Japan Redux

Anyone around my age (46 – ugh!) can still recall one of the dominant themes in every aspect of American life as we were transitioning from adolescents to adults in the early and mid-1980’s. In the news, in entertainment, in pop culture – we heard it everywhere: Japan was taking over the world. From the daily economic reports of Japan’s record exports, Treasury bond holdings and New York City real estate purchases, to Congress’ threats of trade penalties, to popular movies such as “Rising Sun” and bestselling books including “Japan as Number One” – Japan’s world dominance was considered an imminent fait accompli.

Sound familiar? Substitute 2010 for 1985 and China for Japan and it is just a new verse of the same old song. So before we all get too far down the road planning our investment strategies around China and Asia’s new world dominance, perhaps we should ask ourselves: How did that work out for Japan back in the 1980’s? And how did that work out for everyone who invested in the Nikkei in 1985? The answer, of course, is not so good, as Japan’s lost decade now stretches out towards two decades. If China is not careful, they will suffer the same fate.

The details of what happened in Japan, and of how it could happen again in China are complex, but the basics of the problem are relatively simple. After World War II Japan embarked on a managed-economy program to grow from a destitute and devastated wasteland to the world’s second largest economy. Simply put, they exported everything they could to the U.S. and Europe, and then used the proceeds in dollars, pounds, marks, etc. to buy badly needed capital equipment and commodities to further build and fuel their export industries. As they perpetuated and grew this cycle they moved up the value chain to more advanced export goods, generating more foreign currency proceeds to further grow their export industries to move even further up the food chain – a virtuous cycle.

But in the 90’s this virtuous cycle turned vicious. Japan continued to suppress domestic demand and consumption in order to build production capacity well beyond what the world could use. Further excess dollars and euros (earned from exports) that could not be invested in more production capacity were left in bank accounts in the US and Europe, or were used to buy US and European sovereign debt or other assets. Most of the dollars and euros earned from exports had to be either used to buy imports or left abroad, for exchanging those dollars and euros back into yen would have driven the yen way up, destroying Japan’s export competitiveness. But inevitably some of the export wealth did manage to trickle down to Japanese citizens, so to absorb it and suppress demand for goods the government engineered asset price bubbles in real estate and the stock markets.

Eventually these asset price bubbles had to collapse (at one point the land under the royal palace in Tokyo was theoretically worth more than the entire country of Canada). In addition, Japanese exporters had built so much production capacity that they could never find customers for it all overseas (or domestically, where tax and other mechanisms worked to suppress demand). Japanese banks, that had financed the purchase of overpriced assets in Japan and around the world had huge losses and began to fail in massive numbers. Furthermore, since export currency was not converted into yen along the way, Japan now found itself with a significant portion of its wealth, and in effect its money supply, tied up in dollars and euros in foreign bank accounts.

All of the pieces fell into place: Excess production capacity, collapsing asset price bubbles, failing banks, contracting credit, and a constrained money supply formed the perfect deflationary storm. Japan still has not recovered, and their entrenched government shows no signs of making the painful changes needed anytime soon.

Now China is Japan in the early 80’s. Their export industries in technology and complex manufacturing (e.g. cars) have not reached global preeminence, but they are getting there and they have now become the world’s second largest economy. They may soon choose to begin to encourage domestic consumption along with production focused on meeting domestic demand, to import more consumer goods and focus less on exports, and to let the Chinese people innovate and found companies to serve domestic markets, especially in the service sector. But if instead China continues to focus all of its energy and resources on building export capacity while controlling and limiting domestic demand, and continues to use the excess foreign currency proceeds that result from massive trade imbalances to fund the debt of their customers (the U.S. and Europe), then Japan’s fate awaits China as well.

The article linked here (http://www.foreignpolicy.com/articles/2010/09/30/the_japan_syndrome?page=full) explores some aspects of this in greater detail. As the article says, “Japan as Number One now languishes as the 400,000th most popular book on Amazon.com while When China Rules the World is a bestseller.” We’ll see.

