The Chinese ‘Year of the Dragon’ is said to symbolise uncertainty, transition and change. This is a fitting analogy for where we find ourselves at the beginning of 2012. In this post, I look at some key strategies to help navigate this kind of environment successfully.

 
Where am I going and how do I get there?

Many drivers now have GPS units to help them navigate to a destination. All you need to do is input the address, and follow the instructions. But even the best GPS unit can’t allow for unforseen situations such as heavy traffic conditions, closed roads or a host of other variables that may affect the journey. Nor can they allow for extreme events such as floods or bushfires that may change and make the intended route very dangerous.

Even in boom times, investing is never as simple as following GPS directions. There are always uncertainties, and 2012 may appear to have more than its fair share.

A challenge for successful investing is to avoid making poor decisions in the face of this uncertainty. The good news is that it is possible to put in place strategies to bring this risk down to acceptable levels, and still keep access to sound opportunities to grow wealth.

Changing nature of risk

Future investment returns are rarely certain.

Analysts generally think about a range of possible returns, expecting that the most likely outcomes will be near the middle of that range, with a smaller chance that some will be much more or less.

This is commonly modelled as a statistical ‘Normal’ distribution of probabilities and outcomes, as shown by figure 1, which has been a reasonably good estimate of what to expect most of the time.

In this model, 95 per cent of outcomes are expected to be within a range of two ‘standard deviations’ higher and lower than the most likely estimate.

For example, sharemarkets might be expected to return between -12 and +24 per cent in a year 95 per cent of the time.

Since the on-set of the GFC, the ranges of possible outcomes have become wider than ‘normal’. The likelihood of specific events, whether they appear as good or bad, has increased the changes of returns outside the ‘normal’ range.

This is what the world’s biggest bond fund manager, PIMCO, mean when they describe the current outlook as ‘unusually uncertain’.

Figure 1: The ‘Normal’ distribution of risk
 

Source: AXA

Understanding the forecasts

With economic and market forecasts flying thick and fast, there are several potential traps for investors.

The first is being blinded by the headlines. The International Monetary Fund (IMF) recently reduced the global outlook for growth to 3.3 per cent, which is below the long-term average of 4 per cent.

These revisions are not new news, which is one reason markets didn’t react much. In fact the good news is that this growth is still well above ‘recession’ levels. For Australia, the prospects still look relatively positive, with developing Asia projected to grow most rapidly at 7 ½ per cent.

A second trap is not remembering figure 1. In a speech given late last year, the Governor of the Reserve Bank, Glenn Stephens, highlighted the importance of looking at a range of possible outcomes, not just the middle estimate.

However, there can be a sting in the tail of these ranges. The IMF forecasts include some dramatic possibilities, including the potential for similar type of trends to the 1930s.

These warnings are not predictions, but rather stern words to policy makers highlighting the need for clear action on European debt problems.

Just as drivers should not ignore a weather warning, which includes the chance of a gale, investors should not ignore warnings about changes in risks.

Have a plan

Authorities around Australia are urging households to have plans for risks such as bushfires and floods.

Investors also benefit from having a plan, especially in periods of increased uncertainty. It’s important that the plan includes actions that can be taken to bring overall risk back towards the intended level.

Three key actions to help resilience include:

1) Increase diversification. Some investors question whether diversification worked during the GFC, when actually it did.

The ‘flight to safety’ response to stressed markets meant that government bonds rose in value as sharemarkets fell.

Almost all other risk based assets were adversely affected during the ‘financial’ crisis, as portfolios were not truly diversified against that type of risk.

Better diversification now means a greater spread of asset classes, diversification by geographies and different economic risks, and different strategies within asset classes.

2) Align assets with specific needs. For some investors drawing income from a standard ‘balanced’ portfolio may not be the best approach when markets are moving quickly. 

A dedicated set of assets for liquidity needs, and regular income requirements can increase the likelihood of meeting those needs, and also reduce the risk of being forced to sell longer term growth assets when the markets are depressed.

3) Adjust ‘strategically’. When markets move through large ranges over short periods, the basis for the initial investment structure may have changed, and new attractive opportunities may have emerged. 

Adjusting a portfolio in response to these changes has got nothing to do with speculative trading. It is about remaining true to the intended strategy, and adjusting for changes in the opportunity set. Some new innovations in managed funds are building more flexible asset allocation processes to address this need. Others offer forms of insurance against unwanted outcomes.

What this means for investors

While the media loves them, the least useful forecasts for investors are the predictions of future market levels.

Forecasts about the level of the sharemarkets, currency, or the price of gold, by the year end make great headlines, but have no real value for investors.

They are merely predictions about the unknowable and not something to base a strategy around.
An investment strategy that allows for a range of outcomes and includes a plan to manage risks is likely to yield a better outcome.

After months of meetings, we appear to be no closer to a clear solution for Europe’s debt problems. The hard reality is that there isn’t one. In this post Ilook at some of the potential implications for investors as the world goes through painful adjustments.

For more back ground on this issue,  you can also read my previous posts:

Sovereign debt defaults: Not an unusual occurence (July 2011)

Greece is going to come back into the splotlight (May 2011)

Greece – The fire is out, but there are still problems (May 2010)

Greece – A short-term disruption? (February 2010)

It’s a case of two steps forward, one step back

Many investors seem to believe that if European leaders get their act together, the world’s economic problems can be solved quickly. 

