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Market Insights: May 2012

Digby's Umbrella and a Dinner to Remember

In September 1944, Digby Tatham-Warter crossed Arnhem Bridge and politely asked the opposing Panzer Battalion if they would care to surrender. They declined. Not surprising as the Germans surrounded Digby's regiment and outnumbered them ten to one. Digby was armed only with an umbrella. During much of the ensuing battles he only ever used an umbrella to direct troops and movements. As well as employing remarkable sang-froid, there was a pragmatic element. He was forever forgetting passwords and felt that his own side would never fire on him while he was carrying the umbrella. He was right. They remembered him for decades.

In March 1925 Lord Beaverbrook held a dinner with Churchill, then Chancellor, Keynes and a number of pro-gold standard Treasury men. The debate centered on whether a return to gold would:

either i) "prevent life in a fool's paradise of false prosperity" ii) "improve the terms of trade by overall cost reductions" and iii) "mean parity with Germany and the United States";

or i) mean "unemployment, downward wage adjustment, prolonged strikes" ii) "favor the special interests of finance at the expense of production" and iii) "lead to a permanent contraction of production."

Keynes, of course, was in the second camp. He knew of the "paradox of unemployment amidst dearth" when an economy can not clear wages and prices, and falls into a liquidity funk. No matter how much rates are pushed, the desire to delever and withhold purchases prevents growth.

The Treasury position prevailed and reluctantly Churchill went along. One month later, Britain restored the gold standard. It lasted seven lean years. Everything Churchill and Keynes feared came true. Not one of the alleged benefits materialized. Churchill called it the worst decision of his career.

So why do we need Digby and Churchill now? Because Europe is debating just this dilemma: either growth through austerity (and everything else in the or section above), internal devaluations, which mean nominal wage cuts, or fuller employment, spending and growth. The US faces the same problem but does not debate. Only the Fed is working on the problem. The fiscal side has abstained. So the noise we hear is one hand clapping. And what the ECB should be doing is holding a large umbrella to remind itself that it is obliged to uphold Article 2 of the Treaty of the European Union, to " progress and a high level of employment." This means that the coming showdown between Germanic austerity dogma and sensible growth policies is about to enter a new round. Which is good because financial interests should not prevail. Let's look at where we are in Europe and the US, then a quick look at China. And if you want the answer now, it's the US.

Europe in as few words as possible

It all started around 1998 with a treaty in a non-descript town in the Netherlands where two numbers came to dominate the terms of economic union: a budget balance of 3% of GDP and debt of 60%. These were the demons to be slayed. Meet those and you could join the euro club. Only three countries met the criteria at the time: Ireland, Portugal and Finland. Germany broke the rules in seven out of the next twelve years. They benefitted hugely from an undervalued exchange rate. Bond yields converged. But in the aftermath of the financial crisis, it turned out that some countries borrowed too much (Greece), some decided to let taxpayers bail out private banks (Ireland), some took on the losses from a real estate boom (Spain) and some thought it not worth reforming labor markets because, well, it suited them not to (France and Italy). Meanwhile Germany found itself with excess savings and a competitive export market without customers. The ensuing arguments led to six governments falling, the latest of which was the Netherlands. So what now?

  1. Financial Surpluses: Every country has four sources of surplus or deficit that must sum to zero. These are i) households ii) corporations iii) government and iv) rest of the world. If the balance sheets of the first two are damaged, they pay down debts. If the rest of the world doesn't want your stuff, then only the government can replace the demand. Either that or the whole economy sinks to a much lower level. Tax cuts won't help. They're saved. Zero rates don't work. If there's no demand, no investment clears a hurdle rate. Molotovs in Greece and protests in Spain point right at this dilemma. And the Netherlands, with one of the highest current account surpluses in the world, has realized that withdrawing government expenditure, just to meet the demon numbers, comes at a terrible cost.
  2. ECB: The LTROs saved the banks. Between raising credit standards and deteriorating assets, bank flows to the small and medium sized enterprises (SMEs) had all but ceased. These are the backbone of Europe's economy accounting for 99% of firms and 72% of labor. The plan was to provide liquidity by temporarily buying bank assets and then see the funding flow to business. There is evidence that this is happening but demand is hopelessly weak because of the fiscal hair shirts insisted upon by Germany. Half of all Europe's business takes place within Europe so someone (hint, Germany) needs to create that demand. If they keep pointing to the inflation specter, then the whole process will be painfully slow. The good news is, first, that the ECB knows this and is not repeating the mistake of Mr. Trichet a year ago and raising rates and, second, European governments are rebelling against the policies demanded by Germany. If they prevail, some growth may ensue.
  3. Look for Backtracking: Some of the newly elected governments are backtracking on budget commitments. The first was Spain. Italy is finding structural reforms difficult. The Netherlands is in limbo. But we should not be overly alarmed. If these countries can anchor expectations, make their debt a bargain for creditors, employ credible economic programs, prioritize their social safety nets and create popular support for such measures, then recovery and structural reform can be more than aspiration. The ECB needs to keep a cool head. It could happen and the odds are greater now than a few months ago.
The US, on course, just

