The Mirage of the Recovery

The last few months have been quite taxing on any rational person, a fact that has been aggravated by naive (or maybe intentional hype) about the so-called recovery in the economy. Any sane person searching for signs of recovery would have very clearly come to the conclusion that the recovery (if at all it existed) was due to the government support and the near disappearance of the capitalist order that was propounded as the panacea just three years ago. 

It is perplexing that all those who at one point of time were strongly against subsidies are now demanding not just subsidies but doles that are many times more than what the government would spend on public health and education. I remember the years immediately after the process of liberalisation started we had industry bodies demanding that subsides to people (poor as well as middle classes) only made them more lazy and that these should be dismantled because free markets are the best way to reduce poverty and create a work ethic that supposedly doesnot exist in India. Two full years into a crisis, nobody talks about dismantling subsidies, instead these bodies are now clamouring more subsidies, albeit to their own members. 

As a student of Social Sciences, I find it absolutely interesting to watch how fickle the markets are. Till about January this year we had everybody (including the 20 something reporters in the press, who would be hard pressed to explain the difference between macro and micro economics to the policy makers who are willfully lying about the state of the economy) claimed that the world has recovered. Even important members of the bond houses were warning about the era of hyper-inflation that was about to be unleashed - I guess their assistants forget to give the charts of M3 and M2. In reality, the recovery turned out to be the case of 'so near yet so far' - as it has happened so often in the past three years. 

 Two charts given below would probably reinforce the need as to why people should be more circumspect about the supposed recovery.

The Chart above shows the Personal incomes in the USA including the government transfers, often used till now to indicate the 'recovery'. Seems good! Good as long as we dont see the chart along with the rise of government debt. 

The chart below shows the state of Personal Incomes in the USA excluding government transfers. 

The chart is one that I guess our learned friends in the media and among the policy makers would like to think that did not exist. Unfortunately, our elected politicians donot have that luxury as they will learn in the next few months and years - if you dont believe me, ask Germany's Chancellor Merkel. She has stopped making public statements after the provincial elections wiped out their alliance due to a 10% vote swing. Rest assured her political career is likely to come to a spectacular end in the probably the next three years.

For long I have been in the deflation camp. I continue to believe, as I did for the past two years, that we are heading into a deflationary (at least over the next two years, if not more). Nor do I believe the hype about China, India and the emerging markets replacing the west as the major consumers in the present context. It will happen, but the argument is probably a few decades early. By the middle of this century, it is likely to happen but we are likely to be too old (and I am sure i will be quite senile to even think about the issue). 

Interestingly, if my argument is about a likely deflationary environment wrong, then I think it will be unique because the very fundamental nature of capitalism as we have known since the end of the Second World War will have changed - forever

Where are we in the Sovereign Debt Issue?

I am sure the predominant question that everybody would like to ask is the title of the post. So I thought it would be a nice time to take stock of the situation (NOTE: take stock is more of a metaphor). As usual i would like to give you some important statistics and ask a few important questions and then would prefer to leave it to the best senses of the read to come up with rational answers. The last part of the post will consist of some important scenarios that investors have to consider in the present economic environment.

Is the Sovereign Debt crisis winding down or at least are we seeing light at the end of the tunnel? One would only wish and hope that we could give straight short postive answers to the question. Unfortunately the only short answer is that we still have a long way to go. The reason for this negative brutally frank answer is clear. Despite all the rhetoric about the Greek package, Greece is only a small fringe player in Europe. That may surprise the passive observers of the economy. But anybody who follows the bond market will understand that the problems for Greece are only partly over and the problems for ther other countries, especially Spain and Italy are just starting.

The bond markets are likely to panic far more than the present (unless we have dramatic action by the world's central banks) in late June and early July because a number of countries have to roll over or repayment of substantial amounts of outstanding debt.

In the next five months the amount of debt that various countries in EU have to roll over varies from about 4% in the case of Ireland to about 9.7% in the case of Italy. EU as a whole needs to rollover or repay about 6.2% of its total outstand public debt.

The following statistics will probably place the issue in a better perspective (the total quantum of debt is given in brackets).

Italy needs to roll over 9.7% of total debt (which stands at US$1.4 trillion)

Portgual needs to roll over 8% of total debt (which stands at US$286 billion)

Spain needs to roll over 4.7% of total debt (which stands at US$1.1 trillion)

Ireland needs to roll over 4% of total debt (which stands at US$867 billion)

Greece needs to roll over about 6.2% of total debt (which stands at US430 billion)

UK needs to roll over about 4.4% of total debt (which stands at more than 848 billion Pounds)

The total outstanding debt is likely to be more than that cited above as most of the statisitcs are for total debt at the end of February-March 2010 while in the case of UK the outstanding debt is as on 18 February 2010.

