There is no historical precedent for economies as indebted as the EU and U.S. to avoid default, said Gerard Minack, chief market strategist at Morgan Stanley’s Sydney office.
The U.S. public debt-to-GDP ratio stands at 100 percent at the end of June 2011. The EU public debt-to-GDP ratio stood at 80 percent at the end of 2010.
Minack also thinks the default process for the EU and U.S. will not be pretty.
He said past episodes of “successful nation-level deleveraging” only occurred with small, open economies that could devalue their currencies and export their way out of debt. (Moreover, these episodes started from lower debt levels than the EU and U.S.)
However, with giant economies like the U.S. and EU, it is impossible to replicate the “successful” examples, said Minack.
Defaulting in an ugly fashion can happen in two ways: “open default typically associated with recession/depression” or “surreptitious default associated with inflation/hyper-inflation.”
Minack said depression only “scars” a society (e.g. the U.S. Great Depression) while hyper-inflation “destroys” it (e.g. the Weimar Republic).
For the EU and U.S. currently, the only question is when the default will happen, he said.
Minack thinks the default scenario may be a long way off for the U.S.; it is far away enough to not yet alarm the market.
The threat in Europe, however, is more imminent and the market is indeed alarmed over the European debt crisis.
The immediate threat in Europe stems from the lack of fiscal integration and thus the vulnerability of weak Eurozone members like Greece and Portugal.
This is a widely acknowledged problem and some analysts think fiscal integration will solve it. Minack, however, thinks it will only delay the “end-game” of default in Europe.
Minack is also bearish on the U.S. and EU economy in the short-term because of the simultaneous deleveraging of the public and private sector. His base scenario for 2012 is therefore recession with an increased tail risk of deflation.
He added that recession would stymie Europe’s efforts to ring fence its sovereign debt crisis and delay the default “end-game.”
What is the implication of his views for investors?
“In short, the current [risk asset] bounce may persist a little further, but I (and my global strategy colleagues) remain convinced that it's a bounce to sell into,” said Minack.