Market Commentary (July 2011)

On July 27, 2011, in Market Perspective, by admin

Before acting on my advice, let me first offer a caveat that markets imperfectly reflect interdependent economies, each of which are complex adaptive systems that dynamically interact with other complex adaptive economies in a highly interconnected and diverse adaptive worldwide economy under conditions of uncertainty and imperfect knowledge leading to emergent outcomes that are inherently path dependent. Ability to adapt portfolios through the dance of history become critical to success!

 As things now stand, I’ll offer a brief historical perspective along with guideposts to help identify key milestones likely to unfold in the wake of the recent Balance Sheet Recession which I suspect is the first act in what is likely to prove to be a decade of weakness. My strong hunch is that the next generation will look back on this decade as one of Contained Depression rather than a series of recessions.

 My base case scenario is that governments will do everything in their power to delay an Austrian-style depression. But this “Great Debt Supercycle” (as identified by BCA Research) will not end well.

Unless hastened by dominoes of interlocking debt, my bet is that the U.S. can kick the can down the road for at least another decade (and possibly two decades due in part to massive assets that the U.S. could sell if forced into a Greek-style austerity). I am also confident that the U.S. will somehow deal with its debt ceiling whether through short term measures or a claim by Obama that the debt ceiling is unconstitutional under the Fourteenth Amendment (a position that Bill Clinton publicly stated that he would take were he now in Obama’s shoes).

Europe has less time and the European PIG countries (Portugal, Ireland, and Greece) are facing immediate default unless bailed out by EU, the IMF, China. The ECB has already poisoned its balance sheet with Greek debt and will itself need to be supported by the core European countries.  The contagion must (and at least for now probably will) stop with Portugal which ostensibly suffers from private sector debt but could suddenly find an explosion of public sector debt if its banks fail due to ownership of Greek bonds and large numbers of variable-rate mortgages secured by depreciating real assets. If the contagion moves to Italy and Spain, the EU’s future will be seriously in doubt. In the end, I wouldn’t be surprised to find that China plays a big role in any solution (putting them in a much stronger bargaining position on a going forward basis).

I strongly suspect that we will temporarily resolve the debt crises on both sides of the AtlanticPoliticians around the world are still haunted by the memories of Lehman Brothers and understand they are playing a game of chicken in the context of Mutually Assured Economic Destruction.  From this perspective, it makes sense for risk-takers to bet on a temporary resolution of debt crises in the developed world. But because the downside is so great and because we are facing a second soft patch in this cycles (as predicted by the ECRI’s Weekly Leading Index which has happily stabilized in the past two weeks but which nevertheless remains concerning due to the unusual circumstance  of two soft patches in the first two years of recovery).

My guess is that debt crises will be “solved” by more debt & debt restructuring which will ultimately add further steam to a debt snowball that could eventually bring down increasingly fragilized economic and social structures and further support prices of precious metals in world of rapidly sinking faith in fiat currencies. Under a worst-case selloff, everything including precious metals would fall in a cascading avalanche. Happily, I suspect that this Armageddon scenario can be postponed for much longer than most believe. If we are lucky, technology may help to cover our multitude of sins. My guess is that much more pain will first have to be faced sometime in the next  decade (which I might call “2020 or 2025 for short).

 

Where We’ve Been

1.                  60 to 80 year credit cycle in which expanding credit fueled asset prices to unsustainably high levels in relation to income (a peak intellectually typified by the book, Dow 30,000)

a.                   Credit Expansion Was Fueled by an increasingly fragile “Shadow Banking System” which will be difficult to recreate

2.                  The collapse of Lehman Brothers sparked a vicious circle of deleveraging which begat price declines which begat deleveraging which begat further declines in prices. It proved to be the tipping point that turned the economy from an inexorable credit expansion to a long period of consumer retrenchment and an ongoing Liquidity Trap.

3.                  Politicians and Central Bankers prevented an almost certain deep depression by containing this vicious circle with monetary ease and debt-financed public sector spending that helped replace the sudden loss of consumer purchasing power (& thus preventing the downturn from overreaching on the downside)

4.                  Having stemmed the tide of immediate collapse, the authorities appear to be holding out hope that Economic Fault Lines (or forest fires) can be gradually defused with mini-earthquakes (or controlled burns). 

5.                  Facing restive citizens, authorities composed of Politicians and Central Bankers have attacked the problem with a one-two punch of fiscal stimulus and monetary easing.

a.                   The hope is that the propulsion from monetary and fiscal policy will boost the economy out of stall speed into a sustainable orbit.

b.                  The problem is that the economic booster shots have almost run their course and the problems of excess leverage are being covered over with more leverage with uncertain long term consequences.

c.                   But Players Adapt and Unintended Consequences Emerge

6.                  Due largely to structural problems and a weak economy, unemployment remains high

a.                   A large portion of the jobs created in the previous up-cycle were in non-tradeable goods & services which are now in structural decline (reference Michael Spence)

b.                  Homeowners with negative equity positions find it difficult to move to new jobs

 

Guideposts of Where We Appear To Be Going In the Short & Intermediate Term

7.                  Shocks that threaten a new recession after a short lived recovery could be triggered by shocks that not likely to reach their peak before 2012

a.                   The short term risk of not servicing U.S. debt obligations is of very low probability but catastrophic consequences.

i.                    temporary failure to pay measured in days or weeks would come with consequences that are not be as severe as many fear (but would nevertheless be irresponsible)

ii.                  A “flight to safety” could ironically find its way into greater demand for U.S. Treasury Bills

b.                  Uncertainties related to such shocks are not captured in any simplistic measures of risk (such as standard deviation, beta, etc)

i.                    Some risk averse investors in a Wealth Preservation Mode may want to stand  aside for this round

ii.                  Aggressive traders who want to play the short & intermediate term upside might want to speculate that enough fingers are put in European dikes and the US Congress kicks the can down the road. This strikes me as the highest probability event but failure to achieve could prove very bad.

