Counterpoint Commentary

Exit Strategies?

The U.S. economy and financial markets continue to show signs of recovery, fueled by unprecedented government stimulus and a growing sense of confidence. Globally, economies and markets also continue to recover, especially in Asia, where the chief concern is that growth is too strong, rather than too weak.

For the near term, we think this improving trend will continue and will likely carry domestic equity markets higher, albeit with some bumps along the way.


Barring some exogenous shock to the system, the combination of improving economic data and a growing desire on the part of investors to seek higher returns, will likely lure more money from the sidelines into the stock market.

But the recovery remains fragile and is still highly dependent on ongoing monetary and fiscal life support. The Federal Reserve is keeping short-term rates at zero and will continue to do so for an “extended period of time.”

The Fed has also been artificially depressing longer-term interest rates by buying over $1.5 trillion in mortgages and treasury bonds through its “quantitative easing” program.

Fiscal stimulus, primarily in the form of the $787 billion American Recovery and Reinvestment Act passed last February is providing an important additional boost. Approximately 32% of the total was spent last year, leaving the majority to be spent this year and next. This will add a tailwind to the near-term recovery.

Outside of the United States, other countries have annouced over a trillion dollars in stimulus packages.For the time being, the world is awash in public spending.

But all this stimulus is not sustainable and will likely produce unpleasant side effects over time, including currency devaluation, price inflation, and higher long term interest rates.

At some point in the near future, fiscal and monetary stimulus will need to be withdrawn and the U.S. economy - as well as others - will need to run under its own power and become an engine of growth rather than a ward of the State. Whether this is possible remains to be seen.

It will be no small challenge. Major structural problems exist in our economy, as well as in the economies of other developed nations. Most notable of these is the growing imbalance between the cost of social benefit programs and the tax revenues to support them.

At home, there has been little progress in dealing with these problems other than to defer them into the future and allow them to compound. State and local government budget deficits are a source of immediate concern.

Ironically, the best thing that can be said for our economy at the moment, is that we are still in better shape than many others including Iceland, Dubai, Greece, Great Britain and Japan. Everything is, after all, relative.

Which brings us to Exit Strategies.

There are two we want to focus on. The first, and the one that gets all the media attention has to do with the Federal Reserve’s reversal of monetary stimulus. The second, and more important one, has to do with how our economy can overcome its current challenges and get itself on a path towards a new era of sustainable prosperity.

The Fed dilemma:

There may be no graceful exit for the Fed. Whatever they do or do not do will likely produce nasty consequences. Too much, too soon, too little or too late? There is no good answer; only worse and less worse outcomes to weigh.

Sustained, overly easy monetary policy tends to lead to currency devaluation and price inflation. Quantitative easing - printing money to buy our own debt – is even more deleterious to the value of the dollar and government debt.

And so, either outcome – maintaining the treatment or discontinuing it - could put the economy back into a recession.

For the moment, the Fed has most recently said that it expects to maintain historically low interest rates for “an extended period of time” but plans to discontinue quantitative easing by the end of the first quarter.

The $4.6 trillion question:

The United States has enjoyed the blessing and curse of being the World’s reserve currency. It’s a blessing because it has allowed us to borrow large amounts of money at very low rates: something many other countries cannot do. It’s a curse in that it has allowed us to avoid making difficult choices that ultimately need to be made.

Chart 1

And so, as Chart I shows, total Federal Debt has ballooned over the past two years and is expected to pass $8 trillion this year, and keep on growing for years to come.

More concerning, is that the majority of our public debt is short-term in nature. 40% has a maturity of 1 year or less, and 35% has a maturity of 1-5 years. So like a giant subprime loan, our national debt is highly sensitive to changes in interest rates: every 1% increase adds $70 - $80 billion in annual interest expense.

This year, we will need to issue $1.4 trillion of new debt and refinance $3.2 trillion of existing debt.

2010 also promises to be another extraordinary year for sovereign debt issuance outside the United States as Eurozone and other developed economies around the world try to finance their own recoveries.

How well the global capital markets are willing to absorb all this debt issuance is something to be watched very, very closely.

A National Exit Strategy:

However well the Fed’s exit strategy works in the near term, over the long-term, we cannot borrow and consume our way out of debt.

For one thing, the U.S. consumer is tapped out and can no longer be the same driver of economic growth that he once was. Total consumer household debt is equal to about 100% of GDP and according to First American CoreLogic, 25% of all homes with mortgages currently have negative equity.

Meanwhile, the Baby Boomers, who represent 25% of our population are approaching retirement, many with insufficient current assets to do so. They will more likely be focused on saving than spending going forward.

