understanding of the investment landscape'
Debt Crisis Guide: It's about "Return of Capital" not "Return on Capital"
Summary & Conclusion
Investors had better get used to extremely difficult UK and Global market conditions and a new definition of risk, since the corrective process that is underway will take many years. We believe that those who can successfully navigate the numerous market perils and maintain their purchasing power will eventually be in a position to pick up distressed assets very cheaply.
Safe havens that could help investors protect their wealth will be gold, high-quality stocks with sustainable cash flow that pay a dividend and potentially the currencies of nations that benefit from their natural resources.
Potential pitfalls that could be avoided include exposure to the broad stock market indices, overvalued property markets, debt instruments such as bonds which may not be as credit worthy as they appear, and banks/ financial institutions as a consequence of counter-party risk and stretched balance sheets.
From Boom to Bust: How We Got Here
Between 1988 and 2007 the world experienced a huge economic boom. During this period the price of stocks, commodities, bonds and property all rose to historic levels.
As a result, many of us felt wealthier and enjoyed a luxurious lifestyle of new cars, second homes and increased consumption. Much of this affluence however was created by massive increases in public spending and private borrowing and not as a result of prudent investment in productive assets.
Between 1999-2000 and 2009-10, UK government spending increased by 53% in real terms and between 2003 and 2010 government and individuals in Britain borrowed an average of 11.2% of GDP every year. That meant that each additional £1 of national output cost £2.18 - something that was clearly never sustainable. The fact is that basing national growth on ever greater borrowing was always a policy doomed to fail.
From bad to worse...
In response to the global financial crisis of 2008/ 2009 the UK government stepped in to prop up spending causing a dramatic increase in the size of its balance sheet and making the debt burden even bigger.
Chart of UK Public Sector Net Debt 1975-2011
Source: statistics.gov.uk
Paying the piper...
Britain, as with many other Western countries, has lived beyond its means for many years and in doing so has amassed considerable debts and it's a debt burden that continues to grow.
According to the McKinsey Global Institute, Britain's total debt, that is, private, public and financial sector debt is the highest in the world, far exceeding that of the eurozone countries currently being bailed out. Official figures put UK government debt at around £900 billion, which is equivalent to 60% of GDP, however if the financial sector interventions are included, Britain's total debt figure reaches £2.24 trillion, or 147% of GDP. That puts us on a par with Greece and Spain.
As we have seen with Ireland, Portugal, Greece and now Italy, a nation can only live beyond its means for so long before it's time to pay the piper. Indeed, if urgent action isn't taken, it is only a matter of time before the markets wake up to the true size of Britain's debts and demand much higher interest rates in exchange for lending us money.
The Long Road Back To Solvency
The McKinsey Global Institute study found that historically such an unsustainable build up of debt is followed by a prolonged period of deleveraging during which consumers, businesses and eventually governments reduce spending in order to pay down debt. Rebalancing an economy is a long and painful process.
The study found that for a nation to reduce its debt to GDP levels by around 25% takes 6-7 years and it's a process that puts a big drain on economic growth.
Financial repression as a solution?
It seems clear that the "solution" that has been chosen to the global debt crisis is that of financial repression. Financial repression was the policy adopted by the US and other advanced economies from 1945 to 1980 in order to pay down their enormous government debts following World War II.
Financial repression destroys the value of money, and therefore debt, and although it takes a long time, it does reduce the real cost of debt burdens to governments by devaluing the currency, unfortunately it also erodes the value of savings and therefore penalises savers.
It's all about the Return of Your Capital
In an environment of prolonged deleveraging, an investor's primary concern ought to be the return of their capital rather than the return on their capital.
Those that can preserve or protect their capital will have the opportunity to take part in what might be the asset sale of a lifetime. As bubbles burst and assets are marked to their true market value, those with capital will be able to pick up these distressed assets very cheaply. As Richard Russell once said, "In a bear market, the winner is he who loses the least".
Potential safe havens for investors:
- Gold: Gold is in a powerful bull market and has risen for 10 years in a row returning on average 18% with no down years. Investors who have held gold since 18 January 2001 when it made its low of $257 have been richly rewarded as today the yellow metal trades at around $1,770 an ounce. The price of gold is being driven by two primary factors, currency debasement (which shows up as inflation), and negative real interest rates. Unlike modern paper money, gold acts as a store of value because it cannot be created at will by governments.
- Quality stocks: Investors may wish to consider high quality blue-chip companies which pay sustainable dividends. Many large-cap stocks pay a dividend that is significantly higher than the interest paid on a typical savings account, and dividends can offer investor's additional piece of mind since typically companies capable of paying sustainable dividends can only do so if they can generate sustainable cash flow. Companies to look for are those with a history of increasing their dividend payout. Increasing dividends are a sign that a company's management have confidence in the future outlook. Another thing to look for in a quality company is what Warren Buffett calls an "economic moat". Such companies have an enduring competitive advantage which makes it difficult for their competitors to erode their strong market share. An example of such companies would be Johnson & Johnson or Proctor & Gamble.
- Resource currencies: Some investors may also want to diversify their cash and should therefore look to hold the currencies of nations that benefit from real wealth in the ground. These would include the Canadian dollar and the Australian dollar.
Potential pitfalls where we believe investors should tread carefully:
- The equity bear market: Review holding the major stock market indices such as the FTSE 100 or Dow 30. Most of the world's major stock markets are in a secular bear market and are no higher today than they were a decade ago. During a secular bear market there are shorter-term cyclical bull and bear phases, however the overall trend is negative - especially when adjusted for inflation. Investors holding index trackers in a secular bear market may lose money, and if history is any guide this bear market could last until around 2020.
- Asset bubbles: There are two potential bubbles that investors should be wary of: UK property market values and mid to long-term government bond holdings.
- Unnecessary counterparty risk: Due to the interlinked nature of the modern financial system, the lack of proper accounting oversight and the poor track record of the ratings agencies, investors are likely to struggle when it comes to gauging the credit worthiness of banks or other financial institutions. Many of these institutions are highly leveraged and the debts of one often appear on the balance sheet of another. Investors should therefore be wary of any investment that involves unnecessary counter-party risk.