It is clear that a solid plan is needed, otherwise conditions will deteriorate further. Therefore it is right for markets to be concerned that political leaders seem unable to agree on a plan.  But it is not realistic to expect that any such plan will provide an instant solution. There is unlikely to be a specific point at which we can say the problems are ‘fixed’.

Climbing out of the slump was always going to be a very difficult and lengthy process. Progress has been made on a number of fronts, but investors need to adjust to the prospect that the process will include some failures as well as successes.

The priorities over recent months were never about the permanent fix. The key focus has been on containment: measures that will stabilise the system, ring fence the problems in Greece, and avoid an uncontrolled spread to other vulnerable economies.

Markets initially experienced a relief rally in October as new measures were agreed. Over the space of a few days, the global sharemarket rose by 14 per cent, the US market 17 per cent and the Australian market by 12 per cent. In the case of the US, these were the strongest October gains since the early 1960s.

Gains of this magnitude can easily occur any time that steps forward are made, partly because the starting point is relatively cheap valuations.

Even the Australian share market is about 30 per cent cheap relative to long term valuations.
Sharemarkets around the world have very low growth expectations already built into current valuations, providing a big cushion for risk.

Conversely, backwards steps trigger strong sell downs. But setbacks should be expected. Most ‘decisions’ on European policy initiatives cannot be agreed at a single forum. They require agreement and ratification in a number of other forums, by member states, and the markets.

Political instability is slowing this process, which is why a range of workable solutions involves a frustrating process of two steps forward and one step back.

Dialling down the noise

It is important for investors to be able to turn down the noise on the blow by blow commentaries and focus on the key issues at stake.

Commentators often talk about a ‘financial crisis’ and ‘economic crisis’ as interchangeable terms.  They are really two separate groups of legitimate concerns, even though each can impact the other.

Financial crisis concerns

Financial crisis concerns relate to the risks to the global financial and banking system.
To help avoid a repeat of collapses in Europe, the European Financial Stability Facility (EFSF) was set up in 2010 specifically to provide stability for Euro member states.

Recent steps forward have included agreements to widen its scope and increase funding from €750 million to around €1 trillion by extending the guarantees from member states.

This fund is designed to support the borrowing requirements of troubled countries and help the process of recapitalising European Banks.

This type of fund wasn’t in place in 2008.

Over the past month, the European Central Bank has also effectively intervened as a buyer in Italian and Spanish bond markets.

Economic concerns

Economic concerns relate to risks to global economic growth.

The western world faces a long period of adjustment from high levels of debt, much of which is now in the form of government debt. 

Europe is focussed on government debt reduction through what’s being referred to as ‘austerity’ measures – effectively tightening the belt by reducing government spending and increasing taxes.

The markets are concerned that these measures will also drag the global economy back into recession.

But not all economies are equally vulnerable.

One way of looking at the potential impact to the stronger growing region of the world is through its trade relations with the Euro area.

Figure 1 shows that developing countries with large export markets such as the Czech Republic, Poland and Hungary are likely to feel the brunt of the slowdown in the Euro area. Over 50 per cent of these countries’ exports go to the Euro area.

The faster growing Asian economies, including China and India have a lower exposure to a further slowdown in the Euro area, but are likely to still feel a negative impact.

For example, China’s export market is around 30 per cent of its economy (GDP), with around half of its exports going to the Euro area.

In contrast India has a small export market. It is less than 20 per cent of its economy (GDP), with approximately 15 per cent of its exports going to the Euro area.

These trade dynamics may provide a buffer for the Australian economy. We sit within the developed world but are also directly linked into developing economic growth of the faster growing Asian region (as shown by our terms of trade) that is likely to hold up relatively well even if Europe slows further.

Figure 1: Developing countries exports to the Euro area

Source: IMF, National Account, Haver Analytics, and AllianceBernstein. Data as of June 2011

Some investors may need to recalibrate their expectations of an all encompassing solution to Europe’s debt problems. 

Heightened volatility, periods of both ‘good’ and ‘bad’ news and even occasional defaults will all be features of the resolution of current concerns. Market valuations already reflect a high level of anxiety towards these issues.

The global economy is facing major hurdles which require decisive action. Initial responses have not been enough. This post looks at the inter-related risks of a further slowdown and deteriorating sovereign debt situation in Europe.

A sick patient

After a good initial recovery, the global economy is back in intensive care. The recovery that began in the middle of 2009 has weakened. There is now an increased urgency for strong policy actions in Europe and the US in order to avoid a full relapse.

There are two big inter-related problems. The first is that economic recovery has slowed to a crawl in the major developed economies. The second is that sovereign debt problems in Europe, as well as the US, have worsened.

These two trends have increased risks, and taken their toll on confidence – for consumers, companies, and investors.

These concerns are not just hype. The latest data confirms a significant slowdown in the major western economies over recent quarters. The European sovereign debt crisis has deteriorated further.

The medicine has not been enough

The immediate outlook for Greece’s debt problems is very uncertain.

Greece has just missed an important target. The latest budget approved by Greek cabinet predicts a budget deficit for 2011 of 8.5 per cent of GDP, compared with the agreed target of 7.6 per cent.

It’s still likely that Greece’s efforts, which include job losses and big salary cuts, will be enough for European officials to support the next payments due on Greek bonds in the coming weeks.

But the longer term prospects for Greece remain poor.

