If you would have told me a decade ago that we’d be facing the macro and micro circumstances we’re all facing today both domestically and globally, I’d have suggested you were simply out of your ever loving mind. What we’re seeing at the moment would clearly have been on the fringe of at least my thinking or scenario planning. And yet here we are. The journey is far from over. But we’ll all make it through. It’s a matter of how we all get there that has been and will continue to be the key issue.
In the midst of debt deals (or no deals), bailouts really planet wide that seem to continue unabated, and increased market volatility as of late, I thought it appropriate to step back, take a deep breath and ponder the question as to just how the US economy eventually returns to a solid footing. Below is the result of backbreaking, unfathomable, and testing the limits of human…meditation.
Just How Does The US Economy Return To A Solid Footing?
It’s a toss away characterization to suggest that the current “recovery cycle” has been more imbalanced than really anything experienced in a generation or more. I’ve discussed the “tale of two economies” theme far too many times. And this applies not only to large versus small business, but to the gaping differential in US wealth demographic characterized financial circumstances and well-being. From any longer term standpoint, this is simply unsustainable in terms of characterizing the domestic economy. Of course in very good part it’s the result of global economic/corporate evolution coupled with shortsighted political decision making based largely on massive over-reliance on Wall Street/big banks as “trusted financial/policy advisors”. In probably too simplistic of fashion I believe the following are key, and will clearly have bearing on investment decision making as well as real world economic outcomes.
Savings Must Increase On A Sustained Basis
I told you it was going to sound simplistic, did I not? Although this is straight out of the Economics 101 textbooks, for really any economy savings equals investment. I will not drag you through a long harangue, as this is virtually a self-obvious theme. You can see in the chart below that this is exactly what life looked like in the US during the post-Depression economy right up through the mid-1980s.
It was that very savings that “funded” US capital investment, ultimately leading to the build out of the country’s productive and competitive capacity that provided job and wage growth. All one has to do is look at how “savings” has funded the development of countries such as Chile, Brazil, a number of Asian economies, etc. to see just how powerful incentivizing saving can be for an economy. But in the early to mid-1980’s, the then socially acceptable substitute for saving that was credit grabbed the reigns in what became the largest US credit expansion on record. The proliferation of credit was essentially the thematic financialization of the US economy. Without a reconciliation of financial sector dominance or political power, there will be no near term sustained recovery for the US domestic economy. The financial sector has already "consumed" valuable forward public assets in the current cycle via shifting bad debt to the taxpayer. We will continue to rely on the global economy for growth as long as the financial sector dominates domestic policy making. It’s as simple as that.
Looking ahead we need to realize a few things. First, we’re not in Kansas anymore. This is not the post Depression (at least the first one) or posts War US domestic economy anymore, let alone the global landscape. As I've said for years, globalization changes everything. Capital is globally mobile now as it never was in the 1950’s through early 1980’s. Is there a guarantee that if US saving increased, it would actually be reinvested in US domestic productive capacity? Not at all. For that we need independent politicians and independent decision-making. We need tax incentives that focus on increasing savings and domestic investment. We also need a focus and meaningful national capital allocation to education, which at least in our home Golden State of California is being summarily gutted as per the needs of State fiscal reconciliation. Yet throughout the current “recovery”, every single US policy has focused on consumption and near term quick fix highs, necessarily at the expense of longer term capital formation and productive investment. We know what we have to do. Key question being, do we have the political as well as societal will to actually do it?
Deleveraging Must Play Out W/O Government/Financial Sector Gimmickry
Again, very politically as well as socially painful to even contemplate, but lack of regulation and lack of social self control (in very good part egged on by the primary beneficiary that was the financial sector) landed us in our current macro circumstances. We all share responsibility. Quite importantly, I believe it’s very important to think in terms of what has been characterized as the grand super cycle of leverage. This is generational in character and at this point endemic to the global developed economies, not just the US.
