Britain’s economy doesn’t look pretty. It may not be quite as bad as yesterday’s dire GDP figures suggested, but I don’t think anyone denies we’re still in recession.
Our banks still carry huge levels of bad debt on their balance sheets. If house prices collapse again, it could get even worse.
If we were in the eurozone, we’d be one of the periphery countries, not part of the ‘prudent’ northern gang.
So why are people worried about lending to Spain, but not worried about lending to Britain?
And how long can that continue?
Why does anyone buy gilts?
Britain, historically, has been a better credit risk than Spain, which is one reason why our bond yields have stayed much lower. And structurally, our economy is more efficient (although there’s an awful lot of room for improvement).
But on a practical basis, it comes down to one thing. We’re not in the euro, so we can print our own money. Italy, Spain, and even the healthy eurozone economies could, in theory, run out of money and be forced to default on their debt.
Or rather, they might be forced to exit the euro, and print their own new currency to repay their debts. That amounts to the same thing. That can’t happen with the UK.
It doesn’t explain the other part of the problem though. Why is anyone happy to lend to a country that – if pushed – can simply repay its debts with printed money?
Printing money adds to the amount of currency in the world without adding to the amount of ‘stuff’. The value of currency relative to stuff should therefore fall. That’s the most basic explanation of inflation.
If you thought that a central bank was planning to print an infinite amount of money tomorrow, the only sensible action to take today would be to ditch its currency. Because if you divide an infinite amount of money by a finite amount of stuff, you get infinitely high prices.
So why stick with this debt? Particularly when the governments in question are hardly models of fiscal prudence?
The world of ‘disaster’ economics
Well, what’s intriguing is that if you look at the credit default swaps (CDS) market, it’s clear that investors are in fact becoming more concerned about defaults even by ‘safe’ countries.
CDS are a form of insurance that pays out (in theory) if a country or company defaults or has some other specific ‘credit event’. So when the cost rises, it shows that people are increasingly concerned about creditworthiness.
As Gillian Tett pointed out in the FT earlier this week, the price of insuring ten-year debt from both Germany and the US against default has ticked higher over the last two years. The same goes for the UK. Yet the yield on their bonds has continued to fall.
That’s strange, because you’d normally expect bond yields to rise in this situation. The riskier bonds are thought to be, the higher the yield investors expect. So what’s going on?
A recent paper from Fulcrum Asset Management, cited by Gillian Tett in the FT, tries to explain it. In essence, the argument is that investors grew too complacent during the second half of the 20th century.
That’s because there were hardly any significant economic ‘disasters’. A disaster is a fall in GDP per head of at least 10%. There were 58 of these disasters in the 20th century. But only two occurred between 1950 and 2000 (in Finland and Iceland, according to the authors of the paper).
However, we’ve already seen two such disasters this century – Iceland (again) and Ireland. Greece is likely to join the list. And we could see more eurozone peripheral countries added to it in the next couple of years.
In short, the chance of disasters happening has shot up. In turn, that means investors stop thinking about making a return on their money. Instead, they place much more value on protecting their money.
There are only so many ‘safe haven’ assets in the world. So even as the backdrop gets ever riskier (pushing up concerns about default for everyone), investors will rush to the assets that look safe compared to everything else.
So as long as the risk of a country defaulting doesn’t hit a certain level (France for example, is right on the borderline), then investors will keep piling into its bonds.
It also means that the chasm in valuation between shares and bonds is justified. If investors are scared of disaster, then the extra return they demand to hold shares instead of sovereign bonds will be higher.
Now, despite the vaguely academic tone of the paper, this isn’t rocket science. It boils down to this: normally investors want to grow their money. But when investors are scared, they want to keep what little they’ve got, so they pile into the safest assets, even to the point where they’ll pay for the privilege.
What does this mean for you?
One implication of the paper is that bond yields may have fallen in spite of quantitative easing, rather than because of it. Usually, a central bank getting out the printing press would unnerve investors.
But because of the appalling state of the rest of the world, taking your chances with the uncertainties of a printing press is seen as a more acceptable risk than putting money into Europe, for example.
So should we all pile into bonds?
Well, no. Investors may remain in the mood to ‘insure’ against Armageddon for a long period, notes Tett. But she also adds: “Unless of course, an inflation or political shock creates an explosion of default fears in Germany (or the US) – and those bonds and [CDS] finally come into line.”
The point is, this is a precarious state of affairs. Bond investors may feel they have nowhere else to turn now. But what if the European Central Bank starts printing money? That would boost both risk appetite and inflation fears. Or what if the coalition collapses in the UK? That could push gilts out of the ‘safe’ category.
More to the point, I get jittery when experts start reaching for unconventional explanations to describe why we could be in ‘a new paradigm’. Sir John Templeton (who my colleague Tim Bennett profiles in the latest issue of MoneyWeek magazine, out tomorrow -if you’re not already a subscriber, get your first three copies free here) said that the four most dangerous words in investing were: “This time it’s different.”
We’ve become used to hearing this applied to over-exuberant bull markets. But it works on the bearish side too.
There’s a simpler explanation for collapsing bond yields. Investors have become overly fearful – not to mention complacent about inflation – and now they’re over-reacting on the downside. That can’t last.
So hold gold. Stick with blue-chip income stocks. Dip a toe into the cheap parts of Europe. And avoid ‘safe’ government debt. Because at some point this rush to ‘safety’ will reverse, and you don’t want to be caught on the wrong side of it.
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