In debt we trust

7 min read

There’s no denying that Monday was ugly; really, really ugly. But why? Is there sufficient fundamental justification to wipe US$3trn off the value of global stocks? Does unwinding the British relationship with the EU justify this reaction or is it a bunch of traders and hedgies using the uncertainty to whip and drive markets for, pardon the term, the fun of it?

Or, and this is the real question, have the events of the past few days finally stripped the veneer off the so-called “recovery”, following the global financial crisis? It is over eight-and-a-half years since I was called into a meeting room at 5 Canada Square and fired from Bank of America in the first wave of redundancies as the credit crisis began to unfold. The issue was firstly that there was far too much debt swirling around and, secondly, that debt was being incorrectly valued. Not long before, I had sat down with my young niece and had explained to her that debt must be looked at on the basis of one’s ability to repay the capital at some point in the future and not on one’s ability to meet interest payments today.

Low debt servicing costs reduce the propensity of borrowers to default on ongoing obligations, thus creating the illusion of a healthier financial environment than the one that actually exists. The quick and easy response to the crisis of 2007/2008 was for the authorities, largely represented by the central banks, to turn up the power on the monetary life-support system. I used this analogy a lot during those days and wondered whether the patient’s easy breathing when on life support was a sign of his health improving or whether, if the machines were removed and he were asked to survive on his own strength, he would turn up his toes and die?

The problem with debt, both at a public and a private level, is that without the benefit of an inflation-driven debasement of the debt mountain, it will eventually strangle the borrower. I have a mental image from The Jungle Book of Kaa, the snake, wrapping himself (or in the new version, herself) around Mowgli while hissing “Trust in me….” Rising inflation and rising interest rates will always take down some overleveraged borrowers but in the end it is to a good effect as it bails out the government as a borrower and thus, in the fullness of time, the taxpayer too. The most pernicious situation is one where government and households are running deficits without the benefit of inflation being there to rebalance the books.

Again, I have often remarked that governments are perfectly hedged against inflation as their income stream reflected in tax revenues rises fully with higher prices and earnings while the value of their debt is neatly and quietly eroded. The point? Making 25% annualised return on bonds as yields fall towards or below zero might be fine and dandy today but in the longer term it will beggar nations and destroy investors’ capital.

Downgrades

The UK had a two-notch downgrade yesterday from S&P, from AAA to AA, and one notch from Fitch to AA, but in reality the move should be the other way. A fall in the pound and a bout of inflation, even if imported, can help to stop the rot of ever increasing debt. Global credit metrics are deteriorating and have been since inflation fell below the rate at which deficits are being racked up. Why do I get the feeling that the ratings fiasco in the structured credit space in 2007/2008 has spooked the agencies into shooting first and asking questions afterwards?

Moody’s has now put Microsoft on credit watch negative which, if it moves to the downgrade, will leave only one US corporation with AAA ratings, namely Johnson & Johnson. Can that really be true?

The fall in sterling, the risk to the inflation scenario and the influence that might have on interest rate policy in this country will surely affect hundreds of thousands of individual borrowers but the country as a whole should benefit in terms of creditworthiness.

I don’t think traders have taken more than a nanosecond to think through what is happening at base level but they are diving into markets, irrespective which way they might be moving, in the vain hope of earning themselves a bit of a P&L and hence a bonus. Knee-jerk follows knee-jerk.

Politics

At a political level the blind are also leading the blind. Even Mutti Merkel is flip-flopping as to whether the UK should be shipped out in haste or whether a calm and measured exit should be encouraged. Article 50 is very clear; it is incumbent on the UK government to give notice of its intention to leave the union. Like it or not, it is Westminster that determines the timing and nobody else. The British did not write that rule; it was given to them. There is talk of Brussels trying to enforce a reverse invocation which would in its own way justify Britain leaving an organisation that treats even its own rule with flagrant disdain. Rules governing the invocation of Article 50 are just as woolly and unhelpful as those governing the creation of the euro.

I have heard argued in the Continental press that the price that the citizenry of the eurozone has been and is still being asked to pay in order to bail out the single currency project is too high. The disconnect between the people of Britain and the political elite that has led to the vote for a severance from the EU is, in many respects, nothing compared to the disconnect in France or Italy. This will not be changed by beating Britain until she bleeds.

Pardon the political digression but currently there is little room in markets for economic fundamentals.

So the question is whether the US$3trn has been sacrificed to a paradigm shift or simply to a spot of blind panic? I suspect it is the latter which would call for a spot of bargain hunting. If it were to be the former, stock prices could easily fall another 25%-35%. I can’t see the latter happening and expect today, Tuesday, to be a classic reversal day. The volatility will continue although trying to make big plays into the persistent ebb and flow will be hard and fraught with risk. It might be fun for day traders but it’s hellishly frustrating for asset allocators. I’m off to London tomorrow and have a quarterly asset allocation meeting to attend on Thursday. Yikes!