If it weren’t for the time difference, children in Germany would have their presents already. That’s because the Christkind (Christ Child) comes on the evening of the 24th in Germany. Unless you’ve been naughty. Then St. Nick’s farmhand Knecht Ruprecht gives you a lump of coal or beats you with a bag of ashes.
That’s what investors can expect this Christmas. Europe’s debt mess has to come to a head eventually. The break over Christmas is a pretty convenient time for politicians to spring something unexpected on you. Well, unexpected for those who don’t read the Daily Reckoning, that is.
So here is a list of things the governments of the world might unleash on you and your portfolio over the holidays:
1. Sovereign Default
Even if austerity is the ‘right’ thing to do, it may simply be too late.
The short-term pain of reducing government spending to a level that the private sector can support in taxes might just make the debt burden completely unmanageable in the eyes of investors. Why? Government spending adds to GDP. So reducing it decreases GDP. That in turn increases the debt-to-GDP ratio – something debt markets look at closely.
This is a little ignorant considering that only the private sector’s share of GDP really pays the bills in the end. That’s why some people think government spending should be subtracted from GDP, not added to it. A much better way of thinking about sovereign debt would be to look at tax revenue relative to debt.
The Americans have the lowest debt/GDP ratio, but the highest debt/revenue ratio. Their true debt burden is higher than Greece’s.
The most important thing to understand about sovereign debt is that, if austerity doesn’t work in places like Greece, it could trigger a big enough ripple to bring down other countries’ efforts. Even German austerity could – probably would – buckle under defaults in Italy or Spain. This is because the German economy makes a lot off imports within the Eurozone.
So even a small sovereign debt default – one that isn’t carefully engineered by the IMF – could see all hell break loose in share and bond markets all around the world, including Australia. Not to mention the effect on economies of Europe.
A rather odd side note on this is whether a default has already happened as far as the markets are concerned. This idea may seem confusing at first, but it’s quite straight forward. If the price of Greek sovereign debt say halves, that more or less implies a 50% default is expected. Give or take interest payments. The market will have factored in the chance of a 50% default by adjusting the price of the debt. The loss would already be recognised by people who value the bonds at their market price.
Don’t think that solves the problem as far as banks and governments are concerned. You see, the banks hold lots of sovereign debt that is not marked to market – the price recorded on their balance sheet is not the market price. They have yet to recognise the loss.
Secondly, governments need to continue funding their deficits with more debt. That’s difficult to do when the market is signalling it expects a default. To illustrate how this plays out in our 50% example above, the Greek government would have to issue the debt at 50% of par. This means it would issue bonds for $100, but only receive $50 from investors for each bond. When the bond comes due, the full $100 is owed.
All this is simplified. But you can see the nature of the issue. Banks and governments cannot operate for very long once markets lose faith in sovereign debt. Something has to give. And Christmas is the season for giving.
2. Bank failures
The chances of a simultaneous default of two or more banks in the next two years, which were practically zero at the start of 2007, now stand at around one in four, the ECB calculated in a new Financial Stability Review.
- AFP in The Age
The crisis of 2008 was one of bank rescues. This time around, there won’t be enough money to do the rescuing with. Unless more is created. We’ll get back to that.
A lot of investors learnt some harsh lessons in 2008. But not many bank depositors actually lost money. This time could be different. Governments aren’t in a financial position to do much bailing out. Unless they get their central banks to pay for it with new money.
Of course, we’re talking about European banks here. At least at first. Whether a crisis in the European banking system means some sort of rush of deposits to Australian banks, or a rush of deposits out of the Aussie banking system, we’re not sure of. Australia might be seen as safe. Low government debt – compared to Europe – might make bailouts feasible. On the other hand, Aussie banks are very interconnected with Europe – it’s a major source of funds for them. And they face a popping housing bubble too.
No matter what happens, you can expect Aussie bank stocks to plummet if their European comrades fail. Dare we suggest a buying opportunity in the making?
[Since writing this, Zerohedge reported on Italian banks possibly running out of collateral to post with the ECB for emergency funding. This is how Lehman Brothers and Bear Stearns failed, kicking off the crisis of 2008. If Zerohedge is right about the collateral, Italian banks are highly likely to fail within the next few weeks, if not days.]
