March 2010 Economic Update: Do We Still "Have the Bubble"?

"Having the bubble" is a phrase that is typically used among pilots and air traffic controllers to connote a high degree of "situational awareness", which is defined as an understanding of the key elements in a situation, their interrelationships, and the way the situation could evolve over time. To "have the bubble" requires the formation of a mental model of complex system, and the constant updating of that model as the underlying system and situations it creates constantly evolve. It is possible to "lose the bubble", whether due to disruptions to the updating process, or to surprising system behavior that causes you to lose confidence in your mental model. Whether you are responsible for managing many airplanes in a confined space, flying an airplane in combat, performing a complex operation, or managing a large amount of money, "losing the bubble" can be very dangerous, if not catastrophic. Here at The Index Investor and Retired Investor, we constantly worry about whether we still have the bubble, as the world economic and political system enters a period of heightened uncertainty. Quite honestly, over the past month or so, we have read an increasing number of articles by commentators we highly respect that indicate that a number of our long-held views are moving into the mainstream. And that nags at us. If the past thirty years have taught us anything, it is that when your views are the conventional wisdom, it is time to step back and take a good hard look for what you might be missing -- because more often than not, the conventional wisdom turns out to be wrong.

With that in mind, we have been trying to break down the rising uncertainty we (and we're sure you too) feel into the key factors that are driving the evolution of our situation. We've used a framework we have profitably employed over the years to help us evaluate investments in different companies, which includes an examination of the key macro elements in the story, the micro elements, the plan that ties them together to create value, and our confidence in the management team that will execute, and inevitably have to adapt the plan. What then, are the key macro elements in our situation? We believe there are five broad ones. The first are the slow moving yet powerful forces of demographic change, an in particular an unprecedented aging of rich societies around the world. Consider the following table, which shows the United Nation's estimates for the ratio of the number of people 65 and older to those between 15 and 64 (this is technically known as the "Old Age Dependency Ratio"):

This table hints at many stories that will unfold over the next decade, including (1) countries' need to cope with rising social security and health care needs (e.g., which paints Australia's mandatory superannuation savings plan and mixed health care plans in an extremely favorable light), (2) the need to focus even more carefully on the drivers of economic growth, including increased savings and investment, labor force growth (whether by raising retirement ages or becoming more attractive to highly productive immigrants), and, above all, higher total factor productivity (TFP) growth; (3) the extreme challenge facing continental Europe and Japan; (4) the surprising challenge that Canada appears to face; (5) the pressure that rapid ageing will exert on China (which implies a conflict between the world's short term need for higher consumption growth in China and the country's need to maintain high savings to cushion the impact of a rapid rise in the Old Age Dependency Ratio); (6) the relative demographic advantages of the UK, USA, and especially India; and (7) the political conflicts that are likely to ensue simply because the elderly have a greater tendency to vote than do the young.

The second macro factor that contributes to our heightened uncertainty today is the tension between the individual and collective that exists in many societies today. More specifically, in recent years we have observed three key social trends that, to varying degrees, seem to be underway around the world: (a) growth in what we call the libertarian/highly individualistic orientation; (b) a widening gap between the economic resources and social values of people in the top ten percent and bottom 90 percent of the household income distribution (with a simultaneous erosion of both the economic and the social values "middle class"); and (c) a rise in populist anger driven by a rising sense of vulnerability and a prolonged period of debt fueled conspicuous consumption (and in some countries, a rising mismatch between the ratio of young males to young females). We aren't sure where these trends will lead. However, we believe we are facing a very volatile social mix that could generate very unpredictable consequences. Historically, these elements have led to a turn to authoritarian governments, a tendency to blame problems on "the other", rising barriers to trade and capital flows, and in some cases to violent conflict.

The third macro factor is a growing questioning of the legitimacy of current political institutions around the world, particularly as they seem to flounder in the face of the challenges we now confront. Internationally, one form this has taken is rising sentiment against globalization. It also may soon lead to questions about the future of the Eurozone, the governing mandate of the Chinese Communist Party, the power of public sector unions throughout the West, the ability of governments to take difficult budgetary or regulatory actions, or the purpose of political parties dominated by extremists that seem to block the resolution of pressing national problems. In sum, more and more people seem to have a rising sense that many current institutions aren't working.

The fourth macro factor is economics, and specifically the interplay between the impact of debt (and the growing tension between controlled deleveraging and default), and the ability of societies to create jobs and raise worker productivity so as to generate rising real wages and household incomes. If we fail at creating jobs and raising productivity and wages, rising defaults can't be far behind. But what about inflation? I'm increasingly doubtful that it is possible for a large nation to reduce the value of its debts via inflation. Average maturities are no so short -- on the order of four years, or so, for most countries -- that a rapid rise in the returns demanded by bond market investors seems likely to kill this strategy before it gains much traction. Of course, as Zimbabwe and Argentina have shown that isn’t the case for countries that have a low reliance on international bond markets, as domestic investors are easier to bully. But it is hard to see how that could work for large nations, absent a dramatic descent into a world of trading blocs that have little interaction with each other.

