The following was excerpted from Third Eye Capital
Management Inc.'s Q2 2011 Investor Letter.
"Blessed are the young, for they
shall inherit the national debt."
Herbert Hoover, 31st President of the United
The Great Depression brought the
orthodoxy of government involvement in smoothing out business
cycles. Policies of easy money, a weaker dollar, and fiscal
deficits became accepted tools to boost demand during times of
economic contraction. After the tech bubble burst in 2000, the U.S.
Federal Reserve lowered interest rates to 1% in mid-2003 even
though nominal GDP in the U.S. grew to 5%. The government was
successful in averting recession. Eventually, low rates, combined
with government stimulus (including policies to democratize housing
ownership), caused a housing mania and a cyclical bull market in
stocks. Consumers took on enormous amounts of debt between 2000 and
2007 on the mistaken belief that their homes could never decline in
value. Household savings rates went from 9% of disposable income to
zero in ten years, and household debt as a percentage of GDP
doubled from 50% to 100% by 2008. When the housing bubble burst, a
recession loomed, and over-indebted households and over-exposed
lenders fostered the greatest financial crisis since the Great
Depression. Monetary and fiscal reflation by the government was
enacted on an epic scale. Enormous bailouts of the largest
financial institutions in the U.S. and tsunamis of liquidity from
various government programs including TARP, the stimulus plan, QE,
and QE2, pushed interest rates to zero and started another cyclical
bull market in risk assets.
This time, however, policy tools have failed to
encourage the private sector to take on more debt, which, in the
absence of high savings, have been and will continue to be a
headwind to higher economic growth. Households are consuming less
and savings rates around the globe have jumped: in the U.S, to 5%
in Q1-2011, and even in Canada, which has experienced a much milder
recession, the savings rate is expected to rise to 5% next year.
Corporations have retrenched spending since the financial crisis,
with the financial balance of the corporate sector strongly rising
from a deficit of 1% of GDP in 2005 to a surplus of 4% of GDP in
Q1-2011. Investment spending has rebounded but so too have
earnings, leaving the financial balance at elevated levels.
According to a proprietary study by BCA Research, there has been a
strong negative correlation between the unemployment rate and
business investment. So with the unemployment rate in the U.S. not
likely to recover until the middle of the decade, capex should
As the private sector has retrenched, it is not
surprising that fiscal deficits have increased. The U.S.
Federal Reserve's extreme monetary actions have not restarted
credit growth so the U.S. government has had to step in to help
boost aggregate demand. U.S. government debt to GDP climbed from
36% in 2007 to 69% this year; more federal debt has accumulated
over the past four years than during the previous entire history of
the U.S. It will take years to know whether this experiment in
fiscal reflation succeeded in boosting the U.S. economy, but as
some countries in Europe have already found out, markets may riot
against further fiscal stimulus and force fiscal consolidation
before it has a chance to work.
For instance, the recent deadlock in Washington
over raising the debt ceiling was not resolved until rating
agencies and stock markets warned of the consequences of not
dealing with long-term fiscal trends. The legislation that
ultimately passed was done under duress and while much of it
backloads the majority of spending cuts to the outer years of the
ten year plan, there are spending cuts that when combined with the
temporary fiscal measures such as the payroll tax holiday and
accelerated depreciation, could cause the U.S. economy to exhibit
zero, or even negative, growth in 2012.
It does not help that the political
brinkmanship in Washington has cast doubt on the ability of the
U.S. government to function. This dysfunction was specifically
cited by S&P in its recent history-making downgrade of the U.S.
credit rating. There is no global alternative to U.S. Treasuries as
a risk-free benchmark, and any impact of the downgrade on bond
yields, in our opinion, will be short-lived. Moreover, yields
should stay low admist falling confidence and flagging economic
growth. Japan lost its AAA credit rating in 1998, and its 10-year
bond is at a meager 1%. Canada is the only country in the Western
Hemisphere, and just one of eighteen globally, to still have a AAA
credit rating from S&P. Canadian bonds should benefit from some
substitute buying from U.S. investors but the potential of an
economic slowdown in the U.S. will also calm inflation fears and
keep yields low. If bond yields rise without a better economy, then
we can count on the U.S. Federal Reserve to quickly resume asset
purchases. Of course this will spur further asset inflation
and could sow the seeds for the next crisis unless economic growth
is seen to be improving on a sustainable basis.
Excess debt always leads to crisis and
investors only need to look at the areas where leverage is growing
to spot the next bubble to burst. Government finances appear to be
a pending source of instability for global markets. The U.S. is
fast approaching its borrowing limit and the fiscal trend is
reversing toward restraint although the economy is still weak. In
Europe, senior EU officials are already calling the European
Financial Stability Fund, which was given EUR 440 Billion by EU
governments to bailout peripheral Europe, too small. Risks to
investors have intensified along with the shortage of safe assets
in which to seek harbor.
Persistently high savings rates in the private
sector, low economic growth, and fears of a looming government debt
catastrophe, will encourage investors to seek yield with low
volatility. The Fund should remain a core allocation within most
investor's fixed income basket.
Third Eye Capital Management Inc.