The US economy is on a painfully slow road. It is recovering. Jobs numbers are better, even though some hiring in the first quarter may have been brought forward by mild weather. Production, manufacturing and exports, all signs of regained competitiveness in the US, are showing steady improvements, occasional setbacks and improvements again. And the government sector is contracting. Not on purpose mind you, but jumping off a cliff and letting inertia do the work result in the same end. Above all of this, we have a Fed using every monetary policy at their disposal to try and promote growth and employment. Mercifully, their actions indicate they are less consumed with inflation. Of these, the important developments are:

  1. The Fed: is in two broad camps. One is that there has been a fall in productive capacity and that the natural rate of unemployment may be much higher than the broad consensus of around 6%. This camp believes that the liquidity from QE can not find its way into the economy and so may be inflationary. Further, they believe the economy pre-2008 was over-stated and so the output gap now is smaller than most estimates. Here's the output gap by one measure, around 12% lower than trend growth.

    Source: Federal Reserve Bank of St. Louis, Economic Research

    The other camp believes that employment should recover faster and that resource utilization rates in labor and manufacturing remain low. They are right and they prevail for now. The April FOMC lowered its 2012-2013 growth estimates from last November, left its inflation estimates unchanged and projected a 0.5% drop in unemployment. You would think this would lead to no change in forward rate policy and ongoing concern about the state of the economy. But bizarrely, two members brought forward their rate increase estimates from 2015 to 2014. Which shows just how delicate the balance of debate is between growth and inflation. But for now, it's holding Digby's umbrella password of growth.
  2. And Inflation: The 1970s remain the specter for the Fed. They lost control, respect and were constantly undermined by bad fiscal policies. But there are no inflation expectations in the economy. Whether you believe i) excess reserves and monetary balances are inflationary ii) government spending is out of control or iii) employment capacity will drive prices, there's nothing to see.

    Here's the first, with no evident multiplier from monetary infusion to price. Why? Because money is as money does. If it does not move into the system, banks just sit on reserves and buy securities.

    Source: Federal Reserve Bank of St. Louis, Economic Research

    Here's the second, with cyclically induced government spending against the 10-year TIPS. However distorted the TIPS market is (and it is because of lack of inventory), the government has been able to borrow at negative rates for the last year.

    Source: Federal Reserve Bank of St. Louis, Economic Research

    And here's the third, an old favorite, showing no increases in income and declining secular inflation. That's partly because employment costs have grown at around 1.5% down from 3.0% prior to 2008.

    Source: Federal Reserve Bank of St. Louis, Economic Research

    So finally this is where inflation comes out. Less than the "Great Moderation" (how hubristic that looks), less than the inflation era and less than the 1980s growth.

    Source: Federal Reserve Bank of St. Louis, Economic Research

    So the conclusion should be why not try some inflation? Why do we fret about 3% vs. 2%? And if we had a year or so of 3% to 4% inflation, would it not be better than the lurching recovery we have?
  3. Small Government Bad Policy: The Government sector continues to shrink, although you would hardly guess it from mainstream political debate. For most of the last two years, government expenditures, consumption, capital investment and transfer payments have fallen. All government expenditures, throwing in states and locals, stand at 19.7% compared to its 40-year average of 19.9%. State and local government spending is 3% below its 2007 level and represents 60% of all total government spending. Tax revenue has not kept up with transfers which is why the deficit increased. What should happen next? Well, keeping rates low helps fund the deficit. And it could be more easily funded with a progressive tax rate and more sensible, loop-hole-free corporate tax rate. There. Said it.

Generally, the US is on course. The recovery is maddeningly slow and takes one step back for very two forward. But it's unlikely we will have the full setback that we had in the spring of 2010 and 2011, when most numbers rolled over. Consumer confidence is steady. Manufacturing jobs on the rise. Productivity growth has slowed and thus implies more labor demand. There remains stress between the rentier economy, which wants high real rates on their savings and no inflation, and everybody else, who need more aggregate demand, labor and more price inflation. Rentiers eventually lose that struggle.

