Economic Update: Situation, Scenarios, and Asset Allocation Implications

In today's world of broadband internet, 24/7 news cycles, and intense competition between media companies, it seems that every new piece of information that appears is instantly seized upon, globally disseminated, and intensely discussed, often in strongly emotional terms, regardless of its diagnostic value, or sometimes even its reliability. This has created a more dangerous and difficult environment for many investors, with truly informative signals hidden by more noise, and social networks increasingly populated by people with elevated levels of fear or euphoria. While an increasingly complex and uncertain environment has made carefully reasoned investment analyses more valuable than ever, the current mix of technology and social forces seems to have made them increasingly rare relative to the growing volume of noise. With that in mind, this month we are taking a longer than usual look at the current financial, economic and political situation, and what it may portend for asset class returns over the next two years.

In broad terms, the world economy faces three large problems: (1) the previous engine of growth, the U.S. consumer (or, more broadly, the Anglosphere consumer), has reached her or his borrowing limit, and is now struggling to pay mortgage, credit card, and auto debt, while worrying more every day about losing his or her job; (2) thanks to high leverage and tight global connections, these credit problems have triggered a systemic crisis across the world financial system, which is now plagued with uncertainty about the value of its assets and basic solvency; and (3) these problems are intimately linked to deep imbalances in world economy, which for too long has been characterized by Anglsphere countries (especially the US) issuing increasing amounts of debt to enable them to spend beyond their incomes, while other countries, most notably China (but also including Japan and Germany) financed this profligacy in order to facilitate the continued strong growth of their overly-export dependent economies. As a result, when American consumers finally hit their borrowing limit, the consequences exploded across the world with frightening speed, in the manner of those rare mass-cataclysms in complex systems known as "punctuated equilibrium" events.

Seen in a longer historical perspective, recent events have born an interesting resemblance to the last peak of global integration, which occurred around the turn of the twentieth century, and ended in World War 1, the Roaring Twenties, the Great Depression and ultimately World War 2 and the Cold War. Both then and today, rising globalization unleashed a wave of energy (in the most recent case, due to the sudden integration into the world economy of millions of well educated workers in China and India), which generated widespread transformations (e.g., globalized supply chains and shifts in the location of production, an explosion in service industry jobs in OECD countries after manufacturing moved to Asia, more complicated structures for moving capital around the world and managing financial risk, etc.). And in both cases, the changes in control systems put in place to manage and guide the use of this higher level of energy proved insufficient to the task, which ultimately precipitated a collapse, and (depending on your perspective) either a reduction in the energy level or an increase in disorder. Anyone familiar with the prisoner's dilemma game should not be surprised by this result. In the absence of a "world government", keeping a highly integrated global system under effective controls requires very high levels of cooperation between very different parties, who naturally have conflicting agendas and cultural norms. Whether in the case of the United Nations, the IMF, the WTO, Basle 2, or the Kyoto Treaty, there is overwhelming evidence that this level of cooperation cannot be consistently achieved or maintained. And we have just learned the hard way that relying on self-interest and market mechanisms to provide effective control of an integrated global economy is no better an alternative. Hence from the perspective of history (not to mention complex adaptive systems theory and the second law of thermodynamics), we should not be surprised that we have ended up where we are today. Nor should we be surprised if the end result of the wrenching changes underway is a less integrated global economy that is easier to effectively control. Indeed, the more surprising result would be if we returned to a highly integrated global system.

