The Wall Street Journal headlined the close of trading on Friday last as, US Stocks Close Lower as Worries About Greece Grow. It seems that the markets are finally on par with a reality that I have espoused with much conviction in this space for well over a year now. That reality is that the level of Greece's debt is unsustainable and that default, technical or otherwise is the only real option. While there was a fair bit of research that went into that call on the face of it there was little "rocket science" involved. Tax evasion in Greece is almost a national pastime, the debt burden is exorbitant, it could not devalue its currency because it has no control over the level of the euro, interest rates were already low and the austerity measures required to balance the budget were pro-cyclical in that it simply exacerbated the downturn as spending was cut and wages frozen. For a time it was felt that the problem could be solved by lending Greece more money (the bailout from the International Monetary Fund and European Union) which would have provided the necessary funding to allow Greece to stay out of the financial markets for a couple years.
Still that debt had to be repaid as well and so Greece is now at a situation where its two-year bonds are yielding around 25 per cent and the markets are saying "no mas." Let's see if over the coming weeks the European authorities will find another mechanism to kick the can further down the road or whether the inevitable debt restructuring will begin. Either way, my investment strategy at the start of 2011 was envisaged on this year being a mirror image of 2010 and five months into the year this is exactly how it is playing out. In 2010, the global stock markets started off in buoyant fashion and it was felt that US treasury yields could not go any lower and so the trade was to invest in stocks and get out of bonds.
Global growth slowed
By April of 2010, Greece, which this column had warned about at the start of 2010, hit the headlines and the markets sank. Global growth also began to slow with the uncertainty in Europe, leading to what was then QE lite on the part of the US Federal Reserve. This was eventually turned into a second full blow liquidity programme, known as QE2, giving a boost to the equity markets towards the end of the year causing bonds to sell off once again and the ten-year US treasury ended the year just about where it started. So far for 2011, the trend has been the same. The stock markets have been on a run since the start of the year, but as gross domestic product (GDP) growth has shown signs of a slow down and the problems in Europe rears again the stock markets have been to waver.
The "flash crash" of April 2010 has been matched by unprecedented one day moves in silver and crude oil and as risk has come off the table US treasuries have rallied a bit as investors seek the safe haven asset. This has lead to a rally in the US dollar against the major currencies of the world, this despite the fact that most countries have began to hike rates while the US is still in a very accommodative mode.
For the record, even though it is not yet the mainstream view, I am confident there will be another liquidity programme (QE3) over the next 12 months. The above analysis may be interesting in its own right, but just as Greece was the prediction for 2010 that is now on the frontburner, the prediction for 2011 is still lurking in the shadows and when (not if) it blows it will take many by surprise.
Japanese sunset
At the beginning of this year, I cited Japan as the biggest risk to the global economy going forward. This was long before the earthquake, tsunami and nuclear disaster. Since that article, Japan suffered a credit rating downgrade, but that aside it has not had any material effect on the global economy. However, some small cracks have began to show where for example US GDP for the last quarter was negatively impacted by the slowdown in the car manufacturing industry as there were problems in getting supplies out of Japan. It is my view that those problems will continue to loom large and represent just the tip of the iceberg. Consider that nuclear power provides about 30 per cent of Japan's electricity and that this was supposed to grow to 50 per cent by 2030 prior to the earthquake. The current shortfall in Japan's electricity needs is around 12 per cent and there are not many short term avenues to make up this difference. Further industrial production in the post earthquake scenario has fallen to levels last seen in 1987.
This, of course, would be expected given the scale of the catastrophe, but the problem is that Japan went into this crisis with very little wiggle room available. As I had stated at the beginning of this year, Japan's economic metrics are unsustainable and given that this is the third largest economy in the world, it is a cause for concern for if Greece, which represents just about 2.0 per cent of the European union can destabilise markets imagine what can happen with Japan. It is important to understand the dynamics regarding Japan today because there are a number of similarities of Japan ten years ago to the US today. How the story unfolds is going to be critical for the global economy and for investors. During the decade of the 1970s and 1980s the Japanese stock market returned 10.5 per cent and 19.5 per cent, respectively.
However, over the last two decades, the markets have been down between 6 and 7 per cent for each ten-year period. Over the past 20 years, interest rates have been near zero and nominal GDP has not gone past 1 per cent. During the last 20 years, the losses in the stock and real estate market has wiped out around 1,500 trillion yen, which the Japanese government has sort to replace by 2,000 trillion yen worth of stimulus. This is not very different to the current story in the US where the fall off in the stock and real estate market has been countered by fiscal and monetary stimulus in an attempt to reflate asset prices.
Unsustainable debt
The key issue is the transfer of the debt burden from the private sector following from the stock and real estate crash into the balance sheet of the government. In 1996, the net debt to GDP ratio of Japan was 29 per cent, the US for the record was at 52 per cent. Net debt excludes the debt that the government owes to itself and is a better measure than total debt to GDP. By 2000, the metric in Japan stood at 60 percent, rising to 85 per cent in 2005 and 120 per cent in 2011. The US currently stands at around 75 per cent. Appreciate that the level of debt in isolation is not a cause for concern. The issue revolves around the revenues that are available to service the debt. The reason why Japanese debt has been rising so rapidly as a percentage of GDP is because Japanese debt issuance is almost twice the level of its revenues.
At the end of 2010, more than 55 per cent of revenues went to service the interest expense on Japanese debt. This is the situation in a zero interest rate environment. With an ageing population, all of Japan's revenues are taken up in meeting interest and social security obligations. The tipping point is rapidly approaching and the evidence of this comes in the changing of the maturity profile of Japanese debt. In 2006, treasury bills (short-term instruments) accounted for around 13 per cent of total debt. By 2010, that number has jumped to 18 per cent indicating that there is less demand for longer term debt issuance. To put this into context, the current yield on the ten-year is 1.2 per cent. If such a low rate is not providing a sufficient incentive to investors, then rates will have to rise, but it is clear that Japan will not be able to afford the interest cost of higher rates. As the population ages, the savings rate decline and pension assets are sold off for consumption, Japan will have to look to the external markets to purchase its debt. This dynamic will play off in the coming years and this is when the problems identified will come to the fore.
Ian Narine is a broker registered with the Securities and Exchange Commission