Endgame: The end of the debt supercycle and how it changes everything

It’s been a while since I wrote, but my core themes haven’t really changed.  I still believe a fiscal retrenchment is coming by year end with a rally in bonds, particularly the safer municipals.  Aside from a covered call on FTE being called, and switching the money to VXZ, I haven’t been trading lately and my portfolio has been sitting on the following:

Municipal bond funds (BAB, PZA, PZT, PWZ),

Exchange-traded corporate debt, preferreds, and a preferred fund (C-PF, JPM-PI, CEG-PA, HYK, PLP, PRD, etc – most of my portfolio in similar instruments)

Dividend-paying stocks in the energy/utilities sector (EXC, CHK, PBT, PDS).  Note that PDS is a Canadian driller that operates in the US as well and doesn’t pay dividends and that the other 3 are American, so that the yields won’t be taxed in my Roth IRA.  CHK, PBT and PDS are also all natural gas related.  I like the NG story as a bigger energy source as coal becomes more highly regulated by the EPA, oil prices rise, renewables don’t make much of a dent in overall energy supply, and Nuclear plants take nearly a decade to bring on line.

The volatility index fund VXZ giving me positive exposure to volatility in the S&P 500 (particularly downside volatility).  This uses intermediate-term derivatives which somewhat track the 60-day moving average of the VIX – allowing it to hold it’s value fairly well over months of stable VIX readings. Note that VXX is the short-term alternative, but it quickly loses value with a flat VIX so you can’t safely hold that one for more than a week. 

All that aside, there are a number of interesting developments going on.  I’ll start by saying that I no longer get Rosenberg’s newsletter with his fancy graphs from the bloomberg terminal because he started charging $1000 CAD per year for it.  On the other hand, I finished reading “Endgame: The end of the debt supercycle and how it changes everything” by John Mauldin, and I can get his thoughts for free on http://www.johnmauldin.com/subscribe/

While “This Time is Different” follows the similarities of government default cycles and their results in the past, “Endgame” focuses more on where we are and what to expect in the future (and it was published in November 2010, so the predictions are fresh).  As far as what to expect, here’s my quick breakdown:

-Empirically, a country with a Debt/GDP ratio over 90% experiences GDP growth 1% lower, though the relationship is not linear.  This makes sense not only because of interest expense, but also because government debt tends to crowd out the productive private debt.  Almost all jobs growth and GDP growth comes from small businesses – which rely on much more risky venture capital when developing, and often rely on personal and business credit card debt or other asset-backed debt in the formative stages.

United States:  As shown in today’s symbolic S&P downgrade on US debt outlook, the debt and deficit here are becomming a major problem.  This can play out in a number of ways, all of which imply lower trendline growth, higher volatility, shorter bull runs with longer bear runs, and higher structural unemployment.  Either the government will cut back on not just services but entitlement spending and special interest handouts (like Ethanol, bullet-trains, and renewable resource projects which destroy greenspace at great cost for little benefit) – resulting in a multi-year deflationary environment leading to the next real growth cycle, or they will ignore the problem and we’ll end up going the route of Japan.  Either way, lower but positive growth with higher volatility is in the cards for a while. 

We are currently experiencing monetary inflation, part of which is driving commodities higher, but the economy is still in a deflationary environment.  If oil gets back up to $150/barrel then we might see a 2008-9 style recession again.  They know this at the Fed, which is more staffed with inflation hawks than before, so don’t expect a quick QE3 after June.  June is the biggest upcoming month in my opinion – as the end of QE3 and a stable or reducing fed balance sheet will pull excess capital out of the system (primarily from stocks and somewhat with commodities), followed by the end of extended unemployment benefits and perhaps other government stimulus measures. 

Japan:  The book refers to Japan as “a bug in search of a windshield,” and they really have no good options left.  As their population continues to age, the savings rate is going down and new buyers of government debt will have to be found.  They kept rates so low for so long through classic financial repression (as it’s called in “This Time is Different”), by forcing banks and insurance companies with government ties to invest ever more money into Japanese debt at ridiculously low yields.  Foreigners will not come in droves to buy Japanese debt without paying at least the 2.5% that healthy Germany requires for a 10-year note compared to their current 1%.  Their last budget had higher cash flows from new debt issuance than from tax revenues.  To quote from page 252: “Half of all spending on debt is to service interest … Furthermore, and increase of 100 basis points in the cost of Japanese debt would eat up a full 10 percent of the entire tax revenue.”  Japan’s debt is way to big to pay down, as you can imagine.  Once they have to hit  international markets, interest rates will go up on their debt – and an increase of 5% would mean that their entire tax revenue would equal debt servicing costs.  They’ll hang on in limbo for a few more years and then something will hit, investors will lose confidence, and Japan will have to rely on the central bank to purchase new debt leading to a bout of hyperinflation.  I have to admit I’m afraid of the spillover effects on the US dollar because their central bank is neck and neck with China as the largest holder of US treasuries, and they will sell these to bolster their currency once hyperinflationary forces begin and they are cut from international capital markets. 