In order to develop a more detailed understanding of what may happen in the future, we have to look at the current status of the key underlying problems in more detail. I think it is safe to say, if not a gross understatement, that the U.S. middle class consumer has emerged from shock and disbelief, and is now either angry or depressed. In short, the U.S. consumer is in a very ugly mood today. He is scared about loosing his job, his health insurance and his house; about having to declare bankruptcy, sliding visibly down the social status scale, and having to find a way to survive, likely (at least it seems today) at a much lower standard of living than before. She is angry at bankers who are apparently without shame, whose bonuses and lack of contrition for the destruction wrought by their selfish irresponsibility seems to rub her nose in it every day. She is angry at the unionized public sector workers in her town, who blithely demand higher taxes to fund their now depleted pension plans, and lavish health benefits. She has the growing sense that she hasn't been treated fairly by the system, that the deck has been stacked against her, in spite of how hard she's worked. As a result, she strongly supports higher taxes on those whom she now believes have unjustly received high monetary rewards, since they presided over the system that has so shockingly failed. She is angry that her company and her mortgage aren't getting bailed out, that instead she is facing at best flat or declining pay, more saving and less consumption, and at worst the loss of her job and health insurance, and a painful, shameful trip to bankruptcy court. Depending on whom she reads or listens to, she may also be getting increasingly angry at Chinese leaders who tell Americans to tighten their belts to preserve the value of China's investment in U.S. assets, and at leaders in Europe who seem happy to let the American taxpayer shoulder the cost of saving the world economy. Always ambivalent about the alleged benefits of globalization, her doubts about it are growing at an accelerating pace. She is increasingly ready to listen to populist appeals, but is likely holding off until she sees whether the Obama plan will gain traction. Still, our middle class American consumer's anxiety is constantly, grindingly, being ratcheted higher every week by the fear he sees on the faces all around him, by the empty stores and restaurants, and by the incessant flow of news that only reinforces his sense that he and almost everyone around him is in an uncontrollable dive, with no bottom or upturn yet in site.

At an even deeper level, she is constantly having to fight off the tentacles of depression, reaching out from the now empty place inside her that used to be filled with "shopping therapy", conspicuous consumption, keeping up with the Joneses, and the trite but powerfully appealing notion that it was "all about me." With polling data showing no increase in church attendance since the crisis began, it remains to be seen what will eventually fill this hole. The end result is a source of fundamental uncertainty today. In the meantime, our middle class consumer has no doubt vowed that, rather than continuing to support the global economy, if he can only make it through this crisis he'll cut up his credit cards and not get into so much debt ever again, move to a smaller house with a more manageable mortgage, consume a lot less and look for other sources of meaning in life. And when the Obama tax credit comes, it's going to pay down debt, or into the bank. No way is he going to spend it, except on the basics. If polls are accurate, he also strongly supports President Obama's plans to reform the U.S. health insurance system, improve public education, and boost spending on alternative energy. But if the history of the Michigan Consumer Sentiment Index is any guide, it could take two years or more for our middle class consumer's confidence to recover (see "Once Confidence is Shaken, It Takes a While to Stir" by Bill McInturff). In sum, it seems highly unlikely that the U.S. consumer will any time soon return to her role as the growth engine of the global economy, and increasingly possible that he or she will demand a rise in protectionism.

Now let's move on to the financial system, and start with some facts. The following table shows the amounts of credit market debt outstanding in the U.S. at the end of 2008:

U.S. Credit Market Debt Outstanding, 2008 Q4

Source: Flow of Funds, Federal Reserve Z.1 Report

Looking more closely at $14,640 billion of outstanding mortgage debt, we find that this is comprised of $11,030 billion of home mortgages (75% of the total, including $1,115 billion of home equity lines of credit, which are generally secured by junior liens), $2,599 billion of commercial mortgages (18%), $900 billion of multifamily residential, and $111 billion of farm mortgages.

The next logical question to ask is who holds this mortgage debt. At first glance, this is easy to answer: $4,965 billion (34%) is held either on the books of federal mortgage agencies (e.g., FNMA) or in pools sponsored by them that issue securities backed by mortgages they insure; $3,841 billion (26%) is held by commercial banks, $2,585 billion (18%) is held by private sponsors of pools that issue mortgage backed securities; and $1,208 billion (8%) is held on the books of savings institutions and credit unions. However, as investors by now know all-too-well, many mortgage backed securities were purchased by entities that pooled the cash flows from them, and issued yet another set of securities, so-called collateralized debt obligations (CDOs). The most notorious CDO structures took low rated mortgage backed securities (e.g., BBB grade), and issued their own claims against the pooled MBS cash flows. In a true act of financial alchemy or gross negligence (take your pick), the most senior of these claims were awarded AAA ratings, based on the assumption that a pool of mortgages that was sufficiently geographically diversified could not experience a severe increase in average default level (apparently, nobody at the ratings agencies or at the institutions that bought this paper thought to look at the experience in Japan or the UK in the late 80s and early 90s). Unfortunately, too many professional investors who bought this story, including banks, who sponsored CDO issuers, and often took the highest yielding, lowest rated tranches onto their own books, where they were leveraged up to produce rising profits and bonuses for the bankers, traders, and salespeople who keep this "structured finance" machine laying its golden eggs. While the profits proved chimerical, a substantial portion of the bonuses were paid in cash, and are not subject to any sort of clawback. The more these stories appear in the media, the angrier voters will become about spending tax dollars to bail out the financial system.

