Dear Clients and Friends:
The Debt Crisis
"You can always count on Americans to do the right thing – after they’ve tried everything else." – Winston Churchill, Prime Minister of Great Britain
I came across this quote recently and it seemed to sum up our exhaustive search for painless solutions to the most serious financial crisis this country has faced since the Great Depression.
The apex of the Great Recession may be behind us, but the road to sustainable recovery seems as long off as true love to an adolescent.
We are sure that many of you are as frustrated as we are. How could a nation full of such talent and resources be incapable of meeting our challenges? As individuals, and as a nation, we seem capable of addressing problems only when necessary, as if putting them off will somehow make them go away.
If you throw a frog into a pot of boiling water, it will jump out. If you place a frog into a pot of mild water and slowly raise its temperature, the frog will slowly boil to death. The ineffectiveness of this country’s leaders and the complacency of their constituencies remind us of the frog experiment. From year to year our revenue and spending imbalances were largely ignored. In addition, our growing obligations to Social Security, pensions, and medical costs have been to borrow a current phrase, "kicked down the road." As John Maudin points out in his new book, Endgame – The End Of The Debt Supercycle And How It Changes Everything, we cannot count on some bell going off that we have reached the tipping point for our nation’s financial survival. At some point, one more grain of sand is enough to topple the mound of confidence.
As this is being written, there has been no compromise between increasing the nation’s credit card line, also known as the national debt, and a plan to decrease debt going forward. At least there is plenty of light being cast on the problem - the necessary first step in cleaning up any mess.
The current national debt is over $14 trillion. We are spending 40% more than we are taking in. It’s time our leaders get busy.
Investment Considerations & Strategy
Globalization and Financial Interdependencies
There is an old saying that when the U.S. sneezes, the world catches a cold. As the world progresses, it further advances the "we are all in it together" concept. Globalization has been accelerated as a result of technology and financial innovation. While this has been a positive phenomenon as people can more easily do business with others half way across the globe, it also comes with strings attached. The easy flow of capital from one country to another, the unintended consequences of financially engineered products (derivatives), lack of uniform business rules and regulations, and geopolitical risk will ultimately lead to greater market disruptions. The financial crisis of 2008 may be an outlier in terms of severity, but the interdependencies of the global financial world will increase the likelihood of a domino effect during times of crisis, even in countries that may seem far removed. Economies, and therefore, stock markets will display greater correlation.
The financial crisis was not the result of a single event. It was the culmination of over indebtedness and rising asset prices, which became self-reinforcing until we finally reached a tipping point. While the market has recovered most of the losses since 2008, it has done so on the back of an unprecedented financial "experiment" by lawmakers in an effort to re-flate asset prices (to stave off deflation). We can debate as to whether the huge monetary and fiscal stimulus was necessary and how we amassed so much debt, but that would be a pointless exercise. We are where we are. At the end of the day, a period of adjustment will be needed to bring both private and public debt down to a reasonable level, when compared to the size of the economy. We should expect lower average economic growth as debt pay down dampers end demand. This is true not just in the U.S., but in most developed nations, and is the result of a "live in the present" versus "sacrificing for the future" mentality.
High debt creates a less stable environment, which serves as a breeding ground for market disruptions. It’s the equivalent of building a house with a faulty foundation. Without structural reinforcement, the house has a greater risk of collapsing.
Policy Responses (Government Action)
The current debt ceiling "crisis" in Washington represents political risk at its finest. However, it does present an opportunity to make the necessary adjustments to counter the massive buildup of public debt. In our opinion, a proper policy response would be to: 1) layout a reasonable plan for long-term debt reduction and 2) avoid making immediate cuts that are so significant as to land us back into a recession. Depending on one’s political slant, it is arguable as to how much of the debt reduction should come from tax revenues versus spending cuts. While the markets may become increasingly volatile as the deadline approaches for fear of a political stalemate, the longer term impact will be based on the palatability of the deficit reduction plan, not the near term default scare. Again, it is the long view that should be kept in mind here.
