The following thoughts on the economic stimulus and its potential outcomes are excerpted from a letter to clients sent out on April 20, 2009.
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The Stock Rebound
You may have noticed that stocks in general have made quite a rebound over the past couple of months. As I write this, the S&P 500 has moved up nearly 35% from its early-March lows. Also beneficial to our portfolios, the dollar has dropped pretty sharply over that same period and many of the inflation-hedge themes we favor have done quite well.
Which is all very nice. But will it be sustained? Our emphasis on fundamental analysis and long-term returns mitigates the need for us to make short-term predictions. We try anyway.
As a first step in answering that question, let's have a look at: The Stimulus.
The Biggest Stimulus Ever
The economic stimulus being undertaken by our legislative and monetary authorities is absolutely unprecedented.
One of our favorite financial writers, Jim Grant, put some numbers together to put it in perspective. Grant added up the fiscal and monetary stimulus for the Depression as well as every downturn since:
- The average stimulus during each downturn amounted to 2.9% of GDP. (This means that government stimulus spending plus money supply growth added up to 2.9% of the economy's yearly total production).
- During the Great Depression -- which saw GDP decline 27% and unemployment reach 25% -- the stimulus amounted to 8.3% of GDP.
- Thus far during the current downturn, fiscal and monetary stimulus has amounted to 29.9% of GDP.
Measured in terms of GDP decline, the current downturn -- unpleasant as it may seem -- is just 1/15 the size of the Depression. Yet so far, the government has already forced into the economy nearly 4 times as much stimulus as it did during the entire Depression.
I should add that it doesn't seem like they are slowing down all that much, either.
Effects of the Stimulus
The good news is that this massive brute force effort will, eventually, gain some traction. It seems like almost a mathematical reality that if you print and spend to the effect of 30% of GDP, it will at some point have some serious impact.
There are many examples throughout the economy of things stabilizing -- not improving, but halting the unrelenting decline that had been seen up until recently. And some areas are even improving. For example, a big part of the stimulus consists of the government printing money and directly injecting it into the mortgage market, resulting in extremely low mortgage rates. It's no coincidence that housing activity in some segments of the market (particular in lower priced properties) has picked up quite sharply. And -- this isn't a sign of improvement, exactly, but a sign that the stimulus is at least having an effect -- despite the hand-wringing about deflation, the Consumer Price Index has been trending up since the low point it reached in December 2008.
The economy still has many hurdles to overcome, and we certainly aren't going to come roaring back to 2006 levels. But we don't think it's that unreasonable to believe that all the stimulus (combined with the fact that panics and freefalls can only last so long before people start living their lives again) could engender a weak recovery at some point within the next 12 months. ECRI, a forecasting firm with an excellent track record of predicting recessions and recoveries, has projected that the recession could end as soon as this summer. That timing may well end up being on the optimistic side, but ECRI's forecast shows that there are some pretty smart people out there who agree that the gloom may begin to lift in the not-terribly-distant future.
Now, the bad news.
All this stimulating isn't free. It is financed in one of two ways:
- By printing money into existence, which is great for the guy doing the printing, but "debases" every dollar in existence and causes it to be worth less than it would have been. Printing money can be thought of as a tax on everyone holding dollars or dollar-denominated fixed income instruments.
- By borrowing the money. Borrowing is simply moving future spending into the present, so to the extent that we spend money that we don't have right now, that's less money we can spend in the future. (Of course, this problem can be solved by printing yet more money to pay back the debt when it comes due -- but per the above bullet that has its own problems).
Both of these techniques lead to trouble. Printing too much money causes instability in the purchasing power of the dollar, whereas borrowing leads to future sub-par growth as the debt is paid back. Neither of these is good for the long-term health of the economy.
So, if we do get a recovery, we don't expect it to be very robust. And as the consequences of our indebtedness and currency debasement come to the fore, it could lead to another downturn and/or a long period of sub-par growth. And nobody should be surprised to read that we also expect it to lead to inflation and a much weaker US dollar.
