The Tri­umph of Optimism

by Scott Min­erd, Chief Invest­ment Offi­cer, Guggen­heim Funds

Jan­u­ary 2011

There is an old proverb that describes three meth­ods of gain­ing wis­dom: "First, by reflec­tion, which is noblest; sec­ond, by imi­ta­tion, which is eas­i­est; and third, by expe­ri­ence, which is bit­ter­est." At year-end, many of us turn to the nobil­ity of reflec­tion in hopes of glean­ing wis­dom for the new year. Recently, my own rumi­na­tions on the past helped me solid­ify my out­look on the future.

Five years ago, while bulls abounded, I remem­ber sit­ting through prod­uct design meet­ings, client strat­egy ses­sions, invest­ment com­mit­tee meet­ings, inter­nal port­fo­lio man­ager and sec­tor man­ager meetings—all of them focused on what I called "the com­ing cri­sis of bib­li­cal pro­por­tions." Dur­ing those long weeks and months, we planned for crises, dis­as­ters, and even unthink­able sce­nar­ios like zero per­cent short-term inter­est rates and poli­cies that would require cen­tral banks to pur­chase gov­ern­ment bonds. Many thought me crazy. At a cer­tain point in 2007, I might have agreed. But sure enough, just about every night­mare eco­nomic and finan­cial mar­ket sce­nario imag­in­able mate­ri­al­ized; it was only a mat­ter of time.

When I look back over the past five years and con­sider where we are today, I feel two dis­tinct emo­tions: grat­i­tude and opti­mism. Opti­mism because I see the dark clouds finally break­ing. Today, there is pos­i­tive eco­nomic momen­tum in the United States, progress in Europe, and global pol­icy accom­mo­da­tions being imple­mented that are pro-cyclical and sup­port­ive of longer-term eco­nomic growth.

Of course, there is always the pos­si­bil­ity of a cat­a­clysmic event. The "unthink­able" can always hap­pen; how­ever, unceas­ingly dis­count­ing for such events has never been a suc­cess­ful long-term invest­ment strat­egy. As an investor, I have found that the best time to be an opti­mist is when there is a parade of pes­simism march­ing down Main Street.

The Case for Optimism

These days, it seems that every­where I go some­one tells me some­thing neg­a­tive. It is the mir­ror image of five years ago, when every­where I went some­one told me some­thing pos­i­tive. From the talk­ing heads on tele­vi­sion to the man on the street, today's sen­ti­ment is dom­i­nated by pes­simism. But when I piece together the puz­zle, the pic­ture that I see con­tra­dicts the pre­vail­ing doom and gloom.

Start­ing with the United States, the data from the world's largest econ­omy actu­ally paints a pic­ture of heal­ing and mod­est, but sus­tain­able, expan­sion. There is wind in the sails of the cur­rent recov­ery: employ­ment is grow­ing; mon­e­tary pol­icy is extremely accom­moda­tive; retail sales have been strong; there is a back­log in pro­duc­tion; busi­ness inven­to­ries are lean. There is a host of data that sup­ports the idea that eco­nomic growth could be sub­stan­tially bet­ter than con­sen­sus expec­ta­tions. My per­sonal belief is that fourth-quarter GDP could be in excess of 3.5 per­cent, which is cer­tainly nowhere near a reces­sion. The seeds of a self-sustaining eco­nomic expan­sion are finally bear­ing fruit.

The real­ity is that the U.S. econ­omy has momen­tum head­ing into the first half of 2012. Still, the mar­ket seems uncon­vinced of the sus­tain­abil­ity of the cur­rent recov­ery. The doom­say­ers should have more faith in the U.S. government's abil­ity and will­ing­ness to turn on the print­ing press at the first sign of any slow­down or cri­sis. As one of my dear friends and pro­fes­sional col­leagues, David Zer­vos at Jef­feries & Com­pany, often quips, "The Bernanke Put remains in effect." All in all, the U.S. econ­omy is finally find­ing its foot­ing in the wake of the worst reces­sion in gen­er­a­tions. With the pre­pon­der­ance of eco­nomic data turn­ing pos­i­tive, I believe mar­kets will even­tu­ally weary of pric­ing into the U.S. the prob­lems from across the Pond.

There Is Progress, Even in Europe

In Europe, the out­look is cer­tainly more sober­ing, but it is impor­tant to rec­og­nize how far the Euro­peans have come toward a solu­tion. The progress may seem like two steps for­ward and one step back, but that is still a dra­matic improve­ment from ear­lier this year, when the cog­ni­tive dis­so­nance of Euro­pean pol­i­cy­mak­ers reflected denial at the expense of con­certed effort.

