In his February 2010 Investment Outlook, Bill Gross examines historical examples of deleveraging and reregulating conditions through the works of others. He first calls on Carmen Reinhart and Kenneth Rogoff’s recent publication, This Time is Different. The book studies eight centuries of financial crises and discusses how public debt expands after a financial crisis. Gross highlights the authors’ main conclusions, which finishes with “Once a country’s public debt exceeds 90% of GDP, its economic growth rate slows by 1%.”
Gross continues to echo the authors’ conclusions with the confirmation “that bank crises are followed by a deleveraging of the private sector accompanied by a substitution and escalation of government debt, which in turn slows economic growth and lowers returns on investment and financial assets.” Simply put, more government debt hinders economic growth. Armed with this knowledge, Gross provides a visual display of countries that are prone to government debt hurting its own economic growth. The Ring of Fire plots countries current annual deficits (% of GDP) against the countries outstanding debt (% of GDP). The red zone countries are in the most danger of debt hindering economic growth. The green and yellow areas are considered more conservative and solvent, with potential for higher growth.
Consider this like the balance of a credit card on the X-axis and the amount that the statement balance will subsequently change on the Y-axis. Reasonably thinking, when a consumer needs to continually borrow more money (going negative on Y-axis), and the statement balance on the credit card balloons (moving right along the Y-axis), problems get magnified. Now, think of this in terms of entire countries. Government debts are expanding this year (Y-axis) and already owe a monstrous balance (X-axis).
Given Gross’ analysis, I tracked the prices of the countries’ representative exchange traded funds (ETFs) for one month. Twelve such securities exist: Australia (green); Canada, Sweden, Germany, and Netherlands (yellow); and Italy, Japan, Spain, France, UK, Ireland, and US (red). By using commonly found data, the valuations of the countries ETFs provide additional insight—given the debt, here is the market’s perception of the countries’ equities (at the beginning of February).
Contrasting the green/yellow countries (stronger economic growth) against the red countries (economic danger), the green/yellow group trades at a premium to the red group (as measured by fwd P/E and other metrics). This makes sense since investors should be willing to pay more for a better performer. After one month elapsed, the data at the beginning of March was as follows.
Taking the sets of data in the context of two time periods provides some shocking observations.
- The premium on the green/yellow group still exists over the red group, but it has shrunk (from 5.4% to 3.0%). Normally, the conclusion can be drawn that investors disagree with Gross or are seeking more risk. However, a closer look at the data leads into the next observation.
- Not only has the absolute price of all twelve increased in one month’s time, the implied earnings has increased for eleven of the twelve countries (the twelfth being Japan, which was unchanged). What was even more stunning was that expected earnings increased faster than the price on a relative basis. This means that even though the ETF prices increased on an absolute level, they are actually cheaper. (Value = Perceived Benefit/Price; in this situation Price is rising, but Perceived Benefit is rising faster, hence a better value to the investor).
- The implied earnings of the green/yellow (2.9%) group increased faster than the implied earnings of the red group (1.2%). From this, we know that Gross’ debt theory and the earnings expectations are in parallel thought, for now.
From these observations, there are many possible conclusions. First, it appears that the market is generally pricing a premium on countries’ equities based on countries’ debts. The same is true with earnings expectations in that they too compare with countries’ debts. Another conclusion may be that earnings expectations are either too bullish in March or were too low in February. It is also a possibility that Gross is wrong, and the data is just noise. However, I’ll lean on a second study that Gross cites in his Investment Outlook.
Gross’ second study, conducted by McKinsey Group, used a historical approach to analyze current leverage in the total economy. It found numerous examples of sustained deleveraging in the aftermath of a financial crisis and concluded that deleveraging generally begins two years after the beginning of a crisis (2008). Moreover, in 50% of the cases, “deleveraging results in a prolonged period of belt-tightening exerting a significant drag on GDP growth. In the remainder, deleveraging results in a base case of outright corporate and sovereign defaults or accelerating inflation, all of which are anathema to an investor.”
Seeing the severity of potential economic impact, the long term trade would be to buy the debt (and currency) of the green/yellow countries (along with buying inflation protection, such as gold) and sell the debt (and currency) of the red countries. Combining the McKinsey study with the pricing analysis above leads to another long term trade—since the pricing premium of the two groups of countries is small, and there is significant downside with the indebted economies, buy the equity of the green/yellow countries and sell the equity of the red countries.
(For supplemental insight on debt sustainability, here is an article in last month’s Economist).