Busting Out of Rehab

A female drug addict entered rehab. She didn’t want to do it – it was forced upon her. She could not bring herself to quit on her own. Far too many people surrounding her (her suppliers, her addict “friends”, her pimp) all had a vested interest in keeping her addicted. But she could no longer afford her growing habit, she was repeatedly in trouble with the law, and it was taking an increasingly heavy toll on her health, so external factors (a courtroom judge, her family physician and loved ones) forced her into rehab to save her life. Deep down she knew it was her only hope. She knew if she didn’t enter rehab now it would be twice as difficult to quit later. But she still had to be dragged there, kicking and screaming.

Once in rehab it was not pleasant for our addict. The withdrawal symptoms were horrific. In fact, it was so bad that our addict needed a doctor to administer a few more drugs just to keep her from entering a death spiral from which she would never recover. Even with this limited amount of new drugs, withdrawal was awful. Some experts said giving her the drugs to help her through was a mistake – the sooner she went cold turkey on everything the better. Others said she needed more drugs or she wouldn’t make it through the night. The truth was that nobody really knew for sure either way. And either way, quitting would still be a long and painful process. She had been an addict for a long time.

But the addict made it through the night. She started to feel a little bit better each day. So the doctors started to eliminate the drugs they had been giving her in rehab. They had served their function; they had saved the patient’s life. The patient would have to make it the rest of the way through recovery on her own. She wasn’t clean yet.

That night in rehab was a rough night for our recovering addict. As she lay suffering in a nightmarish half-sleep half-waking state, there was a tap on the window. It was her old pusher, her old pimp, and some of her old wasted “friends.” “Come on out,” they beckoned. “Don’t stay in here suffering. We have plenty of good stuff. You can feel great again. Ditch this rehab place and party with us.”

***

The United States, or more accurately our economy and financial system, is also an addict, only in this case the drug of choice is debt, and its close cousin, excess consumption. Known on “the street” as leverage, it comes in many forms, ranging from home equity loans to credit cards to government bonds to commercial paper to asset-backed finance. But it is really all the same thing – debt. And like the addict in our story above, the US has many enablers surrounding it that want to keep the addict addicted. The Chinese and Japanese need to fund the US debt habit so that the US will keep buying their exports. In addition, those debt pushers both have huge inventories of the drug (US Treasuries) and they don’t want to devalue their own inventory. The other addicts out there (all of the other developed debtor nations – the UK, France, the rest of Europe) want to keep the party going as well. They can’t admit the US has a problem, because that would mean they themselves have a problem.

But our addicts got in a little trouble here recently. They want on a bender of historic proportions. They loaded up on the debt drug every which way they could get it. When the party ended they too found themselves involuntarily committed to rehab. Economists have a name for this rehab – it is called a recession, or for really bad addicts a depression. It is painful, but it breaks the addict of their drug (debt and excess consumption) habit.

Immediately our addicts began feeling the painful symptoms of withdrawal – plunging stock market values, corporate bankruptcies and unemployment just to name a few. In fact, like the addict in our prior story, it looked like these patients could also spin out of control in a death spiral if something wasn’t done. The resident doctors at the rehab clinic (doctors Bernanke and Obama) decided that to save the patient they needed to administer controlled doses of the drug (TARP, the stimulus package, Federal Reserve lending, etc.) to wean the addicts off of their dependency. Again, some said it was a mistake to give addicts in withdrawal any drugs at all, while others said it was not enough, but no one really knew for sure. But either because of it or in spite of it, these addicts also made it through that first dark night without spiraling downward out of control. Even the worst addict of the bunch (some guy named “Greece”) made it through, although for him it really was touch-and-go for a while.

So now our group of addicts is facing the tough task of making it the rest of the way through a long and difficult rehab without any more help from any drugs at all – no more TARP, no more stimulus, expiring tax cuts, etc. It will be painful. It will require our addicts to suffer much pain and sacrifice, which unfortunately has not been their strong suit in the past. They are used to having a good time partying. They are not sure they can do it.

