June 2009 Economic Update

Our economic analysis methodology utilizes two alternative scenarios that are based on traditional attractors for complex social systems operating in far from equilibrium conditions. The first is enhanced cooperation and the second is higher levels of conflict. Realization of the cooperative scenario should result in a higher level of stability and predictability in the system's operations, while development of the conflict scenario will prolong and quite possibly worsen the system's instability. These scenarios are described in more detail in our previous issues, which (as you go back in time), also describe the scenarios that preceded them. Overall, our political analysis process is best characterized as a sequence of two scenario alternatives, one which is discarded, and one which develops and then generates two new scenarios that describe the alternative paths along which events could evolve in the future.

We further assume that financial market returns reflect the complex interplay between political and economic conditions and investor perceptions, emotions, and behavior. With respect to current economic conditions, we believe that three issues must be resolved in order for the current "high uncertainty regime" to be replaced by a "normal growth regime" - high levels of household debt, a deeply weakened financial system, and destabilizing structural imbalances in the balance of payments accounts of the United States and China. Finally, we believe that the actions of three groups - middle class Americans, Chinese peasants, and Iranian youth, are linchpins that could have an outsized impact on the future evolution of political and economic events, and, through them, on asset class valuations and returns.

One of our core investment beliefs is that human beings generally have poor foresight in situations where cause and effect are widely separated by time and non-linear in impact. The updating of their views (and departures from the prevailing conventional wisdom) under these conditions is further hampered by the well-known "confirmation bias", which may become more severe as uncertainty (and fear) increase. Under these conditions, investors can gain an information advantage by combining forecasts that are based on different methodologies, and by using a framework that enables them to develop better situational awareness in the face of uncertainty, complexity and rapid change.

Over the past month, the global "green shoots" story began to give way to a more sober view of the future, though this has just begun to show up in financial market returns. One critical aspect of this is the recognition of the full implications of the constraint on U.S. - and indeed, global - growth caused by the continuing high level of U.S. household indebtedness. The Federal Reserve Bank of San Francisco's most recent Economic Letter made the following points: "To achieve a sustainable level of debt relative to income, households may need to undergo a prolonged period of deleveraging, whereby savings is increased and debt is reduced...Since 1960, the growth rate of real household debt in the United States has far outpaced the growth of real disposable income...Beginning in 2000, however, the pace of debt accumulation accelerated dramatically...Going forward, the downward pressure on debt is likely to come from both lenders and households."

As an example, the FRBSF assumes that, as was true of the Japanese corporate sector between 1991 and 2001, the U.S. household sector reduces its debt by 30% over the next ten years. "Given an effective nominal interest rate on existing household debt of 7%, a future nominal growth rate of disposable income of 5%, and that 80% of future savings is used for debt repayment, the household saving rate would need to rise from around 4% currently to 10% by the end of 2018." This would result in an annual reduction in real consumption growth of 3/4 of 1%. Over the five years ended in 2007, personal consumption accounted for more than 70% of real GDP growth, which averaged 2.76% per year. A fall of 3/4 of 1% in real consumption growth would reduce overall GDP growth by at least .5% per year - or by about 20%. In terms of real personal consumption growth, a reduction in the growth rate of .75% is equivalent to 35% of average real consumption growth between 2002 and 2007. This represents a significant shock to the American middle class for whom the "mass affluent" lifestyle had become a (debt financed) habit over the past decade. Given the difficulty of swallowing that medicine, the FRBSF looks at alternative ways the target reduction in household debt could be achieved: "If accomplished through some form of default on existing household debt, such as real estate short sales, foreclosures, or bankruptcy, deleveraging would involve significant costs for consumers, including tax liabilities on forgiven debt, legal fees, and lower credit scores. Moreover, this form of deleveraging would simply shift the problem onto banks that hold these loans as assets on their balance sheets. Either way the process of household deleveraging will not be painless."

