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Sunday, August 19, 2018

Sweden in Crisis: A Hotbed of Instability

Sweden, once the pinnacle of economic, social and political stability, is emerging as a European crisis hotbed. After a quarter century struggling to keep its fiscally unsustainable welfare state afloat, the country is now approaching a perfect storm of political and economic instability. There is still a possibility that the crisis will be contained, but the risk of a runaway crisis is high enough that the world needs to pay close attention.

There are two parts to the crisis, one economic and one political. As always when we are dealing with an advanced welfare state, the two are intertwined to a point where a decline in one will pull the other with it.

To start on the economic side, an August 16 article over at Bloomberg provides a nice summary of the situation as it is today. Erik Penser, a skilled and thoughtful investment banker, is making major portfolio adjustments to protect himself against a looming crisis:

Waiting for the Swedish election results to roll in may be too late. Sweden’s Erik Penser Bank AB has already sold off its small-cap stocks and is avoiding the krona ahead of what may be the most tumultuous time for the Nordic country’s democracy in a century.

There is a lot more to his investment strategy. Officially, his sell-off of small-cap stocks is motivated by experience: they generally fare worse after elections in Sweden. However, this time it is not the sell-off in this segment of the market that matters, but where he is putting his money. In an article in the Swedish financial daily, Dagens Industri (subscription required), the Penser bank explains that it is moving funds into large-cap Swedish stocks and "extremely much" to U.S. dollars.

If it were only for the large-cap investment, we could dismiss this as a cautious but fairly normal portfolio strategy. However, combined with the heavy reallocation from the Swedish currency into dollars, it raises a big red flag.

Before we elaborate on that, though, let us get back to Bloomberg for a moment:
The privately owned bank, which has 32 billion kronor ($3.5 billion) under management, says the Sept. 9 election is a unique event that will require unusual caution in the normally stable Swedish markets. "Does the market have a reason to be worried and stressed ahead of this election?” asks Jonas Thulin, head of asset management at Erik Penser, in a phone interview. “Our conclusion is that yes, it has." ... Added to the uncertainty is a deceleration in Swedish economic growth after a long boom. That means that the central bank will probably not be able to raise interest rates as planned later this year, which will weigh on the krona, according to the bank. 
The Swedish central bank, the Riksbank, has run a negative deposit rate since July 2014. This has contributed to unhealthy over-heating of the real estate market, driven by cheap credit. Household debt has risen as share of GDP, and as reports, the level is higher than it was when Sweden was hurled into a financial crisis in 1991:

Figure 1

The crisis in the early 1990s plunged Sweden into three years of negative GDP growth, massive budget deficits and eventually a collapse of the fixed exchange rate. The domestic part of the real sector of the economy has never recovered from that experience; as I will explain in a later article, the reason why the Swedish economy appears to look good is that since the late 1990s it has been living high on the hog from exports and lax monetary policy. 

For comparison, the U.S. household debt levels were only slightly higher as share of GDP when the Great Recession broke out:

Figure 2

In other words, household debt is at a dangerously high level in Sweden today. However, there are other reasons to worry, reasons that are conveyed by the change in Erik Penser's investment strategy. Back to Bloomberg for a moment:
Erik Penser’s decision to dump Swedish small-caps is based on uncertainty regarding the election outcome, but also on historical data. Its analysis shows that smaller companies have performed worse than their larger peers before and after Swedish elections in the past. A best-case scenario is that things will calm down in a couple of months. But a worst-case outcome, a prolonged situation with a minority government and talk about re-election and budget fights, probably means under-weighting Sweden, according to Thulin. "Our na├»ve hope is that the parties now really start discussing government alternatives to calm this down," he said. "But the probability of that happening is quite small. So far the discussions are more colored by populism.”
The political situation and possible post-election scenarios are not irrelevant, but they will have to wait to a later article. For now, there is another aspect of the Penser investment shift that matters. The strong shift away from kronas to the U.S. dollar is a verdict on the Swedish economy of the same dignity as when people pulled large amounts out of the country prior to the termination of the fixed exchange rate back in 1992. Back then, the Krona to Dollar exchange rate skyrocketed from 5:1 to 8:1 within a very short period of time: if you took $1 million kronas out of Sweden at the 5:1 rate and bought $200,000 you could then buy kronas again at the new rate, and end up with 60 percent more than you had before. 

In other words, Penser is expecting a dramatic fall in the Swedish krona, which is already at 9:1 vs. the dollar. If this happens, it would have many destructive consequences, two of which are:

-The stock market would tank quickly, as foreign investors try to salvage what they can without losing all their equity gains to a tanking currency;
-Investors in Swedish treasuries would pull out because they see an interest rate increase, which is always mirrored by a rapid decline in bond prices.

A combination of dropping treasury bond prices and a tanking currency is toxic for foreign investors. There is no doubt that the Riksbank sees this coming, and they could have countered it with a couple of prudent interest-rate increases. However, they have chosen to not do so, which essentially means that their window for a responsible phase-out of their current negative rates is now closed. What remains is a destabilizing interest rate shock - pretty much like the one Sweden experienced 26 years ago. Back then, the Riksbank hiked its overnight deposit rate to first 75 percent, then 500 percent. 

We will not see such banana-republic measures this time around, but when you maintain negative interest rates you will have major problems with any hike you do. In fact, just to get back to normal rates in the 2-3 percent bracket would be disruptive for the economy, both a deficit-running government and a real estate market drowning in mortgage debt. 

It is important to understand that mortgage lending has been a driver of Swedish private consumption for several years. Now that mortgage lending seems to have peaked, any hike in interest rates will cause a rapid decline in new loans. The decline will be demand driven, which in turn means that consumer confidence about the future is in rapid decline. This, in turn, will spill over on consumer spending in general, with easily imaginable multiplier consequences for the rest of the economy.

Erik Penser's move to the dollar suggests that he is well aware of this scenario. Interest rate hikes that cause a macroeconomic shock will be about as disruptive for the krona's exchange rate as a quick decline on the stock market, though the effects will kick in over a longer period of time. Add to this the inflation effect from currency depreciation, and things are beginning to look bad even beyond an immediate currency crisis.

Market investors will perceive the Riksbanks' rate hikes as defensive, in other words looking at them as having lost command over their own currency. This will exacerbate the erosion of confidence in the Swedish economy. 

There is one more aspect to Penser's investment shift that suggests he is very worried about the Swedish economy. He claims to be leaving small-cap stocks for big-cap stocks because the former perform worse around elections. However, together with his investment in dollars, this move becomes a harbinger for precisely the scenario I explained with a tanking krona. Sweden's big-cap corporations sell almost everything they produce on the global market. A weaker krona - especially one that tanks badly vs. the dollar - will benefit exports, drive up profits and thereby big-cap stocks.

There is just one problem here. Sweden's big exporters do not produce a whole lot of their inputs domestically. Most of them are, basically, assembly lines for imported inputs that are then shipped out as final products to global buyers. This greatly limits the potential for profits that, in turn, would salvage big-cap stocks. There will be a positive effect, but most investors over-estimate it because they forget to look at the correlation between imports and exports in an economy such as the Swedish.

There are many more aspects to the looming Swedish crisis. We will have to get to them one at a time; for now, my stern recommendation is that anyone who has any assets in Sweden pull out of them as soon as possible. Either that, or you may lose a lot of money.

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