“The crisis did not come about because we issued too little money but because we created economic growth with too much money, and it was not sustainable,”
Â Angela Merkel, German Chancellor
Last week your correspondent participated in a World Pensions Conference in Toronto. The event was well-attended by investors, hedge fund advisors, industry representatives and regulators from North America, Europe and the Middle East. I had the pleasure of speaking on a panel together with Cynthia Steer, Chief Research Strategist at Rogers Casey, a well known US Pension Fund Advisor. Our general remit was to answer the question “Has the US turned the corner and are we now seeing the green shoots of recovery?”
In one sense the agenda was timely because it comes on the heels of the recent trumpeting by the news media of the arrival of “green shoots” everywhere in the US and the expectation that a speedy economic recovery is a foregone conclusion.Â Some of this recent chatter has included views to the effect that:
- The US Federal Government deficit blowout is actually a good thing because it will encourage politicians there to reduce it. (Our view: It is a testament to the skill of the DC PR mavens hired to work on this, that this argument actually made onto the airwaves.)
- The stress tests showed the banks to be in relatively good health so don’t worry. (Our view: the whole SPAC exercise is a cause for worry because it was heavily manipulated in order to achieve the announced results. We can all well imagine that the various news leaks surrounding this process would have been vigorously investigated unless they were officially sanctioned.)
- The stock market is signaling a recovery so stop worrying (Our view: It is a Bear Trap. Don’t buy into it!)
For now US banks are again standing tall in the elevator boots afforded them by the machinations surrounding the SCAP exercise. The spin machines in Washington have been working in overdrive to ensure that the message received by the markets and the public in relation to the stability of US banks is quite simple: “Nothing to see here…please move along…nothing to see here”. (For greater insight into how news and the media are regularly manipulated you would do well to read our good friend George Pitcher’s book “The Death of Spin”.)
Of far more interest to us was the turn of phrase coined by Cynthia, into the face of this bullishness when she asked: “What is the ‘New Normal’ thatÂ we seem to be moving towards?”. “Sure”, she commented, “we may have turned a corner, but what are we converging toward and what do we need to do from an investment management standpoint in order to take advantage of what is coming down the track?”
Are we going back to the “spend and borrow” culture that has dominated most of economic activity in the Western World for the last twenty five years? Or are we converging towards a James Howard Kunstler, post-peak-oil severe shrinkage of living standards and lifestyles kind of place? Will it be something in-between? It is hard to profile this Brave New World definitively given the many uncertainties swirling around.
However, in our view a return to the way things were a few years ago seems highly unlikely:
- There is still an overhang of housing inventory in the US;
- Private sector balance sheets are illiquid and must be restructured;
- The Income share of debt servicing is still too high and must come down; For exampleÂ TheÂ Economist recently estimated that US consumers need to pay off $3 trillion worth of excess mortgage debt, alone, in order to get back to year-2000 levels. If all US savings were put to the task, even that would take 4 or 5 years at the present rate.
- Private Sector savings behavior needs to revert back to what it was in the 60’s and 70’s in order to finance a pay-down of debt;
- Manufacturing needs to work off excess inventories and mothball excess productive capacity. Until demand is restored then businesses have no need to invest in more plant and equipment.
- The US Budget and Trade Deficits need to come back into balance.
Add to this mix the fact that the US is no longer a financial superpower. Far from it. Last year the US borrowed 65% of the available savings on the Face of the Planet. On the basis of current projections it is expected to borrow the same ratio or more going forward. Is this sustainable? Is it righteous? Will the surplus nations call a halt to this profligacy or at least seek to change the terms of the arrangements?
