'Sovereign debt market is now in long-term decline'

France and the death of the sovereign debt market

Investors will seek other safe havens

So where was the carnage?

Market Watch,
18 January, 2012

Late last Friday night, the ratings agency Standard & Poor’s delivered its downgrade of French debt, stripping one of the world’s biggest economies of its AAA rating.

Over the weekend, it wasn’t hard to imagine the cataclysm that would follow. After all, the news could hardly be more worrying. The French debt market is one of the largest in the world — with $1.6 trillion of debt outstanding, France is the world’s fourth-largest sovereign borrower.

With its AAA rating gone, all the schemes for rescuing the euro lay in tatters: they all depended on leveraging up the credit-worthy members of the euro to help the peripheral nations, but Germany is now the only major country with a AAA rating, and can’t be expected to bail the whole continent out. The single currency may now be unsalvageable.

Worse, Nicolas Sarkozy’s campaign for re-election as president now looks hopeless. He pledged himself to maintaining the AAA rating, arguing that it was a matter of national prestige, but failed in that as so much else. He will be replaced either by Francois Hollande, an old-fashioned ”borrow-and-spend” socialist who has been making campaign promises as if austerity had never been invented. Or else by the far-right Marine Le Pen, who has promised to restore the franc, a move that would provoke an immediate financial crisis and a run on the French banking system.

There wasn’t any other way to spin it. The downgrade looked like a disaster. But in fact, there was very little reaction. The euro   wobbled a touch. The CAC-40  dropped a few points, then recovered. Yields on French debt nudged up a touch, but no more than they might on a normal day’s trading. Why wasn’t it worse? In reality, ratings downgrades are losing their power to shock us. It is a bit like watching Friday the 13th Part 27. Once you seen a couple of teenagers get gorily dismembered, the next few don’t seem very surprising.

What the French downgrade really signaled was the slow death of the sovereign bond market — and each chapter in that saga is a bit less surprising. Japan’s AAA rating is gone. So is the U.S.’s. Italy’s went a long time ago, and now France’s. The U.K. can’t be far behind. Neither can Germany.

The markets are gradually getting used to the idea that sovereign debt is not safe at all. None of the top five sovereign borrowers — the U.S., Japan, Italy, France and China — are AAA rated anymore. All of them are still running big budget deficits, and show little sign of bringing them seriously under control. If these debts are ever going to get repaid, not only do the deficits have to stop, governments actually have to run surpluses for many years. There is about as much chance of Angela Merkel buying a holiday home in Kos as that happening any time soon.

Only two things can happen from here. Either governments are going to default outright. Or they are going inflate away their debts, using compliant central banks to keep interest rates significantly below rising prices for many years. Either way, everyone is going to lose a lot of money. Whether it is through a default or inflation doesn’t make much difference in the medium term.

There are already signs that investors are starting to realize that. Sovereign debt used to be regarded as an absolutely safe asset, holding the same place in the financial system that gold once did.

What the French downgrade tells us is that that is no longer true. Over time, investors are going to rebalance their portfolios completely to take account of that.

That will lead to two big changes.

First, governments will have to pay a lot more to borrow. It’s already happening. Italy has to pay almost 7% to borrow 10-year money. France has to pay more than 3%. Germany, Japan, and the U.S. can still borrow money at near record low rates. But that is not going to last forever. What we are watching is a bubble bursting in slow-motion. It will move from country to country. The euro zone may be the first in the firing line, but it won’t be the last, nor will it be restricted to Europe. By 2020, interest rates of 7% or more will be common for all the developed countries. The era of cheap government borrowing will slowly come to an end.

Second, money will flow into new safe assets.

What will those be? A mixture of emerging market debt, gold, corporate bonds and blue-chip equities. The switch from the developed world to the emerging markets is already well underway. Whilst developed world ratings are being cut, in other markets they are going in the other direction. Since 2002, Italy has lost five rating notches, and Spain four. Russia is up three and Turkey is up four. It isn’t hard to work out which is the better bet.

Likewise, gold is reasserting itself. Central banks are stockpiling the precious metal again. In 2011 they were buying in record quantities, with countries such as Russia and Thailand leading the way. When interest rates are as close to zero as makes no difference, and central banks are printing money, the precious metal will always reassert itself as the ultimate store of value.

Finally, corporate bonds and blue-chip equities are naturally going to suffer in a recession, but once growth resumes will reassert themselves. They grow at least as fast as the economy, and they pay a regular income.

France reminded us that the sovereign debt market is now in long-term decline. The most important move for investors will be to make sure they get on the right side of that trade — and that means getting out of all developed world government debt, and into the new safe assets.

Matthew Lynn is chief executive of Strategy Economics, a London-based consultancy. His latest book, ‘The Long Depression: The Slump of 2008-2031’ is published by Endeavour Press