Volume 63, Number 8
Much of the world is already in recession and the rest is teetering on the edge, waiting for policy makers to achieve a consensus about solutions that will at least temporarily lift their economies. In Europe, the long awaited outcome of the Greek election appears to be pro-Euro, but still so close that it is hard to believe a strong consensus is forthcoming. More likely, a series of negotiations testing the minimum level of austerity needed to ensure European support. With Hollande consolidating his power in France, there is likely to be growing conflict between the French and Germans regardless of what happens in Greece. Bottom line, while waiting for elections to provide solutions, new developments crop up. The US is waiting for an election in November to solve its fiscal cliff. However, between now and then, the Supreme Court ruling on Obamacare, or new crisis in Europe, or new problems in China, or elsewhere, may alter the playing field. We have seen time and again, that the cost of conflict resolution rises rapidly as one kicks the can down the road. TARP started out at $300 billion. The wars in the Middle East were to cost $50 billion. The Fed was to only double the size of its balance sheet – by $1 trillion. Even if policy were changed today in Europe or the US or China, it takes a year or more for strong policy to gain traction – even longer for weak policy, some of which is never effective. We believe the most likely path in the near term is for Europe to remain stuck in a quagmire of conflicting national interests; for China to struggle as they attempt to shift to a consumer led economy – which they have no experience with; and for a mild recession to unfold early in 2013 as the US deals with the aftermath of the election and the reality of the fiscal cliff. Over time, economic weakness may bring greater political focus – but first we expect political pressure to build up via economic instability.
At the center of the global slump is the inability or unwillingness of banks to lend. The power of a central bank is based on its ability to create reserves that are then lent out by the banking system to generate new economic activity. If the banks do not lend the reserves, then money supply does not expand and entrepreneurs are left to fight over a fixed pie rather than one which is growing. This leads to a deflationary environment or one with negative growth – like Japan. Deflation only exacerbates existing debt problems, ultimately leading to default or debt forgiveness as the core of the healing process. However, private banks around the world are already handicapped by inadequate capital after their last splurge of ill-advised loans. Even in China, where bank loan officers respond to government decree, the orders are not to lend for real estate while increasing loans to small and medium sized businesses or consumers. Unfortunately, these lenders have little experience in this area – after a lifetime of lending primarily to government owned enterprises — and are slow in finding new customers. Bottom line, the glut of capital Ben Bernanke talked about a decade ago is having a hard time connecting with the budding entrepreneurs who would drive Schumpeterian creative destruction and build the path to the next expansion – so we muddle along sideways or down.
Near zero rates of return on capital are the invisible hands way of signaling that we are in a world of excess supply and insufficient demand. To reestablish balance, the invisible hand wants no new investment, while depreciation reduces the capital stock to reduce supply. Historically, there are four paths to reducing capital stock: 1) Schumpeterian creative destruction, which favors new industries over old; 2) Market power concentration, which allows large players to reduce the effective capital base by using scale to reduce costs; 3) Government regulation or protectionism, which picks winners and losers for political reasons; or 4) War, which favors one nation’s capital stock over another’s. Of the four, the first is generally the most desirable in democratic/capitalist economies – but it is also the one which relies most on banking to make small and medium sized loans to start-up businesses. A lack of Schumpeterian creative destruction – that is new competitors – allows market concentration to get traction. Already successful firms will use their profits to buy the best of the rest while driving out the weakest performers through pricing power with suppliers and the ability to sustain incentives to customers. Government interference in markets also rises as small players find their way blocked in the world of one dollar one vote and resort to influence through one man one vote. The least desirable of all solutions, war, tends to arise when politicians find no answers at home and create reasons to blame others for their woes. In the current environment, the lack of bank capital and the presences of nuclear weapons make #1 and #4 least likely as near term solutions. The race is between #2 and #3 – represented by diametrically opposed positions on the political spectrum. In the US, after the Civil War, market concentration won hands down during the falling price boom called the Long Depression. After the Panic of 1893, still quite significant market concentration was managed by anti-trust laws and the new progressive era of regulation. After the Great Depression, FDR’s New Deal focused on heavy government intervention. Unfortunately, all three cases ended with European wars being a deciding factor in the reduction of global capital excess. We believe investors should prepare for a world of increased market concentration and a global shift toward regulation and protectionism, and seek investments that will outperform – which at the extreme may mean losing your capital the slowest – in this environment.
The Good, The Bad, and the Ugly
We see the global economic environment as dominated by three huge trading blocs, each roughly one quarter of world GDP – 1) a commodity bloc centered around China with producers such as Canada, Australia, Russia, Brazil, Argentina, Indonesia etc. feeding Chinese materials demand; 2) the US; and 3) the EU, both within and without the Euro Zone. Today each faces its own unique problems, exacerbated by the difficulties in global finance and trade. We rank them: 1) the Commodity bloc as the Good; 2) the US as the Bad and 3) the EU as the Ugly. Bottom line, the commodity bloc’s woes are less daunting and they have policy levers to pull. The US faces deep fundamental problems – but they are more manageable than Europe’s, so we may benefit from growing global market share (the best horse in the glue factory.) Meanwhile, Europe needs to begin fundamental reforms in its political and financial structure, during an era of declining population growth – a scenario that did not work out well at all for Japan.
