Assuming no congressional miracle occurs by 2020, the government debt:GDP ratio would move into the stratosphere, far beyond where Greece is now. By 2035, U.S. government debt would rise to over twice GDP according to the CBOâs conservative assumptions. Such an outcome is so untenable that it wonât happen. The issue is the circumstances under which fiscal retrenchment occurs. Will the U.S. follow the Greek model and wait for a crisis to drive change? Or will enlightened politicians figure out how to sell fiscal austerity to a complacent public? Given the permanent state of electioneering and partisan gridlock in the U.S., it would not be wise to assume a timely and sufficient cut in the deficit.
Fiscal Adjustment
There are two ways to approach the issues of when and how much to cut the deficit. The IMF has done considerable work on this question both for the U.S. and other heavily indebted governments for comparison.
In the soft approach, the IMF calculates that the U.S. would have to cut the cyclically adjusted primary deficit[3. The cyclical adjusted primary deficit is what the deficit is estimated to be if the economy was at full employment and interest payments are excluded.] by a total of 12%, spread over ten years to bring the federal net debt back to 40% of GDP by 2030. This would be 60% gross debt, which is the Maastricht Treaty requirement. The calculation assumes no recession over this lengthy period of 20 years. It should also be noted that net debt of 40% is not a conservative target. It was just slightly higher than that in 2007 and thus provided no protection against a debt spiral once the crisis hit. Given the precarious shape advanced economies are in, we must expect further economic crises and hence, it is imperative to build a sound buffer into government finances so as to deal with future economic crises without inducing fiscal crises.
The faster the deficit is cut, the smaller the adjustment needs to be, but at the risk of hitting the economy with another shock. Calculations by the IMF and CBO suggest that a one-time cut of around 5% of the cyclically adjusted primary deficit might get the U.S. Federal net debt back to 40% before the end of the decade. However, policy is moving in the opposite direction and too rapid an adjustment risks creating a double-dip recession which would actually widen the deficit sharply. Clearly it is a delicate balancing act between avoiding a fiscal crisis on the one hand, and nurturing a sick, deleveraging private economy back to health on the other. At present, policy makers are leaning heavily towards the latter. Therefore, bet on a continuation of a sharply rising U.S. government debt:GDP ratio.
Would Severe Fiscal Adjustment in the U.S. Work?
There are clearly huge risks of cutting either too fast or too slowly. Even if the U.S. imposed the ârightâ degree of fiscal austerity the result might be disappointing. The IMF has studied many cases of countries trying to cut deficits in order to see what works and why.[4. Fiscal Adjustment: Determinants and Macroeconomic Consequences, Kumar, Leigh and Plekhanor, IMF Working Paper, WP/07/178, July 2007.] There were several important conclusions. First, many countries fail at first and are forced to take a second and third crack at it. Second, it was clear from their research that cutting spending worked much better than raising taxes. While the Democrats tend to be more averse to spending cuts than Republicans, the U.S. is hardly an example of government overspending compared to most developed countries. The fact is there isnât much to cut, compared to say, 1945 when debt was very high but massive wartime military expenditures were set to collapse.[5. While raising taxes is a poor second best to cutting spending, the continuing success of the Tea Party is pushing the Republican agenda further to the right. That means tax increases are not going to happen any time soon.] Third, successful fiscal consolidation programs usually involved steep currency devaluations and sharp interest rate declines. The U.S. cannot easily generate a significant dollar depreciation given its reserve currency status and need for massive foreign financing of its budget deficit. Neither would other countries welcome a large drop in the dollar while global deflationary pressures are acute. Lowering interest rates is also not an option. Short rates are close to zero and long rates are about two standard deviations on the side of being too low. Growth is the key but there is no magic bullet there. The U.S. is in a
long wave decline, it is deleveraging, its population is aging and the deficit is crowding out private investment.
Cutting the deficit will not be easy or painless, which explains why no one really wants to do it. As we have often said, watch what the politicians do and ignore what they say. On the other hand, we have to look at the consequences of not cutting the deficit. With post-war record lows in interest rates and an easily financed deficit, where is the pressure? With the cost of debt service at a low 1% of GDP and painless, we assume that the government debt:GDP ratio will continue to escalate. That is, until something bad happens to interest rates, equities, inflation, the dollar and living standardsâa subject for another letter.
The Current Scene & Investment Conclusions
In our last letter we suggested that stock market investors shift towards a little more caution as it seemed that investor expectations had not yet adjusted to the fizzling economic recovery. Revisions to second quarter GDP growth with adjustments for temporary effects from government stimulus and inventory investment indicate that underlying growth is around 1% per annum. This is consistent with average growth in final demand (i.e., excluding inventory investment) of slightly less than 1% p.a. since the recovery began. This is a record for poor performance following a serious recession. It is particularly disappointing given near zero short-term interest rates, 2.7% 10-year bond yields and a budget deficit of 10% of GDP.
