As we look to opportunistically deploy capital on a bottom-up fundamental basis, with a deep-value bias, we want to take into account, in some measure, the macroeconomic environment that surrounds us. In a recent letter, we discussed the stressed nature of consumer balance sheets. In this letter, we high­light another macro issue, namely government debt levels. We conclude with how our security selection process is influenced by our thinking on this important matter. Hint—we are cautious and paying attention to the potential consequences of current fiscal policies.

 

The national economic debate today seems to be centered on our government’s response to the chal­lenges of the past two years. To wit, should the government “deficit spend” in the absence of sufficient private demand to stop a further economic free fall (an idea promulgated by John Maynard Keynes) or should it stand by, let the scene play out, and perhaps even aggressively cut taxes (further) to stimulate economic activity (supply-side economics, originally put forth to combat the stagflation, or inflation with no growth, of the 1970s)? Well, to quote a recent Hollywood movie title, “It’s complicated.” None­theless, we would argue that the government’s response has been, by and large, necessary, prudent, and effective. How many governments faced with a similar set of circumstances chose a fundamentally different response? None. Are they all wrong? Certainly, we have created new problems that will need to be solved, but as the saying goes, you have to put out the fire first.

 

Political courage and intellectual honesty are in short supply and, thus, more noteworthy when they appear. Bruce Bartlett was a domestic policy adviser to President Ronald Reagan, a staffer to Jack Kemp, and is considered one of the originators of Reaganomics, the supply-side theory that conservatives have long championed. Today, Bartlett is a bit more nuanced in his thinking and believes that there is no magic economic formula but rather solutions that are designed to solve certain economic problems. He’s no longer in the “one size fits all” camp. In his book The New American Economy: The Failure of Reaganomics and a New Way Forward, Bartlett argues convincingly that while supply-side ideas helped solve the crisis of stagflation in the 1970s, Keynesian theory helped drive a successful response to the 1930s Depression and was an appropriate one to the current crisis as well. Unfortunately, economic ideas tend to overstay their welcome as adherents come to believe in their persistent utility. According to Bartlett, “Keynesian economics worked in the 1930s because it was designed for deflationary conditions. But applied when deflation wasn’t a problem, it stimulated inflation.” Regarding the economic frame­work he helped develop, Bartlett now says, “In my opinion, it is time for supply-side economics as a distinctive school of thought to go peacefully into the night…. The things that were right about supply-side economics have been fully incorporated into mainstream economics.”

 

Similarly, Gregory Mankiw, Chairman of President George W. Bush’s Council of Economic Advis­ers and now a visiting fellow at the conservative American Enterprise Institute, has contributed to the debate about government intervention in a thoughtful and reasonable manner that is too often lack­ing. In 1992, while an economist at Harvard University, Mankiw said, “[A]fter fifty years of additional progress in economic science, The General Theory (Keynes’ landmark effort) is an outdated book. We are in a much better position than Keynes was to figure out how the economy works.” In November 2008, however, faced with conditions that were, in fact, reminiscent of the 1930s, Mankiw wrote a piece in the New York Times in which he asserted, “If you were going to turn to only one economist to under­stand the problems facing the economy, there is little doubt that the economist would be John Maynard Keynes. Although Keynes died more than a half-century ago, his diagnosis of recessions and depressions remains the foundation of modern macroeconomics. His insights go a long way toward explaining the challenges we now confront.” How many policymakers, intellectuals, or politicians correct themselves? Few Democrats are willing to entertain the notion that pushing homeownership rates from levels below 65% up toward 70% played a role in the current crisis. And few Republicans are willing to come clean about the consequences of deregulation.

 

Whether in the United States, Europe, or China, the answer to plunging private demand has been strik­ingly similar—government spending. Critics rightly highlight the liabilities associated with the practice but rarely note that a given nation acquires assets as well that will also be passed on to future generations (i.e., balance sheets have two sides). Further, critics often fail to note that 40% of the Administration’s stimulus package went toward tax cuts. Ben Bernanke, Chairman of the Federal Reserve, seems to us to have gotten it right when he recently said, “In the current episode, in contrast to the 1930s, policy­makers around the world worked assiduously to stabilize the financial system. As a result, although the economic consequences of the financial crisis have been painfully severe, the world was spared an even worse cataclysm that could have rivaled or surpassed the Great Depression.” So far, the results speak for themselves:

 

• High yield spreads over U.S. Treasuries have dropped from 2,100 basis points to roughly 600.
• The U.S. stock market has risen 70% off its low.
• Unemployment has stabilized.
• Banks’ equity-to-asset ratio is the highest it has been since 1938—11%.
• Banks have paid back roughly 75% of their debt to taxpayers.

