February 2010 Economic Update

We assume that under normal conditions, the "base case" or "policy" asset allocations employed by our readers are sufficient to achieve their long-term goals within acceptable risk limits. Given this assumption, the main threat our readers' face is a substantial downside loss that breaches these risk limits, and substantially reduces the probability they will achieve their long-term goals. The goal of our economic updates is to provide timely warning about dangerous overvaluations that could lead to such losses in one or more asset classes. Our main focus is on what is known as "strategic warning"- "the what and the why", with a lesser focus on "operational warning" - "the how". Our objective is not to provide tactical warnings - "who, when and where" - that are more commonly known as "trading tips" intended to increase short term returns.

Methodology

Our economic analysis methodology is based on a technique known as "analysis of competing hypotheses", or "ACH." Human beings normally seek to collect information that supports a hypothesis. However, since a piece of information may be consistent with more than one hypothesis, this method is inefficient. In contrast, ACH focused on disproving hypotheses, and values information on this basis. For example, a piece of evidence that has a very low probability of being observed under a given hypothesis is more valuable than a piece of evidence that is consistent with multiple hypotheses.

Our economic hypotheses take the form of two alternative scenarios. When it becomes apparent that one of them is much more consistent with the accumulated evidence, we generate two new ones. Our two current scenarios are based on traditional behavior patterns for complex social systems operating in far from equilibrium conditions. The first is enhanced cooperation and the second is higher levels of conflict. Realization of the cooperative scenario should result in a higher level of stability and predictability in the system's operations, while development of the conflict scenario will prolong and quite possibly worsen the system's instability. These scenarios are described in more detail in our previous issues, which (as you go back in time), also describe the scenarios that preceded them.

We further assume that financial market returns reflect the complex interplay between political and economic conditions, which in turn reflect the actions of key groups (i.e., networks), which in turn are comprised of individuals whose behavior is based on an evolving mix of cognitive, informational, emotional and social factors. In our analysis, we use both bottom up and top down approaches to develop our scenarios and guide our search for information that provides insight about which of them is developing.

The assumptions we make in our analyses, and the conclusions we reach, are inescapably uncertain. We believe it is extremely important for the reader of any estimate or assessment to clearly understand the analyst's confidence in the conclusions he or she presents. How best to accomplish this has been the subject of an increasing amount of research (see, for example, "Communicating Uncertainty in Intelligence Analysis" by Steven Rieber; "Verbal Probability Expressions in National Intelligence Estimates" by Rachel Kesselman, "Verbal Uncertainty Expressions: Literature Review" by Marek Druzdzel, and "What Do Words of Estimative Probability Mean?" by Kristan Wheaton). In our analyses, we are standardizing on the use of a three level verbal scale to express our confidence level in our estimates. "Possible" represents a relatively low level of confidence (e.g., 25% – 33%, or a 1 in 4 to 1 in 3 chance of being right), "likely" a moderate level of confidence (e.g., 50%, or a 1 in 2 chance of being right), and "probable" a high level of confidence (e.g., 67% to 75%, or a 2 in 3 to 3 in 4 chance of being right). We do not use a quantitative scale, because we believe that would give a false sense of accuracy to judgments that are inherently approximate.

With respect to the situation we face today, we believe three critical issues must be resolved in order for the world economy to return to a period of sustained growth and relatively normal conditions in financial markets - (1) high levels of household debt across much of the Anglosphere; (2) a deeply weakened world financial system; and (3) unsustainable structural imbalances in the economies of the United States and China, and in these countries' current account balances. We further believe that the actions of three groups - middle class Americans, Chinese peasants, and Iranian youth, are linchpins that could have an outsized impact on the future evolution of political and economic events, and, through them, on the resolution of the three critical issues we face and future asset class returns.