Inflation/Deflation Tug of War
The threats of high inflation (rising prices) and deflation (falling prices) seem to be of equal concern. A high run-up in debt and subsequent pay down creates heavy downward pressure on future demand by the end buyer of goods or services, which is deflationary. An easy way to think about this is to bring it down to the household level. Consumption (demand) is affected by three things: income, savings, and borrowing. Higher income, a reduction in savings, and an increase in debt, all increase the ability to consume more (increasing demand). A reduction in income, increased savings rate, and debt reduction, reduces the ability to consume (reduces demand).
The existing high unemployment rate dampens aggregate national income growth. Personal savings need to increase and debts need to be reduced. This is a recipe for lower demand and consumption.
Deflation is considered the worst outcome as it increases the relative value of our debt (asset prices and income fall, but debt is unaffected). Our government has and will continue to combat deflation. Theoretically, a government able to borrow in its own currency can create inflation, if that is the desired outcome. The probability of inflation builds as debt levels rise. Just as deflation reduces asset prices and income, inflation increases asset prices and nominal income. In both cases, debt stays the same.
Stock Prices (valuation as measured by P/E)
One of the most widely respected measures of stock market valuation is Robert Shiller’s cyclically adjusted price-to-earnings ratio (CAPE), which normalizes earnings to remove outliers (Calculation: Current Price of the Market as measured by the S&P 500 divided by normalized earnings). It currently stands at 23 (investors are paying $23 for a normalized annual earnings of $1 per share), which is high by historical standards. Prior 20-year periods that started with a CAPE at 23 or higher produced well below average returns. The most recent 20-year period with a starting CAPE above 23 is still in the works. It started in July of 1995. The annualized return of the S&P 500 since that time has been 7.62%, well below the long-term average of around 10%. In every other 20- year period that CAPE started at 23, it ended well below that number. To get back to the average CAPE of 16, earnings would either have to grow at a rate of 7% per year for 5 years, with no price change in the market, or the market would have to drop by 30%. While this data is quite sobering, there is a subset of the S&P 500 that trades at reasonable valuations: High quality large capitalized U.S. multinationals.
While our specific recommended allocation for each client will depend on the client’s particular circumstances, it will be heavily influenced by the broad considerations above. To summarize:
1) Financial innovation and technology have made the world more connected. This creates economic, and therefore, market links that did not exist in the past. Consequently, countries that have not mattered much economically to the global economy now do.
2) Developed economies, on the whole, are overburdened with debt due to financial innovation, private debt accumulation, and the financial crisis that ensued. End demand will drop as a result of debt servicing requirements.
3) Policy responses from governments will be magnified based on the less stable environment caused by ballooning debt.
4) There is a tug of war between deflation and inflation. Either scenario causes P/E contraction. The best environment for financial assets is low to moderate inflation. We believe this is at risk.
5) The S&P 500 is expensive when measured by CAPE, which has proved to be a reliable indicator. However, there is a subset within the S&P 500 that is priced at a reasonable level.
We believe that the risk/reward tradeoff in the equity market warrants a reduction. This will be accomplished in two ways: 1) we are making an across the board cut in equities by 15% into high quality fixed income and 2) we are replacing one of our more aggressive equity funds with one that has better downside protection (and also less upside exposure). Specifically, we will be selling all shares of Dodge & Cox International Stock and Dodge & Cox Global Stock funds and adding the proceeds into the DoubleLine Core Fixed Income Fund I. Also, we will be adding First Eagle U.S. Value and eliminating JP Morgan U.S. Large Cap Core Plus Fund, or an index fund equivalent.
In addition, we are shifting exposure from lower quality, longer duration bonds into short to intermediate term high quality bonds. Specifically, we will be reducing Loomis Sayles Bond and investing the proceeds into the DoubleLine Core Fixed Income Fund I.
The balance of any additional trading will not be substantial, as it is being done for rebalancing purposes to align portfolios to targeted weightings.
We have enclosed fund information on both the DoubleLine and First Eagle funds for your review.
We continue to work daily to earn your trust and confidence.
Vincent A. Schiavi, CFP®, CPA/ PFS Ravi P. Dattani, CFP®, CPA