Sovereign crisis and what it means for your portfolio

By: ispeculatornew
Date posted: 11.22.2010 (6:01 am) | Write a Comment  (0 Comments)

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If you have been following up on economic events in the recent past, you know that there are many doubters about the current situation. I was watching Meet The Press this weekend where Dr Alan Greenspan and others were discussing the the problems that the US economy is facing related to its huge deficits. This is not a trivial issue and while I have been reading about it for months, I have postponed writing about it because it just seems like such a complex issue that getting around it seems impossible. But it is an important issue… And there might be serious consequences in the next years/decades. How should your investment strategy be adjusted? It’s a complex issue but I’d love to get your thoughts about it.

Government debt & deficits

Governments have more debt these days than at any points in history. They have borrowed during the good times and with the economy struggling, most governments have done as the US Government and the Fed has done… borrow massive amounts to stimulate the economy. It has worked to an extent but the world economy seems sluggish at best and governments are unable to get back to a no deficit environment. The prospects for the next few years are dramatic as well. Think about it… In developed countries, the population is aging very quickly and the governments do not have even close to the amounts that will be required to pay for everything that they’ve promised. Planning on living off of a government pension? Think again.

The big problem is that economists and governments know that the numbers do not add up but are unwilling to take the fight. Who could blame them? Barack Obama attacked the health care issue and the French government attacked the retirement age. In both cases, what they proposed was not even close to being a good step. It was like taking a first step in a 1 hour race… it’s a start..but so little. The problem of course is that in both examples, the governments had to settle for less amid huge backlash from citizens and opposition parties. That will certainly not encourage governments to take action. Rather, they will “kick the can” further down the road, as we’ve been doing for years. But at some point, we will need to tackle the issues.

Will it be too late?

S&P is a credit agency that is well known and respected. They do not get any fun out of publishing gloom report. Yet the report that they recently posted about sovereign debt and deficits is very alarming. The conclusion is that by 2045, 60% of governments would have their debts rated as “Junk”. The report is done with assumptions of “no major changes”. Of course, some changes will be done before then. But how late will we wait and how dramatic will things be by then? Just imagine that if a government’s debt is downgraded, the investors require a much higher interest rate which puts the country in further trouble which creates more debt… it’s a vicious cycle.

It’s happening already

Remember the problems that Iceland encountered, and Greece? Both are being helped by European Union members and now that Ireland is also in serious trouble, it’s not as clear how Europe will help. The more serious issue is that bigger countries like Spain and Italy also have a very upward hill to climb in the next few years. They have huge deficits, struggling economies and worst of all.. they cannot be saved easily. Europe and even the US have huge reserves, but saving huge G20 economies might be beyond what they can do right now.

I could go on and on and I’m not even trying to be pessimistic here, these are all serious studies being discussed by very credible economists. The issue could be discussed for hours and days but there are no easy ways to resolve it.

Impact on investment strategy…

I think it’s far from clear how to prepare for such an environment. There are no clear answers. Betting on government bankruptcies 10 or 20 years from now is not an easy thing to do and not an easy scenario to protect ourselves from. Here are some conclusions that I draw from this dark but far from impossible scenario:

1-Do not count on government help: No matter what the government tells you… if you are not yet retired, assume that it will go back on its promises. It has no other alternative. I assume that I will receive none of the money that I should be getting in theory from the government once retirement comes. It will probably not be entirely true but reality will not be that far off in most cases

2-Prepare for the doom scenario: If governments fail, it’s unclear how things would go. Massive cash printing? Interest rates going much higher? I think that avoiding leverage as much as possible is critical. Staying as debt free as possible is the best way to do so. If ever things go wrong and rates go much higher, the impact will be minimal. Having a very valuable house but a huge mortgage with it can be much more difficult to deal with.

3-In terms of investments: It’s quite unclear how this type of thing will play out. There are many leveraged and inverse funds that help you go short on US government debt but the outlook is so long term that those investments would be eaten by the fees on over time. I think that over time some ETF’s will be created for this purpose but in the meantime, safe bets might be:

Gold (uncertainty hedge?)
-Other metals (silver, platinum)
Inflation protected bonds (through ETF’s)

Do any of you have other thoughts on this?

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