July 31, 2012
There is an old Chinese curse that translates to: "may you live to see interesting times." Interesting indeed as there is no precedent for the environment investors face today. None of the many difficulties the world economy faces are brand new. What's new is the decidedly distasteful stew being served as all of the troubles are put in the cauldron together as never before. With rolling recessions across the globe there is the justifiable fear that the recent "Great Recession" will turn into the next "Great Depression". What are the flash points that could bring this perfect storm together? Let's hit them one by one.
Much of Europe is in a dire solvency crisis brought on by the bursting of real estate bubbles across much of the developed world back in 2007. That bubble hit a particularly raw nerve because of the relationship between real estate loans, leveraged bank balance sheets and government deficits. When the bubble burst it caused two things to happen. First, banks had to take heavy losses. Second, a severe global recession ensued. As a result governments were faced with declining revenues and a collapsing financial system. They decided to save the banks by nationalizing their losses. The decision to save the banks rather than put them into receivership was critical because it tied the countries' fortunes to the banks, an unbelievable gift to the bankers at taxpayer expense. The result? Some of the countries are now insolvent too.
The European Central Bank (ECB) and policy makers have thus far treated this as a liquidity crisis in an effort to buy time. But the downward spiral continues as governments pile up excessive debts to bail out troubled banks and in turn rely on the troubled banks to buy the government's excessive debt. Charles Ponzi would be proud. It's quite rational to believe that this situation will not end well. One clue is the interest rates spike in the "PIIGS" countries: Portugal, Ireland, Italy, Greece & Spain. Nobel laureate Milton Friedman was famously skeptical that the European monetary union could not survive its first shock because the only way out of such a downward spiral is to hit overdrive on the printing press. The PIIGS do not have the ability to do that and a rolling recession, if not a depression, continues.
Greece is the canary in the coal mine. The combination of fiscal austerity and skyrocketing interest rates has ground their economy to a halt as they are in their fifth year of recession. Across the Eurozone six countries are in technical recession and unemployment stands at 11.1%, the highest since the project was launched in 1999. In Spain unemployment is 24.6% (52.1% among the youth). The Europeans and the IMF have put together ~EUR600bln, which could be enough to bail out Spain. But Italy, whose bond yields are also spiking and is in recession, would blow the doors off the whole enterprise.
If it seems like it could not get any worse then consider that the solution to these problems are not monetary or fiscal, they are political. The fundamental question is: are the strong countries like Germany willing to save the common currency by making massive transfers of sovereign wealth to weaker countries in exchange for the weaker countries ceding sovereign fiscal authority to Brussels. Each party will either make that hard choice or accept the painful consequences of a breakup. Because of this problem's political nature it is unlikely to reach any resolution without a crisis the severity of which we have not yet seen. The clock is ticking.
If only the European troubles could happen in a vacuum then the rest of the world might march merrily on. However, the European financial system is the primary financier of emerging markets and deeply interconnected with those economies. Additionally, European consumers are a major market for goods manufactured in the emerging world. This double whammy has begun to cause economic slowdowns in the developing economies that have been the growth engine of the world over the past three years. China, Brazil and India have all slashed interest rates in an effort to have a "soft landing", code for modest declines in GDP growth rates. Leading indicators are beginning to suggest that those efforts are not working.
"No, gentlemen, we have tried spending money. We are spending more than we have ever spent before and it does not work." - U.S. Treasury Secretary Henry Morgenthau, Jr., 1939
Our economic recovery since the "Great Recession" has been weak by historical standards. Now, due to global recessionary pressures, high systemic leverage and uncertainty about the proper role and size of government we may be on the edge of another recession. Recent economic gains of winter have proved illusory, driven by weather related factors that are not sustainable. The Federal Reserve, famous for being late to every party, recently lowered its 2012 growth forecast from between 2.4% - 2.9% to 1.9% - 2.4% and extended its latest round of monetary stimulus beyond its original expiration date. Although the Fed has been creative and energetic in its efforts to combat the risks to economic growth, it can do little more to combat the problems we face.
What we can do in the U.S. is move away from a fiscal policy that has thus far been a fantastic failure. Spending growth has far outpaced revenue growth through both Republican and Democratic White Houses and Congresses. The "Fiscal Cliff" of expiring Bush tax cuts, payroll tax cuts, new health care reform taxes and spending cuts may well push the economy over the edge. Although it is much more likely that policy makers will punt for another year than let us go over the cliff, the point is useful to demonstrate that if prudent reform is not taken soon then we will confront our own debt crisis as various entitlements explode governmental obligations.
The preponderance of historical economic data suggests that spending is the problem. Contrary to Keynesian orthodoxy that presumes government spending has a multiplier of greater than 1 (which is to say that $1 spent by the government creates more than $1 of economic activity), the reality is quite different and that multiplier is likely much closer to zero. Sadly, therefore, the short term benefit from spending is dwarfed by the destabilizing effect of a large debt burden and the negative corollary effects on long term GDP growth. In this way spending is like a drug: it produces a short term benefit but exacerbates a long term problem. Japan is a worrisome example of this as they have experienced 23 years of anemic economic growth pockmarked by regular recessions.
Debt problems cannot be cured with more debt, as Europe ably demonstrates. Few would disagree that we are on an unsustainable path. At some point we will reform or the bond market will make borrowing prohibitively expensive. The danger of playing chicken with the bond market is that much of our debt is short term and needs to be refinanced regularly. If interest rates climb precipitously it would only be a short time before the interest expense dwarfed any other budgetary line item. A downward cycle of debt and economic decline would quickly ensue.
Opportunities & Risks
Because I want to end on a happy note, I'll start with the risks this time. Broadly speaking the U.S. equity market does not provide the margin of safety needed to be bullish. At 14, the price/earnings multiple of the S&P 500 is neither cheap nor expensive. Furthermore, corporate profitability is at unsustainably high levels due to corporations' lack of investment and hiring, and hoarding cash. These high earnings levels serve to make the market look cheaper than it actually is. In order for earnings to grow global GDP growth needs to come back. With all the headwinds out there it seems that risks remain tilted to the downside.
However, markets never distribute their gains or their pains equally. There are opportunities out there where the panic is already priced in. Energy is a good example. The long term global imbalance between supply and demand, broad based currency devaluations, low multiples and high dividend yields make this sector and others like it fertile hunting territory.
Suffice it to say that this is a very difficult time to be managing money. We can expect the roller coaster to continue until Europe and the United States makes progress on their issues. From a portfolio perspective, be heavy in cash so that you can mitigate any major portfolio declines, take advantage of opportunities and live to fight another day. Remember that it is better to get ahead by not falling behind.
Brennan R. Redmond, CFA Vice President
(This article contains the current opinions of the author but not necessarily those of Brighton Securities Corp. The author's opinions are subject to change without notice. This blog post is for informational purposes only. Forecasts, estimates, and certain information contained herein should not be considered as investment advice or a recommendation of any particular security, strategy or investment product. References to specific securities and their issuers are for illustrative purposes only and are not intended and should not be interpreted as recommendations to purchase or sell such securities.)