Debt crisis gathers momentum

May 2010

In our last investment update, we reported upon the highly acclaimed study on the aftermath of banking crises by Professors Kenneth Rogoff and Carmen Reinhart. They concluded that the developed economies in the Western world would experience an increasing risk of sovereign debt default as a result of rising national debt.

Events in the past few months have increasingly centred upon Greece, whose national debt is forecast to reach 150% of GDP by 2011.

Markets finally woke up to the fact that the risk of Greek default and financial contagion to other Euroland countries was no longer a remote possibility. Yields on Greek bonds exploded as investors headed for the door. Spreads on Portugese and Spanish debt also shot up with those countries on the verge of joining Greece as countries in the 'unable to borrow from the markets club'. The Eurozone came close to a breakdown. According to reports in a Spanish newspaper a 'fist beating' Nicolas Sarkozy threatened to withdraw from the Euro unless Angela Merkel agreed to back a ?500bn rescue package, with a further ?220bn coming from the IMF.

Wolfgang Munchau, writing in the FT, has repeatedly argued that Greece is effectively bankrupt and will eventually have to leave the EU. Before this happens, holders of Greek bonds will have to take a severe 'haircut', which means that they will receive back considerably less than they lent them. The biggest lenders to Greece are Germany and France.

The EU programme of credit guarantees does not solve the problem of too much debt, it only buys time. According to Robert Peston of the BBC, it covers just over a year's new borrowing by Eurozone members which is not enough "if investors were to lose confidence in the ability of some big countries to honour their debts".

According to Nouriel Roubini, Professor of Economics at New York University and chairman of RGE Limited, we have now entered the "second and more dangerous stage of the global financial crisis - who will bail out Governments that bailed out private banks and financial institutions? Our global debt mechanics are looking increasingly like a giant Ponzi scheme".

He maintains that governments lack the political will necessary to implement the necessary austerity programmes to correct their structural deficits. That leaves two options open to policy makers: "inflation for countries that can monetize their deficits; or default for countries that borrow in a foreign country or can't print their own". As debt capacity reaches a tipping point the result is a government bond crisis, higher interest rates and economic depression.

Where does this leave investors in government stocks?

Remarkably, over the past few weeks we have actually seen US and UK Treasuries rally, mainly as a result of a 'flight to quality' as investors take fear off the table. But this is probably only a short-lived rally in response to equity sell-offs. The warning calls on government bonds are becoming more vocal from an increasing number of 'high profile' people.

Nassim Taleb, New York University professor, hedge fund manager and renowned author of 'The Black Swan' was on CNBC this week forecasting a forthcoming failure in US Bond auctions with dire consequences for bond investors.

Harvard history professor Niall Ferguson, author of 'The Ascent of Money', gave an interview on Fox News on the US deficit problem - the lessons of the contagion threat in Europe today and the collapse of the Soviet Union twenty years ago show how events can "sneak up on you and strike no matter how good your intentions are". The US could collapse much sooner than people realise "maybe even this year".

The UK has never before defaulted on its debt. Furthermore, much of the UK gilt stock has longer terms to maturity, so the problem is not one of an immediate re-financing requirement. However, unless the new government is able to demonstrate that they have the resolve and determination to control government spending and reduce the budget deficit, investors will increasingly demand greater interest for a perceived higher risk.

Higher rates will affect all capital asset values including equities and government gilts. Short-dated gilts will be affected the least, so holders of direct gilts will have the certainty of their income and only a few years to wait before capital is repaid. The biggest problem will be funds that hold medium and long-term gilts.

Investors hold gilts for security and a regular steady income. But with yields likely to rise through 2010, capital values are under risk and the message that we are receiving is that it is no use being complacent, it is better to take early action. We therefore recommend switching out of conventional gilt funds, which would include proprietary insurance company fixed interest funds.

Time to buy gold

The question is where do you place the capital? Equity and commodity markets are without question heading for a major correction, the longer this is delayed the more likely it becomes.

The case for gold is compelling. Gold is highly likely to continue its steady appreciation as indebted governments eventually resort to further desperate measures to keep their economies afloat. It is very clear that our paper-based financial currency system is becoming increasingly instable. Gold is seen as a safe haven from the ongoing debasement of all paper-based currencies.

Gold is on an undoubted bull run and has recently made an all time high, nearly touching $1250/oz, so some may say we are recommending it too late. However, if adjusted for inflation since January 1980 when gold topped out at $850/oz, it is extremely undervalued - $2,500/oz would be the right value.

In 1980, as gold mania took hold with a background of rising inflation and a stock market slump, the final price rise saw gold increase from $400 to $850 between December 1979 and January 1980. The economic situation is far worse than thirty years ago; with sovereign states struggling to beat off insolvency the conditions for a 'gold mania' are in place.

We suggest that investors consider allocating some of their portfolio to gold, preferably through a physical gold Exchange Traded Fund. This is a security traded on the stock exchange. The security is backed with gold bars held by HSBC as custodians in vaults. The advantage is that it is easy to buy and sell, particularly through our own trading platform investment service or a self-invested pension plan.

Alternatively gold mining and gold related equity funds such as the Blackrock Gold and General fund offer gold exposure. These are available through many insurance bonds and personal pension plans and ISAs. Being equities, they are slightly more risky but do offer the potential for increased returns, particularly when the price of oil falls as this lowers production and shipping costs.

Finally, for those with sufficient capital, gold bars can be held directly or through a secure bullion dealer. More information on direct investment can be found on www.bullionvault.com

If you would like to discuss your investments and any of the issues that we have mentioned, please contact us immediately.

Steve Wilson BA(Hons) CertPFS, Certs CII(MP & ER)
Managing Partner
steve.wilson@2hwealthcare.co.uk

The above represent the views of the author and are not necessarily the views of all the partners of 2hwealthcare LLP. The content is for your general information and is not intended to address your particular requirements. It does not represent specific personal advice.