Francesco has a wealth of experience from the financial sector, he has worked for HSBC Private Bank and Credit Suisse Asset Management amongst other.
This article is an updated version of one of his previous articles. I recommend you follow Francesco's website francescomaggioni.com. Francesco is also active on Twitter with the handle @fmaggioni.
Take it away Francesco. (If you prefer to download a pdf version of the article you can find it by scrolling down to the end)
The good, the bad and the ugly, or.. the ugly, the ugly and the ugly?
It is no surprise that the Western world is the sick patient here with more or less developed countries being just behind them. Africa for once, is the best in class with almost no debt.
The reason why I am preparing this study is to try to analyze the situation and come up with some possible forecasts for the future of equities and government bonds from now on.
Next to the map there are pieces of data concerning three countries: Italy, the United States and Germany.
Unfortunately those data, to me, are not correct (or at least it will be beneficial to know how they are computed) since they seems to imply a few things:
- Public debt: this number is a well kept secret. Nobody really knows what is the debt level for the US or Germany. For sure the former has unfunded liabilities which are not taken into account (someone say its debt is in the 100 tril. USD range) and the latter’s displays only the debt at central government level, not taking into account the regional level (Laender) which if summed up, reaches Italy’s level. Italy is very much in the same situation, but there does seem to be a bias to make Italy look worse in comparison to Germany. Unlike in Germany's case I would guess accountants and journalists have added everything in to the mix when it comes to Italy now and for the future (Please note, I am not pro-Italy here).
- Debt per person: even though it is a correct result of the division between debt and population, this data implies that each citizen is able to pay the debt. It doesn’t take into account the level of unemployment, which if it would be accounted, it would make the debt per person much higher due to a less (working) population and the increased level of debt. And even if it takes into account the unemployment level, it is still non-complete information. For instance, in the media the unemployment rate in the US is always trumpeted without mentioning the participation rate, which is the percentage of active people who are looking for jobs on the total population. The current participation rate is at 63%, at 1970s level.
But for the moment lets us take these figures as correct (the veracity of the figures is not my main point in the article).
In the last few months we are witnessing a widespread timid increase in interest rates. Why is this happening? One reason is that since the US economy and in general the Western economies are showing timid signs of recovery. Money is shifting from safer assets into riskier assets, namely stocks. Another reason is that because of signs of recovery, investors are predicting an increase of GDP which means higher spending for individuals in consumer discretionary goods or simply a higher turnaround of goods. That has the effect of an increase in revenues for companies, and that is the bottom line for switching from bonds to equities.
But is it really so? Even data on consumption is difficult to interpret making it almost impossible to really understand the current situation.
However what could bring more clarity to the situation is the Consumer Confidence Index which is at a very low level compared to previous recoveries.
Looking simply at a buy and hold strategy for the last 13 years the highest returns would have come from bonds, while the equities would still be negative (in the Western world only the US and Germany would have given a fractional positive return). The average return from bonds is around 3-4%.
This chart can give an idea of what I am referring to:
The Quantitative Easing in the US, Switzerland, Japan and the United Kingdom which were in part responsible for this low interest rate environment has also had another consequence; driving stock markets to historical highs.
Do you realize how many times the word historical is used above in the space of only five lines?
These are not emphasis added, these are facts. At some point markets will leave this stretched situation of multi historical levels, it cannot last forever.
QEs and rates cuts forced investors to put their money in the only space left with positive nominal and real yield, the stock market. That is true for the average Joe as for the Chief Investment Officers of pension funds alike who are managing pension money within their mandate, probably overweighting (correctly) equities and underweighting bonds.
Let’s look at smart money then, big institutions like Pension Funds of Sovreign Wealth Funds.
With US Treasuries arriving at a 3% yield what will they do with their allocation? They will probably start moving part of their equity (riskier) allocation back to where it should have been in normal conditions namely in the bond space causing redemptions from US equity funds to bond funds.
Not surprisngly in the last few weeks US equity funds had a massive outflows of 22 billion dollars (source: Market Movers on Bloomberg TV).
The same is happening and will happen in Europe, but in a slightly different fashion.
Currently the 10yr German Treasury, the “Bund” has a yield of 1.74% (down from 1.99%), with the Italian counterpart BTP at 4.10% (down from 4.55%); you can see a table at the of the report with a complete list of yields.
If the rise in interest rate will materialize in Europe too, what will happen?
Well the yield chasing made investors in the recent past buy every sort of lower grade bond, from Italy to Spain, Portugal alike. This year is also a historical year for junk bonds emissions, no wonder.
But when the Bund will go back to a quasi average yield of 3%, what should be the yield level of peripheral Europe to lure investors to stay with them? Even if the spread between the German Bund and the Italian BTP stays at current level (237 bpts) it would mean a higher interest expense at 5.30% which is too close to the 6-7% level that is the default area.
If that scenario will unfold, it will become a potential self fulfilling prophecy of higher interest rates in peripheral Europe, and still a considerable low interest rate enviroment for the Northern Europe countries, but why is that?
For the same reason of the US instituational investors effect moving from equity to bonds.
Institutional investors in Europe too (or generally institutional investors who invest in Europe) will move their allocation from overweighting peripheral Europe to underweighting it, and increase allocation to safer assets at a decent return, namely German Bunds.
Today the higher cost of funding for Italy in comparison to Germany is around 20 billion Euros per year, which can only go up if interest rates move upwards.
Let’s assume that the rising interest rate enviroment is correctly forecasted because a true recovery is materializing (which is not the case by the way). Governments will see their cost of funding increase but at the same time their receipts from taxes will also increase. The net effect remains to be seen and hope that the taxes are higher than the increased cost of funding.
But what if something goes wrong, and tax receipts do not increase? In Italy they know exactly what will happen, a spiral effect where at the same time lower tax receipts come with higher cost of funding, jeopardizing every effort that the government and the citizens have made so far.
Italy is not alone with this problem, in fact all Western countries face the same fate if interest rates start to go up, United States, Japan, France, Spain, Portugal all these countries will have to refinance their debt at a higher price and in order to be left alone (from IMF intervention for example, they will have to continue with the austerity measures or increase taxes: what they will not be able to afford is reducing taxes at the very best).
That is why personally I am very skeptical on greeting the arrival of a new rates rising environment, it will have a mixed effect, and we do not know how good or bad that net effect will be.
This historical (!) moment is one of the most complicated time for forecasting markets and their directions because too many variables are there, not even considering external potential factors or geopoitical events.
I often like to quote Donald Rumsfeld, the former Secretary of Defense in the Geroge W. Bush administation when he said:
“There are known knowns; there are things we know that we know.
There are known unknowns; that is to say, there are things that we now know we don't know. But there are also unknown unknowns – there are things we do not know we don't know.”
Which for our purpose can be read this way:
“There are known knowns; there are things we know that we know.
Economic and financial theories.
There are known unknowns; that is to say, there are things that we now know we don't know.
Directions of equity and bond markets in the near future.
But there are also unknown unknowns – there are things we do not know we don't know.”
Events that will interfere with theories and forecasts that could not possibly be foreseen.