Email of the day
Comment of the Day

January 28 2013

Commentary by Eoin Treacy

Email of the day

on deleveraging
“I want to thank you for an excellent audio on Friday. It was all encompassing and very clearly stated. I agree fully with your points particularly the threat of competitive devaluations and how that might affect asset returns. Price is the final arbiter and it does appear that the charts are indicating a continuing uplift in equity markets. However, is the "fly in the ointment" the need for the world's economies (particularly in the West) to deleverage their balance sheets (publically and privately)? Given that we will have trouble growing out of this problem, how does this fit into your medium/long term outlook, keeping in mind that if interest rates start rising again, this will exacerbate the problem?”


“Further to my email above-please see the attached. It discusses financial repression and its effects on the markets & their valuation. With continued financial repression, maybe the "fly in the ointment"(the massive overleveraging) can be delayed for quite a while.”

Eoin Treacy's view Thank you for your kind words and this question which is sure to be of interest to other subscribers. Deleveraging is a tricky subject because different participants have behaved in different ways since the credit crisis. In the USA and Europe consumers have had deleveraging foisted upon them and had no choice but to make less go further. The result is that consumers have already made not insignificant inroads toward repairing their balance sheets. The corporate sector has adjusted masterfully to the new reality by rationalising inefficient practices and fine tuning balance sheets. The performance of globally oriented companies in particular is testament to their ability to adapt to changing circumstances. The greatest threat of deleveraging lies with governments because they have socialised such high proportions of private sector, mainly banking, debt.

Governments must either rely on growth, taxes, inflation or a mix of these measures to reduce debt. So far the stealth inflation route appears to be the preferred strategy in the USA and while taxation and austerity with some quantitative easing has been more prevalent in Europe. Negative real interest rates have been evident across fixed income sectors for a number of years now. The net result is gradual and cumulative erosion in the value of savings. (Also see Comment of the Day on October 12th). Here also in a section from James Montier's report for GMO highlighting the policy of encouraging/forcing participation in government bonds:

What evidence can be offered that financial repression is something that investors need to consider? The prima facie case is surely Exhibit 3, coupled with the Fed's actions. Effectively, bond yields are so low because we have a group of price-insensitive buyers in the market. Obviously, the main such agents are the central banks themselves, but in keeping with financial repression, they are turning to others over whom they exert considerable influence and encouraging them to follow suit. So, the banks are told that government bonds are a zero risk weight asset, and therefore they must own them. The insurers are told that under Solvency II they too must own lots of government bonds. Pension funds are encouraged to liability match with the “best” match being defined as (yes, you guessed it, surprise, surprise) government bonds.

US 10-year yields tested the 2% level today, a rise of 43% from the July lows. A sustained move below 1.8%, which represents the upper side of the underlying trading range and region of the 200-day MA, would be required to question supply dominance.

The above chart suggests that in the absence of commodity price inflation or higher wage demands, that the reduction in risk perceptions and the more sanguine growth outlook for the US economy are being priced into this market. In the event that growth surprises to the upside, not least because of the USA's competitive advantage in energy, the requirement for permanently low interest rates will be reduced. Considering how low interest rates are, they can rise quite a bit before they become a threat to equities. As you say, the charts will be our guide.

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