Europe:  The Euro as a currency has a good chance of holding.  This is because there is no easy exit from the Euro … any attempt by a peripheral country to exit such as Greece or even Spain or Italy would cause a massive run on the banks as Euro’s fled the country at any hint that it might be reclassified in a new currency.  Only the strong countries like Germany can have a clean exit, as investors would likely trust the new Deutsche Mark over the Euro – and they don’t want the currency appreciation to hurt their competitive advantage in exports.  Despite this, restructuring of debt in most peripheral countries is inevitable – not only in Greece, Ireland and Portugal but likely in Spain and Italy as well.  This will happen similar to adjustments during the time of the Gold Standard – with deflation reducing wages and costs in peripheral countries, and a significant writeoff of the face value of debt.  The bailout funds are extremely unpopular in Germany, Finland, and other fiscally conservative countries while the austerity measures are unpopular and perhaps even counter-productive in overly indebted Ireland, Portugal and Greece.  The end result will have to be that Just like Iceland wouldn’t pay Britain and the Netherlands for covering their depositors in the failed bank “IceSave,” these countries will simply stop paying until they can reach a deal that they think is manageable.  This will certainly have political and implications, and will lock them out of financial markets for a time, but they’ll re-enter and sell debt again just like Argentina after it’s hyperinflation & default in the 90’s.  For now though, expect deflation and high unemployment in the peripheral countries along with volatility for the Euro as investors try to figure how much peripheral government debt & troubled bank debt the ECB holds. 

United Kingdom:  They had a bigger property bubble than the US, along with bigger debt and deficit problems, and they have been aggressively undertaking an inflationary responce with their central bank.  The pound went from $2.20 US in 2008 to $1.60 US today in a time where the US dollar has weakened substantially.  They are also experiencing persistent inflation of ~5%, and the central bank in London has purchased all government bonds issued in 2009 (p. 269).  The British Government also has an average debt maturity of 14 years – much higher than most other countries (5 years in the US and 5.5 years in Japan), so they will likely see it to their advantage to keep this up for a while.  Hyperinflation is not expected (that happens when QE begins to increase debt loads because the short-term debt must be rolled over at much higher yields, forcing a cycle of debt and deficit monetization by the central bank … here the debt structure will cause inflation to benefit the debt/GDP in the short term and the government is moving towards greater fiscal austerity.  Needless to say, double-digit inflation 1970’s style is likely to hit the pound. 

Australia:  The country looks strong on the outset, especially fuelled by demand in Asia, but they are sitting on a property bubble much bigger than that of the US which has not yet popped.  There’s no telling when it will burst and what the proximate cause will be (perhaps a commodity slowdown due to massive underreported Chinese stockpiling crimping global demand?), but it will be big, leading to a weaker Aussie dollar and a major downturn.  Their banks have greatly increased their reliance on international short-term funding (which sunk Northern Rock and so many others) and approximately 90% of Australian mortgages are variable rate (p. 280).

Canada:  This country also experienced a property bubble, but the central bank has been letting the air out through methods such as increasing down payment requirements.  Canada has been very strict with lending standards, high down-payments, and they only offer recourse mortgages (meaning the bank can come after you for the loan balance when you foreclose or sell the house at a loss).  As a result, homeowners have significant positive equity and a foreclosure wave is unlikely to happen (and they have a much higher percent of home-ownership to boot).  The country has learned from harsh lessons in the 80’s and 90’s and has become one of the most fiscally conservative – and is in one of the strongest positions today.  With a corporate tax rate at half that of the US – and no tax on foreign earnings – the only question is how many US multinationals will move their headquarters up north. 

China and emerging markets:  The Chinese commodity stockpiling scenario is very real, with warehouses full of unused copper along the ports.  I also often wonder when (not if) the government will start to phase in annual property taxes, and whether this will pierce a strong property bubble.  Chinese investors are limited in what they are allowed to invest in – like Chinese stocks, government or bank bonds, a set allocation of gold, and the big one – Chinese real estate.  There are many really nice condo developments which sit unused – not lived in by the owners or rented out – but owned by passive Chinese investors.  Once property taxes come into play, the burden of significant regular expenses will force many of these investors to at least find tenants if not sell.  This expense will also lower property values significantly as it reduces the size of mortgage a buyer can take on.  Aside from those risks, GDP growth should be strong in emerging markets over the years.  However, don’t rush everything into emerging market stocks because these markets often correlate with investor risk aversion in developed markets more than their own growth prospects, making them volatile.  The market cap of most emerging markets combined is smaller than that of the S&P 500, and foreign investment can considerably affect the price – so it is important to make sure valuation is good before plunging in.  I would suggest waiting for better buying opportunities at the end of the year, as I expect US investors to be a bit more wary of risk by then (that goes for commodities as well). 

Well, this is much longer than I intended, but I highly recommend the book “Endgame,” as it is easy to follow and lays out some interesting long-term implications for the market.  That’s all for now – and don’t expect to hear too much for a while because I belatedly started studying for the CFA level 2 exam this June, and I have a lot of catching up to do.

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About johnonstocks

I've been trading stocks since 2003, active on Motley Fool's discussion boards and using first Hidden Gems, then Global Gains. I no longer have the newsletters, but I keep up on the WSJ and read David Rosenberg everyday at gluskinsheff.com. Education: CFA level 2 candidate MBA-focus in Finance, Marshall, University of Southern California - expected Dec 2010. BS Mechanical Engineering, UC San Diego, June 2002
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