Since our last quarterly outlook called ‘Maximum Uncertainty’ the world has moved from bad to worse. Growth prospects have soured and governments and central banks are everywhere pulling out the stops to save the system once again. In Europe, renewed efforts to save the European Union from its debt crisis are foundering as EU politics have reached an all-time low in solidarity and an all-time high in playing to more domestic national agendas.
Policymakers’ efforts in the developed world to salvage the economy with bailouts, stimulus and money printing have failed to build a sustainable recovery since the 2008/09 financial crisis. And yet, have policymakers and central banks learnt anything? Hardly! In fact, it appears they are ready to double down on their previous efforts, a state of affairs we call Maximum Intervention. Top-down analysis suggests that this Keynesian, extend-and-pretend approach of ever more debt creation is likely to result in one of the following three scenarios:
1. Japanisation – continuing to pile ever more debt onto the sovereign balance sheet as the private sector licks its wounds. The analogy is Japan’s lost decades with the question being whether Japan’s unique strong export/strong private sector savings model can ever be repeated elsewhere. Regardless, an overactive public sector that chokes the potential of more private sector dynamism is hardly the path worth taking for other developed nations.
2. Crisis 2.0 – this scenario is triggered by government bond buyers simply going on strike. It appears to be the scariest, but actually offers the fastest and least expensive way to solve the developed economies’ debt dilemma. In a Crisis 2.0, the short term might get very scary in a “Lehmanesque” kind of way on deleveraging and destruction of bad debts through write-offs, etc. Further out, however, unfettered markets and allocation of capital based on gaining the highest marginal return will get the economy going from a healthier starting point and result in far more private sector job creation.
3. Monetisation – This is the favourite choice of policy makers or at least those that feel Japan went in the right direction, but it was simply not aggressive enough. This is the cult of extend-and-pretend – the endless Keynesian game of bailing out, stimulating and printing money while praying that economic growth will miraculously return if we can just buy a bit more time. It also means all governments and central banks will eventually be engaged in QE and weakening their currencies. Look no further than Japan and Switzerland to see how a strengthening currency can trigger unprecedented policy decisions!
In our last Quarterly Outlook, entitled ‘Maximum Uncertainty’, we discussed how uncertain economic and market outcomes might be in the wake of the end of the Fed’s QE2. At the time, we suggested three potential paths that had solid probabilities: 1970s-style stagflation, Crisis 2.0 and QE-to-Infinity.
The 1970s stagflation scenario has ‘died’ as more countries are facing deflation rather than inflation. Still, we do have another theme from the 1970s that remains, namely that of the problems caused by ‘big government’.
That leaves Crisis 2.0 and QE-to-Infinity as the main two scenarios left, with our Monetisation and Japanisation scenarios as two sides of the QE-to-Infinity coin. We feel odds are about even on the two scenarios. Will a Maximum Intervention scenario trigger a true Crisis 2.0 due to a loss of faith in sovereign debt? This would mean an unprecedented (in recent memory, at least) inability for sovereigns to access capital markets. Or do we get QE-to-Infinity, simply the continuation and even expansion of government into more and more sectors of the economy and even our everyday lives?
Politicians in the EU seem to feel that ever more intervention in the market is worth considering as they have proposed – what was once a dead concept – a Tobin tax (a tax on financial transactions).
Meanwhile, the problem and the solution remain pretty simple for the EU – leaders need to stop the half measures and extend-and-pretend schemes and start talking about a true monetary union if they want the EU to survive this critical challenge intact. Let me stress that I am an EU agnostic, but the only way for the EU to survive is through the creation of an EU Ministry of Finance and a common fiscal policy controlled and implemented to make sure that all member countries comply with common sense policies of keeping debt below a threshold and to secure faith in the EU as a trading zone. This would mean one credit risk for investors and trading partners rather than 27 individual bond markets and the related credit risks for each.
Right now, everyone wants to have a liability in the weak countries and assets in the strong, should or rather when the EU breaks up. The flight of capital is depleting and exposing to everyone the dependence on new issuance to pay for old debt. Nowhere is this truer than in Italy and its EUR 1 trn debt market, where political apathy is now resulting in higher yields than normally less favoured countries like Spain.
The entire exercise, started in 2008 at the depth of the crisis, of transferring private stressed debt onto the public balance sheet in order to secure low rates and easier access to capital has failed to sustain a recovery and has reached a saturation point after all of the rounds of debt-finance stimulus and QE money printing to finance much of the debt. At this point, one feels obliged to quote Albert Einstein; ‘the definition of insanity is “doing the same thing over and over again and expecting different results”.
That’s the context for the next few quarters: extend-and-pretend remains on the political agenda – and is truly global in scale as we have reached Maximum Intervention. With that as a given, how are we to manage our assets over the coming quarter and beyond?
In the next 18 months we are likely to witness investment opportunities not seen in decades. When and if the game of pretend-and-extend ends, there will be companies, real estate and other assets selling at prices which can only be described as ‘deep value’.
Our approach would be to “average into” risk starting when/if the US S&P 500 breaks below 1050/1100 and then putting five percent of the risk capital into the market each month following this development. This leaves out trying to time the markets and respects the need for the markets to work through a volatile period of uncertainty.
We believe, as suggested by the title of this outlook, that the next three months will see the final desperate moves by policy makers to save the world with more of the same ineffective medicine. We also feel that the market and more importantly the voters are losing faith in the solutions on offer. If they rebel sufficiently, we get Crisis 2.0. And in that case we should be optimistic based on the belief that individuals are more than capable of dealing with a crisis scenario. You only need to think back to your grandparents and great-grandparents: they lived through two world wars, drastically changing political systems and scarcity of all goods and products beyond what most of us can imagine! And yet, they went on to produce the strongest growth and greatest welfare for all levels of society that history has ever known. The future can often look dire when the present doesn’t look so good, but it’s so easy to forget how strongly individuals and companies want to survive and thrive.
Ironically, therefore, we can only hope that politicians’ attempts at maximum intervention fail. Rather than extending and pretending and funding past mistakes (keeping bad debts alive), the focus should be on job creation – and to achieve that, policy should focus on writing off bad debts, encouraging the raising of risk capital and reduction of taxes and regulatory burdens.
Most of the developed countries have become Entitlement Societies where public spending and employment is crowding out the private sector. To change course, we need to hire two persons in the private sector for everyone in the public sector and continue to do so for generations if we’re to get back to the right balance.
The bad news is that a rebalancing will be painful. The good news is Crisis 2.0 is either here or eventually on the way; it will hopefully create visibility for what is needed and why. History tells us that only in times of distress will politicians and policymakers ultimately take bolder, more rational action. On that note, now more than ever would be the time in which we ponder the true meaning of the word crisis: a turning point, not an extended period of doom and gloom.