”Sleepwalking Toward a Precipice”: Our Observations and Outlook, Part I

February 26, 2012

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Foreword from dshort: Jason Leach, the Director of Research/Portfolio Management at Craven Brothers Wealth Advisors, sent me a PDF of his latest research — Sleepwalking Toward a Precipice: Our Observations and Outlook, Part I.

Jason kindly granted me permission to share with the Advisor Perspectives audience. The illustrations in the PDF are priceless, so be sure to download and view the PDF format. Below is a snapshot of one of the PDF pages followed by a reprint of the full text without illustrations.

Click for a larger image

What We Will Cover…

It’s Structural: The credit crisis and Great Recession revealed structural problems in the United States, Europe and China which may hinder their future growth prospects.
Political Dysfunction: Political leadership has been unwilling or unable to address these structural issues effectively, resulting in temporary, expedient solutions that often make problems worse.

Fourth Branch Solutions: With the failure of political leadership, “central planning” has been ceded to central banks to “reflate” markets and reliquify insolvent banking systems and insolvent sovereign nations.

The Unknowns: Given the fragile nature of global economies coming out of crisis, a variety of uncertainties could also negatively impact growth.

Market Matters: Over the next decade, we see “double-wide” possibilities for economic growth translating into “double-wide” possibilities for U.S. and global markets.

What follows is Part I of our outlook on economies and markets. It educates and influences our investment approach which we discuss in the final of three outlook installments. We hope you enjoy.

2011 Market Recap: “Much Ado Then Nothing”

Headline Drivers: 2011 was an uncertain time across the world with headlines driving markets up and down in “risk on” and “risk off” trends that lasted hours, days, or weeks, but inevitably turned from “on” to “off” and back again.

Home on the Range to Unchanged: During the first half of the year, the S&P 500 index traded up (1260-1360 range). Sentiment turned negative in the second half with the index trading down violently (1120-1260 range). Remarkably, given a 20% swing from April highs to October lows, the S&P 500 ended the year unchanged.

“Wake Up Little Vixie”: Markets grew complacent over the last six weeks of the year with the S&P 500 Volatility Index (VIX) falling precipitously. The Federal Reserve and European Central Bank had eased markets’ fears with hundreds of billions in liquidity.

“All this Talk about Growth”

What is Growth?: Growth generally refers to growth in gross domestic product (GDP), which is the sum total of economic output of an economy. There are several different ways to look at GDP, including expenditures by different segments of the economy and changes in productivity and population growth.

Why is Growth Important?: Over the long term, GDP growth is highly positively correlated with corporate revenues and thus earnings. Since markets largely trade on P/E multiples, which depend on earnings, over the long term, higher markets require higher GDP.

The Virtuous Cycle: Although the U.S. is a personal consumption-heavy economy (~70% of GDP), it is important to note that personal consumption is an outcome of business hiring. The idea that consumption drives growth is a fallacy. Another is that government has no role – it should provide certainty and means for business to thrive.

“Pax Americana” (1987-2007)

The Fight Card: During the longest uninterrupted U.S. GDP expansion on record, from 1991-2001, many economists, including Ben Bernanke, began to subscribe to the view that the volatility of the business cycle (i.e., expansion, peak, contraction, recession) had been overcome in a “Great Moderation.”

The Fight: The defeat of the business cycle was largely attributed to a more active Federal Reserve, financial deregulation (allowing for mergers) and “financial innovation” (the “merged” creating complex securities). Secondary drivers included the “peace dividend” from the fall of the Soviet Union, oil prices falling by over half from the 1980s and a budding information age spurring business efficiency.

Pax Americana: In the “new economy”, frequency and severity of recessions would be less, GDP growth would trend in the 3%+ range, unemployment would generally stand at the 5%-6% “full employment” rate and inflation could be contained below 3%. Many economists believed the world was in a period of peace and certainty ? a “Pax Americana” of sorts.

“The Flood” (2008-2009)

Debt Accumulo-Nimbus: We now know that much of the U.S.’ prosperity was brought about by a massive expansion of bad credit and accumulation of too much debt on the part of consumers, states, and financial institutions, which inflated GDP growth for over 20 years.

Debt-Luge: During the “balance sheet recession” that followed, credit stopped flowing, consumers, businesses and states began to deleverage, GDP shrank twice as far as previous recessions (-5%), unemployment rose twice as high (10%), and the U.S. experienced the first period of deflation since just after World War II (-2%).

Debt-Tharsis: In the first several years of recovery, GDP growth was half as robust as normal (averaging 2.5% as compared with 5% rebounds in previous recoveries), unemployment remained higher for longer than any time since the Great Depression (8%-10%), and business and consumer sentiment remained at historically low levels far after the recession was deemed “over.”

“The Big Reveal” (2009-?)

Masked by decades of easy credit and debt accumulation, the credit crisis and Great Recession revealed negative structural changes in the U.S. economy and government.

The Vanishing Factory: The ceding of U.S. manufacturing to “Asian Tiger” economies resulted in a shift from a high-wage manufacturing-based economy to a lower wage service-based economy, contributing to a declining middle class, structural (i.e., long-term) unemployment, and slowing U.S. dominance in invention and innovation.

Restoration Infrastructure: Since the mid-1960s, share of U.S. government spending on infrastructure, R&D and defense has more than halved while entitlement spending has doubled. U.S. infrastructure grades out at a “D”, ranks 23rd in the world in quality, costs the economy over $200 billion a year in bottlenecks and delays and needs over $1 trillion in additional funding over the next five years. Meanwhile, entitlement spending is in the red by roughly $1 trillion per year (i.e., revenues less expenses).

