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“[T]he Commission majority’s report ignores hypotheses about the causes of the causes of the financial crisis that any objective investigation would have considered, while focusing solely on theories that have political currency but far less plausibility. This is not the way a serious and objective inquiry should have been carried out, but that is how the Commission used its resources and its mandate.”
Peter J. Wallison,
Financial Crisis Inquiry Commission Dissenting Statement1
Despite the increasing undercurrent of negative news creeping into the financial markets, the stock market remains strong. HCM expects equities to continue to perform well for the foreseeable future (i.e. through the end of June) although most of this letter will discuss the reasons why it shouldn’t. In some ways, this market is a lot like Charlie Sheen. It pretends to have tiger blood and the powers of a warlock, but deep inside it is suffering from an addiction to a substance (i.e. debt) that will ultimately kill it.
The list of burgeoning economic concerns includes the following:
- Rising energy costs.
- Lousy housing data, including rising foreclosures, weak pricing and sales.
- A high jobless rate that is being statistically manipulated to look lower than it really is.
- State government finances in a shambles.
- A federal budget that doesn’t qualify as a shambles.
- Europe deferring rather than solving its budget crisis.
- Rising Middle East instability.
On the positive side, many U.S. corporations are doing extremely well and certain measures such as consumer confidence are rising steadily. Our friend Doug Kass noted in a recent note (“Mea Culpa,” March 2, 2011) that the cyclical recovery in profits had been sufficiently strong to overcome his macroeconomic concerns Consumers also seem to be spending pretty freely, although where they are getting the money is a mystery to HCM in view of the high unemployment rate and generally tepid economy. Of course, every time HCM reads about the consumer confidence measure, we reminds ourselves that these are the same consumers that voted Congress into office (and made Two and a Half Men the most popular comedy on television), so placing too much stock in their wisdom is probably not the best course for preserving one’s wealth. Moreover, concepts such as value investing, contrarian thinking and variant thinking would have to be thrown out the window if investors allowed themselves to be guided by the madness of crowds. Still, as Keynes taught us, investors must choose the least ugly girl at the dance, so one cannot ignore such subjective data in determining how to invest.
The recent downward revision in 4Q10 GDP (from 3.2 percent to 2.8 percent) was not a surprise to HCM, nor we imagine to certain other observers who remain convinced that the U.S. economy is running on empty. We can only wonder what Federal Reserve Chairman Ben Bernanke really thinks when he turns out the lights and counts helicopters in his sleep, but we suspect he worries about the same thing. For if he were more confident that the U.S. economy could grow on his own, he would be hard pressed to explain why he is printing (thank you Kyle Bass) $2.5 million per minute and $3.5 billion per day of new money to keep the economy (and particularly the new object of his affection, the stock market) afloat. With second half 2010 growth coming in at well below 3.0 percent (2.6 percent in 3Q10 and 2.8 percent in Q410), it is apparent that the U.S. economy is being weighed down by the albatross of excessive debt in both the private and public sector.
While much of the private sector debt crisis has been shifted to the public sector both inside and outside the United States, the fact remains that private industry remains scarred by the 2008 financial crisis. Having seen their Christmas bonuses pass before their eyes, corporate executives have hastened to fill their stockings with coal rather than shower the economy with gifts in the form of new plants and equipment and new job offers. This prudence, as HCM has written in the past, makes eminent sense for these companies individually, but on an economy-wide basis has created a paradox of thrift that is retarding economic growth. This phenomenon is compounded by the excess capacity that plagues many industries such as residential and commercial real estate and retail (Blockbuster Entertainment and Borders Group being the latest casualties in the latter space). And this is the situation before state and local governments begin gutting their budgets, which will further starve the economy of fuel.
In order to appreciate the severity of the debt crisis that America is facing, it is important to place it in context. Nobody is better at doing this than our friend David Rosenberg. Mr. Rosenberg writes:
“The United States is a 236-year old country, and almost 40% of the entire public sector debt has been built up by the current Administration in barely more than two years. The United States has a monetary base of $2.06 trillion, and nearly 60% of that has been created since Helicopter Ben took over the cockpit in early 2006. A 236 year-old country, and well over half of the stock of money has been created in just the past half-decade. Remarkable. Maybe the real question we should be asking is why the stock market has only managed to double from the lows with all this massive stimulation.” 2
Reading these words should make all of us feel deeply embarrassed to have witnessed right before our eyes the damage inflicted on America’s economic hegemony in such a short period of time.
