Dear clients and friends:
Over recent weeks we have become more negative in our outlook for the economy and the financial markets. We are sending this update to you to reflect our latest thinking and strategy.
In the context of what we see are overwhelming problems and challenges, we see underwhelming solutions being brought to bear. We remain very defensively allocated in client portfolios.
Conventional Wisdom meets Unconventional Reality.
This is not a typical economic downturn and it is highly unlikely that the outcome will follow any conventional playbook. At best, we are in a deep and long recession. For many, it will seem worse.
Comparisons to recent history – the 2000 dot-com bust, the 1987 market crash, the 1981 recession, or even the 1973-1974 recession – are instructive but not predictive. We need to look further back to the past to understand the future.
Consider the circumstances. The world economy is in the process of unwinding a massive debt bubble 25 years in the making. Between 1982 and 2007 credit market debt as a percentage of nominal GDP grew from 160% to 360%, or about 3.3% per annum in excess of GDP growth. The majority of this growth occurred in the past 10 years and the greatest escalation occurred in the past seven years.
The availability of easy credit fueled consumption and investment and inflated asset values to unsustainable levels. It enhanced economic growth, corporate profit margins, and distorted our future expectations for sustainable behavior.
Finally, it led to the creation of a vast array of new investment products, tools and services, the systematic underpricing of risk, and a false sense of well-being and security.
Although the U.S. economy was at the epicenter of the credit bubble, the party quickly spread around the world. Our excessive levels of consumption fueled exports and growth from Shanghai to Mumbai to Dubai to Rio. Foreign governments and financial institutions, flush with cash, bought our debt to help finance an increasing appetite for borrowing and consumption.
The expansion of credit beyond the growth in GDP also provided the underpinnings for the 25 year bull market in U.S. equities during the same period. Although there were notable corrections in 1987 and 2001, the overall trend-line remained intact and directionally upwards. Meanwhile, the personal savings rate dropped from 10% in 1982 to 0% in 2008 and while we borrowed to fuel consumption, we underinvested in education, infrastructure and all the things that give our economy ongoing competitive advantage.
Also during this time, a generation of financial professionals and advisors came into the industry, and they developed a set of investment beliefs, products and solutions based upon this debt-fueled sense of the status quo. Many of these beliefs and practices, designed by looking in the rear-view mirror, have crashed head-on into a new reality.
Investors are slowly coming to terms with a new reality and we do not think this reality has been fully priced into the stock market. Too many people are hoping for a bottom based merely on the fact that the market has declined 50% thus far from its highs, or the belief that most recessions last only 18 months.
Hope is not an investment strategy. In our experience, market bottoms are not borne out of hope but rather despair and indifference. They also need to be grounded in reality.
And the reality is daunting.
President Obama and Congress have just approved a $780 billion stimulus package, on top of $700 billion in T.A.R.P. funding to help shore up the banking system. Hundreds of billions in additional funds have been committed by the government to backstop beleaguered financial institutions, guarantee deposits and credits. Despite these efforts, we may be on the verge of nationalizing several large banks, and providing up to $25 billion additional aid to the automotive industry. Housing prices continue to fall and mortgage default rates continue to rise. Unemployment rates are also rising sharply, moving from 4.8% last year to over 7.6% currently. We think unemployment will grow to over 10% by year-end. Meanwhile, state and local governments are reeling with unprecedented shortfalls in tax revenues and a number of foreign governments including the United Kingdom are in severe financial distress.
To pay to clean up this mess, we will likely run over a one trillion dollar deficit this year and for the next few years, and allow total outstanding public debt as a percentage of GDP to increase to levels not seen since World War II. This debt will have to be financed, and it is highly likely that future lenders will demand a higher interest rate to buy government bonds. Finally, there is an enormous political change at foot. Some of it is positive, but there is also an unprecedented level of government involvement in the private sector and a populist backlash. When times are tough, it is easy to look for scapegoats. As bad a job as the private sector has done in regulating itself, it has done so with the explicit complicity of Congress and government regulators. The thought of Congress running the financial services and auto industries, dictating compensation and creating zombie enterprises in the process does not engender confidence.
Like we said, this is not a typical downturn. This will be a long and difficult process. It could take years.
Challenging Conventional Wisdom.
Conventional wisdom, widely preached and practiced by many financial advisors and investors suggests that one continue to stay the course, stick to a long-term investment plan, maintain a diversified portfolio, largely geared towards equities, and stay relatively fully invested.
Although we understand and believe in much of the underlying logic, many of these beliefs and practices were not designed to contemplate the economic and market conditions that we experienced last year and continue to experience today and will likely experience in the years to come.
Anyone who followed conventional wisdom and practice and left their portfolio on autopilot last year suffered greatly. Diversification provided little protection as most asset classes became highly correlated, and more sophisticated portfolios designed to include exposure to emerging markets, commodities and real estate, fared even worse. Even alternative assets, which were supposed to offer absolute returns, suffered substantial declines. Almost every asset class save treasuries and cash got hammered.
Part of the value of experience is understanding when things are the same and when they are different. There are times when the risk versus reward of an asset class or an entire market are unfavorable and it makes sense to turn off the auto-pilot, grab the controls and just get out of the way. We did this last year - although we did not emerge unscathed – and we believe that things are different enough and the potential risks great enough that it makes sense to keep a low exposure to equities and a healthy reserve of cash today. If our deleveraging thesis is correct, we will have the opportunity to put the cash to work again at better prices.
We don’t view this as market timing but rather, prudent and active asset allocation as well as risk management. Presumably, this is why one hires a financial advisor in the first place.
Our view could change to the positive as either equity market valuations decline further, to levels that we think compensate us for taking the risk, or as we see meaningful signs of improvement.
Karl Mills, CFA
Mikel Keifer. CFA