The coming world economic crisis and how to survive it

The Coming World Economic

Crisis - and How to Survive It

Dr Sikandar Siddiqui, Heidelberg, Germany

November 2012

Contents

1. Background and Diagnosis

2. Can‘t we be more Optimistic?

3. Historical Experience and Current Developments

4. A Likely Outcome

5. Conclusions and Recommendations

Background

• In the years 2008 to 2009, the sub-prime segment of the U.S.

residential mortgage market virtually

collapsed, leading to the deepest global recession since the Great

Depression of the 1930s.

Source: worldculturepictorial.com

Background

• Governments of the globally leading economies

responded with rescue packages for troubled

financial institutions, and with macro-economic

stabilisation programmes

which, in turn, prompted sharp increases in public

sector deficits…

Diagnosis

• …so that by now, a

disturbing fact has become increasingly

obvious:

• Most of the govern-ments in North

America, Japan, and

Western Europe are about to overstrain their

debt servicing capacity.Source: http://www.economist.com/content/global_debt_clock

Source: Ingram Pinn

Diagnosis

Diagnosis

• The clearest evidence supporting this perception is not provided

by the level of debt-to-GDP ratios in the countries involved,

but by the fact that in all these three regions, central banks have

had to step in and mop up

government bonds other investors were not willing to buy

at current yield and/or risk levels.

A Giant Ponzi Scheme• While the recent banking crisis

served as a catalyst for the

development of this problem, its roots lie further in the past:

• Since the onset of the current debt binge in the late 1970s,

governments in the U.S. and much of Western Europe have

been essentially operating a large-scale Ponzi scheme in

which expiring debt was almost

never paid off but, instead, only passed on to new generations of

creditors.

In 1920, businessman Charles Ponzi set up an arbitrage trading strategy in postal reply coupons which, later on, turned into a fraudu-lent „snowball system“ using cash inflows from new participants to pay off withdrawals from existing ones until it finally collapsed due to the inevitable, eventual cessation of follow-on investments.

• What doesn’t exactly make things easier is that, in some countries,

some of the government’s implicit payment obligations are not

officially counted as government debt.

Source: drpinna.com

A Giant Ponzi Scheme

• Germany, while often setting

itself up as a stern disciplinarian of the Eurozone governments

when it comes to fiscal issues, constitutes no exception:

Subsidies to Germany’s ailing public pension system have been projected to exceed € 81bn, or 26.2% of total federal expenses in 2012.

A Giant Ponzi Scheme

• The country’s implied future payment obligations resulting

from future public service pension liabilities and its

notoriously underfunded public

pension system have never shown up in the official public

debt statistics.

Implications

• Now, with populations ageing

and the limits to growth set by the scarcity of natural resources

becoming increasingly obvious,

the fragility of this giant, government-operated snowball

system is all too evident.

Source: cartoonstock.com

Contents




4. A Likely Outcome


Can‘t we be more optimistic?

• Some observers might dismiss the

assessment made here as overly pessimistic.

• To justify their verdict, they would probably point to the experience

gathered in the 30 years following

WW2.

• At that time the capitalist economies managed to grow out of

their wartime debt without

governments imposing overly painful austerity measures on their

populations for too long.Red lines indicate the debt held by the public and black lines indicate the total public debt outstan-ding (gross public debt), the difference being that the gross debt includes that held by the federal government itself.

U.S. public debt, 1940 to 2011Source: whitehouse.gov/omb/budget/Historicals

• However, virtually none of the factors that fostered this

development historically

continues to be present today:

A growing civilian labour force (resulting from workers

switching from military

service to civilian employment) and increasing

labour force participation rates,…

Source: hdg.de

Production line in West Germany, 1960


…stable or - in real terms - even declining crude oil prices…

Source: Forbes.com


…and a largely fragmented, strictly regulated capital market

leaving safety-oriented investors

with virtually no alternative to holding government bonds

denominated in domestic currency, …

Source: cliffcule.com


…greatly facilitated the reduction in government

debt-to-GDP ratios in

the U.S. and Britain after WW2.


Source: patriotupdate.comAttribution: RJ Matson, Roll Call

The U.S., in particular, used to draw enormous profit from the Greenback’s status as the lead

currency of the Bretton Woods system, which, for a long time, created a huge demand for USD-denominated government debt to be used as a reserve asset by

central banks.

But confidence in the suitability of the USD as a storage of value has

since been eroding (for quite understandable reasons), effectively blocking this exit route today


Contents




4. A Likely Outcome


Historical experience

• In the past, governments with unsustainable debt loads have

regularly taken up two possible “solutions” to this problem (or

a combination of both):

Source: DebtDecreaser.com


• They either forcefully

expropriated some of their lenders, …

Forced expropriation of lenders as an alternative to austerity: Execution of Jews by crusaders in the 13th century

Source: de.wikipedia.org


• …or intentionally devalued

the currency in which their debt was denominated.

