World Global Strategy
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World Global Strategy
9 October 2009
Popular Delusions Inflation is always and everywhere a fiscal phenomenon
Dylan Grice (44) 20 7762 5872 [email protected]
Even before the “Great Recession”, unfunded fiscal obligations made government finances an accident waiting to happen. The crisis has merely brought forward the day of reckoning. The question isn’t whether developed governments will “default” on them, with attendant consequences for other asset classes, it’s when and how. Yet long-term inflation is priced at 2% in the US. This could be the biggest pricing anomaly across markets today.
Believe it or not, the first great inflation occurred in third century AD Rome. The territorial limits of empire had been reached several decades earlier and the huge army, which in former times had financed itself (through the conquest of new, plunderable and taxable lands), was now needed to protect the border from barbarian invaders.
Q
Just like the baby boomers of todays developed world, that cohort of Roman society which had once been its engine of growth became its unsustainable financial burden, straining imperial finances so thoroughly that the government could only fund itself by debasing the coinage. The silver content of a denarius, which had been 75% in 180AD, was a mere 0.02% by 270AD. Fiscal pressure had caused the first inflation and the Empire would never regain its former greatness.
Q
And since this early Roman experience the theme has repeated itself again and again. Medieval Europe, Sung China, revolutionary France, America during its civil war, Weimar Germany and arguably even post WW2 Britain and America, all saw inflations in which money was the vehicle, but the root cause was a government unable to pay its way.
Q
Albert Edwards has always said the Ice Age would end in substantially higher inflation because political desperation to avoid Japans fate would drive government debt to such extreme levels that default would be inevitable. Driven by an age old dynamic, this is exactly what is playing out now.
Q
Official government debt ratios look OK, unofficial ones (including unfunded obligations) don’t Official Net Debt, % GDP *
To tal net liabilities (funded and unfunded), % GDP **
750%
500%
250%
IMPORTANT: PLEASE READ DISCLOSURES AND DISCLAIMERS BEGINNING ON PAGE 4
www.sgresearch.socgen.com
0% Germany Spain France * 2010 OECD pro jectio ns ** 2005 estimates o f to tal Fiscal Imbalance Source: Gokhale, OECD
Italy
UK
EU
US
Popular Delusions
In 2005 net government debt stood at around 40% of GDP. The chart on the front page shows the OECDs projections of the same ratio (red bars) for 2010, where it is expected to average about 60%. If these numbers were an accurate reflection of governments true indebtedness the long-term inflation expectations built into the bond market wouldnt be too interesting. But theyre not. Official government debt statistics such as those represented by the red bars on the front page chart are based on the outstanding stock of government debt, which is only a subset of governments true liability. The rest of it is effectively off balance sheet (SIV like) in the form of promised but unfunded future pension and health benefits. Such commitments are the product of welfare systems designed to fund aged citizens by taxing current workers. They work smoothly when the population is growing as there is a constant supply of young workers to pay for each pensioner. But when population growth slows, so does the ratio of new workers to pensioners and the schemes become underfunded. This is exactly what is beginning to happen now throughout the developed world. The grey bars on the front page chart correct for this. They represent calculations by Jagadeesh Gokhale 1 of governments total liabilities when the unfunded obligations are added to the official numbers. They are truly eye watering, almost unbelievable in fact. The best of those charted is Spain, with a total liability to GDP ratio of only 244%. The worst are France and America with liability to GDP ratios approaching 550%. And in case youre thinking these estimates are the product of some maverick economist desperately seeking attention, Gokhale is a senior fellow at the Cato Institute and former advisor to the US Treasury, the Cleveland Fed and the AEI. His work on the US estimates was co-authored with Kent Smetters, a professor at the Wharton Business School. Of course, that doesnt make them correct or mean that we should blindly follow them, but they are at least grounded in some credible and serious thinking. Govts’ liability to income multiples (net actuarial liabilities as a multiple of current tax receipts) 25
