Counterpoint — A Commentary of Jurika, Mills & Keifer LLC
Second Quarter: April 2010

It’s the Politics, Stupid.

Or perhaps it’s stupid politics.

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Despite all that we have written about this country’s economic problems, our largest problems are political.  For as formidable as the economic challenges are, with the right political leadership and resolve, including the willingness to do what is right rather than popular, we could solve them.  It wouldn’t be easy, but would still be possible. The path is there, if we wish to take it.

But that’s not the nature of our political system, where the prime directive is to get elected, and once elected, to stay elected. This inherent conflict of interest is made worse by a two-year election cycle for many elected officials that puts them in constant campaign mode.

Nor is it the nature of our society. Our tendency is to vote for those who tell us what we want to hear rather than need to hear.  Lower taxes, less government but more services? Sure. I’ll vote for that.

And all of this dysfunction is exaggerated through the powerful and often distorted lens of the media. Complex issues are reduced to simplistic debates between false dichotomies.  Sensational headlines and soundbites rule. Nuance, balance, and perspective are lost in the noise.

This codependence between politicians, voters and the media drives legislation and decision-making based upon what is politically expedient rather than economically sensible. 

Moreover, since what is economically sensible is often politically inexpedient, the system favors short-term thinking and short-sighted policy rather than visionary leadership and legislation.

Today, our system seems more dysfunctional than ever at a time when inspired leadership is more critical than ever. Party interests have been put ahead of national interests and partisan rancor and antipathy has reached a fever pitch. Hyperbole and fear-mongering have replaced constructive discourse.

The partisan divide over healthcare reform exemplifies the current problem.  Our healthcare system is fundamentally broken and the problems are only going to get worse without a major course correction. 

Although we have very high quality healthcare available for many, according to the OECD, as a nation we manage to deliver lower quality overall care at twice the cost as most other developed nations, while managing to exclude coverage for 50 million people in the process.  Something is structurally wrong with this picture.

Charts I and II below tell the story. We spend over 16% of our GDP on healthcare costs relative to about 8.9% for the average of developed nations.  Moreover, healthcare costs in the United States overall are rising 6% to 8% per year and the trends are getting worse, not better. Our population has the highest incidence of obesity and among the highest incidences of diabetes of any developed nation.  As our population ages and the Baby Boomers move into their twilight years these structural problems are only going to get worse.

Chart 1

Chart 2

The recently passed healthcare reform bill mitigates the symptoms by requiring coverage but doesn’t really cure the underlying causes of the disease which are structural and social. These include the for-profit health insurance as the default insurance model, overly rich benefit plans for some and unaffordable coverage for many, physician compensation, litigation and the cost of malpractice insurance,  lack of preventative medicine, and a colossal amount of bureaucracy and inefficiency in the entire system. 

In addition, the number of doctors per capita in this country and patient visits per doctor ranks well below other developed nations. There are fewer doctors to go around, most doctors have less time to spend with patients because of the enormous administrative burdens they carry, and there is less time spent preventing problems before they become serious and expensive.

As with many things, it’s a complex and well-entrenched system involving many parties with vested interests in preserving the status quo. They in turn shower money and favor in the direction of politicians to help them see things their way.

All the talk of “Government Takeovers” of the healthcare system and “death panels” are merely a sideshow to instill irrational fear, curry partisan favor, and distract voters from the fundamental underlying problem: the cost of our healthcare system is growing at a rate that exceeds the ability of the economy to pay for it.  This was the case before healthcare reform was passed, and it remains the case after.

And much of the media attention was focused not on the merits of the policy, but on the polticial drama and potential repurcussions: What is Obama’s approval rating? How will this play out in November elections? Will the Democrats lose control of the House?  This all makes for great theater, but are these really the questions that matter?

The tough decisions have yet to be made and the problems will continue to compound until there is the political will to make the change.  

There are other tough decisions that need to be made as well.

Healthcare is only one piece of a larger imbalance between the cost of government and public sector obligations – at Federal, State, and local levels - and the economy’s ability to support that cost.

Chart 3

As Chart III shows above, Mandatory Spending programs, which include Social Security, Medicare and Medicaid, have grown to represent over 57% of the annual Federal Budget, and are projected to reach 85% by 2019. That doesn’t leave much left for anything else. 

