Question: What do debt crises, Gulf oil spills, Chinese labor unrest, flash crashes, the Japanese Imperial Palace, and the Tea Party all have in common?
Answer: Nothing – or, perhaps, everything – as this post will attempt to elucidate.
Volatility returned with a vengeance in the second quarter of 2010. US stocks suffered their first quarterly loss in more than a year, with the Dow down 10 percent – including the “flash crash” of May 6th – while foreign markets and most other indices fared no better.
A palpable mix of fear, anxiety, skepticism, and uncertainty hung over global financial markets, setting the stage for the triple bill battle royal that will largely determine the fate of markets and economies over the next many years. This fight card features the following match-ups:
1. Stimulists vs. Fiscalists
2. Inflation vs. Deflation
3. Recovery vs. Recession
Battle #1: Stimulists vs. Fiscalists
The emergence of the Tea Party in the US is the most tangible evidence of the growing philosophical battle between what BSW refers to as the Stimulists and the Fiscalists. The Keynesian “Stimulists” (as personified by commentators like Paul Krugman) believe that economies would benefit from further government stimulus, via federal spending, unemployment benefit extensions, holding interest rates low, and “quantitative easing” (a polite term for printing more money). Stimulists contend that a failure to spend risks plunging the US (and, likely, the world) back into recession or, worse, depression. The “Fiscalists” (as personified by folks like Robert Barro and John Cochrane) believe that further government stimulus is simply “pushing on a string” and will create unsustainable public debt levels that erode investor confidence in the US financial system, leading to a debasement of the US dollar or possibly even default on our debt.
This debate is not solely confined to the US, as much of the angst related to the Eurozone debt crisis was due to arguments about whether and how to impose “austerity measures” (a polite term for budget cuts) on southern Europe’s profligate spenders: Portugal, Italy, Ireland, Greece, and Spain. In a nutshell, considering that the global recession was fueled by the expansion of credit and debt, should policy makers impose fiscal restraint and focus on getting their financial houses in order? Or should the focus instead be increasing spending, whereby the government essentially serves as a “buyer of last resort”? Can the answer to a credit crisis really be more credit?
Both Stimulist and Fiscalist arguments have some merit. BSW’s aim, though, is to avoid getting lost in the intellectual debate and instead look for the investment implications of both policy stances. From that perspective, the most likely outcome of the battle of the Stimulists versus the Fiscalists is gridlock and vacillation. Again, because of the emergence of the Tea Party, along with high unemployment levels, much of the November 2010 election chatter will center on economic issues and policy responses. As a result, while it took one election (November 2008) to turn the Federal money spigot “on,” the next election (November 2010) will likely turn that money spigot “off.” Historically, split federal governments have been good for equity market returns, as they often slow the pace of legislative change. Remember that markets, and businesses, abhor uncertainty. So while gridlock may sound like a bad word, the consistency created when nothing happens legislatively – or at least requires bipartisan compromise – is often an ideal environment for business and economic expansion.
However, legislative vacillation on the economic policy front (again, stimulism vs. fiscalism) may further hamper the recovery. One needs look no further than Japan, whose on-again/off-again, stimulist/fiscalist waffling has mired the country in more than 20 years of slow burn recession-style contraction. Regardless of what flavor of economic policy prevails, the only true recession exit strategy seems to be conviction and consistency – which are often in perilously short supply.
Battle #2: Inflation vs. Deflation
At its core, the Stimulist versus Fiscalist debate can be deconstructed to a simple question: Is inflation the cure or the disease? Before jumping into that question, a quick review of terminology is in order. Inflation is a rise in the general level of prices of goods and services in an economy over a period of time. Essentially, in an inflationary environment, a dollar buys more today than it will tomorrow. Deflation, on the other hand, is a decrease in the general price level of goods and services. Deflation occurs when the annual inflation rate goes negative, resulting in an increase in the real value of money. Essentially, in a deflationary environment, a dollar today buys less today than it will tomorrow.
Governments and central banks fear deflation far more than inflation because the tools and techniques used to address inflationary environments, including raising interest rates and reducing the supply of money supply, don’t work so well (or possibly at all) against deflation. Deflationary environments, such as the Great Depression or 1990s Japan, are far more pernicious and troublesome. During a deflationary spiral, falling prices lead to a slowing of consumption. As consumption slows, production levels fall, which leads to lower wages and, ultimately, lower demand. As demand falls, prices fall accordingly, creating a vicious, negative feedback loop.