20
15
10
5
0 Germany
Spain
France
Italy
UK
EU
Source: Gokhalle (2009), see footnote for link
1
2
See Measuring the Unfunded Obligations of European Countries by Jagadeesh Gokhale
9 October 2009
US
Popular Delusions
To properly gauge just how heavy this burden is, consider that the levels are only shown as a share of GDP. A better way to look at sustainability is to compare the liabilities to income, which Ive done in the chart above. Now, I thought quite hard about using this chart because the numbers were so big I didnt think theyd be taken seriously. What they imply is government failure, which until we glimpsed it in early 2009 was not something we had really had to worry about for a very long time. But upon reflection I decided that they are what they are best estimates, honestly produced. That we dont like them doesnt mean we should ignore them. So Ive gone with them. They show that government liabilities range from 6.5x government income in Spain, to 19.3x government income in the US. Bear in mind that the US consumer is widely seen as dead in the water with debt at 1.3x income. Gokhale says that if governments saved roughly an additional 8% of GDP from today and continued that saving for ever they would defuse the time bomb. 2 I say fat chance. Governments act no differently from anyone else faced with debts they cant afford to pay. They default. The only difference is that they default via inflation. A proxy for the governments default risk premium, therefore, is the inflation expectation implied by the bond market which the chart below shows is only 2% over the next 30 years. Bear in mind that US inflation has averaged 4% since 1946 and 3% since 1983 (by which time Volker had successfully brought inflation under control, and less than 30 years ago). At current pricing, markets clearly expect an improved inflation performance over the next 30 years. In Europe the numbers arent much more realistic, running at just under 2.5% in France, to 3.5% in the UK. The last era of problematic inflation witnessed was the 1970s. It saw equity valuations and corporate bond yields reach levels seen only during the Great Depression, and considerably worse than the March 2009 panic. US bond yields rose above 15% and commodities enjoyed one of the all-time great bull markets. So bear in mind, whether we like it or not, we all exist in the orbit of government. The mispricing of inflation implies a mispricing of everything else. Is this the most obvious anomaly across markets today? US implied 30y average inflation is 2% 4.5 4 3.5 3 2.5 2 1.5 US
UK
France
1 0.5 0 30/11/04
11/30/2005
11/30/2006
11/30/2007
11/28/2008
Source: Bloomberg
2
Actually, that was based on 2005 numbers. I suspect an updated figure now would be around 9-10%
9 October 2009
3
Popular Delusions
IMPORTANT DISCLAIMER: The information herein is not intended to be an offer to buy or sell, or a solicitation of an offer to buy or sell, any securities and including any expression of opinion, has been obtained from or is based upon sources believed to be reliable but is not guaranteed as to accuracy or completeness although Société Générale (SG) believe it to be clear, fair and not misleading. SG, and their affiliated companies in the SG Group, may from time to time deal in, profit from the trading of, hold or act as market-makers or act as advisers, brokers or bankers in relation to the securities, or derivatives thereof, of persons, firms or entities mentioned in this document or be represented on the board of such persons, firms or entities. Employees of SG, and their affiliated companies in the SG Group, or individuals connected to then, other than the authors of this report, may from time to time have a position in or be holding any of the investments or related investments mentioned in this document. Each author of this report is not permitted to trade in or hold any of the investments or related investments which are the subject of this document. SG and their affiliated companies in the SG Group are under no obligation to disclose or take account of this document when advising or dealing with or for their customers. The views of SG reflected in this document may change without notice. To the maximum extent possible at law, SG does not accept any liability whatsoever arising from the use of the material or information contained herein. This research document is not intended for use by or targeted at retail customers. Should a retail customer obtain a copy of this report they should not base their investment decisions solely on the basis of this document but must seek independent financial advice. Important notice: The circumstances in which materials provided by SG Fixed & Forex Research, SG Commodity