UNINTENDED
CONSEQUENCES
There
has been a significant stock market rebound since the trough
in early March. In hindsight, the signs of a bottom were classic.
The substantial negativity and bearishness of early 2009 culminated
in masses of investors finally throwing in the towel (capitulation).
To be sure, there was a lot to be worried about back then. However,
the decisive actions of governments and central banks around
the world gained traction. Huge amounts of liquidity were injected
into the global economy, while fiscal authorities announced
major economic stimulus projects and undertook the necessary
moves to stabilize their banking systems.
From
an investment standpoint, the flirtation with disaster had driven
stock valuations to very attractive levels. In addition, there
was a tremendous amount of cash on the sidelines that was earning
very little interest. As the second quarter progressed, numerous
early signs of economic stabilization began to appear - a.k.a.
"green shoots." Suddenly, it seemed, the fear of losing
money in stocks gave way to the fear of being left behind during
a rally phase. So despite an economy still mired in recession,
money flowed into the stock and commodities markets. The move
up in equity prices was by no means unusual, as history has
often demonstrated that the stock market is anticipatory. In
fact, a major portion of most post-recession stock market advances
have occurred prior to the actual economic upturns.
So
now what? Has the stock market moved too far, too fast? Equities
prices have risen a long way and the coming economic advance
seems almost certain to be less than robust. Also, while valuations
can still be considered reasonable, they are no longer cheap.
Furthermore, the enormous and still growing size of our government's
fiscal and monetary stimulus programs has lead many investors
to voice concern about the potential for significant inflation
down the road.
Economic Expectations
The
consensus expectation is that the U.S. economy will begin to
grow again later this year. We agree. Rising energy and commodity
prices seem to indicate a firming global economy. The U.S. housing
market is showing signs of stabilization. And, it appears that
recession-related inventory destocking across large segments
of our economy went too far, such that even a marginal pickup
in end-market demand will inevitably lead to an increase in
output. Furthermore, the ramp-up in U.S. government stimulus
spending is still mostly ahead of us. It is also noteworthy
that the recent surge of debt and equity offerings provides
Corporate America with ample liquidity to support growth, without
government assistance.
On
the other hand, banks are still curtailing loans, the commercial
real estate environment seems to be worsening, unemployment
is likely to remain too high, and it will take a long time for
consumers to rebuild their balance sheets following the tremendous
destruction of real estate- and stock market-related personal
wealth. Years may pass before we see a full return to pre-recession
levels of consumer spending.
In
addition, we expect a prolonged period of substantive economic
headwinds, even after the recovery begins, primarily as a result
of the need for post-stimulus actions to rein in the deficit
and reduce excess liquidity. We also believe that rising global
demand for economically sensitive commodities, such as oil and
industrial metals, will keep their prices high. That would be
restrictive as well, as it increases costs to both domestic
industry and consumers. In such an environment, economic and
corporate earnings growth is likely to be materially slower
than has been typical of previous post-recessionary periods.
Future Inflation?
The
single topic most addressed by clients in recent weeks has been
the risk of future inflation. The Federal Reserve Board's response
to the financial crisis has led to what is, by far, the largest
percentage increase in the U.S. monetary base in the past fifty
years. Also, the fiscal stimulus measures enacted, and proposed
to be enacted, will leave our government with huge borrowing
requirements. Not since WWII has the federal deficit been this
large as a percentage of GDP. The inflation concern is understandable
but, we believe, premature.
Nobel-winning
economist Milton Friedman would tell us that inflation is primarily
a monetary phenomenon - too much money chasing too few goods.
So, is there too much money? Yes and no. Even though there has
been a huge increase in the monetary base, the money multiplier
and the velocity of money have both dropped. In other words,
the monetary stimulus is not being utilized as intended - lenders
are not lending and consumers are not spending. The Fed can
create substantial sums of money, but if no one spends it, economic
growth will stagnate and prices will not rise. So the amount
of money in the system is not currently inflationary. Then,
are there too few goods? No, not by a long shot. There is substantial
manufacturing capacity around the globe, the utilization of
which currently stands at near-record low levels. So, we think
it will take both time and a firm global economy before capacity
limitations put any meaningful pressure on pricing. From a monetarist's
standpoint, inflation is not a near-term risk.
