Big hog GLOBAL MARKETS

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1 US GLOBAL MARKETS Big hog PIGS government bond yields versus US treasuries (%) Feb-9 Apr-9 Jun-9 Aug-9 Oct-9 Figure 1. Source: Datastream Dec-9 Feb-1 Apr-1 Jun-1 INVESTMENT CONCLUSION Bond markets remain focused on the Eurozone sovereign debt crisis, especially in the so-called PIGS (Portugal, Ireland, Greece and Spain). The PIGS' government bond yields are way above those of US treasuries (Figure 1), which continue to enjoy triple-a status. Aug-1 Oct-1 US Spa Gre Ire Por Dec-1 Feb-11 But the biggest hog is not among the PIGS, but across the Atlantic. On a comparison of debt dynamics, the US comes off worse than many of the PIGS: whether it s the size of the private or public sector debt burdens, budget deficits, foreign ownership of debt, dependence on foreign financing or banking risk. And what s worse is that, unlike the PIGS, where fiscal austerity is the order of the day, little attempt is being made to stabilise US public finances. So far, the US has got away with wallowing in its muddy pool of sovereign credit. The dollar s role as a global reserve currency means that creditor nations tend to hold their surpluses mostly in dollars. That means buying US treasuries and notes. And the US central bank has taken up a lot of the slack: the Fed has become the largest single holder of US government debt through its programmes. The PBoC, the Fed and the BoJ will shortly control three-quarters of the stock of US sovereign marketable debt. But foreign creditor nations are gradually diversifying their assets out of dollars; and the Fed s QE2 programme will be complete in June, unlikely to be succeeded by QE3. In the end, the American hog will not escape the knives of the global sovereign debt crisis. We remain short US treasuries and the dollar. 8 February This memorandum is based upon information available to the public. No representation is made that it is accurate or complete. This memorandum is not an offer to buy or sell or a solicitation of an offer to buy or sell the securities mentioned herein. It is provided solely for the information of professional investors who are expected to make their own investment decisions without undue reliance on this memorandum. Independent Strategy Limited has no obligation to notify investors when opinions or information in this report change and may disseminate differing views from time to time pertinent to the specific requirements of investors. Independent Strategy Limited is authorised and regulated by the Financial Services Authority in the UK. Save for any liability or obligations under the Financial Services and Markets Act 2, Independent Strategy Limited accepts no liability whatsoever for any direct or consequential loss arising from any use of this memorandum and its contents. It may not be circulated to or used by private investors for any purpose whatsoever, or reproduced, sold, distributed or published by any recipient for any purpose without the written consent of Independent Strategy Limited.

2 The twin sources of the euro debt crisis Sovereign debt Profligate state Excessive spending, deficits and debt Loss of competitiveness (feather bedding, low productivity and investment) Excessive sovereign leverage Deleverage sovereign debt through fiscal austerity Figure 2. Source: Independent Strategy Temporary fiscal boost: structural budget damage Fiscal damage, collapsing taxes Transfer of financial sector risk to sovereign balance sheet Debt crisis Remedial policies Bank debt Oversized banking sector Credit bubble (asset price inflation, growth mirage) Bubble bursts, banks go bust, economy contracts Shrink and recap banks ANALYSIS Debt sustainability has been breached in many EU countries and not just the Eurozone ones: for two basic reasons, often, (but not always) acting in tandem (Figure 2). One is profligate states spending much more than they raise in tax and then spending it badly, leading to a pure sovereign debt crisis. That s Greece, for example. The other root cause is excessive private sector debt and asset bubbles that dwarf the local economy and swamp the sovereign balance sheet with risk transferred from the financial sector. That s Ireland and Spain. Portugal is a little of each. Belgium excels at both! Italy is a great example of country with huge sovereign debt that costs more to finance than the economy can grow. Its debt therefore increases exponentially and existentially, unless it can run a sizeable primary budget surplus by cutting public services. That Italy has halfway decent banks and a wholly indecent prime minister is neither here nor there. It has perfect and fatal sovereign debt arithmetic. Non-financial debt (as % of GDP) Gre Ire Por US Spa Pub Priv What is shocking is that these variegated symptoms of Europe s debt disease are also to be found when we examine the spots on the US patient. Debt dynamics What is still off the markets radar screen is that the debt dynamics of the PIGS are mostly better than the the US. Take total non-financial securitised debt, both private and public. US debt stands at about 243% of GDP, while it s 18% in Greece; 225% in Ireland, 226% in Portugal and 257% in Spain (Figure 3). Figure 3. Source: IMF, Independent Strategy 2

