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ETF Toronto 2011
Beyond Our Borders – What in
the World is Going On?
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Beyond Our Borders - What in the World is Going On?
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Moderator :
Pat Bolland
Senior Counsel
Veritas Communications
Panelist:
Alex Jurshevski
Founder
Recovery Partners
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A Vicious Cycle Risks Great Pain
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Structural deficits of the public purse exist everywhere, and well beyond
the point where stimulus spending runs out
Ageing demographics come with increasing funding gaps for social
security, public pensions and health costs
With a smaller portion of the population engaged in producing GDP in the
real economy, those that produce income will have to be taxed more to
support structural deficits that have not been taken care of and the part
of the population that is drawing funds from the welfare state
The private sector is not going to pick up fast enough to replenish the
fiscal coffers. In order to survive, private enterprise will continue to
increase efficiencies, migrate manufacturing to low cost jurisdictions,
reduce workforce in saturated economies and write off the cost of
restructuring.
The result is depressed tax revenue from corporations and increased
unemployment in Western economies that transform into pure service
and consumer economies while Emerging Markets pick up the
manufacturing jobs. Cutting the vicious cycle will be painful if not
politically impossible:
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Political Difficulties
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This leads to a picture of Western Economies continuing to pile up
structural deficits with a depressed tax base and ballooning unfunded
liabilities towards a rapidly ageing population. Sound sustainable? We
think not.
In contrast, Emerging Economies (including China) will benefit from lower
current levels of debt and much lower expected future deficits while
manufacturing all the goods that the virtually bankrupt economies in
the West will have to buy from them. Sound sustainable? We think yes.
However, rising prices have destabilized regimes and many countries are
concerned about contagion affecting their populations. This is one of
the headwinds that China faces along with a significant malinvestment, pollution and desertification problem.
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Political Risks
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Europe will face political risk from the fact that a population that has
grown accustomed to benefits from an unsustainable welfare system
will be asked to suffer cuts in public sector wages and social security
benefits. Implementing these changes is extremely difficult in a heavily
unionized environment and in one that sees the gap between rich and
poor increase. Social unrest such as seen in France, Greece and Spain
are just a foretaste of what is in store.
In the US, you can add already unprecedented unemployment levels,
ethnic tensions, regional income gaps and the fact that the population
has constitutionally supported easy access to firearms of all calibers to
the mix. The specter of social unrest turning into violent riots becomes
more than just a remote possibility in this scenario. This kind of
development has the potential to create a significant political crisis in
the US, which in turn would have negative feedback effects on the
Global economy.
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Political Risks
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In one scenario, the US, currently the leading force in global politics will
come under increased global pressure: former and current enemies
(including Al-Qaeda ex OBL) will try to benefit from US domestic and
international weakness; the US will have trouble maintaining its global
military leadership as it is no longer able to appropriately fund not
only their military, but more importantly non-US situated military
bases; China in this scenario might step in to seek a deal with the US
for Eastern Hemisphere control. All signs suggest that the “deck”
holding the global balance of power is being re-shuffled in favor of
what we today still so ironically call “emerging” economies…all the
more true since the Arab Spring…..
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The Track Record
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However, the biggest risk here is simply that it has proven very hard to
sustain political support for fiscal consolidation plans over the
timeframes required for these programs to work.
The reality is that there are only a handful of success stories among the
more than 140 attempts at fiscal consolidation in the last few decades.
Defining “success” as a consolidation that reduces Debt/GDP by at
least 10%, something that is required for all of the Sovereign zombies,
yields a list of only two countries, New Zealand and Canada that have
done so in the past.
To clarify this further, there has never been a successful effort mounted in
a situation where numerous countries are attempting to achieve the
same thing in the aftermath of a Global Financial Crisis (GFC).
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Investment Implications
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Running for shelter will be difficult in a scenario where the public debt
crisis spins further out of control, sovereign defaults and even
bankruptcies of whole nations potentially become a wide spread
occurrence rather than a possibility and civil unrest ensues as
populations lose whatever confidence they had left in their
governments.
Buy-and-hold is definitely over; shorter-term trading is back. Inflation
protection must be part of all investment strategies. Absolute returns
should be the yardstick, not market benchmarks.
 Keep durations short to manage interest rate risk
 Use stop-loss parameters to manage equity risks
 Structured products (issuer assumes the risk of future shock while
capping yields)
 Physical bullion
 Exposure to emerging markets may well become a safer play than the
NYSE
 Avoid Sovereign Debt of the US, Japan and Europe
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Sovereign Debt Management – 50,000 Foot View
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Best Practices Management Summary (e.g.)
Strategic Portfolio Construction
Relationship Management and Credit
LIQUIDITY
FX
CASH
DOMESTIC
OFFSHORE
Tactical
Portfolio
Management
and Risk Control
Systems
and
Disaster
Recovery
Performance Measurement
and Reporting
Governance Panel
Parliament
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Debt Servicing – Cost/Risk Benefits
% of GDP
Annual Debt
Service Before RP
Management
Annual Debt
Service After RP
Management
Debt
Range
EUR High
MM –
Range
EUR Low
MM
EUR Low
MM –
EUR Lower
MM
This type of portfolio management framework offers better predictability
of outcomes; minimizes downside risks, saves cost and thus enables
better fiscal planning certainty making it a very attractive selling point to
the debt rating agencies in support of credit ratings upgrades.