Research, SG Convertible Research, SG Technical Research and SG Equity Derivatives Research have been produced are such (for example because of reporting or remuneration structures or the physical location of the author of the material) that it is not appropriate to characterise it as independent investment research as referred to in European MIF directive and that it should be treated as a marketing material even if it contains a research recommendation (« recommandation dinvestissement à caractère promotionnel »). However, it must be made clear that all publications issued by SG will be clear, fair, and not misleading. Analyst Certification: Each author of this research report hereby certifies that (i) the views expressed in the research report accurately reflect his or her personal views about any and all of the subject securities or issuers and (ii) no part of his or her compensation was, is, or will be related, directly or indirectly, to the specific recommendations or views expressed in this report. Notice to French Investors: This publication is issued in France by or through Société Générale ("SG") which is authorised by the CECEI and regulated by the AMF (Autorité des Marchés Financiers). Notice to UK investors: This publication is issued in the United Kingdom by or through Société Générale ("SG") London Branch which is regulated by the Financial Services Authority ("FSA") for the conduct of its UK business. Notice To US Investors: This report is intended only for major US institutional investors pursuant to SEC Rule 15a-6. Any US person wishing to discuss this report or effect transactions in any security discussed herein should do so with or through SG Americas Securities, LLC (SGAS) 1221 Avenue of the Americas, New York, NY 10020. (212)-278-6000. THIS RESEARCH REPORT IS PRODUCED BY SOCIETE GENERALE AND NOT SGAS. Notice to Japanese Investors: This report is distributed in Japan by Société Générale Securities (North Pacific) Ltd., Tokyo Branch, which is regulated by the Financial Services Agency of Japan. The products mentioned in this report may not be eligible for sale in Japan and they may not be suitable for all types of investors. Notice to Australian Investors: Société Générale Australia Branch (ABN 71 092 516 286) (SG) takes responsibility for publishing this document. SG holds an AFSL no. 236651 issued under the Corporations Act 2001 (Cth) ("Act"). The information contained in this newsletter is only directed to recipients who are wholesale clients as defined under the Act. IMPORTANT DISCLOSURES: Please refer to our website: http:\\www.sgresearch.socgen.com http://www.sgcib.com. Copyright: The Société Générale Group 2009. All rights reserved.
4
9 October 2009
9 October 2009
Popular Delusions Inflation is always and everywhere a fiscal phenomenon
Dylan Grice (44) 20 7762 5872 [email protected]
Even before the “Great Recession”, unfunded fiscal obligations made government finances an accident waiting to happen. The crisis has merely brought forward the day of reckoning. The question isn’t whether developed governments will “default” on them, with attendant consequences for other asset classes, it’s when and how. Yet long-term inflation is priced at 2% in the US. This could be the biggest pricing anomaly across markets today.
Believe it or not, the first great inflation occurred in third century AD Rome. The territorial limits of empire had been reached several decades earlier and the huge army, which in former times had financed itself (through the conquest of new, plunderable and taxable lands), was now needed to protect the border from barbarian invaders.
Q
Just like the baby boomers of todays developed world, that cohort of Roman society which had once been its engine of growth became its unsustainable financial burden, straining imperial finances so thoroughly that the government could only fund itself by debasing the coinage. The silver content of a denarius, which had been 75% in 180AD, was a mere 0.02% by 270AD. Fiscal pressure had caused the first inflation and the Empire would never regain its former greatness.
Q
And since this early Roman experience the theme has repeated itself again and again. Medieval Europe, Sung China, revolutionary France, America during its civil war, Weimar Germany and arguably even post WW2 Britain and America, all saw inflations in which money was the vehicle, but the root cause was a government unable to pay its way.
Q
Albert Edwards has always said the Ice Age would end in substantially higher inflation because political desperation to avoid Japans fate would drive government debt to such extreme levels that default would be inevitable. Driven by an age old dynamic, this is exactly what is playing out now.
