Posted by Joseph Y. Calhoun, III
Thinking Things Over
Musings on the Markets from Inside the Beltway
By John L. Chapman
Vol. I, No.2
07/31/11
In this note:
“Balance sheet-” versus “Aggregate demand-” recessions: is there a difference, and does it matter for investors? What is our investment strategy in light of our findings?
Two days before the debt ceiling “deadline”, it appears the two major parties are close on a deal. ABC News is reporting the following outlines:
- A debt ceiling increase of $2.1 to $2.4 trillion (depending on the size of the spending cuts agreed to in the final deal).
- Spending cuts of roughly $1.2 trillion over 10 years.
- The formation of a special Congressional committee (likely a “Gang of 12”) to recommend further deficit reduction of up to $1.6 trillion (whatever it takes to add up to the total of the debt ceiling increase)
- This deficit reduction could take the form of spending cuts, tax increases or both
- The special committee must make recommendations by late November (before Congress’ Thanksgiving recess)
- If Congress does not approve those cuts by December 23, automatic across-the-board cuts go into effect, including cuts to Defense and Medicare
- Cuts in Medicare will be on providers and not on beneficiaries.
- This “trigger” is designed to force action on the deficit reduction committee’s recommendations by making the alternative painful to both Democrats and Republicans. For example, Republicans could be forced into accepting either tax increases, or automatic cuts in Defense spending.
- A vote, in both the House and Senate, on a balanced budget amendment.
Our brief comments are as follows:
- With the exception of the Balanced Budget Amendment vote, this is pretty well exactly what Dick Morris predicted it would be the other day, and we are continually amazed at Morris’ perspicacity when it comes to the “inside political game” in this town. Having met many of the so-called Beltway pundits personally, we can assure our Alhambra family, stay in touch with Morris (www.dickmorris.com) if one wants deep insights into the reality here. Morris is not without his biases, and he does not bat 1.000 by any means, so we always caution readers to think through what he is saying and why. But that said, he does hit .600 or more, and that is far above anyone else we have met in town here.
- We will leave dissection of “winners” and “losers” in this political game to people like Morris, but from an investment standpoint, we are of two minds:
- The great economist Thomas Sowell is almost certainly correct that the debt ceiling law ought to be repealed. From a cost/benefit perspective, it is ineffective: it is pushed back every time it is broached, and will be again in 2013 when the debt hits $16.7 trillion, around the new “limit”. And indeed, it might be counterproductive to have it as statutory law: it clearly has no real effect on the credit ratings assigned to U.S. government debt (see below). Meanwhile, when it is approached, the incumbent party demands an increase, while the opposition party may balk, depending on the political moment. But the opposition cannot be seen to be permitting a “default” (again, this was demagoguery, as there was never a chance that interest would not be paid or maturity capital not returned to U.S. bondholders), and thus they always sign on in the end to the incumbent’s desires for an increase — often, as is the case here, therefore ratifying the outsized spending programs of the incumbent. At least with no law in place at all, any incumbent pushing continued spending increases against the will of the opposition “owns” the spending, for good or ill. Indeed the law may fuel spending to the degree it provides a ruse for the political class – both parties – to appear to have constraints in place, but indeed are able to continue ramping up federal spending unabated.
- This episode alarms us for the long run for what it says about the depth of the “brokenness” of our politics. Two-thirds of the American people are exorcised by this issue and against more federal debt, and a significant election last November was centered on this as a core issue. In theory there was momentum to force more discipline on Washington. But in the end, the “cuts” are mostly phony, indeed non-existent, mere lowering of the arc of baseline increase. It is telling that when this passes, it is likely that House Republicans will mostly vote against this, and it will pass narrowly thanks to all Democrats voting for it with Boehner and a very few of his colleagues. The Senate will pass it mainly along party lines though some Republicans (e.g., John McCain, Scott Brown) will vote for it; while Democrats running for reelection in 2012 will vote against it (e.g., Claire McCaskill, Sherrod Brown). This will provide cover for them to say they are for fiscal austerity. It is episodes like this that give us confidence that gold at $1630 is still cheap, long term; that is to say, we fear for the U.S. economy in the long run if this runaway spending train is not curtailed.
