The fixed income markets seem to have decided that economic growth will be slow, inflation will be non-existent and debt defaults are unlikely. Pretty much a “Goldilocks” scenario. Retail investors have bought into this scenario in a big way – pouring literally hundreds of billions of dollars of new investments into bond mutual funds in the latter part of 2009 and so far in 2010.
Until September, the equity markets couldn’t decide whether to go along with this “Goldilocks” theme. However, with talk from the Federal Reserve of “QE2”, the stock market finally joined the party. QE2 is not referring to an aging cruise ship but rather a second major round of “quantitative easing.” This is “Fed speak” for easing monetary policy further through direct Fed purchases of securities.
We are skeptical of this newfound optimism because the Fed has little ability to control the structural problems our economy faces. In a normal post recession period, the Fed’s current policies would have been more than sufficient to get the economy moving. Low interest rates would have stimulated consumers to buy houses and cars and businesses to respond by hiring people and making capital expenditures to meet this renewed demand. But things are different this time.
There are four pillars that inform our view that the U.S. economy will be stuck in low gear for a few years. First, the consumer continues to be overleveraged. After years of layering in more and more debt, consumers now need to pay down debt to get their financial houses in order. Indeed, they have been doing so either through repayments or defaults. Since peaking in July of 2008, the amount of consumer credit outstanding has been falling – not a sign of a healthy, growing economy.
Second, banks are overleveraged. This has come about in two ways – by regulators increasing the capital requirements and by customers not paying off loans as quickly as they did in the past. As a result, many banks are effectively out of the lending business until they too can get their balance sheets adjusted to the new regulatory model. Throw on top of this the pressure from bank regulators to write off any loan that looks potentially troublesome, and it will be a few years before banks will realistically be looking to expand their books of loans.
Third, the stock market declines of 2007-2009 had a deep impact on the retirement savings of baby boomers. As a result, many, if not most, will need to defer their plans to retire, increase their savings and extend their working careers.
Finally, governments are overleveraged. Just look at the massive federal debt that was incurred in 2008 and 2009 much of it in an effort to stave off the recession. Now that the fear of depression has passed, the staggering deficit has raised the debate about how big government should be and makes it less likely that additional spending “stimulus” will be forthcoming from the Federal Government.
Almost all fifty states face similarly difficult fiscal issues. Unlike the Federal Government, however, most states need to balance their budgets so they face large service (read, jobs!) cutbacks once federal stimulus money runs out next year. The real problem facing many state and local governments is that they have for too long over-promised and under-funded the liabilities for future pension and health care benefits. This problem will force several changes – a greater share of budgets devoted to funding, cutbacks in current retiree benefits and very significant reductions in new employee benefits.
All four pillars will result in a continuation of high unemployment and underemployment. Nearly eight million jobs were lost in the Great Recession and, with these four structural headwinds, we believe it will take a very long time before the economy returns to anything resembling full employment.
Is there any good news? Certainly. Corporations are in great shape – earnings are strong, balance sheets are solid and revenues appear to be growing. This is one of the reasons GDP is growing – business investment will continue as companies strive to make their operations more efficient while responding to limited consumer demand. If we could get some certainty surrounding tax policy and the costs of health care under the new scheme, we could see corporations expand their investments more and tiptoe back into the hiring market.
In addition, the low absolute level of interest rates is good for both businesses and consumers. Many large businesses have been able to lock in low cost, long term financing by issuing debt. And many consumers have seen their debt service costs come down significantly as rates on variable rate debt have plummeted.
We continually remind ourselves of the need to look at alternative viewpoints to make sure our sober view doesn’t miss the return of a strong cyclical recovery. Positive news can beget confidence which turns into optimism and then, before you know it, we are back to growth mode. Recently, the markets seem to think that we have enough positive news to sustain a recovery. And, if we don’t get positive news, the Federal Reserve will manufacture some. We are cautiously hoping that proves to be correct but investing as if the path may be bumpy.
Client portfolios remain relatively conservatively positioned, with significant over-weights to absolute return oriented investments. The fourth quarter will be dominated by election news and speculation about what may happen thereafter. For our part, we will be happy when we no longer have to listen to negative campaign ads. Now that should put everyone in a better mood!