December 20th, 2011
A Rising Tide of Instability
It's fair to say that since 2007, the overall level of instability has been rising. Like all things, there has been an ebb and flow, with periods of obvious stress, followed by windows of calm. But even during the periods of apparent calm, there has been an ongoing erosion taking place under the surface. The main protagonist has been an insufficient level of global economic growth. Although the global economy rebounded after the recession of 2008-2009, most of the developed economies were never quite strong enough to achieve a self sustaining recovery. The handful of countries that did reach healthy levels of growth (Brazil, China, India) were then forced to tighten monetary policy to offset inflation, which has slowed their economies in the second half of 2011. Follow up:
Follow up:The subsurface erosion first became evident in 2010 in those countries (PIGS) that were carrying too much debt and less than a "sure thing" chance of repaying their sovereign debt. Greece was the first poster child. The erosion of economic growth around the world during 2011 has exposed more countries as being vulnerable to a sovereign debt default, and now includes Italy, the third largest creditor in the world. Many believe that if the ECB would just consent to buying the sovereign bonds of the afflicted countries, Europe's sovereign debt problem would go away. Although markets would rally on any ECB bond buying news, the underlying problem would not be corrected. As we have maintained, the problem facing many of the countries in the E.U. is too much debt and too little growth. ECB bond buying would bring rates down in Italy in the short run, and that's a positive, but unless Italy is able to significantly grow its economy above its 10-year average of .28%, it won't matter in the long run. The onlyway out of the hole Italy has dug is if they are able to receive a haircut on their outstanding debt. This isn't going to happen, since it would crater the European banking system, which is already insolvent.
The debt to GDP growth problem that is bringing the European Union to its knees is no different than what we're facing in the United States and has contributed to two lost decades in Japan. In our August 2011 letter we asked, “What Happens When Fiscal and Monetary Policy Hit the Wall? More than 60% of global GDP comes from the countries in the European Union, United States, Japan, and Britain. Collectively, fiscal and monetary policy has hit the wall in these developed countries. The Federal Reserve lowered nominal rates to near 0% more than 3 years ago, and 'real' rates have been between -2.0% and -4.0%, when adjusted for inflation. Despite unprecedented accommodation, the U.S. economy has experienced its weakest 'recovery' since World War II, by far. Japan has been in a coma for 20 years, even though their short term rates have been near zero. We have no doubt the ECB will be joining the 0% rate club in 2012, and will be rewarded with the same results experienced by the U.S. and Japan.
Over the last 3 years, the U.S. has accumulated $4.5 trillion in deficits trying to stimulate our economy, as we have done after every other recession. It isn't working, and despite these unprecedented deficits, this recovery is the weakest since World War II. Japan's debt to GDP ratio is above 200%, as continuous fiscal stimulus since 1990 has failed to revive growth. In a number of the E.U. countries, fiscal deficits have driven up debt to GDP ratios to the breaking point. Germany and France sport debt to GDP ratios above 80%, which makes them hardly the model of fiscal health.
At last week's European Summit, leaders agreed to a new fiscal compact" that would bind members to reduce their budget deficits, or face the consequences. Sounds good as a press release, but there is a major problem with mandated fiscal austerity that goes beyond the issue of sovereignty. During a period of economic uncertainty, an individual who chooses to cut spending, pay down debt, and increase savings would be deemed prudent. However, when hundreds of millions of individuals collectively make the same prudent choice (or are forced to), it becomes more difficult for each individual to save more and pay down debt. If everyone else prudently spends less, economic growth will be weaker. As a result, the majority will experience less income growth, and be less able to push overall demand upward. And therein lies the paradox of thrift. In medieval times, a gauntlet was a form of punishment or torture in which people armed with sticks or other weapons arranged themselves in two lines facing each other and beat the person forced to run between them. The global bond market will continue to represent a Sovereign Debtor’s Gauntlet. In the next few years, the Paradox of Thrift will affect the 500 million people in the European Union, and most of the inhabitants will not like it.