So this is the problem today: banks, broker dealers, government mortgage agencies, life insurance companies, finance companies, issuers of asset backed securities and CDOs, and other institutions hold on their books a substantial amount of assets whose value is increasingly uncertain as the economy continues to worsen. These include mortgage, consumer, and business loans, and securities issued by pass through entities like mortgage pools and CDOs. The following table, again from the Federal Reserve Flow of Funds, shows the largest holders of credit market assets at the end of 2008, in billions of U.S. dollars:

Broadly speaking, the current high uncertainty about the economic value of these credit market assets (i.e., their risk adjusted NPV) has four root causes. First, in many cases information about the underlying credits (and, in the case of the pass through entities, about the quality of the underlying legal documentation) is often not readily available. Second, there is uncertainty about the future path of the economy, and hence about many debtors' ability to pay. Third, the carrying value of these credit market instruments on the books of the institutions that hold them is reported in three different ways: (a) securities held for trading purposes are "marked to market", where a liquid market is available; (b) where a liquid market is not available, securities are "marked to model" - that is, a model, and a set of parameter estimates (both subject to error, as our readers well know), is used to estimate the reported value; and (c) when the institution claims its intent is to hold a loan or security to maturity, it can continue to carry it at face value, unless a permanent impairment of that value is deemed to have occurred (at banks, this was the traditional purpose of the loan loss reserve). As nobody is sure about who is solvent or insolvent, financial market liquidity contracts, which tends to make the underlying problems worse.

Finally, as you can see, even a further write down of 10% in the value of outstanding credit market instruments held by these institutions (which, obviously, equates to a higher write downs on CDO, consumer credit, mortgage and/or corporate debt instruments) generates a very large loss, relative to either the capital of these institutions, U.S. GDP or outstanding U.S. government debt obligations (which don't include the value of off balance sheet liabilities for future Social Security and Medicare costs, unless those programs are changed). In this regard, it has not been an encouraging sign that there are growing indications that the crisis of confidence is now spreading to life insurance companies (e.g., Aviva in the UK, Hartford in the US, and Manulife Financial in Canada have all seen sharp stock price falls since February). Coming on top of the already record-setting fiscal deficits caused by the Bush and Obama administrations' emergency stimulus programs and Obama's proposed FY 2010 budget, there are, for the first time in modern history, real questions about even the ability of the U.S. government to absorb financial system losses at the upper end of what appears to be possible, if not likely. So that is where we are today.

We know from the study of economic history that financial system crises are associated with the longest and deepest recessions. For example, in "The Aftermath of Financial Crises", Reinhart and Rogoff find that "more often that not, the aftermath of severe financial crises shares three characteristics. First, asset market collapses are deep and prolonged. Real housing price declines average 35 percent stretched out over six years, while equity price collapses average 55 percent over a downturn of about three and a half years. Second, the aftermath of banking crises is associated with profound declines in output and employment. The unemployment rate rises an average of 7 percent over the down phase of the cycle, which lasts on average over four years. Output falls (from peak to trough) an average of over 9 percent, although the duration of the downturn, averaging roughly two years, is considerably shorter than for unemployment. Third, the real value of government debt tends to explode, rising an average of 86 percent in post-World War Two episodes...The big drivers of debt increases are the inevitable collapse in tax revenues that governments suffer in the wake of deep and prolonged output contractions, as well as often ambitious countercyclical fiscal policies aimed at mitigating the downturn." (for additional historical perspective, see "Stock Market Crashes and Depressions" and "Macroeconomic Crises Since 1870" by Barro and Ursua, "What Happens During Recessions, Crunches and Busts?" by Claessens, Kose, and Terrones of the IMF, and "This Time is Different: A Panoramic View of Eight Centuries of Financial Crises" by Reinhart and Rogoff).

