David R. Kotok co-founded Cumberland Advisors in 1973 and has been its Chief Investment Officer since inception. He holds a B.S. in Economics from The Wharton School of the University of Pennsylvania, an M.S. in Organizational Dynamics from The School of Arts and Sciences at the University of Pennsylvania, and a Masters in Philosophy from the University of Pennsylvania. Mr. Kotok’s articles and financial market commentary have appeared in The New York Times, The Wall Street Journal, Barron’s, and other publications. He is a frequent contributor to CNBC programs. Mr. Kotok is also a member of the National Business Economics Issues Council (NBEIC), the National Association for Business Economics (NABE), the Philadelphia Council for Business Economics (PCBE), and the Philadelphia Financial Economists Group (PFEG).
December 23, 2009
Abstract: Sovereign debt is likely to be the big headline issue for 2010. This commentary will look at some debt-related issues of Greece and California in their two respective currency zones and then discuss our view of sovereign debt markets for 2010, particularly with respect to the US dollar and euro currency zones. Some strategy guidance for portfolio management of debt will wrap things up.
“Whatever it is, I fear the Greeks even when they bring gifts.” This is one of the English translations of Virgil’s Aeneid. It refers to the Trojan horse that Greece used to deceive Troy and gain entry into the city.
“During the Depression about half the population of Oklahoma moved to California and the intelligence level in both states went up.” Will Rogers, the great American commentator from Oklahoma, hatched this quip decades ago in his analysis of California’s governmental policies and its finances.
If we were writing a play on the theme of sovereign debt, we might use the following characterization. The US and the EU are the setting: two currency zones. The Fed and the ECB are the dominant members of the cast: two central banks responsible for the two currencies. Greece and California are in leading roles: two states within the two currency zones.
In the United States, California constitutes about 13% of America’s GDP. If CA were a standalone economy, it would be about the seventh largest in the world. The currency in use in California is the US dollar. The CA government determines its own budget, has its own constitution, operates an internal legal system, and decides its own state tax structure. It is also one of the 50 sovereign members of the USA and has legally bound itself to the rules promulgated in Washington, while attempting to preserve some state rights within our highly federalized legal system. CA and most other states have a requirement to balance an annual budget. There are provisions for emergencies in many of these states, and in the coming year we expect the concept of a financial emergency to be deployed and tested in various state courts. CA recently issued “script” during a short-lived budget crisis when it ran out of cash and until its legislature passed a revised budget. That was not the first time script has been used. We do not expect it will be the last.
In the euro zone, Greece is about 3% of the GDP. It is a sovereign state (country), one of the 16 members of the euro monetary system, and one of the 27 members of the European Union. GR maintains its own budget, although it has pledged to adhere to EU budget rules, which it is currently violating along with most other members of the EU. Under present agreements, penalties will occur if GR is not making a sufficient effort to improve its fiscal situation within a year. We do not expect those penalties to be imposed on GR nor on the other EU states in difficulty. Greece has its own tax structure, constitution, and internal legal system. GR is also covered by the newly developed EU Lisbon Treaty and, like other EU member states, is gradually moving into a Europe-wide economic structure.
California and Greece are both lowly rated by the agencies that appraise the creditworthiness of sovereign debt. CA and GR are also on the top of the list of possible default candidates in their respective currency zones. That list is prepared by CMA DataVision, a service that scrutinizes credit default swap pricing in order to determine market-based assessments of default probability over the next five years. CA and GR are both poorly rated, and their scores (default probabilities) are about the same
CA is a problem for the Federal Reserve because the state is a very large part of the US economy and because it is suffering from the financial crisis and the collapse of the housing bubble. If CA defaults, it will lose access to credit markets and contract a governmental economy that is 1/7 of the US. That would be a huge blow to the nascent American economic recovery. The Federal Reserve doesn’t directly place its funds in California’s debt; the Fed does function as the central banker for nearly all of the financial entities that underwrite and distribute CA debt. Commercial bank direct holdings of CA’s $76 billion debt are relatively small, due to the construction of the US tax code, which discourages banks from holding tax-free municipal bonds.