In this respect, recent testimony by Secretary of State Hilary Clinton before Congress is especially painful to hear. Mrs. Clinton warned Congress in some of the most explicit terms used by a public official that the United States is losing global influence to China (and presumably to others) due to its debt problem. “We are in competition with China. Let’s put aside the moral, humanitarian, do-good side of what we believe in, and let’s just talk straight realpolitik. We are in a competition with China.” She continued: “At the core of [America’s] strength is our economic strength, [which creates] the necessity for us to take action to rein in our debt, and particularly our indebtedness to foreign countries, the top of the list being China.” In particular, Mrs. Clinton pointed to China’s active engagement with regimes around the world in an attempt to secure future energy resources, which (these are now HCM’s words, not Mrs. Clinton’s) stands in sharp contrast to the failure of the United States to develop a serious and comprehensive energy policy. Broadening the context of this discussion, this is why the complex of tax and other policies that encourage debt financing and speculation are harming this country’s long-term strategic interests, and why a system that operates to enrich a small elite through such unproductive activities at the expense of productive investments that would benefit a wider swathe of society is so dangerous to the future health, prosperity and freedom of the United States.
This is why the federal government’s lack of serious effort to address the country’s ongoing debt crisis is not merely a political disappointment but a profound moral betrayal and potentially an existential failing. While the budget debate rages on, there can be little question that we are making little or no progress in solving our budget woes and are continuing to make them worse. President Barack Obama released a budget that promised a $1.6 trillion deficit this year and $1.1 trillion in 2012. The budget included $1.0 trillion of spending cuts and tax increases but avoided the only areas that can possibly bring the deficit under control: Social Security and Medicare. Instead, the President said that he wanted to save those tough decisions for discussions with the Republican opposition at a later date. This abdication of leadership was rightly criticized by observers of all political persuasions. The man who ran for president saying he would make the tough choices decided to duck one of the toughest choices of all.
Mr. Obama’s budget has been called highly political. In reality, it is the height of narcissism. By avoiding the entitlement issue, it is in no way intended to solve America’s debt problem (to which Mr. Obama’s policies have in many ways contributed); instead, it is primarily designed to pass the buck and promote the president’s re-election in 2012. In other words, Obama is telling the world that it is more important that he be re-elected than that the broken finances of the United States be fixed. With all due respect to Mr. Obama, no man’s political prospects justify such a choice, and certainly nothing that Mr. Obama has done during his first two years in office suggests that he is any exception.
1. The Financial Crisis Inquiry Report, Authorized Edition (New York: Public Affairs, 2011), p. 449.
2. David Rosenberg, Breakfast with Dave, Gluskin Sheff, February 22, 2011, p. 10.
U.S. monetary policy
As noted above, the Federal Reserve printing press is working overtime in a myriad of forms to reflate the American and global economies. Perhaps this is one reason why the U.S. dollar is showing weakness against a broad range of currencies. Many observers are attributing dollar weakness to rising oil prices and their likely slowing effect on the U.S. economy, which will in turn delay any interest rate tightening by the Federal Reserve. That may be a sound short-term explanation for the dollar sell-off, but it is increasingly difficult to dismiss the idea that sophisticated global investors are looking for safe havens outside the increasingly debauched U.S. currency. With little sign of any serious budget discipline coming out of Washington, how can America’s creditors seriously believe that their loans are going to be repaid in anything but deflated dollars?
While the European Central Bank might actually be foolish enough to raise rates, HCM continues to view the euro as a long-term short and believes it makes eminent sense to move into currencies such as the Swiss franc, Singapore dollar, Brazilian real, and to the extent one can get one’s hands on it through trade or other means, the Chinese yuan. Another reason why the dollar has been weak against the euro may be that there are few alternatives that can absorb large money flows. The strongest currencies like the Swiss franc and the Singapore dollar just aren’t that deep. The euro, on the other hand, can absorb huge money flows. Frankly, HCM can’t imagine why anybody would want to invest in the euro on a fundamental basis in view of the unresolved sovereign debt crisis stalking the Continent and the large bailout costs that the European Union is facing.
