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Tuesday, May 17, 2016

What will happen in Ireland if there is another global financial crisis?

Whatever you do, now is not the time to bet it all on black, by borrowing up the wazoo, by stuffing money away into 'tracker' bonds.

IF there is another global financial crisis, will Ireland be governed by an experimental, minority administration during it?
This is a valid question. Last week, I issued a note to clients that, over the next two to three years, there may be just such a crisis. It’s not a certainty, because central banks may manufacture a soft landing, a gradual repair of debt from slow-cooked growth, but stock markets have moved sideways for a year, and that looks like a portent of trouble. To the left and right of the runway lurk deflation and high inflation, which are both unpleasant.

Should you take notice? In the book Loot, in 2006, I warned about the risk of a burst in the US and advised the reduction of debt to less than 50% of asset values, a move to AAA-rated banks, and the buying of gold. What I didn’t foresee was the interconnectedness of the globalised economy and its capacity to spread contagion — that nowhere was safe.

To understand, take Ireland; we have the highest GDP growth in Europe, so why did Fine Gael’s slogan about spreading the recovery fail? Is it because consumers remain intermediaries between extra economic growth and banks? The big global question: is there too much debt, not just consumer debt, but all debt, and not enough economic growth to carry it? If so, no amount of money-printing will solve what is a structural problem. This is not a certainty.
The political classes handed over the fight to central banks, which, by crushing interest rates and printing money, are using their weapon of choice for cyclical recessions. What if the illness is not cyclical, but structural: ie, too much debt?

Take Ireland again; add our national debt to private-sector debt and non-financial corporate debt, and throw in the off-balance-sheet liabilities in public sector pensions, and the social insurance fund that pays out old-age pensions, and the economy is servicing debt five times its GDP, or close to €1tn. That multiple is little different for many developed countries, with Japan, which is grappling with its ageing workforce, the outlier and already after experiencing decades of deflation.

Underneath the developed world, two magnetic plates are pushing in different directions: deflation and inflation, and the result is disinflation. But if you take John Maynard Keynes’s definition of depression as a long period of chronic, sub-normal growth, without any tendency towards either collapse or recovery, he was foretelling the last number of years, from 1936, of the Great Depression.

Central banks are betting this is merely a long-term, low-growth, ultra- low inflation interregnum, before the next normal cycle, while the excess debt is cleansed from the body of the global economy.

Despite earnest endeavour, the old models used by economists seem incapable of grasping the complex systems that now underpin the global financial web. This is a concern, because adding more debt creates greater, not lesser, instability and magnifies the potential for contagion.
Sustained, very-low energy prices could cause the next default wave from corporate debt rollovers, but the default could just as easily pop out of China, or Brexit, or premature rising of interest rates in the US. It is not the last straw that causes the tipping point, but the combined weight of everything before.

When consumers lose faith in economic management, cash gets hoarded, creating the conditions for deflation, or the expectation of lower prices. Central banks fight with inflation by printing money, hoping that banks will lend it as credit.
But with the muted velocity at which money is circulating, with tight credit conditions and low consumer demand for credit, is it beginning to look like the stimulation of demand isn’t working?

The response will be to print more money, until inflation arrives. The big question, then: can central banks reverse quantitative easing before a spiral of wage increases to match rising prices? Inflation is a burglar, tip-toeing in unnoticed, before becoming widely recognised. If not controlled, it can end up in hyper-inflation. There is no sign of inflation, just yet, so deflation remains the short-term risk, but an outbreak of high inflation is the long-term one.
If there is another global financial crisis, the rules of the game have changed. Just ask the Cypriots. Last time, Ireland entered the crisis with debt-to-GDP at under 25%. It peaked at over 120%, and this year it’s expected to be below 90%. External assistance to a highly indebted country will only arrive after bail-ins, haircuts to deposits, levies on financial assets, and the part or full nationalisation of pension funds.

Last-minute escapes are closed off by shutting banks, typically after close of play on a Friday, and, from Monday, rationing cash while raising exchange controls.
The state will do anything to self-preserve, including fast-tracking emergency powers. A great reset would require debt write-offs through the type of global agreements that accompanied previous emergencies, but the world that would emerge would look very different, if many of its currencies are in intensive care.

Relax. None of this is certain, but be prepared. Do up a lifestyle budget for when income sharply falls. Get out of long, only-unit-linked funds, including pensions stuffed with equities that require you to ride out cycles typically called managed, consensus, or lifestyle funds. Move to defensive funds, including those that give the fund manager the mandate to sell the market short and make gains in falling conditions. Get rid of debt, but keep strong cash levels. Open an account at a ‘safe’ bank or credit union. Put money into funds outside of the jurisdiction, for example at the Luxembourg financial centre, to reduce risk from domestic levies.
Gold is a currency. It is ‘money’, and holding up to 10% of liquid assets in gold, as a hedge against both deflation and inflation, especially if there is a loss of confidence in paper currencies, makes sense. You can have allocated gold in your name in vaults in Zurich, buy certificates for non-allocated gold, from mints like Australia’s Perth Mint, or use life offices in Ireland that have gold funds.

Global, inflation-linked sovereign bonds, issued by major governments and available through specialist funds, are another asset class that make sense. These will respond to unexpected higher inflation and, although a little more volatile than conventional, fixed interest bonds, ‘linkers’ can be a safe haven from risky assets, if there’s a moderate deflationary event.
Watch for liquidity traps. Whatever you do, now is not the time to bet it all on black, by borrowing up the wazoo, by stuffing money away into ‘tracker’ bonds guaranteed by low-grade banks, or by buying illiquid trophy houses at prices that look like they might be artificially inflated by money-printing.

These risks are elevating, even if this opinion runs contrary to the consensus.

Eddie Hobbs