Then They Came for the PIIGS...

  

(with apologies to Martin Niemoeller)

 

First they came for Iceland

But I was underweight Iceland, so I did nothing

 

Then they came for Dubai

But I owned nothing in Dubai, so I did nothing

 

Then they came for the PIIGS

But I had no PIIGS exposure, so I did nothing

 

Then they came for my book

And I would have sold out, but there was nowhere left to go

 

 

Figure 1:  Then they came for the PIIGS…

 

 

 

 

Answer this question.  When an economy is weak, its sovereign interest rates:

 

a)   decline

b)   rise

c)    it depends

 

Most under the age of sixty can be forgiven for selecting answer a).   Recent history tells us that interest rates have fallen during recessions and have risen during recoveries.  However, this relationship, for reasons outlined below, does not always hold.  And so the correct answer to the question above is c) “it depends.”  While being correct might be worth a bonus point or two in an Economics 100 class, I believe the real value of understanding this issue will be in safeguarding and growing personal wealth in Canada in the decade ahead.

 

Interest Rate Drivers

 

Other than the shortest maturities, for which central banks can usually fix rates related to their own currency, interest rates on government bonds are set by the market.  And it is these market-set rates that ultimately drive the cost of interest on national debts and, indirectly, on mortgages and corporate debt.

 

Market participants consider two factors in determining the interest rates at which government bonds are traded.  The first is the return available in other investments – aka opportunity cost.  And the second is the risk of non-payment.  In the case of a sovereign, non-payment risk includes both the risk of default and the risk that repayment will be made in currency that has become devalued through inflation.

 

When interest rates went down during the recessions of 1990-91 and 2001-02, it was because opportunity cost had reduced.  Investors chose to buy government bonds at ever-lower yields instead of discredited dotcoms or other riskier securities. 

 

Then They Came For the PIIGS

 

However as we are starting to see in the case of the PIIGS (Portugal, Ireland, Italy, Greece and Spain), there is a point at which the risk of non-payment becomes the dominant factor in setting market-driven interest rates.  .

 

The Greek economy, dependent on tourism and real estate development (and shipping to a lesser degree) has fallen into a tailspin.  This unfortunate circumstance is exacerbated by the fiscal demands of an aging population that requires ever more pensions and healthcare from the state.

 

The market’s reaction so far has been to doubt whether the situation is resolvable without a sovereign default.  Back in December, Greece could borrow 5-year money at between three and four percent.  But more recently the cost of Greece’s debt has effectively doubled to around seven percent.  From a bondholder’s point of view, a Greek-issued 5 year euro bond has lost more than 15% of its value since December. 

 

What to Do

 

While it is not time to panic, most Canadian investors should take time to understand the implications of the crises that are popping up.  It is also useful to keep tabs on the increasing credit quality of the countries experiencing problems.  Zimbabwe’s 2007 hyperinflation was barely news.  The Iceland and Dubai crises were sufficiently small as to be confined to the “curiosity” category.  But the PIIGS are all investment-grade sovereigns.  If the dam doesn’t hold here, the next stop of the sovereign credit crunch might include Japan and the UK. 

 

I think it is likely that the ultimate policy solution will be that governments print enough money to shrink the real value of the debts that have been built up.  And rather than direct this new money to the banks for the purpose of expanding consumer debt, cash will eventually be put in the hands of ordinary people for the purpose of debt repayment

 

But if the solution mentioned above represents the direction the market is trending, then investors seeking wealth preservation will have few alternatives but to reduce the amount of government paper they hold.  To me it appears sensible to replace cash and bond holdings with non-depreciating real assets.  The most practical of these are precious metals and within this group the most undervalued appears to be silver.

 

And to the extent we hold any bonds at all, let us hold inflation indexed bonds or shorter maturities which afford greater principal protection.  Let us not go like PIIGS to slaughter.