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The Investor Question
Many of the bailed out countries have
an urgent problem because there is very
little overlap between the Investment
Grade and Sub-Investment Grade
investor universe
Current investors have portfolio policies
that prevent them from investing in sub
investment grade
AAA
Investor Universe
SIG
These Governments need to cultivate
new investor relationships in order to
have any hope of re-financing and
managing its liabilities
In order to do this this Governments
must implement robust portfolio
strategies, controls and undertake a
strategic market approach to rating
agencies and key investors on a targeted
basis.
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Charts and Tables
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Top 20 Financial Institutions 1999
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Top 20 Financial Institutions 2009
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Cross Border EU Sovereign Debt*
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(USD millions)
Portugal
Ireland
Italy
Greece
Spain
Britain
$24
$189
$77
$15
$114
France
$45
$60
$511
$75
$220
Germany
$47
$184
$190
$45
$238
Total owed to “Big 3″
$116
$433
$778
$135
$572
Overall Total Debt
$286
$867
$1,400
$236
$1,100
Debt / GDP
75.2%
63.7%
115.2%
108.1%
* Countries in the top row owe the amounts to countries in the vertical column.
debt to GDP ratios are in the two bottom rows.
59.5%
Gross debt and
Source: BIS
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European Stability Pact
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Mandates limits of 60% debt to GDP and 3 % upper limit on annual
Government deficits per individual EU nation states
Used as a risk control, admissions test, and way of ensuring fiscal
rectitude among EU member nations.
The limits have been repeatedly violated.
Current debt to GDP ratios in many EU nation states are already far
over 100%:
 Belgium
 Greece
 Ireland
 Italy
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Fiscal Balances: Cumulative 2008-2010
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Source: OECD
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European Red Ink
Source: Financial Times
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European Default Risks
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Source: Financial Times
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The Morning After
Source: Bloomberg
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Euro Danger – Bond Issuance 2011
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Debt to GDP Projections
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Source: BIS
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Debt to GDP Ratios
Including OBS
liabilities
Source: BIS
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Required Fiscal Retrenchment
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Source: OECD
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World Debt/GDP Projections
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Source: IMF
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Debt Measures: Is the USA a PIIG?
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Source: Morgan Stanley Research
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US Interest on Public Debt: Heimlich Required
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Source: CBO
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Budget Battle Lines – The Phony War
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Can the US Fiscal Situation be Fixed?
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The CBO has said that in order to stabilize the fiscal situation by 2015, the
following needs to happen:
Cut entitlements spending by 12.5%, or
Raise taxes by 11%
What is happening instead?
Obama-care crammed down
Extension of Bush tax cuts
Payroll tax holiday introduced
Failure to agree on symbolic $30 Bn of budget cuts (less than 30 bps of
fiscal adjustment)
Politicization and deep divergences opening up on the budget situation
along political lines, regarding what is essentially an economic fact.
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The Fed’s Balance Sheet and the Stock Market
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Correlation The Fed’s QE and Commodities
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2001-2010 - US Economic Developments
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S&P 500 in AUD and USD
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S&P Returns in Commodity and Currency Terms
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2010/11 Returns
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Chinese Say that US Policy is Causing Inflation
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“Because the United States` issuance of dollars is out of control and
international commodity prices are continuing to rise, China is being
attacked by imported inflation. The uncertainties of this are causing big
problems for companies.”
Chinese Minister of Commerce Cheng Deming , October 2011
“The U.S. is engaged in uncontrolled and irresponsible money printing.
As long as the world exercises no restraint in issuing global currencies
such as the dollar….then the occurrence of another crisis is inevitable.”
Xia Bin, Advisor to the People`s Bank of China, November 2011
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USD Index
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The Chinese have a point
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Source: IMF
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Chinese Holding of US Treasuries
The Chinese
Government has
reduced its holdings of
US Securities by over
10% in the last two
years.
Source: Morgan Stanley Research
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Price Inflation the BPP from MIT
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The Billion Price Project
is
an
initiative
undertaken
by
researchers at MIT to
track price inflation
using live data from the
Internet.
It
was
mysteriously
suspended about a
month
ago.
Before
coming back on line, the
last chart of the U.S.
BPP index was posted
on April 13. It reflected
an annualized inflation
rate of more than 7%
over the past three
months, and over 4%
since the Fed kicked off
QE2 last November.
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In Fed Focus: “Official” US Inflation
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QE: The Real Story
Although advertised as stimulus for the economy, the reality behind QE
has in fact little to do with stimulus and much, much more to do with the
gaping deficits at the Fed, an insolvent Banking system and Washington’s
fiscal deficit which can no longer be properly funded in the open market.
Nothing has changed since the time of our intial analysis to cause us to alter
our opinion. In fact, recent events in Japan and Europe now argue even
more strongly for a continuation of this program.
In the case of the United States we calculate that an increase of between 8
and 12 times the current price level is required to bring US Government
debt ratios and debt servicing capacities back into balance. This means that
we are likely looking at an inflationist program that lasts at least until QE6
(assuming that the size and duration of the operations match QE2). The
path of least resistance for other central banks is to accommodate. Thus, US
inflation will be exported worldwide and will likely be the last hurrah for
the USD as the principle reserve currency.
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Bank Failures and the FDIC
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Failures and Assistance Transactions
United States and Other Areas
(Dollar amounts in thousands)
1990-2007
2008-2010
Number of Bank Failures
949
249
Nominal Value of Defaulted Assets
$403,130,565
$296,467,735
Average Size of Failed Bank
$424,795
$1,235,282
Losses to Insurance Fund(s)
$43,464,818
$73,462,832
Average Loss per Failure
$45,801
$304,825
Weighted Average Loss (%)
10.58%
26.29%
Annual Failure Rate (during Peak)
293
118
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Canada – NPLs and Bankruptcies
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Notes:
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