We think the world of Mr Bond will be rather interesting during 2010 and that certain governments will, at some point, meet Dr No!
The very large levels of debt accumulated by governments over the last year will begin to place pressure on treasured sovereign credit ratings. Credit ratings, however, are a lagging indicator, as investors found to their peril in the credit crunch when ratings agencies were very slow to recognise the poor quality of what is now, euphemistically called, toxic assets. These increases in government debt can be seen in the following chart which shows Dec 08 and Dec 09 debt levels as a percentage of GDP.
Click to enlarge graph
Graph Source: EIU, except Greece, which was source from Bloomberg as of 08/12/2009, and JPMorgan.
The credit crunch caused a worldwide rally in safe assets and investors bought G7 Government bonds, mostly accepting zero or worse as a real yield, with a large number of investors still holding these risk free assets. Smart money moved into investment grade corporate debt in late 2008/early 2009, but this trade has now closed and most, if not all, good quality corporate debt is trading close to par, thus driving income yields down from historic highs to more reasonable levels.
But what of those still holding government debt? Well, let’s start with Europe, where we have the ‘PIGS’ economies of Portugal, Ireland / Italy, Greece and Spain. Just as the cost of credit rose for corporates during the credit crunch, we are now seeing very large increases in the cost of borrowing for the PIGS, compared to their German and French counterparts. The PIGS all face significant economic problems and do not have control of the two favoured economic levers for fixing these problems; interest rates and exchange rates. There has been much commentary from economists that one or more of the PIGS might leave the Euro to regain control of interest rates and exchange rates and, therefore, create a monetary environment more suited to their parlous economic situations. However, we believe this is just not going to happen. At the moment, the cost of borrowing for these nations is effectively supported by Germany’s credit rating and investors’ beliefs that the European Union/Germany will provide support to the troubled PIGS economies. If they were to leave the Euro, the cost of their debt and the cash flows required to service the debt would rise substantially, probably to unaffordable levels. A more possible scenario is the biggest and most stable economy in Europe, Germany, might decide to leave the Euro as Germans become fed up with supporting their more profligate neighbours.
If we travel over to Dubai and explore the issues there, we will find that it is relying on its wealthy neighbour to bail it out and, so far, Abu Dhabi has complied but at what cost (at least they won’t be closing the indoor ski slope!)? Other emerging economies in Asia and Latin America have much more control over their debt. More investors are becoming interested in these markets as interest rates are higher than in the developed world and, as their currencies appreciate over time vs. developed economy currencies, investors will benefit from appreciation in the capital value of these bonds.
In the US, the Dollar has been falling for some time and, for foreign investors, this reduces the value of their holdings in US Treasuries. Cynics believe that the Obama administration is happy with a gradual devaluation as it will begin to rectify the massive US current account deficit which has been growing for years.
The final leg of our journey takes us to the UK where government debt is at historic highs. Even if we believe HM Treasury’s forecasts, we will have a debt to GDP (national income) level of around 80% by 2013. Remember, one of Gordon Brown’s ‘Golden Rules’, which he set as Chancellor, was that the debt to GDP ratio would not exceed 40% over an economic cycle. So, how long will this cycle be? The Institute of Fiscal Studies have estimated that it will be 2032 or later before we are back to a debt to GDP level of 40% so we really are talking about generational debt in the UK. The impact of this debt mountain will be reduced government spending and higher taxes, both of which will reduce GDP even further. When interest rates begin to rise, the cost of servicing the debt mountain will rise and an ever larger part of our national income will go to service historic debt rather than be invested for our future. This will all lead to a demand from investors for higher rates of return from Gilts to compensate for the increased risk of investing in UK Government debt. What this really means is that the capital value of Gilts could be seriously hit and investors holding this debt could suffer significant losses.
Further probable stimuli to the fall in Gilt prices are the eventual withdrawal of quantitative easing which will flood the market with ‘second hand’ Gilts and, secondly, the massive levels of new issuance by all governments in 2010 and beyond to fund projected borrowing levels.
Some investors have been ‘shorting’ (a transaction where investors hope to profit from a fall in value) Gilts recently in expectation of our views coming to fruition. However, so far this has proved to be an expensive trade as Gilts have stubbornly retained values close to their crisis highs. Not all investors believe that Gilts are overvalued; if they did then values would already have plummeted.
So, will Alistair Darling be starring in a new production of Dr No sometime in 2010? Possibly! But whoever is in No. 11 will have a difficult time managing the UK economy and for this reason investors should, perhaps look to good quality corporate debt or ‘high yield’ (below investment grade) debt if they are prepared to take more risk for a higher return. We expect more companies to issue new corporate debt in 2010 as banks continue to shrink their loan books. Unfortunately, this form of capital raising is not available to smaller companies. Be warned, however, that when the cost of UK government debt rises, there will be knock on effects in UK corporate and high yield debt markets.
For our investment clients, we have allocated more funds to managers who have the ability to move across the whole of the bond spectrum from Government debt, to good quality corporate debt, to high yield debt. These managers also have the ability to take short positions if desired and, therefore, are more likely to protect capital when the inevitable happens. We have also allocated funds to (mainly investment grade) emerging market government debt where countries such as China, Brazil and Poland (the only European economy to avoid a recession in 2009) feature heavily.
As always, please take professional advice before acting.
Should you have any questions, please speak to your usual Vantis contact or call Adrian Gough, Investment Director, Vantis Financial Management on 020 7417 0417 Email: investmentadvice@vantisplc.com
Vantis Financial Management Ltd, a Vantis plc group company, is an Independent Financial Adviser, authorised and regulated by the Financial Services Authority.
The contents of this document are intended for general guidance only and, where relevant, represent our understanding of current law and HM Revenue and Customs practice. Action should not be taken without seeking professional advice. No responsibility for loss by any person acting or refraining from action as a result of the material in this document can be accepted and we cannot assume legal liability for any errors or omissions this document may contain. © Vantis, January 2010. All rights reserved.