For investors, there may be more to lose now than after the collapse of Lehman Brothers. In the months following September 2008, as governments flooded markets with capital, investors took shelter in U.S. Treasury debt. Now the deepening sovereign debt crisis in developed-world economies has taken this risk-free refuge away. Negative real interest rates, ongoing money printing and bail-outs have increased the risk of government debt in some of the world’s deepest bond markets. The risk-free asset has been lost, says the bearish Nick Bullman of CheckRisk, and this makes valuing other assets very subjective. If cash is no longer risk-free, how can equities or any other asset be accurately valued? “Are we looking at an overpriced government bond market in the U.S., U.K. and Europe rather than a cheap equity environment?” Bullman asks. An asset is reasonably priced if its price is less than its intrinsic value, he says. This provides a margin of safety.
The loss of risk-free assets is the result of government efforts to rescue the financial system after Lehman failed. Governments absorbed the bad debt of banks running amok, rather than letting the institutions fail. Now the corporate sectors of the U.S, U.K. and Europe are stronger, but their governments are the major source of risk in financial markets. This transfer of risk is “the most important in financial history and will dominate the risk landscape until the debt bubble is completely burst”, Bullman says. “Governments have assumed large levels of risk and they have little understanding of how to deal with it.” It will take some time for politicians to manufacture an endgame. Unlike corporations, “governments can print money, with no apparent cost, until it is too late”, Bullman says. But this would be a calamitous outcome because, as we know, there is no entity to relieve governments of their debt burdens. It is also a likely outcome, Bullman says, because governments are not incentivised to mitigate the worse effects of debt in the same way companies are. Governments do not seek profit. They seek re-election, and they move steadily and slowly so as not to jeopardise their mandate to rule.
They want to be flexible and uncommitted. In contrast, markets want decisive action and certainty. Investors won’t get what they want, though, and Bullman says they should be prepared for much less predictable and more volatile market conditions. Governments are running out of options. European and U.S. balance sheets aren’t big enough to sustain the debt burden. They need strong economic growth or inflation but are getting neither, and are caught in a debt trap. National income can’t even pay the interest on debt, let alone repay the principal. So they raise capital from bond markets, hike taxes and cut spending on services. This crowds bond markets, which then demand higher interest rates on loaned capital and increase the cost of debt. But at some point governments give people the unpalatable medicine of higher taxes and reduced services, leading to less consumer spending and lower economic growth. It also induces civil unrest. This has been seen in Athens and London and will likely continue – particularly in Greece. In September, Greek authorities failed to convince investors that the nation would endure the euro-region sovereign debt crisis without default. Credit default swaps, used to insure investors against a Greek default, priced in a 98 per cent probability that its government would not honour its debt. The yield on 10-year Greek bonds climbed to 25 per cent for the first time.