In the early 1990’s, not so long after the US generational credit cycle commenced, the S&L’s as well as LBO debt were the first casualties of financial sector excess. At the time the S&L's were allowed to actually fail. In the late 1990’s it was LTCM, which ushered in the too-big-too-fail mentality and resulting government policy that has carried through to the present, essentially paving the way for the greatest transference of bad private sector (financial sector) debt onto the public balance sheet in the history of the country. Over the 2006-2008 period, credit cycle casualties included former too-big-to-fails such as Lehman and Bear, but also quite importantly the US household sector. Although the other too-big-to fail institutions indeed did fail, unlike the S&L experience, they then had the meaningful political clout to have the US taxpayer, via political decision making, bail them out. Privatizing profits, but socializing losses became the new normal and remains so to this day for the financial sectors in major developed economies.
For now, it’s the US household sector balance sheet that remains in deleveraging infancy. Quite meaningful in that this set of circumstances is meeting up with demographic destiny. At the very time savings is needed to be drawn upon by the household sector, it’s absent. But quite troubling is the fact that yet to come in the greater credit super cycle reconciliation process is sovereign debt. It’s the last act to a multi-part and multi-decade credit cycle drama. Moreover, it’s an issue with the major developed economies, not just the US. Bottom line being, until the Government and financial sector gimmickry stops and we start down a credible road to orderly deleveraging, we can look to Japan of the last few decades for clues as to how at least domestic US economic tone may “rhyme”.
Two last points here and I’ll move one. Without question domestic US economic growth ahead will be dependent on income. It’s really the same deal for the major developed economies such as Europe and Japan. In essence income will first determine the rhythm and pace of the macro deleveraging process now at the household level and soon to come for sovereigns. Secondly, income will determine just how much private sector credit can accelerate, or otherwise, in each respective economy. I’ve already mentioned too many times that banks need to pick up lending in a post QE2 environment if macro credit acceleration is to move forward. Although I’ll come back to this in a minute, you can see below the dichotomy between bank lending (which we have adjusted for the early 2010 banking system taking back on balance sheet a few non-balance sheet items totaling 0 billion) and investment in USTs and agency paper. (A completely separate issue of course is what happens to Treasury prices if banks decide to lend as opposed to invest in what is government paper.)
Income growth is THE focal point key for the developed economies. Just where will income come from? If we can answer this correctly, we can navigate accordingly. I stopped counting in how many prior discussions I continually referred to the current magnitude of government transfer payments as a percentage of household disposable income. We're at record levels currently. I’m talking about organic income sources and growth as being the key near term focus ahead. In many senses we’re right back to the need for savings and investment that will provide for the global competitiveness that will lead to broad household income growth via domestic job expansion, not just income growth for the top quartile wealth demographic. Although I certainly do not want this to be an “end of the world for the US” discussion, as this applies to all developed economies, jobs provide income plain and simple. To answer the question as to where income will be generated, maybe we first need to successfully identify just where job growth will come from. Again, what has the Government done to help create domestic employment gains? Print money and bid stock prices up as a supposedly key rationale for QE2? All we’ve seen are policies to juice consumption, and by implicit correlation credit expansion. Does the Government actually realize we have economic constituencies other than Wall Street and the big banks? They will at some point, trust me. It’s called an election.
For now, and although these are not perfect economic angels by any means, it’s many of the emerging economies that are generating significant income for their respective sizes AND have the longer term capacity for credit acceleration to support further economic expansion. A very enviable set of circumstances. Not every emerging nation by any means and to varying degrees at that. China has major issues. But for many smaller emerging nations, already realized national saving and prior period investment in productive capacity have left them in very good shape looking forward within the context of the global economy, especially relative to their developed economy brethren.
Risk Must Be Appropriately Priced By The Markets Themselves
I know this theme is also wildly self-obvious, but we need to remember we are watching really generational financial market intervention on a global scale. Although it's simply a personal truism, the higher the level of artificial market intervention, the higher the probability of meaningfully negative forward financial market and real economic outcomes. You'll remember that Greenspan uttered the infamous “irrational exuberance" comments in 1996, and then sat back and watched a dangerous and generational bubble in dotcom stocks form and ultimately break without lifting even one finger to at the very least raise margin requirements in an effort to take the heat out of speculation. In fact his printing of money a year ahead of Y2K provided the rocket fuel for the final ascension of the NASDAQ in early 2000. Mispriced risk? If not, then just what was that?