Source: Hulton Archive | Getty Images

During the German hyperinflation of 1923, some citizens began to consider bank notes a convenient alternative to conventional wallpapers.

Current developments

• For the time being, some influential

decision makers appear to prefer the first “solution”, i.e. the forceful

expropriation of lenders.

• At least, this is what happened when

Greece forced its creditors into a “voluntary” debt rescheduling in

early 2012, only to expropriate

unwilling investors, too, a few weeks later – and with the obvious

consent of its political allies abroad

Source: guardian.co.uk


• The arbitrary nature of the Greek “debt rescheduling” is

all the more evident as the

value of state-owned assets available for privatisation was

estimated to exceed € 100bn by mid-2011.

Source: FT.com


• Greece’s continuously

excessive military spending is another piece of evidence

indicating that the country’s “payment crisis” is due to

deliberate overspending rather

than mere inability to pay.

Military spending as a percentage of GDP (Source: World Bank)

Source: americablog.com

Current developments• So what had started with a mis-

representation of fiscal statistics

ended up as what otherwise might have been called a fraudulent

bankruptcy.

• The fact that this behaviour by the

Greek governments has not been offered any noticeable resistance by

fellow Eurozone member govern-

ments raises perfectly understand-able fears among investors that, at

some time in future, it may repeat itself in the cases of Portugal,

Ireland, Italy, or Spain.

Greek Public Sector Deficits, 1997-1999

1) Figures from the Convergence Programme on which the inclusion of Greece into the Eurozone in 2001 was based.


• On the other hand, some

influential economists, for the time being, appear to favour

the second alternative – a deliberately induced rise in

inflation.

Soruce: harvardmagazine.com


• Given that the single most important lender to the U.S.

government is the People’s Republic of China, which

has obviously already begun to sense the danger, it seems

unlikely that a forceful

expropriation of creditors will be the preferred option

of the U.S. government.

In a 2011 issue of the state-controlled paper Global News, journalist Mo Luo urged a more active role of the Chinese military in supporting the country’s economic interests, arguing that “an invariably humble foreign policy that strictly prioritizes harmonious relationship and the value of compromise will reduce us to a country that serves as an ATM machine for the West and a charity for the developing world”.

Source: globaltimes.cn


• Of course, theoretically, fiscal

austerity remains another option.

• But given that, so far, even

measures only directed at limiting further increases in government

debt – rather that reversing that

trend – have provoked very angry (and, in some cases, violent)

reactions in parts of the public, it seems unlikely that this route will

be seriously considered by

governments.

Protesters take to the streets of Athens and rise up against proposed austerity measures being debated in the Greek Parliament on February 12, 2012.

Source: UPI/Giorgos Moutafis

• It would nevertheless be too hasty to conclude that even if

the last-mentioned viewpoint

prevails, the U.S. and the Eurozone economies are

bound to experience excessively high rates of

inflation during the next decades.

Although fears of inflation keep rising, it remains a possible yet not inevitable consequence of the current economic dilemma

Another policy alternative


• The rationale for this argument is somewhat technical:

- If the central bank of a currency area decides to offer member states cheap

funding by continuously buying

government bonds in exchange for central bank money,

- …it can nevertheless curb the growth in the money supply – and the resulting

inflationary pressures – by increasing minimum reserve ratios or regulatory

capital requirements, or by otherwise

limiting private sector credit growth. Source: en.wikipedia.org

Another policy alternative• The Japanese experience from

the last two decades suggests that

large-scale central bank

purchases of government bonds do not have to produce

inflationary effects, provided that credit growth is limited

- either through institutional

regulations (e.g. regulatory capital standards or minimum

reserve requirements),

- or, quite simply, because of

the risk aversion of lenders and/or borrowers.


• Yet in the long run, the cost of this “solution” attempt will

(most probably) be a long-lasting phase of macro-

economic stagnation or even

contraction, due to a severe shortage of credit available to

private sector entities.Source: inn-service.co.uk

Contents




4. A Likely Outcome


Likely Outcome

• If chosen in isolation, each of the three aforementioned

“solutions” (forced expro-

priation, inflation, and protracted private sector de-

leveraging) is likely to be met with fierce resistance by those

worst affectedPensioners rallying against price rises in St.

Petersburg, Russia, on November 3, 2007.

Source: Reuters.com

• Governments might thus be

tempted to choose a

combination of these three “medications”, allowing the

dose of each of them to be less noticeable.

Source: drugchannels.net

Likely Outcome

• In this case,

- inflation will be restricted to rather low

(i.e. single-digit) levels due to con-straints on private sector credit growth,

- the possibility of further selective expro-

priations (or “voluntary debt reschedul-

ings”) will remain on the agenda.

