The US debt ceiling debacle is a sideshow compared with the real issue – global stagnation. John Stepek looks at the best ways to protect your wealth
“That’s gratitude for you,” US politicians must have thought this week. As they emerged triumphant with a deal on the US debt ceiling, investors seemed decidedly unimpressed. The key US index, the S&P 500, continued to slide even after the final vote on the deal passed on Tuesday. Indeed, the market has suffered its longest losing streak since October 2008 (the height of the credit crisis, you’ll remember). It slipped into losing territory for the year and in the process fell through the 200-day moving average. You can read a definition of this here, but in short, it’s a key indicator for technical analysts. Regardless of what you think of charting, it influences many traders’ decisions, so falling below the line is bad news.
Of course, most of this has nothing to do with the debt ceiling debate. That was always a sideshow – a distracting one, which could and should have been resolved much earlier, but a sideshow nonetheless. What’s really made investors jittery is the fact that growth around the world is slowing down. Manufacturing is struggling across the globe, from China to Britain to the US, while growth figures have been extremely disappointing.
Hopes that the weakness in the sector had been largely a temporary knock-on effect of Japan’s earthquake disaster in March are starting to look like wishful thinking, with “sluggish second-quarter results and cautious earnings outlooks” rolling in from the likes of machinery giant Caterpillar, as Paul R La Monica notes on CNN.
Consumer spending in America also saw a surprise decline in June, falling for the first time since September 2009. This particularly rattled markets, given that consumer spending accounts for about 70% of the American economy.
They’re right to be worried. Below, James Ferguson explains why there’s a very real possibility that America could face a new recession in 2012, and he’s by no means alone in this analysis. Rich Yamarone at Bloomberg (via Anthony Doyle at investment bank M&G) points out that, when US GDP growth has fallen below 2% (as it has now) in the last 60 years or so, a recession has nearly always followed.
The real relevance of the drama over the debt ceiling is that it shows that governments around the world – not just in Britain – are looking to cut spending and adopt ‘austerity’ measures, rather than continue with fiscal stimulus. Some argue that this is a mistake – and it’s true that spending cuts won’t be good news for growth in the short term at least. And given that said ‘cuts’ actually simply mean a slightly slower rate of spending growth, they may not even have the impact on the deficit we all hope for. But as James points out below, for most governments, spending a lot more money is no longer a viable option. That’s because many Western governments are now at the point where their existing debt levels mean that further stimulus is likely to be ineffective, and only leave them open to potential attacks by ‘bond vigilantes’ – as we’re seeing throughout the eurozone just now.
What about QE3?
Of course, there’s an elephant in the room. The conditions in today’s market look similar to this time last year. Back then, investors were worrying about a faltering recovery too, and stocks were sliding as a result. That all turned around in August, when Federal Reserve chief Ben Bernanke announced that a second batch of quantitative easing (QE2 – more money printing) would be launched.
So won’t the same thing happen again? After all, the big jamboree at Jackson Hole – where Bernanke announced QE2 – is later this month. The Fed chief has certainly made no secret of the fact that he’d be happy to see more QE should he deem it necessary. It’s also worth noting that when he merely hinted at it in a recent testimony before Congress, the market’s reaction was to bounce.
But it’s not this cut and dried. For one thing, QE is a political decision. Ordinary voters in America see QE as a bail-out for Wall Street. And it’s hard to argue with them. QE has driven up their cost of living by pushing up commodity prices, but has done nothing to improve the employment market, or boost the price of their house (unlike in the UK, where low rates have more popular support because they’re the only thing propping up housing).
The only people who directly benefit are those with big shareholdings (the wealthy) and those who work in the financial markets (again, the wealthy). So with the 2012 election approaching, there will be pressure from the government on the Fed not to do something that might easily be painted as robbing the poor to give to the rich. Not to mention the fact that it’s hard to see the point of doing even more of the same if you accept that QE has so far failed miserably to boost the ‘real’ US economy, which remains smaller than it was just under four years ago.