3 Gross government debt (% of GDP), Figure 4. Source: OECD Gre Ire Por US Spa * The US government quotes a figure of 64% of GDP for 21, but that is federal debt held by the public. Consolidated gross debt including all public agencies is 93% in 21. Net debt to government revenues (%), Gre US Ire Por Spa And when we compare public sector debt alone, the American hog looms large. The US gross public debt to GDP ratio reached 93% in 21, compared to Spain s 72%, Portugal at 93%, and of course, Greece at 129% and Ireland at 15% (Figure 4). Even more worrying is the capacity of the tax system to service the debt (after all government doesn t 'own' GDP just taxes). The US ratio of public sector debt to government revenues reached 24% in 21 compared to 171% in Ireland, 157% in Portugal and just 118% in Spain (Figure 5). Indeed, as a share of US GDP, tax revenues are just 14.8%, the lowest since 195. But the snapshot picture does not show how fast the American debt hog has been fattened up. Federal debt has nearly tripled in the past ten years and, unless there is fiscal action, the gross debt to GDP ratio will reach 115% by 22, surpassing all the PIGS except Greece (Figure 6). And just like many of the PIGS, the US runs a chronic external trade deficit (Figure 7). It reached a peak in 26, when the current account gap was 6% of GDP. During the recession, it shrank to under 3% in 29 and the need for foreign financing declined. But the external trade deficit is now picking up again. Figure 5. Source: OECD, Independent Strategy Forecast gross government debt to GDP in 215 without fiscal action (%) Current account balance to GDP (%), Gre US Ire Por Spa Eur Ire OECD US Spa Por Gre Figure 6. Source: IMF, Independent Strategy Figure 7. Source: OECD 3

4 That s an important issue because high debt levels can be sustained for some time as long they are financed domestically. Look at Japan with a public debt level of 2% of GDP or Italy with a debt level consistently above % for the last 2 years. Their debt has been financed easily because it has been domesticated. There are several conditions for the successful 'domestication' of sovereign debt liabilities (Inset 1). First, a country requires a reasonably high national savings rate to fund government debt (Inset 1, Figure A). Second, this is mirrored in a current account surplus that denotes surplus savings over domestic investment available to support domestic government bonds (Inset 1, Figure B). Third, it helps if domestic savers have a 'home investment bias' or park their cash in instutions that do. This lowers foreign ownership of govern- The domestication of sovereign debt Figure A: Gross national savings as % of GDP, Figure B: Current account to GDP, 21 (%) Jap Spa Uk Ire US Por Gre -1. Por Gre Spa US UK Ire Jap Figure C: Share of non-resident holdings of sovereign debt (%) Figure D: Size of sovereign debt market ($bn, % of GDP) US UK Ire Spa Gre Jap Por Note: * Eurozone country measures excludes other EMU (euro) non-resident share 2 Por Ire Gre Spa UK Eur US Jap $bn - LHS % of GDP - RHS 4 2 Inset 1. Source: OECD, IMF, Independent Strategy 4

5 ment debt. The PIGS are regarded as vulnerable because so much of their debt is held by foreigners. But that is somewhat misleading because most of the foreigners are other Eurozone institutions. The non-eurozone holders share of PIGS debt is low compared to foreign non-dollar holders of US debt (Inset 1, Figure C). And Eurozone leaders are committed to saving the euro. The bigger the government debt market, the more liquid and less sensitive bond prices are to investor risk aversion (Inset 1, Figure D). On many of these criteria, the US has not succeeded in domestication as well as Japan or even some of the PIGS. Lately, the US has stumbled upon an artificial method to domesticate its excessive sovereign debt, but without any of the characteristics that allowed the Japanese to do so. In the US, the Fed buys sovereign debt or injects cash into banks (often in return for dud assets) that do so too. So, as in Japan, the biggest holders of US sovereign debt are now the central bank (the Fed) and financial institutions. The government also hefts household income and savings with subsidies and some of this money fuels demand for treasuries too. But America's ability to insulate itself is less durable than Japan and is based on more temporary factors. In that sense, the US hog is more vulnerable to a change of sentiment by foreigners than even the PIGS. Any reversal of fiscal or monetary policy will bring it to an end. For a start, the US government must roll over its debt more often than the PIGS (Figure 8). High debt with such a short average maturity also makes US budget arithmetic more vulnerable to any increase in bond yields. Average maturity of government debt (yrs) Gre Ire Por Spa US Figure 8. Source: OECD There is also the hidden exposure of the public sector to banking risk. The debt crisis in Portugal or Greece was not caused by banking collapse. Spanish banks have received state funds for only limited recapitalisation, so far, although Spanish banks have unrealised losses because of the collapsing property market. Only in Ireland, with its huge banking sector relative to the economy, was the sovereign debt crisis caused by state funds being used to bail out its banks (see our report, Solving the euro sovereign debt crisis, 3 November 21). 5

