Seoul, South Korea -- (SBWIRE) -- 01/07/2011 -- 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.