To theoretically right the Greenspan Fed error post the NASDAQ bust, the Fed held interest rates artificially low for "an extended period" and fomented the mortgage credit bubble, the aftermath of which in very large measure caused the circumstances we now face. Mispricing of risk in mortgage rates? If not, then just what was that? Although this is a very basic question, I believe it hits economic and financial market bedrock. If risk is mispriced, then how can any specific business or broader economy efficiently allocate capital efficiently and effectively over time? Hint: It can't. And is it not capital misallocation on a grand scale that we've witnessed over the last decade plus? Sure looks that way to me.
Although this may sound a bit conceptual, and believe me it also applies to the Euro crowd and Japan, up until now the developed economies have not had to "pay" for unprecedented deficit spending and money printing. You'll remember I showed you official US government debt has doubled since the first quarter of 2006, as per the Fed's own numbers in the Flow of Funds statement. Include Fannie and Freddie loans and obligations in the equation and total US debt stands at close to 160% of GDP. Add in the NPV of SSI and Medicare and the number shoots up to something near 500%. So far no worries. Same deal for Japan at 200% of GDP and the Euro world is simply not too far behind.
So far in the current cycle the Government has attempted to stop deleveraging, encourage consumption, and is openly accepting of its own debt monetization (remember 50% of total US Government debt matures w/in three years so there is a huge vested interest here in terms of low cost funding). But the fact is that bear markets as well as economic recessions exist for VERY GOOD reasons. They exist to clear the system and set up financial markets and economies for the next growth phase. At least so far, there has been neither clearing nor a setup for the next cycle, only the creation of an artificial cycle via a doubling of Government debt and more than a tripling of the Fed balance sheet. When the clearing mechanism of a bear market and recession are suppressed by artificial government means, ultimately the government will end up taking the pain as opposed to the owners of and investors in the financial system. Of course by government, I mean citizens (and their heirs). Unfortunately from a government/taxpayer focal point, given that we've borrowed so much from the future in the current cycle, two outcomes become increasingly likely - 1) inflation, or 2) a crisis in the public debt markets. Again, this applies to the global developed economies and not just the US. Unfortunately, the script is playing out as anticipated.
What are the forward implications of current period mispricing of risk in the developed economies?
- There is a very high probability in the years ahead that the assumed risk free asset will no longer be seen as risk free. I’m talking about sovereign debt in developed economies. Isn't this literally exactly what we are seeing in peripheral Europe right now? And this cannot burn toward the center of developed economy sovereign debt instruments? Of course it can and it will unless policy is changed. As I've said over and over, unlike peripheral Europe, the US has the time, but does it have the will to credibly address its imbalances? Japan is running very short on time, and is maybe already past the point of an inevitable restructuring. Europe will see drastic changes ahead in the currency and respective economies.
- Given current trajectories and in place respective government policy decisions, competition for sovereign capital in the years ahead I believe will be a very important investment theme. And not just competition among the developed sovereign economies, but likewise simultaneously in competition with the growing need for emerging nation funding to meet growth needs.
- Does current mispricing of risk in developed economies ultimately precipitate a sooner rather than later currency delinking between developed and developing economy currencies? Although I’m guessing, I believe this is exactly what is to come. Again, if I had to guess, I would not be surprised to see the initial rumblings of this in earnest with 18-24 months. Inflationary pressures driven by the mispricing of risk will accelerate the event. It's a secular game changer for the developing economies. I believe developing economies will come to see their link to major developed economy currencies as an untenable Achilles Heel in the not too distant future (within a few years). Remember, this is not end of the world stuff by a long shot. It's simply the current trajectory of the evolution of the global economy. I’m not predicting wars or cataclysm. This transition can indeed be orderly, but it's a game changer nonetheless, especially for the developed economies.
- Finally, and I've mentioned this in the past, will continued willful developed economy mispricing of risk accelerate the movement of global capital out of public assets and into private sector investments, especially in the developed economies? Simple question being, over the next five to ten years just whose balance sheet deserves the greater trust factor, the US Government (or Japanese, or Euro) or Johnson and Johnson (or Nestle, or Sony, etc)? Although it seems light years from a present concern, remember a truism I’ve cited for many a time - liquidity and capital are cowards. There's always too much when it's least needed and it's never around when needed the most. There will not just be competition for sovereign capital ahead, but a battle between trying to attract public flows at the expense of private sector flows. Major investment theme to come. Major.