Graph 1
U.S. Dollar - Flight from Quality
Finally, there is gold, which continues to reach new highs as the dollar falters. It may look expensive to move out of the dollar now, but it will only be more expensive later unless American politicians get serious in a hurry about tackling the federal budget deficit (which they will not). HCM continues to be bullish on gold because we believe that the U.S. dollar and other fiat currencies will follow the path of history into the junkyard.
As for other asset classes, the Federal Reserve has certainly succeeded in helping risk assets such as stocks, bonds and commodities regain their mojo. Anybody who believes that these assets would be enjoying the rides they are without the full faith and credit of Chairman Bernanke should return to the history books, because sooner or later the lessons told in those history books are going to slam them on the side of the head. There are only a few ways the current scenario (an economy fueled by debt) can play out: inflation; currency devaluation; or a slow motion Japanese deflationary spiral. Within the context of a fractured society such as the United States, the last part of this scenario is social unrest, violence and political upheaval. Those are the stakes that Mr. Bernanke is playing with in his helicopter dreams.
QE2
HCM does not believe that the Federal Reserve will extend QE2 into QE3 upon the expiration of its current bubble expansion/moral hazard program on June 30. In his most recent Investment Outlook, PIMCO’s Bill Gross pointed out that “the withdrawal of nearly $1.5 trillion in annualized check writing may have dramatic consequences” in terms of reversing the tightening of credit spreads and rise in stock prices.3 This would be in addition to the withdrawal of whatever spending cuts federal and local governments are going to make in their efforts to deal with their budget crises. Mr. Gross goes on to point out that the largest buyer of Treasuries since the inception of QE2 (purchasing about 70 percent of issuance) has been the Federal Reserve itself. In other words, the Federal Reserve issues bonds and the U.S. Treasury buys them. Mr. Gross describes this “as foolproof as Ponzi and Madoff.”4 He believes that Treasury yields are currently 150 basis points too low and that the likely result of cessation of QE2 will be higher interest rates for the U.S. government. The key to a successful conclusion to this Ponzi scheme is a successful handoff of public to private credit creation. This is what many observers believe they are seeing in numbers such as the 220,000 private sector jobs that were created in February. The reality is that there is insufficient evidence to conclude that this handoff is happening or is going to happen. While there are signs of some assumption of the burden of credit creation on the part of the private sector, the public sector (particularly the federal government) is still borrowing like gangbusters. Moreover, to the extent the private sector is borrowing, much of that credit creation is being directed at speculative activities such as new leveraged buyouts, refinancing of existing leveraged buyouts, derivatives and other securities trading, and other activities that do not add to the productive stock of the economy. Mr. Gross would certainly agree, we think, that what is needed is not simply private sector credit creation per se but private sector credit creation in areas that lead to productive economic growth. What is clear is that we share Mr. Gross’s concern that the end of QE2 (which we viewed as poor policy to begin with) could lead to trouble. “Bond yields and stock prices,” he concludes, “are resting on an artificial foundation of QE II credit that may or may not lead to a successful private market hand-off and stability in currency and financial markets.”5
The unemployment crisis
On the surface, the unemployment picture is improving. Jobless claims for the week of February 28 dropped to the lowest level since May 2008 – 368,000 – and the more meaningful four-week moving average dropped to 388,500, the lowest level since July 2008. The actual number of people receiving jobless benefits also dropped slightly, by 59,000, to 3.77 million in the week ended February 19. For the month of February, employers added 192,000 jobs and the official unemployment rate dropped to 8.9 percent. The underemployment rate, which includes part-time workers looking for full-time work and discouraged workers who have given up their job hunts (also known as U6) declined to 15.9 percent from 16.1 percent. Private hiring in February rose by 222,000 while public sector hiring declined by 30,000, which is consistent with the dynamics of a private sector debt crisis that has been shifted to the public sector. HCM views all of these numbers as overstated on the positive side. In reality, the employment picture remains grim.