Cuts and changes to mandatory programs are political suicide, but cuts to non discretionary spending and defense are also politically difficult and they don’t amount to as much as they used to.

Meanwhile, as increasing government spending is sucked into to these hemorrhaging mandatory programs, investment in education and infrastructure and other areas that represent productive investment and give this economy sustainable competitive advantage are being crowded out. We are slowly smothering the very factors that are necessary to drive future economic growth.

Sovereign Debt. It’s Greek to me.

Federal interest expense is another growing concern. While only 4% of current annual outlays, interest expense is almost certain to increase substantially in the coming years.  Over the next 10 years annual budget deficits are projected to require more than $7 trillion in incremental borrowing, in addition to the need to refinance over $9 trillion in existing public debt. So interest expense and its impact on our overall fiscal health are highly sensitive to ongoing deficits and changes in interest rates.

The United States is not alone in this predicament. The developed world is awash in debt relative to the ability of their economies to support the debt-load on a sustainable basis.  The recent headlines about Greece and other “Club Med” Countries represent the tip of a large and growing iceberg of sovereign debt.

Chart IV shows current and projected debt as a percentage of GDP among the G7 nations. The United States ranks 5th, only ahead of Italy and Japan - a dubious honor to be sure. 

Chart 4

More importantly, the burden of debt is likely to keep growing among all developed nations in the coming years, acting as a ball and chain at best, and a major seismic fault line at worst.  Japan is a particular concern. With total outstanding debt approaching $12 trillion and 230% of GDP  - almost equal to the United Sates in absolute value- it defies logic how Japan’s aging and shrinking population will be able to support its enormous debtload in the coming years.

As the world’s largest economy and reserve currency, the United States has advantages over other economies, but these should not be taken for granted.  The U.S. isn’t in the worst shape, but its absolute debt load is of greatest magnitude.

All creditor nations will be competing to borrow a lot of money in the coming years, especially the United States and Japan.  As Chart V shows, the G7 nations will also need to borrow about $10 trillion through the end of 2014 to finance projected deficits. This is in addition to refinancing existing debt.

This competition for capital will very likely lead to higher interest rates on a global basis and a growing separation between countries based upon credit-worthiness. Witness the growing spread in borrowing costs between Greece and Germany as well as public discontent on the streets of both Athens and Berlin.  We would expect these differentials to keep growing, creating economic imbalances and social and political unrest down the road.

Let’s just kick the can down the road...

Whether it’s Republicans or Democrats who control Congress or the White House, our problems at home are not going away without major structural and political changes, and/or a major new surge in economic growth and innovation that drives an abundance of new tax revenue.

This is difficult to imagine in our present system. Our national tendency is to put off till tomorrow what is politically difficult to handle today.

This approach allows us to keep kicking the can further down the road, allowing the problems to compound, until one day, we reach the end of the road, usually in the form of a crisis.  Only when faced with an unambiguous choice, do politicians find the necessary political cover to affect change.

But the changes tend to be too little and too late. They are proclaimed to be “sweeping in scope,” but are usually backwards looking - regulating the barn after it has already burned down - and incremental in effect. Incremental change and the preservation of the status quo is not going to cut it.

For one thing, it jeopardizes our nation’s future competive standing in the world.  Without a major course correction, these structural imbalances will keep growing and compounding, consuming more and more of the country’s resources and requiring more and more borrowing to support them.Meanwhile, investment in those things that can create new growth and capability in the economy will be diminished.

For another, it’s an unsustainable path in any case and we have learned from experience that that which is unusustainable will, at some point, not be sustained. 

Of course, this can take a long time to happen. Like a game of musical chairs, as long as the music keeps playing, it doesn’t matter that there are not enough chairs. For now, everyone has an interest in keeping the music playing as long as possible.  So let the bouzoukis play on! Habanera anyone?

How it all plays out is unclear. At best, we would expect a creeping rise in interest rates, a depreciating currency, and slower overall economic growth.  At worst, we could see a more rapid and pernicious acceleration of sovereign debt problems that spread from one country to another.

But, at some point, without a dramatic change in direction, or a dramatic wave of new growth and innovation, the music will start to fade, if not end more abruptly. This represents a growing systemic risk that investors must factor into their asset allocation decisions.

