The truth is rarely pure and never simple

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Are the use of definitions such as “Emerging Market” or “Developed Market” are useful or whether they have been made redundant by the recent financial crisis?

In the CFA curriculum, students are taught that the US market is the safest market there is, because of the transparency, disclosure and regulation that exists; by definition therefore, other places are higher risk and students advised to exercise heightened caution when contemplating investments in such other frontier marketplaces. Perhaps after the recent financial troubles that have afflicted the globe this canard can finally be put to rest!

The traditional approach is to classify economies into two classifications: Developed and emerging (although increasingly a third is being used – frontier). Developed economies are those sorts of places where there exist robust democratic institutions, where the rule of law prevents governments from seizing ownership of assets and where investors have rights that will be respected and regulators who will provide for fair markets. Perhaps the seizure of multiple banks by governments of the developed world or the ownership of car companies was something that had to happen for the good of the respective economies (a view I sympathise with) but the effect was profound nevertheless.

Almost without exception, ‘developed’ markets had a bad crisis, whereas ‘emerging’ markets had a good one (see the Figure 1).

Selected Countries’ GDP Performance Best and Worst Periods (2005-2010) 

Investors would be wise to remember this when they consider their investment strategies. This is not to say that investors should make wholesale reallocations away from their domestic economies to foreign ones since for many that would be inappropriate. But it is saying that the very essence of investment teaching needs to be questioned. Take the case of a fixed income investor:

This person knows that he has no capital upside, relying instead of a steady income stream (coupon payment). Thus the investor will look at factors that determine the likelihood of the company in question being able to repay the debt and make good on the interest payments. Factors likely to be considered (amongst many others) include cash flow, leverage, debt maturity profile and business concentration risk. A company with a consistent record of paying down its debt and generating surplus cash will command a much higher rating from investors and therefore be able to pay a lower rate of interest.

Those who have significant financial gearing on the other hand are, by definition, more exposed to the vagaries of the economic cycle and therefore riskier. The recent credit crisis has shown this to be true. In fact, in aggregate, corporate America has actually done rather well at reducing its level of aggregate indebtedness; most have learned from the bubble and bust and sought to reduce their financial leverage, thus improving their survivability. Of course this might make things less exciting for equity investors, but that is a different story.

How then should investors respond to the recent debt crisis?

We have just lived through a pretty nasty banking crisis and, whether by sheer luck or skill (in all honesty the jury is still out on that and will remain so for a good few years), we escaped, in the main, unharmed. Some banks failed but those that remained are stronger, in easier competitive positions and have the reputation, generally speaking, of being too big to be allowed to fail. That last concept is changing (it needs to) but it will take time and there are few countries in the world that want to go through a Lehman experience on a magnified scale (remember Lehman didn’t even have any retail clients!).

What though to do about a sovereign debt crisis? In the old days it was simple: Avoid ‘emerging markets’. The conventional (western) view was that money was safe in developed markets whereas emerging markets were wild, frontier-like places. The old philosophies, indeed the very distinction between developed (low risk) and emerging (high risk) have been shown to be utterly inadequate for the purposes of risk control.

On the one hand there is political risk – the perspective being that established democracies generally respect property rights better than less established or non-democracies. This remains a generally true statement (despite the misgivings expressed in the opening paragraphs).

On the other hand though, respect for property rights is not synonymous with good economic stewardship. Many emerging economies have managed their economies better over the last few years – having reported stronger economic growth and been less reliant upon debt to fuel their economies. Thus the crux of today’s crisis: The growing economies of the world are often in the criteria of ‘higher risk’ because they have less established property rights.

But because they are growing economically and have low aggregate levels of indebtedness they actually have lower levels of risk than the traditional ‘lower risk’ economies who have almost zero economic growth, highly immobile and inflexible labour systems and large unfunded public debt obligations.

Lower-risk economies got themselves into trouble because of their debt burdens which arose, amongst other reasons, because of lax fiscal discipline and a desire to deliver strong economic growth. What has made the problems worse and immediate however is a worry that was originally unrelated to sovereigns, that of consumers. The developed economies’ collective response to the consumer debt binge wasn’t an orderly deleveraging but rather a debt swap. In other words, an assumption by the public sector of the debts incurred by the private sector. This isn’t just a trivial technical point, it matters. The debt that caused the problems has not, at all, in any shape or form, actually been reduced. All that has happened is that taxpayers are now on the hook for it.

‘Off balance sheet’ liabilities
Apologies to those reading this who thought that the unpleasant expression “off-balance sheet liabilities” had been firmly and soundly put to rest by extra-zealous new regulations, but sadly it still exists and in some rather unexpected places.

For US focused investors, the travails of Greece and other ‘risky’ countries might be considered quirks of Europe but the reality is far more sobering. For instance, if the US economy were to put ‘on-balance-sheet’ its liabilities (Medicare, Social Security, the Housing Agencies etc) the calmness exhibited by treasury markets today would quite easily look misplaced. Indeed the most remarkable element in all this is the performance of 10 and 30 year treasury bonds.

The 10 year US treasury is currently trading at approximately 2.60 per cent. The only time in the data going back almost 50 years when it has been lower was at the nadir of the market – literally when investors worried that there would no longer exist a banking system and as such piled all their cash into US treasuries. It doesn’t feel like a panic out there on the street today…so why are yields so low?

The only other plausible reason is that investors genuinely believe the US is going to turn into Japan. In other words, there will be prolonged periods ahead of us of deflation, recession and generally depressing times. However, with the most recent GDP growth showing 3 per cent growth (year-on-year) and the quarter prior showing 2.4 per cent it is some stretch to assume imminent deflation or depression.

You’ve got to ask yourself one question: “Do I feel lucky?”
While companies have, by and large, been doing the right thing, some governments have been engaged in an altogether different game: whether quixotic or malicious (and the difference really just depends on your politics) governments in the ‘developed’ world have been raising their debt levels dramatically. An investor’s response to a debt crisis is generally to go where things are safest. That has resulted in the yield on the ‘safest’ investment going (US treasury bills and bonds) falling to levels that are genuinely astonishing. If investors changed their view on the riskiness or desirability of holding US t-bills there would be almighty carnage.

A one percentage point rise in the yield on the 10 year would result in a 7 per cent loss for investors. Or to frame the issue a different way, would you lend to the government for 30 years and accept 3.6 per cent as compensation? Perhaps the first time Dirty Harry has been used in the context of the US treasury market, but to close the opening quote to this paragraph: “Well, do ya?” (See Figure 2)

US 10 Year Treasury Yield since 1962

Investors would be wise to remember Oscar Wilde’s quote about how the truth is rarely pure and never simple. Simple labels can be manifestly and disastrously misleading. We are taught when looking at shares or mutual funds that past performance is no guarantee of future performance. Investors need to remember this maxim when contemplating sovereign risk as well.