Considering that in the last two years we have experienced the worst financial crisis in 80 years, seen equity markets fall almost 50% only to rebound 70% (but well below the prior peaks), watched our Canadian dollar fall from over par to $0.80 and then back to par again, and seen country and after country borrow record amounts of money while short-term interest rates remain near zero – we may want the answers to a few questions.
- What will be the long-term impact of record sovereign debt levels?
- Where will the U.S. dollar, Euro, Pound and Yuan be in terms of our own Canadian dollar?
- What does all of this mean for interest rates and equity markets?
- How would you change your portfolio (if at all) if you knew the answers to these questions?
Rob Edel (our Chief Investment Officer) and I have just returned from an outstanding conference where these questions were addressed along with the role that alternative strategies should play in creating a well-diversified portfolio designed to achieve absolute returns. The conference was hosted jointly by John Mauldin (well known writer on economic and investment issues) and Altegris Investments (an investment firm based in La Jolla, California that specializes in alternative strategies). The line up of speakers was impressive, as were their presentations.
As many of you know, in our recent client seminars we have discussed at length the negative issues associated with untrammeled growth in sovereign debt.
It seems the conference’s key speakers agree with our concerns and offered some very valuable insights into how we got here and where we are likely to end up. First let’s look at the key speakers and their consensus observations, followed by more detail on why they reached these conclusions.
- Dr. Lacy Hunt – Economist at Hoisington Investment Management (a $4-billion fixed income investment management firm in Texas)
- David Rosenberg – Chief Economist, Gluskin Sheff and former Head North American Economist for Merrill Lynch
- George Friedman – President of Stratfor, a firm specializing in geo-political analysis and best-selling author of The Next 100 Years.
- Dr. Gary Shilling – President of his own investment advisory firm and who has been making prescient calls with his own newsletter since 1978
- Paul McCulley – Managing Director of Pimco and investment manager for their $200-billion short-term bond fund
- Dr. Niall Ferguson – Professor of History at Harvard and world renowned author for his books The Ascent of Money and House of Rothschild: The World Banker. He was named by Time Magazine in 2004 as one of the world’s 100 most influential people.
- And of course our host (and partner) John Mauldin, whose Thoughts from the Frontline newsletter is read by 1,500,000 people each week.
In addition to all of these bright individuals there were several asset management firms who focus on absolute return investing, including:
- Citadel Investment Group
- Winton Capital Management
- Paulson and Company
- Brevan Howard Asset Management
- Altegris Investments
These firms have all outperformed the S&P 500 by wide margins over the last ten years with a variety of hedge fund and trading approaches including Distressed Debt, Long/Short, Commodity and Futures trading, Global Macro and Event Driven. Many of them focus on institutional and very high net worth clients with minimum investment sizes of up to $20-million. We are in the process of developing a pool to access some of these managers for our clients on a very competitive platform.
First let’s take a look at their views on the current economic landscape and how they see this massive global increase in government debt and the resulting fiscal stimulus playing out. Their views may surprise you.
The first two economists to speak were Lacy Hunt and David Rosenberg and they were in accord most of the time:
- Deflation is the greater risk now and will be until excess capacity to produce recovers. The U.S. alone has to create 12 million jobs to get back to its old unemployment rate and that will likely take 5-7 years.
- The bear market is not over and will come back sometime soon, perhaps lingering also for another 5-7 years.
- While the U.S. government is borrowing record amounts of money and issuing new debt from the Fed, the private sector is retrenching and reducing its overall debt. That deleveraging of consumers in particular will probably last for years. That is part of the reason why trillion-dollar deficits in the U.S. are not crowding our private borrowing and forcing interest rates higher.
- Both overall money growth (what is called M2) and the velocity of money (which measures how quickly it changes hands) are either flat or dropping. In order for inflation to get any traction, this has to reverse; otherwise, deflation becomes the risk.
- Equities are expensive and because economic growth will be low in both real and nominal terms, they will struggle to get any traction. Both speakers feel equity markets are at risk of a significant correction based on fundamentals.
- Even though U.S. Net Worth has dropped by 25%, or $100,000 per household, it is now back to the same percentage of income it was traditionally since WWII. This raises the question about how artificial the wealth was that the housing boom created in the first place.
- As bad as the U.S. situation is, parts of Europe, Britain and Japan are worse off and this will cause the U.S. dollar to strengthen over the next few years in relation to those currencies.
When it came to investment choices, Hunt was willing to take the biggest risk. Right now, 30-year treasuries are trading at a yield of 4.8%. He feels that because of his deflation argument, that will drop to 3% If one buys zero coupon government 30-year bonds, the potential return is 65%. Of course if rates were to go to 7%, the potential loss would be 60%. To make this trade you need to be brave, but if deflation comes, he will be right.
Otherwise, he and Rosenberg favoured the following:
- Corporate Bonds
- Selected REITs
- North American energy companies
- Dividend-paying stocks of companies with relatively low leverage
Interesting to note all of these assets generate a significant part of their return from cash flow.