- limits imposed on private sector credit

supply will cause economic growth to

be low or even negative in per capita terms because private sector entities

will be forced to use considerable fractions of their current income to pay

down existing debt (if they can), and

Source: politicalbetting.com

Likely Outcome

Contents




4. A Likely Outcome


Recommendations for Investors

• It seems that in any case, the most unwise investment

decision will be to continue considering U.S. and

Eurozone government bonds

low-risk investments (at least in inflation-adjusted terms).

Source: interest.co.nz

• Yet another piece of uncomfortable information

is that in phases of

economic stagnation (or recession) and moderate but

perceptible inflation, the equity market as a whole,

too, is unlikely to perform outstandingly in inflation-

adjusted terms

Even in nominal terms, the late 1960 s and the 1970s, marked by mounting inflationary pressures and considerable geopolitical tensions were no easy times for the average equity investor.


• This does not, however, imply that risk-conscious investors ought to

shun the equity market altogether

• The imminent decline in the value

of Dollar, Euro- and Yen-denomi-

nated debt will, most probably, induce investors to exchange their

current holdings of credit assets denominated in these currencies for

- equity stakes in attractively valued companies, and

- commodities essential for the

fulfilment of basic human needs.


Source: stockmarket-investing.com

• Producers of goods that fulfil basic human needs (e.g. food and

drinking water, energy, medical

supplies and pharmaceuticals) are more likely than others to succeed

in a macro-economic environment characterised by stagnation and/or

inflation, because in this market segment, the sensitivity of private

sector demand to price rises and

income losses tends to be lowest.


In most of North America, Western Europe, and Japan, the trend towards population ageing is likely to increase the share of healthcare products and services in total aggregate demand during the next decades

Source: ehow.com

• Moreover, reasonable targets for future equity investments will be

companies with

- strong balance sheets (i.e. low debt to total assets ratios), enhancing their

ability to withstand a protracted de-cline in private sector credit supply,

- stable operating cash flows, and

- attractive valuations in terms of

price/equity ratios, signalling that their current market prices are not

based on over-optimistic growth

expectations.


Source: takcreditmanagement.wordpress.com

• Companies making strong R&D efforts in technologies

related to food and beverages,

renewable energies, and medical care also deserve a

high degree of attention by equity investors.


Source: immobilienblasen.blogspot.com

• Among the companies

that deserve particular attention in this context

are those with strong

innovative potential in the fields of “clean”

energy production…


A technological revolution in the making? The Gemasolar power plant, located near Seville (Spain), uses molten salt as a heat storage technology to prolongation plant's operating time in the absence of solar radiation

Source: torresolenergy.com

• …resource saving

technologies…


• …crop protection/yield improvement, and

irrigation efficiency…


Source: Sygenta International AG

The flooding of rice fields requires around 2,500 liters of water to produce 1 kg of rough rice. As water scarcity increases, so does the need for water saving technologies.

• …as well as life sciences, and health care.


Elements of life: Close-up picture of a nerve cellSource: University of Magdeburg

Conclusions

• Investors can protect (and possibly even grow) their

wealth in the long run if they

anticipate the coming flight from Euro-, USD- and Yen-

denominated debt and “get ahead of the crowd” by

starting to accumulate a well-diversified portfolio of

commodities, arable land, and

attractively valued, “defen-sive” equity investments.

Conclusions

• Sophisticated investors familiar with option strategies and short

selling may even be able to

enhance the risk/return profile of their portfolios by including

actual or “synthetic” short positions in apparently

overvalued stocks to their portfolio.

Source: cartoonstock.com

• Moreover, an emergency reserve physically held in the

form of precious metals may

prove vital in situations of existential peril.

• Priority should probably be

given to substances which also

have a range of important industrial applications.

Palladium, for example, is a rare metal frequently used in catalytic converters, in jewellery, dentistry, in watch making, in blood sugar test strips, in aircraft spark plugs and in the production of surgical instruments and electrical contacts.

Source: en.wikipedia.org

Conclusions

Conclusions

• No-one can tell with certainty when the current debt overhang

is going to develop into the next, full-blown economic

crisis.

• But one thing increasingly

obvious: For investors seeking

to protect their wealth, the

time for action has come, and

the early movers are most

likely to succeed.

Source: 3.bp.blogspot.com

Comments? Objections? Requests?

Feel free to contact the author:

Email: [email protected]

Dr Sikandar Siddiqui, CFA, FRM

Ringstr. 21, D-69115 HeidelbergGermany

Managing DirectorSRS Ecofina UG (haftungsbeschränkt)

The coming world economic crisis and how to survive it

Economy & Finance

Transcript of The coming world economic crisis and how to survive it