That public and private debt in the developed world is colossal and astronomical is something that only the naive and politicians can doubt. But it seems that some have become accustomed to living with more zeros in their debt figures than they are capable of reading, and they overlook a fact that is terrifying despite its simplicity: the higher the debt, the lower the solvency. The following chart shows historical total debt as a percentage of US GDP.
The fact that neighbouring companies and countries are also up to their necks in debt gives us a false sense of solvency. A mirage that will vanish under the harsh blows of reality as soon as mistrust deteriorates even slightly. We won’t need to see a repeat of the mistrust that prevailed in the second half of 2008, nor an Argentine-style «corralito’ in the European periphery – no. This time, a mere dip in confidence will be enough for the precarious situation to trigger extreme volatility in risk premiums – and therefore in the valuations of corporate and developed-country debt in general – which in turn will trigger even more destabilising insolvencies. We warned of this almost a year ago: “Be careful with fixed-income investments«, which has essentially come to the fore, because its cumulative overuse, together with QE1 and QE2 as virtually the sole source of demand, could trigger unprecedented movements in its prices (and in the chain reaction affecting the solvency of its holders).By contrast, fixed-income securities issued by governments and companies in emerging markets face a much brighter future. The growth of their economies and their low levels of debt (particularly when compared with those of the developed world) mean that, through careful and meticulous selection of issuers, we can continue to expect attractive returns from fixed-income investments. However, volatility is bound to be a feature of the coming years, as developed-market fixed income will become increasingly turbulent, whilst emerging-market fixed income has always been more volatile due to its intrinsic characteristics, as we can see in this chart comparing the two before and after the 2008 crash.
We are therefore facing a scenario in which the traditional «safe haven» of our portfolio – fixed-income securities from developed countries and companies, characterised by low volatility, high creditworthiness and steady, moderate returns – has disappeared, even though many have not yet realised it. Because of this failure to recognise the real risk involved, many investors continue to confidently buy deposits, subordinated debt, guaranteed products or bonds issued by companies or governments that are up to their ears in debt, which will suffer unspeakably at the first sign of a squeeze on refinancing or a tightening of the credit market. In other words, as soon as confidence deteriorates once more – for it is only confidence, along with the desperate measures of politicians who are themselves teetering on the brink, that maintains the current fragile balance between debt giants and outright insolvency.
The million-dollar question is: where is that safe now in which to shelter money that must not suffer losses or volatility? Unfortunately, the closest thing we are likely to find at present and in the near future is a good selection of emerging-market fixed-income investments. But if we accept that the absence of volatility is a luxury of the past that won’t return for many years, and that what truly concerns us is not the return as at 31 December but the growth of our money over half a decade, a decade or more, a good selection of equity fund managers capable of consistently and sustainably outperforming the market will preserve our money in the best possible way. This is borne out by history in the face of critical systemic events such as Argentina’s default, as you will see in this chart.
Look at what happened to Argentine bondholders over the past decade (blue line, right-hand scale) compared with the returns earned by stock market investors (the Merval index, red line, left-hand scale). As Paramés rightly said at his recent annual conference, in the face of exceptional crises, the best way to preserve your money is to invest it in excellent assets closely linked to the real economy. And there is nothing closer to it than shares in excellent companies with global operations, bought at a low price. At a conference we recently held in FEMEVAL (the contents of which you can view at here) in which we were discussing these risks associated with developed-market fixed income, a participant asked a question during the Q&A session, asking us to confirm – for his own peace of mind – whether bank deposits and bank-guaranteed products were immune to this risk of fixed-income insolvency. It’s curious to see how ordinary investors continue to place blind trust in their banks, believing they will walk on the waters of fixed-income insolvency just like Jesus Christ himself. But unfortunately, NO. IPFs and other bank-guaranteed products have even lower creditworthiness than the general average for developed corporate debt, whatever their (increasingly impoverished) ratings may say – ratings which are mere assessments that have proven to be corrupt and incompetent. Yes, I know, it’s true that the State has been far more protective of the banking sector than of other private companies. In other words, whilst it won’t lift a finger to prevent corporate debt from defaulting, it will try to keep the financial system afloat, as the state and the local financial system are in the same drifting boat. However, we must not forget that we have sunk so low that it is, to say the least, difficult to discern whether the state can save the banks, or vice versa, or neither, but quite the opposite.
Therefore, given the failure of bank guarantees (IPFs and other guaranteed products), the fallback option that ‘Big Brother’ the State will come to the rescue beyond the deposit guarantee scheme is no longer viable; this scheme is nothing more than a ridiculous and tokenistic stopgap in the face of the tsunami of latent insolvency. And the public ‘wild card’ no longer works simply because the state is as insolvent and hyper-indebted as any other, and the hot potato has been in the hands of the ECB and its US, UK and Japanese counterparts, etc., for some years now. These are the only bodies potentially capable of creating «apparent public »solvency’ based on banknotes. And frankly, it is preferable to lend the money to another, more creditworthy borrower, or, at worst, to one whose insolvency would not have to be bailed out by a central bank such as the ECB, which has so many multinational fires to put out across the EU’s periphery.
The chart above shows the performance of a brilliant asset management strategy focused on the real economy, compared with one based primarily on fixed income. If we consider a decade such as that shown in the chart above, with two market crashes or bursting bubbles – the tech bubble of 2000/01 and the credit bubble of 2008 (a highly exceptional occurrence in less than 10 years) and a calm decade for fixed income—which has been exceptionally strong over the last two years—the comparisons are stark. Therefore, if we envisage a future decade that is less volatile for equities and more risky for fixed income, the conclusion is overwhelming, albeit novel and more uncertain than ever, as it contradicts the traditional asset allocation of most ordinary people. Preservation – the safe in which to shield our money –, cheese, or whatever we want to call it, It has changed both location and form. That’s just part and parcel of the New Normal.
Today it is Bill Gross who is shunning US sovereign debt because of the danger posed by the fact that it is held almost entirely by the Fed itself, but tomorrow it could be yet another – and final – wave of European insolvencies. And in the midst of this credit crisis, heavily indebted multinational corporations may struggle enormously to refinance their operations. It is to be expected that not all of them will succeed, which in turn will lead to a further decline in confidence. Let us not forget that, unlike liquidity, Confidence cannot be instilled through quantitative easing, particularly in the private sector. That is where the bottleneck caused by the erosion of confidence in a heavily indebted ecosystem will demonstrate that developed-market fixed income is no longer ‘fixed’, nor is it even ‘income’. It is time to turn our attention to the only fixed-income market that remains solvent – that of the emerging world – but above all to assets closely linked to the real economy, such as global equities. And we must position ourselves within them brilliantly, as this is the only guarantee of success in the medium and long term. But to do so, the old, traditional compasses are no longer of any use to us; instead, we need a competent guide who is capable of leading us to a successful outcome through a fresh and accurate interpretation of the minefield that lies before us. Today more than ever, our money must be in the best possible hands, because we are venturing into hostile territory. An unfamiliar scenario in which mediocrity will no longer mean merely subpar performance, but a fatal outcome in the medium term, given the limited scope for confusing risk with volatility or security with insolvency.
Charts: Cluster Family Office