3. Sovereign Debt Downgrades
Less dramatic than a default, further sovereign debt downgrades could be the opening act of 2012. Belgium’s downgrade saw Aussie stocks plummet on Monday. So it’s pretty clear what our market would think of more of them.
What’s funny about Belgium’s downgrade is that it comes in lieu of the country finally forming a government. It’s probably a coincidence, but the idea that a government is the problem of governments spending too much makes some sense. That’s why a hung parliament (where no party has the majority) is the best possible outcome in a democracy. And to think we got so close last time around here in Australia!
Anyway, sovereign debt downgrades would force even the most ignorant fund managers to wind down their holdings of sovereign debt. That adds to the selling pressure and price falls, escalating the problem.
But hold on. Ratings agencies aren’t part of the government. So why are they included in our list of things governments could do to you? Well, firstly, ratings agencies react to government debt levels. It’s the spending that’s the problem, not the people pointing out the problem. Secondly, the politicians enshrined ratings agencies into law. Bank capital adequacy standards, for example, factor in debt ratings. That means banks which hold safer assets need, by law, less reserves backing them up.
Back when sovereign debt was rated ‘risk free’, using ratings agencies to implement their rules made a lot of sense to politicians. It ensured the ‘safe’ debt governments issued would be in demand by banks trying to sure up their balance sheet for regulators. But now the bonds politicians issue to pay for their hair brained schemes are the victims of downgrades. Their bonds are no longer the assets favoured by the ratings agencies and are therefore shunned by the banks looking for safe assets. This is a wonderful dose of karma, but if ever there was a perfect scapegoat for politicians to pick on, it’s the ratings agencies.
If the war of words between Fitch, Moody’s, S&P and governments turns into actions, that could leave banks and debt markets in a regulatory no-man’s land. A void that would have to be filled with something.
4. Eurozone breakup
How’s this for foresight from the Iron Lady (Margaret Thatcher, not Angela Merkel) back in 1990:
‘…this Government has no intention of agreeing to the imposition of a single currency. That would be entering a federal Europe through the back-Delors. [Jacques Delors was the President of the European Commission at the time.] Any such proposal involves a loss of sovereignty which Parliament would not accept.
- Margaret Thatcher, 1990
As the more enlightened members of the blogosphere keep pointing out, the Euro is about politics, not economics. It’s about creating jobs for politicians and bureaucrats, keeping peace in Europe, and rubbing shoulders with the US and China. The Europeans can only do the latter by banding together.
The problem with being bound together is that nationalism rears its ugly head when times are bad. That is, at the worst possible time for a political union. So when things start getting nasty between nations, there will be political tension to leave the Euro – not just economic reasons.
This negates the main argument in favour of keeping the Euro – the high cost of leaving it. In other words, the Euro is the least worst option in terms of economics. But this view makes the same error as the one we mentioned above – it sees the Euro as an economic matter, not a political one. If the politics of Europe break down into irrational nationalism, the cost of leaving the Euro won’t matter. Especially to the French.
Already the edges of Eurozone unity are fraying. The Danish closed their borders a few months ago. The English have drawn up evacuation plans for Brits living in Spain. This kind of thing can get out of hand.
5. Wealth Confiscation
A reader asked us to comment on the following: ‘Der Besitz von materiellem Gold und das Risiko, dass der Staat (In Australien oder anderswo) es einem auf fiese Art und Weise wieder wegnimmt.’
In other words, what is the risk of gold confiscation, in Australia and elsewhere? Here’s the part of the reader’s email, quoting from the blog Gold Chat, that will make you look twice:
Australian law already has a mechanism in place to require delivery of gold to the Reserve Bank of Australia (RBA) – Part IV of the Banking Act 1959. There is no need for the Government of the day to have to rush new legislation through that may attract public comment or opposition. All that is required is the Governor General to proclaim that Part IV shall come into operation.
Here is the wording of the Act in case you don’t believe the blogosphere.
…a person who has any gold in the person’s possession or under the person’s control, shall deliver the gold to the Reserve Bank, or as prescribed, within one month after the gold comes into the person’s possession or under the person’s control or, if the gold is in the person’s possession or under the person’s control on any date on which this Part comes into operation, within one month after that date.
