“The Song Remains the Same”

In the world of investment management, results are typically measured each quarter. While markets sometimes experience a dramatic shift in the course of ninety days, usually the most important influences on the economy evolve more slowly. That is the situation today, where from our perspective, little about the investment backdrop has changed in 2010. The rest of this commentary will summarize our view of the current situation, the policy options available and likely outcomes. Finally, we will discuss the expected impact on our portfolio, and how we expect to position it in the future.

 

The Debt Is Still Here

Just like in prior quarters, over the past two years, the main factor overhanging the markets continues to be the amount of debt owed by individuals, certain financial companies and governments. As stock, bond and commodity prices increased during the quarter, this issue received little attention in the media. Temporarily forgotten unfortunately does not mean permanently resolved. In the U.S., total debt to GDP reached its peak of about 350% at the beginning of 2009. According to the Federal Reserve’s most recent Flow of Funds Accounts, the ratio today is little changed from that level. In order to lower it, we can see three options:

 

First, economic growth (similar to the experience of the late 1990s despite the over-investment in telecom and internet infrastructure) represents the best way to achieve a reduction. If the economy grows faster than the growth in debt, more resources are created to pay for the current borrowing. Second, is the repayment of the amount of debt outstanding.

 

Finally, the least desirable option would result from a rise in inflation. In that case, inflation increases the size of the economy compared to fixed rate debt, allowing future repayment with less valuable dollars. We believe economic growth over the next several years will likely be positive, but not robust enough to lower debt levels meaningfully. Repayment appears challenging for individuals and governments for the foreseeable future. Acting like its back is against the wall, the Federal Reserve (“Fed”) has recently endorsed higher inflation.

 

Examining the historical record reveals the difficulty the country faces in generating strong economic growth over the next few years. A recent paper given at the Fed conclave in Jackson Hole by Carmen Reinhart looked back at economic recoveries around the world following severe dislocations over the last seventy-five years. This data series suggests that “economic growth is notably slower in the decade following a macroeconomic disruption.” She finds advanced economies typically lost 1% of real GDP growth per year in the decade after a crisis compared to the decade preceding it. The U.S. average for the ten years ended in 2007 was 3% growth per year, which shows the significance of a potential 1% annual drag going forward. The data also shows a similar pattern of headwinds can be expected over the next decade in employment, housing and credit availability, which is not surprising given the links these have to the economy. No two time periods are ever the same, but due to our current high unemployment, a destabilized housing market, and elevated consumer debt, history suggests we face several more challenging years of modest economic growth.

 

American consumers in total have reduced their borrowing. The Fed’s Flows data suggests households’ total debt has declined by $473 billion or just over 3% since its high at the start of 2008. Based on the work of Reinhart and a study from the Bank for International Settlements, typically the amount of borrowing by consumers in an economy’s run-up phase before a crisis is reversed over most of the following decade. From the end of 2000 until the peak in 2008, U.S. households’ total debt doubled. While a retrenchment of that magnitude is unlikely over the next ten years, consumers have only just started to work down their elevated level of obligations. Over the next few years, as households reduce their debt levels, we expect a substantial portion of this to be offset by higher governmental borrowing.

 

U.S. government debt has increased substantially over the last two years as deficits have annually exceeded $1 trillion. As state and local governments reduced consumption, Washington’s spending has picked up the slack, with a commensurate rise in debt outstanding to a gross total of $13.6 trillion at September 30. For perspective, in fiscal 2010, the entire federal budget outlays were $3.5 trillion. Increased debt issuance in the future appears likely based on projections by the Congressional Budget Office for deficits to total $7 trillion over the next ten years. Such a trajectory is definitely not sustainable. Eventually, if the amount of debt gets too large compared to the size of our economy, even the U.S. will not be immune to much higher borrowing costs. However, that day of reckoning appears to be at least several more years ahead as the country seems to have the necessary capacity today to bear the increased burden. Threatening to accelerate our creditors’ concerns is the looming insolvency of the major entitlement programs. Without belaboring this point already familiar to most of our readers, we will simply quote what we wrote at this time last year (2009):

The present value today of what the government owes for Social Security and Medicare is $46 trillion, according to the 2009 Trustee reports. The CBO estimated in June that federal spending on Medicare and Medicaid will grow from 5.3% of GDP in 2009 to 9.7% in 2035. To illustrate the issue another way, Social Security, Medicare and Medicaid received 43% of fiscal 2008 federal budget outlays. The CBO’s projections imply that the government will easily spend more than half its budget on these programs in coming years, either crowding out other programs or increasing total spending.

The dire outlook confronting these programs requires substantial changes over the medium term.

