Wednesday, 19 December 2012

The Zombies Are Coming! - Part 6

Zombies & Vigilantes
The situation in the international debt markets is a macro version of the situation within each national economy. That is it displays a high degree of bifurcation. On the one hand, we have economies like China and other BRIC nations with large and growing foreign currency reserves, as their economies have boomed over the last 10-20 years, sucking in large amounts of Dollars and Euros in return for their exports. By contrast, economies like the US and UK, over the same period have built up huge foreign debts, which have been financed by borrowing on international markets often from the surplus countries mentioned above. Similarly, within Europe, Northern European economies like Germany have run large trade surplus, building up their own reserves, whilst Southern European countries, like Greece, have run large deficits, financed by borrowing from Northern European banks.

This is pretty much the same as the situation whereby large corporations have over this period built up huge cash surpluses on their balance sheets, whereas small companies have built up large debts. Countries like Greece, could continue to borrow and spend, so long as the global economic boom after 1999 raised all boats, and as long as the lending at low interest rates could continue. When the Financial Meltdown of 2008 put an end to that cheap borrowing, and when the recession that followed it, brought about a sharp reduction in income at the same time, the real zombie nature of economies like that in Greece, Spain, and Italy – and similarly, but to a lesser extent that of the US and UK - was exposed. The case of Ireland and Portugal is somewhat different. Ireland has and had an economy that in many ways fundamentally was sound. Over the last 20 years or so, it has built up a large modern sector of the economy, focussed on high-tech, high value industries. That led to many Irish émigrés returning home. This was part of the problem.

As they returned they needed houses to live in. Sharply rising housing demand, together with cheap credit led to sharply rising prices, which led to further speculation. In short, Ireland caught the British disease of property speculation, which means the same boom and bust that goes with it. It was the bubble in Irish property prices, followed by the inevitable bust that led to the collapse of Irish Banks, which in turn led to the demand that the Irish State step in to save them. That demand did not just come from Irish Money Capital. UK Banks were tied closely to Irish Banks, and the Irish Banks had borrowed heavily from European Banks. Had the Irish Banks collapsed, it would have taken the British Banks, and many European Banks down with them. But, given the small size of the Irish State, and the large size of the Irish Banks debts, it was inevitable that if the State came in to save the Banks, it would do so, only by undermining the financial stability of the State itself.

That is what happened, and which led to the need for the Irish bail-out. In Portugal, there was not the same kind of property bubble that occurred in Spain. Nor indeed did Portugal run up large debts. The problem for Portugal has been that it is a very small economy, that has not had the advantages of a relatively large modernised sector, generating sizeable amounts of earnings. It has been like a small company, simply unable to grow fast enough to cover its relatively low level of debt. In the Eurozone that should not be a problem. The whole point about having a single market, and of having a single currency is that these problems that affect small economies should be resolved with the assistance of the larger body. But, that has not happened. Even where assistance has been provided it has been in the form of loans, rather than what is actually needed, which is investment in new high value productive potential. This is the choice which faces the EU. Either create a real single market, create fiscal as well as monetary union, in other words create a United States of Europe, to regulate the economy and drive investment, or else see the whole thing disintegrate.

Big European, and multinational capital will not wish to see the latter. Capital has continually accumulated in larger and larger clumps for a reason. It means the same kind of economies of scale that operate at the level of the firm and industry operate at the level of the region. Large single markets with single currencies provide Capital with huge savings in transactional costs, as well as in standardisation of products, regulations and so on. For European Capital, it also means that its specific interests can be argued for in international forums as against those of North American and Asian Capital, on an equal footing. That is why, after all the huffing and puffing, there is no way that Big British Capital, and international capital invested in Britain, is going to sit by and allow Nigel Farage, and a few Little Englanders to take the UK out of the EU.

Mervyn King has been printing billions of
pounds of new money, and using it to buy
UK Government Debt, which is why Bond
Yields have been low.  Its also why inflation has
continued to be high, and why the pound
 has been weakened.
It is these kinds of issues that drive international debt markets. It is why northern European economies have been able to issue debt with low interest rates (Coupons) – in fact Germany has issued debt with a negative coupon, meaning lenders paid Germany to buy its Bonds! - whereas the Yields (Coupon as a percentage of current market price of the Bond) for Greek Bonds rose to over 30%! The US and UK, rather like Japan, which also has massive debts, have enjoyed high prices for their Bonds, not because, as George Osborne ridiculously claims, international capital markets are confident in him and his austerity measures, but because Britain, like the US and Japan, has huge amounts of wealth standing behind it, and is also able to print as much money as it likes to be able to pay off its creditors! Indeed, the Bank of England has been doing just that.