For the commodity bloc the central question is whether China can right the ship after it recent slump. China’s woes are both foreign and domestic. At home, it is still trying to rein in a runaway real estate bubble that led to massive misallocation of resources and high inflation, accompanied by artificially high growth. They are trying to shift to a consumer led economy – which is a consummation devoutly to be wished – but they have little experience with such a beast. After a two decade boom supported by robust export growth, they shifted to massive infrastructure spending to sustain and expand the boom right through the Lehman crisis. Now a lack of European credit is stifling growth in both their largest export market, the EU, and their fastest growing export market, Asia. In response, China is trying to drive income growth for those lowest on the income ladder to generate more domestic consumer activity, but there has been little traction. Again, we see a critical shortcoming in the banking system. In the US and around the world, consumerism has gone hand in hand with the development of consumer credit. In the US in the 1920s, consumer lending was invented to finance cars, radios, sewing machines, pianos and other durable items that enhanced both living standards and the ability to earn. In China, most big consumer goods are still paid for in cash and small loans to consumers are almost nonexistent due to high savings rates, informal intergenerational lending arrangements and the focus of banks on lending to the government. Inventing a consumer economy and a credit economy at the same time – in a down market completely unlike the 1920s or 1950s – is likely to be tough. We expect over the near to intermediate term, China (and its bloc) will continue to rely on big infrastructure spending on low end housing, water projects, rail and subways in second and third tier cities. The needs are still great and China has the money, the ability to lower interest rates and reserve requirements, and a currency that it may weaken. These are still a stop gap measures and leave open the question of whether they will ever develop a consumer economy – but they can generate growth for the next several years.
The US is muddling along slowly solving its many imbalances – but faces a hefty test in the fiscal cliff coming on January 1st, 2012. We still has a housing problem which undermines the collateral values of loans, and hence capital, at our small banks. We still have imbalance in government deficits, though they are largely healed at the state and local level. And, there remains a structural mismatch in labor markets, especially with the long term unemployed. Ironically, all these problems may be wiped away by a moderate recession sparked by the inability of whoever is elected to effectively deal with the huge potential hit to growth from the fiscal cliff. Indeed, it may well be in the best interest of whoever is elected to take that recession early in the new term and use it as the whipping post to generate a mandate for their preferred version of change. It is a well-tested strategy used effectively Reagan, Clinton, Bush and Obama. Bottom line, it will be almost impossible for the US to unwind 100% of the fiscal cliff – especially since doing so would likely draw the ire of the bond vigilantes and newly awakened rating agencies – so a soft economy and widening deficits in early 2013 could bring the final shakeout in the housing industry and start the US on longer term reforms of pensions and entitlements by newly elected officials.
On the political front we are picking up signals that the shift toward a Republican sweep may be developing. It’s the economy, stupid, and growth in the second quarter looks to be slipping below 2%, similar to the first. Maybe it is still only a payback for the warm winter, or a byproduct of the European crisis – though more likely it is an awakening to the reality of the fiscal cliff. This week, retail sales, initial claims and industrial production all pointed in the wrong direction. Bottom line, we hear more and more political discussion about Colorado, Michigan and Wisconsin, all areas that Obama must win – and little talk of Florida or Virginia, which appear the low hanging fruit after well discussed Ohio. Political campaigns, like wars, cannot be won when all of the fighting is on your home turf. Advantage Romney.
Finally, Europe has the most intractable problems of the three areas. There is little doubt in our minds that the Euro will survive, especially following a New Democracy win in Greece. However, successful outcomes still require significant realignments of political and industrial roles. Nations will be required to give up some control over banks and budgets to a central authority. The consensus appears to be already moving in this direction – but such changes could take years, not months. However, even after liquidity, solvency, and banking problems are resolved, Germany cannot continue to operate as if no change had occurred. They cannot over-produce and hope to grow through exports as their biggest customer, the rest of Europe, is no longer able to borrow and spend. Indeed, their Asian customers may not be able to borrow and spend without a return of European bank lending, which seems unlikely given capital constraints. Bottom line, Germany benefitted more than any other part of Europe from the very lose credit and deficit policies they are now railing against. Just as booms in housing and small business collapsed in the US after credit became tight, Germany appears to be the most vulnerable sector of Europe. Indeed, if big changes come in Europe – if Spain and Italy finally adopt more German policies on labor and welfare payments — then Germany’s comparative advantage would erode even more. The invisible hand is trying it hardest to rebalance Europe, in the face of entrenched national interest which will take deep economic crisis to change. If the hand wins, most likely Germany loses most. If the hand loses, why would you want to invest there?