We’ve excluded from the quote the exemptions for rare coins, and gold ‘used by that person in connexion with the person’s profession or trade’. The second exemption is the one we’re banking on as newsletter writers.
Here’s another interesting twist: Section 115 of the Australian Constitution says ‘A State shall not coin money, nor make anything but gold and silver coin a legal tender in payment of debts.’
To be honest, Australia’s monetary history is a bungled mess of private currencies, British currencies, pegged currencies, precious metals, and the Australian dollar nearly ended up being called the Royal or Dinkum. Add to this the right of the government to confiscate gold and the constitutional kerfuddle about gold and silver, and you get complete confusion.
Of course, it’s pretty unlikely that Quentin Bryce will decide to confiscate your gold over Christmas. At least this year.
Here’s what’s important. Government’s are willing to confiscate wealth. Historically it has often been gold. This time around in Europe, it’s just as likely to be something else. When property rights are violated, that can change the nature of investing completely. Something worth thinking about.
One way this issue might rear its head in Australia is the way it did initially in the US and much of Europe. There, governments have already raided the pension funds and retirement savings of their people. Usually by forcing those funds to buy government bonds. Could the same happen here, where the Australian government forces you to ‘save’ 9% of your income?
European Central Bank President Draghi has made it clear it would be illegal for him to buy government bonds directly from governments. So he’s a hard money kinda guy then? Unlike his American counterpart in crime, Ben Bernanke?
Ha! Actions speak louder than words. And Draghi has been busy. Get this, from Zerohedge: ‘…the ECB’s balance sheet is not only far greater than the Fed, at $3.2 trillion compared to $2.9 trillion for Ben Bernanke, but at 30x leverage, has the same risk as Lehman did at its peak.’
Draghi and his predecessor have staged what people are calling a ‘back door QE’. It’s quantitative easing (creating more money) by buying government bonds from banks, who in turn buy more government bonds with the new cash they get from Draghi. Because there is no direct link between the ECB and governments, it’s allowed.
So now you know Europe has been busy with QE on a massive, but hidden, scale. This fits into the narrative of James Rickards’ Currency Wars. He suggests that what is really going on is a devaluation battle between the US, Europe and China. All three want an export-led recovery now that the Keynesian solution of more spending is flailing. They are trying to devalue their currency in an effort to stimulate exports – something that Rickards argues ends badly. They do this by creating more of their own currency, decreasing its value. The Europeans, with their backdoor QE, have made the latest move. Now it’s the Americans’ turn.
The Euro is at the low levels that Rickards identifies as a likely spot for Bernanke to begin more QE. Tuesday’s American Daily Reckoning pointed out that Bank of America shares are at the level that previously brought the Fed into action. Improving economic data in the US probably reduces the chances of QE somewhat. But it would only take a worsening crisis in Europe to give Fed Chairman Bernanke an excuse.
6 Things You Can Do About Political Risk
Is cash really a safe place to keep your wealth in the long term? We’re not so sure. The risks above add weight to the idea that our money is not living up to its purposes: Safety, practicality and stability. If governments fail, what will happen to their control of the currency? Will they confiscate wealth to keep the machinery of state running? If banks fail and don’t get bailed out, what will happen to the money you keep with them? If currency wars break out, what will happen to exchange rates? If the EU fails, what will happen to the Euro and the currencies that replace it? If QE – the creation of more money – is the solution to all these problems, what will happen to the value of the existing money?
None of these are an endorsement of cash. At least not in the sense of cash being safe. So what are the alternatives?
Remember, money in the form we know it came into existence in a long protracted process. Once upon a time, every coin was a precious metal. Since then, trust in currency has been abused by bankers and governments. Step by step the connection with precious metals was lost. Now money is nothing more than what governments declare it to be. This would never have been accepted if declared from the outset. The fraud must come to an end eventually. It will only take a loss of faith in money for it to die.
Back to the alternatives to paper money for parking your wealth. In the opinon of Dr Alex Cowie, who used to write the Daily Reckoning Weekend Edition, you want to hold what the world will turn to for real value. And holding shares in the companies that produce those items of real value. He’s found six stocks that meet his strict list of demands.