A Very Quick Look at China

Lower growth, lower inflation, lower trade and current account surpluses. The challenge to rebalance the economy towards final, private consumption and away from exports and capital investment is immense. Right up to the 1980s, the London School of Economics taught that centrally planned economies were the only way to distribute growth evenly. It was not fully understood that what really mattered was a pluralistic society and restrictions on extractive institutions, like central governments, state-owned enterprises and, well, local big men. Some of these implicit trade-offs in China are coming under increased stress. It's very difficult for China to change its growth model and reverse some of the wealth back from the state and elites to the household sector.

What would serve as a clearer signal that things were changing in China would be i) a privatization program ii) slow down in investment growth iii) evident political stability and iv) a lower savings rate. These would have profound implications for global flows on surpluses and savings but would point to more robust consumption in China. But there's very little sign of any of that.

And for Capital Markets

The demand for safe assets far outstrips supply. Reserve managers, pension funds, insurance companies and, importantly, collateral and capital for financial institutions all require safe, liquid debt. Yet, deteriorating fiscal conditions of choice sovereign issuers and the private sector deleveraging has meant less supply. So we continue to expect US treasuries to remain in a low and tight range. When they do move, they can do so very quickly as we saw rates move from 1.88% to 2.38% and back down to 1.98%.

  • Whipsaws in GTs: It's more of the same with long duration bonds moving in tight ranges of 20bps or so. Put together the prospect of QE, the slow recovery, throw in Europe fears, and the mix supports the patter of low rates we've seen for the last six months. The end of Operation Twist removes about $170bn quarterly rate of buying but assuming the same patterns from the end of QE1 and QE2, this only leads to a 10bp change in fair value. So more trading to be had without any break-out.
  • MBS: probably remains the firmest underbid in the market. They remain steady in price with a spread of around 90bp. If there is a QE3, MBS are likely to be the target as it's one way to stimulate the housing market. But the overall attraction is price stability in what might be tense times this summer.
  • Corporates: Spreads at around 190bp are a little higher than pre-recession levels but the market is more bifurcated now. Why? Because the banks are almost a separate asset class and investors demand a premium. Corporates are very well bid and favored by all long duration investors, especially pensions and insurance companies.

Much of the rally so far this year has had a sense of unease, as if the "risk on" trade was still only just better than the alternative. Market valuations have barely changed from a year ago. This is a market of earnings appreciation, dividends and dividend growth and some top line growth. It's not a market of multiple expansions. So the focus is:

  1. EPS Growth: Even stripping out the volatility of financials (all that FICC trading), we should see 10% growth this year along with cleaner financials, improved payouts and cover. Margins may come under pressure as some of the last few years' spectacular productivity gains become too tough to pull off.
  2. Yes, Dividends Again: Between 1970 to 2011, dividends were 35% of SPX equity gains. Even in a recovery phase, like 2009-2010, they were 10%. The yield gap ratio between equity yields and treasuries is now around 10bp. Managements remain gun shy about increasing payouts but the cash flow yields look very attractive relative to IG corporates.
  3. US in the Fore: There's more growth visibility in the US markets, along with higher margins and more cash build up. Some markets in Europe look cheap and nearly all are yielding considerably more than their own sovereigns. But there's not enough demand to pull these markets into higher valuations. And many companies have a long way to go to match US productivity and capital management. Here's an important valuation measure, the market value of equities and net worth of non-financial companies over GNP:

    Source: Federal Reserve Bank of St. Louis, Economic Research

    I like this because it removes financials from the picture and uses net worth, thus eliminating earnings leverage. By this measure, stocks look reasonably valued, no overstretch but no 2009 bargains either. That seems a good place to put new money.
So put all this together:

  1. US looks the best bet from macro management...
  2. Europe now enters a new phase, how to stand up to will be messy.
  3. Monetary policy will remain loose but with no major changes.
  4. There's no inflation that matters.
  5. See #4
  6. Broad growth in the US but occasional setbacks in confidence triggered by uneven demand.

This article contains the current opinions of the author but not necessarily those of Sentinel Investments. The author's opinions are subject to change without notice. This article is distributed for informational purposes only. Forecasts, estimates, and certain information contained herein are based upon proprietary research and should not be considered as investment advice or a recommendation of any particular security, strategy or investment product. Information contained herein has been obtained from sources believed to be reliable, but not guaranteed.

Sources: "Depression is a choice," Steve Waldman; Martin Gilbert, Winston S. Churchill, Vol. 5, 1976; Federal Reserve; Graphs sourced from the Federal Reserve Bank of St. Louis, Economic Research; Sentinel Asset Management, Inc.




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