January 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.
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.
As 2010 begins, we are filled with a sense of foreboding about what lies ahead. Let me try to succinctly sum up the trends, uncertainties, and recent developments that have engendered that feeling:
- In terms of global aggregate demand and economic growth, we have seen a major shock -- the sharp fall in U.S. private consumption expenditures -- offset by two main initiatives: an unprecedented peacetime increase U.S. federal government spending and the fiscal deficit, and unprecedented credit expansion (and a smaller increase in government spending) in China. In the short term, that stimulus prevented a disastrous collapse in spending, and, technically, has caused the end of the recession in many countries around the world. However, the continuation of these initiatives faces growing constraints in both countries.
- In the United States, the expansion of the government debt/GDP ratio comes on top of substantial future growth in off balance sheet federal liabilities for health care and social security spending -- and that is before taking the impact of any new national health care programs and/or a federal bailout of state governments and/or additional support for the banking system into account. In broad terms, there are three ways the United States can eventually reduce its high level of government debt/GDP: (1) Increase the rate of economic growth; (2) Increase the amount of taxes collected; and/or (3) Reduce the real value of the debt via a combination of domestic inflation and/or depreciation of the U.S. dollar. Thus far, the Obama administration has not put forth a credible plan for reducing fiscal deficits and the debt/GDP ratio (which is not to say that others have not: see, for example, the recently published "Choosing the Nation's Fiscal Future" by the National Research Council). Even worse, perhaps, it is increasingly clear that the current U.S. fiscal stimulus program was much more about satisfying traditional Democratic Party constituencies than it was about addressing fundamental obstacles to faster economic growth. Moreover, the paralysis affecting multiple U.S. state legislatures in the face of rapidly worsening fiscal crises (not to mention the intransigence of many public sector unions) has raised worrying concerns about the ability of the U.S. political system to take the politically difficult actions needed to resolve the crisis we face. For example, in a 31Dec09 lead editorial ("Failed State"), the New York Times wrote, "New Yorkers should be appalled at their failed state government, particularly their corrupt and clueless Legislature. Scandal and irresponsibility have been Albany's creed for decades. This year, the gang added another outrage to the list: complete fiscal incompetence." More important, these worries are not confined to the state level. More and more often, high profile writers are questioning whether the U.S. federal government can muster the intellectual insight and political courage needed to make difficult policy changes. For example, in his January 2010 letter, PIMCO's Bill Gross wrote that "Our government doesn't work anymore, or perhaps more accurately, when it does, it works for special interests and not for the American people." In a similar vein, Jim Manzi wrote an exceptionally good article on "Keeping America's Edge" in the Winter 2010 issue of National Affairs. While Manzi does an outstanding job of summarizing the various dimensions that make up today's American predicament, the political achievability of his proposed solutions is doubtful in today's environment.
- Taken together, all of these factors have and continue to raise the uncertainty felt by U.S. domestic taxpayers and businesses, and for foreign holders of U.S. Government debt. More specifically, uncertainty about significant future tax increases, combined with a desire to reduce debt levels, has held down spending by the top 10% of U.S. households that are estimated to account for 42% of household sector spending (see, for example, "Upper Income Spending Reverts to New Normal" published on 10Dec09 by the Gallup Organization, and, for an analysis of household spending by income, "A Detailed Look at the Stratified U.S. Consumer" by Tyler Durden, published by www.zerohedge.com on 15Aug09). Uncertainty about future tax rates has been further reinforced by the rapidly increasing realization that due to substantial unfunded public sector pension and healthcare liabilities, the U.S. also faces a substantial state and local government fiscal crisis. This uncertainty, along with continued tight credit conditions and uncertainty about future demand growth, has also held down new business formation. As a recent report has shown ("Where Will the Jobs Come From?" by the Kauffman Foundation), businesses aged 1 to 5 years have been the critical job creators in the U.S. economy in recent years. Yet today, their growth is held back, even as business failures increase. The net result is higher and longer unemployment, which further reinforces uncertainty, holding down private sector consumption and investment spending, and making continued federal deficits necessary to prevent a collapse in demand. It is, indeed, a vicious cycle.
- An obvious way to break this cycle would be a substantial increase in domestic consumption spending in China, which could, especially if accompanied by an appreciation of the Reminbi versus the U.S. Dollar, increase China's imports from the United States and Europe. To be sure, China alone would not be able to fully offset the global impact of the fall in U.S. private consumption spending -- while the US accounts for 20% of global GDP (per the IMF, on a purchasing power parity basis), China accounts for only 12%. However, policy changes on China's part could certainly reduce the pressure on the U.S. government to continue aggressive fiscal stimulus, and would therefore help to reduce the fragility of the current recovery. However, it does not appear that China is willing and/or able to make these changes. After a dramatic credit expansion since the world economic crisis first began, China has begun to restrain bank lending, no doubt due to growing fears of asset bubbles (especially in property) it may be funding, and the historical tendency of credit booms to end very badly, with debt deflation and a sharp contraction in economic activity distinct possibilities (see, for example, "The Great Depression as a Credit Boom Gone Wrong" by Eichengreen and Mitchener published by the Bank for International Settlements, and "Credit Booms Go Wrong" by Schularick and Taylor on www.voxeu.org).