But wait! There’s a tapping at the window. It’s the addicts’ old pushers – China and Japan. “Don’t worry,” they say, “We are here for you. We will supply your habit no matter what! In fact, we have some new really good stuff for you – better stuff than we have ever given you before. Remember when all we had for you was ten year five percent stuff? Well now we’ll supply with you with ten year two percent stuff!” Also outside the window are the addicts’ old friends from a place called “Congress.” Some of them say, “Hey, come on out – I’ve got some more of that stimulus stuff for you.” Others from Congress say, “Forget that nasty stimulus stuff. You know it leaves you with a nasty hangover. What you really need is some more of these tax cuts! That’s the good stuff!” (Those Congress guys fight a lot with each other, but the one thing they have in common is they all just want the addicts to come out and party.) Then the addicts look outside and they can’t believe their eyes. It’s Dr. Bernanke and Dr. Obama. They’ve gone over to the dark side. “We’ve got even more good stuff for you,” they say. “I’ve got some quantitative easing that you’re going to love” says Dr. Bernanke, and Dr. Obama adds, “And I can help those Congress boys get you even more stimulus and tax cuts!”

This all looks pretty appealing to our addicts. After all, who wants to suffer through months or even years of more rehab?

***

A few months ago I actually thought there was a decent chance the US was going to stay in rehab and get better. Not intentionally perhaps, but since the Republicans and Democrats can’t seem to agree on anything, it seemed possible, perhaps even likely, that the stimulus would run out, the Bush tax cuts would end, and the Fed balance sheet would start to shrink back down. This would likely cause a double-dip recession, unemployment would rise a bit more, the stock market would fall or tread water, and it would last for years. It would be a long sluggish deflationary time period for markets and the economy while everyone (and the government) cut back on consumption and paid down their debts. It would be painful, but in the long run it would be for the best, and it would be easy for investors as well. All one needed to do was buy high quality corporate and government bonds, and indeed that was what we saw in the markets.

The past week or so has changed all of that. It has become clear that the US is intent on busting out of rehab, long-term consequences be damned. The fed voted not to let their balance sheet start to wind down as securities they hold mature, and “Helicopter Ben” made it clear that he is more than ready to expand the Fed’s balance sheet without bounds through quantitative easing (i.e. buying more securities, or lending more money, in the debt markets). Furthermore, it seems that this fall the democrats are about to get a painful lesson in how much the American public appreciates being in rehab, so now it looks like they are getting religion on extending the Bush tax cuts. And once the Republicans win a bunch of seats in Congress they won’t like rehab any better than the democrats, so if the quid-pro-quo for extending the tax cuts is a bit more stimulus spending then they will probably go along with that.

As a result, it suddenly appears that the party may start again. Clearly the markets realized that as well this week as stocks jumped and high-grade corporate debt retrenched. The party will likely be subdued, for a while at least. The addicts are still far from healthy. They can’t party like they used to, and besides, they will claim they have all learned their lesson. In fact, if the addicts aren’t careful they may end up right back in rehab very quickly, or even worse (that Greece guy really doesn’t look healthy enough to be partying again!). And even if the addicts keep the party going for a long long time, they will still be addicts. Eventually the day of reckoning will come, and it will be all the worse for having been postponed this time around. But that could be years, maybe even decades, away. After all, pretty much everyone and every government on earth has a vested interest in keeping this party going. So for now, the addicts say, “Let’s eat, drink and be merry! And put it on our tab.”

Depressing

An overleveraged, overpriced market brutally declines by about half, only to be followed by a rebound of about 50% that is almost as swift as the decline. A description of 2008 to 2010, or of 1929 to 1930? The answer is both. So what happens next? From mid-1930 to 1932 the market declined an additional 86%. Could we see a repeat of this, and the Great Depression that accompanied it?

The short answer is yes, but only if governments around the world repeat the mistakes of the 1930’s. And that would not be easy for governments to do. First of all, several of the missteps of the early 1930’s have already been avoided. With no FDIC or emergency Fed funding, millions lost their savings as over 5,000 banks closed in 1929-1932. This also resulted in a massive contraction in the money supply, contributing to deflation. There was no unemployment insurance to support the spending of millions of unemployed workers as the unemployment rate climbed to almost 25% in 1933, further driving down demand and fueling deflation. Likewise, farmers had no assistance as drought and the dust bowl ravaged the plains beginning in 1930. So in all of these ways, this time truly is different. Programs already in place (the FDIC, unemployment insurance) and actions taken since the current crisis began (emergency Fed funding, Fed securities purchases, TARP, stimulus spending) have supported both demand and the money supply and prevented (thus far) the devastating deflationary spiral that defined the Great Depression of the 1930’s.

