A relative calm has descended on the markets. The Dow is down a little. Gold up a little. Bond rates holding steady.
But what lurks beneath the apparently calm surface?
Santos are laying off staff…again. Why? High debt levels (about $9 billion) and lower revenues mean it’s time to reduce overheads.
Do you think Glencore and Santos are the only commodity companies in the world dealing with this issue? No. This situation is being played out in boardrooms all over the world.
The decisions of Glencore, Santos et al are the boulder in the pond. These layoffs, shutdowns and cutbacks create a multiple ripple effect throughout the economy.
We are seeing the first signs of the debt defaults.
Which leads me to an email we received from a reader.
‘I read with great interest the predictions of doom and gloom by almost all of your so called expert commentators.
‘What I have not seen is any explanation of what the consequences of a national default would be.
‘Who is the Australian national debt owed to and what happens if we default ?? No one I know can tell me. Can you ??’
Thanks TL for the email. Please allow me to correct you when you use the label ‘so called expert commentators.’ Personally I do not consider myself an expert commentator.
My nearly 30 years’ experience in financial markets taught me, above all else, to know and appreciate my limitations. One of those limitations is that I will never fully understand everything related to the markets…The web of interconnectivity in financial markets is beyond the comprehension of all but a handful of people and I am not one of them.
This is why I only commit my capital to ‘vanilla’ investments…ones I can make a considered risk analysis on.
In relation to doom and gloom, you can only call it as you see it. If a teenage boy is given a bottle of rum and the keys to a turbo-charged Porsche, would you suggest we ignore these facts and assume he’ll arrive home safely? Or do you point out the dangers and the probable outcome of hard liquor and speeding?
Conversely, when the world experiences the severe debt crisis and I think it represents an excellent time to buy deeply discounted assets, will I be labelled a ‘Pollyanna’?
Investing is a lot like driving — there are times when you can make great progress; there are times to slow down; and there are times to pull over to the side of the road and wait. Failing to observe the road conditions and the behaviour of those around you can lead to fatal outcomes. The market warrants the same level of respect.
The views I express in Markets and Money and my advisory newsletters are a combination of the following:
- Appreciating the basics (you cannot print money to cure economic ills and you cannot borrow indefinitely without repercussions)
- Personal experiences (what works and what doesn’t)
- The thoughts behind what guides my personal investment decisions.
I fully accept that my approach to joining the economic and investment dots may not be how things pan out. We are investing in a world without precedent. Never before in the history of money has there been such a concerted effort to manipulate the value of financial markets and investor behaviour (forcing savers to abandon bank accounts in search of yield).
Anything is possible in this world…for a while at least. Ultimately imbalances are always corrected. This is a fact. It’s just unclear exactly when. In the interim I’ll wait and invest my portfolio in a very defensive position in accordance with my views.
To answer your question on who we owe our debt to and what happens if we default, you have to stand back and look at this from a global perspective.
Australia’s debt — government, corporate and household — is but one link in the global debt chain.
A debt chain that is, according the McKinsey Report released in February 2015 titled ‘Debt and (not much) Deleveraging’, now topping US$200 trillion.
The following is an extract from The Gowdie Letter published in September 2015 on the problem I see with the record level of global debt:
‘So who owns the US$200 trillion debt?
‘The simple answer is just about everyone, including taxpayers, investors, superannuation members.
‘The Australian Office of Financial Management publishes a Public Register of Government Borrowings. The table is too difficult to reproduce for this newsletter. But you can go here, then scroll down and click on: Table 1: Beneficial Ownership by Country of Residence of Australian Government Securities and State Government Securities Guaranteed by the Australian Government – Face value ($ million) [XLSX 20KB]
‘The table shows you in general terms who owns Australia’s debt.
‘Towards the bottom of the table you’ll see ‘Domestic custodian and nominee companies’ own $256 billion of the $380 billion of government debt.
‘Domestic custodian and nominee companies are entities for superannuation funds, managed funds, private wealthy individuals/families and possibly shelf companies for overseas interests.
‘The purpose of including the table is to illustrate the diversity of debt ownership here in Australia. This diversity is replicated in other countries.
‘Let’s say that the Future Fund invested $1 billion in Puerto Rican debt and had to write this amount off. In this case the ultimate beneficiaries of this fund — public servant pensions — wear the loss.
‘What we have is a situation where individuals, corporates, investment funds and governments have lent US$200 trillion to households, corporates, governments and the financial sector.
‘The question is, are all those borrowers good for the money?
‘My guess is not all of them will be able to honour their debt obligations in a world where growth is slowing or going into the negative.
‘What people forget is: crises happen at the margin.
‘The subprime lending crisis was the match that led to the GFC bushfire.
‘According to estimates, the total amount in subprime loans was US$1.3 trillion.
‘A research paper from University of North Carolina titled ‘Subprime Mortgage Crisis’ stated:
“By October 2007, approximately 16% of subprime adjustable rate mortgages (ARM) were either 90-days delinquent or the lender had begun foreclosure proceedings, roughly triple the rate of 2005.By January 2008, the delinquency rate had risen to 21% and by May 2008 it was 25%”
‘One quarter of subprime loans — US$325 billion — were in arrears in May 2008. This rather piddly amount of defaults was enough to cause tens of trillions of dollars to be wiped off share and property values around the world.
‘This is what I mean by things happening at the margin. You don’t need every dollar of the US$200 trillion debt pile to default to create economic and market chaos. All we need to see is maybe 5% default, or US$10 trillion. That’s 30 times the dollar amount of subprime defaults.
‘So who will default? I don’t know. But what I do know is not all those borrowers are investment grade, and when things get tight, they’ll buckle. And when one buckles another will buckle…and so on.
‘For every dollar that is defaulted on, a superannuation fund, pension fund, or individual lender is on the other side writing off that debt.
‘If you lent someone a $1 million and they say ‘sorry, ain’t got it’, you might have to rethink what life looks like…cut back on your expenditure. This contraction in expenditure becomes deflationary, which in turn puts a greater squeeze on those with debts. Defaults increase. Expenditures decrease. And around we go.
‘Another example of crises happening at the margin is in the share market.
‘The average daily turnover on the Australian share market is around $4.5 billion. The total value of the Australian share market is roughly $1.5 trillion.
‘As a percentage, daily turnover equates to 0.3% of the market’s value. This means 0.3% set the price for the remaining 99.7%.
‘When the market is in panic mode, turnover may double or even treble — this still means 99% of shares ARE NOT sold and just 1% can cause the market to plunge 10, 20 or even 50%.
‘The same holds true for an economy. The 1920/21 recession — the worst in recorded history — saw the US economy contract by 18%. This still meant 82% of the economy was functioning.
‘Crises happen at the margin. We do not need to see all the US$200 trillion go up in smoke, only some of it.
‘Don’t over-think who owns what and try to connect all the dots. You’ll just get in a muddle.
‘Stand back, look at the big picture and be guided by what history has demonstrated time and time again about what happens when there is too much debt in the system.’
You do not have to be an expert to appreciate that every single debt crisis in history has ended badly. Why would you bet your capital against a different outcome this time?
Especially when you consider this debt issue has crept into every single corner of the developed and developing world.
When the debt default dominoes start to fall, the impact is going to be felt all around the world…including Australia — and more specifically, our heavily indebted household sector.
Editor, Markets and Money