Global Story – Debt Threats

It is typical of what is gathering in the left field: a full bloodied global debt crisis, which is likely to turn markets freakish by the end of this year. It will lead to years of low economic growth, tight fiscal and monetary conditions, and sub-par yields on equities, as governments and consumers – notably in the US, Japan and the UK embark on a protracted period of de-leveraging or if they don’t; it may lead to chaos, a currency death spiral and hyper-inflation.

Actually, it’s not likely to be an ‘either-or’ situation but rather a messy hybrid.

And even China won’t be exempt from this as it will still rely on developed world markets to fuel much of its growth for the next several years. China is piling up a lot of toxic bank assets having transformed itself from an export addict into a bank loan addict with new bank loans mandated by Beijing running at 25-30% of GDP last year.  Meanwhile fast growth in India is grappling with a government debt-to-GDP ratio similar to the UK’s and Greece’s ‘official’ ratio. And suffers from a near double digit inflation.

If governments don’t bite on the fiscal bullet, the legendary bond market vigilantes will force them to do so by refusing to refinance at anything like current and artificially depressed coupon rates on bonds.

Crux of the problem

That is the crux of the problem as this will capsize equity markets, kibosh global economic growth and ramify into much higher servicing charges for heavily indebted business and consumers, as well as for governments.  The last time the vigilantes saddled up was in the early nineties when they forced the Clinton administration to focus on balancing the budget rather than passing a lavish universal healthcare program.

You don’t have to be a hard-headed member with hardened arteries of the Austrian school of economics to be making plans for a possible evacuation to the hills with some canned food, firearms and gold.  Indeed, a friend of mine in the US likes to say when the US 10-year Treasury bond yield breaches 5% ‘make for the hills.’  Guess what? Morgan Stanley has just come out with a forecast that the yield will reach 5.5% by the year-end, and bear in mind that when the vigilantes had done it with the Clinton administration, the yield was nearly 9%.

But as economic historian Niall Ferguson has put it,

“this is more than a Mediterranean problem with a farmyard acronym.  It is a fiscal crisis of the modern world.”

The fact of the matter is that much of the West and Japan is bankrupt. Partly as a result of the global financial crisis and the emergency measures it triggered in conjunction with the years of underlying fiscal and monetary laxity. The world economy is now creaking under a huge debt burden.  The average government debt to GDP ratio in the OECD is nearly 100%, with Japan’s going over 200%.

Last month’s G7 finance ministers’ meeting in Canada made clear that member governments are drifting for now. They are not yet getting to grips with the politics and economics of confronting their epic public debts.

So, it’s a fair political bet that G7 regimes will try to inflate, devalue or even default their ways out of the problem, given that their economies are flat linking. This will offer little scope for revenue buoyancy and they won’t have the intestinal fortitude to slash and burn on public accounts and ‘squeeze until the pips squeak’ in the words of a British finance minister in the aftermath of WWII. Britain is set to reduce its government debt ratio of over 200%. This was easier to implement in the past days of more disciplined and war hardened electorates.

Result?

The vigilantes will ride into town.

David Einhorn is one of the world’s sharpest hedge fund managers.  He was first to see Lehman’s gaping wounds and make a mint from the sub-prime crisis.  Einhorn’s assumptions are that governments have debased currencies, almost beyond repair, by printing too much money and will not bite on the fiscal bullet.  It is he who coined the phrase ‘currency death spiral’.  So, what are his main calls?

He bought 5-year options from banks last year saying that US and Japanese 10-year bond yields will spike dramatically especially in Japan’s case. And he is also a gold bull without being a gold bug.

Soros has been accumulating gold, as has last year’s overall hedge fund maestro John Paulson.

These guys are not ones to bet against.

Now we must wait to see how the Market reacts as governments tap it via new bond issues amounting to trillions of dollars over the next several years.  It may not be a pretty sight.

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