Forget the flotsam and jetsam of the great financial crisis for a few minutes.
Yes, that's right; ignore the millions of unemployed people around Group of 20
nations; the debt piling up for taxpayers to see off in perpetuity; the
hundreds of idling ships in the world's ports and the hundreds of thousands of
forever vacant plaster-board houses dotting the landscape. Instead, as behoves
a time of the year when people traditionally look back and ahead, consider the
winners of the year.
When I wrote We
are all Japanese now (Asia Times Online, September 5, 2009), even I
hadn't realized quite how completely the transformation had taken hold of world
markets. Recent events such as the bailout of Dubai World and the goings-on in
the world of sovereign debt signify a dramatic shift in world financial
markets, favoring asset-rich borrowers with strong cash
flows over ideas-rich entrepreneurs.
Disclaimers for asset managers and funds typically state something on the lines
of "past performance is no indication of future returns"; but that pertains to
the laws of probability - in other words, just because a fund manager does well
under a particular scenario is no indication that the strategies would work in
a different environment.
Bank the buck
The lack of such a disclaimer is what defines this year's winners. For they did
not get to be successful by having any special talents, any significant factor
advantages or indeed even a fortuitous turn of fate. They have been, to the
last one, those who have had the right connections and played them out for
whatever they were worth.
Whether it was the big American and European banks that used their government
connections to secure (often illegal) bailouts at the expense of taxpayers in
2008 only to quickly hand them back when the "financial component of the
crisis" ended earlier this year; the big asset managers who have been appointed
to chaperone troubled assets purchased by the government in their rescue of the
above-mentioned banks; the insurers who managed to selectively tear up
inconvenient insurance contracts even as they benefited from government
largesse on the other hand; the increased costs of doing business as a borrower
or investor that has been facilitated by the government bailouts of select
financial institutions; the self-serving financial restructuring plans for
individuals and businesses that ended up benefiting financial institutions
instead; every step that has been taken by the US and European governments this
year has been to the benefit of their large financial institutions.
Comically, at the end of the year, various governments decided to take a stand
on the bonuses being paid to bankers; as always the Keynesians seek the wrong
remedial actions after first applying the wrong medicine to the wrong
diagnosis. Nothing will come of it, for bankers are now emboldened beyond mere
problems with moral hazard, a curious result of what was essentially an
avoidable crisis.
Banks have become more risky, more leveraged and pose greater risks to the
world economy now than at any time in history. Encouraged by their new owners
in government, banks have piled on more dubious assets to their books during
this year, with a view to propping up secondary prices of these instruments, in
turn benefiting their own holdings of hard-to-value assets.
Bring on big government
The second major development of the year is the increase in government debt
around the world. With a decline in consumer and investment spending as a
natural fallout to the credit crisis, governments around the world embarked on
expansion of their spending; with a view to dull the impact of the recession.
Higher spending has been the norm, rather than lower taxes. As a proportion of
gross domestic product, it was China that opened up government purse strings
the most, although this was disguised as increased lending from the banks.
Other governments soon followed suit, ranging from other Asian countries such
as Japan and India to the United States and European countries.
Somewhere along the way, it would have been a good time for investors to stand
back and ask "exactly who is going to pay for all this?", because on a gross
basis, the world has run out of savings with which to fund rising government
debts.
That is the reason the biggest buyer of US government debt this year wasn't
China or Japan, but rather the US Federal Reserve itself. In other words, US
dollars are being printed at a record rate in order to fund the US federal
deficit. In an ideal world, Keynesians wouldn't have been allowed to get away
with such nonsense. Interest rates would have increased massively and
confidence in the US financial system would have diminished considerably.
Instead, thanks mainly to the sheer volume of global excess capacity, that is,
deflationary forces, the volume of money printed by the US Federal Reserve has
basically helped to offset normal market logic. Plenty of cracks showed through
- such as the little fact of inverse correlation between US stocks and the US
dollar (that is, as the dollar fell, stocks rose) and more importantly, the
rising price of gold.
Big brother
The big debt machine chugged along nicely through the second and third quarters
of the year as ample liquidity from various central bank programs, money
printed to purchase government debt and excess savings from Asia helped provide
demand for the vast supply from around the world.
