Despite the equity market rally started at the end of last year, investors remain wary in the aftermath of the volatile investment performance of 2011 and the continuing macro issues that have plagued the market. Investors seem to be in the back seat, while politics and policies drive market direction. Not surprisingly, this makes for an uncomfortable ride. Does it make sense for an investor to stay along for the ride?

The global economy is undergoing several paradigm shifts, and equity investments appear to have the potential for relative price performance that has been absent in the prior decade.  A simple economic principle is that prices rise when demand exceeds supply.  Select equity investments have several characteristics currently in short supply: strong balance sheet, growth in earnings, strong dividend payouts and attractive valuations.

However, the market may be kept hostage to the macro-economic environment – with the attendant market volatility in the short term. In the longer term, fundamentals and valuation have been the winning investment formula.  Even in the new world, this investment approach should provide attractive, if volatile, returns.

The age of leverage is over – the age of balance sheet rehabilitation has begun.  The consequences of this paradigm shift include:

• De-leveraging within the major developed economies.  Fiscal policy has been played out in many developed countries, limiting this growth stimulus.
• Monetary policy is also reaching its limits in many developed economies, with interest rates close to zero and money supply extremely accommodative, partly to ease the banking crisis.
• Restructuring and austerity are the necessary policy requirements, which causes the politically unpalatable decline in standards of living.
• Growth is slowing as both governments and consumers decrease spending. The slow growth makes the austerity programs more difficult.  The euro area is most likely to suffer weak growth.
• The banking system is fragile, as the defaults following excess leverage erode balance sheets just as new regulations are requiring stronger balance sheets.  In the US, the defaults have centered on the housing sector and mortgage backed securities.  In Europe, the defaults are centered on sovereign debt in the peripheral countries.  A credit crunch is already evident in Europe, as banks have been reluctant to lend.

The recovery in the US economy and stabilization of growth in many emerging economies  has helped underpin the global economy.  However, the ongoing euro area issues remain, with two extreme outcomes possible:

1. Default: The inevitability of default is the conclusion of an extensive study of the history of sovereign defaults by Reinhart and Rogoff.  In addition, the historical pattern is a cycle of high defaults in several countries after a period of many years without defaults.
2. Muddle through: The Euro zone will muddle through with assistance of various agencies, including the IMF and ECB, as well as the political will of the euro zone populations.

The uncertainty and significance associated with these outcomes means that investment outcomes are no longer normally distributed, but have a wide distribution with ‘fat tails’.

Macroeconomic Environment

Why is the potential (or ongoing) default of Greece, the world’s 32nd largest economy with a GDP of $305 billion, of such significance to the world’s financial markets? Just as a pebble can start an avalanche, if the underlying structure is unstable. In 2008, the ‘pebble’ was the bankruptcy of Lehman Brothers, which revealed the fallacy of credit worthiness of the mortgage backed securities. These securities were thought to be secure due to the long history of mortgages creditworthiness, their underlying collateral of real estate, and the added benefit of diversification. Greece could play a similar role in highlighting several  commonly accepted fallacies: 1) the Euro zone is a stable political unit;  2) sovereign debt is the risk-free asset;  and 3) the European banking system is financially sound.

The divergent fundamentals of the euro zone countries is illustrated in the government debt levels.  Greek sovereign debt is clearly excessive.  Italy and Portugal are also excessive, though not in the same league as Greece.  In contrast, Germany has relatively low debt.  On a combined basis, the debt in Europe is at a reasonable level.  In question is  the political will can persist for the wealthier northern Europeans,  especially the Germans and Dutch, to continue transfers; and the Greeks to accept the necessary austerity programs.

Source: IMF

he divergent sovereign debt fundamentals are not unique to the euro zone.  Japan leads the developed world in indebtedness levels.

Source: IMF

The conclusion of the influential Reinhart and Rogoff study is that the world is at the start of another wave of defaults.  The prospect of default is unfamiliar to investors today, but history shows that default has not just been more common, but the norm.  For example, Spain has defaulted thirteen times, while Greece, though only independent since 1829, has defaulted four times.  Defaults tend to occur in clusters during which multiple countries default.

Source: Reinhart and Rogoff, 2008

Based on their data from 44 countries over 200 years, Reinhart and Rogoff concluded that at a sovereign debt ratio to GDP of 90% and below, there’s not much correlation between government debt and economic growth.  However, above the 90% threshold, economic growth is compromised.  Unfortunately, much of the developed world is at or approaching this level of indebtedness.

Highly indebted countries can seek to restore growth by improving its international economic competitiveness through devaluation of its currency – not an option to Greece while it is part of the euro zone.  The classic solution for excessive sovereign debt is inflation and devaluation, which means the debt is paid off through a debased currency.  The expansive monetary policies evident globally would be consistent with such a strategy.  The losers in this situation are the bond holders, including banks and pensioners.

Despite the evidence suggested in the Reinhart and Rogoff study, not all over-indebted countries default.  Iceland and Ireland are examples of countries that are working out from excessive debt loads.  However, this takes enormous political will to endure several years of austerity.  The recent counter example is Argentina, which in the late 1990s sought to repay its high debt.  However, the political strains which resulted from the austerity program proved more that could be managed, and the country ended in default.

Investment Consequences

The current environment is causing a paradigm shift in the risk and return profile.  Scare commodities tend to trade at a premium, and this is likely to be the case going forward.  The new environment is characterized by the scarcity of balance sheet strength and growth. International companies that have positioned themselves for the growth areas of the world and kept strong balance sheets are currently trading at discounts, but longer term may be the safe havens investors are seeking.

However, monetary policy has been a key determinate of market direction.  The ECB has been more accommodative recently.  At some point, monetary policy will reach its limit.  In Europe’s case, this is likely to be the limit imposed by Germany, which does not benefit from inflation and currency devaluation.