The New Abnormal
– You know that market sentiment has reached a euphoric extreme when nearly every presenter at a Grant’s Conference is bullish. This conference is known for attracting speakers with a more bearish slant than you would normally find in mainstream finance.
Yet the mood in the ballroom at New York’s Plaza Hotel last week was much more upbeat than the last time I was there, in October 2008. At that point, equity investors were convinced that there was no way the Federal Reserve stimulus efforts could offset a seemingly unstoppable debt deflation spiral. Liquidation of every asset — regardless of its investment merit — was the order of the day.
Eighteen months later, the investing public has moved all the way from abject fear to complacent greed. Stocks go up just about every day. What else do you need to know?
Now a consensus is forming that Federal Reserve policy will support stock and bond prices in perpetuity. Several speakers at the Grant’s Conference held this view. This new consensus view goes something like this:
- The Federal Reserve will keep rates near zero for a long time, because inflation is only a very remote possibility; Paolo Pellegrini was the lone dissenter, implying that a loss of confidence in fiat money could force the Fed to tighten (he said, “quantitative easing is a breach of property rights”).
- Corporate profit margins and cash flow will remain near record levels well into the future.
- Asia will continue to lead the global economic recovery
But economist David Rosenberg shared his non-consensus bearish economic outlook in a debate with Jim Grant. Rosenberg is bullish on U.S. Treasuries, expecting that yields will fall and prices will rise for many more years to come. In the debate, Rosenberg said that today’s U.S. economy resembles the Japanese economy circa 1996.
I agree that today’s U.S. economy resembles that of post-bubble Japan, but there are two key differences:
- The willingness to sacrifice for the “greater good” is much more ingrained in Japanese culture. This made it easy for Japanese governments to issue massive amounts of bonds to the household sector at low yields. The U.S. culture is much more diverse and independent, and those households with capital are not likely to buy Treasuries at low yields.
- The world is already stuffed to the gills with Treasuries. It’ll be difficult to find homes for several trillion more in Treasury securities (at low yields). Jim Grant argued in favor of this point. Chinese leaders may decide that the benefits of a higher exchange rate (cheaper commodity imports) outweigh the costs (more expensive exports). The transition away from decades of mercantilist policies and currency debasement in Asia will lead to lower demand for U.S. Treasuries.
So I agree with 80% to 90% of Rosenberg’s excellent analysis on the long-term credit cycle. But I don’t agree with his view that we’ll see much lower yields for U.S. Treasuries (outside of temporary flights to safety during deflation scares). I expect yields to steadily rise — not for pleasant reasons (faster economic growth), but for unpleasant ones (steadily growing fear among Treasury investors that they’ll get repaid in heavily debased dollars).
Strangely missing from the Grant’s Conference was much discussion about the situation in the “Club Med” countries — Greece, Portugal, Italy, and Spain.
It’s clear that most of the world’s political leaders don’t have the courage to allow painful, but necessary adjustments. Talk is cheap. Thus far, all we’ve seen in the growing sovereign debt crisis is talk. However this crisis is ultimately resolved, or papered over, it will not be painless. In 2010, the European economy could easily be much weaker than the U.S. economy.
French and German banks are exposed to Greek debt, so they want taxpayers to bail them out of their foolish loans. Furthermore, all developed European economies are so dependent on government spending that any plans to cut spending and raise taxes would be self-defeating.
When government spending becomes woven into the fabric of an economy as completely as it is in Europe, actions taken to balance budgets can paradoxically undermine sovereign credit. GDP would shrink rapidly under fiscal austerity, which would shrink the cash flow available to service government debt. This is why, ultimately, we’ll probably see much more radical pro-inflation actions out of the European Central Bank, but probably not before another big recession scare in the big European economies.
In most countries, political leaders aren’t willing to look too far ahead and take action to forestall worst-case scenarios. They want to debase their currencies to ease pain from de-leveraging and to gain an export advantage. (This tactic makes for a potentially explosive situation for gold prices. We’ve advocated a core position in gold since the inception of this letter in early 2008. The time may be approaching for another round of call options on gold mining stocks).
Rather than courageously leveling with their electorates, politicians tend to promise more entitlements, more bread and more circuses. Health care is just one of these new entitlements.
Governments that lose touch with reality eventually lose legitimacy. There are many examples of this fact in the history of Latin American economies in recent decades.
One vivid example — Brazil — was mentioned at the Grant’s Conference. Bruno Rocha and Cristiano Souza manage $1.6 billion in Brazilian equities at a firm named Dynamo. Rocha and Souza are bullish on the future of the Brazilian economy, mostly because entrepreneurs are now confident that they can operate in an environment in which the government respects property rights, and in which the central bank is not eager to destroy its own currency.
Rocha and Souza experienced firsthand the worst of the hyperinflation and statist policies that Brazil suffered through in recent decades. They described how engineers with advanced degrees had to drive cabs to scrape together a living. Those few individuals who possessed some capital tended to invest it in the all-cash underground economy, fearing the loss of it to corrupt or incompetent government officials. Few Brazilians paid taxes, because they didn’t have any confidence in their representative government. But tax receipts in Brazil have been rising for many years, and the government’s finances have been improving dramatically, as Eric Fry pointed out in yesterday’s edition of the Daily Reckoning.
It’s very unfortunate that U.S. policymakers don’t recognize that their actions resemble those of Brazilian policymakers in the 1980s and 1990s. Trust is vital to markets and capitalism. It must be earned over time. Once it’s lost, trouble always ensues.
T-bond buyers beware!