The severe austerity measures that Greece has undertaken to bring its budget deficit down from almost 15 per cent to 3 per cent of its economic growth by 2014 has resulted in deep recession and civil unrest.

This is only making it harder for Greece to implement a range of necessary adjustments to meet its onerous financial obligations.

Some form of ‘default’ on Greek government bonds remains likely at some stage. The challenge will be to control, or ‘ring fence’ the consequences. The markets are not yet convinced that Europe’s leaders are up to this challenge.

Preventing the disease from spreading

Sovereign debt defaults are not unusual. Greece has been in default more than 50 per cent of the time since gaining independence in 1829. But this time Greece’s problems are Europe’s problems and the numbers are much larger than before.

Greek public debt is now about US$500 billion. To put this in perspective, Argentina’s debt was US$82 billion when it defaulted in 2001 and Russia’s debt was at US$79 billion when it defaulted in 1998.

US economist David Hale has concluded that European Banks have around US$163 billion of exposure to Greece, while non-European banks have around US$44 billion. France has the largest exposure followed by Germany and then the UK. More than half of Greece’s public debt is now owned by official institutions such as the International Monetary Fund (IMF) and the European Central Bank (ECB).

The risk of default has come at a really bad time, when growth in the major economies may be about to turn negative.

The worst possible outcome would be an uncontrolled default. This would probably entail Greece leaving the European Union. The risk of contagion would be very high for other high debt European governments and the broader financial system.

The markets are grappling with a range of  possible solutions, including the expansion of the existing bailout fund (European Financial Stability Facility) from €440 billion to around €2 trillion and the formation of common Euro bonds.

A controlled default is a possible option to bring Greece’s debt back to more manageable levels – both in the short and longer term.

What does this mean for investors?

In recent months, the deteriorating outlook has led to a renewed bout of selling ‘risky’ assets such as shares and the Australian dollar and resulted in strong flows in perceived safe markets such as US government bonds and cash.

The recent falls in sharemarkets is already pricing in the risk of a major slowdown in profit growth. On most conventional valuation measures, this means that markets have become oversold.

The global sharemarket is trading at a discount of approximately 30 per cent and the Australian sharemarket is trading at a discount of 22 per cent.

For some stocks in these markets, valuations have been effectively pricing in no real profit growth.

Oversold markets do not mean that markets can’t fall further, or that new developments might emerge to justify these levels.

They do mean that investors should seek to avoid becoming forced sellers at a time when markets are undervalued,and longer term investors face a potentially attractive entry point for new cash into the market.

Another feature of oversold markets is that they can react sharply to any good news.

A combination of a stronger US dollar, slower growth, fall in commodities and uncertainty surrounding future interest rate movements by the RBA has caused more volatility in the Australian dollar.

Over recent months, this volatility has halved the fall in global equities for Australian based investors.

The most recent ‘flight to safety’ has seen US Treasury bond yields fall to 2 per cent. Bond yields and prices have an inverse relationship. For example, a rise in the yield of a ten year treasury bond from 2 per cent to 3 per cent would result in a capital loss of approximately 8.5 per cent.

In this kind of environment, it’s even more important to have a plan which allows for uncertainties rather than relying on predictions.

The current situation may get worse before it gets better. Alternatively, a path to resolving the current imbalances may be achieved, in which case the markets may adjust to a better outlook.

Plans which allow for a range of outcomes can help investor confidence. Ensuring sufficient cash is available for short term needs helps reduce the risk of becoming a forced seller into oversold markets. A disciplined plan for longer term growth assets reduces temptation to switch into overbought assets – which may not be as safe as they seem.

For more back ground on this issue,  you can also read my previous posts:

Sovereign debt defaults: Not an unusual occurrence (July 2011) 

Greece is going to come back into the splotlight (May 2011)

Greece – The fire is out, but there are still problems (May 2010)

Greece – A short-term disruption? (February 2010)

Events that rock investment markets make it hard for us to step back and see the full picture in context.  Relying on the daily newsflow isn’t the answer. It’s hard to avoid the short-term pressures, but the ability to remain disciplined is essential for success.

The current period of market turmoil drives news that suggests urgency or imminent danger. At present, this may be true, but we can make matters worse with the wrong decisions. The human brain is hardwired with a ‘flight to safety’ response when faced with danger, which can trigger destructive reactions for investment decision making.

In the times of our early ancestors, survival was the daily challenge. The survival instinct needed to click in even before a rational thought process had time to work through the problem. 

The hardwiring of our brains hasn’t really evolved much since this time. If a lion were to lunge at us, we would instantly jump back – even if the lion is behind steel bars at the zoo. In effect, we were born to run.

Running from investment risk can mean systematic failure.

Our natural reaction to threatening news on the investment front is similar. When danger appears, our initial response is an urge to run to safety.

These reactions can lead us to become risk adverse when opportunities abound, such as at the bottom of the market when everything seems extremely dangerous. The same reactions can also lead us to become risk seeking at the worst possible time, such as at the peak of a market when everything seems calm. 

The ‘news’ may make things worse

‘News’ is not the same thing as ‘analysis’. It’s just news. For an event to be ‘newsworthy’ it needs to meet criteria such as urgency, emotion, conflict, proximity and significance.

These criteria are about triggering an emotional reaction. But this is a poor basis for making sound investment decisions. In fact, as shown by table 1 below, the most newsworthy stories are designed to meet criteria that can also drive poor investment decision making.