Slower economic growth will hinder job creation throughout Europe, which won't reduce the ranks of the unemployed quick enough. Long term mass unemployment is the Witches Brew of discontent and revolution. As governments are forced to reduce aid to people who depend on their governments' support to live, governments risk an escalation of frustration, anger, and if left to simmer long enough, outrage that explodes in violence. This is not a good time to be a politician. In the last year, there have been seven governments voted out of office within the European Union, and a number of middle-east governments that have been toppled by violent revolutions. Global instability has been rising around the globe since 2007, and has manifested itself in many ways, including an increase in natural disasters, which caused a record $350 billion in damage in 2011. There is a bull market in instability. And, if instability continues to escalate in 2012 and 2013 as we expect, the amount of change experienced globally will be significant and rapid, and represent another crossroad and chapter in human history.
It’s Just Math
A pocket sized tape measure, Phillips screwdriver, Swiss army knife, and the Rule of 72 are indispensible in coping with life's smaller challenges. The Rule of 72 has a built in advantage though, since we don't have to remember where we put it after last using it, an aspect one appreciates more, as the years slip by. Next to the law of supply and demand, the Rule of 72 may be the second article of economics, since it reveals either the rate of return or the amount of time needed for an asset or liability to double. A 50-year old wants to know what rate of return must be earned for their retirement account to double, in order to retire by 60. Simple. 72 divided by 10 (years) = 7.2%. How long will it take for an investment to double in an annuity with a guaranteed annual return of 4%? No problem, 72 divided by 4(%) = 18 years.
As interest rates fell after 1981, consumers were able over time to add more debt and basically keep their monthly payments unchanged. The cost of servicing $1,000 of debt at 12% is about the same as servicing $2,000 of debt at 6%. As a percent of GDP, household debt rose from 44% to 98% between 1981 and 2007, an increase of 111%. The Rule of 72 indicates that household debt grew 3.1% faster per year than GDP, which gained an average of 2.7% between 1980 and 2010. This means that household debt growth chugged along at an annual rate of 5.8% for the 25 year period. As we can see, the lion's share in the increase in household debt occurred between 2000 and 2008, as home owners withdrew equity from their homes. As consumers used debt to buy cars, furniture, vacations, pay for college educations, and enjoy weekly trips to the mall, GDP grew faster between 1980 and 2010 than it would have without the household debt steroids. Since 2008, household debt, as a percent of GDP, has been receding as some consumers voluntarily choose to charge a bit less and pay down debt. In order for this healthy trend to continue, household debt will need to grow at a rate that is less than GDP for the next 5 to 10 years. We think it could take this long, since the ratio of household debt likely needs to fall to under 80% of GDP at a minimum, before the next long term sustainable economic expansion can take hold. If this consumer debt reduction unfolds, which we think it must, GDP will suffer a double whammy. GDP will grow significantly less than it did during the debt buildup phase between 1981 and 2010. In 1980, consumer spending represented 63.0% of GDP, and is now pushing 70%. This implies that the debt accumulation by consumers added almost 2.0% per year to GDP, especially after 2000, as home equity was withdrawn. Using one's home as an ATM, led to an explosion in household debt. Secondly, GDP growth will also be reduced as consumers cut spending to pay down debt and increase savings.
However, we must note, that more than half of the modest improvement in the household to debt ratio since 2008 has been through defaults on mortgages, credit cards, and auto loans. It would be far better, if households were capable of paying down their debt out of earnings, since defaults only further impair lenders. As we have noted many times, one of the fundamental weaknesses of this recovery is that disposable income growth has been lower than the cost of living for the 91% who do have a job. Wages have increased 1.8% from last year, while inflation has increased 3.6%.
