Christopher N. Sandys
Last Wednesday (7 July 2010) the market reversed its down-trend and was strongly positive, so the new talk of the financial news stations was the “summer rally.” Never mind that the Dow was exactly where it was 1 week prior, because the recent history is actually ancient history. Or at least that seems to be the conventional wisdom of the 24-hour news cycle.
Calling a rally on short-term direction of the market is preposterous. I understand the reason behind the positive action: 10 trading days of stocks lower. Every now and then the market takes a breather. I am totally uninterested in what the market does in a single week, let alone one day. I am more interested in what is going to happen through the remainder of the year, and a few more beyond that.
I see only a couple of obvious reasons to invest in equities right now. Large American companies are cheap by historical standards. This is a fundamental analysis, meaning we are looking at the price of the stock and comparing it to the company’s earnings. Remember though, earnings do not occur in a vacuum. There are a lot things going on that can disrupt earnings and send the market lower, despite yesterday’s summer rally kick-off. The other reason is positive employment statistics from Canada, proving that some parts of the globe are effectively repairing their economy.
With little to be optimistic about in the market, it makes investing tricky. This is the first in a series that is going to describe the investing environment, and what we are doing to exploit opportunities while avoiding traps. Each piece of this series will build on the next, and will focus on a discrete topic. I will state the topic early; so that if you feel you are well-versed you can save your time.
The piece is going to focus on sovereign and state debt, and their pending impact on you.
So we hear about sovereign debt on the television and radio all the time, but what is it? Simply stated, sovereign debt is government debt. In the United States you would know it as our National Debt, i.e. the total outstanding debt the US Government owes to its bond holders (US Treasury securities and Savings Bonds). The US isn’t the only country carrying a debt. Scores of developed and emerging countries also issue debt to cover the shortfalls in their national budget.
Debt is not necessarily a bad thing. If managed properly a country, like an individual, can use debt to invest in the future and work its way through tight times. Debt becomes a problem when it starts to exceed the capability of the issuer to service the debt, i.e. make the principal and interest payments. How does this happen? Let’s use an example of an individual first, something we clearly understand, and compare that to sovereignty.
A person has access to debt through a variety of means, including credit cards, mortgages, and margin accounts. Let’s look at an example of Mr. Smith using his credit card. He makes $80,000 per year and has a total credit card limit of $50,000. Years ago both his credit limit and annual income were lower, but they have increased in tandem.
Mr. Smith starts using his credit relatively responsibly. He is paid monthly, and sometimes he needs a little extra liquidity to make it to the next paycheck. At first he was always diligent about paying off his cards in full each month, but eventually he starts carrying a balance. His interest rates are so low, that it makes financial sense to use this cheap money. As time goes on, Mr. Smith continues to grow the balance on his cards, because his income is increasing. At one time it would have been difficult to pay $200/month to a creditor, but now he can easily pay $600. Also with time, and familiarity, he starts using his credit for more than just monthly liquidity. Luxury items and vacations start to accumulate on his credit balance, but at this point it’s not a big deal. He can still cover the monthly payments plus a little extra, and the interest rate is low.
After a few years Mr. Smith finds himself in the unfortunate position of being unemployed. This was unexpected, so he never established an emergency fund. But initially it is not a problem, because he still has $20,000 left on his credit limit; that is equivalent to 3 months of his former salary, or so he thinks. Not considering that each month he was augmenting his lifestyle with some borrowed funds from credit, he doesn’t immediately curtail his usual expenses.
As the weeks pass the job situation becomes to look bleak, and he is going through his credit more quickly than anticipated. Fortunately, he is always receiving offers in the mail for new credit cards, so he applies for a couple and is able to establish another $20,000 worth of credit. Since his outstanding balance is approaching his annual salary, his interest rates are not as attractive on his new cards. He is being viewed as a potential risk.
As a few more months pass he has still not found a job. A couple of weeks ago he received offers for new credit cards, but their rate was exorbitant—he is viewed as a high-risk borrower. Now, he receives no new offers. He has been late on payments, and he has borrowed nearly the amount he used to earn annually when he was employed. He is no longer high-risk; he is credit ineligible. He has recently started to cut back on his lifestyle, but he did so too late. No amount of austerity measures is going to enable him to make ends meet.
Then one day as he examining his tattered finances, searching for an escape hatch, he receives correspondence from one of his creditors. Perhaps it is the credit increase he requested. Unfortunately, the news is not positive. Upon considering his request for additional credit, the lending company saw that he was over 30 days late paying on 4 different cards. They are revoking all his remaining credit. After 5 months of unemployment, he is dead in the water.
Who is Mr. Smith? He is Greece, a few months ago. The main difference being that the European Economic Community has no interest in saving Mr. Smith. His future will consist of misery, austerity, and bankruptcy.
Who could be a future Mr. Smith? Well, the most immediate countries that come to mind are Spain, Portugal, Ireland, and Italy. He may be the United Kingdom, but they have started to cut their spending significantly. He is more likely the United States, in about 10-20 years. But these two countries have one more trick up their sleeves that Smith could not access.
Let’s look at how the United States is similar to Mr. Smith, and where the differences are. First off, the United States has lost its job. Unemployment is through the roof, and it has not improved over the last year. Unemployed or under-employed citizens pay either no or less taxes. Tax receipts for the Federal and State governments have dropped and none of the governments that I am aware of, other than New Jersey, have curtailed their lifestyle. The Federal Government has actually increased its deficit spending (comparable to a credit card). “By how much,” you may ask? They are increasing the debt at an astronomical rate. According to the US Treasury, on 1 January 2009 the entire debt was $10,699,804,864,612.13. As of 9 July 2010 it was $13,181,991,714,131.18. That is an increase of over 23% in the last 18 months.