That is not to say that we are out of the woods. Governments around the world could still take ill-advised actions that could at a minimum drive us back into a severe recession. By 1937 there had been a substantial recovery in the economy and the stock market that was driven (at least in part) by the 1930’s version of the stimulus package (the multitude of New Deal programs). But in that year a conservative coalition in Congress that decried the resulting government spending and deficits as ruinously large and threatening inflation successfully pushed through a roll-back of much of the New Deal spending in an effort to balance the budget. Sound familiar? The result was another plunge in both the markets and the economy that lasted until World War 2.

As in the United States of the late 1920’s and Japan of the early 1990’s, the U.S. today is still over-leveraged. Sooner or later all of that excess leverage has to unwind. It may happen gradually (as it did over more than a decade in Japan) or quickly and severely (as it did in the early 1930’s). At this point in our nascent economic recovery, the more governments here and abroad try to raise taxes, reduce spending and balance budgets, the more likely we are to de-lever quickly and painfully, and with some risk of a deflationary spiral like that of the 1930’s. This seems to be our present course, with the fiscal stimulus money, TARP, and the Bush tax cuts all about to come to an end (and worse yet, many pushing to cut spending even further). On the other hand, an extension of the Bush tax cuts and/or stimulus spending would help the economy, and likely give the stock market a huge boost in the short run. But even in that case we will still need to de-lever, leaving Japan’s “lost decade” (which really lasted even longer), during which banks, individuals and companies slowly paid down their debts while the economy more-or-less flat-lined, as an example of the best we can hope for.

Seeing the Future

So here I am, 46 years old, trying to figure out how to invest for the “future.” I exercise and eat right, so (hopefully) for me the “future” means at least 40 more years, maybe even 50 (what can I say - I'm an optimist). The crystal ball gets pretty foggy looking out that far, but a few things seem obvious, and we can draw some conclusions based on these observations that (again hopefully) will give some insight on how to invest for this “future” that we face. I begin here with a summary of my conclusions, followed by the more detailed analysis (for the hard core finance and economics geeks out there – check out the subsequent post “Observing Today to See Tomorrow”) that led me to these conclusions.

The bottom line is this: The next decade or even decades will be difficult times for the US and Western Europe in a macro sense, as many factors will create headwinds against economic growth. The best long-term investment strategy will be to invest in companies that take advantage of the themes summarized below, but that also have limited vulnerability to the hazards that follow.

Investment Themes:

· People living longer
· People working to an older age in developed nations
· Older workers making up a bigger percentage of the workforce in developed nations
· Immigration into the US
· Immigration from rural to urban areas in developing nations
· Increasing affluence of populations in developing nations
· Technology for work (to increase productivity)
· Technology for play (digital lifestyle)
· Technology for alternative energy
· Dollar devaluation vs. Asian currencies

Investment Hazards:

· Rising interest rates
· Rising tax rates
· Inflation or deflation, but no certainty as to which
· All of the above, plus global deleveraging, creating “headwinds” for economic growth in the US and Western Europe
· General market PE multiple compression
· Another financial market meltdown (a la 2008-2009)
· The “normal” risks of investing in developing nations that do not have seasoned financial markets, stable currencies, fair and transparent legal systems, or even stable democratic governments
· Dollar devaluation vs. Asian currencies

Investing Game Plan:

· Look for solid companies that have exposure to the above themes (e.g. aging, technology, emerging markets, etc.), preferably companies based and traded in the US or Western Europe for their legal systems, property rights, established financial markets and political stability.
· Look for companies that can adapt pricing and expense levels to both inflation and deflation.
· Avoid financial stocks until meaningful reforms are put in place to prevent a recurrence of 2008-2009’s market meltdown.
· Avoid stocks in the long run that will be hurt by higher interest rates
· Do not overpay – wait for corrections to specific stocks or the market overall to find entry points at PE multiples that are less expensive by historical standards.

