Risks & Opportunities
Duncan Morton III, CFA The following document is a compendium of quotes from last month from individuals or institutions whom, we believe, are providing the proper perspective on current global, economic, and fiscal matters. At the bottom of each section, Risks and Opportunities, SummitVIEW will offer our interpretation of the quotes or our perspective on the themes of the quotes. Disclaimer: All material presented herein is believed to be reliable but we cannot attest to its accuracy. Neither the information nor any opinion expressed constitutes a solicitation by us for the purchase or sale of any securities.
Please do not forward
SummitVIEW 9 Risks & Opportunities
SummitVIEW: What explains the human condition to ignore changing forces until one is forced to respond to those changing forces? Those who profess to be forward thinkers by nature of their job title (investment strategist) or vocation (economist) that continue to rely on near sighted analysis of the current economic conditions are many. For an investor, objective thinking requires removal of emotion and individual expectation so that cogent analysis of current conditions can occur. Our country is run primarily by baby boomers and their progenitors. Regarding the decisions the country needs to make on healthcare and government entitlements such as retirement benefits and Medicare, how are the "leaders" of our country going to make the right decisions for the country's future when the baby boomers and their elders believe their retirement includes access to the very services that need reformation? With Congress unwilling to make few (adjusted from 'any' as Obamacare recently came to fruition) decisions on the aforementioned social and economic issues to ensure a future sustained by increasing productivity and economic growth, how does an investor position assets for what will be a tough transition to a new economic and social regime? One does not have to think too long to begin to develop theories as to the "what" to solve the countries structural deficiencies. What if we became an export country? Due to the high debt levels in the public and private sectors the US dollar is weak and expectantly, over the long term, should continue to weaken. Like Japan, couldn’t the country start to export goods to other countries that are growing, those countries where development of a middle class is only beginning? What about easing immigration restrictions so skilled labor can emigrate to the US to stimulate the development of export companies? The newly formed companies could sell goods to the founders' home lands, in turn increasing employment, and ultimately raising productivity levels. Since housing was the recipient of billions of US dollars over the last 10 years, aren't there a lot of vacant homes, whether multi-‐family or single family, waiting to be filled by productive individuals? (Thomas Friedman makes this same appeal in his New York Times column from March 21, 2010.) What if tax laws governing the transfer of wealth from one generation to the next were structured to incent employee ownership? Would our country benefit from an increase in productivity and a reduction of long term government entitlement programs if company owners were incentivized to sell their companies' shares to their employees? Would employees who are company owners work more productively, thereby mitigating the increasing demands on the country's resources by an aging, entitled population?
Please do not forward
SummitVIEW 10 Risks & Opportunities Certainly, company owners would welcome a means to build succession plans with tax advantages, and employees would welcome an opportunity to fund personal retirement plans with shares of the company funding their livelihoods. Tax deferral options for closely-‐held security sales exist currently in the form of employee stock ownership plans (ESOP's). However, restrictions on reinvestment for sellers prevent more from utilizing ESOP's as an option for succession and asset diversification planning. How does the country go about solving our fundamental, structural deficiencies? It is an important question to ask. Considering the age of those running our country, whether political or business leaders, is immigration reform possible? Are the leaders of our country subject to jingoistic views that cloud their willingness to address our social realities? With an aging population, a labor force that supports more and more non-‐ workers, and government bureaucracy that continues to burgeon, what measures are being taken to address, fundamentally, the long term structural reforms that are required? With healthcare's emphasis on longevity will the country's structural problems perpetuate longer? Can those who expect to reap the "benefits" to which they believe they are entitled make choices that benefit their successors more than themselves? The debate about healthcare lacked essential economic discussion. The debate centered on the right of individuals to healthcare. What was lacking in the debate was how the country meets increased demand on the healthcare system without driving up all costs. From an economists perspective, the debate lacks a discussion on supply. Without a commensurate increase in supply of healthcare practitioners, the cost of healthcare likely increases. Perhaps so called 'preventive modalities' offer some relief for the increased demand. Legislators could force insurance companies to cover preventive modalities. The immediate effect would be an increase in the supply of practitioners. Where was that discussion? The willingness of the many to ignore history boggles the mind. If one knew nothing of history, assuming a quick return 1) to full employment, 2) to high consumer spending, 3) to increased demand for housing, and 4) to continued United States global hegemony would appear logical if not inevitable. Not surprisingly, humanity as a culture, as a collective body, has a history of exceeding the economic boundaries of its time. In the development of western civilization, there is more than one example of hegemonic domination and collapse. In each of the historical examples, be it the Romans or the British most recently, the expansion of credit to an economically infeasible level played a part in the culture's hegemonic collapse. For the United States its moment in time to deal with an economically infeasible level of debt has arrived. How the country decides to handle the credit contraction will fill history, economic, and finance books henceforth.
