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Uncharted Waters - Commentary from Frank Haines, Chief Investment Officer We have noted in previous CBIS commentary that the levels of debt and leverage built up over decades in the U.S. and in other developed markets will take years to unwind. Attention is now shifting to such public sector excesses and the resulting sovereign credit risks. Low real interest rates in the developed economies encouraged private and public sector borrowing, and these debt loads must either be paid off through economic growth or a devalued currency (or in a worst case, such as Greece, through restructuring). Strong economic growth seems unlikely given the probable rising tax burden needed to service the debt, rising social entitlement expenses due to aging populations, and the eventual impact on interest expense of rising interest rates. Inflation and currency devaluation is the politically easiest course, although this is not an imminent risk due to global excess capacity and still-high unemployment levels. Private deleveraging will also contain inflation, as income is used to pay down debt rather than support consumption. Politicians have refused to address the over-spending problem for a decade or more. However, they can no longer dodge the consequences. Sovereign debt problems have traditionally been associated with less-developed markets. With Greece and much of the EU under duress, a new facet of risk is emerging, forcing investors to navigate new and uncharted waters. It has always been a given that developed nations could refinance maturing debt, and that the power of taxation along with steady secular economic growth ensured high credit quality for national debt issues. But it is becoming increasingly clear that many nations, including the U.S. and its government-supported institutions, may reach a level of debt which the markets will balk at refinancing. At some point, residents of these nations will not be able to support higher taxes, causing revenues to fall far short of the projections demanded by the rating agencies to maintain credit quality. In such a scenario, investors may come to perceive the corporate debts of highly rated issuers as less risky than sovereign debt. This situation would undermine the credibility of “risk free” government securities and the use of the government yield curve as the foundation for pricing all market debt. Coupled with credible questions about the value of rating agencies’ credit quality determinations, such developments would truly leave investors sailing through uncharted waters. In CBIS’ view, these new threats to sovereign credits demand close monitoring. Investors cannot naively project forward return assumptions based on the experience of the previous two decades. For example, it has been the long-standing consensus view that rising inflation is imminent and that institutional investors should put inflation hedges in place, generally by reducing bond exposure. Aside from global excess capacity and unemployment (conditions that traditionally dampen inflation) and over-indebted consumers and constrained lending, sovereign debt restructurings and defaults will further circumscribe inflationary pressures. The probable steps to address sovereign risk in Europe, or in the U.S. for that matter, will entail higher taxes (resulting in less income for consumption) and the siphoning of tax revenue to pay down debt (reducing funds available for stimulus spending). Far from an inflationary scenario, this sort of situation would favor bond investment over short-duration bonds, Treasury Inflation Protected Securities (TIPS) and commodity-related hedges. There is also a growing movement toward protectionist measures by countries trying to solve their fiscal deficits while maintaining political popularity with electorates. While still in the early stages, U.S. companies have increasingly found themselves on the wrong side of EU tariffs and regulatory restrictions, World Trade Organization decrees and seemingly arbitrary Chinese trade curtailment. While unfortunate, such “beggar-thy-neighbor” protectionism is politically understandable, despite the unfortunate lessons of protectionism during the 1930s. Such a shift from the relatively open global trade of the past two decades will take a toll on a number of companies that have built their growth plans on expanding global market share. The voluntary Google departure from the Chinese market is an indicator of the potential negative impact of this trend. As investors, we have current and future obligations to meet, so there is no option to pull into port until current crises pass. Like prudent sailors, we must simply “batten down the hatches,” hug the known coastline to the extent possible, and keep our eyes open to unexpected dangers – and opportunities – lurking ahead. Please contact your CBIS Investment Advisor if you would like to discuss these issues in more detail. To download a printable PDF version of this article, please click here. |
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Copyright ©2008 Christian Brothers Investment Services, Inc. |