Observing Today to See Tomorrow

In my previous post (“Seeing the Future”) I laid out a vision of the future and its implications for investing for the coming years and decades. For you hard core fin-geeks out there (like me), here is how I arrived at the conclusions listed in that post:

Observation #1: Our starting point for the future (i.e. today) has most of the developed nations of the world (US and Western Europe) in an extremely over-levered state, both at the personal and government levels. Individuals have already begun to cut back and de-lever, but still have a long way to go to get back to anything resembling the personal debt levels of the past. Governments may continue to do their best to offset the personal deleveraging of individuals, but even governments face pressure (from voters, from markets) to begin their own deleveraging.

Conclusion: All of this delivering will inevitably be a drag on the economies of the US and Western Europe.

Observation #2: Interest rates on all types of debt (government and corporate, long term and short term) are very low by historical standards. Many complain that debt is not available to smaller entities and individuals that need it, but that just goes back to deleveraging point above. For anyone who has debt or can get it, rates are low by historical standards.

Conclusion: Just mathematically speaking, rates can’t go much lower, and logic (and history) would say that they won’t stay the same forever, so the inescapable conclusion is that sooner or later rates will rise.

Observation #3: People are living longer all the time, and a huge wave of baby boomers is rapidly approaching retirement in the US and Western Europe. As currently structured in the US, Social Security and Medicare will see expenditures and distributions grow to a point that one, or some combination, of these four things will happen:
· Government deficits will become a huge problem
· We will encourage more immigration of young workers into the US to increase the tax base
· Taxes rates will go up
· The retirement age will be increased
Technology advances will probably help on the margin, but it seems pretty unlikely that we can come up with enough technological advances to grow our way out of the problem. It would seem that similar logic must apply to Western Europe, although they have never had the immigrant draw that the US has.

Conclusion: Given the unpopularity of the last two choices (and for some, the second choice as well), it seems that we will get option 1 (increasing deficits) until the deficits become so large that they begin causing real problems (e.g. increasing interest rates), at which point we will likely get some combination of the other three options (more immigration, increasing taxes, later retirement).

Observation #4: Developing countries (led by China, India and Brazil) have huge populations and far lower per capita GDP than the developed nations. These populations are rapidly “urbanizing” (moving to cities) in many countries. Furthermore their governments do not have huge looming obligations to retirees, and in many cases they do not have the problems of too much leverage and debt. All of this is positive, but over the long run the historical track record of developing nation economies and stock markets has been mixed at best. Many of these countries have not had (and many still do not have) the political, legal and economic systems in place to encourage growth and attract investment over the long term. While some countries have risen from the third world and richly rewarded investors (Japan through the 80’s, Korea and China more recently), history is also littered with examples of foreign investors in other countries being fleeced through currency devaluations, the local “legal” system, or just outright theft by national governments and their favored entities.

Conclusion: Developing countries have greater potential for growth, but investing in countries without adequate property rights, without a clear and fair legal system, and/or run by communists is also quite risky.

Observation #5: There are huge trade imbalances between countries, including (but certainly not limited to) the US and China. Using these two countries as an example, the US trade deficit with China means that China has a dollar surplus. Eventually those dollars must either be loaned to US entities (in practice this has mainly been to our Federal government) or they must be used to purchase US assets (real estate, stocks, entire companies, etc.). As a result, either or both of the following must occur:
· The dollar must depreciate against the currencies of China and other countries with which we have trade deficits (many in Asia).
· China and other countries with which we have trade deficits will have to continue funding Treasuries and other US debt and/or buying US assets.

Conclusion: We will probably see both, and both are inflationary. Consumer inflation is bad for the stock market because it drives down multiples and bad for the economy because it drives up interest rates. On the other hand, inflation of asset prices in US dollars is just another way of saying stock and bond prices rise. So it is unclear whether the net effect of this will be positive or negative for the markets.

Observation #6: Over the long run, it seems we continue to use more and more energy. Some would say God played a cruel joke on the US by putting much of the world’s oil under countries that don’t like us. Furthermore, China has become our new competitor for all of this oil. They want it for themselves and they are more than happy to trade with anyone (good or bad) to get it.

