The U.S. economy continues along the road to recovery. It promises to be a long and winding road, marked by a shifting landscape of challenge and opportunity.
Massive government stimulus here and abroad has helped to backstop the financial system and facilitate a revival of economic activity. It has also led to an impressive rebound in the global financial markets on the premise that this revival can continue.
Large questions remain concerning the economy’s ability to grow under its own power once government stimulus is withdrawn, and what the consequences of the stimulus will be.
Major forces of change are also at work that have equally large implications for investors. These changes include the deleveraging of the private sector of the U.S. economy, the economic ascendance of China and other developing nations, and a powerful wave of technological innovation allowing the world’s people and knowledge to be networked together wirelessly.
Our view is that the economy and financial markets are in the process of transitioning from this rebound phase to a more pivotal recalibration phase where the dust starts to settle and the longer-term implications of our current situation become more readily apparent.
In January of this year we first wrote about this new and changing reality, which has also been dubbed the “new normal” by the folks at PIMCO and the mainstream media. Whatever you want to call it, we are recovering to a future that looks different from our past, with slower domestic growth, long-term structural challenges, shifting public priorities, changes in economic and political leadership and a different and a more difficult competitive environment.
Meanwhile, the growing burden of public debt that is financing the recovery poses a substantial and enduring systemic risk that must be factored into all investment decisions.
Periods of challenge and change create stress but also enormous opportunities for companies, industries, and even countries that are flexible and well positioned to take advantage of the situation.
Global financial markets have recovered more than half of the value lost during the downturn as expectations have rallied to catch up with reality. At current levels, expectations are fairly high and vulnerable to disappointment.
We are therefore keeping client portfolios somewhat defensively positioned, but with a heavy emphasis on companies and other investments that are well positioned to ride out, if not thrive, along the road ahead.
In this Commentary, we explore the three major trends mentioned above as well as a number of shaping forces and other influential factors that drive our asset allocation and investment selection decisions in client portfolios.
I) Deleveraging the U.S. economy.
For 27 years between 1981 and 2008 total public debt grew 3% to 4% in excess of the growth rate of GDP. This debt bubble combined with a secular decline in interest and savings rates fueled above-average levels of consumption, economic growth and asset values. It also engendered a false sense of prosperity: What was unsustainable became accepted as sustainable.
Those forces that provided a tailwind for this era of borrowed consumption, including declining interest and savings rates, easy credit, low inflation and unemployment are now becoming headwinds. Credit is tight, home and other equity has been diminished, the savings rate is considerably higher and unemployment rates are breaching 10%.
These headwinds are likely to persist. The consumer needs to repair his balance sheet and save for retirement. Overextended corporations - both those with too much debt and those with excess capacity - also need to downsize, retool and refocus.
Put another way, after a quarter century of overborrowing, overconsuming, undersaving and underinvesting, the American consumer and U.S. economy at large is in no position to return to the way things were at any time in the near future.
At the same time, as consumers and businesses work to reduce debt and shore up their balance sheets, Government debt levels are hemorrhaging to take up the slack, stabilize the economy and stimulate its recovery.
So we are not solving the problem as much as we are transferring it, in the mother of all Cash for Clunkers program, from the private sector to the public sector and from the present to the future. This is the legacy we are leaving our kids.
Even more troubling, most of the $787 billion fiscal stimulus package is going to triaging the status quo and in many cases sustaining that which is unsustainable. This includes - tax credits, extentions of benefits and aid to states. Less than 20% goes to meaningful investment in energy, infrastructure and other areas that could give our nation new capabilities and improved competitive advantage.
The hope is that all of this fiscal stimulus can jump-start the economy and buy time for it to get up and running under its own power. It is also hoped that the private sector can succeed in stimulating investment in areas of innovation and growth.
We think both things will happen. But it is a tall order to believe that this will be sufficient to overcome the heavy burden of debt, excess capacity, and structural dysfunction, as well as the likely side-effects of inflation and higher interest rates down the line.
Until we can find a way to create an export-driven new industrial economy based on innovation, overall economic growth will therefore likely be slow.
II) The Rise of China, India, and the Developing World.
Our belief is that China, as well as India and other developing economies will drive the majority of global economic growth in the coming decade and beyond.
This is hardly a contrarian view, but neither is it one to be underestimated. The hegemonic economic dominance of the United States and Western Europe is declining and that of China and India, but particularly China, is in its ascendance.
The simple reality is that these economies are large and growing rapidly. They will likely continue to do so for years to come.
We think it is crazy that China, India and Brazil are still referred to as “emerging” markets.
