Future State

It took twenty years of over-consumption and living beyond their incomes for Americans to get to their current economic state; the elected officials in Washington, D.C., continue to hunt for a quick fix, one that just doesn’t exist.  Meanwhile, the economy keeps on lurching, and, at the same time, morphing into what it will look like in its future state as we move further away from the financial crisis and deeper and deeper into a slow growth economy.  In the near to intermediate term, the economy will, I believe, display a tendency for more frequent recessions.

The Consumer’s Financial Condition

The consumer is simply carrying too much debt.  In the U.S., consumption represents 70% of GDP, but the consumers’ debt/GDP ratio, which spurted from 100% in 2001 to more than 135% in 2008, still stands at 126%, nearly three years after the recession began.  Much of the 9 percentage point decline is due to financial institution write-offs as opposed to debt repayment, so it appears that the consumer has a long way to go to even get back to the 100% ratio.  Short of the government waiving its wand and pronouncing that all debt is now magically repaid, the next healthy economic upswing must await the healing of household balance sheets.

Unfortunately, to get a healthy consumer balance sheet, savings must increase to repay the debt, which leaves less for consumption.  Lower consumption means slower economic growth with all the attendant implications for employment.  This is known in the economics profession as “the paradox of thrift”.  Thus, to get back to a healthy and sustainable level of economic growth in which new jobs are created and the unemployment and underemployment rate falls will take much longer than we have experienced in any of the post-WWII recessions.  Unfortunately, the politicians want desperately for this to pass quickly, lest the electorate cast them out.  So, they promote ill conceived schemes that wind up only prolonging the agony – like “cash for clunkers” and the “homebuyer tax credit”.  These programs promote more debt which will have to be reduced in the future, so they simply wind up pulling demand forward at the expense of economic growth a quarter or two out, and prolonging the adjustment, as more debt now needs to be worked off.

Headwinds

For the next few years, until balance sheets are healed, economic growth will simply be sub-par.  Below is a discussion of some of the headwinds and their consequences.