The Great Escape: The U.S. tax system is: (i) immensely complicated (over 70,000 pages vs. 16,500 in 1969), (ii) misaligned (incentivizes debt-fueled consumption), (iii) uncompetitive (2nd highest corporate tax rate in OECD and highest “repatriation tax” of overseas profits), and (iv) gives away too much (tax deductions approximate $1.2 trillion, roughly the size of the entire budget deficit each year since 2008, and 7X the size of the deficit pre-crisis).

The Switch: Since the U.S. de-linked the U.S. dollar from gold in the early 1970s and especially since financial deregulation and financial “innovation” unleashed massive credit expansion in the 1990s, “normal” business cycles that create more value than they destroy have effectively been replaced with distorted credit cycles that destroy more value than they create.

The Big Reveal: The perpetual 3%+ GDP growth believed to be a certainty is in fact a 2% GDP economy reliant on a boom-bust credit cycle of Federal Reserve money supply and financial system credit expansion and, in the current Age of Deleveraging, reliant on temporary and costly federal government stimulus.

“Trillion Dollar Sam”: We Can Rebuild Him!

In a Nutshell: Annually, the U.S. allows $1 trillion in tax breaks and runs a $1 trillion shortfall in the entitlement budget, resulting in $1 trillion budget deficits, and borrowing of $1 trillion to fund them. The U.S. can’t afford the services it provides its citizens. Trillion dollar annual deficits have driven U.S. public debt/GDP over 100%, which may shave 1% per year off GDP growth, and the infrastructure to grow GDP is in disrepair.

Trillion Dollar Sam Plan: The U.S. needs to reverse the trend in entitlements “crowding out” pillars for growth. A private/public financed $1.2 trillion 5-year plan addressing unfunded infrastructure needs could yield up to 7% annual GDP growth and millions of jobs. At the same time, there must also be comprehensive reform in entitlements (retirement age, incentives), regulation (rationalize), taxes (mfg. incentives, lower corp. rates, loopholes), politics (campaign finance, lobbying), finance (housing, replace Dodd-Frank with Glass-Steagall II), and logical energy policy. Bottom line, the U.S. needs a comprehensive “Trillion Dollar Sam” plan.

“Dysfunction Junction, What’s Your Function?”

The Six Month Window: In recent years, the staggered election structure our forefathers put in place to prevent major change has done its job too well. The window for structurally impactful legislation is often open for just one (maybe two) 6-month windows during a presidential term. Clinton’s tax hike (’93), Bush’s cuts (’01), and health care reform (’09) were all passed in the window before mid-term elections. The balance of a term generally yields small policy (e.g., “Botox Economy”) not “Trillion Dollar Sam” overhaul.

Fireside Spats & Rebels Without a Cause: The increasingly polarized nature of Washington began in the late ’60s and ’70s with new primary systems, state redistricting, and incumbents becoming more entrenched and ideologically extreme. The moderate “middle” virtually disappeared in 2010 mid-terms and extreme polarization set in around entitlements and taxes. Less legislation was passed in 2011 than at any time in nearly a century.

Dysfunction Junction, What’s Your Function?: Due to these factors plus the influence of special interests (12,964 registered lobbyists spent a record $3.51 billion in 2010), a “Trillion Dollar Sam” plan is doubtful. Continuous gridlock, haphazard austerity, and debt/GDP growing to well over 100% are more likely, all of which will weigh on GDP growth.

The Fourth Branch of Government: “Don’t Just Do Something, Stand There.”

Fed-ergizer Formation: The Fed has progressively accumulated power since its formation in 1913. Like so many structural problems in the U.S., Fed Power amped up 40 years ago when Nixon abandoned the Bretton Woods system, was bolstered during Greenspan and Bernanke’s supposed “Great Moderation”, and was capped off by the 2008 credit crisis.

“The Capital Mis-Allocation & Market Distortion Device“: With no “anchor” to gold and a fractional reserve banking system, the Fed can create as much money and credit as it desires.

During “good times”, the result is markets fueled by excess credit and capital misallocated to speculation rather than “higher end” uses such as purchase of equipment, hiring and building businesses. When leveraged asset prices decline, more value is lost than was originally invested.

During crisis, Fed actions to save insolvent banks (loans, dollar swaps, 0.25% interest on reserves) prevents deposits and employees from moving to solvent banks (i.e., “creative destruction”) that could stimulate growth. And, quantitative easing (“QE”) measures intended to (i) improve insolvent balance sheets, (ii) lower mortgage rates, and (iii) boost stock market values are futile due to the amount of bad assets banks have, increased regulatory scrutiny of new loans, reluctance to refinance profitable mortgages, consumer deleveraging, and markets deflating when QE programs end.

Post-crisis, “financial repression” via zero interest rate policy, twist, etc., lowers profitability for banks, stymies growth, incents savers to seek out risky products with leverage, incents “innovators” to produce them, and potentially sows the seeds of a new destructive credit cycle.

To Recap?

With (i) numerous structural issues, (ii) the current inability /unwillingness of Washington to implement growth-oriented change/reforms, and (iii) an overactive, distortionary “fourth branch” central bank, U.S. growth, and thus market, prospects are doubly uncertain. Investing in U.S. markets requires tailoring an approach that can profit in spite of these uncertainties which we will address in the final installment of our outlook.

Next, we’ll examine structural issues and growth prospects across the pond. We will see you there.