The fifth and final macro factor is technology, in at least three dimensions. The first is the rise in network connectedness that continues to accelerate around the world. As we have repeatedly noted, this not only overwhelms thinking with a flood of data, but also accelerates the global transmission of emotion. Neither of these suggests a less volatile future; rather they suggest ever growing pressure on our ability to "have the bubble." The second dimension is our increasing dependence on technology, and hence heightened vulnerability to asymmetric threats that range from techno-viruses to electromagnetic pulse. The third dimension is the accelerating capability of what (in the old days) was known as artificial intelligence, but which today encompasses a much wider range of sensor, processing, and decision making technologies. People who write about subjects like "the singularity" (the point at which a machine exceeds the intelligence of a human being) and the implications of rapidly accelerating technological change have always seemed a bit "out there" to me, and probably to many of our readers. But lately, "out there" is feeling more and more like "right here" -- for example, see our comments about the sophistication of today's quantitative trading in this month's Product and Strategy Notes.

The way these macro trends manifest themselves, and the institutions that guide there interaction, will continue to be primarily defined by the nation state, which remains the only organizations whose use of force is generally viewed by outsiders as legitimate. And history has shown that the use of force will never go out of style. In very broad terms, there seem to be at least three archetypical micro models at work in the world today. One is AngloSaxon, which offers relatively high degrees of individual freedom, idealism, and aggregate wealth creation, but at the cost of higher uncertainty, social tension and vulnerability. Particularly in its Presidential form, it is under considerable strain today. The second model is grounded in Continental Europe, and offers less freedom, dynamism, and wealth creation, but also less uncertainty and social tension. For many people, it offers an attractive middle ground between the AngloSaxon and Authoritarian models. Perhaps the most powerful argument against this view is the inability of the Continental model to inspire people to have enough children to perpetuate their society.

Another is that when it has been tried outside of Europe, say in Latin America, it has proven to be quite unstable -- which suggests to me that a deeply rooted cultural identity is essential to its successful functioning. The final model is the one that has proven to be a powerful attractor throughout history -- Authoritarian systems that limit conflict between rival groups, there by enabling them to produce and divide a greater amount of spoils. China is in this category today, as are Russia, much of Africa and virtually all of the Middle East, with the exceptions of Israel and, perhaps one day, Iraq. Arguably a number of countries in Asia and Latin America are teetering on the brink of the Authoritarian precipice, or, as in the case of Venezuela, have already gone over. As we have repeatedly noted over the years in response to our apparent lack of limitless enthusiasm for emerging market debt and equity, investors ignore the institutional context at their peril. Too many people in the West comfortably assume that democracy, and well functioning property and contract law, not to mention a relatively fair judicial system, are all part of the natural order of things, the type of government towards which other countries, with once they achieve a sufficient level of economic development, will inevitably evolve. I'm not so sanguine about that, and believe that history teaches us that the attractions of the authoritarian approach rise with a population’s sense of uncertainty and vulnerability. If anything, it has been the emergence of stable democracies that has been the historical exception, rather than people's continuing attraction to authoritarian governments.

This brings us to the more practical question of which nation states, if any, appear to have a model (I'd say plan, but that is too deterministic) that will enable their institutions to manage the uncertainties and challenges caused by our key macro trends. For example, we know that in the United States, restoring growth will require the nation to address pressing federal fiscal problems like social security, Medicare and Medicaid, similarly pressing problems at the state and local level (primarily revolving around the future ability of government to efficiently and effectively deliver a package of services that voters seek at a price they are willing and able to pay), the need for a substantial increase in private and public sector investment, job creation, the headwinds caused by the debt overhanging the household sector and financial system, and a wide range of regulatory reforms (e.g., to the education system) that are needed to raise long term total factor productivity growth (for a more comprehensive article on this, see James Fallows "How America Can Rise Again" in the January issue of The Atlantic). But does anybody have much confidence in the model that exists today for tackling those challenges?

Contrast the United States with Australia or Canada, both of which have, in my experience, a better balance between the individual and the collective that has already enabled them to take major steps towards resolving, or at least controlling, the challenges posed by aging populations and more efficient and effective government. Not that they are without their problems -- for example, Australia has yet to experience a downturn in an apparently overvalued housing market, while Canada continues to struggle with the need to raise TFP growth and reduce the rate of increase in household borrowing. And both are still quite dependent on commodities exports and Chinese demand for them. But those problems seem more tractable than those facing the United States or many nations in Continental Europe today -- and maybe even China too. The point is, it is hard to point to many models that seem to be working today, which only raises the temptation to pursue authoritarian solutions of one type or another (see, for example, Walter Russell Mead's blog post "Do Soldiers Drink Tea?" on The-American-Interest.com).