Current Factors Facing the Global Economy

The essential predicament facing the global economy is by now well known: overleveraged private sectors in the developed world have sharply cut back spending in order to repay their debts. In order to avoid the collapse in GDP that this would otherwise cause, governments have sharply increased their spending and fiscal deficits as a percentage of GDP, which in turn has boosted Debt/GDP ratios which in some cases were already uncomfortably high. This has provoked rising concern with fiscal deficits and sovereign credit risk, that has recently come to a head in Greece. However, aggressive though it has been, government expansion has usually not fully offset private sector retrenchment, result in some reductions in the size of global current account deficits and surpluses, particularly those that exist in the United States and China. To offset the contraction caused by a fall in its exports, the latter county has embarked on a stimulus program that has been marked by extraordinary levels of credit growth, which in turn (as has been the case throughout history) has fed what many perceive to be a growing bubble in domestic property markets. Moreover, in order to maintain employment and social/political stability, China has sought to maintain its export markets and export led growth model, either because it is unwilling or unable to increase its level of domestic consumption spending. In sum, while unprecedented fiscal and monetary stimulus around the world has thus far avoided a repeat of the Great Depression, the recovery remains extremely fragile.

The first two months of the year have seen a number of interesting new developments. One was the publication of a new research report by the IMF, "After the Crisis: Lower Consumption Growth But Narrower Global Imbalances?" by Mody and Ohnsorge. The authors begin by noting that, "While the role of uncertainty is widely recognized, its empirical significance is rarely examined." Clearly, we strongly agree with their position. Their analysis assumes that "expectation of a rise in unemployment is a useful measure of uncertainty because it proxies for the risk of a catastrophic fall in income." The authors' analysis reaches four conclusions about the underlying forces that are at work in the global economy. (1) "Within a country, over time, two variables show a consistently clear influence on consumption growth. An increase in unemployment over the previous year is associated with significantly lower consumption growth. And higher GDP volatility is similarly associated with a sizeable reduction in consumption growth." (2) "Households tend to set target levels of wealth to act as buffers in bad times....When, as now, the loss of financial wealth is substantial, the effects on consumption are larger. The current drop in wealth will therefore likely have persistent effects on consumption spending." (3) "Countries with a greater long-term tendency for financial instability increase consumption at a slower rate." And, (4), "A country's demographic structure matters. Where the working age population supports more dependents, both young and old, consumption growth is lower. Thus, differences in dependency rates are another contributor to different rates of consumption growth."

Having established the causal relationships, the authors then draw conclusions about what lies ahead. "In the short run, continued income uncertainty will significantly dampen consumption growth in the G-7 economies....As such consumption in the G-7 economies is unlikely to be the engine that revives global growth....Having averted a financial meltdown, the global economy is faced with the prospect of a halting recovery in large part because consumption growth in the richest nations is likely to remain well below the rates experienced before the crisis...However, with the US experiencing a sharper rise in unemployment and, perhaps, more widespread loss of financial wealth than elsewhere in the G-7, the rise in the US savings rate is helping to narrow global imbalances."

The authors also note that "the same fear factor that increases the savings rate also causes households to invest their savings in low risk, low return assets. Thus, the irony is that while German and Japanese households have saved at high rates [in recent years], they have not necessarily benefited from the process by accumulating large amounts of wealth. That, in turn, has kept their consumption growth low. At the same time, low domestic consumption growth rates have implied that growth had necessarily to emanate from exports to the global economy. But exports tend to be significantly more volatile than domestic consumption...Once again, low consumption growth induces volatility in GDP growth, which reinforces the tendency towards low consumption growth."

A further brake on growth is likely to be rising levels of Debt/GDP. As Reinhart and Rogoff note in a new paper ("Growth in a Time of Debt"), when this ratio exceeds 90%, the median national growth rate in their sample was 1% lower (and the average lower still). Some countries, notably Japan, are already past that threshold; others will soon approach it if fiscal deficits continue at their current levels. Yet that seems to be inevitable if other sources of demand growth don't develop. In the short-term, given the constraints on private consumption growth, many countries have pinned their hopes to a rise in exports. Yet with the U.S. unable to play the role of the world's "consumer of last resort", and with China and the Eurozone either unwilling or unable to play this role, and the emerging market countries not large enough as a percentage of the global economy to play this role, it is clear that a strategy of "we’re going to export our way out of this problem" isn't going to work for everyone. That leaves a rise in investment -- both private and public sector -- as the last alternative to the continuation of government fiscal deficits as the means of keeping global aggregate demand at an acceptable level. However, in the case of business investment, the obvious question is, "why should we invest, given the uncertainty we face today?" To be sure, regulatory changes (e.g., in the area of CO2 emissions) could stimulate some increase in investment. But, absent a reorientation of government spending programs towards a greater emphasis on investment, it seems unlikely that business investment alone will be sufficient to solve the world's aggregate demand problem.