Some economic data looks slightly better in recent weeks but the basic situation hasnât changed. Growth is far below normal and the economy and financial system are very distorted and unbalanced. For example, the key housing sector could easily face another 10% drop or more in prices. Weak growth will sustain high unemployment keeping the authorities focused on adding more stimuli. The upward debt spiral is intact.
We believe that the market will most likely remain in a trading range of +/- 10% around 1,100 on the S&P 500. The rally in recent weeks has been driven by Federal Reserve assurances of unlimited liquidity, if needed, and the reporting of slightly better economic data. This has provided investors, wishing to achieve a more conservative posture, with an opportunity to rebalance their portfolios in a rising market.
Bonds and gold have recently attracted a flood of investment money. It would be extreme to call the Treasury bond market a bubble in the sense that huge permanent losses could be incurred by long-term holders. Worst case, you hold the bonds to maturity, get your cash back and a return that might be less than the alternatives. Nonetheless, the move in bond prices seems wildly over-done. According to Ned Davis, close to $600 billion has moved into bonds in the past three years ($325 billion in the last 12 months) about the same amount that flowed into stock funds in the three years prior to the 2000 stock market top. Short-term risk is obvious. Our discussion of the governmentâs debt trajectory also suggests long-term risks are probably high.
Gold is a somewhat different story. The flow of hot money has been huge, but unlike bonds, no one knows where the downside limit is. When the previous bubble broke, the price fell 75% and remained in the doldrums for 20 years. We do not dispute goldâs useful role as insurance and as an inflation hedge. However it is expensive insurance and we believe that deflation and rising real interest rates are a greater threat than inflation. Having said that, gold is in a bull market, has a huge and growing following and momentum investors love it. It could possibly go a lot higher, but it is not a safe place for conservative long-term investors who canât live with extreme volatility.
The big dilemma for stock market investors revolves around the extent to which the huge drop in real and nominal bond yields has supported stock prices in the face of deteriorating economic fundamentals and whether it has led to a switching of investment funds from stocks to bonds. If the latter, it could reverse should the bond bull market falter and drive stock prices up. In other words, if bonds get re-priced to remove their overvaluation, would that hurt or help the stock market? Our guess is that in the short run only, stocks will do okay in that scenario because bonds would probably be selling off due to expectations of a stronger economy and profits. In addition, stocks do not look expensive on a P/E basis (slightly below their long-run average) and on a free cash flow yield basis.
Since relative value does matter, it is likely that a downward re-pricing of bonds would ultimately trigger a downward re-pricing of stocks. Of course there are many other factors which affect stock prices. Corporate liquidity has been extraordinarily strong as has corporate profitability. The prospect of sustained economic weakness virtually guarantees low short-term interest rates and huge liquidity in the banking system, an important offset to the risk of a softer profit outlook.
When we add up the pros and cons for stocks, we come back to our relatively neutral view of a trading range. Number precision is not very useful but it is likely that +/- 10% around the 1100 level in the S&P 500 will contain most of the action for the time being.
As one investment manager wisely and rhetorically asked recently, âWhere is the growth? Where is the edge?â [6. East Coast Asset Management, Second Quarter Update, July 7, 2010] Investors should always allocate their assets with the âwhere is the edge?â concept in mind. At present there does not appear to be any compelling thesis which would offer such an edge, given our overall view. Therefore, we would advocate above average cash positions and general caution until better opportunities arise. Capital preservation is crucial and, as Warren Buffet has often said, âYou donât have to swing at every pitch.â
Others have very different views. Some believe the bull market in gold has just begun. Others believe we are headed for a deflationary depression in which high quality bonds would continue to thrive. Another view is that we are heading into high inflation and a dollar collapse. Yet others believe there will be a return to the good old days of stability and growth. In the time frame of most investors, we are in none of those camps. With bonds significantly overvalued, investors hardly have an edge in that area, except perhaps to go short. High yield bonds are fair value but the weak economic picture suggests growing risk for those companies with poor balance sheets and poor cash flow prospects. Gold as insurance at 5-10% of the portfolio makes sense but only for the long run and only if volatility can be ignored.
With such a wide range of plausible opinions out there, and very high levels of uncertainty, it doesnât make sense to bet big in any one sector. Investors should maintain a defensive, highly diversified allocation and continue to focus on wealth preservation.
Copyright (c) 2010 Boeckh Investment Letter
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