Please do not forward
SummitVIEW 11 Risks & Opportunities Until now, the credit contraction has been offset by an increase in governmental obligations. Increasing governmental obligations likely prevented a major collapse in the socio-‐economic framework that defined the recent past. As a result of the Federal government's fiscal policy and the Federal Reserve Bank's monetary activity, the labor force experienced a contraction of only 6 percentage points, approximately, on an absolute basis and a 150 percent contraction in percentage terms. Credit contractions occur over many years not many months. Many have views that the US will recover from its credit bubble in due course and return to the normal we all remember. As cycles in history take many years to unfold, acceptance of a new reality is not easily achieved. Human nature tends to glorify the past ("the good ol' days") while ignoring current events that will be upon reflection viewed as seminal turning points. What is the probability of our returning to the normal of the last twenty years? The answer to the question certainly rests in the timeline one is willing to wait for the prior normal to return. Achieving investment outperformance requires an ability to remove oneself from the day to day flow of news to establish perspective, enabling objective thinking. SummitVIEW finds few voices in the media mainstream that speak to the structural deficiencies prevalent in the US economy. Most voices, or talking heads in a pejorative sense, see only what they want to see, the cyclical fantasy, while ignoring underlying structural stresses. For example, how many are discussing the manipulation of accounting standards occurring in banks that hold debt collateralized by commercial real estate? Since Fannie Mae and Freddie Mac are the buyers of last resort in the residential mortgage industry, one has to look no further than these institutions' balance sheets to find where generally accepted accounting standards (GAAP) have been loosened. For the loans on commercial real estate properties, one has to look to the regional banks (see quote on page 5 by Elizabeth Warren). Another reason banks are not lending money (besides consumers not seeking new loans) is to prevent an immediate markdown and potential collapse of the banks' equity once loan values are reflected accurately on their books. Cash on hand, thanks to the Troubled Asset Relief Program (TARP), cushions the potential equity valuation adjustment. Which brings me back to a Muppet like conversation referenced in the February SummitVIEW (then known as Headlines), which captures the spirit of the Capitol Hill debate on how to handle the country's structural deficiencies : Patient: Doctor, Doctor, it hurts when I do this. Doctor: Well, then don't do it. Next month SummitVIEW will lay the framework for the US based investor to begin to develop asset allocation strategies, based on his or her risk tolerances and future liabilities, with a view towards systematic and sovereign risks and future, global growth. Please do not forward
SummitVIEW 2 Risks & Opportunities
Risks: Systematic Market Musings & Data Deciphering In one month, the U.S. government turned in a deficit that in other times in the not-‐too-‐distant past, was what was incurred in a full year (1990, 1991, 1992, 1993, 2002, 2003, 2004, 2005 all come to mind). The fiscal year is a mere five months’ old and already we have seen Washington rack up $652 billion of red ink. The chamber voted 62-‐36 for the legislation, which would also extend dozens of expiring tax cuts, ease corporate-‐pension requirements and heads off cuts in Medicare reimbursements to doctors. It begs the question, if things are so great, why the need for this additional stimulus? Oh yes, and in a green shoot of epic proportions, the media today is treating the news that there were “only” 30 States with rising unemployment in January as a really good thing because it was down from 43 the month before (never mind that five states, including some biggies like Florida and California, reported new highs for their jobless rates); and that home foreclosures (as per RealtyTrac) were “just” 6% above year-‐ago levels, which was the slowest pace in four years. (You know, you can reach a level of obesity where the percent increase in your weight from a year ago can go down rather dramatically while at the same time your health continues to deteriorate.)