However, the still unresolved question (itself a cause of uncertainty, which feeds back to worsen the problem) is how to resolve the financial system crisis we face today. I spent a portion of my youth cleaning up the aftermath of the LDC debt crisis, which included bank workouts. Based on that experience, plus issues raised by the current crisis, I have put together the following table, which summarizes the difficult choices facing policy makers who are trying to put the OECD financial system back together again.

Options for Resolving Banking Crises: A Short and Simplified Guide
(Please see PDF, March, 2009 for complete table)

As you can see from a review of this short guide to bank workouts, the challenges and trade-offs facing OECD government policymakers today are undeniably difficult. Perhaps the clearest approach to date has been taken in the UK, with guarantees of wholesale funding, de facto nationalization via equity injections that have given the government a majority equity stake in a number of large banks, and replacement of many board members. Yet despite this logical approach, policymakers have still been bedeviled by a number of lingering issues, including (a) payment of bonuses to departing executives, that, while they may have been contractually guaranteed, were politically toxic; (b) failure to replace lower levels of management or to visibly reform the incentive systems that contributed to the original problem (though belated progress is being made on improving risk management systems); (c) failure to demonstrably improve the regulatory regime; and (d) questions as to whether the UK can afford to simultaneously rescue its largest banks and pay for the fiscal stimulus needed to maintain aggregate demand and avoid depression. All of these issues will have to be successfully addressed as the rescue of the global financial system proceeds. If they aren't, and if the bank rescue founders as a result, the current uncertainty will be prolonged (and possibly increase), which will further reduce consumption and investment spending, worsen the banking crisis, and put more even pressure on governments to issue more debt (which will likely be monetized) and increase public spending in order to maintain some level of demand.

Last but not least, let us now move on to the third issue in this Gordian policy knot the question of severe international economic imbalances. The following table shows the relative importance of different countries and regions in terms of their contribution to world GDP and the size of their current account imbalances:

As you can see, this story essentially boils down to the imbalance between China's heavily investment and export led growth model, the huge foreign exchange surpluses they generated, and their investment in the United States, where they boosted liquidity, held down interest rates and facilitated (along with lax regulation and inept financial institution management) an explosion of borrowing, asset price inflation and overconsumption. When the growing resource demands produced by this model bumped up against global supply constraints, commodity prices spiked, which temporarily boosted commodity exporters' revenues and global liquidity, but which also began the slowdown in global consumption. It is clear that this system cannot continue; however, it is not at all clear what will replace it, or what the full consequences of that transition will be. At best, we can currently glimpse the outline of what might constitute a cooperative solution to the current crisis: a new era of investment led growth in the United States, consumption led growth in China, and a relatively high level of global economic integration.

To be sure, there are some hopeful signs that this cooperative scenario could develop. In the U.S., these include not only the heavy focus of stimulus spending on energy and environmental innovation, but also the 2010 budget's focus on transforming healthcare and education (both of which would boost human capital quality, a key driver of growth), and plans to start a cap and trade system that will put an explicit price on carbon emissions, and thereby incentivize further energy and environmental innovation and investment. There is also some interesting research that suggests that energy transitions (such as the proposed large-scale move away from fossil fuel-based technologies) lie at the heart of the most significant transitions in human history (see "Major Transitions in Big History" by Robert Aunger). As we noted last month, in constant dollar terms, the technology and investment stimulus package proposed by the Obama administration is of the same order of magnitude as the program to put a man on the moon - and the growth consequences of that initiative were extremely large and long-lasting. In China, there have been encouraging indications their stimulus plan's initial focus on infrastructure investment (which would essentially maintain employment in export industries until foreign consumption demand recovers) has shifted to more emphasis on building the stronger social safety net that is a necessary precondition for higher domestic consumption spending and a shift of employment from export oriented to more domestic oriented sectors (e.g., services).

