The Absolute Return Letter

February 2010
If PIIGS Could Fly

“A democracy is always temporary in nature; it simply cannot exist

as a permanent form of government. A democracy will continue to
exist up until the time that voters discover that they can vote
themselves generous gifts from the public treasury. From that
moment on, the majority always votes for the candidates who
promise the most benefits from the public treasury, with the result
that every democracy will finally collapse due to loose fiscal policy…”
Alexander Fraser Tytler, Scottish lawyer and writer, 1770

Travelling with John Mauldin It was always naïve to believe that a crisis so deep and profound was
going to go away with a whimper; however, an increase of more than
50% in global equity prices can be very seductive, and nine months of
virtually uninterrupted gains have led many to believe that the
problems of 2008-09 are now largely behind us.
Well, not quite everybody. Friend and business partner John Mauldin
remains a sceptic. I have had the pleasure of travelling across Europe
with John over the past week or so and, as the week progressed, my
mood swung decisively towards a state where Prozac would probably
be the most appropriate remedy.
Now, John and I do not agree on absolutely everything. For example, I
believe – and have believed for a while – that he is too bearish on
equities. But, before we go there, allow me to share with you the
essence of John’s views which can be summed up quite nicely by two
charts, courtesy of BCA Research.
Photo: Tim Wimborne, Reuters

Chart 1: De-leveraging has a long way to go in the US

Source: BCA Research

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 In John’s opinion – and I do not disagree – we are still only in the
second or third innings of the de-leveraging process (chart 1). Years of
excessive debt accumulation cannot be reversed in 18 months, and it
will take at least another 5-6 years to play out, possibly longer.

Chart 2: US Government borrowing has replaced private borrowing

Source: BCA Research

The other part of John’s argument – and again it is hard to disagree –

is that it remains an open question how much de-leveraging has in fact
taken place. As you can see from chart 2, US sovereign debt has risen as
fast as private debt has declined (and the picture is similar in many
other countries), providing support for the argument that all we have
achieved so far is to move liabilities from private to public balance
sheets, effectively burdening tomorrow’s taxpayer.
The basket case named Greece In the last few days, developments in Greece have totally overshadowed
other events. As I write these lines, the 10-year Greek government bond
trades a shade under 7%, now yielding a whopping 370 basis points
more than the corresponding Bunds. At the same time, and not at all
surprisingly, Greek credit default swaps – measuring the cost of
insurance against a Greek sovereign default – have exploded (chart 3).

Chart 3: Greek Credit Default Swaps are Exploding

Source: Bankinvest

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When I was in Zurich with John last week, I bumped into the famous
Swiss investor, Felix Zulauf, who pointed out to me that Greece has in
fact been in default in 105 of the last 200 years, so never say never.
Having said that, Greece cannot be allowed to default, as the
implications would be catastrophic. Bond investors would immediately
pick apart the next country in line, and it is almost certainly going to be
one of the other PIIGS – Portugal, Italy, Ireland or Spain. Bailing out
Greece is just about manageable, but having to save all of them would
overwhelm the EU. Swift action must therefore be taken, moral hazard
or not.
Back in early January, the research team at Danske Bank in
Copenhagen produced a most interesting research paper1, revealing
how desperate the fiscal outlook is for many EU members. Table 1
illustrates the path of debt-to-GDP between now and 2020, assuming
no change to current policy.

Table 1: Projected Debt-to-GDP in EU, assuming no change to

current policy

Source: Danske Bank

Now, we all know what cannot happen, will not happen. There is a
reason the EU, via its stability pact, set the debt-to-GDP ceiling at 60%
for its euro zone members. Obviously, with the low interest rates we
currently enjoy, one could argue that a higher debt-to-GDP ratio could
be sustained, and that is essentially correct as long as interest rates
remain low; however, you leave yourself seriously exposed, should
rates rise which they almost certainly will as sovereign debt
increasingly becomes junk. .
Danske Bank then went one step further in its analysis. In order to
illustrate the magnitude of the problem, they calculated how aggressive
the fiscal tightening would have to be in order for the euro zone
member states to comply with the stability pact by 2020. Table 2 below
indicates how much the deficit must be reduced every year for the next
five years in order to bring debt-to-GDP to 60% by 2020. Greece, being
in the most precarious position, would need to shave 4% off its budget
every year. We all know that is not going to happen because that would
spell depression.
In the short term, Greece needs to find over €50 billion before the end
of the year to refinance debt which is about to mature. The question is
not so much whether it will fail in its endeavour but what price it will
have to pay. An already fragile Greek fiscal situation could be further
undermined, if Greece is forced to pay 7% going forward which it can
hardly afford.