How are the next 12 months looking? Well, that’s a tough one to answer, since Congress refused to pass a budget this year. It seems that a direct vote on a budget would have cost many congressmen their jobs. So instead they attached $1.3 trillion worth of spending to the Emergency War Supplemental Bill. The people spending your money in DC are afraid to look you in face and admit the degree of their spree. To what degree this will be a deficit (i.e. in excess of tax revenues) is uncertain, but it will likely be high, and there is good reason to believe that even more spending will be attached to other bills.
If the United States were Mr. Smith, there would be a happy ending. Credit would be revoked, medium-term pain would ensue, but eventually recovery would occur. Hopefully with a new system and awareness that prevents reckless spending. But we are not so lucky, because the US government has another line of credit that Smith, nor Greece, ever did. The United States has the ability to issue its own currency.
Here is an elementary explanation of how this monetary system works. The United States needs to fund their operations, but they have no money. They hold an auction for Treasury Securities (bills, notes, and bonds), and people and institutions buy these bonds through an auction, setting the lending rate in the process. Now where does the money come from to pay the interest and principal on these bonds if it doesn’t exist? Simple, they print it. And in the process, they debase (dilute) the value of the current dollar. Eventually, what used to cost $1 will cost $2, because the money will be worth half as much. This is called inflation. No one talks about inflation now, because we are in a deflationary recession, but it will likely happen.
Now I used the word “likely.” What could help stave off inflation? Well, there are 3 measures. The first is to cut services. Using our previous example, this would be like Mr. Smith eating rice and beans at home, and using a fan instead of an air conditioner. These are the austerity measures that Greece is in the process of employing. There are no austerity measures, or even talk of them, in DC today. Rather, all the talk and action is of increased spending. Your representatives are trying to spend their way out debt. Perhaps there is logic to this Keynesian Economic theory, but the luxury of being able to experiment with it is an opportunity lost on other budget items. The new socialized-private healthcare model will likely pile massive deficits to the already failing budget. This is money that could have been used for the so-called “shovel ready projects” needed for economic stimulus (if you believe that theory). So of the 3, eliminate the first one. It is not happening. Few politicians get reelected by showing fiscal restraint.
The second fiscal measure is to raise taxes. This will definitely happen. At first it will target certain groups of people, primarily the “rich.” It will spread to include things like tanning salons, and perhaps even a VAT tax, which will not replace the current sales tax but will multiply it. This is the only reason the US is still able to borrow money. Lenders look at you, the US citizen, and figure that a lot more money can be squeezed out of you. I am not making this up; it is the absolute truth. Your taxes are going up. If not yours, your children’s taxes will increase. That will be legacy of the Baby Boomers.
The third measure is a recovering economy. As more people and businesses are productive, there is more income to tax. There is a problem with this measure though. No one knows when the economy will recover. It could take years. Things could get a lot worse before they get better. We can hope things improve, but this is ineffective planning tool. Further, it is not enough. No amount of growth will be able to fill this gap. Scratch the third measure as viable. The only one we can count on is an increase of taxes.
The summary of all this is that the US Government is spending at an unprecedented rate. The economy is in poor shape. Unemployment is high, and not improving. The most conservative projections call for sustained deficits extending over a decade of over $1 trillion per year. The Fed is continuing to debase the dollar, which will lead to inflation. But this is only the Federal Government, what about the states?
Last week there was an article in the New York Times describing the state of disarray of finances in Illinois. Illinois is running a rather extreme budget deficit. The deficit is so bad that they have been late paying their account receivables—10 months late in some instances. The impact of this is, of course, to drive private enterprises out of business. These small businesses provide services to the government and do not receive payment. The Illinois government is literally destroying Illinois businesses.
One would think that this would serve as a wake-up call for them, but that would be to not understand the politics of states like Illinois, New York, and California (the two right on the heels of Illinois). They are refusing to cut their budget (measure #1). They are raising their taxes (measure #2). Unfortunately for them, they will learn the extent to which people, especially wealthy people, are portable in American society. When taxes are too high, people leave for a different state. When Illinois wants too much, move to Florida. The weather is better and there are no income taxes. Illinois does not have the capability to print their own money, but if they are wise they are studying the Greece playbook right now.
Just like the EEC perceived an interest in bailing out the excess of Greece, the Federal Government will likely perceive a political interest in bailing out the excesses of Illinois. Simply stated, you, the citizen of anywhere but Illinois, will pay for the excessive benefits of the programs and pensions enjoyed by the citizens and municipal workers of Illinois. You can sleep well at night knowing your money is paying for someone else’s retirement benefit 1,000 miles away. Again, I am not making this up.
The only other evident path is the state of Illinois defaulting on their bonds. They have already started an internal default by late-paying businesses for their services. The next internal default would be to statutorily decrease defined benefits. It’s unlikely they will do that (again – Illinois politics), so the only other option would be to delay or skip payments to their lenders, who happen to be people that own Illinois municipal bonds. This is the least undesirable course of action for Illinois, since these bonds are the source of income for rich Illinois retirees.
I am using Illinois as the example here, but California and New York are right behind them. They all have the same political makeup, and they all have the same, limited options.
Hopefully this has served as a primer as to what sovereign debt is, and why it will impact you. Beyond inflation and higher taxes these issues will impact certain investments more than others. Some investments take on an increased risk in this environment, while others actually may benefit from these issues.
Over the next several months I will be writing installments that explain investments, and I will often refer to concepts discussed here.
I realize that there are many statements I made that are controversial, and if you disagree I would sincerely like to hear from you. I welcome questions also. Please use the comment function, so that we can politely discuss them in public, in a joint-learning environment.
DISCLOSURE: Certain Belray clients own municipal bonds of numerous states and Treasury securities.