For example, the number of people who’ve exhausted their jobless benefits and are now receiving emergency and extended payments increased by a similar number – 57,000 - to 4.5 million in the week ended February 12. In total, 8.27 million people are receiving jobless benefits, a figure that excludes those who’ve lost their eligibility for government assistance. From HCM’s viewpoint, America’s unemployment crisis is far from over.
Our friend David Rosenberg places the unemployment crisis in the proper context when he writes that “it may be time for a reality check. The broad U-6 jobless rate measure was 8.8% when the recession began, was 9.0% when Bear Stearns failed, 10.5% when Freddie and Fannie imploded, 11.9% when AIG was taken over, Lehman filed and Merrill taken over, and 15.6% when the stock market hit is cycle low.”6 He also notes, as illustrated in Graph 2 below, that the civilian employment participation rate is back down to the level last seen in the early 1980s, with the actual number of employed (130.255 million) back to where it was in January 2003. This is consistent with the fact that the country is adding far fewer jobs than it was losing at the depths of the recession, and that the types of numbers that would significantly raise employment participation (500,000 new jobs a month or more) just aren’t in the cards. Moreover, the American population continues to rise at a much faster rate than the number of employed, which means that the raw numbers of unemployed are going to remain higher than in the past. These realities bode poorly for social stability, particularly in an environment in which the gap between rich and poor is widening every day.
3. Bill Gross, PIMCO Investment Outlook, March 2011, p . 2.
4. Ibid., p. 3.
5. Ibid., p. 4. Underline in original.
6. David Rosenberg, Breakfast With Dave, Gluskin Sheff & Associates, Inc., February 7, 2011, p. 4.
Mr. Rosenberg notes that the Household Survey showed that the labor force shrunk by 764,000 in the December-January period, that the level of employment dropped by 1.2 million during those two months, and that people no longer counted in the work force dropped by 753,000 during that period. Not only are these numbers virtually unprecedented, but in his opinion represent the large numbers of people losing their extended government benefits and giving up their job searches.
If these numbers are correct (all government statistics, even those supporting bear theses, must be doubted), there is a lot of pain stalking the streets of America. Of course, it doesn’t require confirmation of these numbers to acknowledge the fact that the economic crisis is still haunting many American citizens. We already know from multiple sources that the number of Americans receiving nutritional assistance remains at record high levels. Unemployment for certain sectors of the population remain at unthinkable levels. For example, 25.7 percent of teenagers (age 16-19) were unemployed in January, and 14.2 percent of those aged 25 years or older with less than a high school diploma were without jobs. The unemployment rate among construction and extraction workers was an alarming 22.9 percent. Overall – and these are the official figures of the Bureau of Labor Statistics, not the real numbers, which are undoubtedly worse and probably significantly worse – there are now 25 million unemployed Americans (16.1 percent of the shrinking labor force) consisting of 13.9 million unemployed and 11.2 million underemployed.
Obviously, HCM remains highly suspicious of the official jobless figures. It has been pointed out by others that the shrinking unemployment rate is largely attributable to statistical manipulation in the form of removals of significant numbers of people from the labor force. On a year-over-year basis (January 2011 to January 2011), the number of persons who left the labor force who want jobs increased by 535,000, and the total number of people who left the labor force was almost 2.3 million. This was largely responsible for the headline month-over-month decrease in the unemployment rate from 9.4 percent in December to 9.0 percent in January and the month-over-month drop in U6 to 16.1 percent in January from 16.7 percent in December. These numbers were distorted by significant “seasonal adjustments” (whatever that means, which is pretty much whatever the statisticians want them to mean). Unadjusted data actually showed month-to-month U6 increasing from 16.7 percent in December to 17.3 percent in January.
Bottom line: the unemployment picture is worse than the government would like us to believe, but slightly better than it was last year. When Warren Buffett opined in a March 2 interview on CNBC that the unemployment rate would likely reach the low 7 percent range by the 2012 election, HCM’s reaction was that he may well be correct because the government will continue to manipulate the data to get that result. If those who are unemployed choose not to vote, this may help incumbents. But if the armies of the unemployed and underemployed are motivated to vote, incumbents may be in a heap of trouble, because the actual numbers of people out of work are worse than the government is letting on.
