The global risk landscape is changing. Europe, the bugbear in many investors’ portfolios, appears finally to be on the mend. Volatility fell to record lows during the summer as the dark clouds of recession lifted over Europe. But, as autumn loomed, new clouds formed.
“The argument that these debts can simply be inflated away by keeping interest rates super low is just not correct.”
Lee Robinson
The implications for investors if Western sovereign borrowers cannot put their finances back on track in the medium term could be dire. With populations ageing and the challenge of delivering on open-ended promises on health and pensions, now is not the time to be running up debts.
Yet, in order to generate the inflation governments see as necessary to reducing debt, central banks are flooding markets with cheap money, further extending their balance sheets. Inflation could also cause more damage than good by increasing off balance sheet liabilities, thereby increasing their risk. A delicate balance has to be found or investors will pay heavily as governments are forced to default in one way or another.
“The debt problems faced by Western nations is a longer-term problem than many institutional investors perceive,” says Nick Buckmaster, chairman of the London Borough of Waltham Forest Council pension fund. “Debt is behind the L-shaped recovery and takes time to pay down.”
The problem with massive on-balance sheet debts is less to do with the mere existence of the debts than the way governments deal with them. The most likely strategy, which has been used since Roman times, is inflating them away through financial repression.
“Somewhere down the line governments will have to devalue their way out of debt,” says Saker Nusseibeh, chief executive of Hermes Fund Managers. “The traditional way to default on loans is to inflate. Investors are still comfortable as we are still in a low inflation environment, but the trouble starts when inflation picks up.”
Inflating the problem
Investors are not ready for inflation. The result of a market widely unprepared for a return of inflation was the taper event of May/June 2013, where the reaction to a slight change in perception was a massive rate sell-off resulting in mini-crises in some emerging markets and a significant jump in 10-year Treasury yields.
Paul Singer, founder and chief executive of $22.4bn hedge fund, Elliot Management says discussions with investors in his fund, who control AUM totalling “trillions of assets”, revealed none were positioned for inflation.
According to Waltham Forest’s Buckmaster: “Real yields have not steepened that much. They would have let rip if people were concerned about inflation, but markets are not worried about that yet.
Inflation is on the horizon, but it is still very expensive to go out and hedge it and we don’t see much need at present.” Inflation is an elusive target at present, but when the tide turns, central banks, who are desperately trying to generate growth in a fragile environment, will inevitably allow inflation to run rife before clamping down. “It is a reasonable assumption that central banks will allow inflation to run away a bit given the scale of monetary easing and QE that is going into staving off deflation,” Nusseibeh says. “That won’t stop until they are sure inflation has taken root. Then they will have to put the brakes on hard by raising interest rates very quickly.”
Bond holders are big losers in an inflationary environment. According to Blackrock chief investment strategist, Ewen Cameron Watt: “When yields are negative in nominal terms, the only chance investors have of getting a real return, is if there is a significant period of deflation. Governments are trying very hard to avoid that and, if they succeed, that will be very bad for bond holders.”
There are two ways investors can protect themselves from inflation: either through inflation protection, which, as Buckmaster points out, is expensive, or through real assets linked to inflation. Infrastructure has long been hailed as a good inflation hedge, but, to date, there are few projects ready to absorb the flow of institutional assets. Furthermore, real assets do not count as liability matching securities and the regulators are pushing institutions in the other direction. So, while inflation appears to solve governments’ problems, investors are caught between a rock and a hard place.
Gorilla in the room
But inflation pushes up another, much greater portion of government debt. “The welfare state is the gorilla in the room,” warns Lee Robinson, founder and chief investment officer at Altana Wealth. “That’s what destroyed Russia in the 90s and it will destroy the West. People are sleepwalking into a situation akin to Russia in 1998. At some point there will have to be a grand bargain where the rich pay higher taxes in exchange for cuts to entitlements. People are hesitant to invest in certain western countries as they see the extent of the problem.” Off-balance sheet debt linked to entitlement programmes, such as health and pensions, is a significantly greater number for most developed nations. However, the prettier the girl appears on the surface, the uglier the problem underneath. In terms of perceived creditworthiness, the US, UK, Germany and France have built some of the deepest, most liquid debt and currency markets.
“They have also promised more entitlements along the way,” Robinson points out, “so in terms of true balance sheet liabilities, those countries are in a much worse situation than the likes of Spain or Greece.” Robinson calculates US off-balance sheet debt at around $150trn including medicare, Obamacare and pension liabilities. “The argument that these debts can simply be inflated away by keeping interest rates super low is just not correct,” he says. “The figure is so big because it is implicitly linked to inflation, which is why it’s been kicked down the road for generations.” Two percent inflation might solve the obvious problem for Western governments by reducing on-balance sheet debt, but it will increase off-balance sheet debt by 2%.
The higher inflation gets, the more the liability grows. The safe-haven status enjoyed by those same Western nations has also allowed them to kick liabilities further down the road by extending the average duration on their outstanding bonds. In doing, so they have taken a very significant bet on interest rates. According to Cameron Watt: “Average duration in the US has moved from 48 months to 64 months. This is effectively a huge bet on interest rates. They will have to start rolling that debt at disadvantageous rates as interest rates rise, which could be incredibly viscous if rates pick up quickly.
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