Counterpoint — A Commentary of Jurika, Mills & Keifer LLC
July 2009

The Forest and the Shoots.

For all the talk of “green shoots,” it is easy to lose sight of the forest.

Vital signs in the economy continue to improve. In most cases, the improvements represent a lessening in the rate of deterioration. In some cases, the improvements represent things actually getting better. These improvements have been called “green shoots;” metaphorical harbingers of the coming recovery.


And with the green shoots we have seen a dramatic uplift in the capital markets and investor sentiment. The global financial markets have rallied dramatically off their March lows, companies have been able to issue new debt and equity, there has been a pick-up in mergers and acquisitions activity, and, most importantly, there is a renewed sense of confidence in the stability of the financial system.

Our own view is that the economy has bottomed, at least for now, but that investor sentiment has moved from being overly dour to overly hopeful. Put more plainly: the stock market is writing checks the economy will have trouble cashing.

To understand why this is so, one needs to take one step back from the green shoots to consider the forest. It remains in serious trouble.

The forest, in this case, is the massive amount of debt that has accumulated in the U.S. economy, Europe and elsewhere over a quarter century, relative to the global economy’s ability to sustain and support it. This debt has fueled a secular binge of economic growth and consumption, a false sense of prosperity and well-being, and inflated expectations for future growth.

In this land of plenty, we now have plenty too much: too much debt, too much stuff and too much excess capacity. This excess of plenty is now being unwound. It was years in the making. It will be years in the unwinding.

This is a theme we have repeatedly emphasized in our Commentaries over the last two years because we think it is critically important in understanding what has been, what is likely to come, and how to position ones investment portfolio accordingly. It is the forest in which all green shoots exist.

Which leads us to where we are today and the focus of this Commentary.

The unwinding of years of excess throughout the economy is an inexorable force, mitigated by a massive effort by the Federal Government – and other governments around the world – to counter its powerful deflationary currents.

But there is a limit to what the government can and should do to stem this unwinding process. The cure for a quarter century of overborrowing, overconsuming, underinvesting and undersaving is not more of the same, but less.

It is one thing to use the Federal piggy bank and credit card to help manage and mitigate the process: thereby maintaining order, confidence and liquidity. It is quite another to try to forestall the process and sustain that which is unsustainable. We cannot borrow our way out of debt, no matter how hard we try. The sooner we deal with this reality the better.

The $23 Trillion Question.

In our April Commentary we focused on the total level of outstanding debt in the U.S. economy and how, starting in 1981, it began to grow well in excess of the growth rate of the economy, after many years of being in balance.

In this Commentary, we look at the increasingly precarious financial health of the U.S. Government. We’ve taken a detailed look at the U.S. budget going back to 1940, and looking forward to 2019 based on the Office of Management and Budget’s 2010 Budget of the U.S. Government.


Chart I above provides a good starting perspective. It shows total outstanding Federal debt between 1940 and 2019, both in absolute terms, and as a percentage of GDP (actual and projected).

After reaching a peak of 122% in 1946 following World War II, total Federal Debt as a percentage of GDP declined to a low of 32% in 1979, before beginning to rise again, along with all other forms of debt in the economy.

By the end of next year, 2010, total outstanding Federal Debt is estimated to reach $15 trillion, which will exceed 100% of GDP for the first time since World War II.

It is projected to keep increasing to over $23 Trillion and 120% of GDP by 2019.

Moreover these numbers do not fully reflect all the financial guarantees and backstops that have been made over the past two years, which may amount to as much as another $10 trillion or more.

We are deeply concerned by how significantly and rapidly public debt has escalated.

Part of this increase has been the result of massive, and extraordinary efforts to stimulate the economy and backstop the financial system by transferring debt and financial risk from individual and corporate balance sheets to the public balance sheet.

But a critical part is the result of a systemic and enduring imbalance between government spending and revenues, which, without a major course correction, is likely to persist, if not increase.


