Current environment and to hedge or not to hedge part 1

This follows a thread at Jonathan Chevreau’s Findependence Daysite.

A good question.

Current environment: even if we did not have the sovereign debt default risks, US debt ceiling negotiations and renewed and attendant capital adequacy risks of the banking system, especially the European banking system, the vast amounts of private, public and corporate debt in the system and the need for significant structural rebalancing between consumption and production, globally, we would be looking at growth of between 1% and 2% below historical averages for the next 5 to 7 year, and possibly longer. In other words, real economic growth of between 0.5% and 1.5% for the major developed economies: add dividends and inflation and you would have your nominal total equity return before transaction costs and taxes.

This would have been my upper boundary: the lower boundary outcomes could quite easily involve another severe recession involving a GDP decline of 3% to 5%, and this would not be an extreme expectation.

Once we get to the negative scenario (GDP decline of 3% to 5%), we would probably be in another accelerated debt default scenario (public and private most definitely many financial companies) and what happens once you end up there is anyone’s guess. Human beings are not very good at dealing with such situations.

The risks at the moment, given the structural economic and financial weaknesses, are profound to say the least. As I have said for some time, we are not unwinding the excess of say 1 to 2 years, as would be the case for a plain vanilla recession, but a trajectory that has been some 30 years in the making, and from the late 1990s onwards, in particular. This is what is so different.

When we talk of behavioural issues in decision making, we are talking about individuals using rules of thumb which have worked for them in the past (rules of thumb have come to stand in place of rigorous analysis of structure) and perceptions of reality that they have taken from the small dataset of experiences they have been exposed to, when what is really needed is for these individuals to completely rebuild their decision making framework for the world as it is now.

Growth does not happen out of thin air, which many commentators seem to assume is what will drag us out. While I still believe, that at a fundamental level, if consumption was a smaller percentage of GDP in many countries and larger in others, if saving and investment was larger in some and smaller in others, and if debt (private, public and corporate) was back to where it was in the mid 1990s as a % of GDP, the world economy would be capable of generating the growth that many currently expect. I believe, based on my analysis, that we are not yet at that point where growth and stability can resume.

What are the potential market outcomes: well if we need to retrace excess, then we probably need to knock out a certain level of consumption in certain key markets (in the US government transfer payments have increased by 4% of personal disposable income since the onset of the crisis), possibly 3% to 5% over a 3 year period, and we also need to reduce government debt, possibly by 1% to 2% of government debt per annum over a 10 year period (which could reduce growth by 0.8% to 1.6%), all of which will involve a reduction in investment and cuts in output. In other words capital employed in producing output will fall (capital will be depreciated or made obsolete) as will returns on capital. Dividend yields need to be higher to cover this risk (I,e dividend yields will be a de facto return of capital) and P/Es lower.

What is of concern, is that in places like China and Canada, where debt levels were not as high in 2007/2008 as the rest of the world, debt has since financed a significant portion of growth, and unbalanced growth at that.

There are of course counterbalances such as technological change, demographics, and the increasing maturity of emerging and developing markets that might provide opportunities for developed markets to expand output, but this may not be sufficient and timely to offset the negative forces.

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