Of course, there is an optimistic scenario, in which household incomes grow by a sufficient amount to enable debt reduction with no reduction in living standards or increase in bankruptcies. Realization of this scenario would require both a sustained increase in American productivity growth and, just as important, a shift in the division of the economic pie away from (recently record high) corporate profits to labor compensation. Unfortunately, neither of these developments seem likely to occur. Though undeniably boring to discuss with friends, families and (most) clients, sustained growth in a nation's total factor productivity is absolutely central to fiscal sustainability and growth in living standards over time. For proof of this, one need look no further than the relative decline over the past twenty years (relative to the OECD) of New Zealand and Switzerland, whose economies have both suffered from low TFP growth. Just this month, the Council of Canadian Academies (the equivalent of the U.S. National Academy of Sciences) released a report warning that Canada faces a similar fate if does not make some fundamental changes ("Innovation and Business Strategy: Why Canada Falls Short"). Unfortunately, there is no silver bullet solution to improving TFP. Even in the United States, it took many years for companies to discover that information technology alone did not do the trick, and that many organizational habits and assumptions had to be changed in order to realize its full potential. Moreover, pubic sector changes are just as important as private sector improvements when it comes to increasing TFP. It seems that the Obama administration realizes this - its economic stimulus program and first budget focused on human and physical capital improvements that are critical for productivity growth (e.g., education and health care reform, support for clean technologies and infrastructure improvements, and increased R+D funding). Unfortunately, the Obama proposals are running into serious opposition in the U.S. Congress - most often from Democratic Senators and Representatives! For example, both education and health care reform have run into serious opposition from entrenched interest groups, and the administration's environmental and energy bill has, in effect, been gutted. For example, rather than auctioning 100% of the permits under the proposed CO2 cap and trade plan, 85% will now be given away, and the effective cost of carbon emissions set at about $28/metric tonne - too low to produce much productivity improving (and job creating) investment, much less meaningful reductions in atmospheric CO2 levels. At the same time, the renewable energy and efficiency mandates proposed by the Obama administration have also been weakened, which will further reduce the incentive to invest in this area. And this is just what the U.S. House of Representatives has done to the Obama legislation - the Senate has yet to take it up!

The elimination of the revenue from CO2 permit auctions has gravely worsened the projected U.S. budget deficit, and led to discussion of both higher income tax rates for "the rich" (a term whose meaning, at least in tax terms, has been repeatedly "defined down") as well as renewed proposals for national consumption based taxes, like a European style VAT. This means that a large portion of any wage gains that are realized due to higher U.S. productivity will likely end up paying higher taxes than maintaining consumption while simultaneously reducing household debt levels.  In short, for the American middle class, reduced consumption - perhaps for a prolonged period - seems unavoidable. While on the one hand this seems likely to generate more support for long-overdue health care reform in the United States (as more and more people losing their jobs are losing the health insurance that went with them), it will probably also limit the scope for Social Security reform (e.g., the imposition of an Australian style mandatory superannuation plan in the US, which we have long supported), as the middle class now realizes it is more dependent on Social Security than ever before. At best, a mandatory super with a government "top up" guarantee to achieve a minimum long-term return seems the most we can hope to achieve - and even that is a stretch, since it would leave less disposable income in the absence of strong productivity gains.

I don't think this comes as a surprise to Ben Bernanke, judging from the large number of studies the Federal Reserve has recently published on the impact of the substantial job losses now occurring in the U.S. and other OECD economies. Along with a number of papers by university researchers, they paint a dismal picture of what lies ahead. For example, in "Modeling Earnings Dynamics", Altonji, Sith and Vidangos find that growth in general and company-specific "human capital accounts for most of the growth in earnings over a career, although job seniority and job mobility also play significant roles. [As a result], unemployment shocks have a large impact on earnings in the short turn as well as a substantial long term effect that operates through wages. Shocks associated with job changes and unemployment make a large contribution to the variance of career earnings." In "Long Term Earnings Losses Due to Job Separation During the 1982 Recession", Wachter, Song and Manchester use a very long-term data set to examine the consequences of job loss. They find that "workers permanently leaving their long-term employer in the period from 1980 to 1985 experienced large and persistent earnings reductions lasting 15 to 20 years compared to workers of similar age and earnings potential who did not leave their employer." In "Employment Insecurity: The Decline in Worker-Firm Attachment in the United States", Henry Farber from Princeton University finds that long term employment relationships (especially for men) have become much less common in the private sector, with a significant rise in what he terms "churning" - the proportion of workers who have worked in their current jobs for less than one year. However, the trend in the public sector has been running in the opposite direction. Finally, in "House Prices, Home-Equity Based Borrowing, and the U.S. Household Leverage Crisis", Mian and Sufi of the University of Chicago analyze individual level data on mortgage debt and defaults between 1997 and 2008 and reach a startling conclusion: "borrowing against the increase in home equity by existing homeowners is responsible for a significant fraction of both the sharp rise in U.S. household leverage from 2002 to 2006, and the increase in defaults from 2006 to 2008." Rather than a crisis caused by the overextension of credit to lower income borrowers, the authors paint a compelling picture of a crisis caused by a large portion of the middle class reaching the end of its financial rope.

