Commentary – Quarterly bulletin, January 2012

26 January 2012

The global economy is sailing through dangerous waters but so far it has suffered no more than a few scrapes despite some unsteady hands on the bridge. But there is still some tricky navigation to do. The passengers (aka investors) are feeling more confident after a series of positive reports on the two largest component economies, namely the US and China. Even the perception on the eurozone crisis seems to have improved in recent months although this particular rock still has the potential to hole the hull. We should not allow ourselves to become complacent, though, as financial markets are likely to remain volatile, and we may hit a rock when we least expect it.

History is littered with sovereign debt default events.

I recently came across a fascinating paper written by a couple of academic economists* who have compiled a comprehensive database going back over eight centuries of countries that have defaulted on their debts. These events are far more common than I imagined and, taken in aggregate, offer some insights into their characteristics. One of the more striking features is the clustering of defaults into periods of around 20 years occurring roughly every 50 years. This chart shows the percentage of countries that were in default in any year since the beginning of last century. The good news is that, if the pattern is sustained, we are several years away from another clustering period and the next peak is not due till around 2040. The last cluster included the Latin American crisis in the 1980s. There are many reasons for defaults including the after-effects of costly wars and weak financial controls in the public sector. Clusters of defaults have tended to be preceded by a surge of capital inflows to a group of countries. These inflows can be destabilising by causing debt service costs to become crippling and eventually governments can be forced to default.

But history also illustrates that countries can successfully grow out of a debt crisis.

The UK provides one of the best examples of this. In the 1820s, the ratio of debt to GDP reached 250% (higher than any country at present) but over the next 90 years, this ratio was brought down to 40%. This was achieved through real economic growth rather than inflation. The inflation solution has been used by countries, including the UK at other times, to reduce the debt burden by transferring the cost to bondholders through an erosion of the real value of the debt service payments. More recently, Sweden was able to cut its debt ratio from nearly 75% to under 40% in only 12 years without serious inflation through a combination of tax rises, spending cuts and, crucially, a currency devaluation against a background of strong global economic growth.

Sovereign debt ratios are rising towards potentially dangerous levels across the developed world.

These ratios will inevitably fall and the means by which they fall will be crucial for the financial markets. But the turning point may yet be some time off. Japan's debt ratio has continued to rise for the past 10 years despite being at a level that could have been considered dangerous back then. Analysing past episodes of high debt ratios suggests that there is no foolproof way of predetermining the outcome although growing out of the problem without the help of inflation requires a good deal of luck and the confidence of investors.

Equity markets are continuing to recover from the end September lows.

It's been more about a recovery in investor sentiment than about an improving outlook as earnings forecasts continue to be cut. The economic and political news flow has been reasonably supportive but as I have noted before, the economy is going through a series of mini-cycles and it may not be long before there are some negative surprises. Political developments also have the potential to cause investor unease. Valuations are reasonably attractive and dividend growth is likely to be strong again this year after rising about 15% in the UK last year. However, shorter term market performance is, as always, more likely to be driven by changes in investor sentiment than by valuation measures. As we have seen all too often in recent years, sentiment can turn on a sixpence (or should that now be a five-penny piece!) and while it is has been recovering in recent months, it is still quite fragile.

'Safe-haven' bond yields have continued to trend lower.

As I noted last time, these bond yields are unsustainably low but can go even lower in the short term. Investors looking to benefit from such a move should however be aware of just how far removed the current yield is from the norm and the risk they run should yields move back to the norm. Below, I show the history of the long gilt yield compared to a measure of inflation expectations. Normally the long gilt yield is significantly above inflation expectations (taken here as the 5-year moving average of historic inflation) for reasons that space precludes from explaining here. The yield is currently over 1% below inflation expectations and as much as 4% below what could be considered a norm. The only other time in the 50 year history shown on the graph that the yield has been this much out of line was when inflation was at its peak and this model of expectations was giving a false impression. If the long bond yield rose back to the norm the price would fall by no less than 50% and the price of a 10-year bond would fall by about 30%.

Volatility in asset prices is an incomplete measure of investment risk.

While volatility is an important aspect of risk it does not capture the shortfall risk of the investment failing to meet expectations over the full term it is expected to be held. Investors will have particular objectives and will construct a portfolio of investments which they expect to meet those objectives. Expected investment returns, however, tend to be best estimates which disregard the range of possible outcomes. Volatility measures provide an indication of likely fluctuations in the annual return but what if the investment satisfies the volatility criteria but over the full term the mean return is less than the best estimate? Such an outcome can have serious consequences, particularly if it involves a permanent loss of capital. When the returns are uncertain, investors should allow in their planning for dealing with the consequences of possible adverse outcomes over their investment horizon.

— Ken Forman

Ken is an investment business consultant who spent 30 years as an analyst and portfolio manager at Standard Life Investments.

* This Time Is Different, A Panoramic View of Eight Centuries of Financial Crises: Carmen Reinhart and Kenneth Rogoff, April 2008