The Changing Nature of Safe Haven Markets
Written on 05 January 2013
by Ruth Fisher, PhD
Introduction
Safe Havens
Definition
List of Safe Haven Assets
Size of Safe Haven Asset Markets
Downgrading of Countries’ Sovereign Debt Threatens Global Supply of Safe Havens
Estimates of Global Wealth
Global Supply vs. Demand of Safe Haven Assets
Introduction
Since the end of WWII, the United States economy has dominated the global economy. The size of the US economy, together with its continued stability and growth, have occasioned US debt (bonds) to become the ultimate safe haven for global funds seeking refuge from transient bouts of global uncertainty. The continued stability and growth of other developed (OECD) nations have also granted their sovereign debt safe haven status, but in general, US treasuries reign supreme.
However, the debt load of the US government over the past decade has become increasingly unsustainable. Monetization of US debt – in particular, through QE1 – QE3 stimulus programs – has become the only viable means of reducing the debt to sustainable levels. By its very nature, monetization will decrease the value of US debt, thereby reducing its attractiveness as a source of safe haven assets. Given the historical role US bonds have played in global safe haven markets, one is led to wonder which assets will come to replace US debt as the new safe havens.
This analysis examines (i) the nature of safe haven assets, (ii) the approximate availability of safe haven assets, (iii) the approximate amount of global wealth, and (iv) the possibilities for new safe haven assets as US bonds become downgraded.
Safe Havens
Definition
Investopedia defines a safe haven as
An investment that is expected to retain its value or even increase its value in times of market turbulence. Safe havens are sought after by investors to limit their exposure to losses in the event of market downturns. However, what are considered safe havens alter over time as market conditions change, and what appears to be a safe investment in one down market could be a disastrous investment in another down market...
Gold is typically considered a safe haven when currency markets are volatile. United States Treasury Bills are also considered a safe haven even in a tumultuous economic climate because they are backed by the full faith and credit of the U.S. government. In the forex market, the Swiss franc is considered a safe haven currency. Finally, if an entire economic sector is performing poorly but one company within that sector is performing well, its stock could be considered a safe haven.
In contrast, Q Finance defines a safe investment as
an investment unlikely to lose value
an investment such as a bond that is not likely to fall in value
So, in a nutshell, safe haven is a form of safe investment that is generally used to preserve wealth while markets pass through transient periods of relatively high uncertainty.
More generally, though, in “Economic Commentary - September 2012”, Christopher Bremer notes that (I have rearranged the text somewhat; emphasis mine):
Safe havens serve a variety of purposes for investors, regulators and financial institutions in the global economy. In a report earlier this year, the IMF identified four functions of safe haven assets:
• Reliable store of value: investors can rely on the fact that such investments will generally retain their value over a long period of time. Investors expect that investments they regard as safe will hold up during financial turmoil or crisis, cushioning a portfolio that may be subject to losses on riskier assets.
• Collateral in repurchase and derivatives markets: Financial institutions use safe haven assets as collateral in repurchase agreements and in derivatives transactions. These assets serve as a kind of insurance that the terms of an agreement will be fulfilled; if it isn’t, the collateral will be taken.
• Instruments in fulfilling regulatory prudential requirements: Safe haven assets also play a role in financial regulation, as regulators typically require banks and other financial institutions to keep a certain percentage of reserves in the form of specific type of safe haven assets such as U.S. government bonds. Those reserves serve as a cushion if bank investments or loans go bad.
• Pricing benchmarks: financial institutions use Treasury bonds, bills and notes and other financial instruments such as the London Interbank Offer Rate (LIBOR) as a benchmark to fix prices and loan rates.
When assessing whether an investment is a potential safe haven or not, investors use several criteria. According to the IMF, these include low credit or market risk, ample liquidity and limited inflation risk.
List of Safe Haven Assets
Bremer goes on to list assets considered safe havens:
• Gold: “Because gold is a hard asset that has an intrinsic value, unlike other assets such as currencies or stocks, investors traditionally flocked to it during times of economic, political and market turmoil…”
• “Real Estate is another traditional safe haven, again because of its intrinsic value.”
• “The U.S. dollar, as the world’s reserve currency, is also frequently viewed as a safe haven ... Because the U.S. has the world’s largest and most transparent financial markets, investors are attracted to the dollar despite the high level of debt coupled with ongoing political and economic uncertainty.”
