With any luck, you won’t be hearing from me for the next couple of weeks. So I thought I’d distill some of the themes that I’ve discussed in the past 6 months into terms as simple as possible. For it is when things are simplified that their full import is crystallized.

The US is basically embroiled in a domestic argument about the household finances. One party points at overspending, the other at overtaxing. Both accusations are but duals of each other, evidence of the poor management of the government and economy, testament to a government and people who have for too long simply lived beyond their means. (For details look at nominal GDP less debt, aggregate and per capita, and also look at the same on an inflation adjusted basis. Its quite depressing, showing an economy that has hardly progressed in over a decade.)

You can borrow from you neighbours, you can borrow from your friends, your relatives, loan sharks, other insolvent creditors, but ultimately all borrowing borrows from the future, mostly your own future. For some countries likeGreece, Ireland, Portugal, Italy, Spain, Belgium, the USA, the future is at the door.

For the Greeks, the problem is doubly acute but no more or less complex. They too have simply lived beyond their means and borrowed from their European brethren for a generation or two down the road. Many peoples have lived beyond their means. All the countries whose CDS spreads have surged are simply facing the cold judgment of the market.

The Emerging Markets have so far seemed quite clever and immune. That said, even they have expanded their sovereign balance sheets in an attempt to help stabilize a world which in 2008 seemed to have no future to borrow from.

The future seems especially bleak this last week as the market picked on Greece, on Italy and on European equities in general just as the credit ratings agencies in all their forward looking wisdom downgraded Ireland and prepared to downgrade the USA.

But this will pass. Economies have cycles, so do markets. The evolution of a time series consists of the aggregation of cycles of varying wavelengths from ticks to days to months to years. While the gloom will pass, probably within the next two weeks, this is not the time to be complacent. Risky assets cannot trend up unless either 1) central banks resume a wholesale debasement of fiat currency, or 2) there is a real improvement in economic fundamentals.

The former stores downside for the future. The latter will not occur for some years yet, 5 – 6 at the earliest. Why? The sheer scale of the problem, the track record of the economy even in the boom years leading up to 2007 if properly accounted for, various vested interests, governments which either do not or soon will not have the mandate from the people… to name a few. The political consequences bear some thought. The Weimer Republic fell under the weight of hyperinflation and ushered in an era under the leadership of a democratically elected lunatic.

Printing of money is likely to resume in earnest within the next 6 months. This is over and above the coercion of banks to abet a continuation of debt monetization which apparently was to end in June 2011.

A tangent. Whilst previous sovereign crises have always found ad hoc solutions, not always wise ones, the near systemic scale of the current one is likely, or if not likely, should trigger an interest in an internationally accepted equivalent of the Chapter 11 process. It is certainly sorely needed.

What of the bright spots in the global economy likeChina, India and Brazil? It is reasonable to expect China’s economy to truly be in rude health. It is even justified to say that a domestic consumer driven evolution is already well underway. To see this, simply separate out entire low cost manufacturing regions and designate these the 52nd state of the USA. This actually brings balance between China and the USA, except that these poor regions are RMB based and are basically being deliberately underpaid by both American and Coastal Chinese alike.

The implications of Globalization have not been sufficiently developed or have been forgotten. Businesses have become increasingly global making the association between a company and its country of origin or domicile increasingly irrelevant or misleading. Many European companies operate globally some even with decentralized regional decision making centres.

Despite a generally gloomy outlook for global growth, the dispersion in growth rates between developed, developing and frontier markets provides potential opportunities for the globalized business in the hands of enlightened management. Production can often be compartmentalized and sent to where the demand is. Research can be located close to centres of relevant academic excellence. The internet increasingly brings goods and services across borders.

Despite a generally difficult investment environment, the dispersion of returns between companies with differing positions within this globalized context provides the enlightened investor ample opportunity for profit.

These opportunities are the continuing evolution of our global economy. Human ingenuity almost guarantees a recovery at some point in time, at the global level. The winners and losers are another matter. The job of identifying these opportunities is non-trivial and will keep some of us in gainful employment. We hope.

The problems that exist today have a deeper cause. They are rooted in moral hazard and a culture of entitlement. Too many people have lived beyond their means. This has been inculcated by a society that over-protects. The solution requires an admission of the root cause followed by a change in mindset and then a policy of financial education beginning at an early age.

People need to realize that public goods come at a price. We can transfer or share the cost but we cannot make it go away. Military might, law enforcement, basic education, medical care, unemployment insurance, and other public goods and services all have a price which must be paid for. Households who do not understand the basic principles of economics will elect leaders who either themselves do not understand economics or worse, prey on their electorate’s lack of understanding.

