July 2010: Adapting to Change

Open Client Meeting Review:  July 2010

Adapting to Change

        “The key to success is often the ability to adapt.” – Unknown Source

In this Commentary we examine the cause of today’s financial problems, our prognosis for the next phase in the economy and stock market, and our plans to address the coming events.

The Problem Is Too Much Debt:  Last quarter we reviewed the origins of the financial crisis that erupted in 2008.  The financial crisis was the culmination of decades of burgeoning debt --- private and government --- and the realization that existing debt obligations had become unsustainable.

The debt problem is improving in the private sector; total private debt has contracted since the onset of the financial crisis.  However, debt levels continue to rise in the public (government) sector.  Much of the federal government’s additional debt stems from the usual decrease in tax revenues during a recession as well as spending programs attempting to jump-start the economy.

Nonfederal Debt and Federal DebtThe problems arising from over-indebtedness cannot be resolved by shifting debt from the private sector to government, or borrow-and-spend government stimulus programs, or keeping interest rates at ultra-low levels.  Neither an individual nor government can spend its way out of a debt overload.  Only higher incomes (personal and government) derived from increased production and/or an outright reduction of debt through repayments, mark-downs, defaults and foreclosures can resolve this problem.  Period.

In an ideal world we could grow our way out of the debt burden.  In that scenario higher personal and government incomes would make meeting debt obligations (interest and principal payments) more manageable.  That might work if the economy was growing robustly, but that’s not the case.

Unemployment:  Growing our way out of a crushing debt burden relies upon a rapidly growing economy and that requires an expanding, employed workforce that will produce more and boost personal incomes and tax revenues.  Unless and until there is meaningful job growth, this will not happen.  Private (non-government) job growth during the first half of 2010 was 595,000, an average of about 100,000 new jobs per month.  Job growth slowed the past two months, averaging just 62,000 per month.

Monthly Job Gains/(Losses)The economy needs a net increase of 125,000 jobs per month, twice the recent rate, just to absorb new workers entering the labor market due to population growth.  Restated, if fewer than 125,000 new jobs are added each month the number of unemployed, under-employed and “marginally attached” (the Bureau of Labor Statistics’ phrase for labor force drop-outs) workers will continue to increase.   So far, we haven’t even begun to put a dent in creating jobs for the 8.4 million workers that have lost their jobs since the recession started in 2007.

Psychology Matters:  When people and businesses tighten their belts and stop spending -- whether in response to tangible events or, more commonly, in anticipation of forthcoming events -- demand for goods and services diminishes, starting a negative feedback loop of more belt-tightening.  Following the initial impact of the financial crisis, dramatic measures of central bank intervention and government spending broke the vicious negative cycle.  Consumers and businesses slowly regained confidence and started reversing their prior belt-tightening, initiating a positive feedback loop.  That positive cycle is in jeopardy because consumer confidence has weakened recently.

The Stock Market:  The stock market usually moves in anticipation of the perception of coming events and conditions.  Anticipated robust gains in the economy, as reflected in last year’s stock market run-up, haven’t yet materialized.  Expect the stock market to falter as recognition of unmet expectations grows.

Out of Bullets:  What makes this worrisome is the lack of tools usually available to combat a weak economy.  Governments have no effective tools left in their macroeconomic policy arsenals. They can’t lower interest rates below current near zero rates and additional government borrowing to stimulate the economy will only add to an already onerous federal government debt load.  They are out of bullets and the enemy (round two of recession and deflation) is closing in.

Governmental Limitations:  Knowing the nature of our governments’ elected officials (local, state and federal), and observing their consistent pattern of seeking painless solutions, we can expect more stimulus in the future, regardless of its effectiveness.  This will merely postpone, not resolve, addressing a solution to excessive government debt.  There are no easy solutions here.  The “easy button” is broken but politicians will pound on it as long as they think it might work (and they can get elected).

The Greek Lesson:  After years of denial, Greece has become painfully aware that accumulating evermore debt was not a viable way to indefinitely finance a nation living beyond its means.  Solving Greece’s problem by extending more credit to them is like trying to cure a heroin addiction by giving the addict more heroin.  It might help the addict get by in the short-run and temporarily postpone the day of reckoning, but it does not fix the problem and will surely cause even greater damage in the long-run.

Greece is an object lesson in what happens when economic realities are ignored too long.  Greece is beyond the point of being able to get on a sustainable course of economic solvency.  A default on Greek sovereign debt is inevitable.  The European Union’s attempt to “bailout” Greece is merely a ploy to buy time for Germany and the rest of the EU to prepare for a Greek default and its aftermath.

The Bottom Line:  We believe the U.S. economy is faltering.  Job growth is inadequate, meaning a sustainable economic recovery cannot happen.  We anticipate deflationary pressures from a weak economy.  More stimulus programs will follow as surely as politicians like to garner votes.  In time, the Federal Reserve will ultimately be forced to monetize the federal government’s debt (print money to pay the bills).

U.S. Treasury debt stands at $13.2 trillion.  This year’s federal deficit is estimated at $1.8 trillion and at least $1.0 trillion each year for the next decade without additional stimulus programs and assuming a continued windfall from ultra-low interest rates on Treasury debt. With very optimistic assumptions the Office of Management and Budget projects the debt to be $20 trillion in five years.   This does not include trillions of dollars of unfunded federal obligations for Fannie Mae and Freddie Mac mortgage guarantees, Social Security benefits, Medicare benefits, and the new federal healthcare program.  Although deflation is the immediate problem, inflation will surely follow if the only way to meet federal obligations is, in fact, printing money.

Our Strategy:  There are no simple or easy solutions for fixing today’s economic problems.  However, these formidable challenges do not mean there won’t be ways for investors to profit.  Investment opportunities invariably arise from a changing world.

“When the world is changing and there are realignments, it means that nature of risks and returns change.  You have to invest for the world of tomorrow, not for the world of today.” --- Mohamed El-Erian, co-Chief Investment Officer, Pacific Investment Management Co. LLC

We recently initiated a series of actions to accommodate the slowing economy.  Our plans include steps to:

     1. Reduce stock market exposure (stocks are harmed by a slowing economy),

     2. Increase high-quality bond investments (interest rates will decline in a weakening economy),

     3. Increase foreign government bonds issued by nations with healthier economies (growing faster and not burdened by heavy debt loads), and/or

     4. Increase cash reserves.

We believe that increasing portfolio income and added measures to preserve capital are warranted in anticipation of a slowing economy.

Moving Forward: The stock market run-up of last year was a gift.  We would prefer to not return the gift.  Rather, we will reduce our risk exposure and proceed cautiously.  Our task is to maintain sufficient reserves to be able to exploit coming opportunities, identify opportunities as they arise, and take the actions needed to profit from them.

Neither we nor anyone else can predict the future with certainty.   We must always accept the possibility that we will be wrong. Regardless, we know for certain we would rather err on the side of being too cautious, thereby potentially risking loss of opportunity, instead of erring on the side of being too aggressive and potentially risking preventable losses of principal.

You have entrusted us to manage your portfolio.  We take our responsibilities in earnest, applying our knowledge, experience and judgment to navigate your portfolio through all seasons and conditions.  Please feel free to call us to further discuss this commentary, our plans and your portfolio.

We appreciate and thank you for your continued business and support. ***

Greg Schultz & Bruce Grenke
© 2010 Asset Allocation Advisors, Inc.