The big accomplishment of 2011 was that many people − particularly in finance − realized that the global financial crisis wasn’t over and wasn’t about to be, either. Apparently things will only get worse, since this is a debt crisis. By nature, debt crises form over time and take years to resolve, generally causing acute pain and losses along the way.
This means that for the foreseeable future − certainly in 2012, and probably in the following years, too − the goal of every investor should be surviving the crisis with minimum losses.
The usual aspiration for high returns, or positive returns at all, has been shelved. The main emphasis needs to be on preserving your money’s real value. Anything else is gravy.
The biggest drama in 2011, as things went from worse to dreadful, was the escalating debt crisis in Europe, brought on by the high debt-to-GDP ratios of the euro zone countries. But other factors included the failure of economic stimulus plans in the United States, and China’s switch to a restrictive policy that slowed growth there. These factors sharpened the understanding that things were rough − for the global economy, for companies and for investors too.
For 2012, investment strategy − for individuals or financial institutions − needs to be based on expectations of where the global debt crisis is heading, and how this will affect Israel.
There are three main scenarios. Two are very bad. The third is more upbeat, but it isn’t realistic.
Let’s start with the positive one. The ideal way to solve a debt crisis − meaning, a financial or economic crisis that stems from excessive debt that the borrower is struggling to pay off − is through growth. The more the company or the economy grows, the smaller the relative size of the debt burden. The higher the revenues of the company or the economy, the easier it will be to pay off the debt.
However, there are no indications whatsoever that we’re heading into a period of healthy economic growth. In the best case, we will see feeble growth that will barely cover the interest on the debt, to say nothing of the debt itself. Meanwhile, nations are constantly increasing their debt burdens by running deficits. Without getting into the specifics about every euro bloc state, let’s just say that what they have in common is that none are expecting brisk growth in 2012, and probably not in the following years, either.
Since the best-case solution seems highly unlikely, we’re left with two bad solutions to the debt crisis. One is eroding the debt burden through inflation. The second is declaring bankruptcy: simply not paying off some or all of the debt, as part of an organized or unorganized process. There are many historical precedents for both scenarios, and let’s just say that history has taught us that the repercussions aren’t pretty.
The main problem facing investors is that preparing for either scenario requires taking steps that would leave them unprepared for the other one. Thus, investors need to decide which they think is the more likely scenario and behave accordingly, while taking any new developments into account.
The inflation scenario
The inflation scenario seems logical and relatively easy for governments to carry out. To present the economic logic simply, most of the debts are nominal − meaning, not linked to inflation − so the faster inflation runs, the more the real value of the debts is eroded.
Inflation would put more money into pockets and bank accounts. Maybe not for everyone − inflation often transfers wealth from the citizens to the government − but it would save the governments from going bust. But purchasing power won’t increase, since inflation means higher prices. More critically, though, the money supply would increase relative to the debt, which would remain fixed, and it would thus be easier for the nation to pay it off.
This scenario relies on two critical assumptions − first, that someone needs to create the inflation, and that someone needs to be the government. Namely, governments and their central banks would need to embark on an expansionary fiscal or monetary policy. For instance, banks could buy up a massive quantity of government bonds, pouring huge quantities of money into the economy and creating inflation.
The second assumption is that an expansionary policy would actually create inflation. But it doesn’t necessarily have to.
Let’s say this happens, and countries start ramping up their inflation rates. This has dramatic implications for every aspect of investments, including the average household’s portfolio.
First off, any investment that is nominal and not inflation-linked will lose value, including bank deposits and many corporate and government bonds. We can also presume that central banks won’t be raising interest rates because this would ultimately lose them money: This would push down bond prices, and the banks are stuffed to the gills with their government bond investments.
On the other hand, inflation-linked assets will preserve their real value. These include real estate, stocks in most non-financial institutions, and commodities such as precious metals.
Thus, anyone who thinks inflation is the main threat needs to swap bank deposits and unlinked bonds for inflation-linked bonds (government or corporate, presuming the companies are healthy). Shares in healthy companies would also be a good investment.
Given the raging debt crisis, though, investors need to be very choosy about which companies they pick − recent history has shown that both companies and banks can fail.
The deflation scenario
The second scenario is bankruptcy and deflation, or more precisely, a deflationary collapse. This would mean wiping out at least part of the world’s massive debts so that the remainder would be of proportions the borrowers could pay off.
Clearly lenders would sustain losses under this scenario. Since the quantity of debt is massive, the losses would also be astronomical and would drive many lenders into bankruptcy.
Most of the lenders are banks and financial institutions. The result would be that many nations’ financial systems − in fact, the global financial system − would be at risk of total collapse.
If this happens, then global economic activity would sink into a recession, complete with high unemployment and mass bankruptcy.
That’s enough to show why this scenario isn’t desirable, and why it is considered even more serious than the inflation scenario and the many misfortunes it would bring. It’s also clear why governments and international economic bodies will go to great lengths to prevent this from happening.
But I believe this is the more likely scenario, and here’s why. First off, the system-wide meltdown will happen despite the best efforts of governments and institutions − but not entirely. In other words, they won’t do everything they could to prevent it. Almost no countries have an expansionary fiscal policy at the moment − meaning increasing spending and covering the ensuing debt through additional loans. There are several reasons for this, both political and psychological: First off, citizens are not willing to support increasing debt.
It isn’t happening in the United States. Even China is tightening its belt.
Second, the funding doesn’t exist, since lenders − citizens and foreigners, and financial institutions around the world − are unwilling to give any more to borrowers who aren’t aggressively working to cut their debt load. So deficits won’t be increasing, and increased government spending won’t be a factor driving inflation.