6 The US hog is in the fiscal danger zone: net government debt and structural budget deficit (% of GDP), 21 Net debt/gdp Figure 9. Source: OECD, Independent Strategy Forecast % reduction in budget deficit from 29 to 212 (%) US Gre Por Ire Spa Figure 1. Source: OECD Cyclically-adjusted fiscal tightening (% pts of GDP, 211) ! DANGER ZONE! Jap Ita Gre 8 Bel Por 6 Fra US Ger Eur UK 4 Aus Spa Ire 2 Neth Swz Den EMU Export bloc -2 Swe EMU Austerity bloc Other Structural deficit/gdp But none of this matches the exposure the US government has to its banking sector that has yet to be realised. The bailout of its banking sector has driven up net debt and deficit levels much more than in any of the PIGS (Figure 9). Moreover, it is in effect the owner of the major mortgage lenders, Fannie Mae and Freddie Mac, which continue to lose money every quarter. The government is therefore exposed to significant banking risk. If the liabilities of these so-called government-sponsored enterprises plus other off balance sheet items were added to the public debt it would push up the gross public debt ratio by another 44% points. Stabilising the debt What about action to deal with the sovereign debt crisis? Greece and Ireland have been bailed out and the EU has imposed strict fiscal austerity programmes in return for cash. Portugal and Spain have also introduced austerity programmes aimed at getting their budget deficits down by over 5% from their peaks in 29 and to the 3% of GDP Maastricht level by 213 (Figure 1). No such measures have been enacted by the US government. On the contrary, the US federal budget deficit hit a record $1.42trn in fiscal 29. At 1% of GDP, it was the largest deficit since the second world war. The 21 deficit was not much less at $1.29trn, or 9% of GDP. In fiscal 211, the deficit is now expected to reach $1.5trn, or nearly 1% of GDP again Spa UK Fra Eur Ita Ger OECD Jap US Current Nov'1 proj Indeed, according to the IMF, Japan and the US have relaxed fiscal policy for 211, not tightened it (Figure 11). Eurozone governments are tightening by an average 1% pt of GDP, while the US is easing by nearly the same. Figure 11. Source: IMF 6

7 Underlying structural deficit on budget in 21 (% of GDP) Spa Por Gre Ire US Struct Struct primary Figure 12. Source: OECD Even more important, when you strip out one-offs and the cyclical impact of economic recovery, the underlying structural government deficit in the US is way higher than any of the PIGS (Figure 12). The US deficit (and thus its debt level) is not going to come down anytime soon. Once public debt gets to these levels, it means that a country can easily fall into a debt trap where the cost of servicing the debt outstrips the ability to pay it. It just takes interest costs to rise above the rate of nominal GDP growth. Liquidity and the dollar's reserve status US domestic economy Credit Excess US current bubble consumption account deficit Liquidity drained Foreign liquidity flows enter US credit system Liquidity boost = stable dollar International economy Local currency bubble Surplus dollars for US trading partners Bloated central bank Recycled dollar dollars reserves Getting away with it So America s hog is is as sickly as the PIGS, but so far bond markets have chosen to ignore it. How does the US get away with it? The answer is two-fold. First, there is the US dollar s role as a global reserve currency. This recycles the current account deficit dollars that the US haemorrhages. Those dollars buy government and agency debt (Figure 13). Figure 13. Source: Independent Strategy Foreign share of US treasuries outstanding (%) Q1 21 Q3 21 Q1 22 Q3 22 Q1 23 Q3 23 Q1 24 Q3 24 Q1 25 Q3 25 Q1 26 Q3 26 Q1 27 Q3 27 Q1 28 Q3 28 Q1 29 Q3 29 Q1 21 Q3 21 Figure 14. Source: Datastream, Independent Strategy Originally, this feedback loop was voluntary, based on the belief that the US economy was a good investment. But now it is involuntary because foreign holders of treasuries cannot sell them, or even stop buying them, without taking a considerable loss on the stock they own. So bad money follows good. Second, the dependence on foreign purchases of US government debt has been reduced (Figure 14). The Federal Reserve has launched a series of QE asset purchasing schemes to buy US treasuries. At the same time, the Fed has provided cheap liquidity to the banks. In turn, they have bought government bonds. 7

8 China: share of US treasuries in FX reserves (%) Feb-9 Mar-9 Apr-9 May-9 Jun-9 Jul-9 Aug-9 Sep-9 Oct-9 Nov-9 Dec-9 Jan-1 Feb-1 Mar-1 Apr-1 May-1 Jun-1 Jul-1 Aug-1 Sep-1 Oct-1 Nov-1 And the federal government introduced fiscal stimulus programmes that subsidised household incomes, allowing households to save more and buy more bonds. But this domestication will not last. The US remains, at heart, a low-savings economy. Already, foreign holders of US dollar assets have begun to diversify. The share of China s FX reserves held in US treasuries is steadily falling (Figure 15). The fiscal and monetary support for domestic buying of US treasuries will come to an end by June, when the Figure 15. Source: Datastream, Independent Strategy Fed s QE programme ends and nearly all the government s fiscal stimulus has been exhausted. Then US government debt issuance will have to be absorbed by the bond markets alone. They might then recognise the US hog for what it is. 8 INDEPENDENT STRATEGY 1 QUERIPEL HOUSE, 1 DUKE OF YORK SQUARE, LONDON SW3 4LY TELEPHONE: FAX: main@instrategy.com WEBSITE: AUTHORISED AND REGULATED BY THE FINANCIAL SERVICES AUTHORITY

Europe Outlook. Third Quarter 2015

Europe Outlook. Third Quarter 2015 Europe Outlook Third Quarter 2015 Main messages 1 2 3 4 5 Moderation of global growth and slowdown in emerging economies, with downside risks The recovery continues in the eurozone, but still marked by