Inside Investment: Debt levels and politicians up against the ropes
There is no solution to indebtedness and the inevitable and painful process of deleveraging, so lean back and protect yourself like Muhammad Ali and the US Congress.
In the Rumble in the Jungle, the famous 1974 world heavyweight title boxing match in the oxymoronically named Democratic Republic of Congo between Muhammad Ali and George Foreman, Ali created the term ‘rope-a-dope’ to describe the secret strategy he used against his bigger and more powerful opponent.
After a few rounds of trying to go toe to toe with Foreman, Ali was getting the worst of it. He decided to hang back on the elastic ropes, which acted as shock absorbers, deflecting the champ’s blows until Foreman was exhausted. All the time Ali taunted his opponent. "They told me you could punch, George!" In the eighth round he moved in to land the knockout blow.
I was reminded of this particular rumble by the failure of the recent US congressional super committee. The problem was that both sides were playing rope-a-dope, which only works if one of the combatants follows a different strategy. In fact, the 12 Solons were so committed to this tactic that they did not meet in the month preceding their late November deadline. President Barack Obama also played rope-a-dope by staying out of town, although he did make a few calls from Bali to see how things were going.
It is not difficult to imagine my senator, mister John Kerry, lingering sullenly on his yacht, but in truth it is not clear where he was. He does not appear in the Congressional Record even once in the month to date even though the Senate was in almost daily session. Kerry’s boat, by the way, is called Scaramouche. Unfortunately there are even more roguish clowns in Congress than on the waters of Nantucket Sound.
There is a strong argument in favour of playing rope-a-dope in the current crisis: there is no solution that will work, so why should a politician stick his neck out by promoting any one of the doomed options? Any solution must be politically acceptable, but none of them is. Financial conditions in most developed countries are very bad and declining rapidly. We have passed the point of no return.
A brief look at the numbers shows that the financial situation is untenable. Let us consider debt levels and trends in four areas: corporate leverage, financial system leverage, household leverage and government leverage.
Corporate leverage is the least troubling of these four categories. Industrial companies, including those in the real estate sector, have either reduced leverage or have already defaulted.
Financial system leverage is much more troubling. Bank assets as a percentage of GDP in the US are about 90%; this ratio has been declining recently but is still high compared with 50% to 60% in the 1990s. The situation in Europe is much worse, with the ratio generally between 300% and 400%. One should expect a continuing sharp decline in bank assets, and economies cannot grow until this process is complete.
Household leverage has not declined much in either the US or Europe. Household debt levels for the US and the UK are both over 100% of GDP. In the US, this debt is now at the highest level since 1929, and, as Lady Bracknell might say: "You know what that unfortunate moment led to."
|All good things must come to an end, they say, and ends are generally messy. Ours will involve financial liquidation and the end of the welfare state|
The situation in the US is exacerbated by the fact that student loans and reverse mortgages are providing upward pressure on household debt. Student loans have just reached $1 trillion as young people without jobs go back to school and borrow the money needed from various government programmes. Retirees with diminished savings have been entering into reverse mortgages in increasing numbers. They are paid a lump sum for the house in exchange for the right to live there until death. Government debt levels are extremely high and rising in both the US and Europe. A normal level is around 60%, which is the global average now. The US is at 100% (IMF calculation) and the European Union is at 80%. In both the US and the EU this ratio is increasing rapidly. The EU has an average budget deficit of 7% of GDP (Estonia, Sweden and Norway have surpluses) and the US and the UK sport deficits of 10%. There is little prospect of deficits declining.
Some sort of default in all the main countries will likely resolve the crisis, whether it is by restructuring or inflation. All good things must come to an end, they say, and ends are generally messy. Ours will involve financial liquidation and the end of the welfare state.
The suggested strategy for investors is to imitate Ali and the US Congress by playing rope-a-dope. Lean back and protect yourself. This could involve high-quality cash, for example Singapore dollars, Norwegian kroner, Swedish kronor and Canadian dollars. Precious metals also have a role.
Once the coming great liquidation is complete, one will again be able, as Ali also said, to "float like the butterfly and sting like the bee." I hope this will happen in my lifetime.
Lincoln Rathnam, PhD, CFA, is an investment professional based in Singapore and Boston. In a career spanning almost 30 years he has managed equity, debt and venture capital portfolios and was a pioneer investor in emerging markets in the late 1980s