Conclusion: Sooner or later it seems we will wake up to all of this, and the right wing national security hawks and the left wing global warming hawks will team up to have the government provide the incentives needed to finally get companies working on the technology for alternative energy sources in a big way.

Observation #7: Historically, so-called “secular bear markets” (the long term bear markets that often last a decade or more, like the one that we can now see began in early 2000) have always been deflationary, although historically governments did not respond with the massive fiscal stimulus that is being implemented this time around.

Conclusion: While many people are worried about inflation, the evidence is not clear cut on this. Massive government deficit spending and a depreciating currency are indeed inflationary, but deleveraging, excess industrial capacity, and seemingly unlimited cheap labor from rural China and India are all deflationary. It seems an investor must be prepared for either.

Observation #8: Stock market multiples are not historically cheap right now. At 1100 the S&P500 is trading at a little over 14x estimated 2010 earnings. Throughout the vast majority of the 20th century, PE multiples of around 15x were about as good as it got for any sustained period of time, and during times of meaningful inflation or deflation multiples fell significantly lower, often times into the single digits.

Conclusion: Today’s market multiples seem reasonable given the current environment of very low inflation and very low interest rates, so these PE levels could be sustained for some time or even slightly improve. But just as with interest rates, history tells us that the market’s PE multiples don’t stay the same forever. Sooner or later they will change significantly, and when they do, unless there is another bubble (a la the late 1990’s), they could decrease a lot more than they could increase.

Observation #9: No new financial regulations have been implemented since the market meltdown. People disagree about what should be done, but there is no denying that so far almost nothing has been done.

Conclusion: Until new regulations are put in place, we will be at risk of a repeat of the financial meltdown of 2008 and 2009 that cut most portfolios in half and destroyed myriad financial firms.

Dear Republican Party

Please give me a credible alternative to the Democrats! I used to be a full-fledged supporter of GOP, back in the days of Reagan and even GHW Bush. You remember, back when you stood for fiscal responsibility, limited government, and a competent national defense. Back before you became the Sarah Palin / Glenn Beck / Sean Hannity party (a.k.a. the stupid party). Well, needless to say, you lost your way. I am not sure which is worse – the meddling in our personal lives, the incompetent use of the world’s best military, or the unrestrained spending that would shame a drunken sailor on his first weekend leave in three years. Clearly we grew apart.

But sadly, the Democratic Party provides a pretty unsatisfactory alternative. For starters, I can’t even tell where I agree with them and where I disagree with them, because even though they control both Houses of Congress, they can’t even agree with each other long enough to pass anything. My main issue with their party leader in the White House isn’t his occasional verbal pandering to the liberal left, since that has amounted to absolutely nothing as far tangible results. No, my biggest problem with Mr. O is that he has continued all of the Bush era mistakes (e.g. the crazy deficit spending, the incompetent use of the world’s greatest military, the failure to implement any meaningful and effective financial market reforms, etc. – even Guantanamo is still open!).

So listen up, Republican Party! This is your big chance for redemption. There has been a lot of screaming during the past few days about Obama’s recent proposal to (gasp!) increase bank regulation. For the most part, your reaction has been something along the lines of “What is he thinking? The regulations that we’ve had in place for the past ten years have worked just fine.” This is a BIG mistake. The old regulatory system did NOT work fine in the years that culminated in 2009. When you defend the status quo then John Q. Public concludes that either (a) you are in the pocket of Wall Street, or (b) you are just not very smart (confirming our worst Palin/Hannity suspicions). Either way it is bad for the Republican Party and bad for the country.

I will admit that I am not a huge fan of Obama’s first shot at increasing bank regulation last week. It smacks of populist pandering, unfairly penalizes some and favors others, and only partially addresses the real issues. So again, Republican Party, this is your big chance. Stop being the party that says “NO.” Stop being the party that says “all new regulation is bad.” Don’t just tell us why the Democrats are wrong. Instead, propose something that is better! Propose some effective regulatory alternatives to the Obama plan. Give us some fixes that will prevent future problems and encourage productive capitalism. The Republican Party needs that. The whole country needs that.

