The Bad Magician
One of the joys of having children is arranging birthday parties. Excited little friends, games, presents, sugary drinks, junk food, birthday cake and maybe a swimming pool are the time honored ingredients for a successful party. But, occasionally, we try to take it up a notch by hiring a Magician. This can work wonders the first time or two because a decent Magician can mystify the children and keep them quiet for as long as 30 minutes. But as the years go by, the kids figure out the tricks, the magician is not as brilliant as we remember and the kids are running amok only a few minutes into the show.
That is where we are now with government policy in most of the G7 countries. In the US and EU, we were fascinated with the magicians who were able to perform magic tricks like the Great Bull market of 1982 to 2000 or the economic revival of Europe and the creation of the Euro. We were less thrilled with the show being put on by Japan after 1989 but even there we have witnessed a few brief rallies of enthusiasm during the otherwise Lost Decades.
But now, we are no longer fooled or even impressed by the Magicians. As a result, the markets are not responding to all the old tricks. This may confuse Nobel Prize winning economists who continue to ask for more of the same, but it would not be a mystery to a child who has seen one too many magicians at a birthday party.
What are the old tricks?
Zero Interest Rate Policy (ZIRP) and Taxpayer Guarantees are the two magic tricks still being trotted out on the stage today. A third magic trick, coordinated government stimulus, got booed out of the room at the G20 summit in Canada. Unfortunately, these two policy tricks are no longer as potent as when the financial system was spiraling down into the pit of doom in 2008.
Let’s start with ZIRP. This trick was employed several times by the “Great Maestro” himself, Alan Greenspan, to pull the US financial markets out of trouble. Since financial services were becoming an ever larger part of the US economy at the time, what was good for Wall Street turned out to be sort of good for Main Street as well. But, as pointed out by the Austrian School of Economics for years and Andy Kessler last week, as interest rates approach zero, investors lose the most important input in the investment calculation. When we were younger and more gullible, this led to malinvestment. Now that we know how the trick turns out (Global Financial Crisis), investors are not so easily duped. From a corporate point of view, a near zero risk free rate of return suggests that all but the craziest investment projects are economically viable. But with capacity utilization in the low 70’s, that conclusion is irrational. The result: US corporates have rationally piled up an estimated US$1.8 trillion in cash. From an individual point of view, historically low mortgage rates are telling us to borrow as much as we can, despite the evidence of continued property market distress all around us. In the past, we might have “bought the dips” but this time, we are still applying ointment to our burned fingers. And lest we forget the other side of the equation, the banks, which still have lots of losses to write off, do not have the balance sheets or the intestinal fortitude to accommodate such a lending boom.
The second trick is Taxpayer Guarantees. This trick used to be called Government Guarantees and when they were smaller relative to GDP and/or times were dire, almost everyone was willing to suspend disbelief. Now, as even normally docile German voters have reminded us, these “guarantees” are going to cost us dearly as taxpayers. The biggest manifestation of this fading magic trick was Freddie Mac and Fannie Mae which currently guarantee up to 90% of the new mortgages being written in the US. But a bigger attempt is happening in Europe in sovereign debt. Recently, Ireland was able to raise €1.5 billion in six and ten year bonds despite a recent downgrade by Moody’s. The press noted that Ireland had to pay punitive rates of 5.5% on the ten year paper. The only reason that they did not have to pay credit card interest rates is because the debt is implicitly guaranteed by the European Central Bank. No bank would touch the paper without that guarantee. And, since the German consumer knows that he or she will be on the hook for these guarantees for years to come, the natural response is to export more and consume less.
How do we get out of this mess?
For better or worse, the magic show is scheduled to end fairly soon. In Japan, the Post Office will stop buying JGBs in 2011 because the population is growing older and on balance will be consuming more than saving. Gaiatsu (“outside pressure”) will return to Japan after a two decade hiatus when interest rates rise. In Europe, Chancellor Merkel retains some of her popularity but her government is undergoing severe strain as voters push back in the regions. And in the US, the Democrats are on track to lose control of the House of Representatives, the constitution wellspring of spending bills.
On the US consumption side, we are seeing green shoots in the American Express 2nd quarter earnings report. As pointed out in the Bloomberg article, AmEx’s business model is largely immune from legislation proposed by Rep. Richard Durbin, which probably gives it a head start. Once Visa and MasterCard are able to lobby for loopholes through the new legislation, we could see credit flowing back into the consumer segment.
Once the corporate sector can see a path for a resumption of consumer led growth, we should see inventory building first, investment and employment should follow (with a long lag) and interest rates will rise.
The trail back to solid economic growth will not be straight as years of Magic Tricks and other quick fixes need to be unwound. We therefore continue to recommend an active portfolio management strategy which scans and reevaluates a broad investment universe for investment opportunities on a regular basis.
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