A sovereign crisis

The words have been so frequently used over the last 18 months that they have lost much of their weight.

A sovereign crisis, for those who need reminding, is a very serious issue indeed.

When a country continuously uses capital it has accumulated from successful ventures in the past in an unproductive manner, the return on that capital is lower than what it once was. This creates a difference between the liquidity expected and the liquidity you have. This creates an incentive to borrow. Often, at this stage of the evolution of an economy, few are aware of where in the cycle this once great economy is at. Historians such as Giovanni Arrighi have discussed such “supercycles” in great detail, describing the evolution of an economy, an evolution that is eerily similar irrespective of the economy or the period we look at.

An economy with a great recent history ensures that borrowed funds are easily accessible, even from those economies that are currently generating higher returns. However, without a change in behavior, attitude, management etc, these funds also generate below average historic returns. This continues whilst lenders/investors belief this is a blip from the continuation of the growth of a great economy. However, at one point, the game changes. Though we are strong believers in mean reversion, understanding the drivers of an economy, market, industry, company, are vital to identify when the dynamics of the game changes. Looking at figures is simply not enough.

At this point there is an understanding that returns on capital are potentially lower for these economies, and may be permanently so without change. This realization in itself makes it harder to fight this tendency. The market will adjust their sentiment by increasing the cost of borrowing for this economy, by reducing the flow of capital towards it. These changes will make it harder with the same resources to generate returns that were achievable in the past. We have feedback loops appearing that are so inherent to market based systems. It is these feedback loops that make the transition from bubble to bust so rapid, and therefore, so dangerous.

So how can this economy grow itself out of trouble?

By using the same capital to generate more return. This can come from 4 prinicipal ways, which are not mutually exclusive:-

1. Reducing costs to generate the same product
2. Being innovative and generating a new product that can offer higher margins
3. Being more organized to develop the same product than your competitors. As a result, you are more efficient
4. Develop the same product at the same cost but have a weaker currency

Unfortunately, points 1 aqnd 4 have been making the headlines recently. The worst solutions.

When investors realise that growth is weak, cost management becomes the focus to try and increase margins. However, this is to the detriment of everyone, as the quality of life will decrease as wages fall and the number of unemployed increase. It is at this moment in time that innovation, a culture to learn, explore and develop must come to the fore to develop new solutions so that capital can flow into these economies again - not because they make the same product cheaper.


Conclusion

The lack of growth from the unproductive usage of capital in developed economies created a heavy debt burden that, for a moment in time, masked the structural growth problems inherent in these economies that resulted from globalisation. Now that debt is a heavy burden which forces the same economies to focus on cost cutting to reduce that burden. This will lead to a transfer of wealth from developed to developing countries.

It is an uncomfortable position to experience, but it must be done. The debt burden must be reduced so new capital can be available to chase new, more productive, projects. Ideally it should be done via creation, by value generation. Having new projects today to invest in. However, inevitably, pain must also be suffered via the reduction in the quality of life for many as consumer spending is replaced by greater savings to pay down debt.

There are some signs, however, that are creating even more fear within me. Negative real interest rates are providing a strong incentive to move from cash to real assets. There is an opinion that this could carry on for an "extended period of time". It is understandable, debt was the straw that broke the camels back, and the authorities do not want to increase the cost of that burden whilst the economy is so fragile. It is this reasoning that led us to believe that rates would stay low in 2009 for many years, as we wrote to our clients back then.

However, it seems there is appearing a 5th option in how to increase the return of an economy, and it has little to do with the real economy, it has to do with the role of asset markets. I fear that asset markets are being used as a transmission channel to inject liquidity into the economy, particularly so in the US, as the financial system has yet to recover from its shock in 2008 (as detailed in many recent blogs).

The distortional rising of asset markets and weakening of a currency are an interesting mix that generate the desired results on paper, in theory. However, in theory there is no difference between theory and practice. In practice there is...




PS. History suggests all great economies die eventually from the unproductive usage of capital; be it for war, lack of innovation or poor spending. Developments in the financial system over the last 300 years has meant once great economies can go a little bit longer by using other peoples money via borrowing. Modern economies therefore often die from being bloated in debt, taking on more than their economy can handle. Once the cost of debt is consistentñly greater than the GDP growth of an economy, it is the beginning of the end. In a market based system, destruction would be swift and fatel.