More worrisome has been the observation that while asset prices have been rising strongly in China, core consumer prices (without energy and food included in the index) have been falling, reflecting the deflationary consequences of higher Chinese supply and much lower demand, as weaker export demand has not been offset by stronger domestic private demand. Equally troubling have been reports that much of the Chinese lending surge has favored relatively inefficient state owned enterprises, while private Chinese businesses -- which account for the bulk of job creation in politically critical cities -- have been starved of credit and continue to struggle. Given this, we weren't surprised to see Chinese Premier Wen Jiabao warn of "a bumpy road ahead" in a year end interview. More specifically, we fear that some of those bumps may be quite large. In the United States and Europe, the issue of China's continuing refusal to allow its exchange rate to appreciate versus the U.S. Dollar is growing in visibility and importance, and seems to be inexorably pushing the world towards the beginning of a trade war. For example, in a December OpEd in the New York Times, Paul Krugman noted that "in today's depressed world, that policy is, to put it bluntly, predatory." The same month, the U.S. Federal Reserve Board published "Are Chinese Exports Sensitive to Changes in the Exchange Rate?", and found that "if the trade-weighted real Renminbi exchange rate had appreciated at an annual rate of 10 percent per quarter since mid-2005, Chinese real exports would be roughly 30 percent lower than they are today." Similarly, in a recent paper ("The End of Chimerica"), Niall Ferguson and Moritz Schularick noted that "the scale of Chinese currency intervention has been without precedent, as have been the resulting distortions in the world economy." Moreover, the authors unfavorably contrast the Chinese development experience with that of Germany and Japan, which both allowed their currencies to appreciate as their productivity improved and trade surpluses grew. Given this, the authors forecast a breakdown in the "Chimerica" system that has driven global economic growth in recent years. Meanwhile, in China, this view is vigorously rejected, and the onus of the need to change placed on the U.S., which is accused of resisting a necessary and prolonged period of deep austerity to correct its domestic imbalances. In light of current trends, it is not surprising to see articles like Gideon Rachman's "Why China and America Will Clash" (Financial Times, 18Jan10) appearing more frequently. What we found most interesting about Rachman's piece was his point that the central assumption upon which U.S. policy towards China has been based for over two decades is increasingly being called into question: "Both Bill Clinton and George W. Bush firmly believed that free trade and, in particular, the information age would make political change in China irresistible...So far, the facts are refusing to conform to the theory." Across multiple domains, our research has shown that when the reliability of an underlying mental model is called into question, both uncertainty and the potential for substantial change dramatically increase.
- Finally, we have long noted our hypothesis that one indicator of rising domestic social and political stress in China would likely be a deliberately orchestrated increase in conflicts with the West, designed to stimulate nationalist and pro-government sentiments. With that in mind, in recent months we have observed a disturbing number of incidents that together form a pattern consisted with our hypothesis. These incidents include conflict with Rio Tinto (including imprisonment of its local representative) over annual iron ore pricing discussions, rising concern over Chinese defense spending, and development of dangerous new anti-ship ballistic missile systems (see "Chinese Buildup of Cyber, Space Tools Worries U.S." in DefenseNews, 13Jan10), more aggressive Chinese actions against domestic dissidents, Chinese leadership in scuppering any deal at the Copenhagen climate conference, and most recently the controversy involving Google, that has now escalated into a war of words with Secretary of State Hillary Clinton. In sum, uncertainty about the true state of China's economy is sharply rising, in parallel with tensions between China and the United States (we highly recommend two articles that present both sides of the argument about the state of the Chinese economy: "Contrarian Investor Sees Economic Crash in China" by David Barboza in the 8Jan10 New York Times, and "Bears in a China Shop" in the 14Jan10 Economist).