Q
Official government debt ratios look OK, unofficial ones (including unfunded obligations) don’t Official Net Debt, % GDP *
To tal net liabilities (funded and unfunded), % GDP **
750%
500%
250%
IMPORTANT: PLEASE READ DISCLOSURES AND DISCLAIMERS BEGINNING ON PAGE 4
www.sgresearch.socgen.com
0% Germany Spain France * 2010 OECD pro jectio ns ** 2005 estimates o f to tal Fiscal Imbalance Source: Gokhale, OECD
Italy
UK
EU
US
Popular Delusions
In 2005 net government debt stood at around 40% of GDP. The chart on the front page shows the OECDs projections of the same ratio (red bars) for 2010, where it is expected to average about 60%. If these numbers were an accurate reflection of governments true indebtedness the long-term inflation expectations built into the bond market wouldnt be too interesting. But theyre not. Official government debt statistics such as those represented by the red bars on the front page chart are based on the outstanding stock of government debt, which is only a subset of governments true liability. The rest of it is effectively off balance sheet (SIV like) in the form of promised but unfunded future pension and health benefits. Such commitments are the product of welfare systems designed to fund aged citizens by taxing current workers. They work smoothly when the population is growing as there is a constant supply of young workers to pay for each pensioner. But when population growth slows, so does the ratio of new workers to pensioners and the schemes become underfunded. This is exactly what is beginning to happen now throughout the developed world. The grey bars on the front page chart correct for this. They represent calculations by Jagadeesh Gokhale 1 of governments total liabilities when the unfunded obligations are added to the official numbers. They are truly eye watering, almost unbelievable in fact. The best of those charted is Spain, with a total liability to GDP ratio of only 244%. The worst are France and America with liability to GDP ratios approaching 550%. And in case youre thinking these estimates are the product of some maverick economist desperately seeking attention, Gokhale is a senior fellow at the Cato Institute and former advisor to the US Treasury, the Cleveland Fed and the AEI. His work on the US estimates was co-authored with Kent Smetters, a professor at the Wharton Business School. Of course, that doesnt make them correct or mean that we should blindly follow them, but they are at least grounded in some credible and serious thinking. Govts’ liability to income multiples (net actuarial liabilities as a multiple of current tax receipts) 25
20
15
10
5
0 Germany
Spain
France
Italy
UK
EU
Source: Gokhalle (2009), see footnote for link
1
2
See Measuring the Unfunded Obligations of European Countries by Jagadeesh Gokhale
9 October 2009
US
Popular Delusions
To properly gauge just how heavy this burden is, consider that the levels are only shown as a share of GDP. A better way to look at sustainability is to compare the liabilities to income, which Ive done in the chart above. Now, I thought quite hard about using this chart because the numbers were so big I didnt think theyd be taken seriously. What they imply is government failure, which until we glimpsed it in early 2009 was not something we had really had to worry about for a very long time. But upon reflection I decided that they are what they are best estimates, honestly produced. That we dont like them doesnt mean we should ignore them. So Ive gone with them. They show that government liabilities range from 6.5x government income in Spain, to 19.3x government income in the US. Bear in mind that the US consumer is widely seen as dead in the water with debt at 1.3x income. Gokhale says that if governments saved roughly an additional 8% of GDP from today and continued that saving for ever they would defuse the time bomb. 2 I say fat chance. Governments act no differently from anyone else faced with debts they cant afford to pay. They default. The only difference is that they default via inflation. A proxy for the governments default risk premium, therefore, is the inflation expectation implied by the bond market which the chart below shows is only 2% over the next 30 years. Bear in mind that US inflation has averaged 4% since 1946 and 3% since 1983 (by which time Volker had successfully brought inflation under control, and less than 30 years ago). At current pricing, markets clearly expect an improved inflation performance over the next 30 years. In Europe the numbers arent much more realistic, running at just under 2.5% in France, to 3.5% in the UK. The last era of problematic inflation witnessed was the 1970s. It saw equity valuations and corporate bond yields reach levels seen only during the Great Depression, and considerably worse than the March 2009 panic. US bond yields rose above 15% and commodities enjoyed one of the all-time great bull markets. So bear in mind, whether we like it or not, we all exist in the orbit of government. The mispricing of inflation implies a mispricing of everything else. Is this the most obvious anomaly across markets today? US implied 30y average inflation is 2% 4.5 4 3.5 3 2.5 2 1.5 US
