Maybe the Mayans Were Onto Something About 2012
Fourth Quarter 2011
In this year’s final perspective, we relate Mayan-calendar commentary with political policies while reflecting on domestic macro economic conditions vis-a-vis Europe, asset valuations, and investment outlook. Our conclusions can be summarized as follows:
Cartoons continue to reflect the pervasive mindset
- Some in the doom-and-gloom crowd see significance in the apparent end of the Mayan calendar later this year
- An “end of the world” may indeed be unfolding—but it’s the world of ever larger government spending as fiscal tipping points are reached
- Whatever the outcome of upcoming elections, fiscal discipline will likely result even if imposed by the markets
- Canada provides a terrific blueprint for reversing government spending trends
- Domestic economic fundamentals warrant rational optimism
- Economic expansion and employment growth to continue
- Eurozone financial contagion remains a risk, but insulation exists
- Stock and bond prices reflect pessimism that time will likely reveal was excessive
- This renders stocks under-valued and bonds (Treasuries in particular) over-valued
- Economic dynamism remains alive and well
As if the levels of fear, uncertainty and doubt about the economic, financial and geopolitical backdrop weren’t already sufficiently elevated, the New Year also brings the apparent end of the Mayan calendar. In scary-movie fashion, all sorts of end-of-the-world types are counting down to the Mayan calendar event which appears to coincide with the Winter Solstice next December. Whether the Mayan’s amazing ability as astronomers also means they possessed the special powers of prescience some ascribe to them, time will soon tell.
But 2012 indeed holds the potential, economically speaking, for the end of one “world” . . . and the beginning of another. In many countries around the globe, the year promises more evolving circumstances that are forcing a curtailment of the ever-expanding reach of the visible hand of the government into the economy. Recent comments by former Federal Reserve (“Fed”) Chairman Alan Greenspan help describe the end-of-this-world and circumstances necessitating its change:
Although Greenspan was speaking about our domestic fiscal issues, the tipping point of the bloated welfare state is on full display within Europe’s debt woes. Many are learning that the entirety of government promises of “security” supported by unsustainable spending and borrowings, becomes instead a major source of insecurity not just for some, but entire nations, and (through a global financial system) regions of the world. Elections here and abroad this year will play a significant role in shaping the speed and path the trend follows towards a new world of public fiscal “austerity”.
Fortunately, there are promising blueprints for transitions from unsustainable fiscal situations. As noted last quarter, in the early 1990s Canada hit the fiscal wall, its debt was downgraded, and its economy was stagnant.
At about the same time, Sweden was experiencing a similar fate as its famous welfare state model also met the brick wall. In both countries, parties from the left and right came together and reversed course via material cuts to current and future government spending, tax rate cuts as well as regulatory rollbacks. These actions established the solid growth, low government-debt-to-GDP trajectories these two have been on for years.
Conditions are ripe for action and change in the U.S. as the pressures build and Eurozone countries provide real time examples of the consequences of not realistically addressing fiscal issues. We suspect that however the elections play out, 2012 should prove to be the year when a “new world” is launched and a giant overhanging wet blanket for financial markets begins to lift.
In the very early 1980s, when inflation was the primary affliction, economist Ed Yardeni coined the term, bond vigilante. His intended meaning was that if policymakers (primarily the Fed) failed to take appropriate measures to address inflation, the bond market would, in vigilante fashion, drive interest rates high enough to do the job. In other words, the markets had assumed leadership of the situation and the so-called “leaders” (policymakers) were forced to follow.
In today’s context, the bond vigilantes are back and active within Europe. This time it’s not about inflation per se, but rather unsustainable government debt levels. If governments won’t rein in their debts, the bond market will do so by making the cost of debt prohibitive.
So far, the U.S. has benefited from the bond vigilantes’ Eurozone actions via a massive flight into U.S. Treasury securities as investors flee much of Europe. While the flow into Treasury securities has driven already ultra-low U.S. yields even lower, there is no room for U.S. policymaker gloating. The vigilantes can, and likely will, turn on U.S. Treasuries and render our elected “leaders” followers if they later fail to curtail government spending.