Then suddenly in the fourth quarter, the cycle juddered to a halt as a number
of previously tethered naval mines came undone from their anchors and started
bobbing into the shipping lanes of global debt finance.
The goings-on in Dubai appeared merely a test case as a number of smaller
European countries received adverse attention from rating agencies as well as
debt markets. Some, like Greece and even Ireland, appear destined for a
gut-wrenching series of debt workouts, perhaps with the tender loving care of
the International Monetary Fund. Other European states like Portugal, Spain and
Italy may take a while to get to their days of reckoning, although from purely
a fundamental debt perspective, I am hard-put to recognize how these countries
could ever evade a painful restructuring.
The key benefit of being in Europe is that countries get to send their
collective bills to stronger economies, such as Germany and France. In
particular, Germany has been the model of a strong partner, in effect bailing
out smaller debt-ridden European nations through the refinancing window at the
European Central Bank (ECB).
However, when it emerged that a bunch of Greek banks had been misusing the
refinancing facility in order to bump up their returns, buying a boatload of
local government debt at 4%, refinancing with the ECB at 1% and pocketing the
difference, this was a bit too much for the staid ECB to tolerate; and when the
Greek banks were put on notice, it became apparent to the still-clueless people
at rating agencies that without the "captive" purchases of Greek banks it would
be virtually impossible for the government to refinance itself.
What makes the Greece story really interesting is the very obvious evidence
that the rating agencies and bond investors have learned precisely nothing
from the travails of the market from 2007 to now. The Greater Fool theory of
investing remains at the forefront of market movements, and woe betide anyone
who decides to play outside the sandbox.
All that said, the most painful case of debt restructuring in the developed
world would likely be the United Kingdom. Here is a country that has lived far
beyond its means by borrowing heavily during the period of economic surplus for
the past 10 years. It was hit very hard (and early) during the financial
crisis, as I wrote two years ago (see
Rocking the land of Poppins, Asia Times Online, September 22, 2007),
and appears to have compounded the errors made prior to the crisis on financial
supervision with measures subsequently designed to expand government stimulus
but also to cut back on "excesses" in the financial system.
The net result is a country that appears not just delusional but positively
suicidal. With a freely floating currency that has been weighed down by low
interest rates of late and a significant quantitative easing program, the
United Kingdom represents the broadest test case for government responses to
the financial crisis.
A reduction of confidence has already been signaled by the debt markets as
10-year UK Gilt yields have risen from less than 3% in March this year to just
over 3.85% now. In contrast, Germany, with much the same economic conditions as
the UK, has seen its 10-year ("Bund") yields go from around 3.1% to 3.19% over
the same period. Importantly, there are no measures to support German bond
issuance, ie no central bank is buying them outright as the Bank of England has
with UK Gilts; therefore the difference in performance is that much more
indicative of a failed approach to the crisis.
It would be fitting after all if Keynes' theories were finally buried in the
very country where he wrote them.
Looking ahead
I do not seek to write investment commentary for readers. Indeed, my personal
disclaimer to readers has always been to not follow the advice of a
pseudonymous writer such as myself but instead secure appropriate advice for a
reader's specific situations.
With that said, here are a few things I am looking toward for 2010:
a. US dollar volatility continues well apace as investors square off
between the longer-term uses of the currency versus the short-term demand on
their liabilities side.
b. Inflation starts peeping out as the sheer volume of monetary
expansion catches up in the prices of goods; expect to see some jarring prints
for negative real interest rates by the third quarter of next year.
c. Markets lose confidence in a few more sovereign borrowers, with my
least-favored sovereign for 2010 remaining the United Kingdom.
d. Gold prices oscillate around the US$1,000 per ounce level through the
first quarter of next year, but then breaks out higher as mounting evidence of
a regime shift in financial system metrics becomes apparent to more investors
from the second quarter.
e. Stocks are currently overvalued significantly, which, combined with
substantial easy money, suggests that the natural course from here is up,
not down. Much like the death throes of the technology bust in the 1990s were
only signaled with record stock prices in 1999, investors should expect further
gains in the first quarter 2010. After that, stocks will probably fall by 50%
or so.
Happy hunting.
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