Jun 2

“Obscure Deleveraging” and Your Company’s Portfolio


Soon after I wrote about the ‘Restructuring Dance’ helping to maintain the climate of greed in financial markets, the cycle swiftly turned.

The ‘Dance’ ended quickly as none of the dancers requiring restructuring took to the floor.
Neither Greece, nor other highly levered sovereign credits, nor Wall Street, nor the rating agencies took the restructuring tango.  With no other good solution posed and no restructuring in the offing, the markets quickly entered fear mode.
But, it was deep concern more than fear that emanated from the participants at our company’s recent Insurer Investment Forum X.  Although some saw opportunity within the growing clouds in financial markets, many indicated concern for what may occur in the months ahead.
It is quickly becoming apparent that although the ‘lifeguards’ (governments) have rescued the banking sector to some degree, the major issue now is ‘who will rescue the lifeguards?’
At IIF VIII (March, 2008), I noted that we should expect, “The Greatest Deleveraging in the History of the World.”  Then, at IIF IX (March, 2009), I observed that the governments have followed the greatest deleveraging with the greatest re-leveraging.
Now at IIF X, I noted that we are entering ‘Obscure Deleveraging’.  If you think understanding the financial statements of a large financial concern is difficult (especially those with material off balance sheet and contingent liabilities), imagine trying to understand the financials of a government (with even more off balance sheet and contingent liabilities).
Fully understanding the amount and timing of the ‘Obscure Deleveraging’ at the governmental level and its impact on their close cousin – the banking system – will be a key tool in understanding the future of the global economy.  And, I do mean global economy.
As the US economy has recovered from recession, its respite from recession may be limited in size due to a global slowdown. The Economic Cycle Research Institute’s latest Weekly Leading Index (WLI) tells us to expect materially slower growth towards the end of this year.
“The downturn in WLI growth evident since early 2010 has recently intensified, so it should be no surprise when U.S. economic growth slows noticeably in the months ahead,” said Lakshman Achuthan, managing director of ECRI.
Economic slowdowns in the U.S. have usually been accompanied with rather specific trends in equities, credit spreads, etc.
Meanwhile, one of the best overviews of what is happening in Europe, can be found on a recent Yves Smith’s article.  The picture isn’t pretty with Spain a large potential problem – if not the Euro banks due to their sovereign holdings.
In Asia, Japan grapples with its own set of problems, beset by deflationary trends, an aging demographic and growing debt (perhaps sounding like the US in the near future?).
But, what of China?
Our final speaker of the day, Professor Patrick Chovanec spoke to us live from Beijing, and outlined the problems facing the soon to be second largest economy in the world. A real estate bubble similar to the US bubble but mostly accomplished without large amounts of debt; and an overheating economy that received a 1/3 increase in money supply to offset the Great Recession outside its borders are just the start.
Most likely, stability is very important to the ruling Communist Party, and stability is quite difficult when trying to rein in runaway real estate prices and banks following ‘extend and pretend’ to the n-th degree.
Other speakers at the conference provided a glimpse of what to expect from the regulators, AM Best and the auditors (yes, we discussed mark to market and the move to IFRS – look out).  But, we also heard about silver linings to be found in many insurer’s commercial mortgage portfolios (versus those found at banks where underwriting standards slipped materially) and in opportunities (albeit a few basis points) in short term investments.
But the issues of what to expect in the uncertain times of ‘Obscure Deleveraging’ remain.
We also should not forget the deleveraging being forced upon state and municipal governments in the US – we now tax bottled water, candy and gum in WA. Nor should we be surprised by increasing civil protests and violence related to cuts in government services. Financial populism will undoubtedly rear its head in short order, as we noted over a year ago.
For insurers, “Obscure Deleveraging” raises several issues, including:
What should our equity v fixed income allocation be? A slowing economy, coupled with disinflation and/or the threat of deflation, should mean downward pressure on rates (perhaps offset by rising spreads). But, such a scenario may wreak havoc on expected equity returns. If deleveraging lasts a long time, that may impinge on future expected equity returns for some time.
And, if we are concerned about ‘obscure deleveraging’, should we not try to avoid or materially reduce investments in those sectors directly facing such activities?
First in line, of course, would be deleveraging governmental entities, but next, in line, I believe, would be large financials – owners of those government bonds and obfuscators of sufficient disclosure of their financial risks.
This becomes a more important issue with the highly likely passage of ‘financial industry reform’ in the US Congress. As I understand it, the likelihood is that there will be no protection afforded investors in these financials’ debt, such as we saw in the last major bailout by the government.
That means, the financials must stand on their own…but on what ground?
It is difficult to understand their ability to stand on their own when there is way too little disclosure of the risks and way too much obfuscation of off balance sheet and contingent exposures. This new law, coupled with continued obfuscation on financial reports, will undoubtedly make investment in the financial sector’s bonds or equities an increasingly dicey proposition.
Of course, all is not ‘doom and gloom’.  We’ve noted a US slowdown, not a recession, despite global issues.
However, in a world of ‘Obscure Deleveraging’, we must simultaneously plan for the most likely – low, slow growth in the US. – while considering a reasonable ’worst case’ scenario.
Our ability to do that was perhaps best challenged by F. Scott Fitzgerald.  Writing in 1936, as the world struggled to exit the icy grip of the Great Recession, he correctly provided the backdrop for portfolio management today:
“The test of a first-rate intelligence is the ability to hold two opposed ideas in the mind at the same time, and still retain the ability to function.”