China alone, boasts an official population of 1.3 billion people and a GDP currently estimated at $4.4 trillion, making it the 3rd largest economy after the United States, and Japan. Both China and India have burgeoning middle classes measured in the hundreds of millions and growing by the millions each year eclipsing entire “developed” countries in a single bound.
As these populations grow and become more affluent, their own consumption increases. They are able to generate more of their own economic growth while becoming less reliant on exports. Put another way, China will become the largest markets for its own goods and services.
And with an estimated $2.5 trillion in reserves, China has become the world’s largest creditor nation, able to invest in its own future growth and potential for many years.
Finally, as their economies develop, their capital markets - debt and equity - are also in the process of becoming deeper and wider. This improvement should allow them to attract and accommodate a growing share of global capital investment while reducing the volatility that has traditionally been associated with emerging markets.
Although it would be foolish to think that China and India are going to grow in a straight line without setbacks along the way, we think it would be a much bigger mistake to bet against them, rather than on them.
III) The wireless data wave.
If a traditional cell-phone is a moped in terms of its data consumption, then an iPhone is a large SUV. A true data-guzzler.
That’s because an iPhone is much less of a phone than a mobile computing platform and an example of a major secular trend we have referred to as the wireless data wave.
Over the past decade, mobile devices and their capabilities have evolved rapidly. They have progressed from transmitting pages and analog voice signals to digital voice signals to photos, to music files, to video files to applications.
We have gone from using them primarily for short-term person-to-person communication to the constant gathering and disseminating of information, often from and among large networks of users.
As the devices become more powerful, more applications are written for them that make them evermore useful. The more useful they become, the more we use them and the more applications are written to make them more useful.
This same virtuous cycle of increasing capability driving increasing demand played out in personal computers in the 1990s and with the internet since then.
Already, the demands of the users and devices are overwhelming the networks and technology that support them. AT&T’s chief technology officer recently said that smartphones and the applications they run has caused a 5,000% increase in data usage in just the past three years.
The wireless data-wave that the trend of more data, more users, more devices, more places, all networked together, will continue. It is a bet that these devices will have much greater capabilities than they do today. And finally, it is a bet on the need for large-scale investment in network capacity to make this all possible.
Shaping forces are smaller trends and other forces that influence how major trends will play out.
Our economic recovery has been financed by the equivalent of a national subprime mortgage. Our ability to keep refinancing this mortgage depends directly on the willingness of others to keep lending us money at low interest rates. A meaningful rise in long-term treasury rates, will tend to slow economic growth and significantly increase the cost of financing our ongoing debt burden.
There remain significant structural imbalances between the cost of government and the tax revenue to support it. This is true at the Federal, State and Local levels. Even as corporations downsize, government spending continues to grow. These imbalances are unlikely to reverse without major changes and painful cuts to government programs, or large increases in taxes, or both.
We see little evidence that our elected officials have the political will to effect the bold changes necessary. These changes would require major cuts to sacred spending programs and higher taxes, both of which are political suicide. And so we end up with incremental change that has the veneer of progress but sustains the problems into the future.
The U.S. Dollar:
The U.S. dollar continues to decline and serve as the posterchild for dysfunctional currencies. The reasons for its decline are well known, and include economic weakness, mounting deficits, and a loss of faith in its primacy as the World’s reserve currency. As a result, all things priced in dollars, such as oil and metals and stocks have inflated in value. Although it wouldn’t surprise us to see the dollar regain ground relative to the Euro and British Pound, we would expect the dollar to continue to lose value relative to developing economy currencies. If there is a silver lining, it is that a weaker dollar makes U.S. exports cheaper and more competitive.
The regulatory pendulum is in full swing along its arc from too little to too much. Pendulums almost always swing too far and this time will not likely be an exception. The degree of government regulation will impact the speed and nature of the recovery. Too little and too much regulation are both dangerous things.
The growth in China and India is predicated on the availability of energy and basic materials, as well as safe food, clean water and air. The incremental demand for these commodities will likely outpace the incremental supply, resulting in higher prices. We have already seen a dramatic rebound in energy and commodity prices off their lows earlier this year. Some of this is anticipation of the secular demand cycle. Some is a function of the dollar, but we think the prevailing trend will involve greater competition for increasingly scarce resources.
Inflation and deflation are often presented as mutually exclusive. We expect both.With a world awash in too much stuff, too much capacity and too much debt, we think asset deflation is a larger risk than conventional “headline” inflation. Because of the dollar’s woes however, we do see a high probability for inflation in the price of energy, resources, and other things priced in dollars.
