Salamat Shaw Capital Management Korea: Portfolio Recommendations

We have made no changes in our portfolios this month.
The latest developments in the government debt
markets have increased the uncertainties about
prospects for both the bond and financial markets.
However, although the pace of the global economic
recovery may be affected, there appears to be enough
momentum to enable it to continue.

We have therefore maintained the level of our exposure
to the equity markets; and we have left 10% of the funds
in the portfolio in cash deposits as a contingency
measure. Bond exposure is zero.

Shaw Capital Management Korea: Portfolio
Recommendations - The UK Hung Parliament

The bond markets are totally calm about the hung
Parliament, as they are about both UK and US bond
prospects, with yields still below 4%, in spite of the
huge deficits both countries are running.

What is going on?

The first point is that both countries are recovering,
and seem set for growth rates in the 2–3% range.
Such growth is not ‘V-shaped’ but a V was unlikely
given the shortage of oil and raw materials, which
continues to limit world recovery potential. It does
give a prospect of improving tax revenues and falling
benefit expenditures.
As growth goes forward it will be possible to work out
more accurately how much of the current deficit is
‘structural’ — i.e. will not disappear with returning
growth.

For the UK the current estimate is that about 8% of
GDP is structural: still requiring a huge programme of
retrenchment.

The second point is that neither the UK nor the US has
ever formally defaulted in modern times.

Indeed for the UK, they can date this from the end of
the Napoleonic Wars when public debt reached around
300% of GDP.

The third point is the new unwillingness to use higher
inflation to bring down the debt in real value. Inflation
(implying an ‘inflation tax’ on government monetary
liabilities which thereby lose their value) is now
proscribed after the poor experiences of developed
countries during the ‘great inflation’ of the 1970s.
Electorates have rejoiced at the new inflation targeting
policies that have formally ended governments’
experiments with this form of taxation.
The electorates hated the messy and unintended
redistributions of wealth this tax implied — often from
the weak such as pensioners to the wealthy and the
unionized.

In this context bond markets have treated Mr. Obama’s
delays and the UK’s election result as simply policy
deferred.

In that they are likely to be right.

Shaw Capital Management Korea: Portfolio
Recommendations - The state of the eurozone

By contrast the situation in the euro-zone looks
increasingly difficult.

The problem is that Greece and Portugal — the two
main current problem cases — joined the euro in the
expectation that low interest rates would keep their
public finances under control.

Internally these countries have difficulty in raising
taxes and curbing expenditure but joining the EU and
then the euro gave them the authority to insist on fiscal
discipline as the ‘price’ of joining.

Now the discipline is becoming harsh and yet interest
rate premia are rising, as the risk of default increases.
Germany and the other euro-zone countries are
unwilling to transfer resources to them — and even to
provide loans on terms below these market rates.
Germany’s position in particular has hardened
massively under hostile home reactions to perceived
‘bail-out’.

Germany is simply unwilling to make transfers after
the huge costs of its integration policies for East
Germany.

There will come a point where the advantages of being
in the euro are outweighed by the disadvantages for a
country like Greece.

Once interest rate premia get high enough inside the
euro, the attraction of floating the currency down
outside it and still paying similar interest rates will
become overwhelming to governments faced with
public hostility to further sacrifice.

A large devaluation is a way of allowing the economy
to recover and produce extra revenue.
Furthermore reintroducing the local currency will
allow the government to re-denominate the debt in
that new sovereign currency … so effecting a de facto
partial default.

These exits would not spell the end of the euro. But
they will remind markets that the euro is bound
together by political convenience only and not by some
deep commitment to European integration.
Up to now there has been a general belief in such a
commitment; however, Germany’s recent actions have
destroyed this belief.

It was this belief that kept interest rate premia down
on sovereign debt of euro-zone countries; rather like
the debt of UK local authorities — formally underwritten
by the UK government, it was felt that these countries’
debt was being implicitly underwritten by other eurozone
members. No longer.

But of course what can happen to Greece could happen
to any other country. If so its risk premia too would
rise and it too would face the same trade-off between
staying in or exiting with the freedom to float at similar
interest rates outside.

Hence the chances of more break-up would get larger
and the system would become gradually closer to a
system of ‘fixed but adjustable’ exchange rates like the
old European Monetary System.