- We see it as a near certainty that one of the Big Three ratings agencies will downgrade U.S. debt; but not all will. We believe there is collusion on this matter between them, with the tacit knowledge of the SEC and U.S. Treasury authorities, who seek to limit any volatility across the maturity spectrum. This is the continuation of a slow water torture for the U.S. bond market and the dollar, and the collective Fed/Treasury policy here, of being the “tallest midget in the room”, is a fool’s errand, long term (more on this over time, as this is a major theme of our research moving forward and informs our investment decisions).
- The only other thing to say is, this was a missed opportunity for all. What if a “grand bargain” had been reached here, with Reagan-Tip O’Neill type drama per their 1986 tax rate cuts and loophole closings, coupled with deep spending cuts. It is merely a fantasy given the actors, but equities and bonds and the dollar would have all rallied strongly. All of that will happen – but perhaps only after a collapse.
In closing, our research has us reading a great deal lately at the intersection of three different “literatures”, which all converged this week in this debt ceiling issue: (1) monetary reform based on gold (and specifically, for the gold enthusiasts here, the viability of the recommendations set forth in the latter part of the 1953 edition of Theory of Money and Credit, by Ludwig von Mises – more on this in the time ahead in detail, as a gold-linked dollar is axiomatic before this decade is out), and elimination or at least curtailment of Federal Reserve power; (2) the nature of recessions based on drop in aggregate demand versus those caused by bubbles and financial market crashes (and whether that distinction is real, or important, see next week); and (3) government spending and control thereof in a constitutional republic which over time has morphed into a democracy (as classically understood – and discerning readers understand the distinction).
The conclusion is that this country is in trouble now because not only is the political system broken, but there seems to be little ability to force the bipartisan political “elites” to do what is in our interest – but for the most part not theirs – to end this economic torpor. It is not a hopeless situation and it is a fight worth having, as the history of economics and economic theory clearly point to what policy needs to be to turn things around. And by “trouble” we mean, for investors, higher volatility, lower long term real returns, and more frequent recessions (if indeed we are now in a recovery of two years). But we earn our fees at Alhambra scanning the globe to defend against this environment, and so shall.
Even in the 20-year sclerosis that has been Japan, or the high-unemployment welfare states of Western Europe, life muddles along (albeit they have done so always able to import American progress, as a general matter, allowing them to live with many of their own fiscal “sins”; alas, there is no United States-like engine to backstop us once we backslide to a permanently-lowered standard of living trajectory, if that is our fate), and there are winning investment strategies that at least preserve capital accumulated over time: this remains our focus. But readers should know, a hundred year call on a day of reckoning first elicited by Woodrow Wilson, and enshrined by big spenders such as FDR, LBJ, Nixon et al., is now soon approaching, given the entitlement and demographic math we face in the years ahead.
II. Investing in China
We will have much to say in time about China, holder of $1.15 trillion in U.S Treasury debt and seemingly an endless trade surplus country. But we offer here a preliminary thought on how we will frame our thinking about opportunities there. Many of the world’s best and most famous investors are in China and bullish on its economy long term. Jim Rogers, who moved there (to Singapore). Warren Buffett. KKR. Well-known economists and ardent pro-free market supporters such as Nobel winner Bob Mundell, John Rutledge, and Jim Dorn are all bullish long term. So it has become conventional wisdom that China offers an ex-U.S. opportunity, where needed, which can diversify away from dollar assets and co-opt the years of 9-10% growth. It is important to understand China, if the U.S. is indeed in a “new normal” of 2% (or less) GDP growth indefinitely.