In the United States, the baby-boomers are moving beyond their peak spending years and are starting to retire – or at least think about it. Meanwhile the number of workers to support the mounting benefit costs of an aging population is shrinking. These imbalances are even more acute in Europe and Japan where the population is older and the social benefit obligations represent a far greater percentage of GDP. By contrast, emerging and developing economies have younger work-forces and faster growing populations.
Investable Outcomes: Valuation, Risk and Opportunity.
We try not to be either bullish or bearish for the sake of being one or the other. Instead, we try to be realists, evaluating potential outcomes relative to the risks and opportunities involved.
From where we are today, we see three possible outcomes on the road ahead. The first, is that the economy has a relapse, most likely caused by an accelerated deterioration in the dollar and a sudden and substantial rise in long-term interest rates. It could also be caused by some exogenous event, such as the H1N1 virus. Although we do not see this outcome as probable, the larger point is that our economy is not in good shape to survive another shock to the system. One should therefore plan accordingly.
The second outcome and the one we think most probable, is that growth in the United States and Europe is slow, unemployment rates remain high, the consumer economy remains in a retrenchment mode. Long-term interest rates start to creep higher as do the prices of commodities and other stores of value. Asian economies continue to grow and prosper, helping to partially offset weakness in the United States and Europe.
The third outcome is that we are being too cautious, and the recovery is much stronger than we expect, leading to an increase in real-estate values, corporate profits, personal income and tax receipts. Deficits start to decline, the dollar strengthens, restoring faith in the economic well-being of the United States. Stock market valuations recapture lost ground and move higher.
Through a completely subjective process, we might assign a 20% probability to the first and last outcomes, and 60% to the middle. But given that we are stewards of our client’s assets, we would rather err on the side of caution.
We are therefore keeping our client portfolio allocations between stocks and bonds somewhat conservative and oriented around the following ideas and conclusions that flow from our analysis:
1) It is important to differentiate between economies and companies:
Although they are related, companies and their stocks can do well even when the economies in which the companies are based are struggling. Consider that during Japan’s “lost decades” of growth, Toyota became the largest car company in the world. Therefore, while our view of the U.S. economy is guarded at best, we are actually quite optimistic about many U.S. based multinational companies. They are in much better shape than the broad economic headlines might suggest.
2) Tilt towards Asia:
Over time, we intend to keep building our portfolio allocation to developing market equities and debt. We are also building our allocation to resource companies and resource-rich countries like Canada and Australia that are major exporters to Asia and provide a natural hedge against the dollar.
3) As the American economic pie grows more slowly, the strong get much stronger. Focus on the “pie-takers:”
Well-managed, well positioned and well capitalized companies will trounce weaker competitors. The gulf between winners and losers will only grow wider. Companies like Google, Goldman Sachs, Apple and Amazon continue to differentiate themselves by flourishing while others flounder and fade. Our stock selection is therefore focused on innovative, well capitalized market leaders.
4) Financial Winners:
Invest in companies that can benefit from deleveraging. As companies try to restructure and realign themselves for the road ahead, we expect mergers and acquisition activity to increase. We also expect deleveraging to continue, leading companies with too much debt to sell good assets at bargain prices. Companies like Berkshire Hathaway, The Blackstone Group and Goldman Sachs, all of which are core holdings, are well positioned to benefit from both trends.
5) Invest in the wireless datawave:
Technology leaders like Cisco, Qualcomm, Apple and EMC are at the heart of the wireless datawave. They have superior technology, management capabilities and large piles of cash on their balance sheets. They are well positioned for future growth.
Dividend payouts for many companies like Verizon and Vodafone rival the yield on corporate bonds and yet offer equity-market participation and more favorable tax treatment over time. We are therefore allocating a significant portion of our equity allocation to stocks with strong defensive characteristics and attractive dividend yields.
7) Get in the way of government stimulus and out of the way of regulation:
We are focusing on companies that benefit from global spending on infrastructure, energy, and healthcare. Examples include General Electric and ABB. Meanwhile, we are avoiding companies that face undue government regulation.
8) Hedge for inflation, rising interest rates, and a continued deterioration in the value of the dollar relative to real assets.
We have allocated a portion of client portfolios to gold and securities that should benefit should there be a meaningful rise in long-term treasury bond interest rates.
And finally, remember a lesson that we have learned over many years of investing: that your worst fears and greatest expectations rarely come to pass. Things are constantly changing and capital is not static. Problems tend to beget solutions and events come out of left field that put everything else in a new context. It is therefore important to remain flexible in your thinking.
So, keep your seatbelts fastened, drive defensively, but keep your eyes out for opportunities as they present themselves. This is not a time to invest on cruise control.
Jurika, Mills & Keifer, LLC