If anything, the spectre of QE could prove to be negative for stocks. Why? Because investors may already be pricing QE3 in to the market. It’s clear that many hopeful traders are still banking on the ‘Bernanke put’, just as they bet on the ‘Greenspan put’ in the days when interest rates were still a decent distance from zero. Indeed, the bigger risk now may be that, if Bernanke now fails to mention QE at the jamboree this month, markets will crater in disappointment.
But most importantly, basing your investment decisions on second-guessing the Fed’s actions, and other investors’ reactions to it, is no way to run a portfolio. If you hold gold (and if you’ve listened to our advice at all over the years, you probably do), then that’s your insurance against further QE and dollar debasement. I’ve already gone into the key reasons to hold gold here. But how else can you protect your portfolio?
In a slowdown, one natural ‘safe haven’ is government bonds, as this week’s slide in gilt, Treasury and German bond yields goes to show. But the fact is that – despite James’s exhortation to ‘buy gilts’ below – we are reluctant to hold government debt (certainly Western government debt) for the simple reason that it carries too much political risk. We’re not suggesting you short US Treasuries or any other form of government debt – even the world’s biggest bond fund manager, Bill Gross, has had difficulty timing that market. But it strikes us as taking a lot of risk for little potential reward.
Instead, we’d be more inclined to put our faith in strong companies. Terry Smith of interdealer broker Tullett Prebon warned BBC Radio 4 listeners the other day that the world was still living in a fantasy world and avoiding the hard fact that, with the demise of debt-fuelled growth, our standard of living is set to decline. As well as gold, Smith is putting his money into ‘safe’ currencies, such as the Norwegian krone.
Smith also favours “very big, safe companies that sell everyday necessities and luxuries”, which makes sense to us. Big blue-chip defensive firms are not immune to pressures on economic growth. But if you favour the ones that provide goods that consumers ‘need’ rather than ‘want’, and which pay out chunky dividend yields that are well covered (see www.moneyweek.com/tutorials for more on dividends), you should do well. One risk to be aware of, however, as James Saft notes on Reuters – and it’s a point Merryn Somerset Webb has made here in the past – is that these sorts of big cash-rich firms will be very tempting tax targets for indebted governments. “Athens’ woes may not be Apple’s woes, but Washington’s woes definitely will be.”
We’re also keen on Japan. As James noted recently, Japan is a lot further through its banking crisis than we are, having lived with a slump for two decades or so. It’s also cheap. So while it won’t be immune to the rest of the market falling, your downside risk should be a lot smaller than that involved in buying a general S&P 500 tracker right now.
We’re heading for a double-dip – so buy gilts
The recovery of Western economies seems to have run into a brick wall. Since the start of the year, economic growth in America slowed to less than 1%, adjusted for inflation. Revised figures have shown that the US recession was some 25% deeper than first estimated, with the economy shrinking by 5.1% overall. As a result, GDP adjusted for inflation was lower at the end of June than it was at the same time in 2008. Usually, two years after a recession trough, growth has hit escape velocity and is running at closer to 4%-6% a year, not threatening to stall completely.
In Britain, the situation is even worse. All we have to show for the last three quarters is a miserly 0.2% growth. The eurozone is no better. Of course, the peripheral countries – Spain, Ireland, Portugal and Greece – are barely growing, but now France and Italy show clear signs of slowing too.
Admittedly, short-term prospects are a little better. American growth should pick up in the third quarter to an annualised rate of 2%-3%. There’s also the matter of a 100% capital depreciation allowance that expires at the end of this year. As companies rush to take advantage, it could well boost corporate capital expenditure in the final quarter.
Meanwhile, Britain’s growth was hit hard over the winter by the unseasonably fierce snow storms. More recently, trading days were lost due to the royal wedding bank holiday. These effects should fall out of the numbers for the third quarter. However, even if the third quarter holds up, the outlook for 2012 is sure to reignite talk of ‘double dip’ recession.