Dollar Purchasing Power Risk
You knew we couldn't let a letter go by without a few thoughts on this issue.
The mainstream view acknowledges that the stimulus underway is massive, but claims that the monetary accommodation won't cause problematic inflation because it will be removed before that can happen.
We are, to put it mildly, skeptical.
To begin with, history doesn't support the idea that the Fed is going to yank all those extra dollars out of the system as soon as inflation pokes its head out or a recovery begins. I will once again invoke the inestimable Jim Grant, who wrote the following on this topic:
It's difficult to express just how unlikely it is that the Fed will start tightening up monetary policy any time soon. The Fed has lost a lot of independence during this crisis, rendering it even more difficult to remove the monetary accommodation when the time comes (not that they have been too quick about it previously). And it's not just a political problem. As I have often discussed, mainstream economic thought demonizes deflation to a degree that the Fed is almost certain to err on the side of choosing inflation over deflation. For a sample of what passes for mainstream economic analysis these days, you might be interested in this Bloomberg article, published 5/19, describing how two highly influential economists are preaching that the Fed should purposely create high inflation.In the past two recessions, of which one was very mild, the Fed removed accommodation with a significant lag. In the early 1990s, the National Bureau of Economic Research dates the end of the recession as March 1991, while bank charge-off and delinquency rates peaked three months later and the unemployment rate in June 1992. Yet the Fed did not begin to raise the funds rate until February 1994.
In the tech bust, the NBER dates the end of the recession to November 2001. Bank charge-offs peaked at about the same time, delinquencies in the second quarter of 2002, and the unemployment rate shortly thereafter. Yet the Fed was still cutting rates and fretting about deflation until June 2003. The funds rate did not actually rise until June the following year, more than 2 1/2 years after the dated end of the slump.
It boggles the mind to think that the Fed is going to be quicker to raise rates this time around, after the near-collapse of Wall Street, than it was in the wake of the prior two. And even if inflation begins to trot a little quicker, the Fed will probably hold back.
All this said, it's actually a bit optimistic to assume that the entire issue comes down to whether Ben Bernanke turns a monetary dial the right amount at some undetermined point in the future. This is because our foreign creditors are as much in the driver's seat as Bernanke and crew.
We used to believe that the dollar would likely experience a long, orderly decline in which inflation slowly crept upward as confidence in the dollar was inexorably eaten away. We were wrong about that. For reasons I've explained in prior letters (and which I won't drag you through again), the financial crisis caused a panicked flight into the dollar, which lead to a sharp increase in the dollar's value.
This flight to "safety" (that last word should be read dripping with sarcasm) didn't just happen despite the dollar's horrible long-term fundamentals. It happened despite them, and also made them much worse. This is because the entire deflation panic and dogpile into Treasuries and US dollar cash provided an opportunity for the authorities to print and borrow to the previously discussed unprecedented degree. The dollar's fundamentals went from really bad to even worse.
Because of this turn of events, we think the risk of a disorderly decline in the dollar has increased. The panic drove the dollar's imbalances -- the external debt overhang and the ocean of dollars circulating the planet -- to new and unimaginable (to us, anyway) levels. It's still possible that confidence in the dollar will slowly be chipped away over the years. But the imbalances have become so huge that it's also a real possibility that the confidence will collapse suddenly and violently, just as it did for mortgages in 2007 and stocks in 2008. This would not be pleasant, but it's a possibility we need to acknowledge.
Foreigners Don't Have to Lend Us Money
It struck me with renewed clarity the other day that a huge amount of analytical disagreement comes down to whether or not one shares the very common belief that foreigners will indefinitely continue to lend us enormous amounts of money because "they have no other choice."
The purported lack of choice is credited to two things: 1) the fact that foreigners already have huge dollar holdings, and those dollar holdings will lose value if they don't continue to prop up the dollar with new purchases of our debt; and 2) that their economies will collapse if we don't buy their exports.