 

Choices are Limited

We mentioned earlier that the best way to mitigate the debt overhang is economic growth. Facing the headwinds of high unemployment, weak housing and reduced credit, policy makers have two options at their disposal. One is fiscal (the ability of Congress to increase/decrease spending or taxes), and the other is monetary (the ability of the Fed to increase/decrease interest rates or the supply of money). Unfortunately, neither seems likely to provide compelling benefit. Looking to fiscal options, U.S. mid-term elections largely focused on whether Congress should have spent to stimulate the economy, or cut to reduce deficits. Arguments can be made in support of both positions. Practically, however, it likely won’t matter. Public opposition to more stimulus and Republican gains have made arguments for higher fiscal spending moot. We should expect no benefit for the economy from fiscal options, leaving only monetary ones. The most direct impact of monetary policy occurs when the Fed changes the level of interest rates (its discount rate). In past downturns, rate cuts helped boost economic activity. With current rates already at practical lows (0.25%), there is no ability to cut further. In reality, even these rock-bottom interest rates are not having any economic impact because banks are unwilling to lend, individuals show limited desire to borrow and companies forego new investments. Facing this situation, the Fed is preparing to utilize its secondary monetary option which involves changing the amount of money in circulation. In theory, greater supply of money will be used for additional investment and spending which would boost the economy. From the time of his speech at the same Jackson Hole conference, Chairman Bernanke has communicated a desire to begin expanding the money supply through purchases of government bonds. This is known popularly as QE2 (the second program of quantitative easing).

 

Impacts

Will it work? We have a hard time seeing any tangible economic benefit from QE2. The U.S. government bond market is huge and very liquid. Even at the size of indicated Fed buying, rates on 2 to 10 year Treasuries are expected to fall from their already very low levels by 0.10% - 0.25%. It is extremely difficult to imagine such a reduction would have much impact on lending rates, particularly with lenders and borrowers on the sidelines. Another problem confronting the Fed’s attempted monetary stimulus is what economists call leakage. When its purchases of Treasuries cause yields to fall to even more meager levels, the Fed hopes to force capital into riskier assets. Since the U.S. is not a closed economy, instead of boosting investment and employment in the U.S., leakage means that this capital will get channeled into areas like commodities and emerging markets. The initial stimulus flows of the last eighteen months appear to have already inflated the values of these markets. The Fed’s next round could potentially push commodities and emerging market valuations into bubble status.

 

Since Chairman Bernanke’s advocacy began in September for a renewed Fed purchase plan, there was an obvious impact on the dollar. Against nearly all the major floating currencies, the dollar weakened. The longer the Fed engages in open-ended QE2 buying, and the larger the amounts it acquires, we believe the greater the downward pressure will fall on the dollar. In turn, the more the dollar weakens, the greater the risk of competitive devaluations (by other countries) and trade restrictions.

 

This recent move in currencies has occurred because investors feared the Chairman’s program will allow the Fed to engineer higher rates of inflation. In fact the September 21 statement of the FOMC explicitly endorsed higher inflation. Theoretically, one could argue that a small increase in the rate of inflation could be beneficial. As we mentioned before, much of U.S. consumers’ debt excesses are found in fixed rate mortgages. The Fed had hoped that when its initial stimulus measures drove down mortgage rates, this would allow consumers to refinance this debt at significantly lower rates. That phenomenon never occurred because of more stringent lending standards combined with falling home prices and the resulting negative equity positions of many borrowers. Since the refinancing play didn’t work, the Fed now appears to be turning to inflation to create growth in wages, or particularly in home prices. A recent study from the Quarterly Review of the Bank for International Settlements found that in 19 of the last 20 episodes of credit booms which resulted in banking crises, inflation was a major part of the subsequent deleveraging process. The Fed seems to be following a well trodden path.

 

Based on the initially published size of the QE2 program, we expect the Fed will struggle to increase the rate of inflation. Persistently high unemployment, uncertainty about government regulation and its scope, and a limited appetite for capital investment mean the Fed will have to shock markets to have inflation achieve its desired outcomes. The Fed will potentially have to buy more than expected for longer periods if it wants to make the most important impact — a shift in psychology. After more than thirty years in the U.S. with the experience of negligible inflation, dramatic actions are required to shift thinking of individuals and markets.

 

Conclusion

Congress’ hands are tied on the fiscal front. Proposed Fed actions are potentially inflationary, depending on the size (how much they buy). The dollar should continue to feel the effects of investor concern on this issue. An initial toe stuck in the QE2 water will probably not cause a lasting change to investors’ expectations about inflation. It will take an enormous amount of buying to change psychology. Over the longer term, if the Fed does resort to massive asset purchases, and succeeds in causing a real pickup in inflation, we are skeptical that the Fed will magically be able to put that genie back in the bottle.

 

(c) First Pacific Advisors

www.firstpacad.com