Finally we come to management, or, more accurately, the quality of the leaders who will implement and adopt the model. I have read enough history to know that this is the ultimate wild card, a source of both uncertainty and hope. To cite but one example, over a decade spent working in Latin America I saw countries ruined due to the corrosion of public and private sector leadership by corruption and self-interest -- but I also saw the triumph of leadership in the form of Luiz Inacio Lula da Silva who had confounded his detractors (and they have been many over the years), risen above what his past had indicated, and led Brazil’s amazing turnaround story, so that it is finally realizing its enormous potential. So while I can't say that I'm overly impressed with many leaders on the world stage today (in both the public and private sectors), neither am I without hope about the positive surprises that difficult and challenging times can produce.

What then, are the asset allocation implications of these observations? Obviously, given the ground I have just covered anything I write runs the risk of sounding too glib. Yet there are still some important takeaways. Obviously, everything we have written in the past about the likelihood of a return to the high uncertainty regime, and the asset classes that will do well under it still stands -- particularly for volatility, which seems extraordinarily cheap today, given our outlook for the future. We also stand by our long held positive view of real return and short term government bonds issued by Australia and Canada, and our much more negative view of debt issued by many U.S. states and municipalities, to which we must now add the debt of the so-called Club Med countries (perhaps it is because I hold an Irish passport, but I have more confidence in that nation's ability navigate and benefit from a period of deep austerity than I do their neighbors to the south). In other segments of the fixed income market, I side with Bill Gross, and his view that real old fashioned credit analysis skills will be making a comeback in the years ahead. Fortunately, all of us here still remember the 5 Cs. Beyond that, with the passage of time, I become more and more confident that India's best days still lie ahead of it -- a statement that I am much less willing to make about China, which faces much more serious challenges in the years ahead, some of which could very easily have very negative implications for the rest of us.

In an uncertain world, I can also see commercial property making a comeback, as investors come to appreciate of an asset they can kick, even if it is only half leased. As for equities, I remain convinced that valuations are for the most part too high today, but are likely at some point in the future to come down to levels that, for buyers who have the courage of their analytical convictions, will generate very attractive long term returns. But in most cases, we haven't reached that point yet. As for timber, even in a very uncertain world, it keeps growing, and cares not a whit what happens to other asset classes. Enough said. I also think that, given the enormous amounts of natural gas that have been discovered in the United States (and potentially in other countries too), increasing demand for this fuel in a world that will be more concerned with CO2 emissions (I don't think the underlying problem is going away any time soon), we should see growing interest in direct energy investments as a way to gain exposure to commodities.

Last but certainly not least, the three critical indicators we will very carefully watch over the next two years are job creation, levels of public and private investment spending, and changes in total factor productivity growth in the countries and regions we track. If all these recover, I believe that the negative effects of gradual deleveraging will remain within acceptable bounds. However, if this isn't the case, then I think we will see a surge in bankruptcy filings, strategic mortgage defaults, debt/equity conversions and quite possibly the Northern Rock style nationalization of many banks. On the positive side, my experience in Latin America, not to mention a reading of economic history, tells me that a short sharp extinguishing of substantial amounts of debt can result in a very strong recovery, which will particularly benefit countries that aren't also looking at a rapid increase in their old age dependency ratio. On the negative side, this can be a very painful time for creditors (e.g., holders of paper backed by residential mortgages) and shareholders who are radically diluted by forced debt/equity conversions. Whether all this adds up to still "having the bubble" remains to be seen.

| Advisers' Corner: What Makes Clients Tick? | Overview of Our Valuation Methodology | Uncorrelated Alpha Strategies Detail | Global Asset Class Returns | Table: Market Implied Regime Expectations and Three Year Return Forecast | Table: Fundamental Asset Class Valuation and Recent Return Momentum | March 2010 Issue: Key Points | This Month's Letters to the Editor: Changes to Attitutudes About Investing - Mad for Alpha; Does Index/Retired Have a "Black Box" Toward Your Asset Allocation Strategy? | Global Asset Class Valuation Updates Detail through February 26, 2010 | March 2010 Economic Update: Do We Still "Have the Bubble"? | Product and Strategy Notes: Investment Strategies; MSCI Barra - What Drives Long Term Equity Returns; Implications of Algorithmic Trading to Active Management Strategies; and New Products - Longevity Risk Indexes, Disturbing Trends in the ETF Market | Investor Herding Risk Analysis |