Here we are entering the final quarter of 2011 and nothing really makes sense. Fundamental investors are throwing in the towel as Hedge Funds and Day Traders play “Risk On, Risk Off” with the markets. Like the 1960’s black comedy film Dr. Strangelove, unhinged European policy makers are playing Russian roulette with their economic union risking financial destruction.
Also of great concern to us is the failure of the Belgium bank Dexia which believe it or not is the world’s largest lender to municipal governments in the U.S. and overseas. A natural assumption will be more belt tightening and job cuts at local governments everywhere. Also Dexia was one of many large banks that actually PASSED Europe’s official “stress tests” just three months ago. And yet it’s the first to go down!? So what happened to Dexia? It was a bank run — the sudden and mass withdrawal of its funding. Moreover, the run on Dexia funds was not by consumers lining up on the street to pull out their deposits. Rather, it was by so-called “wholesale funding” sources — other big banks and institutional investors. What makes this truly shocking is that nearly all large European banks depend very heavily on these same funding sources. The promises made last night by France and Germany — to “recapitalize the banks” — do NOT fix this problem! Finally some of our largest banks, including Bank of America and JPMorgan Chase, are equally vulnerable.
In the past several years, we worried that the U.S. risked repeating the mistakes of Japan. Fortunately, the U.S. is not Japan. The U.S. was quick to act with several rounds of quantitative easing to respond to our banking system crisis. The Federal Reserve did a good job. The European Union, on the other hand, is looking more like Japan and seems to be repeating their broad policy mistakes. While we are still weak from our body blow, our markets are attempting to repair themselves. A different kind of November surprise may be on the horizon.
So what’s the problem in the U.S.? Well for one thing it is Big Government! Under the cover of the 2008 financial crisis, Congress and the President ushered in a sneak attack of market-stifling regulations, spending and big government policies. Without this sneak attack, we suspect that the economy would have been back and humming along.
Regardless of government proclamations, we are in what Dr. Judith Bardwick describes as a “Psychological Recession.” To a large extent many Americans feel that they are no longer stakeholders in the direction of the country and feel as though they just can’t get ahead. The great concern is that the longer this takes hold in people’s psyche, the more likely it will result in long term structural changes to the way people think and behave. Think of this as a negative economic self fulfilling prophecy. In the past you could bet that Washington would pull out all the stops in an attempt to reverse course just in time to claim victory during a typical presidential election cycle. It may not be that simple this time. Many small business owners seem to be adopting the same posture “you go first, not me” making persistent unemployment an extremely challenging problem. So in come the advocates of the “Stimulus Calvary.” What many fail to realize is that government stimulus does not solve systemic unemployment. Instead, its productivity gains that shock the economy back to action. During the 1930s, the growth that followed the low point of the Great Depression was primarily due to productivity. Productivity is considered a supply-side factor by many economists. It is determined by the technology and regulatory structure of the economy and is largely independent of spending policies. The policy changes in the late 1930s benefited the economy by increasing competition, by bringing wages more in line with productivity, and by improving the incentives for investing. Many assume that World War II spending singlehandedly brought the economy out of the Depression, but nearly half of the increase in nonmilitary hours worked between 1939 and the peak of the war already had occurred by 1941, well before major wartime spending took place. In addition there are no data points to suggest that government stimulus will cure the psychological recession.
Productivity growth continues to be overlooked today. But, as in the case of the Great Depression, economic growth since the low of the Great Recession in June 2009 has been largely accounted for by productivity growth rather than the restoration of jobs. Congress has an outstanding opportunity to initiate broad-based tax reform that adopts the recommendations of most bipartisan tax reform commissions of the last 20 years: a simpler tax code that improves the incentives to hire and invest, broadens the tax base, lowers the corporate income tax, and also eliminates loopholes to equalize tax treatment of capital income. In addition, sensibly addressing our long-run challenges will do more for the psyche of the economy than continuing the stop-gap measures that have dominated policy-making for the last three years. People want to see a real plan. The government should consider establishing enterprise zones in those areas where the unemployment and poverty rates are the highest. Then consider such radical ideas as suspending the minimum wage along with restrictive regulations and taxes to allow those who invest the incentive to risk capital. In addition, policymakers should actually go even farther by completely eliminating taxes on the profits that are reinvested within the enterprise zones.
As for the investment markets, everyone has an opinion but, quite frankly, the market does not care. Many professional money managers are scrambling to explain why gold and U.S. Treasuries are leading the way when so many have avoided them out of fear of a market bubble (whoops they got it wrong, at least in the short term that is!). Meanwhile, all the technical signals are telling us to protect capital and avoid risk which is classic “Bear Market” thinking. One market watcher recently stated “take the income and run.”
We suspect that in the short term that most active manager will continue to underperform. We believe that Greece has technically defaulted and that the end is near. It is hard to anticipate the cross over contagion, if any, and just which emperor has no clothes. Strangely enough, we feel that these events could actually benefit the U.S. as a safe harbor destination to ride out the storm although we might feel more pain as well. Our risk management strategy is working to limit losses while the market decides which direction it will go next. To say we are waiting for the storm to pass is an understatement. The hatches are battered down and no cowboys need apply, especially those riding missiles.
All our best,
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