In truth, China has been good to Alhambra portfolios, but what of the future there, and how to play it?
We have concerns, so will step into this closely, but are watching:
- A third round of non-performing loans in its banking system; clearly there has been significant mal-invested capital in China, the losses of which have not yet been booked
- The threat of domestic inflation, as the Bank of China has expanded pari passu with the Federal Reserve.
- An over-extended real estate market in many major cities
- Municipal debt problems that, while opaque, are known to be significant. Bloomberg ran an article July 21 about the Olympic sports complex being built at Loudi, a city of four million people in Hunan, replete with a 30,000 seat stadium, swimming complex, and landscaped sunken concrete Olympic rings – with no prospective Olympic Games in sight. The city sold a $185 million bond issue, and intends to pay off this debt via sales of wildly overvalued municipal land (i.e., the land there is valued at $1.5 mm per acre with per capita annual incomes of $2300). The city may feel Beijing will bail them out in the event of a negative cash flow problem, but if so, this has repercussions for the value of U.S. assets which would be sold.
- Residential land values have dropped 30% this year and many Chinese banks and mutual funds that own debt collateralized by this land will realize significant losses – at least $75 billion, says Standard Chartered.
Hence, there are warning signs. Our larger long-term concern about investment there at this point is macroeconomic: China, in our view, cannot be fully modern until it is more fully Western. Here we do not refer to any sort of cultural jingoism; indeed, we respect the historic nature of Confucian and later dynastic China. But the West IS modernity, because the West IS civilization itself. The West is not a place, so much as it is an IDEA, or rather, bundle of ideas wrapped around a core concept: the sacred worth of the individual. The West in this sense has venerable historical antecedents: the Roman republic, Greece, Magna Carta, English Common Law, John Locke, all of which were progenitors of a society built upon the primordial worth of the individual. And what flows from the individual? Liberty, property, the rule of law, limited government, viz., the institutional conditions under which civilized life can flourish – and, for our narrow purposes, by which open and liquid and transparent capital markets can fully develop.
This is why, for the most part, the rest of the world emulates what happens or develops in the United States, and not the other way around. This is NOT to say that Americans are any better than anyone else, or smarter, or work harder. But Western civilization is an IMMENSE idea and fact, and the U.S. is the epicenter of it. To say all this colloquially, here as nowhere else, human beings can chase their dreams and become whom they wish, subject only to the physical constraints of the universe. Self-determination in liberty is a dear thing – in the sense of rare – and it is worth propagating to the rest of the world as able, including China, which has enormous promise.
Given this as an “undergirding” for investment, we will move slowly. While we are already and will be selective there for now, the political environment matters. In contrast to China, we have fewer fears in Japan, South Korea, and Taiwan. All are “Western’ in the sense they have imported Western institutions to a significant degree: rule of law, rights of free speech, parliamentary democracy, and Western cultural proclivities, such as respect and equal treatment of women, greater class mobility and tolerance, et al. Indeed, to the degree a country is NOT as modern as others, e.g., in Asia, say, Indonesia, it is because it is not as “Western”. To say this differently, non-Western societies are institutionally inferior precisely because they are more illiberal politically.
In time, we agree China will more fully “Westernize”: baseball, McDonald’s, Coca-Cola and the like are already there, and all this can only portend political liberalization, which ensures more foreign direct investment. But for now, the level of state intervention is so significant, that for Alhambra it is a case-by-case analysis with respect to any further diversification there. Certainly the hope is that China’s liberalization is per force sooner in time rather than later, as it can then help lead a revival of world growth in the years ahead.
Dr. Chapman, an economist with Hill & Cutler Co. in Washington, D.C., is an advisor to Alhambra Investment Partners’ family of actively managed portfolios as well as a contributor to Alhambra’s research services. He and Alhambra founder Joe Calhoun are writing a book on how to invest and preserve wealth in today’s complex and turbulent markets.