Europe
Europe is already experiencing a debt crisis but deferring a solution. The German public remains skeptical of the euro and reluctant to support its troubled southern neighbors. Angela Merkel has presented a set of criteria for Germany’s approval of further reform and extension of the European Financial Stability Facility (EFSF) that is highly unlikely to gain the approval of the European Union. Germany’s conditions make eminent sense – balanced budget amendments, corporate tax rate equalization, elimination of wage indexation and pension age harmonization. But entrenched political interests in France, Belgium, Portugal, Spain, and Italy make the odds of agreement extremely low. The outcome of Europe’s debt crisis will therefore depend on whether Germany will blink before some countries run out of options and default. If Germany does blink, it will only be at the last minute and after a great deal of market volatility.
One obstacle to moving toward a resolution of Europe’s debt crisis has been the allergy to compelling holders of sovereign debt to take losses. But the financial system cannot have its cake and eat it too, as we say in America. Either bondholders or taxpayers are going to have to bear the losses, and it is time for the market to distribute the pain where it belongs – on the bondholders who freely decided to invest in sovereign debt. Unless this occurs, the market will never have an opportunity to play its important role in disciplining sovereigns by setting the appropriate interest rates for their debt. The reluctance of the European Central Bank to allow this to happen in Ireland is postponing the inevitable and harming the long-term economic prospects of the Continent.
Short-term borrowing rates in most European countries, even the most troubled, are still far too low. For example, Spain pays only 3.2 percent for two year money, while Portugal pays only 4.3 percent on its two year borrowings. In the next tier of credit quality, Belgium pays approximately 2.7 percent to borrow for two years, while Italy pays a slightly lower 2.6 percent. Investors are still not demanding very much in the way of compensation for lending to over-indebted countries that have little or no prospect of repaying them. In other words, investors in European debt are fiddling while Rome (and other European capitals) burns their money. But unlike the pre-euro days, when countries could have resorted to devaluing their currencies (an effective default by another name), they no longer have that luxury in the single currency system. They are left with the option of sharply cutting expenditures, which will cause real hardship among its population and political unrest, defaulting, or being bailed out (which is another name for defaulting).
Sooner or later, the decision will be taken out of countries’ hands. The market will wake up and demand much higher interest rates in order to lend to these troubled credits. This has already happened in Greece and Ireland and is on the cusp of occurring in Portugal, whose 10-year borrowing rate has breached 7 percent, a level that most observers believe is unsustainable. Investors will wake up faster if central banks and governments start sending the important message that they will not be bailed out in the future. The sooner this moral hazard regime ends, the sooner the day will come when public sector finances will regain some stability. It appears that the markets will have to impose this discipline, however, because central bankers and governments are failing to do so.
Michael E. Lewitt
March 4, 2011
Disclosure Appendix
This publication does not provide individually tailored investment advice. It has been prepared without regard to the circumstances and objectives of those who receive it. This report contains general information only, does not take account of the specific circumstances of any recipient and should not be relied upon as authoritative or taken in substitution for the exercise of judgment by any recipient. Each recipient should consider the appropriateness of any investment decision having regard to his or her own circumstances, the full range of information available and appropriate professional advice. Harch Capital Management, LLC recommends that recipients independently evaluate particular investments and strategies, and encourage them to seek a financial adviser’s advice. Under no circumstances should this publication be construed as a solicitation to buy or sell any security or to participate in any trading or investment strategy, nor should this publication or any part of it form the basis of, or be relied on in connection with, any contract or commitment whatsoever. The value of and income from investments may vary because of changes in interest rates or foreign exchange rates, securities prices or market indexes, operational or financial conditions of companies, geopolitical or other factors. Past performance is not necessarily a guide to future performance. Estimates of future performance are based on assumptions that may not be realized. The information and opinions in this report constitute judgment as of the date of this report, have been compiled and arrived at from sources believed to be reliable and in good faith (but no representation or warranty, express or implied, is made as to their accuracy, completeness or correctness) and are subject to change without notice. Harch Capital Management, LLC and/or its employees, including the author, may have an interest in the companies or securities mentioned herein. Neither Harch Capital Management, LLC nor its employees, including the author, accepts any liability whatsoever for any loss or damage arising from any use of this report or its contents. All data and information and opinions expressed herein are subject to change without notice.
The HCM Market Letter
Michael E. Lewitt, Editor
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