Officials would be well served to recall Clinton campaign strategist Jim Carville’s 1994 quote:
For investors, heightened financial market volatility will likely again be part of the journey through the year ahead. The volatility will likely continue to be largely driven by a tug-of-war of sorts between the domestic economic situation and the Eurozone debt troubles.
The good side of the tug-of-war is the (surprising to some) resilience of the domestic economic expansion. The bad side is represented by more anxious days likely out of Europe as the bond vigilantes may have unfinished business trying to “persuade” Europe to adopt solutions to their problems.
Here is our assessment of some of the key underlying fundamentals and their investment implications within the tug of war.
- Recessions require a credit freeze – the coast is still clear in this regard for the U.S.
- Our banking system is very well capitalized and extremely liquid
- Employment and economic expansion continue to move ahead
- Our economy is not “brittle” in the form of accumulated excesses that render it prone to recession
- U.S. economic expansion can withstand recession in Europe
- Treasuries have moved further into the over-valuation zone
- Economic dynamism is a better forecaster than past experiences
In the past, we’ve compared the role of credit within the economy to the flow of water within a plumbing system. If the credit “pipes” become frosty, credit flow is inhibited and commerce either stops or slows to a trickle. With incredibly “easy” monetary policy by the Fed, a super steep yield curve structure, and ample bank liquidity (click on the chart to the left for a larger view), the financial system is not at high risk of a credit freeze from domestic origins.
It is conceivable that a freeze could be transmitted via contagion from the Eurozone. Debt troubles there are unleashing a credit freeze within the European banking system. For those interested, the Appendix presents an indicator we’ve been watching in the midst of this possibility. The indicator suggests a healthy amount of insulation exists before a contagion freeze warning for the U.S. economy would be warranted. Should a freeze signal emerge, we would take investment action to assume a more defensive portfolio posture.
In stark contrast to The Eurozone situation, our banking system is very well capitalized, extremely liquid, and strong signs exist that business lending is expanding–a very healthy economic signal (click the chart to the right for a larger view). These conditions are also entirely inconsistent with credit freeze vulnerability.
Employment and economic expansion continue to move ahead. Last summer, the stock market swooned as double-dip recession fears again intensified. As was the case with similar fears during the course of 2010, the fears proved overblown. The economy’s growth path may be slower than most desire, but there is little risk of operating at “stall speed” as some contend. Granted the economy labors under a burden of policy uncertainty as demonstrated by the chart to the left 2 (click it for a larger view). Anxiety about big increases in spending, deficits and regulatory burdens do raise the prospect of major tax increases and substantially higher business costs. This anxiety adds to the desire on the part of businesses to build large cash cushions and limit hiring.
But despite this wet blanket, there is enough economic dynamism to continue to drive growth ahead. The technology revolution, solid productivity growth, globalization, and an unfolding manufacturing renaissance are powering the dynamism. With continued economic expansion comes employment growth, which has significantly improved over the past year. At a minimum, expect the grind forward trend to continue this year.
Our economy is not “brittle” in the form of accumulated excesses that render it prone to recession. For reasons just outlined, companies are flush with cash as sales, earnings, and free cash flow grew strongly again in 2011. If an excess exists in this situation, it lies in companies maintaining “excessive” cash holdings—hardly a recession prone condition!
By the way, combine this cash abundance with cheap stock prices existing in the marketplace, and the ingredients for many company takeovers looms large. We suspect that several of our portfolio holdings could become targets when corporate “animal spirits” in the form of mergers and acquisitions do begin to stir. Similar to the corporate cash situation is the status of inventories. As the chart above reflects (click it for a larger view), inventories look too low rather than excessively high.
The chart to the right (click it for a larger view) also indicates that, in aggregate, the consumer financial position is in pretty good shape. Rather than recession prone, it appears more consistent with periods that served as launch-pads for economic growth in previous decades.
U.S. economic expansion can withstand recession in Europe. Sufficient action to prevent the type of financial contagion noted above is all that’s necessary. And, while Euro-policy actions have been characterized by a fumbling and stumbling process, recent actions by their institutions are consistent with a muddle through—rather than an Armageddon unleashed–path.