Chart II underscores this reality. It shows total government receipts, outlays and the resulting deficit or surplus going back to 1940, and projected forward to 2019. This year alone, the government will need to borrow close to $2.7 trillion to cover a projected deficit of $1.8 trillion and additional borrowing of $887 billion for various extraordinary financial programs. Over the next 10 years, as far out as the government publicly forecasts, deficits are projected to continue, adding another $10 trillion to the national debt; almost as much as all the debt that has been accumulated to date. And none of this takes into account any additional stimulus programs or aid to state and local governments.

If we haven’t cheered you up yet, there’s more. We think the government projections are overly optimistic. The key assumptions of the government’s current plans are highlighted in Chart III. These assumptions include: 1) that unemployment peaks at just above 8% before declining back to 5% in 2013; 2) that real GDP growth rebounds smartly to above 4% and then averages between 2% and 3% for the rest of the decade; 3) that inflation remains benign and 4) that the yield on 10-year treasury bonds remains at 5% or less through the end of the decade.


Unemployment has already surpassed the 8% assumption and we expect it to reach 10% to 12% in the next year. We also think that in a de-levering economy, it will be hard to achieve real GDP growth above 2%. And so, assumptions for tax receipts are likely overstated. Finally, we believe that in the coming years, the cost of borrowing for the U.S. government is likely to rise substantially.

So what’s Uncle Sam to do?

There are only four ways to bring the budget back in balance: A) increase tax revenues, B) decrease spending, C) print money, or D) all of the above.

Spending cuts will be the hardest to achieve. For one, they are politically unpopular, especially with an economy in recession. For another, there are only so many places one can cut.


Chart IV underscores the quandary for policy-makers. It shows the composition of government outlays going back to 1962 and projected forward to 2019. Back in 1962, defense and non-defense discretionary expenditures represented almost 70% of the Federal Budget, with mandatory programs and interest expense on the national debt making up the difference. Today, defense and discretionary programs constitute only about 36% of the budget and mandatory programs represent about 55% and growing.

Interest on debt makes up the balance and represents the wild card in the budget. For the moment, the United States is blessed with a very low borrowing cost relative to many other nations. This is a mixed blessing in that it makes it easier for us to get ourselves into more trouble. The more debt we have, the more vulnerable we are to any increase in the cost of financing that debt.

And so it is highly likely that we will see rising tax rates and the necessary creation of trillions of newly printed dollars by the government printing press, both of which will have implications for economic growth, savings, spending, interest and inflation rates and stock market valuations. Welcome to the forest.

Bail-Out Nation.

Our biggest concern is that the federal, state and local governments, all controlled by politicians who We-The-People elect, lack the leadership and motivation to make the tough but necessary choices.

If the Federal, State and local governments were to make the necessary changes to bring budgets in line with a sustainable model, it would likely involve millions of additional job cuts and the elimination or restructuring of many sacred programs.

This would make the current recession much worse than it already is, although less worse than what will happen if we don’t. This reality flies in the face of public and political sentiment: make the pain stop now and we can deal with the consequences tomorrow.

It is too easy to suspend disbelief, and keep adding new spending and stimulus programs to the government tab with the hope that somehow, some day, well after the next election, things will all work out.

And perhaps it will for a while. This has been the experience in Japan that has managed now for many years to run large deficits without a commensurate increase in its long-term borrowing rate. Japan’s debt as a percentage of GDP is a whopping 190% while the interest rate on long-term Japanese government bonds is only 1.8%.

But Japan’s borrowing needs pale against those of the United States, which will need to borrow four trillion dollars just this year and next, and many trillions more thereafter. And many other countries are also running large deficits that they need to fund. The world is likely to be awash in sovereign debt competing for buyers. It is reasonable that those buyers will be looking for the most attractive yield relative to the perceived risks of Sovereign default and currency devaluation.

Conversely, it stands to reason that a world where investors are happy to sop up $4 trillion of new U.S. debt at historically low interest rates, is likely to be a world where investors are more worried about deflation than inflation and probably not a great environment for stocks and many other asset prices.