8.                  Some Good Things Will Likely Happen First, Supporting the Market in 2011 (& Possibly 2012)

a.                   We should benefit from inventory rebuilding and catch-up auto production as supply chains are restored after the Japanese Earthquake

b.                  We should benefit from Capital Expenditures driven by the 100% expensing options granted through the end of 2011

c.                   We should The Economy should further benefit from an extension of a payroll tax reduction just proposed by Obama and unlikely to be opposed by the GOP

d.                  Profit margins should remain high although they will begin to compress with new competition and as workers are slowly rehired.

e.                   Gradual rehiring should counter recessionary pressures but will be offset by a fall in Personal Consumption Expenditures arising from the expiration of Extended Unemployment Benefits (which have already been lost by over 1 million employees)

f.                   Strong corporate balance sheets (albeit with large amounts of oversees cash, much of which may be invested oversees to avoid high US taxes)

g.                  Earnings are near all-time highs (helped by productivity gains enhanced by resistance to hire)

h.                  Growing likelihood of tax reform that will reduce taxes on corporate repatriation of cash, stimulating some US CAPEX

i.                    Exports remain strong (aided by a weak dollar that may soon strengthen against the Euro)

j.                    Technology cycle is on the upswing

k.                  We are on the cusp of major new domestic energy development (including fracking & deep water drilling with weakening opposition from the White House)

 

9.                  Fiscal Drag Threatens Recovery

a.                   The Drag could subtract 1 to 1.5% from GDP, slowing the economy to a velocity only a little above stall speed and making us vulnerable to any further shocks

b.                  Politicians are determined to contract fiscal deficits while the Fed has few remaining arrows in its quiver

c.                   Contractionary fiscal policy will slow the economy as postulated by the Keynesians (the flip side of the recent Expansionary Fiscal Policy that has sustained our “Sugar High”

 10.              Fiscal Drag From the UK & Europe Adds to the U.S. Fiscal Drag from the Municipalities, States, and Ultimately the Federal Government

 a.                   Unwilling to tolerate deep recession, politicians have incentive to delay pain with a “fix” of more debt now and even greater pain in the future

 b.                  The Doctrinaire Tea Party would accelerate the pain, unwittingly lead us into a deep recession that could ultimately cleanse the system but turn impatient voters against them (i.e. Michelle Bachman should be careful of the painful medicine she wishes for! Despite its possible efficacy, it would come with some very serious side effects!)

 c.                   The Private Sector Eventually Adapts and We are Better For It.

 i.                    But Adaptations Take Time

 

Guideposts of Where We Appear To Be Going Longer Term

 11.              Recovery Fueled Largely By Fiscal Expansion Remains Vulnerable To New Economic Shocks

 a.                   Fiscal expansion has mitigated the damage and led to a “Contained Depression” in which excesses will likely take longer to resolve than would be the case with a second Great Depression.

 b.                  But fiscal expansion will eventually end (either by political force or by the bond market vigilantes)

 12.              Fiscal Contraction Risks Accelerating the Next Recession

 13.              Government Will Respond In the Face of Growing Political Pressures

 a.                   Learning from what are perceived as the mistake of allowing the Lehman Brothers failure, government will respond

 i.                    with any remaining viable tools of fiscal &/or monetary policy

ii.                  with new command and control “solutions” (which ultimately stifle adaptation & further fragilize the system)

 b.                  Government response will initially limit the extent of any second downturn but may lead to unintended consequences that worsen economic fault lines that set the stage for an even seismic shift in the next downturn

 c.                   This affect may be lessened if the Tea Party takes over after 2012 but their power would likely be short lived as the public will be unwilling to tolerate the years of pain before the benefits from their common sense solutions become widely recognized

 14.              Activist Government Policies Mask Problems But Make Them Worse

 a.                   Public Debt Replaces Private Debt to Extend the Great Debt Supercycle

 i.                    Sugar Highs Beget Sugar Highs Painful Symptoms of Deleveraging

 b.                  Side Effects of Government Debt Eventually Overwhelm the Immediate Stimulus

 i.                    Debt Burden Saps Growth & Limits Ability to Stimulate

ii.                  Guarantees of Private Party Debts Contaminate Sovereign Balance Sheets

iii.                Interest rates rise on sovereign debts threatening a deflationary death spiral

 c.                   Government Regulatory Response driven by ‘just do something” motivation saps dynamism & adaptability and hastens the “Day of Reckoning”

 

i.                    Dodd-Frank weakens community banks, making small business loans more difficult

ii.                  ObamaCare uncertainty

iii.                more anti-business NLRB

iv.                tightening EPA restrictions

 v.                  In short, the government is making a lot of anti-growth choices but needs growth to stimulate job creation.

 

d.                  An eventual slowdown in China & the rest of the world also accelerate the downturn

 e.                   Relative Calm Remains Until We Pass A Tipping Point of too much debt & stifling inefficiencies brought by anti-evolutionary regulations

 f.                   Fiscal &/or Monetary Responses to each new downturn lose their effectiveness while the system is slow to adapt to new regulatory burdens

 

15.              In Short, “It Won’t End Well” (Absent Structural Reforms That Break the Cycle)

 a.                   Politicians play on ignorance of voters who have insufficient incentive to learn

b.                  Breakdown of moral strictures limit statesmanship & undermine willingness to sacrifice for the common good

c.                   An Economic Pearl Harbor Evokes unpredictable response

i.                    could lead to anything from societal breakdown to concerted public action

 16.              A Radically Different New World Order Emerges

 

17 Responses to Market Commentary (July 2011)

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