“Revolutions have never lightened the burden of tyranny. They have only shifted it to another shoulder.”  - George Bernard Shaw

 

Greek Prime Minister George Papandreou and Italian Premier Silvio Berlusconi may not suffer the same ultimate fate as King Louis XVI and Queen Marie Antoinette, both of whom were guillotined during the French Revolution, but their leadership has been called into question by popular uprisings with kindred characteristics at their core.   As a result of this developing crisis, we’ve already seen changes in the governments of Ireland, Portugal, Spain and Greece.  The seeds of the French Revolution originated in the large national debt accumulated during the Seven Years War and France’s assistance in the American Revolutionary War.  A financial crisis ensued and class warfare flared up thanks to a regressive tax system as well as the decision to send the king’s army into the countryside to arrest farmers and seize crops. 

 

Now, it wasn’t war that drove the massive sovereign levels of debt this time around, but the same financial trouble that inevitably accompanies such heavy obligations has resurfaced.  We are on the front end of fiscal policies and plans that will cut back benefits and increase taxes for the vast majority of the developed world’s population.  This is the stuff that revolutions are made of.  The widespread lack of acceptance for leaders in the West has less to do with current policies and more to do with simple bad timing.  Most of the financial problems the world faces were baked into the cake long before current leaders stepped into the kitchen.  Once global debt levels have reached the point of no return, as they have, there are no policies that can be implemented without the requisite amount pain and sacrifice.  That’s where we stand.  And while “the people” have thankfully stopped short of pulling out the guillotines again, opposition parties are wasting no time in taking advantage of the revolutionary spirit sweeping the world.  But be careful for what you wish.  As they step into the vacuum to assume new leadership roles, opportunistic politicians may find little patience and public support for the medicine they will be required to dole. 

 

Fake it ‘til you make it 

Bill Rhodes was a key negotiator during the Latin American and Asian credit crises in the 1980s and 1990s. He is currently a senior advisor at Citigroup, Inc. and commented on the European crisis during a recent Bloomberg interview.  “What you need is an agreement.  You’ve got to get it done.  One of the things that I did was that I never used to make any announcements until the deal was done.”  Rhodes doesn’t understand why the European leaders continue to make general announcements that lack any real detail.  In his view, an actual agreement needs to be hammered out long before vague concepts of an agreement are made public.  But there seems to be this “fake it ‘til you make it” attitude and approach in Europe.  Of course, this is not a new tactic.  Is anything in finance ever really new?  King Louis XVI knew he had financial problems well before the official start of the French Revolution in 1789.  He established and abandoned a number of assemblies while going through various ministers of finance.  He was able to “fake it” for several years but never did “make it”… the Republic was finally toppled in 1792 and King Louis was beheaded in 1793. 

 

Nonplused

The state of global finance continues to deteriorate but you wouldn’t know it if you only followed U.S. equity markets.  Since the October 3^rd low last month, the S&P 500 has rallied over 15% while small cap stocks have surged almost 25%.  Granted U.S. equity markets are barely in positive territory year-to-date, but the credit and precious metal markets are painting an entirely different picture.  So, while equity investors appear to be nonplused by the events unfolding in Europe, bond investors are busily selling peripheral debt by the barrel full.  Italian bonds, the third largest debt market in the world, have reached a new high in yields with 10-year notes soaring to 6.75% (As this goes to press, yields spiked to almost 7.5%!).  Italy has $400 billion in debt to rollover during the next year alone and borrowing at rates approaching 7% only worsens its budget deficit issues.  Meanwhile Credit Default Swaps (CDS), a measure of a country’s likelihood of default, have risen sharply for several European countries in 2011.  The CDS market places odds of an Italian default 36% by 2016.  Even “AAA” rated France has seen the odds of a default rise to 15% within five years. 

Perhaps it is the increased liquidity that is supporting risk assets.  Money supply in the U.S., as measured by M2, has risen over 10% in the last year.  The last time M2 shot up 10% year-over-year was in December 2008, just a couple of months before the U.S. stock market bottomed out.  Of course, stocks had to fall over 50% in 2008 and early 2009 before reaching bottom then and have only fallen 5 – 10% from the April 2011 peak. 

 

Secular Market Cycles

Ed Easterling, author of Unexpected Returns and Probable Outcomes, has spent many years analyzing the key drivers secular stock market cycles.  His research found that secular Bull market cycles are the result of expanding Price / Earnings (P/E) ratios while Bear market cycles are the function of contracting P/E ratios.  So, what drives changes in P/E ratios?  Inflation.  Or more precisely, shifts from low, stable pricing environments to unstable pricing environments (high inflation or deflation) and vice versa.  So how does this view align with the current inflationary environment around the world?  (For more information, you can go to Easterling’s website at www.CrestmontResearch.com)

Most developed and developing countries have experienced low and stable inflation for the last couple of decades.  Consider the U.S. where inflation peaked in the early 1980s and moved steadily toward a lower, more stable pricing environment.  During that period, equity values rose sharply during a massive secular bull market.  The world faces much greater uncertainty now.  Most of the developed world is confronted with powerful deflationary forces as a result of the systemic build-up of debt.  These deflationary forces can only be offset by global central bank policies that generate a rapid increase in the monetary supply.  However, if the central banks print too much money, inflationary pressures could be unleashed. 

 

It is hard to know now whether deflationary or inflationary forces will prevail.  But we don’t have to know.  I do not expect that central banks will be able to get monetary policy just right and so it is clear to me that the current environment of low, stable inflation around the world is going to be short lived.  If Easterling is right, what follows is a contraction in P/E ratios leaving us with a secular bear market with which to deal.  This outlook combined with the extremely low interest rate environment cause us to focus on the preservation of capital.  Avoiding losses is very important now.  With yields so low, offsetting or recouping any losses is very difficult and would take much longer than is typical

 

 

 

 

(c) Sextant Investment Advisors

www.sextantinvestment.com