Tuesday, December 1, 2009

Morgan Stanley (MS) Lists UK Sovereign Debt/Currency as Potential "Fat Tail" Risk for 2010

As investors quickly forget about Dubai, and shield their eyes (apparently using now almost limitless US dollars or Japanese yen) from any potential sovereign road bumps ahead [Nov 27, 2009: UK Telegraph - Greece Tests the Limits of Sovereign Debt as it Grinds Toward Slump] Morgan Stanely (MS) Europe is out with an interesting report for 2010 that highlights some "fat tail" risks, one of which is:  UK becomes the first of the G10 to have a major fiscal crisis as elections lead to a hung parliament.

Effectively, very little has been "solved" in terms of fixing root causes the past 2 years; the main solution has been to transfer liabilities from the private sector to the public - we've written about this extensively. [May 19, 2009: Paper Printing Prosperity Defined]  Obviously the public balance sheet is multiple iterations higher than any private balance sheet and its ability to expand is relatively open ended, since a country can lean on its taxpayers.  But eventually there is an end game, and the currencies of said countries will reflect it.  I've often called the UK a mini US... many of the same fiscal policies and Anglo Saxon beliefs and policies, but without either the same amount of natural resources nor the massive benefit of the world's reserve currency. [Apr 23, 2009: Britain's Deficit Reaches World War 2 Levels; Very Little Room to Maneuver] Hence, while their actions have been in almost complete parallel to that of the US, the costs of said actions should be born sooner. 

But as always the question is timing... people who warned on real estate in 2005 were smirked at; those in 2006... openly mocked.  Being "early" does not mean wrong... to steal a line, markets can remain ignorant far longer than you can remain solvent.  So as we take the cancer of debt onto the back of the US taxpayer, let us watch the canary that is the UK... I expect suffocation will happen there first, but even a permabear realist such as I would not believe something dramatic would happen to our neighbors across the Atlantic until mid decade (2015) or later.  In fact, I expect rolling sovereign crisis (plural) to be the "Black Swans" of the 2010s.... all we've done as a globe is kick the can down the road.  But as with any long term warnings based on rational thought, those who worship at the alter of "now is all that matters"  will smirk... again.

Let's see what Morgan Stanley (MS) Europe thinks; while I think its premature based on economics alone, the authors are over laying politics as a potential driver to speed up the potential crisis.  Either way the UK pound seems a very flawed currency... same bad policies as ourselves but no reserve currency status. [Oct 13, 2009: UK Sterling Following US Dollar into Abyss] Keep in mind this report is co-authored by another permabear realist Teun Draaisma [Oct 26, 2009: Teun Draaisma of Morgan Stanley Europe Says Rebound Rally in Last Stage; Prepare for Fallout from Tightening]  Now the irony is.... such a crisis might be very good for equities in the UK... read on. 

  • Britian risks becoming the first country in the G10 bloc of major economies to risk capital flight and a full blown debt crisis over the coming months, according to a client note by Morgan Stanley.
  • Growing fears over a hung parliament would likely weigh on both the currency and gilt yields as it would represent something of a leap into the unknown, and would increase the probability that some of the rating agencies remove the UK's AAA status,” said the report, written by the bank’s European investment team of Ronan Carr, Teun Draaisma, and Graham Secker.
  • In an extreme situation a fiscal crisis could lead to some domestic capital flight, severe pound weakness and a sell-off in UK government bonds. The Bank of England may feel forced to hike rates to shore up confidence in monetary policy and stabilize the currency, threatening the fragile economic recovery,” they said.
  • Morgan Stanley said that such a chain of events could drive up yields on 10-year UK gilts by 150 basis points. This would raise borrowing costs to well over 5pc - the sort of level now confronting Greece, and far higher than costs for Italy, Mexico, or Brazil.
  • High-grade debt from companies such as BP, GSK, or Tesco might command a lower risk premium than UK sovereign debt, once an unthinkable state of affairs.
  • A spike in bond yields would greatly complicate the task of funding Britain’s budget deficit, expected to be the worst of the OECD group next year at 13.3pc of GDP.
  • Investors have been fretting privately for some time that the Bank might have to raise rates before it is ready -- risking a double-dip recession, and an incipient compound-debt spiral – but this the first time a major global investment house has issued such a stark warning.
  • No G10 country has seen its ability to provide emergency stimulus seriously constrained by outside forces since the credit crisis began. It is unclear how markets would respond if they began to question the efficacy of state power.  (utter panic comes to mind)
  • Morgan Stanley said sterling may fall a further 10pc in trade-weighted terms. This would complete the steepest slide in the pound since the industrial revolution, exceeding the 30pc drop from peak to trough after Britain was driven off the Gold Standard in cataclysmic circumstances in 1931.
  • Morgan Stanley said Britain’s travails are one of three “surprises” to expect in 2010. The other two are a dollar rebound, and strong performance by pharmaceutical stocks.
Now here is the irony of such a situation...
  • UK equities would perform reasonably well. Some 65pc of earnings from FTSE companies come from overseas, so they would enjoy a currency windfall gain.
It is going to be the era of multnationals it appears.

Other comments:
  • David Buik, from BGC Partners, said Britain is in particularly bad shape because the tax-take is highly leveraged to the global economic cycle: financial services provided 27pc of revenue in the boom, but has since collapsed. (very similar to how almost all growth in the US in the past decade has been concentrated in the hands of healthcare, or our financial oligarchy; I believe I read 40% of all profit growth in the decade before this collaspe the past 2 years was from financial firms)
  • The UK failed to put aside money in the fat years to offset this time-honoured fiscal cycle. (that should sound familiar to Americans) It ran a budget deficit of 3pc of GPD at the peak of the boom when prudent countries such as Finland and even Spain were running a surplus of over 2pc.
  • We need to raise VAT to 20pc and make seriously dramatic cuts in services that go beyond anything that Alistair Darling or David Cameron are talking about. Nobody seems to have the courage to face up to this,” said Mr Buik.  (we should expect a VAT tax in the US within 2 election cycles ... 4 to 8 years)

Full report below - as always hit "full screen" for easier reading; if you are only interesting on the UK portion go straight to page 14, but the whole report, entitled 'Tougher Times in 2010' is worth a read if time permits.

Morgan Stanley Tougher Times 2010 R1130TD

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