Finally, whatever the ultimate borrowing rate, massive government deficits tend to crowd out investment and curtail economic growth.

Investment Strategy: The Long and Winding Road…

Against this backdrop, most assumptions about typical recessions and recoveries need to be thrown out the window. There is nothing typical about this recession, nor will there be anything typical about the recovery.

The unwinding of leverage and excess capacity throughout the economy, the systemic structural imbalance between Government receipts and spending, and the continued hemorrhaging of public debt will create long-term headwinds for domestic consumption and growth.

At best, any recovery will be a long, winding and bumpy road, requiring good defensive driving skills and more frequent lane changes in response to changing conditions.

There are opportunities and there are things to do.

We continue to combine our overall long-term strategic outlook, with a more short-term tactical approach to asset allocation based on economic developments, asset valuation levels and specific opportunities and insights as they present themselves.

Our focus is to find those investments that are likely to do well in this environment, while maintaining a more cautious bias in favor of capital preservation and income-producing strategies.

Our client’s portfolios are currently structured around a number of guiding ideas including:

1) The strong get much stronger: We are investing in companies and countries that are likely to gain significant competitive advantage at the expense of floundering competitors. (Goldman Sachs and China, for example).

2) Emphasize Growth: Emphasize companies that can grow even if the U.S. overall economy doesn’t. (We would favor technology over consumer discretionary companies).

3) Brains and Bucks...and Culture. Invest in financial companies that have the human and financial capital to be shrewd and opportunistic buyers of good assets on sale, and that aren’t going through a personal identity crisis as they try to integrate major mergers or acquisitions. (Examples include Goldman Sachs, Berkshire Hathaway, the Blackstone Group and Wells Fargo).

4) Green, Networked and Thrifty. Companies well positioned to benefit from spending on alternative energy and other sustainable practices; well-financed technology companies involved with the global build-out of internet and wireless capabilities; and companies well positioned to appeal to a thrift-oriented consumer. (Examples include ABB and Florida Power; Cisco and Qualcomm; Wal-Mart).

5) Dividends. Companies with stable business models and high dividend yields. (Examples include Verizon and Pfizer).

6) Think and invest globally: Marginal global growth is more likely to come from outside the United States and, specifically, from China, India, Brazil, and the resource economies and companies that supply that growth.

7) Favor Corporate Bonds. Investment grade, bank loans and high-yield offer attractive yields and potential for return relative to stocks. (We made a push into high yield debt and bank loans earlier in the year, both of which are up substantially).

8) Cash is a strategic Asset. When in doubt, we feel very comfortable holding higher levels of cash.

Concluding Thoughts:

Recessions are a natural part of the economic cycle just as fires are a natural part of the ecological cycle of the forest. They wipe out the excess and make room for new growth.

A major period of excess, like we have experienced over the past two decades requires a major period of retrenchment and political leadership with the wisdom and fortitude to manage but not prevent the process.

The mortgaging of our economic future to sustain that which is unsustainable cannot end well if not stopped. We can’t borrow our way out of debt. The harder we try, the worse the long term consequences.

And so we move forward with our eyes wide open, looking for green shoots of opportunity, but fully aware of the forest around us.

As always, we welcome your questions, referrals, and the ability to be of service.

Jurika, Mills & Keifer,
July, 2009

Important Disclosures

Opinions expressed are those of Jurika, Mills & Keifer, LLC, and are subject to change.

Investments in securities involve the risk of loss. Past performance is no guarantee of future results.

This communication is neither an offer to sell nor the solicitation of an offer to buy a security or advisory services, which can only be made by the appropriate offering document.

As of June 30, 2009 Jurika, Mills & Kefer held positions on beahlf of its clients in Berkshire Hathaway, Cisco, Goldman Sachs, Qualcomm, The Blackstone Group, Wells Fargo, ABB, Florida Power, Wal-Mart, Verizon and Pfizer, among other holdings.