In the last six weeks or so, many of these issues have begun to come to a head, with Greece as the most recent flashpoint. The immediate issue there has been a sharp widening in spreads (i.e., insurance premiums) on credit default swaps on the countries sovereign debt, and growing worries about its ability to rollover outstanding government debt that is coming due. The larger problem is one that goes far beyond Greece. Even before the onset of the 2008 crisis, Greece had been running significant government deficits, due to weak tax collections, the high cost of public sector payrolls, generous social spending programs, a thicket of regulations that has held down productivity growth and job creation, and increasingly uncompetitive exports due to both the rise in the value of the Euro versus other currencies (e.g., the U.S. Dollar and the Chinese Renminbi) and declining competitiveness as an exporter within the Eurozone (due to its slower productivity growth and higher inflation over the years compared to Germany). To a significant extent, this also describes the plight facing many U.S. states, most visibly including California and New York. The good news is that the latter two aren't saddled with a rising Euro. As is true in the United States, the other nations that comprise the Eurozone, and European Union more broadly, face a painful choice. A Greek default on its sovereign debt would run the risk of setting off a contagion, raising investor uncertainty and driving interest rates far higher at a time when the Greek, Eurozone and global economies are all in a very fragile state. Yet to simply use funds from other member nations (or, in the U.S., other states, via the federal government) to bail out Greece might also raise uncertainty, in that it would send a clear signal that nations that have followed irresponsible economic policies can expect to have others pay for their negative consequences. Put differently, a bailout that does not impose very tough conditions runs the risk of sharply increasing moral hazard. To be sure, the Greek leadership responded by making all the correct statements and proposing all manner of policy changes. And that, along with somewhat comforting noises about potential transitional support from the European Union, Germany, and/or the IMF as these policies are implemented may end up getting Greece through its next few bond issues without serious carnage. But the announcement of these sharp policy changes, which will force a prolonged period of austerity and probably some degree of deflation upon the nation for many years (as both price falls and sharp productivity increases will be needed to restore the competitiveness of the Greek economy, absent a sharp fall in the Euro), also led to nationwide strikes by public sector employees, complaints from the beneficiaries of social spending programs, and, undoubtedly, a flurry of planning by those people most likely to see a sharp increase in their taxes in the next few years. This highlights the essence of the underlying issue, which we suspect is an important and growing source of rising investor uncertainty around the world. Do we really believe that the social and political systems in most Western nations can sustain a prolonged period of austerity without triggering substantial, and quite possibly (from an investor's point of view) very adverse changes in the financial and regulatory environment? How many democracies throughout history have been able to divide up a shrinking pie without substantial conflict and dramatic change? We will undoubtedly move further down this road when the Icelandic people vote on March 6th to reject the proposed Icesave settlement with the Netherlands and U.K. (which paid out billions to cover the losses of foreign depositors in Icelandic banks that went bust, and which now want Iceland to repay them). And the worsening condition of many U.S. states' budgets may soon push us further down still. In sum, the issue that has first come to a head in Greece will not go away any time soon.