The Bank of England, like the Federal Reserve and the Bank of Japan, has been printing money, and using it to buy up huge amounts of those Government Bonds. The Bank of England has bought about a third of all the UK Government Bonds issued in the last couple of years. Its now buying 50% of all UK Gilts issued. As a bonus for the Government, even the interest the Bank would have received on those Bonds, amounting to around £35 billion, was handed back to the Chancellor! So, these countries have benefited not just from that, but also from the fact that in very uncertain times, money that would have been productively invested, has instead been hoarded. It has gone into cash deposits even with very low interest rates, it has gone into safe Government and Corporate Bonds, it has gone into Blue Chip Company shares, and it has gone into Gold and similar sorts of assets. In Germany, which has a large rented sector of its property market, and has never in recent times had large rises in house prices, it has even gone into blowing up a small property bubble.

But, for the reasons, set out in Part 4 in the US and Ireland, property can no longer act as a haven for such cash. In Britain, and to a lesser extent in Spain, the large cash hoards in some hands have stopped the property bubble completely collapsing, but they cannot reflate it. For the property bubble to be reflated masses of ordinary people have to have access to cheap credit, and have to be able, under current conditions, to be able to convince the lenders that they will repay it. Those conditions certainly, do not exist in the US and Ireland. Nor do they exist in the UK and Spain. Spain is in Depression, and the UK economy is heading for a triple dip recession, whereby its real zombie nature will be exposed. Millions of people are in tenuous employment, the collapse of Comet being only the latest example. Around 2 million are employed in zombie companies, with millions more in part-time work, casual employment, zero hours contracts, as well as all the millions in jobs that pay such low wages that the workers depend on their income being topped up with Housing Benefit, Tax Credit, Child Benefit and so on.

Even then, millions of people only manage to make their income last until the third week of the month. That has fuelled the massive growth of the usurers, the pay day loan companies charging 4000% p.a. interest. That is the same at a micro level as the charging of huge rates of interest to Greece at an international level. But, its clear that this situation is itself sowing the seeds of its own destruction. Take the situation at a micro level first.

Millions of people, mostly of the older generation, have built up savings of one form or another. Investing in the Stock Market has become dangerous, so money invested in pensions or Equity ISA's and so on, has moved towards Bond Funds. But, now there is very little income to be earned from the kind of safe Bonds, these funds are able to invest in. At the same time, there is little possibility of compensating for the lack of income through Capital Growth, because the price of these bonds is now at 300 year highs. If prices rise at all, from here, it will be only by small percentages. At the same time, anyone who has put their savings into a savings account recently knows that even if you shop around for bonuses, the best you can get is around 3%.

At the same time, people with large amounts of debt are paying 4000% p.a. interest. Whenever such situations arise, markets always bridge the gap, by what is called arbitrage.   In economies where attempts to abolish the market have been introduced, or where markets highly regulated, it takes the form of the Black Market.  That is what is beginning to happen now. The Internet has made it possible. Rather like Internet Dating, or music file sharing, its possible to bring together lenders and borrowers at a peer to peer level. That means people with cash who would otherwise have received little interest from the bank, can make it available to people heavily in debt who are paying 4000%. Obviously, as always happens in such cases, the intermediary who brings the two together takes the largest slice of the difference, and usually absolves themselves of the risks attendant on the borrower not repaying the loan.

But, its obvious that all this does is to continue the process of pretend and extend described in relation to the banks earlier. Its also obvious, with the experience of the sub-prime crisis, how this will end. Once a piece of rubber has been stretched beyond a certain point it snaps. So too with all this debt. At some point – and at these kinds of rates, a point in the not too distant future – the debtors will simply be unable to repay.

But, the same is true at a macro level with the Bond Markets. In reality, Greece defaulted on its debt long ago. It has simply been written off by its creditors, along with the ECB, EU and IMF paying off some of those creditors. We have yet to see whether that will be repeated in Spain, Portugal and Italy. But, whilst the threat of default hangs over these debtor nations, a question also hangs over the Bonds of the US and UK, and possibly Japan. It is hard not to describe the situation in regard to the Bonds of these economies as bubbles. The low yields are not based on economic performance, but merely on money printing, together with the consequences of financial repression.