1 ‘Debt on a dangerous path’, 4th January, 2010, by Danske Bank. You can find the
entire report here.

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Is Spain next? Towards the end of last week it became apparent that there might be
some appetite for rescuing Greece, although few details are currently
available. However, I am not convinced that there is a strong consensus
in favour of a rescue package. Most of the positive vibes have come
from Spain, whereas Germany and France have been decidedly less
forthcoming. It is perhaps not surprising that it is the Spanish who
seem most eager to bail Greece out, considering that they could very
well be the next victim of the bond market’s invisible hand.
In the last few days, Spain has gone out of its way to demonstrate its
commitment to greater fiscal discipline in general and to the stability
pact in particular. The government has just proposed for the retirement
age to be increased from 65 to 67 (to be introduced gradually from
2013), and a fiscal programme designed to reduce the annual deficit to
3% of GDP by 2013 has been presented. The problem for Spain is that
words are cheap. Few commentators believe that 3% is a realistic target
given the depth of Spain’s problems at the moment. Don’t hold your
breath.

Table 2: Annual tightening of primary deficit required between

2011 and 2015 in order to reach 60% debt-to-GDP by 2020

Source: Danske Bank

The outlook is very grim The outlook goes from murky to unbelievably grim, if one includes off-
balance sheet items such as social security, pension and health
liabilities, which have been promised to us over the years by well
meaning but financially inept governments (see chart 4). As Societe
Generale’s Dylan Grice puts it:
“I don’t see how our governments can pay these liabilities. EU and US
net liabilities add up to around $135 trillion alone. That is four times
the capitalization of Datastream’s World equity index of about $36
trillion, and forty times the cost of the 2008 financial crisis.”2.
I also note that Greece, not included in the chart, stands at 875% debt-
to-GDP when including off-balance sheet items!
The bond market will ultimately determine when enough is enough. As
President Clinton’s campaign strategist James Carville once put it:
“I used to think if there was reincarnation, I wanted to come back as
the President or the Pope or a .400 baseball hitter. But now I want to
come back as the bond market. You can intimidate everyone.”
It can play out in a couple of different ways. Either bond investors will
go on strike until they feel that they are being sufficiently rewarded for
the higher risk associated with sovereign debt following the credit
crunch or governments will implement budget curtailments designed
to bring the debt escalation under control again, but that will be
detrimental to economic growth. My bet is that the latter outcome will

2 ‘Popular Delusions’, Societe Generale, 12th November, 2009

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 ultimately prevail but not until the bond market forces the hand of our
governments.

Chart 4: Are our governments solvent?

Source: Societe Generale, Popular Delusions, 12th November, 2009

The end game for Japan? The first country to really feel the pinch could very well be Japan; in
the bigger context, Greece is just the appetizer. Japan’s debt-to-GDP
ratio has grown from 65% in the early 1990s when their crisis began in
earnest to over 200% now. Fortunately for Japan, the high savings rate
has allowed shifting governments to finance the deficit internally with
about 93% of all JGBs held domestically3. This is the key reason why
Japan gets away with paying only 1.3% on their 10-year bonds when
other large OECD countries must pay 3-4% to attract investors.
Now, predicting the demise of Japan has cost many a career over the
years. Despite the ever rising debt, and contrary to many expert
opinions, the yen has been rock solid and bond yields have remained
comparatively low. I often hear the argument from the bulls that the
Japanese situation is sustainable because they, unlike us, are a nation
of savers. Wrong. They were a nation of savers.

Chart 5: Japanese savings rate under pressure

Source: Societe Generale, Popular Delusions, 10th January, 2010

Looking at chart 5, it is evident that the demographic tsunami has

finally hit Japan. The savings rate is in a structural decline and the
Ministry of Finance in Tokyo may soon be forced to go to international
capital markets to fund their deficits. I very much doubt that non-
Japanese investors will be as forgiving as the Japanese, and that could
force bond yields in Japan in line with US and German yields. Herein
lies the challenge. Japan already spends 35% of its pre-bond issuance
revenues on servicing its debt. If the Japanese were forced to fund
themselves at 3.5% instead of 1.3%, the game would soon be up.