It is in this context that we have also noted a growing number of stories by writers we respect that hint at the possible passing of an important turning or tipping point. To begin with, we are seeing more and more stories about U.S. homeowners, and especially upper income homeowners, choosing to "strategically default" on their mortgages. See, for example, "US Housing Market Hit by Walkaways" by Aline van Duyn in the 22Feb10 Financial Times, and "Walk Away from Your Mortgage" by Roger Lowenstein in the 10Jan10 New York Times. We are also seeing evidence of rising popular frustration, and a widening gulf with the perceptions of the governing class. See, for example, "We're Living in Broken Britain Say Most Voters" (Times, 9Feb10), which reports "nearly three fifths of voters say they hardly recognize the country they are living in, while forty two percent say they would emigrate if they could." See also the 19Feb07 polling report from RasmussenReports.com, which found that 84% of mainstream voters reported they were angry, while 84% of the political class reported they were not; 87% of mainstream voters said Washington was broken, while 73% of the political class disagreed; and 68% of mainstream voters think neither Democratic nor Republican leaders have a good understanding of what is needed today, while 61% of the political class disagree.

Meanwhile, the intransigence of public sector unions in the face of high private sector unemployment and rapidly deteriorating state budgets is clearly rubbing more and more people the wrong way across a range of countries. For example, in the United States, a 23Feb10 Pew Research Poll found that favorability ratings for unions have fallen sharply, from 58% favorable/31% unfavorable in January 2007 to 41% favorable/42% unfavorable by January 2009. More and more commentators are noting that the conflict between public sector employees and the private sector taxpayers who pay for most of government’s cost looks likely to be a long and bitter battle.

Another much cited article, which we highly recommend, is "How a New Jobless Era Will Transform America" by Don Peck in the January issue of The Atlantic. He makes it clear why pollsters are finding that job creation is now people's top concern, why high levels of joblessness are likely to persist for years, and how this will affect society in many ways for many years. As Peggy Noonan wrote in the 19Feb10 Wall Street Journal, "voters are feeling as never before in recent political history the vulnerability of their individual position."

Yet in the face of the many challenges we face, there is also a growing fear that governments aren't up to the task. In the United States, Evan Bayh's decision not to run again for the United States Senate seemed to crystallize this fear. As the New York Times editorialized on 17Feb10, "rarely has the political system seemed more polarized and less able to solve big problems that involve trust, tough choices and little short term gain" ("Party Gridlock in Washington Feeds New Fear of Debt Crisis"). Other stories on this same theme by respected, long-time observers of the political process include Charlie Cook's "Spinning Our Wheels" (Cook Report, 20Feb10), "Government Running to a Standstill" by Clive Crook in the 14Feb10 Financial Times, Dick Morris' "The New Two Party System" in the 6Jan10 edition of TheHill.com, which highlights how moderates are being forced out of both the Democratic and Republican parties, Bill Gross' observation that "government doesn't work any more" in his January PIMCO commentary, Charlie Munger's "Basically, It's Over" article published on 21Feb10 on Slate.com, and Thomas Friedman's lament, in the 21Feb10 New York Times ("The Fat Lady Has Sung") that the Obama administration has critically failed to provide a simple, clear narrative to tie together the myriad of reforms that will be needed to get the U.S. economy back on track.

Unfortunately, it doesn't look like the world economy is going to give political leaders much more time to get their act together. The February report from the U.S. TARP Oversight Panel painted a grim picture of the deteriorating situation in commercial property markets: "Over the next few years, a wave of commercial real estate loan failures could threaten America's already weakened financial system. The Congressional Oversight Panel is deeply concerned that commercial loan losses could jeopardize the stability of many banks, particularly the nation's mid-size and smaller banks, and that as the damage spreads beyond individual banks that it will contribute to prolonged weakness throughout the economy." In the U.S. residential property market, rents continue to fall, and mortgage delinquencies, defaults, and foreclosures remain serious problems, with, as previously noted, a growing number of "strategic defaults" often by affluent homeowners. In Canada, in contrast to other countries, the ratio of debt to household income has continued to climb, reaching 145%, its highest level ever (the peak in the US and UK was between 150% and 160%). In the UK, there are growing worries that, as the Economist noted on 11Feb10, "the recovery in British housing prices is built on sand." Elsewhere in the Economist, Philip Coggan has produced an excellent series in his Buttonwood column and blog on the factors driving the growing concern with sovereign debt levels around the world. As we have noted in the past, the combination of already high Debt/GDP levels, relatively short average debt maturities, unprecedented peacetime government deficits (combined in some countries with substantial off balance sheet liabilities for future social security and healthcare payments), and the prospect of lower rates of GDP growth (relative to the interest rate on outstanding debt) for years to come is a very dangerous mix. As we have repeatedly noted, in our view Australian and Canadian government debt is looking more and more like a legitimate alternative to U.S. government debt as the world's ultimate risk free asset. Unfortunately, their capital markets are far smaller than the market for U.S. government debt, so as a practical matter, short term U.S. Treasuries and real return bonds will likely remain the world’s most popular risk free assets. Yet for individual investors, who can more easily diversify their holdings, these other countries are increasingly attractive alternatives.

