Disclaimer. After nearly 40 years managing money for some of the largest life offices and investment managers in the world, I think I have something to offer. These days I'm retired, and I can't by law give you advice. While I do make mistakes, I try hard to do my analysis thoroughly, and to make sure my data are correct (old habits die hard!) Also, don't ask me why I called it "Volewica". It's too late, now.

BTW, clicking on most charts will produce the original-sized, i.e., bigger version.

Friday, July 29, 2011

What keeps me awake at night

  1. Something goes seriously wrong in China.  Without Chinese growth, there would be virtually no world growth.  The countries in Europe which are doing well (Sweden, Germany, Switzerland, Czech Rep) are doing it on the back of exports to China, and surrounding the success stories is a fringe of over-indebted potential defaulters.   I'm not saying it's likely, but it's what I'm keeping a close watch on.  After all, Czarist Russia was the fastest growing economy in the world in the decade up to 1914.  It didn't get back to that level of output again until the mid-1950s.
  2. Fringe Europe defaults messily.  An organised default (labelled a "restructuring") would be OK.  But if Greece walks away from its debts, and then Ireland, and the Portugal, things would be grim, because after that we'd be wondering about Spain and Italy.  Of course, the crisis would force the pollies to act.  But while they dithered, share markets would decline.  This is a reasonably high risk.  And what really worries me about this is that an already sluggish Europe would be pushed back into recession, taking the rest of the world with it.  My judgement:  a Greek default/"restructuring" is a certainty sooner rather than later.  The others should struggle on.  But I worry that I'm wrong.
  3. The US has its own excessive debt/too low savings rate problems.  Plus ... the US might inadvertently default on its debt.  This is the world's largest, deepest and most liquid bond market; the dollar is the world's reserve currency;, the US has (still) the world's largest economy.  I don't think the Tea Partiers will push the US into default, but if they do, all bets are off.  Default would paralyse the banking system and crush loans.  A second GFC.  That's just what we need right now.  If that happens, I'll be selling everything and going into cash.
Bull markets climb a "wall of worry".  However ....

Thursday, July 28, 2011


Big falls overnight on Wall Street and in Europe.  The brinkmanship continues.  Are US pollies really going to push the world into another GFC?  Can they really be that partisan and demented to drive their economy and the rest of the world into another serious recession?  Whatever happened to noblesse oblige?

I'm starting to worry, now, that they will.  O tempora!  O mores!

Tuesday, July 26, 2011

The US Debt Ceiling

Common sense suggests that that spending be cut and taxes be increased.  But so mired in their dislike for the other party are they that Congress cannot come to an agreement.  From here, it looks as if it's the Republicans who are being more recalcitrant, refusing point blank to raise taxes.  

If the debt ceiling isn't raised, the Federal Government won't default on the debt.  What it will do is stop paying salaries of government departments.  Maybe, to concentrate their minds, they could start with salaries and expenses for Congressmen and Senators.

Friday, July 22, 2011

Tea Party Numpties

Looks as if some sort of compromise is happening. As some political commentator once said about the British Cabinet:  Nothing concentrates the mind of the Cabinet quite so much as a fall in the Pound.  Do any of the pollies playing chicken with the US debt cap know just how dangerous a default by the US would be?  I suspect the intelligent ones (if that's not an oxymoron) do.  Which is why I'm not selling and running screaming for the hills.  (Why the hills?)

Monday, July 18, 2011

The Debt Doom-Loop

Let's suppose a country (Greece, for example) owes 150% of GDP.  Now let's suppose that it has been paying, say, 4% on 10 year money.  That means that the interest on government debt as a percentage of GDP is 6% (4%*150%).  If tax revenue is, say, 30% of GDP, interest alone will use  up 20% of tax revenue.   Put it another way:  if the government wishes to run a balanced budget, taxes as a percentage of GDP have to be 25% higher than they would have to be if there was no debt.

A moderately parlous situation, but the markets could live with this if they believed the government was going to "trade its way" out of the mess, by for example, running a balanced budget.   Over ten years, real growth of 2.5% and inflation of 2.5% will increase nominal GDP by two thirds.  This will reduce the ratio of debt to GDP to below 100% and the ratio of debt interest to revenue to below 4%.  You don't even need to run a surplus for this improvement to happen.

However, suppose the government goes on running deficits.  Let's suppose its deficit is a modest 5% of GDP.  Let's also assume that its outstanding debt has an average life of 10 years, so that one tenth comes up for refinancing each year.  In fact (bizarrely) most governments have debts with much shorter average lives, often as low as 6 or 7 years, with maturities skewed towards 3 or 4 year paper.  On our assumptions, the government would have to borrow 15% of GDP each year, 10% refinancing and 5% new money.  In practice the numbers would be much higher, because more of the debt would mature each year.

All well and good, as long as the markets trust the government.

What happened in Greece was that the previous (Conservative!) government lied about the level of debt and the size of the deficit (O tempora!  O mores!)  The new government trumpeted the sins of its predecessors to the market shortly after it came to office (instead of keeping quiet and moving as fast as it could to rectify the situation behind the scenes).  The market panicked and the yield on Greek debt started to soar.

At an 8% yield, say, the debt cost doubles as a percentage of GDP.  Not overnight, because only some of the debt is maturing.   On our very conservative assumptions, the Greek government would have to borrow/refinance 15% of GDP each year -- though in practice it could easily be as high as 30% of GDP because of the short profile of total oustanding debt.   That means that the deficit widens by at least 1.2% of GDP more each year that interest rates remain at 8% instead of 4%.  Remember that debt maturities were much shorter in Greece and the deficit much larger.  And that current yields are now 17%.   Suddenly the situation slips out of control. The markets sell more Greek bonds which pushes up bond yields even more, the deficit gets worse, the markets get more frightened ... and wham!  A massive doom loop emerges.