Unfortunately, there are also plenty of obstacles that may prevent successful realization of this cooperative scenario. In the United States, there are bound to be intense political battles over education and healthcare transformation, as well as the passage of a cap and trade system to control CO2 emissions. The resulting delays will only deepen consumer's gloom and spending cutbacks, which (along with uncertainty about the shape and impact of cap and trade) will further depress business investment. The failure to implement this agenda and achieve a sustained increase in U.S. private investment will logically have a number of consequences, including higher inflation (due to the monetization of larger government deficits, as well as greater popular pressure for reduction of real consumer debt burdens) and calls for more protection of U.S. jobs. In addition to uncertainties about the fate of the Obama recovery program, it also remains to be seen whether the financial system crisis can be politically and economically contained, and the current decline reversed. The recent behavior of industry leaders, while understandable to those who know the industry culture, seems to be making a bad situation worse, not better. Of course, the same could be said about U.S. union leaders, who seem intent on going down the same road with their vigorous support for ever-higher public sector benefits and passage of undemocratic "card check" legislation to stimulate unionization in the private sector. There are also growing indications that, whether due to inexperience or lack of staff, it will take longer than expected to actually get the stimulus plan money flowing, particularly into energy and environmental investments. These delays will lead to deeper declines in demand and employment, place more stress on the financial system, and worsen the mood of the American middle class, making it more likely that they will call for inflationary and protectionist solutions, particularly if they see that a major result of high U.S. spending is employment growth in China, but not the United States. Rising conflict between the U.S. and China seems the likely result.

In China, the government still appears divided over how best to address the current crisis. While the overriding goal of the Communist Party is to maintain employment and avoid social unrest that could threaten their hold on power, it is not clear that they can develop and successfully implement the policies necessary to facilitate a shift from an investment and export-based to a consumption and service-based economy. For example, there are significant political obstacles to land reform (which would help raise peasant incomes), infighting between party factions (e.g., those who favor developing the coastal regions' export industries, versus those who advocate faster rural development), and strong cultural barriers to higher spending and lower saving. Yet the longer this transition is delayed, and the more that China is perceived by other nations to be pursuing a "beggar they neighbor" policy of maintaining export demand and employment at all costs, the greater the chances of provoking conflicts that will lead the world away from an open and integrated global system, and toward one dominated by trading blocs.

An alternative, and more worrying hypothesis, is that this may in fact be China's intention. In addition to retaining power, China's leadership seems to be pursuing a long term goal of making their country one of the most powerful in the world - returning the Middle Kingdom to its proper place, if you will. To pursue this goal, China needed to rapidly acquire advanced technology and develop world scale production capacity. These are not only key to supplying rising domestic consumption demand and building advanced military power projection capabilities, but the process of their development also resulted in the "hollowing out" of production capacity in many competing nations (e.g., due to production facilities being relocated to Asia in pursuit of supply chain efficiencies). Moreover, it is now clear that the recycling of export surpluses back into Western, and especially U.S. economies had the additional benefit of helping to create an extremely debilitating banking, economic, and political crisis, that has not only caused domestic turmoil, but has also weakened the NATO Alliance, the European Union, and potentially the United States' alliances with Australia and Japan. On the other hand, China also faces significant constraints including the need to import energy and other resources, a rapidly ageing population, rising domestic economic inequality, environmental problems, and corruption that together undermine the legitimacy of the Communist Party leadership. Hence, attaining its long-term goal requires China to gain secure access to resources and markets with younger demographics, secure their ocean supply routes, and maintain the party leadership's legitimacy, using the twin tools of economic growth and Chinese nationalism. It is clear that China is pursuing these goals. For example, in recent years it has used its foreign exchange reserves to make a range of investments in African, South American and Southeast Asian resource suppliers, as well as Iran; it has made a $29 billion loan to Russian to develop Siberian oil and gas reserves that will be purchased by China; it has systematically worked to improve its relationships with Indonesia and Australia; it has established new naval bases along its key supply route to the Middle East (in Pakistan, Sri Lanka and Myanmar); it has substantially expanded its navy and capability to wage asymmetric war against the United States (e.g., emphasis on submarines, information warfare, and area denial weapons); and it has expanded its "strategic dialogue" (at the economic, military and political level) with Taiwan and Japan. More recently, it has staged a naval "incident" with the United States in the South China sea, given a lackluster response to proposals to increase the IMF's resources to enable that organization to head off the potential for a new developing country debt crisis, and publicly questioned the trustworthiness of the United States as a debtor nation (which also reinforces growing domestic anger at the losses suffered by China in its investment in U.S. companies like the Blackstone Group). One is reminded of some of the classic admonitions of Sun Tzu, the great Chinese military strategist: "All warfare is based on deception...Be extremely subtle, even to the point of formlessness. Be extremely mysterious, even to the point of soundlessness...For to win one hundred victories in one hundred battles is not the acme of skill. To subdue the enemy without fighting is the acme of skill."