• According to the U.S. Chamber of Commerce and National Federation of Independent Businesses, uncertainty as to economic policies, taxes, the cost of health care, new regulations in the financial reform bill, and the ongoing credit crunch are causing businesses to hold back on hiring.  But, even if this is resolved, the need to work off debt together with the loss of retirement income by the baby boomers will cause them to put off retirement for several years.  This will trickle down to the younger generation who will find it increasingly difficult to find satisfactory employment.  We will see the U6 unemployment measure (which counts the underemployed) continue to maintain a much wider spread against the traditional U3 measure of unemployment that it has over the last couple of decades.
• The purchase of big ticket items will be significantly impacted.  Houses and cars are the first items that come to mind.  Expect continued downward pressure on home prices, especially the high end homes, until the debt ratios are significantly reduced.  And, don’t expect auto sales in the U.S. to return to their former peaks anytime soon.  It is likely that they will continue to be below the replacement level of 12-13 million units per year required to keep the average age of the U.S. auto stock from climbing further than it already has.  Besides autos and homes, other big ticket items will continue to be impacted.  Travel and vacations will be closer to home; restaurant tickets, on average, will be lower.  So will just about every other consumer discretionary purchase.
• Financial institutions will continue to struggle.  John Hussman, in his July 12th blog, observed that while financial “operating profits” appear to have recovered (leading to large management bonuses), below the surface, large write-offs and one time charges continue.  And it is quite apparent from the state of the housing industry and from the condition of consumer balance sheets that large foreclosure related write-offs will continue.  Both David Rosenberg (Gluskin/Sheff) and Hussman point out that consumers continue to pay for the items that they absolutely need (their credit cards, cars and even their HELOCs), but many have simply stopped making their mortgage payments.  As a result, they have the cash to spend that they would have used to make those mortgage payments, thus giving consumption the slight lift we have seen in the last couple of quarters.  Sooner or later, however, that cash will have to go to rent as their foreclosures are consummated.  This will inevitably put even more downward pressure on the growth rate of consumption.
• For the larger financial institutions, write-downs will continue and capital raises will be necessary.  Meanwhile, smaller financial institutions have loan portfolio issues of their own.  These are the institutions that are the lenders to the local communities and to small businesses.  While some of these just won’t survive, the majority that do will be capital constrained, meaning that they won’t be able to increase their loan portfolios.  Unlike their big brother brethren, these institutions have little or no access to raise capital via Wall Street.  Thus, small businesses will continue to experience a credit crunch, and small business expansion, with its commensurate job creation, will continue to be non-existent.  This is clearly shown in the latest bank loan data.  Three years after the recession began, commercial and industrial loans in the banking system continue to rapidly contract.  Furthermore, the new financial legislation looks like it will put a crimp into large bank profits, and, at the same time, increase the already unmanageable regulatory burden on the nation’s community banks.
• The Treasury has become more and more dependent on the Wall Street banks to finance its exploding borrowing needs.  Because they are considered “safe”, no capital is required for banks to hold U.S. Treasury securities.  As long as the Fed promises to keep the Fed funds rate at 0%, the large banks can “borrow” from each other, from the Fed, or from the public (via deposits) at a near 0% rate and buy the 10 year “riskless” T-Note at 3%.  Why should they make risky loans to the private sector which require additional capital on the balance sheet?  Of course, the artificially “low” deposit rate is borne by the public; this is simply a continuation of the big bank bailout.
• Changes in state and local government finance are already manifesting themselves in reductions in force (i.e., layoffs), changes in wage and benefit policies, higher employee pension contributions, lower COLAs, and higher taxes and fees on the general population.  All of these actions dampen consumer demand.  It appears from the political climate that voters, at least at the local level, will make sure that their elected officials continue to reduce the cost of government.  And, it is likely that the electorate will send a clear message about trillion dollar deficits, about unchecked entitlement spending, and about general profligacy by Congress at the upcoming mid-term elections.

Bear Markets

In the 20^th century, in the investment arena, there were three bear markets.  They ranged in duration between 13 and 20 years with an average of 17 years.  The current bear market started in 2000; so, if history is any guide, this one won’t be over until sometime between 2013 and 2020.  Given the fact that the consumer is just beginning to repair his balance sheet, and given the lateness in policy maker recognition that more debt (or money thrown from helicopters) is not the answer, 2013 looks to me to be optimistic.

For the next few years, given the debt constraints on U.S. consumer budgets, the continued high unemployment expectation, the inevitability of growth slowing tax increases, the poor state of housing, continued high write-offs at financial institutions and their capital constraints, and the horrible condition of state and local government finances, it is really difficult to make any kind of a case for healthy economic growth.  Without such growth, equity markets cannot help but languish, like they have for the past 10 years, at least until the time that consumer balance sheets have healed.  There is simply no way around this; and the sooner that policy makers recognize this (like they apparently have done in Europe), the better.

Portfolio Allocations

While we wait for such healing, maybe several years, investors need to adopt an attitude such that “return of capital” is paramount, and “return on capital” is secondary.  Allocations to bonds should be extraordinarily high, say in the 50% to 60% range.  Be selective.  Pick companies with large cash positions, high levels of free cash flow, low debt and ones without unfunded pension liabilities.  Pick muni bonds in a similar way.  Avoid the tendency to move to longer durations for more yield.  While the economics say that low interest rates will be with us for a long time, misguided economic policies, including money thrown from helicopters and structural trillion dollar deficits may cause a loss of confidence in the dollar and in Treasuries resulting in rising interest rates.  Of course, a liberal position in precious metals also protects against such policy blunders.  Bear markets also call for smaller allocations to equities, perhaps as little as 25%.  Again, be selective as indicated above.  Also, choose companies with solid and growing dividends; make sure those dividends are not in any danger of being cut.

Robert Barone, Ph.D.

July 15, 2010