It becomes impossible for the government to "trade its way" out of the crisis.  Tax increases and spending cuts become inevitable.   But this reduces GDP growth, which makes the deficit worse and also makes the market more convinced that the government will in the end be unable or unwilling to honour its debts.  Yields rise again, the deficit gets bigger, another "package" is introduced, things get still worse, etc, etc.  That's where Greece is now.

And that's why most analysts reckon that a government shouldn't let its debt get above 100% of GDP.  At that point the risks of a self-feeding meltdown rise alarmingly.

Chart from http://www.usgovernmentspending.com/index.php
US government debt is perilously close to 100% of GDP.   The Tea Party crackpots want to cut expenditure (while not cutting Medicare, despite it being "socialized medicine").  The Democrats want to raise taxes (while not cutting entitlements).  Either remedy would slow growth, making the deficit worse.   Draconian tax increases and spending cuts now will push the US back into recession.  But reforms in the out years, cutting both spending and increasing taxes would convince the markets that the problem is only temporary.  Right now, it looks as if the US is going down the Greek path of pollies taking no action at all.  Greece is just 0.5% of the world economy.  The US is over 20%.  The risks are obvious.

[As usual, clicking on the chart will produce a bigger image]

Friday, July 15, 2011

Getting out from under

An interesting interview with Jim O'Neill of Goldman Sachs London about the Greek debt crisis, made before the Greek Parliamentary vote.  Longish but worth listening to.  (For those who don't know, his accent is midland English, though the 'f' instead of 'th' is an individual quirk, one my dad had too.  Of course, maybe he's just lived in London a long time: the f/th alternation is something the Cockneys do too.)

Greek 10 year bond yield
The problem is that raising taxes and reducing expenditure merely deepen the economic downturn which in turn reduces tax revenue and increases government expenditure all over again.  This dynamic has already happened in Greece which is why we're having this second package, and in a smaller way is happening in the US, where employment growth is puny because state, local and federal government employment has fallen by nearly a million since the GFC as states and municipalities try to balance their budgets.   At the same time, the doubts about creditworthiness lead to interest rates on government debt rising (as shown in the chart on the left, from Bloomberg.)   Refinancing old debt at higher interest rates causes the deficit to balloon even further, thus increasing doubts, which causes even higher rates and further tax increases ....  The doom loop continues until there is a circuit breaker.  So far the pollies on either side of the Atlantic haven't produced any suggestion of a circuit breaker, as O'Neill points out.  A circuit breaker would be O'Neill's suggestion of a central Euro lending authority, for the portion of government debt below 60% of GDP.  Or it might be a refinancing of short-dated debt liabilities with longer-dated instruments at lower yields, a la Brady bonds plan from the late 1980s, with the banks "taking a haircut".  The ECB (European Central Bank) is against this, but frankly, the ECB hasn't covered itself with glory over the last few years, and it may be time to tell them to go take a jump.

If the crisis spreads to the other PIIGS (Portugal, Ireland, Italy, Greece, Spain) it could be both bad and good.  Bad initially, because markets will not like it at all, but good later because it might be enough to get the pollies to engineer a solution.  We shall see.  Getting out from under will take more than pious protestations.

Thursday, July 14, 2011

China leads the charge

China continues to grow at astonishingly rapid growth rates.  Malcom Maiden of The Age comments here.

If you smooth the data, IP continues to grow at around 14%, which means, if it goes on (and it prolly will), that industrial production will rise over three and a half times over the next ten years.

Sounds ridiculous?  Remember, Japanese IP grew at between 15 and 20 % from the early 1950s until the first oil shock (1973).  No reason why China shouldn't do the same.  Except pollution.  (Which is why, BTW, China is going to become a very keen member of the control-carbon-emissions mob)

The most recent piece of data which jogged the share markets higher was Q2 GDP.  Now Chinese data are a bit dodgy, everybody knows that.  All the same, if you cross-check IP with say electricity usage, freight volumes, etc. etc., whatever the exact growth rate is, the number is large.  So the Q2 yoy GDP increase of 9.5% may well in fact be somewhat lower.  Or higher.  Whatever.  It's still much much higher than in other countries.  And if true, and continued, Chinese GDP would rise 2.5 times over the next ten years.  And that would make it the world's biggest economy.

A while ago, I noticed that Wall Street had started to respond to Chinese data.  And I found that most intriguing.  The rise of China changes everything:politics, economics, the global power balance, the environment.  Whereas Europe and the US are constrained by low savings rates and high debt, China is not. Not that any of the US pollies would notice that their petty childish deliberations are irrelevant in the face of this major shift in the world's centre of gravity.  They might just let off the bomb by not raising the debt ceiling.  Sigh.  Tell me, do democracies deliberately select cretins to run themselves?

Monday, July 11, 2011

Mid-cycle blip ... or something worse?

Friday's employment data weren't exactly scintillating.  Everything was worse than expected: payrolls, the unemployment rate and overtime hours.  I've mentioned before that the payrolls data underestimate employment growth initially in the first year of the recovery, with the underestimation only being corrected years later with the census.  So the employment numbers are prolly a bit better than the headlines.  But this underestimation doesn't affect the unemployment data (which come from a different survey).  And unemployment and the unemployment rate went up.

Click to enlarge

This is the first time in 50 years that the unemployment rate has risen so soon after the cyclical turning point. OK, the Japanese earthquake and tsunami had some impact, as did the mid-west floods. All the same ...

So far I'm sticking to the view that this is a classic mid-cycle blip. But I'm now watching the data very closely.  And I suspect the Fed is too.  Japan had 20 years of stagnation after its property bubble burst back in 1990.  What if America is going to go through a similar experience?

More on that dismal prospect in the next post.