To be sure, it may be that the true long-term goal of the Chinese leadership is simply for their country to become an equal member of a globally integrated and open world economy. And it may be that both the naval incident and the comments about U.S. creditworthiness were intended for a domestic audience, to increase nationalistic feelings and support for the government as unemployment rises and the economy begins a politically dangerous transition. But the evidence is also consistent with the alternative hypothesis, that China is pursuing a strategy whose goal is the isolation of the United States and the establishment of a powerful Chinese-led bloc at the center of the world economy.

In sum, we see two scenarios that could develop over the next two years. One is characterized by cooperative solutions to current problems, including the rescue of the global financial system, the restructuring of global demand, the acceleration of a major energy transition, and maintenance of a reasonably open and integrated world economy. As this scenario develops, investors will face two challenges: (1) an inevitable period of higher inflation that is the logical consequence of the monetization of the debt issued to fund fiscal stimulus and financial recovery programs; and (2) a sharp spike in commodity prices as demand recovers, which will be the unavoidable consequence of the reduction in supply expansion projects that is taking place today.

The other scenario is characterized by much higher levels of conflict, and seems likely to end up in a less globalized world that is divided into trading blocs and hinterland regions led by China and the United States (call them the Sinosphere and the Anglosphere). This scenario could develop either by accident (e.g., as a result of the interacting social and political consequences of an extended recession in China and the United States) or by design. This conflict scenario would present far greater challenges for investors. It also seems likely to include a period of high inflation, and could also result in much slower economic growth, particularly if the Obama administration fails to successfully enact its education, healthcare, and energy and environmental initiatives. There are many ways this could happen, including effective political opposition in the United States, or the diversion of resources to the financial system, to military contingencies (e.g., renewed conflict in the Middle East, if more radical elements win the June elections in Iran, or Pakistan collapses into chaos), or to support struggling countries in the Western Hemisphere or Eastern Europe. Thus, it seems likely that the conflict scenario would produce not only higher levels of inflation, but also higher levels of uncertainty, and lower levels of growth (for another excellent discussion of the challenges we face, and likely scenarios that could develop, see "Adjusting to Global Economic Change: The Dangerous Road Ahead" by Robert Levine of RAND).

So what does this mean for investors and their asset allocations? We have constructed the following table to provide insight into the balance of market views as to which of three regimes - high uncertainty, high inflation, or normal growth - is developing. Under each regime, certain asset classes should deliver relatively higher returns. We assume that the rolling three month return on these asset classes is a useful indicator of the market's collective estimate of the regime that is most likely to develop in the short-term.

Potential Evolution of Asset Class Prices Over the Next Two Years
(Please See March, 2009 pdf for Table - Cooperative Scenario and Developing Scenario)

| 2008-2009 Benchmark Portfolios - All Currencies | Economic Update: Situation, Scenarios, and Asset Allocation Implications | Letter from the Publisher | Asset Class Valuation Update | Product and Strategy Notes: Two Interesting Papers on Commodities; News of Note for Advisors; Two Interesting Hedge Fund Papers; On the Product Front and Foreign Currency Bonds....Again | Uncorrelated Alpha Strategies Detail | March 2009 Issue: Key Points | This Month's Letters to the Editor: Why Academic Research? and Why Not More Frequent Updates on Where Markets are Headed?; Why Not Currencies as an Asset Class? Is Your Use of Uncorrelated Alpha Strategies in some of your Models Inconsistent with Your Belief in Passive Investing? | Global Asset Class Returns |