David A. Rosenberg, Chief Economist & Strategist, Gluskin-Sheff, March 11, 2010
How to Handle the Sovereign Debt Explosion We should expect (rather than be surprised by) damaging recognition lags in both the public and private sectors. Playbooks are not readily available when it comes to new systemic themes. This leads many to revert to backward-‐looking analytical models, the thrust of which is essentially to assume away the relevance of the new systemic phenomena. There is a further complication. Timely recognition is necessary but not sufficient. It must be followed by the correct response. Here, history suggests that it is not easy for companies and governments to overcome the tyranny of backward-‐looking internal commitments. Where does all this leave us? Our sense is that the importance of the shock to public finances in advanced economies is not yet sufficiently appreciated and understood. Yet, with time, it will prove to be highly consequential. The sooner this is recognized, the greater the probability of being able to stay ahead of the disruptions rather than be hurt by them. Entire article found here. It's worth a read -‐ Mohammed El-‐Erian, CEO and Co-‐CIO, PIMCO Please do not forward
SummitVIEW 3 Risks & Opportunities
The Defining Moment of the Year Coming Up... ...A Peak in Leading Economic Indicators! At the heart of the double-‐dip recession vs. sustainable recovery debate is the consumer and whether or not job growth will come back strongly enough to offset consumer deleveraging in the years ahead. At this point in the recovery we should expect to see the yield curve begin to decline as short-‐rates rise. We do not suspect this will happen given the strong disinflationary trend from core, and the Fed’s outright statement to keep rates low. What is more likely is to occur is a flatter yield curve on the back of lower long-‐rates, which is a recipe for a weak, not strong equity market (& and economy in 2011).
Francois Trahan, Wolfe Trahan & Co., March 19, 2010
Primary Trends The primary trend towards consumer frugality, liquidity preference and deflation has not vanished just because of the impressive bear market rally in risk assets that has occurred over the course of the past year. Japan lost its AAA rating in February 2001 and over the next three years, the 10-‐ year JGB yield still ended up declining almost 100bps to the lows two years later and the yield is still lower today than it was at the time of the downgrade. Just goes to show that not even the rating agencies or the fiscal largesse is a match for sustained below-‐trend economic growth in a post-‐credit-‐bubble-‐collapse economy and all of the lingering deflation pressure that comes with it. David Rosenberg, Gluskin-Sheff, March 17, 2010
Another Leg Down We are not the only ones who see the prospect of another leg down in home prices. The banks seem to have given up any hope that we would see a rebound at any time on the horizon, which explains for example why it is that BoA is now more fully engaged in principal write downs and expect to see other lenders follow suit. It is the right thing to do. It will speed up the process of price discovery at the expense of revealing just how much more downward price pressure there is going to be in the market for residential real estate. Never before have new home sales gone on to make a new cycle low after a recession ends — until now. In fact, in practically every other cycle, housing is the first sector to bottom and lead the economy out of the downturn. Please do not forward
SummitVIEW 4 Risks & Opportunities That said, without the traditional credit-‐sensitive sectors leading the economy into the upturn, as has traditionally been the case, then it is hard to believe we are going to see a sustainable recovery. Already we are seeing capital spending slowdown as companies opt for cash and liquidity as opposed to new investments and the export story is going to grow old very soon with Europe moving back into recession and equity markets in Asia pointing to a moderation in growth there as well. Not to mention what the stronger U.S. dollar is going to do in terms of a competitive roadblock for U.S. producers.
