Counterpoint — A Commentary of Jurika, Mills & Keifer LLC
Third Quarter: July 2010
- Government debt levels and structural imbalances are growing unsustainably.
- Systemic and deflationary risks are rising.
- The economic recovery continues but is facing mounting headwinds.
- This should lead to greater levels of market volatility.
- We therefore continue to allocate client portfolios defensively.
- This is not a time to leave your portfolio on autopilot or wander too far from your chair.
The developed economies of the world are currently playing a giant game of musical chairs. Almost everyone knows that there aren’t enough chairs. Almost everyone knows that the music can’t go on forever. And yet, as long as we can suspend disbelief, think happy thoughts, keep borrowing money and put another dollar in the jukebox, perhaps we can play on a little longer.
The game relates to the ability of many of the G7 economies to overcome their escalating debt loads. The focus is on Europe at the moment, where the problems are most acute, but the United States and Japan are large accidents waiting to happen.
The crux of the problem is that most of these economies are on an unsustainable path. Their debt burdens are growing faster than they can reasonably grow their GDP. This rising imbalance represents a gathering systemic risk, like a giant fault line expanding deep under the capital markets.
One can look at the rebound of economic growth here and in Europe on an absolute basis and build a hopeful argument for ongoing economic recovery. But one needs to be fully cognisant of the role that debt and government policy have played in shaping the outcome of events so far, and the challenges that that they will pose to growth going forward.
Our view is that sovereign debt burdens, the cures they require and the side effects they engender will, at the very least, stifle and, sooner or later overwhelm growth initiatives in Europe, the U.S. and Japan. Barring some miracle of growth, like a new source of unlimited free energy, or an alien race willing to absorb our piles of debt in exchange for iPads and Happy Meals, we see no easy way out of the mess. (Full disclosure: We do own Apple and McDonalds on behalf of our clients, but not for this reason.)
Nor do we think the risks and likely outcomes are properly priced into the investment markets. Sure, there is pessimism and distrust to be found. There are also a number of bargains to be found across global equity and debt markets. But overall valuation levels for many asset classes only look cheap if you presume a return to normalcy. We don’t, and see the very real potential for things to get materially worse at some point in the not- too distant future.
While we hope that they do not, we prefer to err on the side of caution in managing our clients’ assets. We are therefore continuing to allocate client portfolios defensively, pursuing selective opportunities, but sticking close to our chairs, in case the music ends sooner rather than later.
Sustaining the Unsustainable.
Over the years, we have developed a list of what we call “Unconventional Wisdoms.” They are all grounded in common sense, almost all seemingly self evident, and yet they are too often ignored by investors. Among these we include:
- That which is not sustainable will not be sustained.
- Things don’t matter until they do. Then they can matter a lot.
- Perfect storms are rare, but happen frequently.
“Duh!” You might exclaim. And “Duh” would be right if the markets and investors were truly rational and efficient. But they aren’t as the history of world economies and investment markets reminds us time and again. To the contrary, markets and the forces that drive them such as investor emotion, leverage, technology, and politics tend to compound irrationality, reflecting a process that George Soros refers to as “Reflexivity.”
We have been harping on the issues of debt and government policy for over two years, and we probably sound like a stuck record (which works well with our musical chairs metaphor). But credit and policy have proven themselves to matter quite a lot, and we think they will matter even more going forward.
This Time Is Different:
In their recent book entitled “This Time Is Different” authors Carmen Reinhart and Kenneth Rogoff go back eight hundred years to examine the relationship between debt and economic fortune and misfortune. Their work represents one of the most comprehensive historical analyses, covering centuries of bubbles, crises, periods of inflation and deflation, and everything in between.
What the data show, is that debt can exert a powerful gravitational force, and that when sovereign debt levels cross a critical threshold of between 90% and 100% of a nation’s GDP, it becomes almost impossible for the economy to escape this gravitational force without eventual default. Another lesson from their work is that the belief among sovereign superpowers that they are too big and important to default often sows the seeds of their eventual downfall. No nation in the course of history has been too big to fail, but many have become too big to save. Empires tend to end in bankruptcy more than military defeat.
According to the International Monetary Fund, and as reflected in Chart I below, five out of seven G7 countries will cross this 90% threshold by 2014.