As evi­dence of progress, take the pol­icy changes at the Euro­pean Cen­tral Bank ("ECB"). Since Mario Draghi took the helm in Novem­ber, there has been a 180-degree change in policy—two imme­di­ate rate cuts and an unprece­dented three-year lend­ing oper­a­tion to pro­vide liq­uid­ity to the finan­cial sys­tem. The lend­ing oper­a­tion, which is sched­uled to dole out a total of €489 bil­lion, is par­tic­u­larly inter­est­ing. Essen­tially, the ECB has cre­ated a poten­tial means whereby the banks could be used to recap­i­tal­ize Europe, if necessary.Over the past six months, the ECB bal­ance sheet has increased by €820 bil­lion (more than 1.5 times the size of the Fed­eral Reserve's QE2 pro­gram), and its balance-sheet-assets-to-GDP ratio has reached 29 per­cent. This means that the ECB's bal­ance sheet, in pro­por­tion to the eco­nomic union that it serves, is already larger than that of the Fed­eral Reserve. At the cur­rent rate, it will soon sur­pass the Bank of Japan's ("BOJ") ratio as well. What all this means is that the ECB is tak­ing mea­sures to put air bags of liq­uid­ity into the sys­tem to safe­guard against a crash.

Liq­uid­ity alone will not solve Europe's prob­lems, but it will help buy time. On the fis­cal side, I see Europe in a slow march toward struc­tural solu­tions. I expect that addi­tional rounds of crises, along with many more sum­mits, will be required to com­pletely address these issues, but it is worth not­ing that pol­icy progress has been made.

I believe the ECB will even­tu­ally deem that there are suf­fi­cient reforms in place to war­rant sub­stan­tially more accom­mo­da­tion. This will likely include fur­ther rate reduc­tion and quan­ti­ta­tive eas­ing (as opposed to the "closet QE" we have seen thus far). As ECB offi­cials have vowed to not pur­chase sov­er­eign debt directly, I believe they will uti­lize the Inter­na­tional Mon­e­tary Fund and/or other finan­cial insti­tu­tions as the vehi­cles to prop up the gov­ern­ments around Europe. Directly—or more likely indirectly—the ECB will end up financ­ing the Euro­pean sov­er­eign powers.

Such ECB actions will result in a weaker euro, prob­a­bly declin­ing to par­ity or even lower against the U.S. dol­lar, but this too will be good for strug­gling Euro­pean economies. A depre­ci­ated cur­rency will help soften the eco­nomic pain of the reces­sion (which I believe the euro zone is already in), espe­cially in coun­tries like Italy where a lower exchange value of the euro will make man­u­fac­tured goods more com­pet­i­tive and drive export growth. Export growth will lessen the pain of aus­ter­ity and make bud­get reforms a more palat­able option for Euro­pean nations. So, we are already begin­ning to see a path to res­o­lu­tion of the Euro­pean cri­sis. Quan­ti­ta­tive eas­ing and a depre­ci­ated cur­rency will prove a potent pol­icy mix to alle­vi­ate the strains in Europe. This will buy time for pol­i­cy­mak­ers to affect the tough struc­tural changes nec­es­sary to form a closer fis­cal union, or what I would call federalization.

Con­cern­ing China

Over the next 12 months, I believe China will replace Europe as the head­line story in the global finan­cial mar­kets. Even now, the news has become increas­ingly neg­a­tive out of China. There are reports of grow­ing social unrest, slow­ing indus­trial pro­duc­tion, declin­ing prop­erty val­ues, and ris­ing fears of a hard land­ing for the econ­omy. But before hit­ting the panic switch, remem­ber that the resources of the Chi­nese gov­ern­ment are substantial.

In a worst-case sce­nario, it could cost as much as $1.5 tril­lion to recap­i­tal­ize the Chi­nese bank­ing sys­tem should the hous­ing mar­ket utterly col­lapse. To put that in per­spec­tive, $1.5 tril­lion rep­re­sents about 20 per­cent of China's 2011 nom­i­nal GDP, which is esti­mated to be about $7.0 tril­lion. Con­versely, the $1.5 tril­lion price tag would rep­re­sent less than half of China's for­eign exchange reserves, which are cur­rently around $3.2 tril­lion. So, although China may be in trou­ble, the gov­ern­ment likely has both the finan­cial resources and the polit­i­cal effi­ciency to address the ram­i­fi­ca­tions of a dra­matic cor­rec­tion in real estate prices.

