Market Outlook: January 10, 2012

NEW YEAR, OLD PROBLEMS

For as long as humankind has celebrated the New Year, we’ve had hopes and expectations associated with this symbolic spot on the calendar. We all wish for fresh starts, and investors are no exception. This year, it is especially tempting to want to leave the past twelve months behind. Investors were beset by enormous challenges in 2011: the burdens of paying down a staggering global debt, the uncertain footing of the euro, and the slowing growth rates in China and other emerging markets. It is natural, then, to hope for better in 2012. The truth, however, is that the next several quarters will likely present us with a familiar set of economic challenges. Instead of a clean slate, we’ll have a continuation of several worrying trends. The good news is that we’re smarter now, or perhaps wiser, than we were this time last year. And if we keep the right investment mindset, we just might get one step closer to realizing the goal of a happy and prosperous New Year.

In our discussion of today’s economic landscape, let us start with the aggregation of global debt in relation to GDP: a process many years in the making. Figure 1 displays the rise in government debt for the largest developed countries. In the global financial crisis of 2008-2009, much of this debt shifted from the private sector, particularly the financial segment, to the public sector. Additional fiscal stimulus was undertaken to offset the collapse in private sector demand thereby adding to the growth in overall debt as well. These actions were necessary to buy time to deal with a potentially catastrophic situation, but the end result was and continues to be an over-leveraged world burdened by significant deflationary pressures. In an attempt to restore balance to the global economy, some countries in the developed world have enacted fiscal policies geared toward austerity, but there is little evidence to suggest these policies are working (This is the Paradox of Thrift1 at work.)

The debt burden illustrated in Figure 1 has important implications for the growth outlook in the developed world. In Ken Rogoff and Carmen Reinhart’s landmark book, This Time is Different, their data show that when a nation’s sovereign debt reaches 90% of GDP, structural unemployment rises and future real growth rates are affected negatively by 100 to 150 basis points.

We can therefore assume that an escape from this debt quagmire will require sustainable growth in real GDP. Real GDP is driven by two variables — growth in the work force and productivity. Demographics suggest there will be little growth in the workforce of the OECD countries over the next few years. Productivity has been mixed in these countries: for a while, it was trending mildly positive, but is now decelerating. The outlook for real GDP, then, is not particularly reassuring. We’re looking at 2% growth at best. On the bright side inflation should not pose much of a threat. The enormous supply of unemployed people and low factory operating rates plus the significantly negative OECD output gap (see Figure 2), will mitigate inflation risk going forward.

So far we have not discussed the impact of the euro crisis nor the outlook for emerging economies, particularly China. In brief, we believe the euro crisis aggravates the debt problem and the slowdown in growth for the emerging economies is real and inevitable given their need for exports to OECD countries.

With all due respect to the euro, it is going to cost an enormous amount of money to save it: approximately €3 trillion by our count. The consequences and potential costs of not saving the euro, however, vastly exceed the sum mentioned above. Talk about unintended consequences! The global financial system, with all of its linkages and counterparty risks, would be shaken to the core by the euro’s collapse. The good news is that most policy makers realize the euro must be rescued, no matter the price, and likely steps will include gestures toward a fiscal union that would allow quantitative easing and quite possibly the issue of a euro bond. Nevertheless, this nagging issue will hang around for most if not all of 2012, mitigating growth plans and slowing any nascent economic expansion.

In terms of emerging markets, growth rates here should slow considerably. China provides a good example. It remains a mercantilist model in which exports are critical for growth. Yet if the OECD economies grow little, what happens to this export model? The outcome cannot be positive.

China, then, must rebalance its economic model so that it relies less on exports and capital investment. These two components of GDP are 52% of the Chinese economy, and both are losing steam. The marginal efficiency of capital spending in China is based more on keeping people employed than earning an economic return. Thus, we expect a slowdown in China’s growth rate this year. Note, however, that even if the growth rate slips to five or six percent, the absolute increment to GDP remains very large. China, once again, will comprise the largest increment to global GDP in 2012. The rest of us will still be dealing with the consequences of three long decades of accumulated debt.

What should the investor do under these circumstances? In many respects, the answer depends on how policy makers deal with the debt issue. They have five broad policy options: default, devaluation, inflation, austerity or financial repression.

Austerity is already being pursued in a number of countries. Inflation is what many policy makers would like to see, but it is just not present today at the macro level given the very large output gaps that exist. Default and devaluation are loaded with unintended consequences. It is the fifth and final option, financial repression, which is being deployed by the central banks. By keeping interest rates at near zero across the entire system (preferably a negative rate if one uses the Taylor Rule2), savings will be gradually invested in risky assets or lost to inflation. With the savings in the private sector and the debt in the public sector, the government will attempt to transfer those savings to its balance sheet to resolve its debt obligations.

China, too, is practicing financial repression, and with certain unanticipated consequences. By slashing savings rates at the banks and allowing wage inflation of 15% or more, real estate speculation has increased, creating a bubble of large proportions.

In this environment, we have seen bonds perform well. In 2011, bonds surprised many pundits with very strong returns: 17% for 10-year U.S. Treasuries. Despite earnings yields for equities (E/P) at three times the level of bond yields, bonds beat equities handily. Can that happen again? Yes, if 2012 turns into a recession and global GDP declines. But if that is not the case, then equities will beat bonds.

Equities, after all, are a hedge against inflation and they capture productivity gains, unlike bonds. If deflation prevails, then bonds will provide competition for equities. Be assured, however, that every policy maker in the world wants inflation — not deflation — and economic policies (such as QE3 in the U.S. and a bail-out of the euro) will be implemented with this
in mind.

Simply put, investors should seek out bonds that look like equities and equities that look like bonds. Corporate bonds, for example, will fare better than sovereign bonds, as corporations have better balance sheets and more transparent financial statements. As for equities, the emphasis should be on “global champions.” These multi-national companies operate in industries with high barriers to entry and can reconfigure their factors of production and reposition their marketing efforts to parts of the world that are still growing. It is equally important to seek out companies with high-quality management teams, strong histories of successful capital allocation and consistent shareholder yield creation (i.e., cash dividends, share buybacks, and debt pay downs).

In other words, we may not be entering 2012 with a clean slate, but we are greeting the New Year with an investment strategy that can weather even the roughest economic conditions. With a bit of insight, and a lot of intelligence and luck from the world’s policy makers, we might be raising our glasses soon enough to an auspicious 2013.

¹ The Paradox of Thrift states that if everyone saves a larger part of their income, they will become poorer instead of richer because of a decline in consumption and economic growth. So while individual thrift is a virtue, collective thrift can hurt the economy.
² In 1993, economist John Taylor proposed a formula for setting U.S. monetary policy that takes into account output gaps and inflation. While the Federal Reserve does not explicitly follow the Taylor rule, the principle of tight policy in times of full employment and rising inflation and loose policy in times of recession and falling inflation has been thought to accurately describe Fed policy over the past three decades. The original formula takes on the simplified form:
i_t=1+1.5π_t + 0.5y_t*,where i_t is the Fed funds rate, π_t is the rate of inflation over the previous four quarters, and y_t* is the percent deviation of real GDP from potential GDP, the so called “output gap.”