• “Sovereign debt, especially the sovereign debt of financially secure developed countries …. including Germany, France, Australia, Switzerland, Sweden and the United Kingdom”
• Currencies: “the U.S. dollar, Japanese yen, United Kingdom pound, Swiss franc and – to a lesser extent – the Australian dollar, Norwegian krone, Canadian dollar and Swedish krona are viewed by many as safe havens.”
• High quality corporate bonds
• “Hard assets such as raw land and commodities are beginning to emerge as additional safe haven outlets, mostly due to the fear of decreasing purchasing power of the U.S. dollar.”
Size of Safe Haven Asset Markets
The IMF, “Global Financial Stability Report: The Quest for Lasting Stability, April 2012” provides the following chart depicting the market sizes of safe haven assets, which I label Figure 1:
Figure 1
Note, in particular, the large role that sovereign debt plays in the supply of safe havens – they constitute more than half of all safe havens globally.
I collected information from other sources as well, as a sanity check of and a supplement to the IMF’s estimates:
Currencies
• U.S. Dollar: Total currency in circulation 2011: $1 T
• Japanese Yen: Total currency in circulation 2011: 88.5 T Yen = $0.885 T
• 2009 Currencies in Circulation (Figure 2)
Figure 2
Based on the 2011 estimates of dollars and yen outstanding, I would estimate 2011 currencies in circulation as being about 16% higher than the 2009 estimates, or about $4.9 T. Given the tremendous amount of money printing that occurred globally in 2012, I would estimate 2012 currency circulation as being roughly 10% higher than the 2011 estimate, or about $5.4 T.
US Bonds
Figure 3
Gold/Silver
• Average Cumulative World Silver Production = 44.542 B oz @ $30 ~ $1.3 T
• Average Cumulative World Gold Production = 4.25 B oz @ $1,700 ~ $7.2T
• “Number of tonnes of gold mined since the beginning of civilization”
171,300 tons x 2,000 lbs/ton x 16 oz/lb x $1700 /oz = $9.3 T
Real Estate
• Commercial: 2011 $26.6 T
♦ $9.4 T Europe
♦ $7.5 T US/Canada
♦ $7.2 T Asia Pacific
• US Residential 2011: $21.9 T
Sovereign debt
Figure 4
This estimate of OECD sovereign debt is several years old during a period in which many (most?) OECD countries have issued record amounts of debt.
• According to Global Finance Magazine, “Total debt for OECD countries went from 73.3% of total OECD GDP in 2007 to almost 106% in 2012 (estimated).”
• According to OECD statistics, 2009 OECD GDP was $40.2 T, GDP growth rates for 2010, 2011, and 2012 were, respectively, 3.0%, 1.8%, and 1.4%. Putting these together yields an estimate of 2012 OECD GDP of $42.7 T
• These two sets of estimates together yield an estimate of 2012 OECD debt of almost $45.3 T.
Summary of Safe Haven Assets
Aggregating these estimates of safe haven assets gives us of rough estimate of $108 T – $110 T
Currencies: 2012 Currencies in Circulation $ 5.4 T
Gold Cumulative Production $ 7.2 T – $9.3 T
Silver Cumulative Production $ 1.3 T
Real Estate: 2011 Global Commercial $26.6 T
Real Estate: 2011 US Residential $21.9 T
Sovereign Debt 2012 OECD Total $45.3 T
The estimate of 2012 total OECD sovereign debt ($45.3 T) is at odds with the Q3 2012 estimate of US bonds ($37.7 T). Given the information available, I would guess that the estimate of total sovereign debt is significantly understated.
What am I missing from my estimates of safe haven assets? Of course, some of the estimates are a year or two out date. Other than that, I’m missing estimates of non-US residential real estate and of liquid commodities.
Equity in public and private companies is not considered a safe haven. However, the size of the equity markets is relevant to the analysis, since they constitute a means of holding wealth. According to the World Bank, the total market capitalization of listed company as of the end of 2011 was $45.08 T. The World Bank defines “listed companies” as follows:
Listed domestic companies are the domestically incorporated companies listed on the country's stock exchanges at the end of the year. Listed companies does not include investment companies, mutual funds, or other collective investment vehicles.
The $45 T estimate does not include private companies. Forbes provides a list of the 220 largest companies in the US, which reported combined revenues of $1.49 T for 2012. As such, the total value of private companies globally must be at least several tens of trillions of dollars.