What this Means for Investments

Hav­ing looked around the world and decided that maybe things are not as bad as adver­tised, we are left with the usual ques­tion: "What does this mean for invest­ments?" I believe we are in a for­tu­nate environment—one that offers excep­tion­ally high risk pre­mi­ums for cer­tain asset classes. In other words, investors are being well com­pen­sated in cer­tain asset classes rel­a­tive to the down­side risk that they are being asked to bear. I would like to empha­size that my view per­tains to long-term invest­ment hori­zons of three to five years. The near term will require will­ing­ness to stom­ach short-term volatil­ity and ride out the bumps as they come.

As I orig­i­nally men­tioned, there is always the pos­si­bil­ity of a cri­sis erupt­ing unex­pect­edly. Very few antic­i­pate nuclear melt­downs, the bubonic plague, or a uni­ver­sal flood where the only hope is to pack our ani­mals into an ark to sur­vive the storm. Such events may occur, but con­stantly invest­ing with cat­a­stro­phe as the expected out­come has proven to be a fool­ish strat­egy. Bet­ter is to look for peri­ods when the tide is turn­ing, to iden­tify inflec­tion points, to gauge when the mar­kets have become sat­u­rated with con­ven­tional wis­dom and are in need of correction—regardless of whether that "wis­dom" man­i­fests itself as irra­tional exu­ber­ance or dra­con­ian dread.

Today, I believe the mar­kets are so pre­oc­cu­pied with pric­ing for the most dis­as­trous out­comes that they have essen­tially become vul­ner­a­ble to upside sur­prises on any bit of good news. Through the tra­vails of 2011, a num­ber of the uncer­tain­ties have been taken off the table in Europe. This should clear the way for equity prices to improve over the course of the next year, both in the United States and in Europe.

Another pos­i­tive sign is that global poli­cies have clearly become more accom­moda­tive. As usual, pol­i­cy­mak­ers have been late in rec­og­niz­ing and address­ing prob­lems, but over the past few months the num­ber of steps taken to either reduce rates or stim­u­late economies is mind numb­ing. A back­drop of accom­moda­tive poli­cies is pro-cyclical and good for eco­nomic out­put. I expect that the cur­rent era of accom­moda­tive mon­e­tary pol­icy will even­tu­ally lead to mean­ing­fully higher nom­i­nal prices for a num­ber of risk assets, such as equi­ties, high yield bonds, bank loans, and even real estate. In the near term, there will likely be patches of dif­fi­cult weather, but over­all I believe that things are look­ing up. If I am cor­rect about the U.S. economy's growth and momen­tum, then U.S. equity prices should be sig­nif­i­cantly higher over the next 12 to 18 months.

While equi­ties and other select risk assets are cheap, one asset class that looks par­tic­u­larly over­val­ued and rep­re­sents a poor risk return is U.S. Trea­sury secu­ri­ties. I have remained bull­ish over the past five years on this asset class while many of my indus­try col­leagues felt com­pelled to avoid, and even short, Trea­sury bonds. But there comes a time when an invest­ment reaches price lev­els that no longer rep­re­sent good value. I see lit­tle risk of an immi­nent, dra­matic rise in rates, but I gen­er­ally rec­om­mend using cur­rent strength as an oppor­tu­nity to reduce expo­sure to Trea­sury secu­ri­ties while the Fed­eral Reserve is still a will­ing buyer. There is a his­tor­i­cal prece­dent for Trea­sury prices remain­ing inflated for a num­ber of years under the sup­port of Fed­eral Reserve purchases—it hap­pened dur­ing the 1940s, prior to the Trea­sury Accord of 1951. Dur­ing that period, the yield bot­tomed at around 1.65 per­cent, very near where we are today. In a future com­men­tary, I hope to share more about this topic in the con­text of Key­ne­sian eco­nom­ics, finan­cial repres­sion, and infla­tion. For now, suf­fice it to say that I do not believe Trea­sury secu­ri­ties rep­re­sent good value for long-term investors.

The Sun Will Come Up Tomorrow

To con­clude, the cur­rent envi­ron­ment reminds me of a story from the Euro­pean exchange rate cri­sis in 1992. I was in Rome work­ing on the restruc­tur­ing of Italy's Eurobond debt. At the time, Italy was in big trou­ble and there was no promise that it could reestab­lish itself as a cred­i­ble cap­i­tal mar­kets borrower—the prospect of an Inter­na­tional Mon­e­tary Fund bailout was very real. In the thick of our work with the Ital­ian gov­ern­ment, I walked through the famed Roman Forum with sev­eral peo­ple from the Ital­ian Trea­sury. I was taken aback by their rel­a­tive calm­ness and felt com­pelled to com­pli­ment one of the gov­ern­ment offi­cials on his com­po­sure through­out the cri­sis. I'll never for­get his answer, as he coolly replied, "Scott, look around. Rome has been here for over 2,000 years. The sun will come up tomorrow."