The Inevitable?
It’s more than clear, isn’t it? And nothing you don’t already know. We currently have a near record gap between US Government expenditures and receipts both in nominal dollars and as a percentage spread. We’re down from the highs of early 2009, but still at near record levels. For now, actual governments receipts remain blow the highs of 2007. Certainly this is just the Federal Government, but we can conceptually include the States in the very same boat in terms of fiscal mismatch. So, just what does this mean looking ahead and how will themes coming from this set of circumstances influence investment decision-making?
- Higher taxes and reduced government spending at the Federal, State and Local muni level lie ahead. Again, this should not be new news. How it plays out is the important issue. Moreover, the States will lose critical Government funding dead ahead. The stimulus funds are over. Remember, household income as a percentage of corporate profits (we’ll spare you the chart) rests near historic lows. There could be no other way corporate profits could have been so good so far into the current cycle. Likewise, households simply cannot afford a much higher tax bill while balance sheet deleveraging still looms so large. This is telling us tax revenue acceleration will need to come from those that have benefited the most over the last few years – corporations and high net worth families.
- Although the US politicians have clearly favored the corporate sector, with special emphasis on the financial services sector, in this cycle they will have to turn against their largest campaign contributors at some point when addressing the pressing need for government revenue generation. That will ultimately cut into profits. Or corporations will rebel and we’ll have a different set of circumstances with which to deal (movement offshore, etc.). Did you see Amazon immediately shut down their California sales affiliate operation when the State passed internet tax collection legislation? Tax rates will be a battlefront ahead, not only domestically, but globally. And what does this mean for the rhythm of corporate profitability? This is not a here and now issue, but will be coming soon.
- Lastly, spending cuts at all levels of government will be inevitable. It’s already started in earnest at the State level. Job shedding will only continue and probably intensify at the State and local levels. But the Federal Government will not be immune. Think about the potential impact on companies quite levered to government contracts. Tax receipts simply will not support spending. Government borrowing has been the plug figure up to this point, but that also will change meaningfully ahead.
- As I’ve already discussed, but clearly relates directly to this topic, US interest rates are at risk longer term, specifically US Treasury as well as State muni rates. As said earlier, so far in the current cycle there has been no “penalty” for profligate borrowing and money printing. But that’s simply unsustainable. How high will government cost of funds rise? As I’ve maintained for a while now, the US has the time to deal with the historic excesses, but does it have the will? Proactive reconciliation of leverage excess is a must, otherwise the financial markets will reconcile the excesses for governments at all levels. The taxation and spending issues loom large.Bad debts in the system must be allowed to clear. Although this may seem a strange subtopic, it’s the Federal Government that has been picking up the tab for private sector bad debt throughout the entirety of the current cycle. If Fannie and Freddie are not poster children for this comment, then we’re nuts. And this is the reason why the mismatch between revenues and outlays is so critical an issue. Certainly this comment has meaningful implications for the financial sector looking ahead.
- Bad debts cannot be piled on top of taxpayers who have no way to fund these liabilities while record corporate profits are privatized. It’s only a matter of when, not if.
Again, I do not mean this rather lengthy discussion to be some end of the world litany of issues. These are just some of the key issues I view as critical looking ahead. These are the speed bumps around which we must navigate as investors and ultimately protectors of capital on a real purchasing power basis. I’m not suggesting the government was wrong to have gone to such excess to stimulate over the 2009 to present period. But what I am saying is that a very credible plan for reconciliation/reorganization must be forthcoming (not a chance until after the elections). Point blank, will it continue to be all about playing politics ahead, or will we focus on key strategic reform and investment? Of course the choice is ours. So far into the current cycle, our “leaders” have chosen to protect the old system at all costs. The result is unimaginable leverage and the pressing need for market manipulation (interest rate suppression). Has this been the correct path and does anyone in power have a plan B? As investors we simply need to anticipate all possible outcomes.