Regarding our stock market, last year most stock prices on U.S. exchanges simply floated up and down on the waves of volatility in nearly unprecedented fashion as indicated by the chart to the left (click it for a larger view). Despite the volatility waves along the way, prices in aggregate treaded water for the year. This price action belied the fact that corporate earnings and cash flow again grew strongly during the year. With “E” (earnings) growing and “P” (stock prices) stagnant, the “P/E” (market valuation) declined still more.
The P/E compression reflects, in large part, investor fear about the potential for an earnings crushing recession. While the fear of this occurring is high, the chances of recession and an accompanying material earnings decline actually unfolding are low—as explained earlier.
Investor confidence therefore looks ripe for improvement. From current valuation levels, the prospects for rewarding returns from general stock prices remain compelling. Prospective returns from the quality growth stocks that populate our selections are even more so.
The prices of Treasury securities have moved further into the over-valuation zone.
The prices of Treasury securities have moved further into the over-valuation zone.We mentioned earlier that the Eurozone troubles and fear of an associated U.S. recession triggered yet another flight to the “safety” of Treasuries. Like stocks, bond prices reflect abject pessimism. However, even as stock prices recovered some from their summer swoon as double-dip recession fears abated, bonds remain priced for imminent economic collapse. The chart to the right (click it for a larger view) contrasts 10-year Treasury yields with an index which measures whether the economy is exceeding economists’ expectations (a rise in the blue line) or falling short of expectations (a blue line decline).
Until recently, when the economy is exceeding general expectation, Treasury yields rise as extreme risk aversion abates. By contrast, yields fall as investors pile into Treasuries when the economy surprises on the downside.
Since last summer, yields have remained at rock bottom lows even as the domestic economy proved the doom and gloom fears wrong. Treasuries remain very vulnerable to a significant price decline as a result. Other areas of the bond market (corporate bonds, selected bank preferred stocks, and municipal bonds) have at least a modest margin of protection relative to the Treasury market. Even here, however, investment nimbleness will be required.
For our last point, we want to circle back to the concept of economic dynamism that was mentioned earlier. Because of its hard-to-quantify nature, it is easy to overlook and difficult to fully appreciate even if recognized. A scan of the headlines, a few minutes in front of a TV “news” program, or an Amazon search of today’s best sellers reflect a deep pessimism about the future. Some of this is certainly understandable in light of the 2008 financial panic, Europe’s current troubles and the threats of Iran, North Korea, Russia, or other oppressive regimes.
We spoke earlier how pessimism is priced into the markets. However, we also note that forecasting is often just the extrapolation of recent trends. When it comes to the economy and the financial markets, it’s important to recognize what author Matt Ridley calls “the pessimist’s mistake”. 3
This mistake occurs largely as a result of economic dynamism. Because the economy never sits still, as its multitude of participants are busy competing by innovating, taking risks, and combining ideas in new “recipes” in search of ways to solve problems, dynamism often leaves pessimistic forecasts wide of the mark. Ridley is also a source of perspective from others that help frame current conditions in historical context – Author Thomas Babington Macaulay writing in the 1800s:
Economist Paul Romer writing much more recently:
In a world where ideas and information from fertile minds around the globe can be shared and combined in new recipes at the speed of light renders economic dynamism alive and well. Economic progress is ready and able to push forward even as the “old world” of ever expanding governments meets the fate suggested by of the end of the Mayan calendar. Investing in sustainable growth companies, especially at today’s depressed valuations, remains one of the best ways to capture the rewards of dynamism.
The indicator to the left (click it for a larger view) captures an array of credit market relationships. Adverse changes across these relationships reflect whether any ice is building within the credit market pipes. The pipes reflected a bit of stress as the EZ fears intensified last summer, but remain a long way from the freeze zone.
As always, we remain focused on understanding the current trends in fundamentals because it gives us the best probability for success. And if you’re an active social media user, please consider sharing this topic with your acquaintances.
1 Greenspan, A. (2012, January 4). The Tea Party and US Fiscal Gridlock. Financial Times.
2 Baker, S., Bloom, N., & Davis, S. (2011. October 6). Measuring Policy Uncertainty. Bloomberg.
3 Ridley, M. (2010).Rational Optimist, How Prosperity Evolves.