UK
France
1 0.5 0 30/11/04
11/30/2005
11/30/2006
11/30/2007
11/28/2008
Source: Bloomberg
2
Actually, that was based on 2005 numbers. I suspect an updated figure now would be around 9-10%
9 October 2009
3
Popular Delusions
IMPORTANT DISCLAIMER: The information herein is not intended to be an offer to buy or sell, or a solicitation of an offer to buy or sell, any securities and including any expression of opinion, has been obtained from or is based upon sources believed to be reliable but is not guaranteed as to accuracy or completeness although Société Générale (SG) believe it to be clear, fair and not misleading. SG, and their affiliated companies in the SG Group, may from time to time deal in, profit from the trading of, hold or act as market-makers or act as advisers, brokers or bankers in relation to the securities, or derivatives thereof, of persons, firms or entities mentioned in this document or be represented on the board of such persons, firms or entities. Employees of SG, and their affiliated companies in the SG Group, or individuals connected to then, other than the authors of this report, may from time to time have a position in or be holding any of the investments or related investments mentioned in this document. Each author of this report is not permitted to trade in or hold any of the investments or related investments which are the subject of this document. SG and their affiliated companies in the SG Group are under no obligation to disclose or take account of this document when advising or dealing with or for their customers. The views of SG reflected in this document may change without notice. To the maximum extent possible at law, SG does not accept any liability whatsoever arising from the use of the material or information contained herein. This research document is not intended for use by or targeted at retail customers. Should a retail customer obtain a copy of this report they should not base their investment decisions solely on the basis of this document but must seek independent financial advice. Important notice: The circumstances in which materials provided by SG Fixed & Forex Research, SG Commodity Research, SG Convertible Research, SG Technical Research and SG Equity Derivatives Research have been produced are such (for example because of reporting or remuneration structures or the physical location of the author of the material) that it is not appropriate to characterise it as independent investment research as referred to in European MIF directive and that it should be treated as a marketing material even if it contains a research recommendation (« recommandation dinvestissement à caractère promotionnel »). However, it must be made clear that all publications issued by SG will be clear, fair, and not misleading. Analyst Certification: Each author of this research report hereby certifies that (i) the views expressed in the research report accurately reflect his or her personal views about any and all of the subject securities or issuers and (ii) no part of his or her compensation was, is, or will be related, directly or indirectly, to the specific recommendations or views expressed in this report. Notice to French Investors: This publication is issued in France by or through Société Générale ("SG") which is authorised by the CECEI and regulated by the AMF (Autorité des Marchés Financiers). Notice to UK investors: This publication is issued in the United Kingdom by or through Société Générale ("SG") London Branch which is regulated by the Financial Services Authority ("FSA") for the conduct of its UK business. Notice To US Investors: This report is intended only for major US institutional investors pursuant to SEC Rule 15a-6. Any US person wishing to discuss this report or effect transactions in any security discussed herein should do so with or through SG Americas Securities, LLC (SGAS) 1221 Avenue of the Americas, New York, NY 10020. (212)-278-6000. THIS RESEARCH REPORT IS PRODUCED BY SOCIETE GENERALE AND NOT SGAS. Notice to Japanese Investors: This report is distributed in Japan by Société Générale Securities (North Pacific) Ltd., Tokyo Branch, which is regulated by the Financial Services Agency of Japan. The products mentioned in this report may not be eligible for sale in Japan and they may not be suitable for all types of investors. Notice to Australian Investors: Société Générale Australia Branch (ABN 71 092 516 286) (SG) takes responsibility for publishing this document. SG holds an AFSL no. 236651 issued under the Corporations Act 2001 (Cth) ("Act"). The information contained in this newsletter is only directed to recipients who are wholesale clients as defined under the Act. IMPORTANT DISCLOSURES: Please refer to our website: http:\\www.sgresearch.socgen.com http://www.sgcib.com. Copyright: The Société Générale Group 2009. All rights reserved.
4
9 October 2009
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