Given the growing size of the issues at stake, though, it's been a surprise that markets have not fallen more sharply: we've said before that this is as much a function of the lack of real investment alternatives to equities as anything else (cash and fixed income returns are low or negative in real terms, and this seems unlikely to change any time soon, unless you feel the urge to load up on Greek debt?).
There's no doubting, though, that sentiment remains extremely nervous as we saw by last week's bear raid on the Italian bond market and the sharp drop in the EUR.
The spectacle of Eurozone politicians and officials failing to produce a credible long term solution to the problems of the periphery is growing ever more pathetic, notwithstanding the difficulties of resolving the diametrically opposed political and economic objectives of the Germans, the French, the ECB and the debtor nations. Although a managed default by Greece (and possibly Ireland and Portugal) seems inevitable and unavoidable, achieving this without triggering more widespread contagion and a possible break up of the EUR looks beyond the wit of the current bunch of "decision makers".
Speaking of turkeys, the current "debate" in the US between the equally intransigent Democrats and Republicans is every bit as unedifying as the squabbles and indecision in Europe, as we head closer to the August 2nd deadline for raising the US debt ceiling.
Once again, the effect of this on markets has so far proved virtually non-existent (the yield on ten year US treasures has actually dropped below 3%), on the basis of the widely held assumption that "something will turn up" in true Micawber style. One has to assume that this will indeed be the end result, since the prospect of a government default and shut down will do little for the credibility of either side.
The fact remains of course, that the debt problem is so large that both spending cuts and tax increases will be required. Both sides know this, but distilling that into a 5 second soundbite for Fox news is proving challenging.
To put this into perspective, take a look at these charts from JP Morgan:
The first shows the steady rise in the debt ceiling since 2006, and the % of GDP accounted for by that debt... after a trifling 100% of GDP and about $14.3tn. The proposed increase would take it up to 109%. With the help of this week's 'Economist' magazine, the need for budget cuts becomes ever clearer:
The US's primary budget deficit as a % of GDP is the largest of all the major developed economies: without rigorous action to bring this under control, the problems will simply grow ever larger due to the nature of spending commitments on Medicare, Medicaid and Social Security, and the reality of demographics in an aging society.In the past, the US has always relied on growth to help push these problems into the background. Not any more: sluggish growth and productivity improvements have meant that US companies can do more with fewer workers (which is why the current Q2 results season is once again exceeding expectations), whilst tax revenues slump due to the moribund state of the US property market and consumer spending.
No corresponding cut in spending or increase in tax rates results in the US is living beyond its means. As a result, commitments made in the good old days when the US economy dominated the world must now be renegotiated, as shown by JP Morgan's second chart which illustrates the present value of future entitlements. These make the current debt of $14.3tn look like chicken feed.
One assumes that some form of reason will prevail, and a mutually unacceptable solution will be found, although in true "Turkeys voting for Thanksgiving / Christmas / Festivus" style, rabid tea-partiers, signatories to Grover Norqvist's "no tax increases" pledge, and spendthrift Democrats might just feel that a default is their only alternative if they want to get re-elected. Never mind the country's credit rating, or doing the right thing. It's all looking a bit like Europe.
We're still of the view that a resolution will occur to both the EU & US deliberations since there are signs that all parties involved are getting the point. Watch for creative solutions in the next couple of weeks (the Europeans will want to get it sorted before they take August off). On that basis, we still hold the view that markets will stage a rally in the latter part of this year.
Hopefully.
Steve
e-mail: steve.davies@javelinwealth.com
contact: +65 65577186
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