And "green shoots" and rising equity markets aside, the situation seems to be steadily growing worse. According to the Mortgage Bankers Association, one in eight American households with a mortgage is now late on a payment or in foreclosure. At least half of homes with a mortgage have negative equity. While there has been some pick up in sales at the lower end of the housing market (based on rental economics), at the higher end conditions are worsening - homeowners are losing jobs, while tightening lending standards, rising mortgage rates, high debt levels, and uncertainty about future income eliminate demand from "move up" buyers. Half the loans now in foreclosure were made to prime borrowers.

In our view, this confluence of events has created a politically explosive situation among the middle class - and not just in the United States. The recent explosion of anger at expense fiddling by UK MPs is a perfect example of what happens when the populist rage that now boils just out of sight finds an outlet. As with the 2007 - 2008 financial crisis, it is hard to say in advance what the trigger event will be that sets off what will likely be a political crisis of some type. Resentment of public sector union intransigence in the face of rising economic pressure on middle class taxpayers is a growing theme across the OECD, with California (and the unions' suggestion that the Federal government should bail out the state, to avoid cutting spending in excess of tax revenue) recently becoming the most visible example. So too is anger at the apparent lack of suffering in the financial sector (can't you just wait for the first headline trumpeting the large bonuses earned for trading carbon emissions credits, while business leaders lament that uncertainty about future carbon prices is holding down job-creating investment?). If the teachers unions and private health insurance industry successfully block reforms in these two areas in the U.S., they may also become targets. And there's no telling what will happen when and if the legislative dismembering of the Obama energy and environmental proposals prolongs the current absence of significant cleantech investment.

In this environment, it comes as no surprise that a coalition of U.S. Senators and Representatives recently proposed legislation that would impose tariffs on countries that were found to be artificially holding down their exchange rate (no prize for guessing who they have in mind). With job losses and foreclosures in nice neighborhoods accelerating, special interests blocking what seem like overdue reforms, and the perception that everyone but them has been bailed out by the government, there is an inescapable logic to the middle class demanding a sharp rise in protectionism as the price of their continued support for the Obama administration, if not U.S. democracy itself. As a friend from the UK recently remarked, we have not seen such political volatility for close to a hundred years - and nobody knows where it will lead.

Of course, with more than a trillion dollars of government fiscal stimulus underway around the world, not to mention unprecedented monetary expansion, the odds are that the day of reckoning is still a ways off. There is little doubt that massive stimulus of this sort will produce some green shoots and trigger market hopes that this has all been just a bad dream, and things will soon return to the way they were "before." Nowhere is this more true than in the U.S. banking system, where the massive expansion of bank reserves by the Fed is enabling an equally huge investment by insolvent banks in Treasury securities, which, along with cheap government backed funding, has widened interest spreads and raised hopes of being able to "earn our way out of these (temporary, and of course unforeseeable) problems". Hence the tepid reaction to the Public Private Investment Partnerships proposal to get bad debts (oops, "legacy loans and securities") off the banks' books -- of course, fiddling with creditor seniority rights in the Chrysler bankruptcy and slamming "greedy bankers" also probably didn't help the Obama administration's sales pitch. It reminds us of the Wizard of Oz, where Dorothy is told not to look behind the curtain. In this case, we wouldn't want her to be frightened by the rising volume of credit card, mortgage, real estate construction and development, leveraged buyout, and other loans and securities on the banks' books whose probability of future repayment declines by the day. No, we're all just going to hope they can earn their way out of it, while keeping their bondholders whole. Time will tell. But we've seen this movie too many times before (granted, in foreign languages with English subtitles) to be optimistic about the way this one will end. At some point, we still expect to see more banking crises erupt (and not just in the U.S. - European banks seem quite on the brink too), some type of debt/equity conversion plan for home mortgages (in the US and possibly elsewhere - say, the UK, Ireland and Spain) and (via government mandated good bank/bad bank restructurings) the conversion of at least some bank bondholders into shareholders in an asset management companies with lots of questionable paper on their books (let a hundred Resolution Trust Companies bloom...). We have no doubt that this is preferable to a prolonged period of ever-more-creative plans to support overleveraged "zombie" homeowners and banks, while the economy endures prolonged low growth and (at the point when the dollar starts to seriously decline) quite possibly much higher inflation. Unfortunately, we're still a long way - and probably not a few painful twists and turns of events -- from that point.