An additional problem is that the news needs to focus on the very latest developments. Investors need to be able to see the whole story in context. The focus inevitably shifts to the short term, especially when the short term seems bad.

The emotional content of the news is often drawn out in the headlines. Consider some of the headlines that were used to describe market falls in recent days and weeks – ‘The GFC is back and it’s here to stay’, ‘Armageddon’,  ‘Markets tumble as investors fear GFC II’, ‘Bell rings for crisis, round 2’, ‘Turmoil wipes out share recovery’, ‘Time to take cover’, ‘What the meltdown means for you’.

There was some good economic and financial news through this period, but it didn’t appear on the front page.

Unless an investor can step back from this noise they are at risk of making an emotional decision.
 
Table 1: The criteria to be newsworthy leads to poor investment decisions

Seeing things differently

Graphics used in presenting a story can set the tone, but perspective makes a big difference. Contrast figure 1 with figure 2. They are both showing the same markets and include the impact of recent market falls, but with different scales and time frames.

Figure 1 makes the 15 per cent fall that occurred in late August seem like it was more severe than it was. As the headlines suggest, it really looked like the markets were falling ‘over the cliff’.

Figure 2 highlights a different perspective. It reveals that the global sharemarket is still up by just over 60 per cent since March 2009 lows, even taking the recent 15 per cent fall into account.

This is hardly the case of heightened market volatility wiping out the sharemarket recovery as the headlines implied.

Figure 1: Global sharemarket from Aug 10 to 11 Aug 2011

 
Figure 2: Global sharemarket from 1 Jan 09 to 11 Aug 2011

Source: Datastream. Data for both graphs up to 11 August 2011

Investing when anxious

A danger for investors is that if decisions are made on the basis of fear and panic, they are heightening the risk of simply following the ‘herd’ and creating a permanent capital loss. 

A number of things can be done to reduce this risk.

Firstly, investors need a plan. This is not as obvious as it sounds. In good times, it is possible to achieve investment objectives in many ways, and even get away without much of a plan. In tough times, a plan can help ensure that investors don’t become ’forced sellers’ of assets during market downturns, by allowing for short term needs with appropriate assets. A plan can also provide peace of mind, which reduces the urge to sell when anxious.

Having a plan doesn’t necessarily mean no change. But a plan allows for any adjustments due to personal or market conditions to be made on a sound basis. In tough times, having the right level of cash, diversification and financial protection are all decisions that are best evaluated in the context of a plan.
 
Secondly, be emotionally ready for bad news – markets are likely to have already priced this in. Most stock markets are already trading well below their normal long-term values, building a weak outlook into their prices. There can still be a short-term overreaction, but typically markets that are cheap eventually recover well.

In recent days, the increased potential for the Greek government to default on its bonds has spooked the market. That risk has been known for some time, and is reflected in the current interest rate of nearly 100 per cent on some one-year Greek government debt.

Thirdly, don’t ignore positive developments. Sharemarket investors are invested in companies, not countries. Despite all of the volatility of recent months, many company profits are growing strongly. Compared with forecast profits, nearly 60 per cent of the western companies that make up the global sharemarket (as defined by MSCI) recently beat second quarter expectations. Company balance sheets are strong and in many cases, awash with cash.

Finally, turn off the news. Perhaps not literally, but tuning out to the day to day cut and thrust of the market movements improves the prospects for sound investment strategies to stay on track. In particular, it is important to be alert to the risk that newsflow could lead to poor investment decisions.

September 2011

The recent downturn in share markets is distressing and confusing for investors. The emotional charged coverage of the market turmoil and the multitude of conflicting views can derail even the most disciplined investor.

It can be helpful to step back from this noise and view the current events in perspective.

Other sources that are useful in this regard include:

Olivers Insights:
The US loses its AAA rating from S&P. Not good but maybe not as bad as feared

Slumping global sharemarkets and debt debacles

Ipac:
Recent events and global sharemarkets

Past posts (covering European debt issues)

Greece is going to come back into the splotlight (May 2011)

Greece – The fire is out, but there are still problems (May 2010)

Greece – A short-term disruption? (February 2010)

Big market falls after a strong rise

The US sharemarket has fallen by 13 per cent over the past week, and nearly 17 percent over the last 4 weeks.  Panic trading during the past few days has fuelled some of the largest one day declines since 2008.

While substantial, these declines need to be viewed in context. Investors should note:

• Markets have risen strongly since the GFC

The falls in the US sharemarket have followed a very substantial rise in global markets since the Global Financial Crisis (GFC). Despite economic concerns, the US sharemarket has been one of the best performing in the world. From a low point in March 2009, it gained almost 100 per cent through to early July this year. Even taking recent market weakness into account, the US sharemarket is still up by 65 per cent since March 2009, as shown by figure 1.

The Australian sharemarket has also fallen sharply over recent weeks, posting a decline of 11 per cent in the last week. While the market is now also back to similar levels reached in August last year, it still is almost 30 per cent higher than its lowest point in March 2009, as shown by figure 2.

Figure 1: US sharemarket since January 2009

Source: Datastream, data up to 8 August 2011 

 Figure 2: Australian sharemarket since January 2009

Source: Datastream, data up to 8 August 2011

• Markets are cheaper and profits increasing

The rise in the US sharemarket reflects the strong performance of US companies – company profits have risen by 94 per cent since December 2009.

