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Condition: An Altered Global Economic Landscape

It’s an upside-down world: Developed countries now dominate the list of highly indebted countries, and developing countries top the list of creditor nations.

Investment Implications

Home Biases Are Risk—Scour the Globe

The current era is a remarkable one, where the mighty have fallen and the meek have risen to the top. Developed nations such as the United States, Japan, and those in Europe are now at the bottom of the wrung in terms of fiscal health, and emerging nations, including China, Brazil, and India, as well as many of their regional brethren, which were once at the mercy of the developed world but now supply capital to the capital-starved developed world rather than vice versa. It is a topsy-turvy world where emerging countries have become creditor nations. China’s $3 trillion in international reserves are a towering testament to the shifting global tide. In a world where investor confidence in any single nation can quickly evaporate and money can flee—call it moneytourism—keeping money invested in nation’s whose poor balance sheets put their economies and financial markets at risk is an unattractive proposition. In contrast, countries that have built up reserves and have self-insured themselves against risk can self-finance their economic expansions and escape the worst of the Keynesian Endpoint. These nations, particularly those that entered the financial crisis with favorable initial conditions including demographics (relatively young populations and an increasing labor force), low budget deficits, low debt-to-GDP ratios, current account surpluses, high national savings rates, and high international reserves (relative to the size of their economies) are likely to have a strong ability to meet their payment obligations. For bond investors, this makes the high real interest rates of the developing world attractive, like blood to a vampire, yet many investors keep their money trapped in their home countries even though real interest rates there are either very low or in some cases negative. Assuming the emerging world has truly learned lessons from its past and will continue to behave as prudently as is has over the past decade or so, these real interest rates represent a glorious opportunity both outright and on a risk-adjusted basis. Investors need alter their old ways of thinking with respect to sovereign credit risk and broaden their opportunity set by exploring the many investment opportunities that exist in the emerging markets.

Intransigent Nations—Bad Places to Invest

In many countries, there will be little or no integration between the Keynesian and Austrian schools of thinking because the Keynesian camp will be intransigent. The implementation of austerity measures in these countries will be challenging and painful. For years these countries made social promises to their citizens that have become too burdensome to keep. Yet the citizens of these nations will be unwilling to wean themselves from the familiar and comforting hand of government for the free market’s invisible hand. As a result, these countries will see their economies languish because the Keynesian Endpoint means it will be impossible for them to raise money to support their social contracts and efforts to use debt to stimulate economic activity. In these cases, social unrest, income inequality, currency devaluations, debt restructurings, high unemployment, accelerated inflation, high real interest rates, and low investment returns will be key features. In short, the standard of living in these countries will decline.

In addition to differentiating between intransigent and flexible nations, investors must also examine the nature of programs developed to battle the financial crisis. The Austrian school believes that temporary government programs can be viral, becoming permanent features of an economy and stifling the private sector. This is why investors must judge which countries might become victim to policies that could crowd out the private sector. Investors must examine not only the size of government programs, but their half-lives; in other words, the speed and extent to which the programs will be unwound. Investors must also closely examine the exit strategies of governments from the fiscal and monetary programs they implemented during the financial crisis.

When nations reach the Keynesian Endpoint they have no choice but to reverse course on many of the priorities that brought got them there because reaching the Endpoint means they have gone too far or at are at the risk of going too far, a verdict easily surmised through a variety of market-based indicators such as real interest rates, the shape of the yield curve, credit default swaps, credit spreads, bank deposits, capital flows, and so on. These indicators will reflect underlying trends in key gauges of fiscal health, including debt-to-GDP ratios, budget deficits, primary balances (a nation’s budget deficit minus interest payments; see example forthcoming), savings rates (internal and external), reserve accumulation, and factors that influence these trends including budget rules, effectiveness in tax collecting, demographics, and the level of personal consumption relative to GDP (a gauge of the excess within an economy).

When reaching the Keynesian Endpoint, it is important for nations to ultimately achieve a zero primary balance because without it they cannot stabilize their debt-to-GDP ratios. When a nation achieves a zero primary balance, the amount of debt outstanding will tend to increase at the same rate as the nominal interest rate paid on the debt, leaving the debt-to-GDP ratio unchanged. For some nations, a stable primary balance fails to stabilize the debt-to-GDP ratio because the nominal interest rate paid on the national debt exceeds the growth rate of GDP. This will be the case for nations that are heavily indebted and that lack credibility in their fiscal affairs. Greece is an example. This presents an extra hurdle for many nations caught in today’s sovereign debt dilemma: To stabilize their debt-to-GDP ratios, not only must these nations reduce their primary balances to zero, but they must gain sufficient credibility in the financial markets to keep their nominal interest rates at or below their growth rates in GDP. If they can’t, they won’t be able to alleviate their debt burdens. In a world of finite capital, serial defaulters and those with burdens deemed by investors as likely to be too difficult to fix with austerity measures alone will lose—the nominal interest rate will stay high, thus raising the risk of a default, which would be the only means of reducing their debt-to-GDP ratios.

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