The events in world markets over the past 36 months confirm that financial and political risk are far greater than we may perhaps expect.
The collapse of Lehman Brothers in September 2008 and the massive process of deleveraging and debt workout that started with the decline of US real estate values a year earlier indicates the role of financial system risks. Today, these risks have hardly been mitigated, even though stock market indices have recovered and economic growth has resumed:
· The United States is rapidly approaching a 100% debt-to-GDP ratio at the Federal level, with further unfunded liabilities at the state and municipal levels. The 2011 FY deficit is forecast at $ 1.5 trillion. With political deadlock in Washington, we believe that the US dollar risks a continuing erosion of value, while US inflation and interest rates will have to rise. Interest rates will have to rise to attract creditors; inflation is likely set to rise on the back of higher energy prices and a rebound in corporate pricing power. The Federal Reserve has purchased over $ 1.3 trillion of toxic, sub-prime mortgages; Fannie Mae and Freddie Mac currently own 1 in 4 US mortgages, many of which are non-performing. Apart from the advantages of seignorage and as a safe haven, there is no guarantee that the US itself will not come under pressure from bond markets.
· The Chinese economy risks overheating and potential collapse. Chinese growth over the past 24 months has been fuelled by over $ 2 trillion in low-interest loans mandated by the Chinese government, and extended through government banks. This has caused a massive overcapacity in manufacturing capacity, and although Chinese became the world’s largest exporter in QIV 2010, the profit margin on Chinese exports is typically less than 5%, while in exports of foreign manufacturers, the share of Chinese-produced value is low. There is no guarantee that China will be able to maintain its high growth levels into the future, and certainly not if the renminbi increases in value.
· European and western governments in particular continue to lose ground on core economic competitiveness. The fact that expensive social welfare systems can no longer be maintained without deficit spending, at the same time that demographic changes lead to irrevocable shortfalls in pension funding, indicate that absent drastic measures, the next 5 years will see most OECD countries hitting a debt:GDP ratio of over 100%.
· The toxic debt problem in European banks has not been fully solved, and has now been compounded by potential haircuts on government bonds. The fact that between EUR 700-800 billion on commercial property loans must be refinanced in the next 2 years, and that between 30-50% of all loans now exceed the value of the property assets they have been taken on, are indications that major financial turbulence lies ahead.
· The revolutions in Egypt, Tunisia and Libya are far from over, and may spread to Saudi Arabia. A political revolt in Saudi Arabia would cause a massive spike in the price of oil, leading to higher inflation and lower consumer spending in Europe and North America.
· A range of unresolved problems remains around the periphery of Europe. These include the simmering Kurdish war against Turkey; the temporarily-stable problem of Hezbollah and Hamas versus Israel; the uncertain fate of Egypt; the question of Iran’s nuclear programme; and the power structure in Russia. Any one of these situations has the potential for major short-term economic disruption.
In this environment, we believe it paramount that corporate and individual investors take active and rapid steps to analyse the specific risks which confront them, and take active measures to mitigate these risks. Among the risk scenarios to prepare for include:
· The prospect of a bank collapse in Europe. The leading indicators will be an announcement on the European Financial Stability Fund (EFSF) future, as well as movements in the European Central Bank’s repo window loans to banks. German, Spanish, Italian and UK banks are among the major countries where toxic loans on bank balance sheets remain, and where the only source of stability is the implicit sovereign guarantee and emergency liquidity by the ECB. Investors should take active measures to investigate risks in pension plans and bancassurance policies, and consider changing providers as a means of risk mitigation.
· The prospect of rapid movements in the Euro, UK Pound Sterling and US Dollar. Investors with loans in other currencies, e.g. Japanese Yen or Swiss Francs, may face rising loan costs if their main income is denominated in USD or EUR.
· The prospects of rising taxation as the American and European governments attempt to deal with a dramatically-declining macroeconomic and fiscal situation.
· The possibility of a change in real estate values, which so far have remained buoyant in urban markets such as Paris or London. Measured in terms of annual salaries : property values or salaries : mortgage values, it is difficult to see how property values will continue rising at historic rates, particularly once new taxes and austerity programmes are levied.
We would also not discount the possibility of a dramatic contagion in public debt to certain Eurozone countries, in particular Italy and Belgium. Both countries are characterised by political paralysis, political fragmentation (requiring consortium governments) and ethnic or regional tensions. The debt of both is currently over 100% of GDP, and we are certain that there is undeclared debt which is not on the central governments’ books in either country.
For companies or individuals in Greece and Cyprus: we believe there is an 85% change of a debt restructuring and haircut on Greek debt by 2013. Investors with exposure to Greece and Cyprus should be extremely careful, in particular of their banking choice. Greek and Cypriot banks are heavily invested in Greece, have a relatively high share of Greek government bonds on their books, and have lent extensively to Greek semi-governmental organisations. Besides the recession in Greece, which is leading to a higher ratio of non-performing loans, it is unfortunately clear that the major banks are exposed to a Greek debt restructuring.
We firmly believe that the emerging situation in Europe as regards political and financial risk is in fact not over, but is just beginning. While attention has been concentrated on peripheral markets such as Greece, Ireland and Portugal, we consider these to be an early warning of the competitive, social and demographic problems which affect far larger markets. Apart from the UK, we see very few real efforts at structural reform—including in Germany, where we see a political coalition which is increasingly fragile, and an export-driven growth which is unsustainable.
© Philip Ammerman, 2011
Navigator Consulting Partners LLP