Europe is a mess.
Greece is broke. Investors no longer believe that big countries like Italy and Spain are certain to repay their debts. This is a crisis of confidence, it is contagious, and it is bad for investors.
In this article I will explain the source of the European debt crisis, outline the pain that Europeans and Americans are likely to feel, and suggest implications for investors.
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How did Mercedes get to be so cheap?
The problem in Europe is not just the outrageously high levels of debt, but also the currency union that makes it impossible for Greece to become a cheaper place to visit when their economy tanks.
Have you wondered why German cars are now so astonishingly competitive with Japanese cars? When did making stuff in Germany become so cheap?
I keep selling, you keep buying…until you blow up.
Those uber-efficient Germans make more stuff than they consume, so they are net exporters. The PIIGS, including Italy, Greece, and Spain, do more consuming than making, so they are net importers. Needless to say, this isn’t sustainable.
I cannot keep selling you stuff forever, while you keep buying forever, without you eventually blowing up.
Before and After the Euro
Before the Euro, balance could be restored by drachmas becoming cheaper relative to deutschmarks, driving Greek labor costs down relative to German labor costs. Jobs move from Germany to Greece, more stuff gets made in Greece, and balance is restored.
After the Euro created one currency, it became impossible for German goods to become more expensive in Greece. In effect, Germany got the benefit of being able to sustain its exports, and Greece got the benefit of being able to borrow at cheap German rates to finance all of their imports. But if something is unsustainable, it is unsustainable.
The Blow Out
The blow-out is happening now, with Greek debt so huge that investors no longer believe that they will be repaid.
Unfortunately, crises of confidence tend to spread. This crisis is spreading from Greece to Italy and Spain. Italy is the 10th largest economy in the world, about 7X the size of Greece. As the Wall Street Journal just reported, Italy is having trouble marketing its bonds.
Let’s take a look at the government debt the developed world has amassed:
Government debt in the developed world as a percent of GDP
(By the way, anyone looking at this chart might have noticed Japan’s 213% debt to GDP ratio. That is not a typo, but will have to be addressed in a future email. The only thing I’ll say here is that Japan’s stock market is still down more than 70% from highs in 1990.)
How did this debt happen?
During a recession, central banks lower interest rates, making it cheaper for companies to fund new business ideas. This creates jobs.
After a recession has passed, the central bank is supposed to raise rates again to prevent excess borrowing. For the last 30 years, rates have been lowered often, but raised rarely. As rates dropped, debt became cheaper and cheaper. Surely anyone would borrow more at 2% than they would at 10%. Think of all the stuff you can do with cheap money!
US total debt (gov’t + corporate + consumer) vs 10-year bond yields:
The squiggly line going down is the interest rate paid on the 10 year government bond, as reflected on the right axis. The steadily rising line is total debt, measured in $ billions on the left axis.
Source: Bloomberg
Rich, trusting foreigners
The problem with low interest rates and endless borrowing is that it ends in tears. All of a sudden, in some mysterious crowd phenomenon, confidence evaporated that Greece would ever repay its debts.
When you owe 132% of your entire annual national output, mostly to foreigners, you are in big trouble if your source of rich, trusting foreigners dries up.
Greece is now on German life support. The Greeks are no longer in control of how this story ends.
Leaving the Euro
I’ve seen reporters bat around the idea that Greece might leave the Euro. One tiny problem: there is no provision in the European Monetary Union for leaving. Greece would have to go hat in hand to every member country, most of whom it owes money to, and ask them to ratify a Treaty change to add an opt-out clause. This would take years.
If Greece were to suddenly and illegally leave, they would have some problems, starting with food and electricity. Greece imports 70% of its electricity. How would they pay for it, with “new drachmas”?
The reason Greece, and shortly Italy, are in this mess is because they don’t make enough stuff at home. Unilaterally leaving the Euro could lead to darkness and starvation. Needless to say, the Germans can’t have a bunch of hungry, angry Greeks running around Europe, so they are currently propping up this tiny economy, sized about 10% of their own. But Germany can’t rescue everyone.
Germany’s debt to GDP ratio is almost 80% at this point, and Italy is big – about $2 trillion in GDP vs German’s $3.3 trillion.
What happens next is uncharted terrain.
Over the course of the next year or so, we will see more failed bond auctions, where large countries such as Italy and maybe Spain are unable to roll their debt over without the support of the European Central Bank, which really means Germany. The debt rollover doesn’t stop either – more government debt just keeps coming due.
If Germany buys this debt at below-market prices, they will simply be transferring the burden to their tax-payers, just as the United States did during the 2008 credit crisis.
The truth is that the Euro crisis puts us on uncharted financial terrain. We know what happens when third world countries blow up, such as Thailand in 1997, Russia in 1998, or Argentina in 2002, to name a few. They devalue their currencies, start fresh, and reestablish their credit rating after a terrible 1-3 year recession.
We really have no experience with large, heavily-industrialized countries undergoing a crisis inside a monetary union that is collectively the world’s largest economy.