The prospects for constructive change are therefore poor, and at best such change will take a long time, at least a generation.

In the shorter term, it is unwise to write off significant rallies in risky assets, or indeed local improvements in economic growth. An example is illustrative. It wo
uld be advantageous for the US to default on its debt if it did not have to bear the consequences of that default (in the form of higher borrowing costs for example.) For a JPY or CHF denominated investor, however, the US government has effectively already defaulted on its treasury debt with a recovery of some 60-70%. It may not be long, especially if the USD was to fall further, before the US could produce some basic goods more cheaply than some of their current trading partners. The trade balance could quickly swing into surplus.

The longer term prospects, to reiterate, are poor. The emerging market investors who bought developed world debt will learn that you cannot eat money. They toiled and transferred real wealth in the past two decades to developed economies in return for empty promises written on paper. The developed world will struggle to recover as external investors eschew their debt. Only a captive and or coerced domestic investor will fund their debt. That means more saving and less consuming.
For the astute investor, making sweeping general allocations will be inadequate as this fails to recognize the tapestry of the new globalized world in which we live. Traditional strategies reliant on the accuracy of directional bets are also inefficient on a risk adjusted basis. Delegation to professional alternative investment managers whose mandate is to capture alpha and to filter out beta is a much more secure way of making money. Yet even here the talent scouting is difficult and even long track records are confounded by the new reality. There are no easy answers. The investor must reason for themselves, applying common sense, exercising due care and a healthy skepticism, but most of all studying the causes of phenomena and making up their own minds based on knowledge.

Fortunately, the future is not written and I might be wrong, and we may against the odds embark on an era of growth and prosperity. If I am wrong.

In a commercial case, faced with an intransigent debtor, (eschewing austerity, rioting in the streets, railing at creditors), the creditors would file an involuntary petition for a plan of reorganization. That they haven’t in the case of Greece is interesting. (Practicalities notwithstanding.)

It stems from a number of things, not least the nature of sovereign debt, its unsecured nature, the absence of an accepted protocol such as US chapter 11 for dealing with distress and the difficulty in accurately ascertaining the assets of a country, the priority of claim, to name a few.

The only recourse for the creditor who is worried the ability and willingness of the debtor to repay is to protect their position by declining to roll over maturing debt, or to sell the loans before maturity (at the market price of course.) This type of behaviour tends to create contagion as selling pressure leads to price discovery in the secondary and derivative markets, triggering or encouraging further selling.

In the case of Greece, it is interesting that the creditors, private investors like privately owned banks, have not led negotiations with their delinquent borrower, governments have. And the approach of governments is also interesting. They are throwing good money after bad. The exchange offer they propose, subject to certain conditions such as austerity, are not as strong as a defacto debtor-in-possession financing. It is clearly a bailout. A proper reorganization would require Greece to clean house, to establish better enforcement of tax collection, to probably reduce marginal tax rates, to reform the economy, practice fiscal restraint and discipline, to run the country as a better business. No reorganization can save a fundamentally flawed business. There should be a suspension of interest payments on all debt until such plan of reorganization is agreed. A restructuring of debt needs to follow. Interest costs need to be managed but these are a function of creditors’ expectation to be repaid. Some form of collateralization or attachment of cash flows is probably a good idea.

Absent a credible plan, a bailout is a futile and long term counterproductive exercise.

The German people are furious that they may have to bail out Greece. They are furious at any compromise their government may propose or accede to. The Greeks are furious that they may have austerity forced upon them by creditors abroad, or arrogant regulators in Brussels. These are diversions. The German people are not being asked to bail out Greece, they are being asked to bail out German banks, amongst other creditors. The Greeks are not being exsanguinated by rapacious capitalists abroad but by the ineffectiveness of their own government, their own financial irresponsibility and intransigence in the face of financial reality.

Bailouts will do nothing but harm. They will sow the seeds for the next ill advised loan, investment and venture. Financial discipline needs as much stick as carrot. This generation has lived too long with an indulgent lender of last resort, a coddling and cosseting government, that it can no longer fend for itself.

It has been my forecast that the US economy would be in recession in the first half of 2011. If you use an ex Shelter deflator, it just about gets you there. A dynamic economy does not sit in a recession for long unless there are structural inefficiencies. I do not see that for the US and have therefore been seeking signs of an economic recovery .