 

These are not small accomplishments. Market responses to the Administration’s efforts have led to much needed private “animal spirits” resulting from a rise in confidence. In March 2009, as the stock market plunged and credit spreads widened, critics often argued that the market was effectively “voting” its view of the Administration’s policies. Are the critics willing to concede the vote tally today?

 

What will all this cost? Taxes must be raised and spending must be cut, principally by reforming entitle­ment programs, to ensure a sounder future economy. This shouldn’t kill us. In fact, total federal tax receipts as a percentage of Gross Domestic Product (GDP) have consistently ranged between 15% and 20% for the past sixty years (regardless of marginal tax rates) and now stand at just under 16%. More­over, a meaningful federal tax increase has not been enacted in the United States since 1993. Charges of “redistributionism” from Wall Streeters who cloak their arguments in the need to incentivize capital formation are self-serving. Hedge fund managers enjoy a reduced 15% tax rate on their fees since these fees are characterized as capital gains—that’s redistributive. Where are the New York congresspeople (principally Democrats) who are typically populist in their rhetoric but absolutely AWOL on this give­away?

 

There is little question that rising national debt levels raise serious risks to mid- and long-term economic prospects and should in no way be discounted. The U.S. federal debt as a percentage of GDP is at levels not seen since World War II. However, unlike then, we do not have the tailwinds of a youthful popula­tion or the task of rebuilding Europe. Our debt-to-GDP is now at roughly 84%; it is believed to have a material impact on growth at 90%. Further, the debt crisis could hardly be happening at a worse time for the United States. The first boomers turn sixty-five years old in 2011, which will no doubt be accom­panied by pressure to increase federal spending on Social Security and Medicare.

 

Our country’s budget problems are compounded by our past failure to save during the boom times. Among other things, we went to war without asking our citizens to pay for it: the nation’s total public debt stood at $5.7 trillion when George W. Bush took office; it was $10.6 trillion when he left office; it’s at $12.8 trillion today. Ideally, a country works like a well-managed company or family: you squirrel away savings during the good times (because they never last) to help you through the challenging ones.

 

The problem could worsen when interest rates rise. Creditors are beginning to demand a greater return for financing our debt needs. Most economists believe that rising rates are an inevitable outcome of ris­ing debt levels. In fact, the thirty-year decline in the cost of borrowing appears to be coming to an end.

 

Will we enact initiatives that bend the curve on deficit spending to put the nation on firmer economic footing? It’s questionable. Larry Diamond, a Stanford University democracy expert, says, “If you don’t get governance right, it is very hard to get anything else right that government needs to deal with. We have to rethink in some basic ways how our political institutions work, because they are increasingly incapable of delivering effective solutions any longer.” Our inability to craft real solutions that require tough choices about taxes, spending, and entitlements will not be judged well by history. When George H. W. Bush’s economic advisers convinced him that tax increases were necessary to combat Reagan-era debt, he reluctantly went along even though the move was counter to a strongly worded campaign promise. Bush’s actions serve as an example of real political leadership. Will President Obama break any campaign pledges, or challenge his own party, because his economic advisers say he must do so in order to strengthen our economic prospects?

 

Help in crafting legislation may be on the way from the old bulls. In 2007, four former Senate majority leaders, Democrats Tom Daschle and George Mitchell, and Republicans Howard Baker and Bob Dole, came together to found the Bipartisan Policy Center (BPC), which seeks to “develop and promote solu­tions that can attract public support and political momentum in order to achieve real progress. The BPC acts as an incubator for policy efforts that engage top political figures, advocates, academics and busi­ness leaders in the art of principled compromise.” In addition, former Republican Sen. Alan Simpson accepted the President’s appointment to the bipartisan National Commission on Fiscal Responsibility and Reform. Hopefully, these efforts will overtake the “food fight” theatrics with sound, responsible solutions to our fiscal challenges.

 

In the meantime, what does all this mean for how we construct portfolios and, specifically, select secu­rities? First, we are not buying into the headlines populating the financial press. For example, Barron’s March 22 cover confidently states, “Double Dip? Hell, No!” Second, in our bond selections, we look for mispricing in high yield corporate debt and are, therefore, less concerned about rising interest rates than investors in U.S. Treasury or investment grade bonds. That said, we are cognizant of the effect of rising interest rates on bond prices, particularly on longer-term maturities. For this reason, most of our bond holdings have maturities of seven years or less. Finally, we patiently wait for mistakes—mispricing—to occur in specific securities. The one stock among our top purchases in the first quarter, Great Lakes, illustrates this point well. Great Lakes is an asset-rich company we have been watching for about two years. It dropped 25% in one week because disappointed growth investors who had expected better fourth quarter 2009 earnings dumped the stock. We believe caution, patience, and a healthy skepticism about the market’s current euphoria will serve us well. We remain mindful of what can go wrong while looking for specific investments that meet a high margin of safety requirement.

(c) Roumell Asset Management

www.roumellasset.com