The countries of the European Union are in a particular predicament in that they are locked into a common currency but have very different economic circumstances and agendas and lack a common Treasury. The U.S., the U.K. and Japan have the ability to print money, with the U.S. and Japan having the ironic honor of being “safe havens” relative to Europe.
We will come back to the U.S. in a little bit, but at this point it’s worth considering the means by which an economy can try to escape the gravitational force of debt. There are only a few viable solutions available:
- Raise Tax Revenues
- Cut Spending
- Print Money
- All of the Above.
Raise Taxes: The healthiest way to raise tax revenue is through real economic growth; more taxes raised on the back of more economic activity. But the higher the debt burden, the more economic activity one needs to overcome the cost of servicing the debt.
The aggregate GDP of G7 economies is $32 trillion and the aggregate debt load is currently $36 trillion. The current run rate of deficits across the G7 is $3 trillion, or 9.4% of annual GDP. So if tax rates and spending stay flat, the developed economies would have to generate an improbable amount of new economic growth and tax revenue to make a meaningful dent in the debt.
A more probable course of action is for indebted governments to increase the taxation of the existing economic base. In the United States, tax receipts account for 16% of GDP. It would take a very large increase in taxes to make a meaningful dent in existing deficits, and that would almost surely smother rather than foster new economic growth and investment.
Cut Spending: The challenge with this option is that it is politically difficult and economically dangerous, likely requiring the restructuring of sacred benefit programs and large layoffs of public employees.
As Chart II below shows, while the private sector has shed over 8 million jobs since the end of 2007, the public sector has actually added jobs, not counting the recent temporary blip in census hiring. And over the longer term, despite all the rhetoric about cutting the fat in government, public sector employment has grown year after year after year.
Few politicians want to face this battle, especially with unemployment hovering around 10%. The scenes of rioting in Athens and strikes in Spain are a preview of coming attractions. But we may be approaching a tipping point where overall public sentiment shifts in favor of facing the music rather than keeping the party going.
Keynesian Catch 22.
To their credit, the Europeans have shown a greater willingness to do this sooner rather than later. Over the past two months, Germany, Spain, Portugal, the United Kingdom, not to mention Greece and a few other countries, have announced $169 billion in budget cuts over the next one to four years, as well as an intention to halve their deficits by 2013. This still leaves large deficits and a lot of work to do, but it is a step towards fiscal balance. Germany, which is in the best fiscal shape, has actually been the most aggressive at pushing austerity measures.
There is divided opinion on whether it is a step in the right direction. If too many countries put themselves into austerity programs at the same time, they risk starting a “run on the chairs,” a deflationary spiral that causes economic growth to fall at a much faster rate than the debt burden, and so the economies end up “saving” themselves into a deeper and deeper hole.
U.S. policy, which is based on the Keynsian idea that in times of recession the government has to step in to pick up the slack (with public borrowing and spending programs) until the private sector gets back up on its feet. The limitation with this approach is that it can only be a temporary solution. Care must be taken to ensure that the obligations of government do not exceed the ability of the economy to support them.
And this is the crux of our current predicament. This is not a typical cyclical recession, but rather a secular one. It is the result of decades of economic excess and imbalance. Private and public debt, mandatory spending programs and social benefit obligations have been allowed to grow to a level which is no longer sustainable.
And so the Keynsian approach, to borrow and print more money to keep the music playing, won’t work if it is not matched with effort to address and fix these underlying structural imbalances that helped to create the problem in the first place. Like paying your credit card bill with your credit card, all we are doing is postponing the reckoning, while allowing the problems and costs to compound.
For now, Europe is in a worse predicament than the Untied States, but the American blessing, that its problems are not currently as severe, is also its curse; we are not compelled to do anything about them.
And what is alarming to us, is that the underlying structural imbalances in the U.S. economy are actually getting worse, rather than better.
Chart IV shows the growing projected allocation to mandatory spending programs and interest expense as a percentage of the U.S. Federal Budget. Currently, this number is 61% and is expected to grow to 72% by 2019, leaving less and less for other uses like education and infrastructure and other investment that can give this country ongoing competitive advantage. Over time, it appears that the U.S. government is turning into a giant employment and benefits program.
Most alarming is Chart V which shows the forward annual and cumulative deficit projections of the Office of Management and Budget as of June of 2009 and 2010. Notice that the forward deficit projections have increased in a very meaningful way between last year and this. So even as the economy has recovered, the deficit outlook has gotten worse.