- Moving beyond the fiscal situation and international imbalances, on the monetary front the world's financial system remains far from healthy, despite the excruciatingly large bonuses paid by some firms. European banks are still burdened with large volumes of bad debt to Eastern and Southern European borrowers. U.S. banks continue to struggle with worsening conditions in their commercial real estate portfolios. And while U.S. households appear to be struggling mightily to pay down their debt, continued unemployment is making this more difficult. More dangerously, with large numbers of adjustable rate mortgage loan interest rate resets and payment recasts coming up in 2010 and 2011, and with more and more commercial borrowers walking away from their mortgage loans, a growing number of articles are asking why individual households are not following the same course of action (see, for example, "Underwater, But Will They Leave the Pool?" by Richard Thaler in the 24Jan10 New York Times, "Debtor's Dilemma: Pay the Mortgage or Walk Away?" in the 17Dec09 Wall Street Journal, and "Underwater and Not Walking Away: Shame, Fear and the Social Management of the Housing Crisis" by Brent White of the University of Arizona). Both banks and non-banks face growing concerns about the quality of state and local government debt in the United States, while in the Eurozone questions have been raised about the willingness of countries like Ireland, Spain, Greece and Portugal to take the fiscal actions necessary to maintain their debt servicing ability at acceptable levels. More dangerously, Iceland has taken a step down the path of debt repudiation or default (and, presumably, Argentine-style renegotiation and reduction) with its President's refusal to sanction proposed legislation that would use public funds to provide payments to foreign creditors who lost money under IceSave and similar plans, that were supposedly backed by Iceland's deposit insurance fund.
- In Iran, the Ashura holiday saw bloody clashes between demonstrators and the security forces, more aggressive moves against the opposition's leaders, publication by the Times of London of more damning evidence about Iran's nuclear program, and some evidence that the Obama administration's initial attempts to negotiate with the Iranian regime and giving way to a much tougher stance that logically increases the likelihood of a military confrontation that would probably drive oil prices through the roof, providing a negative shock to the weak economic recovery that is now underway.
- Last but not least, there is growing evidence, from the Ukraine and elsewhere, that the latest evolution of the H1N1 virus is significantly deadlier than previous versions. As more stories appear alluding to "changes in D225G/N" that cause the virus to be much deadlier, we expect another rise in uncertainty and a further setback to economic growth.
What then, are the asset class valuation and allocation implications of the situation we face at the start of 2010? While acknowledging the uncertainty we face on the upside (we like to remind people that at Bill Clinton's post-1992 election economic summit in Little Rock, the word "internet" appeared only six times in over 600 pages of briefing books), we believe that the balance of risks is increasingly tilted towards the downside. More to the point, we believe that for various reasons, the 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). In particular, as we noted in this month's feature article, gold should do particularly well to the extent that doubts increase about the U.S. Government's ability (or, in the extreme case, willingness) to service its debt (which includes taking steps to avoid partial de-facto default via prolonged high inflation and exchange rate depreciation). We also reiterate our conclusion that under such circumstances, Australian and Canadian government bonds should also do well, given that these countries are rich in resources and have done a far better job than the United States in addressing their liabilities healthcare and social security (though both could still do more to increase their total factor productivity growth).
In the same vein, we have not changed our oft-stated conclusion that asset classes that perform best under the normal regime -- specifically, all equities (including emerging market equities) and credit bonds – are most likely overpriced today (though, as we note in this month's asset class valuation section, the UK equity market appears to be the exception to this rule).
With respect to the "inflation versus deflation" dilemma that many investors face today, we reiterate our long held view that deflation is more likely in the short-term, as it is a phenomenon associated with the liquidation of private sector debt and the reduction of aggregate demand relative to aggregate supply that this creates (e.g., look at the falls in residential property prices in many markets). Over a longer time horizon, however, we believe that the risk of inflation increases to the extent that (a) governments either absorb private sector debts and/or are forced to engage in prolonged deficit spending to maintain aggregate demand, and (b) fail to set forth a credible program for increasing economic growth and reducing the ratio of government debt to GDP. To the extent that the yields on medium and longer dated government bonds are being bid up today in anticipation of a sharp increase in inflation, we would regard this as premature and perhaps a good short term trade for those of our readers looking for those ideas. On the other hand, while oil prices could easily spike in response to actions in Iran, we view the balance of risks for commodities as on the downside, with a fall in global demand likely to cause a fall in commodity prices. We also regard the balance of risks in commercial property to be on the downside as well.
| Feature Article: What is the Proper Role of Gold | Investor Herding Risk Analysis | January 2010 Economic Update | Global Asset Class Valuation Updates Detail through December 31 2009 | This Month's Letters to the Editor: Investing for Different Time Horizons; Uncorrelated Alpha Strategies- Beneficial?; Why Didn't the Three-Year Return Forecast Change?; Equally Weighted vs Model Portfolios; Why Don't You Include Emerging Bonds as an Asset Class? | Table: Fundamental Asset Class Valuation and Recent Return Momentum | January 2010 Issue: Key Points | Global Asset Class Valuation Updates Detail through February 26, 2010 | Global Asset Class Returns | Table: Market Implied Regime Expectations and Three Year Return Forecast | Financial Advisors' Corner | Overview of Our Valuation Methodology | Uncorrelated Alpha Strategies Detail | Product and Strategy Notes: New Research Papers; Analysts' Recommendations |
