“The U.S. economy remains almost comatose....The current slump already ranks as the longest period of sustained weakness since the Great Depression....Once-in-a-lifetime dislocations...will take years to work out. Among them: the job drought, the debt hangover, the defence-industry contraction, the (banking) collapse, the real estate depression, the health-care cost explosion and the runaway federal deficit.”
-Time Magazine, Sept.1992
History doesn’t always repeat but it sure does rhyme! With all this talk about a “double dip” in the media lately, one would conclude that it must be a certainty (just like all that Depression talk 18 months ago). The fact that back-to-back recessions are extremely rare events matters not if it sells newspapers and gets you to hold tight until after the commercial break. In reality, while we have had many recessions in the last 80 years, only 2 of them turned out to be “double dip” situations so it is a very low probability event. One of those was during the Great Depression when after several years of decent economic growth, policy makers rushed to balance the US budget prematurely. They forced higher taxes and lower spending on a fragile economic expansion and the result was another recession. The second double dip occurred in 1982 (following the 1980 recession) when the head of the Federal Reserve intentionally pushed the US economy back into recession to end runaway inflation (remember those 18% interest rates?). So one instance was a policy error and the other was intentional. History hardly supports the double dip camp.
While the debate will rage on until more economic clarity emerges, I wanted to provide a bit of balance to the overwhelming pessimism that investors are being subjected to on a daily basis through the media. For what it is worth, I am not in the double dip camp, nor am I in the “sustained deflation” camp. We have lived through the equivalent of a financial nuclear bomb and that has caused disruptions in employment, household net worth and consumer demand but these are all temporary in my mind. Yes, US unemployment is remaining persistently high but for lots of good reasons. After slashing to the bone in 2008, employers are very reluctant to bring back workers until they are absolutely forced to do so. This is always the case coming out of recession but this time, it has been exacerbated by the unknown health care costs and uncertain tax increases that the Obama administration has downloaded to the employers. The simple fact is there is a lot of uncertainty about these extra costs and employers are going to push their current employees to the breaking point before they commit to new hires. But make no mistake, unemployment has always proven to be a lagging indicator and it does not tell you where the economy is going but rather where the economy has been.
I believe the markets are acting almost irrationally pessimistic, continuing to ruminate about everything bad that has happened and worry about everything bad that may happen. It is like the market is looking over its proverbial shoulder expecting to get smacked by the boogie man again. When everyone is searching for bad news and looking under every rock to support their negative thesis, the markets often climb the “wall of worry”.
I have said before, when there is nothing to worry about, we need to get worried. But in the current environment, there are just way too many bears (including the celebrity bears like David Rosenberg and Nouriel Roubini) and too few bulls. A recent Investor Sentiment Survey highlighted that 50% of respondents were bearish and about 20% were bullish (the balance were just plain confused) and this is in itself a very optimistic reading as most have positioned for bad markets already. These numbers rival the readings that we witnessed at the market bottom in March of 2008.
So how have the bears positioned their portfolios at the moment? An astonishing amount of money has flowed into the bond market chasing ever increasingly diminished return potential. Something like USD $750 billion has run into the bond market YTD while $75 billion has fled the stock market over the same time period. And with the US 10 year Treasury yielding around 2.60% at the moment, there is very little room for error should inflation re-appear sometime over the next 10 years which continues to be my greater concern looking out 18 months.
The Bears point to these low yields to support their pessimistic outlook because after all, the bond market is supposedly the “smart money” and they argue that these low yields must be foreshadowing a double dip and deflation. But guess what? The bond market doesn’t always get it right and I remind readers that in the spring of 2003, the 10 year yield got down to about 3% only to rocket back up to 4.5% within 6 months. And during the financial crisis, investors were so desperate to protect capital that they bid up the price of the 10 year US Treasury until it yielded as little as 2% only to sell off bonds and drive the yield to 4% about 6 months later. Does this sound like the “smart money”? I continue to think that anyone “investing” in government bonds at the moment with a plan to hold them for a few years will have a similar negative experience. But that is just it. Most players are “renting” the positions.
I indicated in my last market letter that the central governments around the world averted the Depression threat last year by pumping historic amounts of stimulus into the system. I also indicated that there was ultimately going to be a consequence to those actions and in April, these challenges began to appear. Governments strapped on huge debts and now they have to deal with those debts. There are no easy solutions, particularly if you don’t control your own monetary policy like those countries in the European Union. Prior to the Euro, if a country like Greece got in over its head, it would simply devalue it’s currency (or allow it to be devalued) in order to deal with it’s debt burden with the result being a lower standard of living for Greek residents. But since Greece no longer has control of its currency, it is a more challenging situation for the whole union. Ultimately, Greece (and possibly others) will either be forced to take their austerity medicine or will have to leave the European Union.
Now if you are a country that controls its own currency (like the USA) and have strapped on way too much debt, what is the path of least resistance in paying back that debt? The USA could cut spending (unlikely), or raise taxes (hard to do enough of this and get re-elected) and both of these options will crimp the fragile economic recovery. The other option is to devalue the US dollar to diminish the future value of those obligations. I continue to think the currency devaluation option is the path of least resistance and the Federal Reserve’s manipulation of the bond market (by way of quantitative easing) is trying to create demand and ultimately, inflation. Inflation is easy to deal with (if you are motivated to deal with it) and better that than entrenched deflation which is what Japan continues to fight after ignoring the threat in the early critical years.
The challenge becomes, what will other countries do in reaction to a devalued US dollar? After all, every country wants a weaker currency to support exports so a theme of mine for some time has been “competitive currency devaluations” where all paper money buys less down the road.
When all governments want inflation, I think we ultimately get inflation and all this talk about deflation serves to push rates lower so that governments can finance their historic debt burdens with historically low interest rates. Even corporations are getting in on the act and rushing to issue debt with record low yields to assist in merger activity which is now heating up. IBM recently issued a 3 year bond with a 1% yield! And there is even talk of 100 year corporate bonds coming to a market near you!
The markets have gone sideways now all year, going up and down based on the most recent economic data point that often conflicts with the one that came before it. Yes we hit an economic soft patch but that almost always happens along the road to recovery. Many pundits have been warning that September and October are historically challenging months and many think that we will break out of the trading range to the downside. I am growing more convinced that the market will once again “humble the majority” and will break to the upside ahead of the US elections in November. Either way, portfolios should continue to hold lots of inflation hedges by continuing to add “hard asset” companies that produce gold, copper, oil and anything else that hurts when you drop it on your foot.