Wednesday, 17 August 2011

Global financial turmoil part I: running out of safe places to invest

By Stephen Spratt

Financial markets are characterised by fear and greed, and fear is in the ascendency. As each unprecedented disaster is followed by a worse one, financial pundits are running short of hyperbole, and investors are running out of safe places to put their money.

When markets are spooked investors pile into gold-plated assets like government bonds, particularly US Treasuries. Despite the fact that earlier this month ratings agency Standard & Poor’s downgraded US debt from the gold-standard Triple-A, money has continued to flow into the US. Far from rising to reflect higher risk, interest rates on US debt have fallen since the downgrade, in stark contrast to the experience of ‘peripheral’ Eurozone countries.

This is all relative of course. No-one really thinks the US is a particularly safe investment any more, they just think it’s less unsafe than the alternatives. But while cracks are starting to appear in the edifice of US financial invulnerability, they are nothing to the chasms that have opened up in the Eurozone. Bond markets have looked at the levels of debt in Greece, Ireland and Portugal and concluded they cannot be repaid. The EU has repeatedly kicked the can down the road, organising one bailout after another, bringing in the International Monetary Fund (IMF) to co-finance and co-enforce spending cuts as the price of support, but not addressing this basic reality. The result: yields on peripheral countries debt increased and the crisis spread to Spain, Italy and, most recently, possibly even France. Nothing emerged from the recent Franco-German summit to suggest a serious change of approach, with the muted market response reflecting very low expectations of action rather than any sense of approval.

Traditional safe-havens currencies such as the Swiss franc and Japanese yen are so high that authorities are intervening to reduce them so as to avoid choking off exports. The oldest safe-haven of them all, gold, is trading at around $1,800 an ounce, more than double what it was a decade ago. There are not enough safe places left, and even the havens that remain are not considered safe enough. As the Financial Times reported on Saturday 13 August, $50 billion was pulled out of equity and bonds funds last week and placed in cash, the ultimate safe asset. This is akin to stuffing money under the mattress, and represents a greater ‘flight to safety’ than that which followed the collapse of Lehman Brothers in 2008. At the end of one of the most volatile weeks in market history, the Financial Times quoted David Shairp of JP Morgan: “The degree of the moves shows the markets are pricing in something really apocalyptic.

For those who have studied financial crises in developing countries, financial panics amid doomsday scenarios seem rather familiar. Tomorrow, I’ll be outlining what lessons we can learn from the experience of developing countries.


Dirk Willenbockel said...

Stephen, I always enjoy your blog posts, both in terms of style and substance - but this time I got lost when you labeled cash as the "ultimate safe asset". When government debt has risen to unsustainable levels, the standard response short of formal default is taking resort to the "inflation tax". In the case of the Eurozone,the ECB would have to buy up the debt of the PIGs by printing fresh Euros -some prefer to call this "quantitative easing". Not possible under the EMU rules of the game? Well, it's already under discussion - and if Eurozone members had obeyed the rules of the game, they wouldn't be in this mess to begin with

Stephen Spratt said...

Dirk, over the longer term you are right - both in Europe and the US, the lure of inflating away debt is strong and will get stronger. But markets do not deal in the longer term. Most investors are not really worried about a couple of percentage points being added to inflation on an annual basis, but of losing 10% of their holdings in a week. On this basis cash is perceived as the safest asset, since over the short term it is. Now a very interesting exception is China, which is very concerned about the debasement of its vast dollar assets over the longer term. If the 'inflators' win out, and China no longer sees its dollars (and Euros?) as safe assets, which haven will it move to?

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