Downgrading of Countries’ Sovereign Debt Threatens Global Supply of Safe Havens
The global economic environment -- in particular, the unsustainable levels of sovereign debt in many countries together with the continuing recession in which the global economy has been mired -- threatens the future use of sovereign debt as safe havens for global stocks of wealth. Only highly-rated debt by developed countries may be considered truly safe havens, yet within the last two years, many countries have had their debt downgraded. A list of recent debt downgradings includes:
• 2011 US
At the same time, however, the very same precarious global economic environment that has decreased the supply of safe havens has also increased their demand, as global wealth seeks refuge from the highly volatile and uncertain markets. As the IMF States in “Global Financial Stability Report: The Quest for Lasting Stability, April 2012”:
… safe asset demand is expanding at the same time that the universe of what is considered safe is shrinking…
While many assets have some attributes of safety, the global universe of what most investors view as potentially safe assets is dominated by sovereign debt…
Traditionally, the issuance of sovereign debt by the advanced economies has been a key source of safe assets in global financial markets. Before the crisis, the safety of these instruments was underpinned by two features: the rarity of sovereign default, and the strength of advanced economies’ political institutions, including government taxing power.
However, the recent considerable deterioration of some advanced economies’ fiscal profiles has reduced the supply of sovereign debt perceived as safe. The sharp increase in advanced economies’ public indebtedness after the global financial crisis, combined with low tax revenues and high current and future public expenditures, has raised concerns about the sustainability of their debt…
Thus, while 68 percent of advanced economies carried a AAA-rating at end-2007, the proportion dropped to 52 percent by end-January 2012. This amounts to approximately $15 trillion of sovereign debt globally as of end-June 2011.
At the same time as public debt is losing is safe haven status, so too is private debt. Again, from the IMF:
The production of safe assets by the private sector largely collapsed with the onset of the global crisis. Total private sector securitization issuance declined from more than $3 trillion in the US and Europe in 2007 to less than $750 billion in 2010.
The IMF concludes that the shrinking availability of safe haven assets, precisely when demand for them is increasing, threatens global financial stability:
Considerable upward pressures on the demand for safe assets at a time of declining supply entails sizable risks for global financial stability. The unmet demand drives up the price of safety, with the safest assets affected first.
Estimates of Global Wealth
A discussion of the source of supply of safe havens naturally begs for a discussion of the nature of global wealth that may seek safe haven status. So, now let’s get some idea of the magnitude of global wealth, together with its distribution across countries and asset classes. Most wealth is ultimately held by people in the form of hard assets (e.g., real estate), business equity, fixed income assets (bonds – government and corporate), or cash (currencies, deposits, etc.). The wealth that is not directly held by people includes assets held by government (sovereign wealth) and assets in pension funds.
Figures 5 through 9 present estimates of the various constituents of global wealth.
Global Household Wealth
Figure 5 displays the magnitude and distribution of global household wealth across countries, taken from Credit Suisse Research “Global Wealth Report 2012”. Credit Suisse estimates “that global household wealth in mid- 2012 totaled USD 223 trillion… ”
Figure 5
Wealth of High Net Worth Individuals
Figure 6 displays the distribution of high net worth individuals’ (HNWI) wealth across asset classes, taken from CapGemini, “World Wealth Report: 2011”. CapGemini reports that Globally, “HNWIs’ financial wealth grew 9.7% in 2010 to reach US$42.7 trillion, surpassing the 2007 pre-crisis peak.” The wealth of HNWIs is presumed to be included in the previous estimate of global household wealth.
Figure 6
Pension Funds
Figure 7 displays the magnitude and distribution of pension funds by country across asset classes, derived from Towers Watson, “Global Pension Assets Study 2012”. According to Towers Watson Global Pension Asset Study, “The study covers 13 major pension markets, which total USD 27,509 bn in pension assets.”
Figure 7
Wikipedia provides a list of assets held by the 12 largest pension funds. All but 2 of the Wikipedia pension funds are captured in either the Towers Watson Pension Study or the list of sovereign wealth funds provided below. The 2 additional funds listed in Wikipedia are funds in (1) South Korea, holding $0.27T in assets and (2) Malaysia, holding $0.13T. Adding the assets from these 2 pension funds to the Towers Watson estimate yields an estimate of $27.9 T in the pension funds of the largest funds. Based on the information available – namely that the largest funds have been captured, and the smallest of the largest funds is a small fraction of a trillion dollars – I would conclude that the assets in pension funds not captured herein would amount to a few trillion dollars at best.