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The sad thing is that things really could be different if we could only eclipse this destructive cycle of stupid politics, stupid press and stupid policy and look to and invest in the future. 

Remember, for example, that the internet started out as a government project to create a redundant communications capability in case of a nuclear war. Today, only 22 years after it was first commercialized in 1988, trillions of dollars of new economic wealth have been created as a result, and the way our global economy works has been transformed.  Most businesses could not function without it. 

Our greatest challenge today is to turn our energy and attention from partisan bickering, grandstanding, finger pointing, and politics as usual to a bold and constructive focus on problem solving and laying the groundwork for a new period of productive economic growth.

Energy would be a good place to start, as global growth and political stability is dependent on an abundant, affordable, and cleaner energy.  Alternative energy could be the next internet.

But this would require bold political leadership. The path is there. We all need to choose to take it. If we remain on our current path of politics as usual, we are not going to like where we end up.

Investment Outlook & Portfolio Strategy.

For now, investors are primarily focused on more immediate things, such as the economic recovery and rebounding stock market, although the Greek debt, situation, as well as uncertainty around the nature and impact of financial services reform have the markets on edge.

Beyond the European debt saga, the U.S. economy continues to mount an impressive recovery across most sectors. The recovery reflects not only healing of damage done by the downturn, but also new growth in a number of areas such as technology.

The corporate sector is doing particularly well.  Companies aggressively cut costs during the downturn, and also restructured debt and raised new capital as the credit and equity market improved. And so companies, by and large are lean and well-capitlalized.

This has helped to drive strong profit growth as the economy has rebounded.  We are also seeing a strong rebound in sales growth, indicating that final demand is improving here and abroad.

Credit growth is slow and banks remain reluctant lenders, but large U.S. bank balance sheets are healing and, barring an economic relapse, we think the worst is behind them.

Unemployment remains high, and employment is usually the last vital statistic to improve.

This makes sense as companies, having gone through the pain of downsizing and restructuring are reticent to start adding back to payrolls.  Given the severity of the downturn this time around and the excess capacity in the economy, we expect the employment situation to improve but slowly. 

Beyond our shores, the developing and emerging economies, including China, the Asian Tiger countries, India and Brazil, never really lost much ground during the global credit crisis and are flourishing.  They are much less reliant on exports than in the past, but are still benefitting from the pickup in global trade.  And unlike the developed economies of the G7, they are in much better fiscal shape. 

Our near-term view is that the rebounding economy will likely drive equity prices higher, at least for a while longer, until we see a meaningful rise in interest rates, or until valuation levels get too far ahead of fundamentals.

That being said, although we think a solution to Greece, Spain and Portugal will be found, there is a possibility that things start to deteriorate faster than the European Central Bank, the IMF and German and French Governments can react.  As we have learned, it is important to react quickly and massively to these situations. 

Our longer-term view is much less optimistic for all the reasons discussed in this Commentary.

Without transformative change, economically and politically, here and in Europe, our economy and financial markets are increasingly vulnerable to, if not almost certainly headed for, another fall. These things will all matter sooner or later.  We just don’t know when. Things have a way of not mattering until they do. And then they matter a lot.

And so we remain somewhat guarded in both our outlook and asset allocation.

Our client equity portfolios remain balanced between high quality domestic large capitalization stocks, focused in technology, financial services, healthcare and industrial cyclicals,  and non domestic funds that offer exposure to developing economies.  We have almost no current exposure to Europe and Japan, other than through multinational companies.

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Fixed income portfolios are geared towards corporate credit, ranging from high yield and bank loans, to investment grade. We have minimal exposure to longer maturity bonds of any sort, and especially to municipal and treasury bonds. State and local government balance sheets are in worse shape than Greece and don’t have the luxury of printing their own currency.  Without a major resurgence in tax revenues, either from strong economic growth, and/or more taxation, we expect trouble down the road.

Finally we continue to hold some gold and cash. We think the trend for the Dollar, Euro and Yen is to weaken in absolute terms relative to the value of real assets.

As always, we welcome your comments, questions, and referrals.

Jurika, Mills & Keifer
April, 2010.

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 March 31, 2010 Jurika, Mills & Kefer held an investment in Goldman Sachs Group in certain client portfolios.