GR is a problem for the European Central Bank. The ECB doesn’t own Greek sovereign debt, but it does extend credit to Greece’s national banks in the euro zone, and they hold Greek debt. Furthermore, the ECB must consider the non-Greek euro zone banks, since they too hold Greek sovereign debt. There are rules in place that will disqualify the Greek sovereign debt from use as acceptable collateral in ECB lending operations to banks. These rules apply because of the credit rating downgrades of Greece and will take effect within a year if they are not suspended or deferred. This should motivate the Greek bank lobby to spur the government of Greece to action.
Moody’s (December 22, 2009) describes the Greece situation like this: “Government action has been swift. We believe they know what they need to do and are under a great deal of external pressure to deliver. Trend growth is likely to be slower than in recent years, which means that growth will not make a significant contribution to addressing the problem. The government is likely to meet its fiscal targets in 2010. What happens in 2011 and beyond is uncertain.”
PMI reports that in California about one out of 20 (5%) of all prime mortgages are in foreclosure. Worse is that one out of five subprime mortgages are in foreclosure. CA house prices fell 8% in the year ending September 30. Payroll employment dropped 4.6% in the year ending October.
The continuing saga of California’s budget crisis is well-known, so we won’t recount details here. In a recent report (November 23, 2009) Moody’s said: “Last Wednesday, the California Legislative Analyst’s Office (LAO) released a report stating that California’s current-year budget gap is approximately $6 billion and that the gap for next year is $14.4 billion. Gaps of this magnitude were expected, however, and were built into our current rating for the State of California (currently rated Baa1, with a stable outlook). This new report, therefore, does not affect California’s long-term or short-term rating. Although the size of the budgetary gap is important in determining the state’s rating, actions taken by the state to resolve the gap are even more critical because it is within the state’s power to address these large imbalances. If the gaps were to grow significantly from what has been announced by the LAO, however, or if the state cannot execute a plan to address these gaps in a timely fashion, this difficult situation could signal credit deterioration beyond our expectations. Downward pressure on the state’s ratings could result.”
To sum this up: these are two central banks, the Fed and the ECB, with two currencies, the euro and the dollar, operating within two federations of sovereign states, the USA and the EU. The EU is new and only recently became the world’s largest economy, if you add up the entire 27 member states’ GDP. The 27 states are divided into three groups: those in the euro zone, those that want to be in and are trying to get in; and those that have elected not to go in or cannot qualify to get in. The US has a seasoned 50-state membership and is over 200 years old. It started as a loose and weak federation of strong sovereign states and has gradually and solidly tested a constitutional structure of strong central government, which now dominates its states.
About 75% of the combined debt of the entire world is pegged to one of these two currencies. The benchmark interest rate on the euro is the 10-year German government bond; it is paying about 3.25% interest. The benchmark debt of the US dollar is the 10-year US Treasury note; it is paying about 3.75% interest. Both the EU and the Fed are central banks whose jurisdictional boundaries have involved them in episodes of hyperinflation and depression. Both civil and international wars are parts of that history.
Both banks have the same problem. What do they do with policy when they have weakening credit among their sovereign member states? Greece is not the only problem for the ECB. It has to also keep an eye on other weak member states, like Ireland, Portugal, Italy, and Spain. California is not the only problem for the Fed. It has to deal with issues that are surfacing in places like Michigan, New Jersey, and Florida. Both central banks face huge issuance of more sovereign debt, as the budgets within their jurisdictions are in large deficit.
Can any of these states in either system default? Of course they can. California actually flirted with it when it issued script for a brief period. Will the action of a state cause the federal currency to collapse? That is the key question plaguing the markets. We think the answer is no, but acknowledge that this is an untested question. Can the currency’s relative value be maintained by the monetary authority when a state within the currency zone defaults? We think the answer is yes, but with a qualifier.
At Cumberland, we do not expect to see a mass of sovereign defaults. The issues involved are political, and the political price of default is more severe than that of toughening up budget standards. In the end, politics will raise taxes and restrict spending to avert defaults. And actual default comes about when economic pressures cause it and when they leave the political body without a choice. In our view defaults are rarely politically expedient, because default threatens a change in the political regime. Therefore, we expect both Greece and California will pay their debts.
