Fiscal Follies (Q2-11)
Jun 30th, 2011
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 States
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 remain subdued.
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.