Market participants’ nose for conflict, figuratively for blood, has kept them well occupied this year with the constant scrapping in Europe and the US on debt issues. Long-term, however, investors carry a sober lesson away from the skirmishing: government debt has lost its reliability.
To quote an esteemed American colleague, the US labor market report for June of last Friday contained “no silver lining at all.” Only 18,000 new jobs added, an unemployment rate creeping upward for the third month in a row and downward revisions of previous employment data. Even starry-eyed forecasters have begun trimming their growth forecasts for the US economy. Whether the “soft patch” is becoming “softer” or “patchier” is left for economists to debate. It took not even a day, however, and market participants were again tooth and claw into the European sovereign debt crisis, with Italy the newest prey.
The whole first part of 2011 has been like this: hopping back and forth from one potential risk to the next, from Europe and its sovereign debts issues to the US and its growth and debt issues. From the outside it appears a competition is taking place between Europe and the US. The sides point fingers across the Atlantic, taunting “You’re uglier!” Many US market participants are aghast at the amount of debt in some European peripheral countries; they mock European politicians as lacking the will to decide, the courage to attack problems at the heart.
Europeans counter these charges by arguing that the US shrouds its own problems with statistics which obscure the true size of the government debt. Moreover, US politicians play with fire, when – as in the present debate about the debt ceiling – some even consider a technical, temporary default by the US as a means to achieve certain goals.
Finally, European politicians get incensed at “Anglo-American” rating agencies and accuse them of exacerbating the European peripheral debt issue. As a Swiss, hence neutral and unbiased, one first notices that the piles of public debt on both sides of the Atlantic are of the same order of magnitude. The approaches to mitigate the debt problems, however, are quite different. Basically there are four possible ways to reduce a debt-to-GDP ratio: austerity (more government revenues, less government spending), inflation, higher economic growth, and default. So far Europe has played the austerity card and – in the case of Greece – is likely to play the default card down the road. The US, on the other hand, has bet on a yet-to-come recovery, and by monetizing some of the debt is also playing the inflation card.
For investors, these different approaches to ease public debt problems ultimately boil down to a choice between a long erosion of the real value of the investment through inflation, in the case of the US, or to a quick loss through default in the case of the European periphery. Thus in both cases the attractiveness of sovereign debt as a safe investment vanishes. We can only repeat our mantra (all together now): avoid long-term government bonds.
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