In the meantime, at least some global investors seem to have jumped the gun a bit (at least from the Obama administration's perspective), and begun betting more heavily that some version of the conflict scenario will develop. Alternatively, they may be inadvertently raising its probability by taking actions (such as selling long-term U.S. Treasury bonds and driving up their yields) that seem rational from the perspective of an individual investor (or country), but whose cumulative impact can bring about the scenario they wish to avoid. The simultaneous increase in oil prices (while physical storage is still bulging and demand remains flat) also raises suspicions that more than a few investors are taking steps to hedge against a future rise in U.S. inflation. Unfortunately, rising interest rates and energy costs only serve to undermine the positive impact of governments' fiscal and monetary stimulus, and raise the chances that in the near term our main threat will come from deflation, not inflation.

Meanwhile, it has been a relatively quiet month outside the United States as well (again, we believe that much of the important change is taking place below the surface, at the individual level). Both the Chinese and U.S. Treasury Secretary Geithner made appropriately conciliatory statements ahead of the latter's visit to Beijing. On the other hand, China has also apparently been shifting more of its Treasury bond holdings into shorter maturities, which not only affords better protection against inflation, but potentially provides more leverage on U.S. policies. China also announced that one quarter of its stimulus package would go to Sichuan province to stimulate recovery from last year's earthquake. This raised quite a few questions about what this meant for the efficacy of its stimulus program, as well as the extent of social unrest that may be occurring in Sichuan. Similarly, more analysts have been raising questions about the medium-term consequences of China's rapid expansion of bank loans to support employment at state owned enterprises. The worry is that these companies will not be able to repay them, forcing the government to cut back on other spending (e.g., on better health care and social security, which are needed to reduce private savings and increase domestic consumption) in order to recapitalize the banking system. Finally, April export data was worse than March, providing further evidence that, whatever the official statistics say, China's economy - and therefore social and political system - is still under considerable pressure.

In Iran, Supreme Leader Ayatollah Ali Khamenei was reported to be urging voters not to support "pro-Western" candidates in the June 12th election -- which is apparently anyone other than President Ahmadinejad. This marks an apparent increase in Khamenei's support for Iran's embattled president, and raises the probability of him winning another term (if no candidate wins a majority, there will be a runoff between the two top candidates on June 19th). Last but not least, last month India also had national elections, and saw an unexpectedly strong win by the Congress Party, which observers are hoping will translate into a quickening in the pace of economic reforms and GDP growth.

So what does last month's data mean for investors and their asset allocations? We use the following table to provide insight into the balance of market views as to which of three regimes - high uncertainty, high inflation, or normal growth - is developing. Under each regime, certain asset classes should deliver relatively higher returns. We assume that the rolling three month return on these asset classes is a useful indicator of the market's collective estimate of the regime that is most likely to develop in the short-term.

| June 2009 Issue: Key Points | This Month's Letters to the Editor: Fidelity vs Schwab vs TD Ameritrade - Opinion?; Index Investors' Allocation Models vs MVO Models - Superior? Yes; Asset Class Valuation Updates: Possible, Likely and Probable - What They Mean; and Commodity Valuations Long/Short (LSC) or Long-only Fund? | Global Asset Class Returns | Uncorrelated Alpha Strategies Detail | Asset Class Valuation Update | The Role of Property in a Portfolio, Given Recent Experience | June 2009 Economic Update | Product and Strategy Notes: Powerful Impact of Regret; More Research - Why Successful Actively Managed Funds are Rare; Did the Media Do a Good Job Predicting the 2008 Crisis?; and How Rigorous is you Investing Logic? | |