In the last several years, we have grown accustom to moving from one financial crisis to another, like a roller coaster. Like a roller coaster, we return to an old crisis that everyone thought it had passed. How should investors take advantage of the ride they are on?
It's Portugal Again
On Saturday, October 30, 2010, Portugal's government and their largest opposition party reached an agreement that will add new austerity measures to the already strapped budget for 2011. This move put another stopgap measure in place as the Portuguese debt crisis threatened to embroil the rest of Europe requiring a bailout similar to the one arranged for Greece.
In July 2010, Moody's and Standard & Poor's downgraded rating on the Portuguese outstanding debt indicating that the financial strength of the government will "weaken over the medium term." The yield on Portugal's 10-year government bonds increased to just over 6 percent driving the yield spread vs. Germany for the same maturity to over 400 basis points (more than 4%).
Portugal's debt to GDP ratio is at 83.5% far below Greece's 132%. The United States has a 94.3% debt to GDP ratio while Ireland stands at 1,267%, Switzerland at 42.2% and the United Kingdom at 408%. In comparison, Brazil comes in at 13%, Singapore at 10.7%, China at 4.7% and India at 4.6%. All these figures are from the World Bank.
The unfortunate 10 million Portuguese people face years of cuts in pensions, healthcare programs, and falling salaries.
China to the Rescue
Who might step in and absorb some or all of the debt that Portugal has outstanding or must issue. Surprise, it is China. Chinese President Hu Jintao looks favorably on investing in Portuguese government bonds. He is visiting Portugal in the first week of November 2010. While Portugal is keen on diversifying its investors, China sees a strategic opportunity to invest for financial and political reasons.
Should the current spread narrow over time as many investors expect, anyone who owns the Portuguese bonds will realize a nice capital gain. The purchase of some of Portugal's debt is a smart financial decision, assuming the country can remain solvent.
Politically, a financial relationship with Portugal gives China added leverage in any trade agreements. While Portugal is a small country, it is a member of the European Union. As an investor in one of the EU's countries, China can try to extract better trade terms with other EU countries. Besides, China is likely to buy the debt of other EU countries. After all, they already own some of the Greek debt.
Where is the next Crisis
With each new crisis, the threat of the problem worsening grows. Just like families and companies, you cannot live beyond your means for long. Eventually you will have to make some hard adjustments. The countries in the EU are realizing this now. Whether the governments will step up to the table and deal with the problem or just try to pass it along remains to be seen. So far, many of the European governments are taking some steps to rein in the cost of government by trying to raise the retirement age, reduce some government wages and eliminate some government positions.
So far, the debt problems of the larger nations have remained contained. However, the opportunity for one of the major countries to encounter the same debt crisis remains. The United States will add about to 1.2 trillion to their debt in their next fiscal year. At some point, this growing debt must end.
If the Federal Reserve in their quantitative easing ends up buying $100 billion a month for 12 months, they will have monetized the deficit for 2011. Then what happens?
Move forward at least a year. Should the economy rebound and there are signs of inflation, the Fed will start to sell their enormous Treasury holdings. When the Federal Reserve sells bonds, they withdraw money from the economy, encouraging interest rates to rise. Selling treasuries also puts downward pressure on bond prices, especially those that match the maturities the Fed is selling.
Since the annual deficits for the United States are likely to remain in the $1 trillion range for years to come, the government will have to sell more bonds into the market as well. If the Fed is selling bonds and the Treasury is selling bonds, it is reasonable to assume the price paid (interest rates) will rise to try to attract willing buyers. This could trigger the debt crisis in the United States that many have been expecting for years.
The only way any one with money would be willing to buy all these Treasuries is when they believe the rates have reached a high enough level to warrant a low risk purchase. A buyer would want to see the proper austerity measures in place to give them more confidence the government would remain solvent.
Like what is taking place in Portugal, the United States will face the difficult choices of reducing expenditures for real, before they can expect any investor with enough capital to step in and purchase enough debt to slow the upward spiral of interest rates. Countries like China will be in a position to dictate terms.
The Bottom Line
While we might become accustomed to the crisis of the month, investors need to consider the long-term ramifications of this onerous cycle. While longer-term interest rates may fall 20 - 30 basis points more over the next year, a time will come when the risk of rising rates is upon us. When that time comes, the United States will face the double whammy of the Fed and The Treasury selling bonds into the market. Rising rates tend to slow economic growth. It also means money will be flowing out of treasuries and into other higher risk investments like stocks and commodities. This will energize the markets as a rising tide floats all boats. To beat the market, we will need to be in the sectors that are likely to perform the best under these circumstances. Technology, industrials, energy, materials, transportation, and consumer discretionary are good candidates.
