The long era of debt games in Western markets is certainly looking a little faded. What I think this ultimately means is that the very concept of debt is coming under pressure, debauched by financial engineers — hedge funds, derivatives traders, algorithmic traders.
At the very least we are seeing something similar to what happened in Japan for the last two decades. The same deleveraging is now occuring in Europe and America. Most likely there will be a long period of stagnation in the latter two, much as occurred in Japan. It is certainly the same pattern of cheap money failing to ignite credit growth and economic activity. A Deutsche Bank report looks at the implications for investors of deleveraging:
The dramatic decline in bank share prices over the last three months has taken place against a background of downward revisions to global growth estimates and deterioration both in the economic reality (lower growth/higher fiscal deficits) of the European Sovereign Debt Crisis and the political consensus on how to deal with or contain it. The bank sector is unusually sensitive to the economic outlook firstly because the combination of private sector debt to GDP and government debt to GDP stands at all time highs, and secondly because the assumption that credit quality improves accounts for around 90% of estimated 2011 earnings growth and 35% of 2012 earnings growth in developed markets. Whatever the ultimate outcome of the Eurozone crisis, the bottom line to us is that the problems in the periphery economies, Italy and Spain, are potentially quite to very negative for the GDP outlook, may put further pressure on normal asset quality measures, and possibly set the scene for a “super severe” downturn in credit quality with unquantifiable spill-over effects.
Deutsche ask the question of how to make money in such an austere environment:
It is axiomatic first that it is very difficult to make money in financial stocks during a period in which the market anticipates a financial crisis; and second that such periods can be productive for long-term investors, providing there is no recapitalization requirement, as stocks tend to price in a very high cost of equity before, during and in the aftermath of a crisis, which subsequently declines. Our danger map, which we discuss below, suggests there are parts of the world where bank sectors are not particularly risky. These include Japan, the Nordic countries, Australia and Germany in developed markets and Thailand, Malaysia, Indonesia and Mexico in emerging markets. The danger map also suggests that the Eurozone countries generally are not attractive even in the absence of a crisis (see Matt Spick’s report European banks Strategy: Ex-growth and challenged: a bleak outlook for banks 24th August 2011), and we find it surprising that the deleveraging process in Europe is so slow relative to the US and UK.
We think that within developed markets there will be long-term winners in this environment. These include the names that have the combination of financial strength and strategic/geographic positioning to take market share or extend their foot print, or which simply have the capital strength to pay dividends and weather further turbulence without diluting their shareholders. In the US this category would include Wells Fargo and JP Morgan and in Europe, Barclays and BNP Paribas. In Japan we find SMFG attractive and in Australia ANZ. In spite of the slightly elevated risk scores in our danger map we believe that Brazil’s Itau Unibanco and China’s China Construction Bank will outperform the bank sector. In Emerging Europe we like PKO Bank Polski.
What I find interesting here is the “high price of equity” comment. Debt is extremely cheap, which should mean that equity is not especially expensive. That is probably where the real gains are to be made. Finding places where the risk premium on equity is too large because of the intense risk aversion of the whole market. Deutsche notes we are in unusual waters. There are some historical precedents.
We are in an environment like no other: debt levels are at all time highs, interest rates are at 200 year lows, and there is a real risk of developed country sovereign defaults for the first time since 1936. In the most severe crises we identify that have taken place against the background of asset price and debt deflation shocks we find that: government debt rises very sharply, real GDP growth over a four year period is very slow, the stock of private sector debt contracts or grows very slowly, and the ratio of credit to private sector credit to GDP declines and in some instances starts a multiyear journey to mean reversion. The major difference between these past post crisis environments and this one is that in previous post crisis periods the expansion in government debt levels started from much lower levels and that government credit was considered good.
Quite. Welcome to post modern finance, where decades of demonisation of governments by markets has resulted in the markets cannibalising themselves. Layers of debt on layers of debt on layers of debt is now imperilling the very concept of debt.