Sovereign Wealth Funds
Figure 8 displays the magnitude and distribution of sovereign wealth funds by country across asset classes, derived from the SWF Institute’s “Asset Allocation Report 2012” and Rob Wile, “The 20 Sovereign Wealth Funds That Are Buying Up The World”. The 36 largest sovereign wealth funds collectively hold about $5 T. The Ireland fund is also included in the previous estimates of assets held by pension funds. Excluding Ireland’s assets from the sovereign wealth total yields about $4.9 T.
Figure 8
Again, based on the information available, I would conclude that the information not captured herein would amount to a few trillion dollars at best.
Central Bank Reserves
Figure 9 displays the magnitude reserves held by central banks globally, taken from Cumberland Advisors, “Total Assets of Major Central Banks”, is approximately $10 T.
Figure 9
Again, based on the information available, I would conclude that the information not captured herein would amount to a few trillion dollars at best.
Summary of Global Wealth
Aggregating these largest sources of global wealth gives us a rough estimate of $266 T
Global Household Wealth $223 T
15 Countries’ Pension Funds $ 28 T
36 Largest Sovereign Wealth Funds $ 5 T
Major Central Bank Reserves $ 10 T
What am I missing in my $266 T estimate of global wealth?
In the previously referenced IMF report, the IMF provides information as to the entities that are holding government securities. I have presented the IMF figure as my Figure 10.
Figure 10
Banks and insurance companies are companies whose equity is held by public and private shareholders, which I have captured through estimates of global household wealth. I have captured pension funds, sovereign wealth funds, and central banks in my estimates. It appears that I have captured most holders of significant wealth who hold most of the safe haven assets.
Global Supply vs. Demand of Safe Haven Assets
Based on estimates of the magnitude and allocation of the various components of global wealth, I come up with very rough estimates of total wealth by asset class presented in Figure 11.
Figure 11
Combining the estimates of the current allocation of global wealth displayed in Figure 11, together with the sizes of current safe haven asset classes, I get the estimates presented in Figure 12.
Figure 12
FINALLY, we come to the crux of the analysis.
The purpose of Figure 12 is to present relative magnitudes of the current sizes of global asset markets.
I assume that supply currently equals demand in the asset markets depicted in Figure 12, so any discrepancies between supply and demand in the table are due to inaccuracies and/or omissions of captured assets.
The availability of highly rated sovereign debt is expected to shrink, as discussed earlier. So the question becomes: where will the assets currently sitting in sovereign debt migrate to as the availability of safe sovereign debt continues to decrease?
The demand for currency ebbs and flows with market uncertainty. At the same time, however, the monetization of debt occurring in all markets (an unfortunate race to the bottom for fiat currencies) will lead to higher levels of global inflation, so holding cash will become more costly. As such, some of the wealth currently in sovereign debt may flow into currencies as global uncertainty increases, but probably not too much.
In the definition of safe haven, Investopedia includes safe equities (blue chip stocks) as safe havens in times of global turbulence. However, as inflation increases stock market P/E ratios decrease. From John Mauldin, “Thoughts from the Frontline - Somewhere Over the Rainbow”
P/E is driven by the trend and level of the inflation rate. Higher inflation drives interest rates upward. Investors demand higher returns to offset the adverse impact of inflation. Thus, higher inflation drives P/E lower, so stock-market investors can achieve higher returns from lower prices and higher dividend yields.
With sluggish global economies expected in the coming years, earnings growth will be low. Taken together, these two points – decreasing P/E ratios and slow growth in earnings – suggest that stock markets aren’t expected to deliver high returns in coming years. So while wealth flowing out of sovereign debt may flow into safer stocks, the general equities markets probably won’t receive a tremendously large portion of funds exiting sovereign debt markets.
What this leaves is hard assets into which the majority of money leaving sovereign debt markets may be expected to flow.
This is consistent with the increasing global demand for precious metals by people and by central banks globally (see, for example, http://www.gold.org/investment/statistics/demand_and_supply_statistics/). This is also consistent with the recent global buy-up of natural resources, in particular by China (see, for example, “China Buys Up the World”).
Given the relative sizes of the two markets, (sovereign debt and hard assets) hard assets could potentially increase significantly in value as funds flow out of sovereign debt funds in search of more stable assets.