Confronting the European debt crisis

Current shuffling of the deckchairs on the Titanic that is Europe will not solve the euro crisis, according to Martin Conlon.

The significantly positive returns provided by equities during October were a welcome respite from the unfortunately familiar declines.

Ascertaining why confidence has improved and whether the market recovery is sustainable, is more problematic. 

We cannot claim any insight whatsoever into the short-term direction of sentiment.

However, cursory observations on the price of bonds, gold and other perceived defensive investments (and I use that term loosely in relation to gold) relative to their riskier peers would indicate that investors still aren’t positive.

We are, however, far less sure that fundamentals are likely to provide the reassurance for investors to become more optimistic.

For some time, we have believed that the investment landscape over coming years will be characterised by an environment of developed world deleveraging.

This does not necessarily answer the question as to whether one should buy equities or bonds, but it suggests that investing on the basis of extrapolating recent decades could prove painful. 

We have never believed that growth – particularly gross domestic product (GDP) growth, as it is most popularly defined – is an important driver of investment returns.

However, investor adherence to this delusional yardstick means its evaporation is likely to create headwinds. 

The search for GDP growth has, in our eyes, been a significant contributor to current problems. GDP is no more than an estimate of the value of goods and services produced in an economy – it is not an indicator of economic wellbeing. Its value is measured in monetary terms. 

If more money is introduced into the economy – generally through individuals or governments borrowing it – the measured value of GDP will generally increase, even if no more goods and services are produced. It should not make us feel better.

If we doubled the amount of money in the economy tomorrow, we could all get a big pay rise, see our house prices double, and Coles might even raise the price of milk – but we wouldn’t be any richer. 

Measurement units don’t create wealth. Explosive credit growth has created the illusion of wealth whilst actually delivering increasing wealth disparity and dismal productivity outcomes.

Investment returns are no different – they are about maintaining purchasing power, and must be thought of relative to the things we’re trying to purchase.

The centre of attention in this regard remains Europe.

Rather than focusing on whether the current shuffling of deckchairs on the Titanic which policymakers have disguised as a solution to the current euro debt crisis will have any impact whatsoever, it is probably more important to step back and put the situation into context.

The key issue – which outgoing European Central Bank (ECB) president Jean-Claude Trichet has raised – is the restoration of credibility in sovereign debt. 

“If we don’t have the credibility of the sovereigns, we don’t have a backstop if we have new possible crises”. The reason the credibility of sovereign debt is progressively declining across the world is two-fold.

Firstly, there is too much of it.

Secondly, the use of it is abysmal. As observed above, levels of both government and individual indebtedness across most of the developed world have been on a consistent trajectory for some time – and it’s not down.

This deterioration has occurred in peacetime, when demographics were favourable, publicly owned assets were rundown and sold – rather than improved – and a good portion of liabilities (significantly pensions) weren’t, and still aren’t, actually recorded as liabilities in government accounts.

Increased debt levels have primarily been funding bloated bureaucracies and wasteful spending.

We are now supposed to believe that a voluntary haircut by some bondholders (not the ECB – they’re a public institution and don’t need to mark assets to market) on the government debt of the worst offender – together with a plan to leverage the little remaining firepower of the European Financial Stability Fund to provide artificial confidence in those yet to default – will solve the problem. 

Not only that, having not generated any meaningful productive growth whilst they racked up all the debt, growth will remain almost unaffected as governments pay off all the debt and fund pensions for citizens not prepared to work anymore.

The real hope of policymakers in this latest deception is that European banks can convince European bank shareholders to contribute large amounts of new capital to an insolvent banking system to allow bondholders to mitigate some of their losses.

It’s about time equity holders and taxpayers asked bondholders to fund their own losses. The only way debt issues are going to be corrected is for a lot of it to be written off.

Closer to home, the Qantas Airways saga – which dominated headlines during the month – highlighted the increasing imbalances impacting the Australian economy, and why complacency is ill-advised. From a company perspective, cost structures have become untenable. 

Fares are already high compared to global peers, with currency adding to the difficulty in raising prices. Wages and conditions, also exacerbated by currency strength, are uncompetitive. 

The position of Qantas highlights the vulnerability of many Australian businesses. Unemployment, collapsing asset prices, and overcapacity are plaguing much of the world.

To expect that we can continue to deliver significant wage gains and maintain almost full employment without significant productivity gains is ‘cloud cuckoo land’. The longer this situation prevails, the more vulnerable the domestic economy will become. 

Outlook and strategy

As we’ve raised previously, sustained confidence and sustainable economies and businesses will require some deviation in thinking from the currently adopted methodologies.

Adding more liquidity, deceiving investors and not acknowledging mistakes, is not the recipe for success.

We credit investors, and citizens generally, with more intelligence than that accorded to them by policymakers.

They will generally see through deception. It is for this reason, that despite apparently attractive valuations in equities, we remain somewhat cautious. 

International equities are still at valuations below that of Australia – evidence that sentiment can deteriorate further.

The UK prices of BHP Billiton and Rio Tinto are our reliable anecdotal benchmark. Billiton closed the month at a 20.5 per cent discount to the Australian listing, and Rio Tinto 25.3 per cent. It is for this reason, that where possible, our preference is for the vast majority of the portfolio holding in these stocks to be held offshore.

Martin Conlon is the head of Australian equities at Shroder Investment Management Australia.