The typical policy response to deflationary environments is to lower interest rates and increase the money supply, which is exactly what the US Federal Reserve has done. But with the Federal Funds rate already at 0 percent, the “interest rate gun” is seemingly out of bullets. Yet while prices have continued to fall for a variety of assets (houses, cars, equities, iPhones, etc.), it remains unclear whether we are truly suffering from deflation or simply dis-inflation? The situation is raising alarms, including the head of the St. Louis Federal Reserve, James Bullard, as he discusses in this very recent paper.
To answer this question, many economists again look to Japan, the most recent example of deflation, for clues, signs, and analogs. Consider that at the height of the Japanese real estate bubble, according to the Financial Times, the three square kilometers of land underneath the Japanese Imperial Palace in Tokyo was equal to the value of all land in the state of California. When the bubble burst however, real estate prices declined in some areas by more than 80 percent. What followed was a long (and ongoing) period of economic stagnation, despite Japan holding interest rates at the lowest level of any developed nation.
As discussed in our June 3rd Economic Update, BSW believes that the US is likely to avert a full scale deflationary environment and, instead, is suffering from an acute period of dis-inflation. The US economy is exceptionally diversified and businesses have been quick to shed workers and rebuild their balance sheets, while US domestic demand strongly benefits from immigration and positive demographics. We are less convinced that the Federal Reserve can successfully “thread the needle” of both halting dis-inflation and avoiding significant inflation in the future. Consequently, our investment portfolios include allocations to assets that benefit from dis-inflation (bonds, consumer staples), as well as assets that protect against inflation (TIPS, gold, commodities, growth equities).
Battle #3: Recovery vs. Recession
For investors, the Stimulists vs. Fiscalists and Inflation vs. Deflation debates are merely a prelude to the main event: Will the recovery survive or is a double-dip recession at hand? The recovery argument is supported by many “micro” positives, including corporate earnings, falling consumer loan default rates, inventory levels, home sales, and business activity measures. Unfortunately, these positives have been overshadowed by “macro” negatives such as the Eurozone debt fiasco, anemic job growth, legislative and regulatory uncertainties, and the ongoing negative psychological impacts of the Gulf oil spill, Iraq and Afghanistan wars, and the Flash Crash.
Despite these very real “macro” challenges, BSW believes that a double dip recession is possible, but not probable. Quite simply, the US economy failed to rebound strongly enough to set the stage for another, deeper crash. The most likely scenario is that the current, sluggish and tepid pace of domestic economic growth will continue through the remainder of 2010. In terms of the global recovery, however, it is far more useful to look beyond the United States, and Europe, for that matter.
As discussed in our Fourth Quarter 2009 Portfolio Commentary, one of BSW’s key investment themes is the general transfer of wealth and power from the West to the East and, specifically, the rise of the Asian middle class. And while the US news media was busy navel gazing about American Idol judges, the Twilight saga, and Chelsea’s wedding this summer, three news stories of immense economic and historical proportions quietly emerged from Asia to further bolster our conviction about this investment theme. First, China has now supplanted Japan as the world’s largest economy, a three decade “economic miracle” that has lifted hundreds of millions of people out of poverty while creating one of the world’s largest and fastest growing markets.
Second, China has now supplanted the United States as the world’s largest consumer of energy – a dubious title that the US has held since the early 1900s. Third, as discussed in our June 15th Portfolio Update, widespread labor unrest and, remarkably, strikes have resulted in steadily increasing Chinese wage levels (Apparently The Economist is also reading BSW’s blog! See their July 31st cover below).
In terms of the Recovery vs. Recession battle, the impact of these developments cannot be overstated. Perhaps the biggest challenge to the global recovery has been that the historically voracious spending of US consumers is likely to be absent for quite some time, as US consumer struggle with elevated unemployment levels, underwater home values, and upside down personal balance sheets. What could possibly take their place? The emerging market’s burgeoning middle class, composed of 1.15 billion people throughout Asia and Latin America – the largest such cohort in history.
BSW’s growth portfolios are fundamentally aligned with this long-term trend, via investments in Asian companies focused on domestic Asian markets and consumers, countries engaged directly in trade with Asia (like Australia and Germany), and global companies that provide the basic staples first purchased by emerging market consumers. As Mark Twain might say, “reports of the global economy’s death have been greatly exaggerated.” Indeed, the global economic recovery is in better shape than news reports often suggest – but its center of gravity continues to shift away from the US and toward Asia.
We hope this Portfolio Commentary provides you with better insight into the components of your growth equity portfolios and our current economic and investment outlook. If you would like to discuss these positions or your portfolio in greater detail, please don’t hesitate to contact BSW. As always, we are happy to help.
-David Wolf, Chief Investment Officer