Therefore the options that the Central bankers, especially ECB, have are rather limited. They (ECB) can either rollover the debt by printing more money and using the procceds to buy bonds or simply allow a default. The second option is inconceivable, especially on such a scale. So they will have to buy bonds and concurrently allow the banks to pledge any collateral, even if it has 100% likelihood of default being pledged with the ECB. Among the other smaller measures that the ECB will invariably take up will include a cut in interest rates (all the way to Zero - and they can still cut 1%: not bad) and providing the banks with unending supply of loans on very easy terms. This money will (after about 6-12 months) come back into the markets. But in the process the ECB would have only postponed the issue by that much time and would help create the mother of all bubble which will probably burst in about 18 months time - IF EU is able to weather the present perfect storm.

There are a number of scenarios that an investor would have to seriously consider. These are enumerated below. Though some of them are unthinkable at the present juncture, the more prudent investors should probably have an open mind about various options.

1. What would be the market reaction if the ECB were to announce Quantitative Easing by buying their own bonds (most of which are anyway near junk)?

2. What would the government do with their largely insolvent banking system? Till date sovereign debt was considered a risk free asset and its holdings went into the calculation of the banks capital adequacy ratio. Imagine if this were to happen in India: most of our public sector including LIC would be insolvent as they hold GSec's.

3. How to deal with the hitherto unthinkable: How would the market react to a collapse in the Euro (as it exists in its present form)?

Probably the Governments will ask their banks (or even better Goldman Sachs) to rig up the markets by buying all the indices and would ask JP Morgan and HSBC to keep selling gold futures so that people dont panic.

Deja Vu all over again.

Don't Stop Looking for the Exits

How many times have we heard the Policy makers emphasise that there is no crisis and that they are top of a situation? Their bland speeches, ad nauseam content is actually taking a toll on my health (though not the financial part, because I dont believe them anyway). In late 2007 and early 2008, we were told that the banks were safe and then were told that the bailouts were essential to save the financial system. Any discerning investor should have avoided investing in the financial sector (unless one was a speculator). Everybody loves a rally, especially the financial sector and the policy makers for the simple reason that for one (financial sector) they can profit immensely from the proclivities of investors who think this time is different; while for the other (Policy makers) capital is easy to come by during market rallies. They dont have to do anything. Rising asset prices give a false sense of capital buffer (as they did during 2003-2007 rally).  

This time is different. But, for the wrong reasons.

It is imperative to note that the basis of calculating the price of an asset is at best inaccurate or at its worst speculative. It depends on two parties making a lot of inferences about the future, which is essentially unknown. This could have remained at the realm of abstraction but for the fact that with fiat money and financialisation the financial markets cannot be ignored. In 2008 and 2009, the policy makers transferred private risk from the banks onto themselves by massive bailouts and by assuming more debt by attempting to reinvigorate the global economy. The money would probably have been well spent had they immediately forced the much delayed structural change that was needed. Instead, their thinking was based on only one assumption: hoping that private demand would come back. Unfortunately, that has not and now we are in the throes of yet another crisis: only this time it is much larger than the previous only. The postponement of a surgery only leads to greater problems down the line. 

I am reproducing two important charts. One chart shows that Europe is so interconnected that we have now reached the end of the road because till date various countries were only running a ponzi scheme.  The chart below shows the amount of debt that each country owes the other cannot and no way can they repay such large amounts. Add to this other obligations of the countries including those related to pensions, health, etc and the only way that a country can meet its obligations to all other stake holders is by defaulting on their loans. I believe that it is a matter of time before there is one form or another of debt default (or call it restructuring if you may).

The bond market is not going to like that and it would instead prefer that the governments' cut down on spending, which would hurtle the global economy into a deflationary spiral. But creditors will be big winners in such a scenario. I am quite sure that it is going to be disappointed in the long-term because the polity of west is not like China. Take the case of Greece: It has promised austerity measures that are nearly 13% of its national income spread over the next four years. If the government actually attempts to deliver on its promise then rest assured that the ruling party will not be elected for at least another 20 years. 

A candid confession to this possible outcome created a flutter in UK recently when Mervin King is supposed to have claimed that if the parties deliver on their promised reduction in expenditure then they will not be elected for a generation. 

The Second Chart (above) shows why the problem has just got out of hand. The banks in most of the countries are on the verge of insolvency. Hence the urgent need for the Greek bailout (and many more down the line).It shows that the banks of Europe have exponentially large amounts of money (nearly 150 billion Euros) to Greece and Portugal. Add to that the monies lent to Spain, Italy and UK. Compound that to the lending spree in Eastern Europe, Latin America and USA.

There is another short-term solution to the problem: create an even bigger bubble by pumping in more money. The interesting aspect that has been missed is that the very fundamental nature of Capitalism has changed due to the most recent crisis in the following ways:

1. State Capitalism now rules most parts of the developed world (OECD, India, China, etc)

2. Public Sector is the only game in town

3. The time duration between two recessions have been cut short: in the 1970s the next recession was 10 years, by the 1990s it was 5 years away and now it is probably 18 months to 2 years (or who knows may be even more)