Wednesday, March 24, 2010

The gentlemen of Newport Beach...

...having a good run. I agree with most of the analysis, per previous posts.

The uncertainty comes from a number of
structural headwinds in PIMCO’s analysis: deleveraging, reregulation,
and the forces of deglobalization – most evident now in the markets’
distrust of marginal sovereign credits such as Iceland, Ireland,
Greece and a supporting cast of over-borrowed lookalikes. All of them
now force bond and capital market vigilantes to make more measured
choices when investing long-term monies. Even though the government’s
fist has been successful to date in steadying the destabilizing forces
of a delevering private market, investors are now questioning the
staying power of public monetary and fiscal policies. 2010 promises to
be the year of choosing “which government” can most successfully
substitute the governments’ fist for Adam Smith’s invisible hand and
for how long? Can individual countries escape a debt crisis by
creating even more debt and riding another rocking horse winner? Can
the global economy?

The answer, from a vigilante’s viewpoint is “yes,” but a conditional
“yes.” There are many conditions and they vary from country to
country, but basically it comes down to these:

1. Can a country issue its own currency and is it acceptable in
global commerce?

2. Are a country’s initial conditions (outstanding debt, structural
deficit, growth rate, demographic balance) moderate and can it issue
future public debt as a substitute for private credit?

3. Can a country’s central bank be allowed to reflate via low or
negative real interest rates without creating a currency crisis?

These three important conditions render an immediate negative answer
when viewed from an investor’s lens focused on Greece for instance: 1)
Greece can’t issue debt in its own currency, 2) its initial conditions
and demographics are abominable, and 3) its central bank – The ECB –
believes in positive, not negative, real interest rates. Greece
therefore must extend a beggar’s bowl to the European Union or the IMF
because the private market vigilantes have simply had enough. Without
guarantees or the promise of long-term assistance, Prime Minister
Papandreou’s promise of fiscal austerity falls on deaf ears.
Similarly, the Southern European PIGS face a difficult future
environment as its walls whisper “the house needs more money, the
house needs more money.” It will not come easily, and if it does, it
will come at increasingly higher cost, either in the form of higher
interest rates, fiscal frugality, or both.

Perhaps surprisingly, some of the countries on PIMCO’s “must to avoid”
list are decently positioned to escape their individual debt crises.
The U.K. comes immediately to mind. PIMCO would answer “yes” to all of
the three primary conditions outlined earlier for the U.K. in contrast
to Greece. We as a firm, however, remain underweight Gilts. The reason
is that the debt the U.K. will increasingly issue in the future should
lead to inflationary conditions and a depreciating currency relative
to other countries, ultimately lowering the realized return on its
bonds. If that view becomes consensus, then at some point the U.K. may
fail to attain escape velocity from its debt trap. For now though,
“crisis” does not describe their current predicament, yet that bed of
nitroglycerine must be delicately handled. Avoid the U.K. – there are
more attractive choices.

Could one of them be the United States? Well, yes, almost by default
to use a poor, but somewhat ironic phrase, because a U.S. Treasury
investor must satisfactorily answer “yes” to my three conditions as
well, and the U.S. has more favorable demographics and a stronger
growth potential than the U.K. – promising a greater chance at escape
velocity. But remember – my three conditions just suggest that a
country can get out of a debt crisis by creating more debt – they
don’t assert that the bonds will be a good investment. Simply
comparing Greek or U.K. debt to U.S. Treasury bonds is not the golden
ticket to alpha generation in investment markets. U.S. bonds may
simply be a “less poor” choice of alternatives.

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