Where to look? I would have expected the recovery to occur in the export sector. So far I have not found signs of this. In 2008 there was a one time surge in the trade balance towards a less negative balance. Since early 2009 this has reversed and the trend of increasing trade deficit resumed. Since then the trade balance has threatened to bottom in January 2011. Export growth has accelerated over January to April 2011. Import growth has stabilized rather than accelerated in the same period. This provides mild, not overwhelming support for the thesis.

The June 2011 ISM numbers released last week were encouraging, an improvement in the ISM PMI from 53.5 to 55.3. The stock market certainly was encouraged by the data. The data, however, is equivocal.

In manufacturing:

• Prices paid fell from 76.5 to 68.0.
• Production rose from 54.0 to 54.5, hardly significant and significantly weaker than March.
• New orders recorded a paltry improvement from 51.0 to 51.6, well below February’s 68.0.
• Backlog orders fell from 50.5 to 49.0.
• Supplier deliveries improved from 55.7 to 56.3, again a paltry improvement.
• Inventories rose significantly from 48.7 to 54.1, not the most encouraging sign.
• Employment showed a more encouraging increase from 58.2 to 59.9.
• Export orders fell from 55.0 to 53.5. Imports fell from 54.5 to 51.0.
• Quite how the above numbers translated into an improvement in the PMI I struggle to understand.

In non manufacturing the picture was just as ambiguous.

And so the search for a fundamental underpinning for a stronger economy goes on…

It is never a trivial exercise to guess the direction of markets and asset classes. The best investment managers barely get it right more than half of the time. They make money because they are tactical and quick to cut losing positions and let winners ride, or they find trade expressions which give them an edge such as where there is convexity, or they find arbitrage opportunities where they build in their edge structurally. With that in mind, I will venture into speculation.

Sentiment has improved once again. A number of factors have contributed to this:

• A possible Greek sovereign debt default has been averted. The solution is neither perfect, nor sound but it is adequate for Europe’s purposes for now.
• China has announced victory over inflation and represented that it has successfully engineered a soft landing.
• The US economy while it has weakened significantly in the last quarter appears to have some bright spots, notably in the ISM numbers.
• The rate of decline of the US housing market looks to have stopped accelerating.
• The Fed has called to a close QE2 and has not seen the need for a further round of quantitative easing.
• Oil prices have fallen from recent peaks to more manageable levels in the low to mid 90’s.

Sentiment alone can carry equity markets and risk assets a few months, call it 3 at the most. And it can still easily falter much earlier than that. Thereafter some fundamental or liquidity reasons are needed to sustain any rally. So let’s try to find some fundamental or liquidity support for risk assets.

Which of the problems from before 2008 have been resolved or addressed adequately?

• The US housing bubble is still deflating. There is little that the government can do except buy time. Or buy houses. The latter strategy is not as ridiculous as it sounds but will likely face considerable political headwinds. Otherwise, employment and wage growth are necessary conditions for a housing recovery and prospects for both look muted. Two years to a recovery seems to be a reasonable time frame. Without a recovery in employment there is no recovery in housing. Without a recovery in housing, there is no recovery in domestic consumption. The US needs to become an export economy.
• The world is still in deleveraging mode. The deleveraging process has been a complex, path dependent one where leverage has been passed from private to public hands with little paydown or restructuring. In the interim, efforts at releveraging have punctuated the deleveraging. This is no way to manage a deleveraging process. Policymakers have completely overlooked the necessary symmetry of the market mechanism and seek solutions which avoid allocating any form of pain to any constituency of the economy. The taxpayer is not a constituency, it is everyone, and so the strategy represents a socialist redistribution of the damage.
• The Euro clearly imposes differentlal pressures on the different member countries’ economies. Greece’s problems are not entirely due to 2008 but are symptomatic of a more fundamental inefficiency. The temporary solutions sought for Greece’s debt refinancings indicate no recognition by the EU of the inefficiencies imposed by the Euro. The Greek saga is by no means at an end.
• Commodity inflation is a secular trend interrupted by the recession of 2008. The commodity curves show that commodity price inflation is fundamentally supported and not speculative. The inflationary pressures are therefore expected to persist since no concerted solution has been sought.
• China’s credit expansion in response to the 2008 crisis, investment in infrastructure, has been largely funded by credit which has resulted in a surge in credit creation in 2009 and 2010 via SIV like conduits (LGFVs). The government’s efforts to rein in credit in 2011 has apparently addressed these conduits, however, due to the opacity of the market, risks remain, especially given that assets are long term infrastructure debt while liabilities largely consist of retail short term credit linked investment products. The resolution remains to be seen. A recent inspection of Chinese banks’ CDS spreads is not encouraging. It was estimated that the size of the LGFV market totaled over 2 trillion USD.
• Underfunded pensions in the Western world. This is a chronic problem from over 10 years ago which was unfurled in the aftermath of the 2000 recession and which drove pensions into yield, the arms of structured credit and fictitious or more appropriately, imaginary investment grade paper.