During the 10 year period ending in 2019, they now project the U.S. will need to borrow $10.6 trillion versus a projection of $7.1 trillion for the same period last year. This is not a step in the right direction, nor is it sustainable.
And these numbers do not take into account the fate of state and local governments, nor the present value of future obligations under Medicare and Social Security. According to the Center on Budget and Policy Priorities, all states save Arkansas, Alaska, North Dakota and Montana are running significant deficits, with aggregate shortfalls projected to run $180 billion in 2011 and $120 billion in 2012. The present value of projected Medicare, Social Security benefit obligations is estimated to be a mind-blowing $53 trillion.
Finally, Chart VI reminds us that the majority of U.S. debt is short-term in nature. 75% of outstanding debt has a maturity of five years or less and 43% has a maturity of less than one year. Like a giant subprime mortgage, the U.S. economy is highly sensitive to changes in interest rates.
Printing Money & Default
Which leads us to the inevitable conclusion that at best, developed economies are going to have to devalue their debt burdens by printing money and/or by finally restructuring or defaulting on their debt.
This is a treacherous slope as systematic currency and debt devaluations will lead investors to demand higher interest rate to offset the likely devaluation in purchasing power of the debt, which will increase the default risk of the debt, and lead investors to require a higher rate of interest to offset this rising risk. The cycle will continue with higher risks leading to higher rates until, again, the music ends. And so we print on, giving new meaning to “Freedom of the Press.”
Meanwhile Back in the Economy:
The offset to the daunting long-term picture of Sovereign Debt and structural dysfunction has been the robustness of the economic recovery.
The recovery is now showing signs of fatigue and stress and causing worries of an economic “double dip.”
Much of this recovery was supported by major fiscal and monetary stimulus programs enacted last year, here and abroad. These programs are now winding down at the very same time that old and new economic challenges are mounting.
Although the overall economic trends are positive, business, consumer and investor confidence is declining and recent housing and employment data are downright weak.
In addition, the credit markets are signaling trouble. Credit spreads have been widening both as a result of Sovereign Debt concerns and deteriorating business conditions. Many companies and U.S. large banks are very well capitalized and sitting on large cash reserves, but they are reluctant to spend and lend.
China, the anointed engine of growth in the global economy is also showing some signs of slowing, although it is still growing at an impressive 8% per year. We have no doubt that China will continue to grow and prosper, although it may be a bumpy journey in their capital markets.
China is free of many of the structural burdens that plague Europe, the U.S. and Japan. They are investing in areas that give them long-term competitive advantage, and China has a strong and improving fiscal balance sheet, boasting trade and budget surpluses.
But China’s $4.4 trillion GDP is a fraction of the combined $32 trillion GDP of the U.S. and Europe. China is too small to pull us out of the ditch we have dug for ourselves. Conversely, if the U.S. and Europe slow, it will have a meaningful, although not crippling impact on Chinese growth.
To be sure, investor, consumer and business sentiment has been justifiably squelched by the torrent of negative headlines about Sovereign Debt, sweeping regulatory reforms, austerity measures, oil spills, volcanoes, “flash crashes” and criminal investigations. This, combined with worries about an economic relapse led to 15% to 16% declines in many of the world’s major equity market indices from their highs in April, before the recent rebound.
But beyond the headlines and near-term pessimism, many of the indicators are signaling a slowing in economic activity.
We think this is likely for all the reasons elaborated on above, although perhaps not just yet. The economic tailwind from fiscal and monetary stimulus is winding down and the economic headwind from debt, deleveraging, regulatory reform, higher taxes, currency debasement and forced austerity is picking up.
This won’t happen all at once and there is some additional room for the government to try another round of fiscal stimulus or quantititative easing, although not much. These measures only serve to undermine our long-term fiscal health and credibility.
Meanwhile, corporations are much leaner and better capitalized than they were in 2007. Earnings this quarter should be strong. It is management’s outlook for the rest of the year and next year that will set stage for what happens next.
Investment Outlook: Global Allocation Portfolios:
We try to be neither optimists nor pessimists, but rather pragmatists, looking at the facts, evaluating a range of outcomes and risks and then steering a prudent course for our client portfolios. Our view is not static, but rather dynamic, combining a longer-term strategic view with near-term tactical shifts in client portfolio allocation to take advantage of opportunities and to avoid trouble spots.