Furthermore, we do not expect the sovereign debt of any of these mature economies to default. The 27 EU member countries and the 50 US states are not anywhere near the same types of cases as Argentina or Venezuela. Those possible defaults are driven by economics and are a result of desperate politicians who have run out of room. Argentina and Venezuela are isolated, not in a currency zone and are victims of terrible politically driven policies. It is in no neighbor’s interest to help them financially.
History shows that most governments do not pay off their debts. They refinance them indefinitely, and their governing central bank applies its directives and mandates and accommodates its sovereign states within that context. It is in the difference between the Fed and the ECB that we may find the outcomes for 2010 and beyond. The ECB is a governmental entity structured under a treaty that clearly established its independence and directs it to maintain inflation under and close to 2%. The Fed is a creature of Congress and is under the most intense political pressure we have seen in the US in a very long time. The Lisbon Treaty did not affect the independence of the ECB. All of the various proposed legislation in the US Senate or the House removes or diminishes some aspect of Fed independence. None enhances it.
Since governments do not pay off their debt and, instead, use their political mechanisms to refinance it, that is what we should expect to see in 2010 and beyond as this large post-crisis infusion of sovereign debt is issued. Here is where the central banks come in and assist with the issuance. And here is where the market may be misjudging the impact.
Debt service is the key issue, not the debt aggregate. And since the principal is not paid off, it is the interest burden alone that constitutes the debt service item. So the market-related issue is, how much of the annual budget will be consumed in paying the interest, since that is where the debt-service cost will be applied. Furthermore, this burden is placed in the cash market only and not as an accrual. Markets seem to ignore accrued liabilities until they become real payments.
Another aspect of this construction about sovereign debt is that it is deflationary. Rising debt burdens consume greater and greater portions of income. They restrain spending. That is why the assumption that the increasing debt will bring on a large inflation is not necessarily correct. Japan is testimony to this outcome.
In order to get the inflation that can accompany large sovereign debt issuance, the central bank has to monetize the debt at very fast and accelerating rates for a prolonged time. In Japan, that policy shift is now a subject of debate, since they are weary of fifteen years of deflation. In Europe the ECB has a clear mandate to avoid an inflationary outcome. Only in the US is this a question, and the Federal Reserve continues to say it will provide liquidity for as long as is needed but will withdraw it slowly and after the economy achieves a more sustainable growth path. The Fed is counting on a new policy-management tool for this purpose. The Fed’s own quarterly FOMC long range forecasts confirm its commitment to avoid a rising inflation rate over the next several years.
The pressures on the Fed will intensify as the sovereign debt loads in the US rise, and especially as the difficulties of finance expand in many of the sovereign 50 states. Rising interest rates hurt the economic recovery, and particularly in the troubled states. Higher mortgage rates slow the incipient housing recovery, and they raise the debt burden of refinance. Help from the US federal government will certainly be forthcoming for the states, as it already has been, but the federal deficit is quite large and not likely to shrink. Remember that federal aid to a state is merely the substitution of one type of sovereign debt for another.
In sum, we expect government bond issuance and higher debt burdens to slow the recovery and to dampen inflation tendencies. That means the Federal Reserve is likely to have the room to continue its “extended period” construction for most of 2010. Hence, we believe the short-term interest rate in the US will remain quite low. The same is true in most of the rest of the world and certainly in the euro zone, the UK, and Japan. 90% of the world’s debt is linked to one of these four currencies: the US dollar, the euro, the British pound, or the Japanese yen. For 2010, the average short-term rate of the four is projected to be between zero and 1%.
Bond portfolios are best deployed in spread products and not in the debt of these sovereigns. Forward rate analysis helps in determining where on the yield curve to position. And individual credit work is needed to ascertain and select the single issues that are desired. Sovereign debt issues will drive markets in 2010. We think they will dominate the headlines all year. It is a fascinating time to manage bonds.
We wish all our readers the very best for the New Year.
David R. Kotok, Chairman and Chief Investment Officer, email: firstname.lastname@example.org
Copyright 2009, Cumberland Advisors. All rights reserved.