Although it would be a mistake to write the obituary for the American consumer, he will likely be on bed-rest for a long time.

The 2.5 billion person opportunity:

For another thing, and on a much more positive note, this is a time of major change and opportunity for industries focused in the right areas. There are over 2.5 billion people in developing economies who want to improve their standard of living. To do so, they will require access to clean energy, clean water, clean food, healthcare, natural resources, and global information networks.

Meanwhile the advancement of technology and science offers enormous new potential in all of these areas, as well as many others.

Our only viable national exit strategy is to generate meaningful new economic growth fueled by innovation, investment and productive enterprise. Put more bluntly, we need to produce products and services that add value, that solve problems, that create new possibilities and capabilities, that make people’s lives better. This is our heritage, it is our strength, and it needs to be our future.

Prosperity that is driven by the transfer of wealth rather than the creation of wealth tends to be short-lived. The credit crisis is a prime example of this. Many of the fortunes garnered by some, came at the expense of countless others. The towering levels of compensation on Wall Street for questionable value-added stand in sharp contrast to Silicon Valley, where compensation rates tend to be low and fortunes are made through long-term equity ownership in the building of a successful enterprise.

The current climate in Washington is very much focused on assigning blame for the crisis, mostly on Wall Street, and as far from Washington as possible.

Much of this strikes us as counterproductive political theatre. First, we regard Congress as completely complicit in the making of the mess.

Second, while they are busy feigning innocence and casting blame, we as a nation continue to move backwards rather than forward. Our national priorities remain off track.

It seems necessary and logical to us that global capital investment will increasingly flow to those areas where there is both need and opportunity and away from areas of prior excess. It remains to be seen how much of that capital investment in innovation and new growth will happen here, and whether it will be enough to offset the heavy burden of debt and structural dysfunction that we carry with us.

Our political leaders need to be figuring out how to stimulate major new capital investment in these areas of industrial and technological innovation that are the most likely source of new jobs, and future wealth creation. They also need to be figuring out how to invest more in areas of the economy such as education and infrastructure that actually increase the competitive advantage of our nation relative to others, rather than allowing them to erode further.

This won’t be possible unless we make some politically difficult, but essential choices. A return to an economy based on debt-fueled over-consumption is not the way out.

Portfolio Strategy:

We continue to see a range of potential outcomes and are managing client portfolios with a balanced view of risks and opportunities.

As we wrote at the outset, for the near-term we think the prevailing trend of improving economic fundamentals and investor sentiment will continue and will outweigh the negatives. The forces of fiscal and monetary stimulus at work are powerful and after such a dramatic fall, it makes sense that the cyclical rebound would be strong. This has historically been the case. Capital expenditure has been repressed, inventories need to be replenished, and there are pockets of renewed growth and innovation.

At the same time as long as greed trumps fear, the prospect of low returns in money market funds and rising interest rates will likely drive investors out of money market and bond funds into stocks in search of higher returns.

Although U.S. equities are no longer a bargain, they are not, on the whole expensive, and certain areas, like technology, healthcare and selected financial stocks offer an attractive combination of business quality, value and growth potential.

Although we are more positive about the near term, we remain quite concerned about long-term fundamentals for the U.S. and European economies and are paying particular attention to Treasury and other Sovereign debt markets, as well as the regulatory and tax environment.

We are currently allocating the equity exposure of our client portfolios in three areas:

1) High quality growth: Very high quality companies that are well-positioned for growth, with an emphasis on technology, healthcare, financial services and clean energy;

2) Dividends: Companies and ETF’s that offer attractive dividends. In many cases one can invest in companies that offer dividend yields that rival corporate bond yields, have preferable tax treatment, and the potential for future appreciation;

3) Developing Economies: Funds and ETF’s that offer exposure to China, India and other emerging and developing economies. As we have written in the past, we expect China and other developing economies to be the major drivers of global growth going forward and will use dips to add to this exposure.

Because of our concern over rising long-term interest rates, our allocation to bonds is mainly focused on short to medium term corporate bonds, balancing income with credit risk. We are avoiding longer-maturity treasury and municipal bonds.

Finally, we continue to maintain an allocation to gold. As long as sovereign debt levels rise unabated, the value of paper currencies is likely to decline relative to hard assets.

As always, we welcome your comments, questions, and referrals, and wish you the best for a peaceful and prosperous New Year.

Jurika, Mills & Keifer
January, 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. There can be no assurance that investment strategies referenced will be successful, or that investment objectives will be achieved. The net performance represents performance figures net of all fees including management, performance fees, transaction costs and commissions. Past performance is no guarantee of future returns, which may vary. Please note that one cannot invest directly in an index.

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.