David Rosenberg, Gluskin-Sheff, March 25, 2010
What Does Greece Mean to You? (in letter addressed to his kids) It's all connected. We built a very unstable sand pile and it came crashing down and now we have to dig out from the problem. And the problem was too much debt. It will take years, as banks write off home loans and commercial real estate and more, and we get down to a more reasonable level of debt as a country and as a world. And here's where I have to deliver the bad news. It seems we did not learn the lessons of this crisis very well. First, we have not fixed the problems that made the crisis so severe. We have not regulated credit default swaps, for instance. And European banks are still highly leveraged. Why is Greece important? Because so much of their debt is on the books of European banks. Hundreds of billions of dollars worth. And just a few years ago this seemed like a good thing. The rating agencies made Greek debt AAA, and banks could use massive leverage (almost 40 times in some European banks) and buy these bonds and make good money in the process. (Don't ask Dad why people still trust rating agencies. Some things just can't be explained.)
John Mauldin, Millennium Wave Advisors, March 26, 2010
Warren Issues Warning on Commercial Mortgages Elizabeth Warren, head of the Congressional Oversight Panel for the Troubled Asset Relief Program, said that by the end of the year, about half of commercial-‐property mortgages in the U.S. will be underwater. "They are [mostly] concentrated in the midsized banks," Warren said. "We now have 2,988 banks -‐-‐ mostly midsized -‐-‐ that have these dangerous concentrations in commercial real estate lending." She added that the economy likely will not return to normal for several years as it strives to resolve this issue. CNBC, March 29, 2010
Please do not forward
SummitVIEW 5 Risks & Opportunities
U.S. adds $600 million to foreclosure-crisis fund A special fund that helps U.S. states prevent residential foreclosures will get an extra $600 million, the Obama administration said. The funding will go to North Carolina, South Carolina, Ohio, Oregon and Rhode Island. The money is on top of $1.5 billion previously allocated to California, Nevada, Arizona, Michigan and Florida.
The Washington Post, March 30, 2010
China warned of growing "land loan" threat The Guanyinxia forest stretches up to the mountains north-‐west of the big central Chinese city of Chongqing. Most is protected land. “Our purpose is mainly preservation – not to make money,” says Liu Siyang, Communist party secretary of the government bureau that manages the forest. Yet the same forest has a double life in the commercial world. It has been used as collateral by a company controlled by the local government forestry bureau to help secure a Rmb300m loan it took out last year from a state-‐owned bank, which was then spent on infrastructure projects in Chongqing. Finally, the local governments can make up for losses at their investment companies by selling land. Yet, as the Guanyinxia forest indicates, not all of the land used as collateral is commercially viable. And the volumes could become huge. Stephen Green, an economist at Standard Chartered in Shanghai, estimates that the collateral used to back loans issued to these investment companies is equivalent to three times all the land sold over the past five years. “It is hard to see how this game can continue without an unhappy ending,” says Mr. Green. “If land values fall or the market stagnates . . . this game can never be brought to a successful close.”
Geoff Dyer in Chongqing, China, Financial Times, March 28, 2010
Art Cashin of UBS summarized the above best by saying, "Kind of like borrowing against Yosemite or Mount Rushmore."
Please do not forward
SummitVIEW 6 Risks & Opportunities
Opportunities: New Normal Investments U.S. Apparel Retailers Map an Expansion to the North The border crossings underline a wider dilemma facing CEOs in many industries. Many feel the economy is still too fragile to take big ambitious risks, but they still need to restart growth. Canada offers a baby step: a way to expand internationally, but in a market that's closer and more familiar than Europe or Asia.
