Thursday, 8 April 2010

The one where Tyler predicts the future.

This is just an excercise, but I'm going to be right, so there. I'd trust me.

Gilts are going to get a shooing, and it's going to set off a UK death spiral much like that of Greece. Especiallyif Labour hang on to power at the election, as no one trusts them to actually reduce the deficit till forced to.

What will happen?

Not sure the exact mechanics, and it might take some time, but my guess is it will go a little something like this (with apologies to RUN DMC);

Gilt yields are already near all time lows. Gilt issuance is running near all time highs. Inflation is a mixed bag, but could easily spike. Base rate is as low as it can go, so there will be no help there for a long Gilt position. QE has been spent, and at some point will need to be unwound.

Unsurprisingly, many players have already been unloading their Gilts - before QE started 10y were at 3.70%, and now, despite the BoE buying the entire years issuance and more up, they've still managed to sell off...they now trade 4.05%. The money these guys have liberated from their Gilt positions has gone straight into equities. Why the hell do you think they were rallying so much - it's not because the world is suddenly a pretty place. It's jsut asset allocation.

So here's the rub. We now have a situation where governments worldwide are issuing huge amounts more debt, yet pension funds are being more selective about what, and the amounts they buy. For some countries, with sound economies and decent deficit reduction plans, this won't prove a problem. Germany comes to mind, and many of the EM countries.

But for some countries, it will. Greece is the current ongoing example, but I think the UK could easily fall victim as well. People jsut aren't really taking the problem seriously enough, as the general public haven't felt enough pain yet, and there is an election on. Portugal, SPain and Italy could also fall, though I think the Baltic states, Ireland, Iceland and Hungary have all had to take their medicine early, with either internal or external devaluations. Which make people a lot poorer.

So, back to the UK. If the deficit isn't brought under control rapidly, this is what I think will happen. Gilt yields will start to drift up, until there is some kind of market reaction. The market doesn't have the same fear about the UK as it does Greece, but that isn't really the dangerous part. Nor is that the UKs national debt will have tripled, and interest payments will hit around £75bn in 2015 from £35bn now.

What will cause the problem, is that politicians, especially Labour, would try to issue more debt to cover existing debt, to maintan spending, whilst the interest payments are going up, and growth hasn't yet picked up enough. It's called a debt trap.

In itself, the UK will never go bankrupt, and the increase in interest payments is manageable. That isn't where the danger lies though. Rates will start to go up, as investors demand more risk premium, and it's the secondary market where the real crisis is brewing.

I'm not sure what the trigger will be. It could be the Chinese bubble bursting. My guess though, is that rising rates, and large mortgage resets will cause a nasty shock to the £1300bn of outstanding mortgages we have in the UK. If times aer already tough, and disposable incomes are reduced, having 10y rates creep up by 1-2% will push mortgage rates up by roughly double that.

The intial effects will be more saving (as people store up cash to get through hard times ahead. We are already seeing this), then squeezed disposable incomes leading to lower sales figures, and then finally we'll see a flurry of defaults on home lending. Basically a smaller version of the US subprime collapse.

This will in turn depress house prices and stocks, and growth will get smashed hard. All the spending to get the economy out of recession will have actually mired it in something worse, as there will be no room to really manouver. Tax reciepts will drop, and budget deficits will again explode, forcing Gilt yields again higher.

The great deleveraging will have begun. it won't be pretty.

So, to my absolute predictions.

10y Gilts will sell off. Whatever happens. I expect them to trade to 6.50-7.00% at least in a crisis, or 5.50% if things don't go so badly.

Sterling will probably trade up to 1.60 vs $ intially, but I don't give it much room to go past that (unes sthe US debt balloon bursts first, at which point I'd go and invest in a generator, barbed wire, tinned food, a water purifier, shotgun and some big angry dogs. When the looting starts, you'll be ready). If the Uk does death spiral, I can see Cable as low as 1.25.

FTSE will probably trade up to around the 6100 mark. I'd look for a couple of false tops followed by quick reversals as part of my group of indicators. A selloff could go anywhere, but through 5000 is probably a given. If it is really bad, and it looks liek we will have a full on delever, or worse still, a situation like Japan, it could go to 3500.

So, I'm a bear.

Where would I invest? I'd look at things from a fundamental point of view. Look for countries with low debt stocks, smaller budget deficits and room for real economic growth. Ideally with relatively low tax burdens as well. Effectively look for places where there is enough room for manouver should things go wrong again. Some of Latam, non-Japan Asia and South Africa are good places to start. India as well, though I would avoid China. It's too opaque, and I think that there is a huge bubble being blown up there.

I'll finish here. This is Tyler prediciting the future, it's not investment advice. Though I think I'm going to be proved 90% correct over the next 2 years or so.

You read it here first people.

Tyler out.

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