/ 28 June 2011

Turning risk on its head

With the US at risk of default, bonds and cash are a bigger risk than you realise.

At a recent presentation, Chris Hart, chief strategist at Investment Solutions challenged the current notion of risk and what we consider “risky” assets.

In a global environment where many countries, the United States included, are so indebted as to raise the question of defaulting on their sovereign debt, one could argue that shares (or debt) held in individual companies are actually a safer bet than government bonds.

At the same time most developed economies are running negative interest rates , so cash is effectively delivering a negative return after inflation: cash loses you money.

Add into this mix the fact that we are all living longer and the inflation rate for retirees is substantially higher than the official inflation rate due to higher medical costs, and the idea of bonds and cash as ‘risk-free’ savings is turned on its head.

While in the short-term cash may offer some capital protection, the volatility of interest rates combined with its inability to keep pace with inflation makes it a significant risky asset for retirement savings. As a result savers are forced to put their money at risk in order to seek growth that will outpace inflation.

“Equities may not guarantee you a return above inflation, but at least they give you a fighting chance,” says Hart.

Plundering the savers
In this economic climate where further debt seems to be the only solution put forward by governments to dig themselves out of debt, Hart says savers have become a pot of money to be plundered by low interest rates and higher tax rates.

At current interest rates a logical response would be to spend your money rather than save it. This is of course exactly what the governments of developed economies are hoping their citizens will do because economic growth is driven by debt, not savings.

Hart argues that the way GDP is calculated is what drives this debt cycle. There is no differential between growth through wealth creation or wealth through spending. If an economy is growing by 5%, no one is asking about the quality of that growth and whether it is eroding the savings base (balance sheet) of the country.

Hart argues that investors should be looking at the balance sheet of the economy rather than simply the growth rate; it is easy to stimulate an economy with cheap money and debt, but it is not sustainable. Hart says a country like Zambia is lower risk than the United Kingdom as Zambia’s growth is driven by wealth creation, not spending.

End of the welfare state
Developed countries have been overspending for too long, driven by an election process which, Hart argues, is about offering voters ‘a packet of goodies’ where voters elect those governments that offer them the best selection of freebies. Greece has now reached a point where it can no longer deliver those goodies and America is not far behind.

Hart believes that the US is on the road to sovereign default. If congress does not lift the ceiling on the US’s credit line allowing it to borrow more, the country may very well default on this sovereign debt (US treasuries). However by borrowing more, the US runs the risk of becoming indebted to a level from which it will not be able to recover.

The only solution is for governments to cut back dramatically on social spending and therefore Hart predicts that the next big economic event will be the end of the welfare state.

Read more news, blogs, tips and Q&As in our Smart Money section. Post questions on the site for independent and researched information