Since 1950, the U.S. economy has averaged annual growth of 3.09%. The Rule of 72 tells us that our economy thus doubled in size every 24 years, and last year was roughly 4.8 times its size in 1950. Total government spending, which includes spending by the Federal government, and state and local governments, has climbed from 21% of GDP in 1950, to almost 40% of GDP today, as spending grew faster than GDP. How much faster? The Rule of 72 says total government spending has grown about 1.1% faster than GDP over the past 60 years, or 4.2% per year, versus GDP's average annual growth of 3.09%.
Income taxes were instituted in February 1913 with the passage of the aptly named Revenue Act of 1913. The initial tax rate was 1%. As the tax rate increased over the years, total federal taxes finally reached 20% of GDP in 1953 (Chart above). As GDP continued to grow after 1953, the relationship between GDP and the percent of federal tax receipts held. The relationship between federal taxes and GDP was first observed by W. Kurt Hauser of the Hoover Institute 20 years ago. The stability between federal taxes and GDP is remarkable since our country has been through numerous recessions and wars (Korean, Viet Nam, Afghanistan, Iraq, and the Cold War), and an ever changing tax code during the past 58 years. This suggests that our budget deficit problem has been more the result of spending than low taxes. By limiting total government spending to less than GDP growth, we can gradually shrink government spending as a percent of GDP, so it is less than 20% of GDP within 10 years.
Between 1965 and 1980, total U.S. debt, as a percent of GDP, held steady near 150% of GDP. This meant that for every $1.00 of GDP, the combined total of government, non-financial corporate and financial debt, and household debt was $1.50. As consumers piled on debt to maintain their lifestyle, and the federal government ran chronic budget deficits, the ratio of debt to GDP soared to its current level of $3.53 for each $1.00 of GDP. No one needs a degree in economics to understand that this is unsustainable. Furthermore, since 1965, each additioanl dollar of debt has progressively generated less than $1.00 of GDP. In the not too distant future, possibly as early as 2015, we will reach the point of no return. If we don‟t begin to curb government spending and total debt accumulation, we will go over the edge, just like Greece. It will happen sooner, rather than later, if our interest costs begin to rise. The Federal Reserve cannot buy enough government bonds through Quantitative Easing, to hold interest rates down, if global investors stop buying.
Thankfully, the solution is straightforward. We must establish policies that enhance GDP growth, while curbing the growth rate of debt, at both the government and household level, so it is less than GDP growth over the next 5 to 10 years. However, by also raising selected taxes, we will shorten the time it will take to get through this difficult period, and lessen the burden on those who truly need and depend on government assistance.
In the 1960's, the average CEO was paid 35 times the average workers' income. Last year, the CEO of a public company was paid 350 times the average worker's pay. We don't believe anyone is worth that much money to run a company. But, if the Board of Directors of a public company believes they must pay that much in compensation to attract "talent," and shareholders don't object, we see nothing wrong with it. At the same time, the gap in wages between the average working stiff and a CEO is just too large to ignore. The income for the top 1% reached 23.5% of total income in 2007, which is just a hair below the level reached in 1928. These income figures include capital gains and income from stock options, so their income levels fluctuate with the stock market. Although raising taxes on this elite group won't raise that much in taxes, it will serve as an appropriate symbol. The austerity that must be imposed on government spending will prove a hardship on almost half of the 300 million citizens in this country. For most of those in the top 1% of income, higher taxes will not represent an actual hardship.
Going forward, every year the rate of growth in government spending exceeds GDP growth, total government spending as a percent of GDP will edge higher. If the next 60 years mirrors the trends of the last 60 years, government spending as a percent of GDP will exceed 75% in 2070. But don't worry, the economy will collapse long before we reach that level! But if spending does reach 75%, Lenin won't be spinning in his grave, he'll be dancing. Next year is an election year, and as a nation, we must decide whether government spending should continue to grow faster than our economy. It is important to keep in mind that this discussion has almost nothing to do with one's political bias. It’s just math. This issue transcends every political party, since it goes to the heart of what the founding fathers and authors of our Constitution had in mind when they wrote about limited government. At what level of government spending is economic freedom compromised? It's the right question to be asked in the coming election year. We doubt that either party will bother to ask it, and they certainly won't answer it.