There
are other factors, as well, indicating that inflation is not
a current problem, and perhaps even suggesting some continuing
deflation risk. With high unemployment, for instance, wage growth
is anemic both here and abroad. In some industries, compensation
is actually declining. Also of note is that many state and local
governments in this country must, by law, balance their budgets,
necessitating outright cuts in personnel and, in many cases,
reduced wages for those remaining. If people earn less, they
spend less. That is not a recipe for inflation.
But
what about the fiscal situation? Isn't that inflationary? The
projected federal deficit for 2009 will approach $2 trillion,
and it is estimated that the government will need to borrow
at least $5 trillion cumulatively over the next three to four
years. Who is going to lend us that money, and what interest
rates will they demand? What if investors (either domestic or
foreign) believe that our government's policies are so irresponsible
that they will ultimately get paid back with "cheap"
dollars? If there are not enough buyers of all the debt, the
only option will be for the Fed to step in and monetize the
deficit by buying U.S. Treasury obligations. Taking such action
would no doubt be inflationary, causing interest rates to rise
and the dollar to decline.
For
the moment, however, we do not see a lack of lenders willing
to finance our deficit; Foreign central banks currently own
more than 20% of U.S. Treasuries outstanding. While it is not
unreasonable for creditor nations to want to diversify their
reserves, there are only a few countries whose currencies have
enough transaction volume to provide meaningful liquidity. And
currently, most of those nations' economies and government debt
levels are in worse shape than ours. Furthermore, it would not
be in the interest of creditor nations to drive down the value
of the dollar. China, for instance, would have no incentive
to raise the relative value of the Yuan, thereby undermining
the competitive position of its exports.
Thus
we do not see inflation as a likely current problem but, in
time, the global economy will start to gather steam, the velocity
of money will increase, and excess manufacturing and human resources
will become more fully utilized. At that point, the Federal
Reserve Board will need to move quickly to unwind its balance
sheet expansion, or inflation will become a problem. In like
manner, the federal government will need to move aggressively
to scale back spending and rein in the massive budget deficit.
Unfortunately, entitlement programs are politically quite difficult
to unwind. The path forward is fraught with risk, and the prospect
of insufficient efforts in this regard is worrisome. Again though,
these are longer-term issues.
Financial Market Outlook
Regarding
the fixed-income markets, we believe it is important to differentiate
between Treasury obligations and corporate and municipal bonds.
Over the past nine months, yields on Treasury bonds fell dramatically,
reflecting a combination of the Federal Reserve Board's liquidity
injections and the mass flight to safety by fixed-income investors.
However, yields on corporate and municipal bonds moved higher
and their spreads over the yields on Treasuries rose to record
levels. This increase has resulted in attractive investment
opportunities in corporate and municipal bonds. Within those
sectors, we strongly favor investments with short- and intermediate-term
maturities, recognizing the risks of higher inflation and interest
rates, longer term.
As
far as the stock market is concerned, equity prices and valuations
have risen strongly in recent months, reflecting both relief
that the financial crisis has passed and anticipation of the
coming economic recovery. Nonetheless, we do not think it will
be that difficult for stocks to continue beating the returns
from cash and most other asset classes in the months ahead.
The economic recovery is still ahead of us, and there remains
a very large number of under-invested individual and professional
investors. Money market assets currently total 47% of the market
value of the S&P 500, a number well above the 20% average
of the last twenty years. The yield on those money funds is
miniscule, and most of the alternatives to stocks do not seem
very attractive at this time. Consequently, we believe that
still-sidelined investors will feel an increasing pressure to
invest in stocks - particularly institutional investors, who
are judged by their quarterly performance results. We sense
a growing "buy-on-weakness" camp. As such, we think
that any near-term stock market setbacks are not likely to be
all that substantial.
Further
out in time, the uncertainties increase. That our monetary and
fiscal authorities adopted extreme measures to deal with the
financial crisis is understandable. They had little choice.
However, history has shown that massive policy interventions
usually yield unintended consequences. For instance, the reflationary
effort following the bursting of the dot-com bubble in early
2000 unquestionably enabled the housing bubble which followed.
That bubble has now burst, as well, and the current efforts
to reflate the economy pose a serious risk of creating an even
larger bubble of government borrowing and spending. The massive
distortions created as a result of the financial crisis will
have to be unwound. The exit strategy will be hugely challenging,
presenting risks and uncertainties to both the economy and financial
markets. Investors must pay attention. The bottom line is that
we expect stocks to move higher in coming months, but given
the uncertain outlook, we will stay conservative in our asset
allocation and overall portfolio composition. And as ever, we
will remain focused on the preservation of capital. 