The Wall Street Journal, March 29, 2010
Yield! The complex, multi-‐layer system of government in America is slowly shifting from extreme “free spending” to austerity. And American households are in the early in the process of “right sizing” their debt levels to their modestly growing income streams. We believe these fundamental shifts in government and household behavior will dampen economic growth, and constrain private fixed capital formation in the United States. We expect US corporations will increasingly allocate cash flow to dividends and share repurchases. And we are also likely to see elevated M & A. activity. We believe a high – perhaps an uncomfortably high – percentage of future total returns from large cap US equity portfolios will come from current yield rather than price appreciation. (emphasis added) US households are not just sitting still and wringing their collective hands about their often stressed financial situation. They have slowly changed their behavior and are now working to lower their debt service payments by chipping away at the amount of debt outstanding. But it is a very slow process. Household debt peaked at $13.85 trillion in mid 2008, and was down to $13.54 trillion at year-‐end 2009. This translates into an average pay down of roughly $18 billion per month over the past 18 months. Americans have paid down debt by lowering their monthly cash outlays to 96% of their disposable personal income – this “spend rate” is even with that of 1999 on the way up and 1947 on the way down. Our guess is this ratio trends “flat–to-‐down” for the foreseeable future.
Douglas Cliggott, US Equity Strategist, Credit Suisse, March 19, 2010
Please do not forward
SummitVIEW 7 Risks & Opportunities
Rocking-Horse Winner Even though the government’s fist has been successful to date in steadying the destabilizing forces of a delivering private market, investors are now questioning the staying power of public monetary and fiscal policies. 2010 promises to be the year of choosing “which government” can most successfully substitute the governments’ fist for Adam Smith’s invisible hand and for how long? Can individual countries escape a debt crisis by creating even more debt and riding another rocking horse winner? Can the global economy? The answer, from a vigilante’s viewpoint is “yes,” but a conditional “yes.” There are many conditions and they vary from country to country, but basically it comes down to these: 1. Can a country issue its own currency and is it acceptable in global commerce? 2. Are a country’s initial conditions (outstanding debt, structural deficit, growth rate, demographic balance) moderate and can it issue future public debt as a substitute for private credit? 3. Can a country’s central bank be allowed to reflate via low or negative real interest rates without creating a currency crisis? In today’s marketplace, prudent lending must be directed not only towards sovereigns that can escape a debt trap, but ones that can do so with a minimum of reflationary consequences and currency devaluation – whether it be against other sovereigns or hard assets such as gold. Investment strategies should begin to reflect this preservation of capital principal by positioning bond portfolios on front-‐ends of selected sovereign yield curves subject to successful reflation (U.S., Brazil) and longer ends of yield curves that can withstand potential debt deflation (Germany, Core Europe) (emphasis added). (Editor's note: Gross added Canada to this mix in a follow-‐up to this piece while on Bloomberg Radio.) William Gross, PIMCO Co-‐Chief Investment Officer, Investment Outlook, April 2010
For Brazil, It's Finally Tomorrow How the country of the future has at last made it—and what remains to be done For the past century, Brazil has been a land of great potential—but few results. With runaway inflation and stratospheric national debt, the country was too much of a mess for anyone to take it seriously on the world stage. How times have changed. Consider this: In the face of the worst global economic crisis since the Great Depression, Brazil's economic output dipped a tiny 0.2% last year, and is expected to grow as much as 6% this year. Please do not forward
SummitVIEW 8 Risks & Opportunities Everyday Brazilians have been too busy buying washing machines, cars and flat-‐screen televisions to even notice the downturn. Brazil is already the biggest economy in Latin America and the 10th-‐biggest in the world. By 2050, it will likely move into fourth place, leapfrogging countries including Germany, Japan and the U.K., according to a study by Goldman Sachs. (The entire article is available here.)
Paulo Prada, The Wall Street Journal, March 29, 2010
Please do not forward