The only question is when that bubble will burst, and what sparks it. The irony of the current situation is that the spark could come from one of two opposite causes. Firstly, it could arise from some new scare. If the US goes off the Fiscal Cliff, sending the US economy into a sharp decline, if Greece defaults, or some other unforeseen European panic sets in, then Yields on Spanish and Italian Bonds could soar again, whilst the already inflated price of German, UK, US Bonds etc. could cause investors to pause before investing in them. On the contrary, if there were some kind of general dislocation, as happened in 2008, it could simply result in widespread panic selling of everything from shares to gold. Concern that deflation might set in would cause a rush for cash, which would appreciate in value as prices fell. Concern that inflation might set in a would cause a rush for gold.  I suspect that as Gold has failed to rise above its 2011 highs despite all the money printing since, means it has probably peaked.  That would correspond with its peak in the previous Long Wave Boom.  Gold peaked against other commodity prices in 1960 i.e. 11 years after the start of the boom, just as 2011, was approximately 11 years after start of current boom..  Its 1980 peak, was a peak only in money terms.  It was a consequence of inflation, and the collapse of the international monetary system.  All the money printing is now failing to get into circulation, so without that changing, I don't see Gold rising from here.

But, Bonds could collapse for the opposite reason. If the US resolves the Fiscal Cliff issue, then billions of dollars are sitting on the sidelines waiting to be invested. In a recent CNBC interview, CEO of GE, Jeff Immelt, said that in addition to trillions of dollars sitting in bank accounts, mutual funds, etc. waiting to be invested, companies like his also have trillions of dollars waiting to be invested in new production, once the uncertainty is removed. I'm not so convinced that resolving the fiscal cliff will have such a massive effect, because it only removes a recent concern rather than dealing with the fundamental issues. The concerns surrounding the EU, are probably greater than those about the fiscal cliff, and those concerns are still to be dealt with. The EU remains the biggest market in the world, and if it goes into a major crisis it will have a global effect.

Ed Yardeni coined the term Bond Vigilantes
to refer to those large Bond Funds that intervened
to sell Bonds, when Governments and
Central Banks were adopting policies that risked
But, if the US resolves its immediate issues, and if the EU avoids a major crisis, then as the cyclical upturn begins next year, assisted by stronger growth in China, then the global economy will start to grow faster again. Some of the constraints in Europe will be relaxed, and money will begin to be invested again, both in productive activity, and in equity markets. But, that very fact means that the Financial Repression that has under pinned record low Bond Rates will be removed. The Bond Bubble will burst. But, for those very facts, it is likely to burst before that anyway.

If you have billions of dollars invested in Bonds that are at record high levels, then knowing that the most likely direction for their price is down, why would you hold on to them, and risk losing 10,20 or more percent of their worth overnight, when that bubble bursts? The most sensible thing would be to start moving your money out now. In fact, some large Bond investors are already doing just that.  Given that Bond Yields are in bubble territory, and the reasons they are at those low levels, and given the danger of inflation, it is surprising, in fact, that we have not already seen the arrival of the Bond Vigilantes, who in previous times, intervened to sell Bonds, and drive their prices lower.

Back in November, Caisse de dépôt et placement du Québec, which is Canada's second largest pension fund, announced that it was moving out of Bonds. The Company's Chief Executive, Michael Sabia, told the FT that “the party is over” for bonds. The company manages around £100 billion, about a third of which is invested in bonds currently. On CNBC yesterday, David Tepper, also said that Bonds look rich. Tepper has a good record on calling turns in the market, as other contributors agreed.

If Bond prices collapse, at a time when the UK is also likely to be losing its Triple A Credit Rating then the result will be that UK interest rates will rise sharply. That means that the only thing that has been holding up all of the Zombie Companies, and the Zombie Property Market will have gone. That will expose the true nature of Britain's Zombie Economy, an economy that has been built on rotten foundations.

When the Roman Empire went into decline it was reflected in a decline of Roman Civilisation, in its culture etc. The concerns and needs of the people were diverted through the provision of bread and circuses, just as today they are diverted by the cult of celebrity and pulp TV. The society became decadent and corrupt. Today, the same kind of corruption is rampant as witnessed by the MP's Expenses Scandal, by Phone Hacking, by the LIBOR Scandal and so on. Day-time TV is full of the representations of such a decayed and rotten society. Every other advert is for Ambulance chasing solicitors, or for Usurous Pay Day Loan Sharks, which have replaced the Cash For Gold Merchants. As even the sharks realise that buying houses, from desperate people, prepared to accept big discounts, for immediate cash, is risky, under current conditions, the “We Buy Any House” adverts have been replaced with those offering to buy your car, your mobile phone, your CD collection, and so on.

These are the manifestations of a society that is rotten, and an economy that has been hollowed out.

Back To Part 5

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