Gary Shilling spoke the following day and basically has the same view of deflation risk as Rosenberg and Hunt. But he also felt the following were on his list of assets to acquire and sell.
- US Treasuries
- Dividend-paying stocks
- Consumer staples
- Rental housing
- Energy producers
- Health Care providers
- The Euro and perhaps the pound, which he anticipates dropping to par with the U.S. dollar (no one who spoke felt the U.S. dollar would drop in relation to other western currencies)
- Junk Bonds
- Commercial real estate
- Many commodities (but obviously not oil and gas)
- Developing country stocks and bonds
On this last item, his reason is that American consumers are entering their 50’s in large numbers and will both deleverage and start to save. Each $1 in saving reduces imports by $3. He expects the U.S. trade deficit to eventually get to zero. (Given that about 70% of that deficit involves oil imports alone, it is hard to see that occurring without a significant push to replace oil with natural gas, which the U.S. has in abundance.)
John Mauldin wanted to focus on the limits to debt overall and the end game for the U.S. and many other countries. His belief is that they are close to a debt wall, leading him to the following conclusions:
- Lower overall growth as debt-to-GDP ratios have to be reduced.
- Tax increases, especially in the U.S. (whose overall tax burden is about 10% less than most European countries and about 5% less than Canada).
- High unemployment leading to a “muddle through” period of growth which will last at least 5 years.
- That being said, much of Europe, Britain and Japan are worse off than the U.S.
Some of his information was taken from the book This Time Is Different (Eight Centuries of Financial Folly) by Reinhart and Rogoff. We have quoted from this book before and it is an exceptional study of what occurs when sovereign debt becomes excessive.
Therefore, since the U.S. is not likely to default on its debt (the same would apply to Europe, Japan and Britain), spending will have to be reduced, promises for unfunded benefits will be cut back and become based on need, and taxes will rise. Not a pretty picture, but perhaps an accurate forecast.
This is what happens when countries make promises their checkbooks cannot keep.
Paul McCulley was perhaps (along with Niall Ferguson) the most entertaining speaker. With no notes, he educated us on how this crisis developed and the impact of the “Shadow Banking” system on the mortgage markets.
For those of us who have had teenage children, he used a personal story to drive home a point.
When his son was 18, he reminded his father that he was an adult now and as such he could do what he wanted and could not be under his parents’ control. McCullley replied that was fine, but as long as Junior was making withdrawals from the Bank of Mom and Dad, then “house rules” would apply.
In our current system, banks guarantee checking and saving deposits because of the federal deposit guarantees backing those accounts and the fact that the Central Bank in most countries acts as a lender of last resort. In return for these guarantees from the state, they must agree to minimum capital requirements and have to be audited and regulated. They can, in return, make loans that offer a good profit margin to the rates they pay on deposits.
Along come the Shadow Banks (much like McCulley’s son) and insist they are grown up and can act as banks by offering liquid money market funds. These funds have no bank capital behind them, are loosely regulated and have no deposit insurance. Nevertheless, investors treat them as a savings account and the Shadow Banks now have cheap money they can use to lend on questionable mortgages and use to leverage their balance sheets as much as 60-to-1. As long as the housing market continued to rise, this perpetual machine kept making money.
When it imploded, many of the so called Shadow Banks wanted to get in under the protection of being a real bank with federal guarantees. So first Wall Street became very greedy and irresponsible, then whined long enough to convince federal officials to backstop them.
This, McCulley believes, is changing as we write and they will have far more regulations than before (two bills are being considered by Congress now) and as with Mauldin, he also sees taxes rising as well.
He concluded by saying that the ” Invisible Hand” of Adam Smith (Wealth of Nations, 1776) will be met by the “Visible Fist” of government, and banks will be reformed.
Niall Ferguson spoke at the end. If you have not read his book, The Ascent of Money, I would highly recommend it. He writes with humour about the history of money and that history helps explain a great deal about how and why we are where we are now.
While he was in general agreement with many of the observations above, he was less enthusiastic about the U.S., because at the rate government debt is accumulating, the U.S. will also hit a wall soon enough. He suggested that perhaps the IMF may want to change its name to PIIGS “R” US.
Overall as a group, the speakers had similar conclusions:
- Debt growth will first have to slow and then reverse itself. The private sector has already started and eventually governments will have to as well.
- This means sub-par growth and low inflation even as deficits remain huge (deflation is a real risk, with Japan of the last twenty years being the example).
- Equities are susceptible to a significant correction as this volatile secular bear market continues.
- Interest rates remain low for longer than most investors assume.
- Strong portfolios will have a diversified asset base with strong cash flows and a decent percentage in alternative absolute return strategies.
As you know, we have recommended the above as an investment approach for many years now. What will change as we move forward is that we will have some new options and managers to look at in the alternative strategy space.
One might assume from all of this that these individuals were all gloom and doom. In fact, most of them feel that this crisis will sow the seeds of a resurgence that will see the world healthier and wealthier in 10 years time. For now, though, it has to pay the price for its previous excess spending.