Is the “New Normal” expected to feature a bond market where yields seem impervious to rising inflationary expectations, and massive increases in US note and bond supply amid fears of a Sovereign Ratings downgrade? We think not. In fact we warned last January that the configuration of currency values and bond yields was not at all consistent with the underlying fundamentals.Â SinceÂ bottoming in January 10 Yr Treasury Yields have popped by over 130 basis points. our fears haveÂ thus proven out to some extent already, but we caution that we have yet to see the full force of the selling fury will impact the US bond market in the near future. Nothing would derail a recovery faster than a serious increase in term interest rates.Â Â
So Wrong; So Soon
In January President Obama promised that his Recovery Plan would create millions of new jobs. Take a look at the foregoing chart to see how right anyone was to have believed him then (The March and April actual Unemployment numbers are superimposed on the chart he presented in early February). So far the authorities appear to have have succeeded in doing only one thing: They seem to have slowed the downward spiral of the economy. They have not stopped it. Things are only getting worse at a slower rate. They have not yet begun to improve despite the rhetoric and jawboning that has been inflicted on the markets to date. “When will the US authorities run out of credibility?” is in our opinion a more relevant question than whether there are “green shoots” springing up.
This is because to expect that we will return to the type of world that existed before the Sub-Prime Crash is to bet on very long odds indeed. To illustate this in part, one would need to hope that:
- The US Housing correction will shortly have run its course;
- US Employment trends will reverse imminently;
- US Consumption spending will snap back;
- The US Bond Market yields will stay around current levels or move back down;
- The Fed will be able to sterilize the injections of high powered money that they have put into the system;
- The Fed will be able to reverse its purchases of un-fundable toxic waste from various market participants;
- Foreign Investors’ appetite for US Government debt will hold steady and not wane;
- Commodity prices (especially oil) will remain in check.
- The US regains its status as the World’s sole superpower and economic Pole Star
- Solving a Debt Crisis by creating more Debt is the way to go;
Yet, this spread of outcomes appears to be exactly what the US authorities are betting on. They are making the bet that the “New Normal” is in fact the “Old Normal” and that that is where we are all heading.
The authorities there are hoping that economic conditions will improve enough and in a short enough period of time to re-float the many failed businesses and banks that need to be re-liquified and recapitalized. They are hoping that foreign investors don’t find another home for their surplus savings. They are hoping against all available evidence showing that the current policy moves have never succeeded in restarting activity in other economies and at other times does not, and will not, apply in this instance. They are hoping that the goal of returning to the relationships and old ways of doing thingsÂ is not only a desirable objective, that it is in store.
We are not alone in registering these fears. Several Federal Reserve Bank Presidents including Thomas Hoenig of the Kansas City Fed, Jeffrey Lacker President 0f the Richmond Fed and Gary Stern President of the Minneapolis FedÂ have all publicly criticized the line taken by the Fed and Treasury in managing the banking crisis, saying essentially that the moves have increased, not decreased, systemic risks.
Â The Financial Lifeboat for the “New Normal”
Getting back to Cynthia on the investor panel: Her contention was that a risk-neutral portfolio for the “New Normal” environment might well be one that is sitting in a mix of cash denominated in different currencies accompanied by a 5-10% precious metals allocation and an allocation to some alternative strategies (Distressed Debt and Distressed Bank Deals) . No Stocks. No Bonds.
In our humble view, and looking ahead over the next several quarters and years, we completely agree withÂ her prescription. This is because we expect the “New Normal”Â to feature severe bouts of market volatility and economic uncertainty accompanied by political instability intermittently punctuated by periods ofÂ apparent calm. The “New Normal” is therefore going to be a relatively inhospitable place for investment managers following strategies that rely on friendly markets and a ready supply of gullible clients. Added to the mixÂ will be the additional financial pressures in the US that are associated with theÂ shortfalls in the Health Care and Social Security spending envelopes. With the passing of the Baby Boomer generationÂ into retirement these excesses will figure strongly in the investment environment and the financial flexibility (or lack thereof) that the US will be able toÂ wield in relationÂ to its fiscal challenges.
Together with recent geo-politicalÂ concerns (Al Quaeda, War on Terror, War on Drugs, the loss of US hegemonyÂ etc) we are concerned that the ongoing global transition into a multi-polar political paradigmÂ is fraught with a paucity of leadership and beset by conflicting policy prescriptions emanating from countries with new found influence on the world stage. The process is further encumbered by a veritable witches’ brew of unprecedented monetary stimulus and fiscal excesses. It will not be a smooth ride nor one that will likely end with a soft landing.
Brace for Impact – the “New Normal” is on the way!!