Hamish McRae: The risk to global sovereign debt and why Greece is now under the cosh
Sunday 12 February 2012
It is inherently improbable, is it not, that a bit of pushback by the government of Greece towards the conditions being imposed on it should be sufficient to unsettle shares around the world and break the pretty strong bull market?
It is all the more improbable when you factor in the widespread acceptance that the bail-out will buy only a few months' time and Greece will soon be back for more help. Yet if you look at the market reports last week that is what appears on the face of it to have happened.
So something else must be happening. Let's leave aside the Greek business for the moment, except perhaps to reassert my own view that the conditions being urged on the country are unrealistically harsh. Of course the previous generation of politicians should not have got the country into this mess in the first place but punishing ordinary people for the transgressions of these people cannot be right. So what is happening?
The first thing to say is after a serious economic downturn, associated with a collapse in share prices, you typically get a decent share recovery. This is a global phenomenon but you can see it particularly clearly if you look at Wall Street. The chart shows what has happened this time, the blue line on the timescale below, compared with previous experience. The red line shows what happened if you take the previous six bear markets and align this cycle with the top of the average of these markets. The green line shows the same data aligned from the bottom of the cycle. the collapse of share prices this time was more serious than the typical bear market– ie the blue line declined further than the red – but the recovery was more akin to previous experience – ie the blue line has pretty much tracked the green line.
However, it does not matter whether you start counting from the top or start counting from the bottom, this share recovery is now the average of previous experience. It has been a scruffy economic recovery but it has been a strong share recovery, at least in the US. Why might that be? Simon Ward, the economist at fund managers Henderson who put this chart together, thinks it is liquidity. The world is experiencing extraordinarily loose money conditions as the main central banks pump out the cash. We had our own Bank of England agree last week to buy another £50bn of gilts, which will mean one quarter of all British government debt will be held by the central bank.
That is astounding. It has never happened before in peacetime. What we have been doing is in addition to the similar policies of the US Federal Reserve and the European Central Bank. The technical methods employed are slightly different in each case. For example, the ECB is not allowed to fund national governments directly in the way the Bank of England can. But the effect is the same, with the €500bn of three-year money it has lent to the European banking system helping to turn round interest rates on most European sovereign debt. It is actually questionable whether what the ECB has been doing is legal and it will be interesting to see whether someone in Germany seeks to bring a test case. But for the time being the printing presses are allowed to keep running.
That money has to go somewhere and shares are one place. Simon Ward thinks the excess liquidity will support share prices for some months but warns: "another wrenching correction is likely when monetary conditions tighten, either because central banks dial back on stimulus or stronger economies divert liquidity away from markets – a possible scenario for later in 2012."
That brings us back to the debate as to the relative value in equities and bonds. Last week saw the publication of the Equity-Gilt Study, the one that stockbrokers de Zoete started and which is now published by Barclays Capital. This looks back over more than a century of returns on different types of investment and, since we have just experienced a long bull market in bonds, should remind us that over the past century equities have been a much better investment. But the particular point it makes this year is that at the moment the equity-risk premium, the gap between the return you get on a typical portfolio of shares and the interest you get on a selection of fixed-interest securities, is at record levels. That leads to the killer question: are shares too cheap or bonds too expensive?
Or maybe both. Come back to Greece, or rather the implications that the Greek default/collapse/emergency, call it what you like, will have on the rest of us. Almost all the comment has focused on the implications for the eurozone economy, European banks and the future of the euro itself. There is nothing wrong with that, for these are indeed the front-line issues. But behind the concern about Greece, and perhaps explaining if not excusing the way Greece is being savaged, is the much wider concern about sovereign debt itself.
At some stage the UK national debt held at the moment by the Bank of England will have to be sold on to permanent holders: real savers. But before that happens there is likely to be a bear market in bonds, for the present values are way out of line with their historical performance. The present equity-risk premium cannot be sustained. At the moment the Government has been pretty good at persuading financial services companies to buy gilts, while poor retirees are being coerced into buying annuities that deliver disgraceful returns. But this cannot continue indefinitely. Similar concerns apply to holders of US and European national debt.
So behind all this pressure on Greece is not just the European financial establishment wanting to buy time so it can create a firewall behind Greece, stopping the run before other countries are sucked in. It is also a wider fear that all European sovereign debt, including even German debt, indeed all sovereign debt in the developed world, will come under suspicion. Meanwhile, they just keep printing the money.
Who will be proved right if France and Germany go head to head on policy?
It is just possible that later this year Europe is going to be able to carry out something close to a controlled experiment in economic policy.
In an ideal world you would be able to take two similar countries, give them quite different economic policies and wait and see what happened as a result.
The closest that Europe has done on that score was the two Germanies, East and West, after the Second World War.
Now it seems that we might have the opportunity to see two very different economic approaches test-driven by Germany and France.
Germany will continue to follow austerity and urge it on the rest of Europe.
But if, as now seems quite likely, France elects François Hollande as its new president we will have quite different policies followed there.
The pension age will be put back to 60 from the recently raised 62; more than 250,000 new state-funded jobs will be created; the fiscal consolidation programme will be relaxed, and so on.
If France were able to fund such a programme and if in three or four years' time the country were doing much better than Germany, then it will not just be France that would be changed.
The entire eurozone's economic approach would be discredited.
On the other hand, were France to have to reverse policy after a few months and go back to austerity, then Germany would have won the intellectual debate, after doubtless pretty severe damage to the entire eurozone.
So the stakes are high. But there is a precedent.
Another François, François Mitterrand did indeed follow an expansionist agenda after he was elected in 1981.
He did indeed reverse it 18 months later.
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