Item 1 is kind of ridiculous. This is like saying that Bernard Madoff's investors would have stood to lose their prior investments if they didn't keep putting more money into his fund, so they had no choice but to keep investing more and more with Madoff, so his funds would do just fine. It simply doesn't make sense to believe that foreign central banks will forever throw good money after bad just to prop up the value of prior investments. As Madoff's fate shows, it just doesn't work that way. (And the comparison between Madoff's Ponzi scheme and the Treasury market is sadly not that far off base -- I discussed this in the prior letter, which I can send to anyone who'd like to take another gander).
Item 2 has an element of truth in the short run. Many foreign economies are structured to provide a lot of exports, and we are the ones buying many of those exports (or at least we were before the current downturn). Restructuring those economies would be painful in the short run. But in the end, these countries are the ones with the means of production, and it's arrogant for us to assume that they will continue to bend over backwards to ensure that we (and not their own citizens) get to consume the fruits of their production. These countries have amassed huge wealth from their prior exporting activities, and at some point they will start to spend that wealth on themselves instead of us. They have gotten some benefits from the current scheme, but there is no doubt that at some point those benefits will be outweighed by the costs. Given our recent borrowing-and-printing excesses and the dropoff in US import purchases, that point may already have passed.
So while there may be some factors keeping the dollar-recycling scheme in place for the time being, it is very dangerous to assume that it is some sort of birthright that much poorer countries than us will continue to lend us vast amounts of money to finance our excessive consumption and lack of saving. "They have no choice" strikes me as 2009's version of 2004's "We have a housing shortage." It is a platitude that is repeated and believed by a huge number of people and that forms the unspoken cornerstone of an entire analytical framework -- but one that few people have bothered to notice is not actually supported by the facts.
A few lessons can be learned from 2004's oft-proclaimed yet non-existent housing shortage. First, just because a lot of people believe something doesn't mean it's true. Second, even if it's not true, mass belief in a mistaken concept can temporarily prop up an overvalued market. And third, the emphasis on that last sentence should be put on the word "temporarily."
Strategy
For a long time we've been positioned for an eventual decline in dollar confidence and purchasing power. The possibility that such a decline could be more abrupt than we initially anticipated doesn't actually change our strategy all that much, because the end result would be fairly similar.
In our equity exposure, we continue to emphasize companies that deal in things that would hold up in an inflationary or stagnant economy. This includes things people need like food, energy, consumer staples, and healthcare. We also have exposure to equities in foreign countries that are not nearly as susceptible to the debt-induced stagnation we in the US are liable to experience. Additionally, we continue to maintain a healthy exposure to direct inflation hedges such as precious metals mining stocks, foreign currencies, foreign short-duration bonds, and US inflation-indexed bonds.
There may be ups and downs, but we believe that over time these investments will maintain and grow their purchasing power a lot better than US dollar cash.
As I mentioned earlier, the portfolios have rebounded nicely these past couple of months. In this relatively calm environment it's a good time to brace yourself for the fact that there will be more scares ahead.
We have seen astonishing levels of market mispricing over the past year, both in things becoming overpriced and underpriced. For instance, Treasuries became so overpriced in December that the yield on the 10-year note fell to just 2% -- that's locking in a 2% rate of return for the next 10 (highly inflationary) years. On the underpriced end of the spectrum, during the worst of last year's combined deleveraging selloff and deflation panic, the HUI gold stock index reached a low of 150 -- a level that basically priced the entire sector for bankruptcy. The HUI has already increased by 133% since then, and it's still substantially underpriced compared to its historical relationship with gold (which we believe is itself underpriced due to the misplaced confidence in the dollar I described above).
The point is that huge mispricings can take place in such turbulent times. We should be mentally prepared for them to happen again. And that means avoiding getting panicked by these short term market swings, and staying focused on the fundamentals and on the fact that the fundamentals will dictate the long-term returns that we seek to optimize.
