish this week. European debt markets, already nervous, took this badly: it wasn’t just Irish bonds, but those of Spain and Italy that moved lower. Even France saw the yield on its ten year paper gap to its highest spread over ten year Germany since the mid 1990s.
In the event that no further emergency lending is made available to the weaker eurozone countries, we should expect further rating downgrades and spread widening. The bond market, over time, would force the default of successive states by cutting off their access to funding.
We are a long way from that grim destination at present. A yield of 6% on Spanish ten year bonds is a far cry from the double-digit rates seen in Portugal, Ireland and Greece. But if nothing is done to stop the dominoes falling, that yield will get higher, and the higher it goes, the more worried we should be.
To some, Europe may be a faraway country of which we need know nothing. But the economic reality is that any default-led devastation in euroland would sweep over Britain too.
This isn’t just a question of bank lending – though our banking system’s exposure is huge. It’s a question of bank ownership. Banco Santander is Spanish. Following its purchases of Abbey, B&B and A&L it’s also one of the largest players in the UK retail banking market with 26 million customers.
Imagine all of them lining up outside Santander’s 1,400 branches a la Northern Rock.
Then there’s the trade aspect. Export growth on the back of currency weakness has been a conspicuous bright spot for the UK these last couple of years.
Well over half those exports go to other EU countries.
There are systemic risks too. The euro is the world’s second reserve currency after the dollar. The eurozone is the world’s second largest economy. The collapse of these things would be a world event.
President Obama gave an impromptu acknowledgement of this on Wednesday while expressing his frustration over having to negotiate spending cuts to deal with his own country’s debt burden:
He walked out of a meeting with Republican congressional leaders on deficit reduction, telling them “enough was enough” … “They’re in one week and they’re out one week,” he said, making his irritation plain. “You need to be here. I’ve been here. I’ve been doing Afghanistan and bin Laden and the Greek crisis. You stay here. Let’s get it done.”
Afghanistan, bin Laden and the Greek crisis – the three most significant issues which came to the mind of the world’s most powerful man in an outburst of frustration.
If it’s that important to him, it’s at least that important to us. In fact, the tragic irony of the idea that Britain would save a bit of cash if the eurozone periphery were left to burn is that nothing would be more injurious to our economic interests.
It is fair to say that markets were blindsided on Tuesday by the decision of Moody’s, the credit rating company, to junk Portugal. Confidence was creeping back in after Athens took its austerity medicine, securing the release of emergency funds – and then, wham! – a cent off the euro, a down day for equities and a two point jump in Portugal’s 10 year yield.
From Moody’s full statement it is clear that their main concern is the possibility that private sector creditors may be expected to incur losses in a hypothetical future renegotiation of Portugal’s bailout. This concern arises from the possibility that such private sector losses will form part of the renegotiation of the bailout of Greece.
Given that no details on Greece’s second bailout are available yet this looks a little precipitate. The Portuguese certainly think so, pointing out that the new government has only been in office for a month and is fully committed to implementing the austerity measures which form part of the country’s existing bailout package – a package which was itself only agreed in May. Furthermore, since the EU’s finance ministers are meeting on Monday and Tuesday of next week and discussions on the Greek bailout are ongoing, some have accused Moody’s of trying to influence the outcome.
Whatever the truth of this, the relevance of these rating company decisions is being challenged. The ECB have suspended the ratings requirements on Portuguese debt, meaning it can still be used as collateral for lending – exactly as they did for Greek paper last year. And although Moody’s and its peers may consider a rollover of private lending an event of default, ISDA – the International Swaps and Derivatives Association, key arbiters in the world of over-the-counter derivatives – have said that they will not, and that such a rollover will not, therefore, trigger the settlement of credit default swaps.
If central banks and derivative market participants are beginning to ignore credit ratings, perhaps their days are numbered. That would certainly suit a number of European polticians who are taking Moody’s decision personally.
Before we get carried away, however, let’s remember that two percent leap in Portuguese bond yields. In the bond markets – whether for better, or as in the case of the subprime fiasco, for worse – credit ratings still count.
At some point in the future, those countries in receipt of emergency lending will need to go back to the bond markets to raise funds. When they do, it looks as though an adequately strong credit rating will still be required.