His words remind me that over the course of his­tory there is a cer­tain tri­umph of opti­mism. Bet­ting against the col­umn of progress of human his­tory and the inno­va­tion of mankind has always proven to be a los­ing propo­si­tion. Yes, in the short run, there are times to become cau­tious, as the past five years have exem­pli­fied. But a stopped clock is cor­rect for only a brief moment before time marches on. Cir­cum­stances change; mar­kets are cycli­cal. Broad-based eco­nomic expan­sion and its atten­dant out­size invest­ment returns fol­low con­trac­tion and panic just as the day fol­lows the night. As dark as the cur­rent envi­ron­ment may seem, the sun will come up tomor­row. When it does, I believe it will shine favor­ably on the opti­mists of today.

About B. Scott Min­erd
Invest­ment Offi­cer / Man­ag­ing Part­ner,
Guggen­heim Part­ners Asset Man­age­ment, LLC

Mr. Min­erd joined Guggen­heim in 1998. Mr. Min­erd is Chief Invest­ment Offi­cer of GPAM and its affil­i­ate, Guggen­heim Invest­ment Man­age­ment, LLC (“GIM”), and a Man­ag­ing Part­ner of Guggen­heim Part­ners. Mr. Min­erd guides the invest­ment strate­gies of the sec­tor port­fo­lio man­agers. He was for­merly a Man­ag­ing Direc­tor with Credit Suisse First Boston in charge of trad­ing and risk man­age­ment for the Fixed Income Credit Trad­ing Group. In this posi­tion, he was respon­si­ble for the cor­po­rate bond, pre­ferred stock, money mar­kets, U.S. gov­ern­ment agency and sov­er­eign debt, deriv­a­tives secu­ri­ties, struc­tured debt and inter­est rate swaps trad­ing busi­ness units. Pre­vi­ously, Mr. Min­erd was Mor­gan Stanley’s Lon­don based Euro­pean Cap­i­tal Mar­kets Prod­ucts Trad­ing and Risk Man­ager respon­si­ble for Eurobonds, Euro-MTNs, domes­tic Euro­pean Bonds, FRNs, deriv­a­tive secu­ri­ties and money mar­ket prod­ucts in 12 Euro­pean cur­ren­cies and Asian mar­kets. Mr. Min­erd has also held cap­i­tal mar­kets posi­tions with Mer­rill Lynch and Con­ti­nen­tal Bank. Prior to that, he was a Cer­ti­fied Pub­lic Accoun­tant and worked for the pub­lic account­ing firm of Price Water­house. Mr. Min­erd holds a B.S. degree in Eco­nom­ics from the Whar­ton School, Uni­ver­sity of Penn­syl­va­nia, Philadel­phia, and has com­pleted grad­u­ate work at the Uni­ver­sity of Chicago Grad­u­ate School of Busi­ness and the Whar­ton School, Uni­ver­sity of Penn­syl­va­nia. Mr. Min­erd is a reg­u­lar fea­tured guest on FOX Busi­ness News, Bloomberg Tele­vi­sion, and CNBC shar­ing his insight on today’s finan­cial climate.

Past per­for­mance is not indica­tive of future results. There is nei­ther rep­re­sen­ta­tion nor war­ranty as to the cur­rent accu­racy of, nor lia­bil­ity for, deci­sions based on such information.

This arti­cle is dis­trib­uted for infor­ma­tional pur­poses only and should not be con­sid­ered as invest­ment advice or a rec­om­men­da­tion of any par­tic­u­lar secu­rity, strat­egy or invest­ment prod­uct. This arti­cle con­tains opin­ions of the author but not nec­es­sar­ily those of Guggen­heim Part­ners, its sub­sidiaries or its affil­i­ates. The author's opin­ions are sub­ject to change with­out notice. For­ward look­ing state­ments, esti­mates, and cer­tain infor­ma­tion con­tained herein are based upon pro­pri­etary and non-proprietary research and other sources. Infor­ma­tion con­tained herein has been obtained from sources believed to be reli­able, but not guar­an­teed as to accu­racy. No part of this arti­cle may be repro­duced in any form, or referred to in any other pub­li­ca­tion, with­out express writ­ten per­mis­sion of Guggen­heim Part­ners, LLC.

© 2011, Guggen­heim Partners.

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