Even though profits have continued to grow, share prices are now back to the levels of a year ago. This means that shares are now cheaper than they were a year ago.

This holds true whether we are considering price relative to profit, or price relative to book value.For example on a p/e basis, US and Australian shares are currently trading around 30 per cent cheaper than their long term average.

Panic in the share market is ironically driving high demand for US treasury bonds and the US dollar, despite the fact that these are now very expensive, low yielding assets. The yield on shares is now higher than the yield on bonds – historically a clear sign of relatively cheap share valuations.

It’s bad – but not all bad

As markets fall, news reports are uniformly negative.  The media has been relentlessly negative, peppering reports with words such as ‘meltdown’ to ‘Armageddon’. No wonder fear has been the order of the day.

The focus on negative developments in the US and Europe is understandable. But that doesn’t mean that nothing good is going on – it’s just not ‘news’.

To help balance the scales a little, it’s worth considering some of the positive trends with an unapologetically one-sided list of ‘good news’.

• The world is experiencing solid economic growth

The world returned to positive growth quickly following the global financial crisis, returning to positive growth in 2010. According to the IMF, growth for 2011 and 2012 should exceed 4 per cent.

Even though forecasts may be lowered, any further economic slowdowns in the US and Europe are unlikely to pull the entire global economy into double dip recession.

The developing economies now comprise more than 50 per cent of the word economy, and according to the IMF, they are expected to grow at more than 6 per cent over the next few years.

The strength of the developing economies provides an important counter weight for overall global economic growth.

Importantly for Australia, China – now Australia’s major trading partner for both exports and imports – is growing at more than 9 per cent per annum.

• The Japanese economy is rebounding sharply

Japan’s economic growth is showing signs of recovering more quickly than expected from the negative impact of this year’s natural and nuclear disasters. The forecast growth for 2012 has been around 3 per cent, and this may be exceeded. For example, Toyota, which manufactures more motor vehicles in Japan than other Japanese manufacturers, has now revised its forecast profit up by 39 per cent for the full year, noting a quicker than expected recovery from the March 2011 earthquake and tsunami.

• The new US budget constraints won’t add to the risk of a recession

The US Congress resolved to approve an increase in the government borrowing limit after agreement had been reached on the US Budget Control Act. This act requires adjustments to the Federal Budget, which are estimated to reduce the US deficit by $2.1 trillion dollars over the next decade.

Markets reacted with concerns that these cuts would slow US economic growth to the point of recession.
As shown in figure 3, US government policy was providing a boost of more than 1.5 per cent to economic growth when it was needed in 2009.

The withdrawal of that stimulus was expected to detract around 1.5 per cent from growth in 2012. The US Budget Control Act only marginally increases this impact. On its own, these measures are not enough to shift the outlook from growth to a recession.

Figure 3: Contribution of US fiscal policy to US GDP growth

Source: The Economist

• The Australian economy is well placed

With a low government debt of 24 per cent of our economic output, strong growth, low unemployment, and record demand for our exports, the Australian economy is very well placed to absorb global shocks.

Australia’s AAA credit rating is solid.

• Some inflationary pressures are falling

From their peak last year, oil and food prices are down by 15 to 20 per cent, reducing inflation pressures.

• The global banking system is in a stronger position post GFC

Recent stress tests undertaken by the International Monetary Fund (IMF) have shown European banks are in sound shape.

• Corporate balance sheets are in very good shape and profitability is increasing

On the whole, corporate balance sheets are in good shape with low levels of gearing and high levels of excess cash.

• The long term track record of the market is compelling

Among all of the disasters, crises, and disruptions that have impacted markets over the past century – many have seemed much more serious than the concerns we currently face.

And yet over time, the stock market has always finished higher. Throughout the entire period since 1900, the Australian market has returned 11.8 per cent per annum, despite all of the bad news that could be thrown at it.

Acting, not reactingWatching others aggressively selling in the markets understandably creates a massive desire to do the same. But this approach crystallises a loss and prevents any long term investor from realising gains when the markets eventually stop panicking and start to price in strong underlying profit growth.

Confidence is at an all time low at present – it may not seem like it now, but confidence will eventually improve in the future, potentially unlocking significant value in the markets.

Greece has been in default more than 50 per cent of the time since independence. In this post, I note that sovereign debt defaults are not unusual, and can be an important part of the rebalancing process.

For more back ground on this issue,  you can also read my previous posts:

Greece is going to come back into the splotlight (May 2011)

Greece – The fire is out, but there are still problems (May 2010)

Greece – A short-term disruption? (February 2010)

Some respite from European sovereign debt concerns

The markets have spent much of the past few months worrying about the risk of a sovereign debt default.

A sovereign debt default means that a government (like a company or individual) isn’t able to meet its obligation to pay interest and capital when due.

A key risk here is panic spreading to other countries and markets seizing.

The recently announced ‘bailout’ package for Greece marks a likely turning point in this ongoing story.

It includes elements of a negotiated default, or rescheduling process, that reduces Greece’s overall debt burden, while also providing enhanced support measures for other troubled European countries. 

The real breakthrough is that it spreads the pain –most lenders are now willing to accept a loss on their exposure.

While this is a positive development that has calmed the markets, the underlying problems facing Europe are still far from solved.

High deficit and debt situations take a long time to correct

The problem for many European countries, not just the European periphery, is that they are dealing with very high deficit and debt levels, as shown by figure 1.

