‘Wriggly’ believe it or not – Few rich nations now boast what we would call a margin of safety
If a company’s stockmarket valuation stands at a significant discount to its fundamental worth, then investors enjoy not only the potential for share price appreciation but also some protection against the impact of adverse events. This so-called ‘margin of safety’ is integral to the appeal of value investing and so it was interesting to see The Economist tackle something similar – only at a national level.
In A tight squeeze, it argues many countries used up so much policy firepower responding to the financial crisis – cutting interest rates, introducing quantitative easing (QE) and so on – that “should recession strike again, as inevitably it will, rich countries in particular will be ill-equipped to fend it off”. In other words, they have little margin of safety or, as The Economist puts it, “wriggle room”.
The piece uses International Monetary Fund (IMF) data to build “a composite measure of debt, deficits and interest rates – the weapons policymakers typically wield to dispel threatening conditions” – and then rank 22 leading nations. “Though crude, the analysis yields a clear and troubling conclusion.” it says. “A few economies could mount a robust defence against a new shock, but most are sitting ducks.”
On interest rates, for example, countries would receive a maximum score of 100 for having the wriggle room of rates of 10% or more, falling to zero for rates of zero or less. The Federal Reserve’s main policy rate of 9% before the recession of the early 1990s and just over 6% before the 2001 downturn would have scored the US 90 and 60 respectively. Today’s rate of 0.125% nets it just a single point.
The Economist notes that, at the beginning of 2007, the average central bank policy rate among the countries in its table was just under 4%. At the time that was seen as low by historical standards and yet now the average rate for developed nations is 0.3%. For the record, Australia scores highest in the table on this measure, gaining 25 points, while Sweden and Switzerland score zero for having negative rates.
Moving on to government borrowing, the wriggle room scores run from a maximum of 100 if a country can run a budget surplus of 5% or more down to zero for deficits of 15% or greater. Here scores range from the full 100 (Norway) down to 44 (Japan) but, overall, the picture is more encouraging than it was for interest rates, with the average budget deficit having fallen from 6% of GDP in 2010 to 2% today.
Things turn bleaker when public debt is added into the mix, with debt as a share of a country’s GDP on average 50% higher than it was before the crisis. In the table, Norway again scores the maximum 100 as, in the view of the IMF, it could borrow a further 250% of GDP or more. On the other hand, Greece, Italy and Japan are judged by the IMF to be “testing the market’s faith” and so all score zero.
Once the scores are combined, the table is topped by Norway, followed by South Korea and Australia. Overall, however, it shows most countries have a lot less room for manoeuvre than they did before the crisis. “On average, the rich world’s wriggle room has fallen by about a third since 2007,” notesThe Economist. “The leeway of hard-pressed countries such as Italy and Spain has shrunk by nearly half.”
Now clearly – and as the article itself concedes – these crude numbers may be instructive but they do not settle the question of which countries have run out of economic firepower. After all, the IMF felt Japan had no fiscal wriggle room back in 2007 when its debt-to-GDP ratio stood at 183%. Since then, of course, it has continued to borrow heavily and has embarked on an enormous programme of QE.
As The Value Perspective observed in Bonderland: “The aims behind low or negative rates and other elements of QE are well-known – to encourage people to save less and spend more, to reduce the cost of corporate debt, to spur growth, to create a ‘wealth effect’ and so on.” We went on to express our concern about the number of central banks that had chosen to embark down this path.
That concern has only been deepened by the conclusion of The Economist article that “the experience of Japan, where the central bank now owns almost 30% of the public debt, suggests markets will tolerate much more QE than economists had thought. Wriggle room seems to expand with central banks’ readiness to print money”.
So the world’s central banks really ought to be replenishing their arsenals of economic ammunition to improve their chances of fighting off the next recession and yet clearly they believe their only chance of keeping a recession at bay is to fire off what few bullets they have left. There is an element of chicken and egg here – or perhaps just chicken, as in ‘World’s most dangerous game of …’
Is this a bad time to remind you that few economies have ever gone more than a decade without falling into recession and that the US, the world’s largest, has been growing constantly since 2009? Either way, the risks are building ever higher as – if you will permit us one final metaphor – the QE merry-go-round spins ever faster and those on board find it ever harder to get off.
Here on The Value Perspective, we are seeing inflated prices across many different asset classes but, as ever, we will let valuation be our guide. We will continue to root out businesses with low absolute, as opposed to relative, valuations and with strong balance sheets that can still provide us with the sort of wriggle room that so many developed nations apparently now lack.
Fund Manager, Equity Value
I joined Schroders in 2001, initially working as part of the Pan European research team providing insight and analysis on a broad range of sectors from Transport and Aerospace to Mining and Chemicals. In 2006, Kevin Murphy and I took over management of a fund that seeks to identify and exploit deeply out of favour investment opportunities. In 2010, Kevin and I also took over management of the team's flagship UK value fund seeking to offer income and capital growth.
The views and opinions displayed are those of Nick Kirrage, Andrew Lyddon, Kevin Murphy, Andrew Williams, Andrew Evans, Simon Adler, Juan Torres Rodriguez, Liam Nunn, Vera German and Roberta Barr, members of the Schroder Global Value Equity Team (the Value Perspective Team), and other independent commentators where stated.
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