Just this week, our friend Marc Garrigasait (who, by the way, has just launched a new fund called Panda Agriculture & Water), this article on Cotizalia, which includes the interactive chart I’ve linked to at the end; although it’s somewhat outdated and inaccurate, it provides a very revealing insight into the current state of global solvency.
A few voices such as Bill Miller's are beginning to dare to say what we have been warning about for years in articles such as «The Flight to Quality in Solvency«: that risk has taken hold of what was traditionally considered the Holy of Holies in terms of safety, that is, fixed-income securities from the most developed countries and companies. And that includes, of course, all products guaranteed by the banks (such as companies with bankrupt balance sheets), ranging from deposits to the bank’s own debt in all its forms, or the more or less Machiavellian structured products. In other words, the rules of the game have changed and What used to be safe now carries a risk – and a significant one at that. Because let us remember that the risk involved in investing in an asset issued by an insolvent fixed-income issuer is that of a definitive, irrecoverable loss. And the developed economies are sitting on a bubble of public and private debt that is a frightening Debt Bomb. Anyone who says that this amounts to spreading an unfounded politics of fear is a liar, a naive person, a lazy person, a mediocre person, a reckless person, or a – naturally explosive – cocktail of several of those ingredients.
It is of vital importance to determine unequivocally where solvency stands in the current ‘New Normal’, as portfolios that are less exposed to high stock market volatility should rely on investments more permanent, but whose financial standing is beyond doubt. Otherwise, the more fearful and cautious investors who decide to avoid share price fluctuations by putting their money into fixed-income securities and other «guaranteed» products would, in reality, be putting their money at risk of permanent losses – that is, irrecoverable losses. Just ask Argentine or Greek bondholders, who have never recouped – nor will they ever recoup – their losses, unlike the stock market investors in those same countries.
Does all this mean that we will only find security in equities? No. Equities, in itself, does not determine its intrinsic risk. It may be safe or risky, depending on how accurately we analyse the true value of the shares we buy in relation to their price. And to ensure that our returns outperform the market in the long term, we must invest in the world’s best equity fund managers, as we have repeated ad nauseam in various articles. Only in this way can we regard investment in equities as safe, that is to say, without the risk of incurring permanent losses, only temporary ones. This phenomenon, which forces us to accept potential short-term losses, is called volatility, and has nothing to do with risk – the risk of permanent losses – which is what every investor should be most concerned about. Therefore, even whilst accepting potential short-term losses, equities are now more than ever a safe haven worth considering for preserving our wealth.
However, not all investors, nor all investment portfolios, are necessarily prepared to put up with the volatility inherent in equities. Fortunately, there is still a part of the world where debt issuers are solvent – in other words, safe. And these are none other than the so-called emerging markets and companies, whose volatility currently lies somewhere between that of the traditional fixed-income markets of yesteryear and that of the stock market. In other words, we will also have to accept potential short-term losses, but these will be more moderate than with equities, and can also be recouped over somewhat shorter periods of time.
Why is emerging-market debt more creditworthy than developed-market debt? Well, logically, because their debt levels are lower and their economic growth is higher. In other words, their balance sheets – whether they are countries or companies – are in better shape. And let’s not forget that Lower current levels of debt, coupled with rising economic figures, also point to even greater future growth – and therefore future solvency (until, unfortunately, the abuses and mismanagement of their governments or leaders lead them into the same situation as ours; yet even today they still have an enviable and highly promising future ahead of them). Just as, conversely, increased debt issuance – for example in Spain – condemns our future generations to recession and fiscal stranglehold. In other words, the vicious circle in which the peripheral European economies – and, to a lesser extent, the rest of the developed economies – are mired is, by contrast, a virtuous circle in an emerging and growing economy, be it a country or a company. And these high-quality emerging-market fixed-income assets, despite any potential price falls we may see in the short term, are the main safe haven (alongside a sound share portfolio) that investors should seek out in these times.
Let’s take an example: So far this year, US fixed-income funds have lost (due to expectations of a scaling back of US accommodative monetary policy – QE) approximately between 1% and 2%. And emerging market fixed-income funds have fallen by approximately between 1.5% and 3% over the same period. However, the Solvency The risk associated with US bonds is much lower than that of emerging-market fixed income, not to mention the political risk posed by decisions taken by the Fed, which have a decisive influence on the price at which US bonds are traded. In contrast, with emerging market debt (provided well-managed funds are chosen), creditworthiness is its main asset. It is true that in periods such as the present one, the volatility of emerging market debt is higher and prices are falling further in 2013, but in the medium and long term we should, above all else, prefer to lend our money to creditworthy issuers, despite any short-term price fluctuations we may experience. Furthermore, we must remember that, at present, the coupons paid on emerging market debt are still higher than those on developed market debt, meaning that past and likely future returns are much higher than in the saturated fixed-income markets of developed countries.
Obviously, other assets can also offer a degree of safety, such as property investments in growing (emerging) markets, or – on a more speculative note – physical precious metals (be wary of metal warrants, which are already starting to trade at a discount to the physical metal… but that’s a topic for another article). But beyond this, we would be recklessly venturing into uncharted territory and debt instruments from high-profile issuers, which will soon wipe out the wealth of those who fail to adapt and make the leap towards solvency in this New Normal. Only the desperate pursuit of solvency must be our guiding principle in the times we are facing. And anyone who, fleeing volatility and potential short-term losses, recklessly parks their money in deposits and developed-market fixed income, will in fact be risking the permanent loss of a significant portion of their fortune.
Here’s the chart I promised from Marc’s article. Have a play around with it and take a look at how public and private debt has evolved in each country individually. And bear in mind that the figures for Greece are obviously incorrect, and those for Spain aren’t up to date following the bank bailout, which has already pushed us past 100% of GDP and counting… At a glance, it’s clear to anyone that our money would be safer invested in the debt of the countries closest to the lower-left quadrant, which essentially coincide with the so-called emerging economies. I recommend that you pay particular attention to Russia’s trend and current situation:
Interactive chart: Debt Dynamics, via the Wall Street Journal