To ease this situation, these countries need to reduce their deficits to sustainable levels. There are only two ways this can occur: the first is by increasing income and the second is by decreasing spending.

In practice this is very hard to do, and it takes a long time when the starting points are so high.

In the case of Greece, it’s almost impossible because the country is effectively bankrupt and already experiencing recessionary conditions.

This is largely why a workable solution for Greece still requires external help.

Figure 1: European govern deficit and debt levels

Source: International Monetary Fund. AMP Capital Investors. As of May 2011

The trade-off European leaders grappling with

European authorities have been grappling with the trade-off between governments reducing deficits and avoiding potential defaults.

The trade-off is seen to be:
• Reducing deficits = slowdown / recession and social / political problems
• Default = slowdown / recession and higher interest rates / locked out of markets and contagion

Up until now, the possibility of a managed, orderly default has been off the table because European authorities see the risk of contagion as too high.

But in practice you can’t dodge the issue – markets transmit risks and concerns quickly.

This was highlighted in recent weeks with the markets driving up yields on Italian debt to their highest levels in a decade, even though Italy is economically sound, and has longer-term debt duration than other European countries.

The spill over of tension into Italy partly accounts for the change in sentiment among European Leaders for the private sector to accept some loss on their exposure.

Overall, this is a positive development that has been well received by the markets. But there is still a lot of detail to work through, and the rating agencies could unsettle the markets if they regard the latest instalment of support measures as a technical ‘default’.

Historically, sovereign debt defaults not unusual

It may come as a surprise to learn that historically, sovereign debt defaults are not unusual.

Research shows there have been 246 sovereign debt defaults since 1900. (Reinhart & Rogoff, This Time is Different  These defaults typically occur in waves and are separated by many years, or decades, which make these events seem rarer than what they are.

In fact, Greece has spent 50.6 per cent of its time in default or in a process of rescheduling since it gained independence in 1829.

Many government defaults tend to occur after a large scale financial crisis, such as the GFC.  Most are managed in an orderly way, but the impact for investors is a period of very slow growth that lasts between five to ten years.

What about the US?

The US is also in the headlines because its deficit and debt levels are very high.

The US places a legal limit on how much the government can borrow. Every few years, this limit gets reached and Congress is asked to approve an increase.

This time they are playing hardball, and the markets are likely to be spooked further if it takes up to the eleventh hour for an agreement to be reached.

In contrast to Greece, the US is not bankrupt. Its deficit is due to the massive stimulus measures that were deployed at the onset of the GFC.

Another key difference is that the US dollar still remains the global reserve currency, which has been allowed to depreciate, while Greece is tied to the Euro.

In addition to these factors, US government debt is seen as a safe haven in times of risk, but this may change if the government doesn’t outline credible exit strategies to manage and reduce current debt levels.

What this means for investors?

Government debt levels will continue to disrupt markets until balances become more manageable. This is likely to take a long time and involve a period of very slow growth.

The processes of avoiding, or managing a default may be unnerving at times, but history suggests that markets will eventually climb over the disruption. There is always the risk of a mis-step and markets are currently pricing in much of this concern.

A big lesson from the GFC is to ensure that cash is set aside for cash and liquidity needs. That security needs are met and that longer-term strategies, where appropriate, take advantage of historically cheap markets.

The Global Financial Crisis (GFC) has changed the way Australian households regard risk and manage their saving, spending and their investments. In this post, I look at some of the impacts of these changes.

The shockwave

The GFC was a shock to all households and investors. Debt markets froze, companies and banks collapsed, and the world’s financial system appeared to be balanced on the edge. The global sharemarket fell by around 55 per cent.

These are the types of events that we read about in history books, but never think will happen in our time.

Yet, when an event does take place of this magnitude, it’s often accompanied by a big shift in the way investors regard ‘risk’ and manage their finances.

Prior to the GFC, Australians borrowed a lot

Australia went into the GFC with a fairly strong economy, but there were some serious distortions in our markets.

Like the rest of the world, Australians had been building up their debt levels during the good times. For decades, Australian households maintained reasonable levels of total debt which were around 40 per cent of income. About three quarters of that debt was for housing.
 
Then through the 1990s and 2000s, these debt levels skyrocketed. By the time the GFC hit, household debt ratios had quadrupled to about 160 per cent of income, as shown by figure 1.

This high level of debt needs a ‘goldilocks’ economy to survive, with everything just right – low interest rates, rising house prices, low unemployment, and rising wages.

We had it for a while, but these conditions can’t last forever. The GFC shock reminded everyone of the need to always be ready for the good times to end.

Figure 1: Household debt to disposable income

Source: Reserve Bank of Australia. Data up to March 2011

Now we are reversing this trend and saving

Households have reacted with a substantial increase in savings, as shown by figure 2. Now, more than 10 per cent of household income is being saved rather than spent – a level not seen for 25 years.

This change has coincided with a continued fall in the rate of growth of household borrowings, from a peak of almost 25 per cent in 2003, to a current level of around 6 per cent, as shown by figure 2.

Figure 2: Household savings and credit growth

Source: Reserve Bank of Australia. Data up to May 2011

This is the slowest rate of household credit growth since the early 1990s recession.
In many ways, the change over in savings and credit growth is a healthy occurrence. It has helped to restrain debt to disposable income levels from climbing to even more unsustainable highs, as shown by figure 1. This in turn has helped to take some of the heat out of the Australian housing market.