We may also have reached a tipping point internationally, in terms of the way the world views China. It is clear that conflicts between China and the rest of the world have been increasing across a range of domains, including commercial (e.g., disputes with Google and Rio Tinto, as well as new rules giving preference to domestic suppliers for government technology purchases), foreign policy (sharp Chinese responses to President Obama's meeting with the Dalai Lama and to U.S. arms sales to Taiwan, and refusal to support tough sanctions on Iran), military (China's development of anti ship ballistic missiles that threat U.S. aircraft carrier battle groups), trade (the imposition of an increasing number of sanctions and controls), exchange rates (China's ongoing refusal to allow substantial appreciation of the Renminbi), climate (China's obstinacy at the Copenhagen conference), and finance and economics (sharp Chinese comments about the underlying causes of the global crisis, and the need of the U.S. to sharply retrench). The cumulative impact of these growing conflicts has triggered a round of articles by writers around the world questioning the fundamental assumptions upon which relations with China have operated over the past two decades, particularly the belief that increased integration into the global economy would lead to growing Chinese support for the current international system, and liberalization of its domestic political environment. Examples of articles that question the premises upon which policy towards China has rested include, "Fear of the Dragon" in the 7Jan10 Economist, "The Year China Showed Its Teeth" in the 16Feb10 Financial Times, "The Arrogance of China's Leadership" by Erich Follath in the 23Feb10 Spiegel, and Robert Samuelson's "The China Miscalculation" published on 15Feb10 on RealClearPolitics.com. To be sure, there are contrary views, such as Bill Emmott’s "Why China is Stoking War of Words with US" in the 8Feb10 Times. In Emmott's view, which is also one we have advanced over the years, increasing conflict and heightening nationalist passions may be a deliberate strategy on the part of the Chinese leadership to deflect attention from the painful social consequences of unavoidable changes in domestic policy, such as attempts to slow a rapidly growing property market bubble and accelerating inflation. The risk, obviously, is that, even if Emmott is correct about its motivations, the Chinese leadership will be unable to control either the domestic and/or the international consequences of this strategy. The articles we have just cited do not provide encouragement in this regard.

Last but not least, the past few weeks have seen a further ratcheting up of tensions between the West and Iran, with President Ahmadinejad ordering the nation's nuclear agency to begin enriching uranium, and the IAEA announcing that it has information suggesting Iran may be working to build a nuclear warhead. With China and Russia continuing to play a cat and mouse game with the West about their willingness to support economic sanctions on Iran, the chances of a military strike by either the United States and/or Israel continue to increase, which in turn would likely trigger a sharp increase in oil prices that would choke off the current global recovery.

In sum, as we noted last month, we continue to believe that a majority of investors continue to underweight the probability of a return to a regime of high uncertainty later this year. As we have noted, asset classes that perform relatively well under this regime may still be undervalued today. These include short maturity U.S. Treasury and other government bonds, including real return bonds, volatility, gold, and some property markets (e.g., Switzerland and other European countries in which property is a traditional refuge in unsettled times). We also continue to believe that the chances that we will soon enter the high inflation regime are remote, and that in the short term deflation is far more likely. Finally, we believe that asset classes that perform best under the normal regime -- specifically, all equities (including emerging market equities) and credit bonds -- are probably overpriced today.