Just to show you that my heart is in the right place, I am going to help you out. Here is a recap of my list of regulatory fixes that will prevent future problems and encourage productive capitalism. (For the rationale and details on these proposals, please see the Appendix to my October 19, 2009 post “Forget all the screaming about socialism. Have We Fixed Anything?”)

1. Reinstate the uptick rule
2. Prevent financial institutions from getting “too big to fail”
3. Regulate hedge funds
4. Regulate or prohibit dark pools, naked access and high-speed trading
5. Implement meaningful margin requirements for derivatives
6. Increase margin requirements on leveraged ETF’s or prohibit them completely
7. Put some teeth in the prohibition on naked shorting
8. Increase financial institution capital requirements
9. Increase deposit insurance levels
10. Stiffen regulation and disclosure requirements for consumer credit and residential mortgages

Democrats have proposed addressing about 10% of this and have actually implemented almost none of it. Republicans, this is your opportunity to win back John Q. Public and save the country in the process.

New Year, Same Worries

By any objective measure, 2009 was an absolutely stellar year for investment returns. But for obvious reasons, after 2008 and early 2009, no one feels like celebrating too hard. The future looks… perhaps not scary, but worrisome at the very least.

Maybe we should all lighten up, at least for now. All of that fiscal and monetary stimulus will continue to push the economy forward and markets up, at least for a while. I mean, what are you going to do? Sell your stocks and bonds and then let the cash sit around making about 0.1%? That’s no fun.

But (and there’s always a but) sooner or later all that cheap money and government spending will cause inflation, or so everyone says. That fear is driving much of today’s unease, and has driven up gold and oil to very high levels (in spite of declining oil demand and excess production capacity).

Certainly this inflation scenario is possible, but I do not believe it is the most likely outcome. The fear of inflation seems so wide spread that it is far more likely that before the governments of the debtor nations (mainly us!) are able to spend their way to inflation, lenders (i.e. purchasers of government bonds) will say “no way.” Put another way, governments will face a choice: Either show some fiscal and monetary restraint, or have rising interest rates forced upon them by bond buyers. Either way, it slows the economy and the worry becomes recession and deflation.

When that happens, the question will be which path will we take? Will the government and the Fed capitulate to the market, reigning in government spending and tightening monetary policy? I hope so, because even though this would be painful for a while it would finally be the beginning of the great unwinding of the excess leverage that drove our economy too far and too fast for too long. Perhaps we will finally come to grips with the fact that you can’t borrow your way out of having too much debt. While painful, this would set the country up for future prosperity for our children.

The other option is much worse. If our government can’t find some fiscal and monetary restraint then Treasury buyers will demand higher and higher interest rates as the government borrows to fund its spendthrift ways. This will quickly become untenable, because (as noted above) these rising interest rates on treasuries will drive up rates throughout the economy, pushing us back into recession and perhaps deflation. The feds will have two ways to get around this – one is quantitative easing (basically the Fed just runs the printing press to fund the deficit) but this would make the problem worse as world markets would panic at the prospect of the U.S. becoming Argentina. For that reason, I think that outcome is extremely unlikely.

The likely outcome in this scenario is actually much simpler, and (at first) much more benign. The government could start selling more TIPS (inflation protected treasury bonds). If investors start demanding higher rates on standard treasury bonds dues to concerns over our free-spending easy-money polices, then we can issue them TIPS at much lower rates because they are inflation protected. This will work and for a while will continue to enable our government to keep the good times rolling. But in the long run it is horribly insidious, because when inflation does begin to rear its ugly head both interest payments and outstanding principal amounts on TIPS will skyrocket. You can’t inflate your way out of debt when it is indexed to inflation, so the only two options then will be to (finally, belatedly) reign in spending and monetary policy (much more painful for having been postponed several more years) or just become Argentina after all and default on your sovereign debt.

So watch TIPS issuance – it could keep the party going a while longer, but too much could be a sign of even bigger problems in the long run.

BTW, did you see the article in yesterday’s WSJ titled “U.S., in Nod to Creditors, Is Adding TIPS Issues”? I wish I was making that up.