3 Source: http://econompicdata.blogspot.com/2009/12/real-lost-decade-japanese-
gdp-edition.html

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Why stock markets go up Despite the grim outlook, the world’s stock markets have produced
brilliant returns over the past nine months. This has provoked some of
the best and brightest in our industry (most recently Mohamed El-
Erian, CEO of Pimco4) to declare that there is a dis-connect between
the economic reality and the picture painted by Wall Street.
I am not convinced. Firstly, global equities reached extremely
depressed levels back in February 2009, and the recovery, however
muted it may ultimately turn out to be, has stopped the bleeding in
most large companies, giving investors an excuse to accumulate stocks
again (smaller companies is a different story altogether, but that is one
for another day). What matters to the likes of Coca Cola, Rolls Royce
and Volkswagen is not so much how the domestic economy performs,
but rather what the global growth prospects are, and these are
considerably more upbeat than, say, the US, UK or German domestic
equivalent.
Secondly, equities usually do very well in the very late stages of
recession and early stages of recovery. I refer to our July 2006 Absolute
Return Letter for an in-depth analysis of this, which you can find here.
Thirdly, valuations are not prohibitively high. Many bears refer to the
stock market (whether European or US) as being very expensive at
current levels, but that is plainly untrue. Based on 2010 projected
earnings, most OECD markets are either in line with or 10-20% below
historical averages (see table 3). Only in emerging markets can you
reasonably argue that current P/E levels are not cheap relative to the
long term average.

Table 3: Global equity market valuations

Source: Goldman Sachs Investment Strategy Outlook, January 2010

In 2009 there have been massive flows of capital towards emerging

markets – and towards Asia in particular – and valuations have been
driven up as a result. It is hard to argue that those markets are yet in
bubble territory, if one uses the valuations in table 3 as a benchmark;
however, by pegging their currencies to the US dollar, Asian countries
have effectively adopted a monetary policy which is entirely unsuitable
for economies growing as fast as they do. That is how bubbles have
been created in the past and why Asian equity markets should be
monitored closely for signs of overheating in the months to come.
Conclusion Summing it all up, the fate of global equity markets is very much in the
hands of bond investors. Under normal circumstances, this is the best
time to be in equities. But these times are not normal, so do not expect

4 Source: http://www.investmentpostcards.com/2010/01/16/el-erian-markets-not-
facing-reality-of-slow-economy/

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that the outstanding performance of 2009 will be repeated in 2010. If
international bond markets calm down again – and that may happen,
at least temporarily – equities can probably post further (but modest)
gains in 2010; however, the end game is approaching. If bond
investors do not revolt in 2010, they probably will in 2011, so playing
the economic recovery through equities is a dangerous game.
As far as the bond market is concerned, as often pointed out by Martin
Barnes at BCA Research, if you want to know where the next crisis will
be, then look at where the leverage is being created today. And nowhere
is there more leverage being created at the moment than on sovereign
balance sheets. What is happening is an experiment never undertaken
before. As John Mauldin puts it, we are operating on the patient
without anaesthesia.
The big challenge will be to get the timing right. These situations can
run for longer than most people imagine. Japan’s crisis has been widely
predicted for almost a decade now, and the ship appears to be as steady
as ever. As I suggested earlier, the key to predicting the timing of
Japan’s demise – because there will be one – may very well be
embedded in the savings rate, which could quite possibly turn negative
in the next few years.
The Dubai crisis taught us that markets are in a forgiving mode at the
moment and, before long, Greece could very well find some respite
from its current problems. But then again, ultimately, governments will
find – just like millions of households have found over the years – that
you cannot spend more then you earn in perpetuity. The enormous
debt levels being created at the moment will haunt us for many years to
come and we may have to wait a long time to see PIIGS fly again.

Source: Matt, Daily Telegraph

Niels C. Jensen
© 2002-2010 Absolute Return Partners LLP. All rights reserved.

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Absolute Return Letter Contributors

Niels C. Jensen [email protected] tel. +44 20 8939 2901
Nick Rees [email protected] tel. +44 20 8939 2903
Tricia Ward [email protected] tel: +44 20 8939 2906