But while the housing market has cooled a little, it hasn’t experienced a major correction. Debt to disposable income levels remain historically high, and this means the housing sector is vulnerable to further interest rate rises.

Impact to Australia’s two speed economy

The recent change in the way households manage their finances marks a necessary shift to a more sustainable position.  But as households save more and borrow less, they spend less, which is in turn is contributing to the slowdown in Australia’s two speed economy.

For as long as households continue to adjust, the change will be a drag on economic growth. But households aren’t the only parts of the economy going through these types of changes.

Businesses have been undergoing similar adjustments, as they feel the effects of the weaker consumer spending.

The government sector is also adjusting – shifting from a budget deficit to a surplus means more taxes, less government spending, or both.

What this means for investors

The desire to boost savings and not risk has contributed to a huge growth in Australian bank term deposits since 2007.

Figure 3 shows the rate of growth in term deposits reached 50 per cent by early 2009, as investors sought the safety of cash amid falling markets.

Signs are starting to emerge that this trend is moderating, with the savings now sitting in the 10 to 20 per cent growth band.

This growth rate continues to help Australians strengthen their financial house and ensure they have a reasonable buffer in place to manage unexpected changes.

Figure 3: Rate of growth in term deposits

Source: Reserve Bank of Australia. Data up to May 2011

Investors are still jittery over threats to the global recovery, and prone to panic over potential impacts to risk based assets, such as shares, that were very hard hit during the GFC.

An emotional reaction to a shock is usually one of the worst decision-making frameworks. It can perpetuate the cycle of buying at high prices when everything is going well, and selling at low prices when there is a problem.

US studies have shown that this behaviour has helped turn an annual sharemarket return of about 8 per cent over the past 20 years into an average investor return of less than 2 per cent per annum.

A more sound approach is to ‘act and not react’. To have a strategy that allows for stresses and shock – and that doesn’t become compromised by looking backwards rather than forwards.

The RBA’s official cash rate is a target interest rate set by policy. In economic jargon, this is referred to as ‘monetary policy’. By setting a target interest rate level for cash, the RBA is effectively determining the benchmark rate for borrowing and lending transactions across the whole economy.

The RBA’s official cash rate is set by members of the RBA board, who meet every month, except in January – although if needed they can call a special meeting anytime.

In setting the official cash rate at a certain level, the RBA is effectively either putting its foot on the accelerator to stimulate growth, or putting on the brakes to slow growth and reduce inflationary pressures.

The RBA has historically viewed a ‘neutral’ level for the official cash rate to be around 5.25 per cent.

This means that with the current official cash rate sitting at 4.75 per cent, monetary policy is still below ‘neutral’, and could be expected to rise further in the future.

What’s the likely path ahead?

The Reserve Bank Act states that RBA is responsible for economic prosperity, stability of currency and prices, and full employment.

However, the only economic policy tool the RBA has is ‘monetary policy’ – the rest is up to the government, business and consumers.

Since the early 1990s the RBA has pursued the ‘practical expression’ of these objectives by explicitly declaring a target range for inflation of 2 to 3 per cent.

If inflation looks to be trending above this range, we can expect to see the official cash rate to go up.

The old cliché – ‘it’s a blunt instrument’

A key difficulty with using monetary policy to target inflation is that it’s a blunt instrument.

It changes the cost of borrowing and lending across the entire economy. 

Australia’s economy is currently often described as running at ‘two speeds’. The mining and energy related sectors are booming, while some other sectors, such as manufacturing, retail and tourism are still doing it tough. 

Market participants are particularly concerned that even small rises in the official cash rate in the coming months could slow these sectors further.

The RBA acknowledges this risk, but is clear that containing inflation is a higher priority.

What this means for investors

Good news for savers, bad news for borrowers

In our current environment, saving and lending rates are influenced by movements in the RBA’s official cash rate and the risks and costs of accessing funds from wholesale markets, including overseas markets.

For most of the 15 years prior to the global financial crisis (GFC), Australian bank term deposit rates were below the official cash rate, and moved in line with changes to it, as shown by figure 1.

This relationship changed when the market hit rock bottom in March 2009. After this point, the rate of return on term deposits shot ahead of the RBA’s official cash rate.

When the assessment and pricing of risk changed, Australian banks could no longer rely on relatively cheap funding through overseas markets.

This meant that Australian banks had to intensify their competition with one another in an attempt to gain market share of local term deposits.

The rise in term deposit rates has been a positive development for savers. They are now able to get a relatively high ‘risk free’ rate of return above the current inflation rate.

Figure 1: 1 year term deposit versus the official cash rate

Source: The Reserve Bank of Australia, as of June 2011

But it hasn’t been such a positive result for borrowers. The banks have cited increased funding costs as the main reason for moving out of sync and raising lending rates by more than the RBA’s changes to the official cash rate.

Australians hold around 140 per cent of disposable income in debt rating to housing (both residential and investment). This sector is vulnerable to both further rises in the official cash rate and adverse developments in overseas wholesale markets. 

Risks for Australia’s concentrated sharemarket

Rising funding costs haven’t been a positive development for Australia’s sharemarket, partly because it has a high, 36 per cent concentration in financials stocks, as shown by figure 2.