Global Economic Outlook
In our November letter, we reviewed the growth outlook for Europe and eastern European countries that are heavily dependent on lending from large European banks. We reviewed how Brazil, China, and India are all slowing, after each country tightened monetary policy. And we noted that the U.S. economy was getting a lift from the business investment tax credit, which is slated to expire on December 31. This tax credit is clearly pulling investment demand forward from the first half of 2012. GDP estimates for the fourth quarter have been rising toward 3% or higher, which has led many analysts to conclude the U.S. will not be materially affected by Europe. Our analysis from last month concluded with the following.
“World GDP in 2010 was 63 trillion, according to the International Monetary Fund. Of that total, the E.U., United States, China, Japan, Britain, Brazil, and India comprise more than 70% of world GDP, with the E.U. and the U.S. contributing almost 50%. Growth in every one of these countries is slowing, and much of the E.U. will be in a recession in 2012. The notion that the U.S. will be able to decouple from the global slowdown that will intensify in 2012 is pure fantasy.”
We believe the U.S. stock market is in a secular bear market that could last until 2014-2016, and could prove similar to the secular bear market that held the DJIA in a broad trading range during 1965-1982. This secular bear market could extend until 2020 or longer, since it is associated with the largest financial crisis in history that is global in its nature. The fiscal and monetary challenges we're facing are unprecedented, and may require more time to work through than the 17 years of the 1965-1982 experience.
Our investment model suggests the cyclical bull market from March 2009 has ended, and a new bear market has begun. If this macro analysis is correct, one or more declines of 25% to 35% will occur during the next five years, before the current secular bear market ends. Given the European banking crisis and the fragility of the recovery in the U.S., it is not hard to see the S&P 500 falling to 1040 or 950 in 2012. Investors should consider allocating a small portion of their portfolio to the Prudent Bear fund or the inverse S&P 500 ETF SH, especially if the S&P climbs above 1292. Both would rise in value as the market declines.
As long as the S&P holds above 1190, there is still the potential for the S&P to push above the late October high at 1292. Can the notion of the U.S. decoupling from Europe provide the fundamental reason investors need to buy U.S. stocks? Maybe. A more compelling factor would be an announcement by the ECB that it will buy European sovereign bonds more aggressively. Unfortunately, this seems like a long shot.
In our November letter we suggested buying TLT, which is the ETF that mirrors the yield on the 20-year Treasury bond. It traded as high as $125.03 on October 4, just as the stock market was making its low. “We think it will trade above $125.03. Add to the position if it drops below $115.00.” TLT never traded below $115.00. Use a close below $115.80 as a stop
In our May letter we recommended going long the Dollar via its ETF (UUP) at $21.56, and in our July 31 Special Update, we suggested adding to the UUP position below $20.91. A close above $22.62 should constitute a breakout, and set the stage for a rally above $24.00 in coming months. Use a close below $21.64 as a stop.
Since gold topped on September 6 at $1923, we have expected gold to decline to the September low of $1535.00. So far the low has been $1562.50. We recommended buying the gold ETF GLD if it fell below $154.00, which it did on December 14. We recommend selling 65% of the position now, for the following reason. From its September 6 high at $1923, gold dropped $388.00. An equal decline from the secondary high on November 8 at $1804, targets the potential of gold falling to $1416, if the second decline equals $388.00. If this decline develops, GLD would trade under $140.00. We will repurchase one-third of the GLD position at $145.00, and another one-third below $140.00.
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Macrotides is a monthly subscription newsletter written by a wealth manager associated with a major Wall Street investment bank. The author’s firm has requested that he not use his name to avoid any incorrect implication that his views might reflect those of the bank. The author has written investment advisory subscription newsletters based on macroeconomic analysis and market technicals for more than 20 years. Enquiries can be made email@example.com.