I thought it may be useful to try to put what is happening in the markets into some perspective and to explain our thoughts and analysis of the current situation.
To begin with let’s clarify what is at the root of the current anxiety and why is this different from what happened in 2008.
2008 and the failure of the Western banking system was simplistically the realisation that the amounts of debt and leverage within the economies and financial companies had grown way above what was sustainable or warranted.
In effect it was the ‘King’s new clothes’ moment when finally everyone engaged with the reality (which had been plain to see for some time previously) that too much had been lent, a bubble in property had been created and the price of assets were way overvalued, once the collective insanity bubble was pricked and the momentum turned from positive to negative all hell broke loose.
Why was it so bad
Because the banks created fancy new ways of selling credit which increase returns but also conversely increased losses.
The wizards who designed the products through algorithms etc factored in historic data for property (the US for instance had not suffered a major nationwide property fall in decades). So the reasoning went, ‘even if it gets as bad as it has ever been we will be ok’ – the fault with this was that just because something had not happened it did not mean it could not happen (i.e. I have never died but that does not mean one day I won’t). So the losses were magnified and the very fabric of the world’s economic wellbeing was imperilled, it really was potentially Armageddon.
How was disaster averted
Again simplistically the debts of the economies (Financial Companies) were consumed by States so the Countries bailed out the Companies. They did this for good reason, simply there was no alternative, meltdown was averted, everyone breathed a huge sigh of relief and asset prices rose.
In addition central banks embarked on a mission to stop their economies from falling into depressions by printing huge amounts of new money.
Countries and companies
To understand the finances of a Country is simply to apply the same criteria as applies to a Company or individual household.
A country gains its income from taxes and then spends this income on stuff it is committed to providing (defence, healthcare, unemployment benefits etc). The aim is to have a balanced budget, that is to say that income is equal to expenditure.
Now over the course of an economic cycle there will be good years when the economy is strong and therefore tax revenue is higher than expenditure and vice versa but overall it should balance.
Now comes the tricky part, in democracies political parties get voted in for spending and voted out for taxing i.e. people vote for who gives them what they want not for who does the right and responsible thing.
The markets are aware that a number of Countries have built up huge debts and their expenditure significantly exceeds their income. Now this has two outcomes:
- The Countries keep borrowing more, the cost of servicing the interest costs increase, the imbalance between income and expenditure gets ever more unbalanced OR
- The Countries cut expenditure, increase taxes and run their Countries like proper businesses
The electorates in these Countries don’t want services and benefits cut and don’t want higher taxes so politicians that try to do this are voted out of office (this is why democracy as Winston Churchill said is the least bad system of government).
To put this another way, it’s like appointing a new Managing Director of a Company who comes in and says, ‘look we are making massive losses and we need to restructure here, cut costs, reduce employment numbers, reduce pensions, stop paying for total healthcare coverage; these are all great things but if we continue the Company is going broke’.
Rather than getting on with it however the employees are then asked to vote on whether they want the MD to carry on or if they would rather have a new MD who says that none of that is actually necessary, guess what happens in that scenario.
There is a saying that when politics fights economics it will always ultimately lose.
The markets have no political allegiances they look at the facts and tell it as they see it, especially in the debt markets (the bond vigilantes).
So the markets are now saying to the overly indebted Countries, ‘hey – no can do, if you carry on we will charge you far higher interest rates for your borrowing because you are going broke’.
If one was being cynical it is possible to believe that politicians are allowing the turmoil to occur in part because the only way to get their electorates to agree to change is to firstly scare the crap out of them.
In numerous recent surveys people have said:
Do you want debt reduction? YES
Will you agree to higher taxes? NO
Will you agree to entitlement cuts? NO
Europe has to have a single financial debt structure so that all Countries’ debts are held by a central bank and the markets can’t sell off the debts of individual Countries.
This is perfectly doable but requires German agreement which is very difficult (history of inflation fears and the question: ‘why is this, our problem?’).
If the US has a sales tax at a federal level (sales tax is a state by state thing currently) of I believe around 5% the deficit is pretty much sorted (if they stop going to war as well then they will be loaded, in a good way).
This situation was always the second shoe to drop. In saying this, the markets have been very rewarding over the last two years and trying to time getting in and out is impossible (well no one has ever done it consistently up to now).
I tend to say try looking at this process in positive terms; these issues need addressing for our long term wellbeing, people have to accept that the promises made to them in the past about universal healthcare and pensions etc have to be broken because they are unaffordable unless they want to pay more tax.
People will only accept this when the alternative is less appealing than the pain of compliance which is the process of education we are now in but this is only for Europe and the US remember.
The good news is that the world is growing, huge new markets are coming on stream, multiple national companies are doing well, and innovation will transform the world ever faster and finally:
The reason that successful investing is so difficult is exactly this type of situation, it is scary and one sees one’s wealth depleting. Think back over the last 60 years and all the turmoil, disasters and potential problems that have been faced – we got through them, markets recovered and rose and those that profited were the ones that focused on value NOT price.
Price is what you pay BUT value is what you get, TESCO is no less valuable today than it was a week ago but you can buy a share for a much lower price!
NOTE: This is written in a personal capacity and reflects the view of the author. It does not necessarily reflect the view of LWM Consultants. The post has been checked and approved to ensure that it is both accurate and not misleading. However, this is a blog and the reader should accept that by its very nature many of the points are subjective and opinions of the author. This is not a recommendation to buy any product or service including any share or fund mentioned. Individuals wishing to buy any product or service as a result of this blog must seek advice or carry out their own research before making any decision, the author will not be held liable for decisions made as a result of this blog (particularly where no advice has been sought). Investors should also note that past performance is not a guide to future performance and investments can fall as well as rise.