The other way of creating inflation is printing money. This means central banks creating new money out of thin air, thus increasing the money supply relative to the quantity of goods and services in the economy.
This is a recipe for inflation, and many analysts expect that this is what’s going to happen, particularly given the decisiveness with which central banks in the United States, Britain, Japan, Switzerland and even Europe are pursuing steps that amount to printing money.
But despite the aforementioned policies, the stated goal of central banks − which for some is formally defined by law − is to prevent inflation. While this mandate also includes preventing deflation, it’s inconceivable that central banks would play a role in driving inflation.
Beyond their legal and professional commitments, they’ve felt the change in public opinion. Plus, there is no case in history where a country suffered from high inflation − not to mention hyperinflation − that was not intentionally caused by that country’s authorities. Inflation is never a side effect, a coincidence or an accident.
There’s a difference between a policy of preventing deflation, as the U.S. Federal Reserve Bank and others are doing, and a (theoretical) policy of creating high inflation − something that doesn’t exist in any developed nation. The moment it becomes clear that a country is attempting to create inflation, the market will drop its bonds like hot potatoes, refuse to lend it more money and destroy it financially and economically.
In practice, that’s what happened with Greece, Portugal and Ireland, albeit for a different reason. Therefore, anyone who wants to print money won’t actually be able to do so.
Another reason an inflation scheme could not succeed is that printing money alone is not enough.
The banking system, by means of a concept known as a money multiplier, needs to turn every new dollar into several more by lending the money to the public at large. The meaning of the multiplier is that banks can lend out several times the actual capital they possess.
But since the public at large − companies and households − does not want to increase its debt load, and since banks are currently uneasy at the prospect of lending any more to entities that they suspect won’t pay them back − there is almost no chance of this cycle kicking in. It didn’t kick in over the past few years as central banks poured large sums of money into their economies; it halted at the commercial banks and didn’t drive economic activity.
Beyond financial factors preventing inflation, there are also economic factors. It’s extremely hard, if not impossible, to create inflation when many manufacturers are idling and the world has excess production capability for most products. Unemployment in most developed countries is very high. Likewise, the level of manufacturing capacity − utilization of equipment − is very low in historical terms.
Thus, from all perspectives, it seems like inflation is not a possible scenario.
What to do
In terms of developed countries’ policy, we can expect to see more of what we’ve seen so far − varied attempts to prevent a collapse, stimulate the economy and create employment, among others.
None of this will be enough given the magnitude of the problem. These steps will always be too little, too late.
Meanwhile, while they may not be pursuing expansionary policies, countries are expanding their deficits and taking out more loans to finance them, which nevertheless is increasing their debt load to new monumental heights and slowly bringing down the borrowers.
The first ones to be hurt are the financially weakest − countries and companies leveraged up to their eyeballs, or that cannot push through cutbacks. Greece is one such notable country, but far from being the only one. Given these conclusions − that the debt crisis will grow in significance and size − let’s go back to the question facing every investor: How to prepare for a deflationary collapse.
In principle, the answer is to choose financial strength and liquidity over all else, certainly over higher returns. There’s no choice but to sacrifice returns, possibly entirely, for the time being.
The goal is survival, and the prize for doing so is that once rock bottom has been reached, everything left will be up for grabs at bottom-basement prices − at which point the chances of profit will be extremely high.
But for now, there’s no thinking in terms of profit, but in terms of surviving. This isn’t some cheesy reality show. This is for real.
Bunker down. Pick government bonds issued by strong, stable nations. It’s not easy to figure out which nations these are, but the United States, Germany and possibly Britain and the Scandinavian countries appear to be leading candidates. Japan is very risky; Israel is not, at least in financial and economic terms. Therefore, you can give Israeli government bonds significant weight in your portfolio. In any case, choose relatively short-term bonds for maximum liquidity.
The question of what currency to use to anchor your investment portfolio is quite an interesting one under the deflationary scenario. Anyone who expects the euro bloc to dissolve − a nearly certain result under this scenario − needs currency protection to balance any investment in the bonds of euro zone nations. The same applies to other European currencies, since a euro breakdown will negatively affect other currencies on the continent, too.
Under the deflationary scenario, the U.S. dollar wins clear preference, since it will be in high demand − most of the world’s debt is in U.S. dollar terms , and any debt that is redeemed or erased will decrease the relative supply of dollars accordingly, thus increasing the dollar’s value. (The opposite would occur under the inflationary scenario.)
Regarding real estate, deflation means dropping prices due to pressure to sell off leveraged assets. Thus, real estate will take a bad hit, and the more leveraged the location, the harder the fall, as we saw when the real estate bubble imploded in the United States and elsewhere. Other real assets, possibly including precious metals, will lose value for the same reason.
In theory, Israel is part of this process too, even though it has relatively low leverage in most respects, which gives it some defense against deflationary forces. There is also a possible silver lining that will make Israel’s suffering relatively brief, and it’s not because of our wits or our government’s.
Past experience has shown that for Europe’s Jews, particularly during the 1930s, serious social and economic crises bring large outbreaks of anti-Semitism and therefore mass Jewish emigration. This time, due to a lack of choice if not actual desire, many are likely to come to Israel.
An immigration wave could bring a 180-degree turnabout for the economy, lifting it out of recession and the global financial quagmire. When this happens − not next year, and possibly not within the next two years − entirely new investment strategies will be called for. It’ll be time to emerge from the bunker and take part in the Israeli economy’s next stage of growth.
Pinchas Landau is an independent economic consultant. This article was originally published in TheMarker Magazine’s December issue in Hebrew.
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