It appears that no long term solutions to any of the problems have been sought and that policy has so far been aimed at addressing symptoms rather than underlying fundamentals. The result of this is likely to be increased volatility as each solution to a specific symptom peters out and imbalances find new m
anifestations. In other words, we face a very interesting sentiment, psychology, liquidity and event driven market over the next few years.

We noted that sentiment had improved and that a 3 month rally in risky assets is possible, but is it probable? All speculation of course. Absent government efforts to create a liquidity driven risky asset rally, operate inflationary policies and currency debasement, the reality of the underlying economies should depress markets. The only rational reason that governments have paused such policies is because the market recognizes the funding constraints for sovereigns in pursuing this policy. The market recognizes this in the form of increased reported headline and core inflation, in sovereign credit spreads, in the levels of sovereign debt issuance, on the structure of demand for such government debt and in the forward borrowing requirements of governments. Without these constraints, governments would be diligently printing money and creating inflation.

My best guess:

• The momentum from the recent spate of good news will be short lived. Broad based net long exposure will not help.
• Governments will not be able to resume stimulus due to tight balance sheet constraints.
• Economies have decoupled. Buy the China plays listed and domiciled abroad. Continue to short the China exporters. Note this is quite a stale trade but it has legs. However, if a credit crisis surfaces in China, all bets are off. Keep a close eye on the Chinese shadow banking system. The new exporters from the US to the emerging markets need to be identified (easier said than done.)
• Treasuries will resume their yield compression on bank buying pressure – QE3.
• Agricultural commodities and their derivatives and equities are likely to remain supported. This is simply the resumption of a long term secular trend that was interrupted in 2008. The decoupling between developed and emerging markets is likely to boost secular demand. A slowdown in China and a very weak recovery in the US is unlikely to support the industrial commodities. While the forward curves for industrial metals look strong today, this is probably a lagging indicator and weakness is likely to set in later.
• There is a significant risk of another credit crisis, so trade with caution. The Greek solution is not a good solution. It is a bailout not of the Greek economy but of the Western European banks. A voluntary (sic) exchange offer is not a solution to a poorly run business or country. The fundamentals of the Greek economy require a repricing which the Euro effectively precludes. Contagion risk dominates solvency, particularly where sovereign solvency is concerned because of the problems with defining the assets of the sovereign, namely the capitalized value of the tax base. The level of Chinese debt in off balance sheet vehicles is also worrying especially in light of the opacity and compromised corporate governance associated with Chinese businesses. The US economy still looks recessionary although there are signs that a recovery may be a real prospect in the next few quarters.

The investment world is replete with opinions and scenarios of a Greek sovereign default. Many commentators speak of Greece being insolvent, but what does this mean in the strictly technical sense of the word.

It is difficult to envisage the insolvency of a sovereign. Default, however, is another matter which is related to solvency but neither necessarily follows from the other incontrovertibly.

The issue is explored in an earlier article on Hedged.biz entitled: Sovereign Debt Investing: A Distress Investing Approach

In that article, a sovereign default was considered highly improbable to impossible in the currency of the sovereign. Being written before May 2010, it did not consider the case of a Eurozone sovereign defaulting.

The consequences and implications of a Greek default have now been discussed ad nauseum by many credit experts. The question that remains is not the consequences or implications for the market, for financial systems, fairly dire would be a good approximation, or “good enough for government work” as the Americans say, but what is the nature of the claim held by a sovereign bond holder? In a corporate, the seniority of claim is usually clear. The assets are (hopefully) well defined, as are the liabilities. What are the assets of the sovereign? Apart from the definable assets of the sovereign, such as land, property, licenses, gold, resources, financial assets, operating businesses, foreign reserves, one of the largest assets of the sovereign are tax revenues, appropriately capitalized. This begs the questions what is the meaning of properly capitalized? Can these assets be transferred? Can they be securitized? What claim can possibly be attached to these assets or cash flows?

If these issues are scrutinized and analysed, innovative solutions might be found to the Greek debt problem.