A decade of austerity
My guess is that we flounder our way into a worldwide semi-recession lasting a decade, after which the European Union will be a true fiscal union, and the United States will be running a 3% budget deficit with a 130% debt to GDP ratio, which is high but survivable.
Thanks to their deficit reduction efforts, the UK is the first big economy to experience the pain, with standards of living falling 3.5% in one year, and the bad news set to last a decade, per the Financial Times of September 12: Cuts to hit UK households for a decade, IFS says. “As governments attempt to repair their public finances, household incomes now look set to be squeezed for a considerable length of time.”
The arithmetic behind the pain
We can use some simple arithmetic on the US economy to easily understand the cost of deficit reduction. First, the facts for 2011 in trillions of dollars:
- 15.0 is the 2011 US GDP. Non-economists can think of this as roughly the total of personal income plus corporate profits.
- 3.8 is the US Federal Budget (expenses)
- 2.2 is US Federal Revenue
- -1.6 is the Budget Deficit (expenses minus revenue)
Our government is bringing in 2.2 and spending 3.8. That means we are borrowing 42% of the cost of our federal government.
We have almost twice the government that we can afford. Whoa!
Balanced budget = food riots
If we were to balance the budget tomorrow, we’d be cutting 1.6 out of 15, which would mean unemployment in the low twenties, and food riots.
If we adopt a glide path that shrinks the deficit over 8 years from 11% of GDP to a more sustainable 3% of GDP, then we will be taking $160 billion out the government every year. That’s a lot of unemployed people. Do you think they will all find work in the private sector?
Both parties agree
Both the Obama and Republican 2012 budgets call for a reduction from this year’s $1.6 trillion deficit to a seemingly reasonable $1 trillion. This is $600 billion that won’t be spent, which is 4% of the entire US economy. Will the private sector pick up the slack?
Deficit reduction in the teeth of a recession is tough, but it is better than becoming Greece in 5-10 years.
The worst case in one short paragraph
Worst case for Europe is that the taxpayers of Germany and France reject the idea of propping up the PIIGS, the PIIGS reject the austerity measures necessary to prevent default, credit freezes up as banks stop loaning money to each other, and the crisis spills over into the United States, causing a cascade of bank failures here and pushing us into a deep recession.
I think our leaders are smart enough to avoid this catastrophe, but there’s no getting around the pain of deficit reduction.
The challenge for investors.
This is all pretty grim news.
Investors with portfolios consisting of mostly US large companies have already had a terrible decade. While Ross Asset clients in small-value and emerging markets had very good returns, my sense is that every asset class will face challenges as governments worldwide grapple with reducing budget deficits in the face of a worldwide semi-recession.
The problem is simple: reducing budget deficits means reducing consumption, which reduces corporate revenues and profits. This in turn reduces the value of corporations to shareholders.
If shareholder returns are lower.
If shareholder returns are likely to be lower for 10 years, then the expected returns from owning stocks is lower. The only way to improve your personal returns is market timing (risky) or increasing fixed income yields.
Given the massive uncertainty and high stakes of the current situation in Europe, I’ve lightened up on equities for myself and my clients. This is a fairly uncharacteristic bit of market timing for me, but the future is so uncertain and the various alternatives so equally painful that I felt I had no choice.
If near-term wealth preservation is of primary or high importance to you, then now may not be a good time to own the same level of equities as you have owned in the past.
Fixed income yield
On the fixed income side, I’m looking to alternative asset classes to increase yield above the very low rates available in municipal and federal bonds. One example would be consumer loans serviced by LendingClub.com.
As with any move you make, be sure to place a premium on diversification. Now is not a good time to have your eggs in one basket.
Cash
There is also nothing wrong with holding more cash than usual for the next little while, as we see how things develop. Perhaps there will be a further decline in equities, and buying will get much more attractive sometime in the next year than it is today. I hope to capitalize on this.
Balancing it all out
The economic period from 1980 to 2008 has come to be called The Great Moderation. Now we know that this Moderation came at a cost: unsustainably high deficits that may result in a decade or more of economic pain.
Building wealth today is possible but not easy.
If you are still working, then try to avoid an extended bout of unemployment. If you like your job and it offers decent prospects, you will be well-positioned to weather this instability with your retirement opportunities intact.
If you are already retired, then you will need to be nimble and creative to get through this period. Remember that fixed income yields have fallen considerably, and models that use average yields from the last 20 years for both fixed income and equities may overstate your expected returns, putting a squeeze on your principal if you stick to your desired drawdown schedule.
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Additional Reading
- In Is Capitalism Doomed, NYU Professor Nouriel Roubini puts his spin on our problems and some solutions. Roubini because famous for predicting the 2008 crisis in some detail back in September of 2006.
- Endgame by John Mauldin (March 2011) is a book that lays out the current sovereign debt crisis in very readable detail.
- Why Ross Asset – RossAsset’s boutique approach combines investment science with macroeconomic trend assessment.