Figure 2: Australian sharemarket

Source: Bloomberg, ASX300, as of June 2011

According to an RBA September 2010 bulletin, ‘mum and dad’ investors are twice as exposed to the Australian financial sector as institutional investors.

These ‘mum and dad’ investors hold on average 65 per cent of their portfolio in financial stocks, while institutional investors hold around 30 per cent. 

The benefits of investing directly in the Australian sharemarket include relatively high rates of dividend income and franking credits to help reduce tax obligations.

However, such a high exposure to one sector of the sharemarket could leave investors exposed to specific events – like rising interest rates or further disruptions to global credit markets.

Australia may still be the ‘lucky country’, but investors should always be looking to ensure that they have a well diversified investment strategy, which may include cash and assets outside of Australia.

Audio

For more back ground information as to what’s happening with Greece, you can read my
previous posts:

Greece – The fire is out, but there are still problems (May 2010)

Greece – A short-term disruption? (February 2010)

Otherwise, for a current analysis please read on.

An uphill battle continues

Just over a year ago, European policy makers approved a €750 billion stabilisation package to provide troubled Euro area countries with enough money and time to get their financial houses in order. A further €110 billion package was specifically targeted for Greece.

These bail-outs came with strings attached. In accepting the rescue package, Greece agreed to reduce its budget deficit to 3 per cent of GDP over a five year period.

This was always going to be a massive task, given how high the starting point was initially perceived to be.
At the beginning of last year, Greece agreed to reduce its 2009 budget deficit from what was thought to be 13.6 per cent of GDP to 8.1 per cent of GDP in 2010 – a recession inducing adjustment of nearly 5.5 per cent of GDP.

Surprisingly, Greece came very close to reaching this target, as shown by figure 1, except that revised estimates show the task to be greater than first thought.

It’s now estimated that the 2009 deficit was really closer to 15.4 per cent of GDP, which means that when last year’s deficit came in at 10.5 per cent of GDP, it was also above target.

It’s a similar story for Greece’s debt to economic growth projections.

A year ago, the Greek government’s debt to GDP ratio was expected to peak at around 150 per cent of GDP in 2012/13. But recent revisions show that ratio reached just under 145 per cent at the end of last year.  It’s now expected to rise to almost 170 per cent in 2012/13.

On current estimates, Greece is going backwards as it tries to go forward.

Figure 1: Reduction in budget deficits as a % of GDP
2009 to 2010

Source: European Commission and AllianceBernstein

Europe looking for the lesser of evils

Interest rates on Greek debt have continued to rise dramatically over the past week. It now costs the Greek government 22 per cent to borrow in Euros for two years. This compares with 1.8 per cent for German two year Euro debt.

Initially, the stabilisation packages were about avoiding a debt restructuring programme for Greek government bonds.

Recent developments mean that the problem has entered a new and more challenging phase in which some form of restructuring or further additional support has become more likely.

Restructuring can involve a ‘soft’ process, which allows bond holders and issuers to agree to an extension of due dates for payments or maturities.

The process, often referred to as ‘reprofiling’, is less disruptive than an imposed ‘hard’ rescheduling process and significantly less disruptive than outright default.

One problem is that this potential solution doesn’t have widespread support across Europe.

The alternative ‘hard’ rescheduling process could involve a ‘hair cut’ arrangement, where all bond holders incur a loss and have their credit cut back to reduce Greece’s overall debt position.

This solution would help keep Greece solvent, but would incur large losses for European governments and banks.
The European Central Bank (ECB) remains very motivated to avoid a default event on Greek bonds, or even a ‘soft’ restructuring event.

Authorities consider that the risks of contagion, and of a collapse to the Euro itself, are too high.
Greece needs to raise €27 billion of medium and long-term finance from the markets over the next year, and is unable to fund this new debt through the capital markets without European support.

If Europe’s leaders decide to cover this gap with additional financial support, then depending on the maturity of these purchases, the overall exposure of the EU, IMF and ECB to the Greek government could be as high as €200 billion by the end of next year.

Figure 2 shows that’s equivalent to the EU, IMF and ECB holding around 50 per cent of outstanding Greek government debt by the end of next year.

European authorities are likely to view this outcome as the lesser of evils, providing it avoids debt restructuring.
The cost for Greece will be even tighter targets for budget savings and demands for increased asset sales, all deepening an already serious economic recession.

Figure 2: Projected share of Greek debt held by the EU, IMF and ECB

Source: European Commission and AllianceBernstein

What this means for the markets

Greece’s debt problems have been out of the mainstream media for a while, but they have not gone away.
In fact, the situation has worsened and nervous investors can expect more volatility across all markets, as governments and central banks wrestle with this issue in the coming weeks and months.

Bond markets are clearly already pricing in potential losses. Greek government bonds have been downgraded to ‘below investment grade’ by major credit rating groups.

Equity markets are likely to react negatively in the short term if current negotiations look like failing. But the most likely outcome looks to be European leaders agreeing to further support rather than precipitating a more risky environment.

Here are three summaries that I think will be helpful in focussing on the key issues:

1. ipac has prepared an excellent summary of the budget, which covers What it means for financial planning and What is means for the economy.
2. AMP’s Dr Shane Oliver has recorded a webcast looks at the economic environment which frames the budget, and the limited impact of announcements.
3. AXA’s Technical Services Manager, Amanda Abdula webcast provides a debrief on technical advice impacts of this year’s Federal Budget.

 Hope you find this information useful.