Throughout much of the Spring, we have maintained a conservative allocation to equities and bonds, as well as higher cash positions and a significant allocation to gold.
As we head into the summer, we will be paying close attention to the ongoing debt situation in Europe, as well as second quarter corporate earnings and forward-looking guidance from management. Both will provide greater insight into the overall health of the global economy.
Our domestic equity exposure has been focused on high quality multinational companies, primarily in the technology and healthcare sectors. We also hold positions in high quality dividend paying equities and funds.
Our non-domestic equity focus has been geared entirely towards Asia so far, with the greatest emphasis on China. Although Asian stock markets have been hit disproportionately hard in the recent market downturn, this is the part of the world that has the greatest opportunities for growth. We will keep building our allocation to developing economies as well as those companies and economies that benefit from their growth.
As a general comment, while we are cautious on stocks overall, we are finding more pockets of value today among individual companies and washed out sectors.
Macro factors have trumped fundamentals and investors have tended to shun any company that has any problems, no matter how small, or happens to be in the wrong neighborhood, such as in the energy and healthcare sectors.
Economies, markets and companies are all connected, and if economies and markets are not acting well, stock prices and fundamental value may mean very little in the short term. Cheap stocks can get cheaper.
But it does seem that there is a growing disconnect between the perception of a company’s worth as reflected in its stock price and the actual value of the enterprise.
While connected, over time, individual companies can do well even if economies do not. In fact, periods of adversity create opportunities for strong companies to grow stronger. And so the combination of weak economies, weak stock markets and good companies creates unusual opportunities to buy good assets at good prices. This is our focus.
In the bond portion of our global allocation portfolios, we have also reduced risk exposure. Our main focus is on higher quality, shorter duration corporate bonds and we have reduced or eliminated our allocation to high yield and bank loans. Over the past year, client portfolios have benefitted from our allocation to both, but these asset classes have had a huge rally since March of last year and will be vulnerable should credit conditions deteriorate further.
Finally, we continue to like gold. We don’t like that we like gold but it is clear to us that developed nations will have no choice but to devalue their currency and debt obligations. Gold and other real assets should at least preserve their value.
The challenges we have outlined are large and unsustainable and, like the fault lines that run under the San Francisco Bay Area, most days, we don’t think about them even though we know they are there. They don’t seem to matter until they do, and then they matter a lot.
Will the music come to an end tomorrow or the next day? We can’t say. Periods of excess can go on for years until they reach a tipping point. Another wave of fiscal stimulus and quantitative easing could assuage the situation for a time and provide for a last hurrah.
What we can say is that unsustainable trends and behaviors eventually will not be sustained. Whether that results in years of anemic growth or something worse, remains to be seen.
We can also say that the vast amount of debt, and the uncertainty about how governments will respond to it, through taxation, regulation, and restructuring, represents a gathering systemic risk that all investors need to factor into their asset allocation decisions.
Most investment advice and portfolio allocation models are built upon a belief that markets and investors are efficient and rational. They also presume that backwards looking data is predictive of future looking results, and that most results fall along a normal distribution, and within one standard deviation. We now live in a two to three standard deviation world and investor portfolios need to be positioned to withstand perfect storms and other outlier events.
The challenge of wealth management is not only to grow capital, but to preserve it. The more you reach for growth and income in a higher risk environment, the greater the chance you face of losing capital. Real losses are far more costly than lost opportunity.
There are times to go on the offensive and times to stay defensive. Perhaps we, as a nation, can continue to borrow and spend, perhaps we can generate a wave of new innovation that helps us grow our way out of debt, or perhaps we can elegantly inflate our way out of trouble without causing an inflationary or deflationary spiral. Perhaps a new era of fiscally responsible, forward looking political leadership will be ushered in that can effectively cut spending and tackle the structural imbalances that are crippling our economy. Perhaps some combination of all of these factors will be enough to overcome the mounting challenges. Perhaps the music never ends.
But history and current trends do not support this hope, and hope is not a reasonable investment strategy in the face of substantial evidence to the contrary. This is a not a time to leave your portfolio on autopilot, or to wander too far from your chair.
Jurika, Mills & Keifer