Why has the recovery been so weak? Because there hasn’t actually been a ‘recovery’ from the ‘Great Recession’ at all. The periods following a banking crisis are more accurately described as depressions. But depressions are vote-losers, so the knee-jerk response of any government is always the same. Like a bankrupt with one remaining credit card, governments load up on the plastic, enjoying one last spending binge to try and keep up the appearance that the good times are returning. Like the ever-optimistic bankrupt, they hope that self-sustaining, private-sector recovery will come along to rescue the situation. Scholars of past crises, for example Ken Rogoff and Carmen Reinhart, have found that, for the first three years of the many financial crises they’ve studied, the average increase in government borrowing is 83%. Since the crisis began more than three years ago, the question we now have to address is: what then happens in the next three-year period?
What tends to happen is that government borrowing hits an impasse. The International Monetary Fund (IMF) has noted that, once a country’s debt-to-GDP ratio rises above 60%, the extra benefit to the economy of each borrowed £1 spent slips below £1 – the fiscal multiplier falls below one, as the jargon has it. This is the reason why the Maastricht Treaty set the eurozone debt-to-GDP entry requirement limit at 60%. The IMF further notes that, above 100% debt to GDP, the fiscal multiplier can even turn negative, as the population starts to fear the future higher tax burden that such high deficits bring in their wake. In other words, at a certain level, extra borrowing actively sucks the life out of the economy.
Britain’s debt-to-GDP was already 80% at the end of last year. With a deficit that could reach double digits again this year, we’re only 18 months from the dreaded 100% mark. US debt also exceeded the 60% mark for the only time in its history (with the exception of World War II) late last year, hence all the hullabaloo on Capitol Hill about raising the debt ceiling. The Republicans, and the Tea party particularly, are horrified about the runaway train that is government debt.
It’s not just the fiscal multiplier that puts a stop to outsized deficits. So-called bond-market vigilantes can suddenly threaten to call a buyers’ strike if government spending appears out of control. That raises the cost of bond issuance and effectively cuts off access to the credit markets. A sharp increase in the interest costs of an already heavily indebted country tends to trigger a default. We’ve already seen this phenomenon in action this year, with the eurozone peripheral countries. But the real problem lies at the heart of the type of recession we are experiencing. Normally it’s not fiscal stimulus (government spending) that gets an economy out of recession, but monetary stimulus. Sure, automatic stabilisers, in the form of increased social security payments, push government spending up in any recession, which offsets the impact of the private-sector downturn. But the sheer scale of the government intervention this time has been unprecedented. Assistance to the banks in the US is estimated by Sheila Bair, outgoing chair of the US Federal Deposit Insurance Corporation, at $14trn (almost the same as US annual GDP). Cumulative deficits since the crisis began total some $3.6trn (24% of GDP). Quantitative easing (QE) has added another $2.3trn (15% of GDP) or so on top.
And what has America got to show for all this spending? Real GDP (adjusted for the mainly imported inflation, which has been due to the dollar weakness caused by QE) hasn’t even recovered to where it started in late 2007. Even from the trough of the recession in early 2009, nominal US GDP has risen little more than $1trn. Total American workforce jobs number 139 million, down from 147 million in late 2007, and up just one million on the low point at the end of 2009. For a combined $5.9trn in deficit and QE spending, the US government has created employment over the last 18 months at an average cost of $6m per job.
So it’s clear that the vast ‘Keynesian’ (how he must be turning in his grave) borrow-and-spend plan just isn’t working. However, it’s all we’ve got. So when Western governments start to turn off the fiscal tap as we go into the end of this year, GDP growth will slump. Unless, that is, the private sector can ‘crowd in’ to fill the gap left by public-sector spending.
The trouble is, we know that can’t happen. That’s because, after a banking crisis, while the banks are still suffering a deficit of capital, they are forced to shrink lending. That in turn forces the rest of the private sector to save more out of falling incomes. So any meaningful fiscal slowdown from the current anaemic growth rates on show across the developed world implies nothing less than widespread ‘double-dip’ recession. I’ve said it before and I’ll say it again: ‘buy gilts’.