Economic Backdrop

Today’s Economic Backdrop for Investing

Forecasting the economy (or stock market) is a hazardous undertaking.  Many feel there are just too many variables and interactions to accurately forecast and translate useable top down investment ideas.  Since value investors tend to be bottom up investors and contrarian in nature many ignore top down economic forecasts and stick to a bottoms up approach.

So can we continue to ignore macroeconomic (top down) factors?  I don’t think so, at least not in today’s investing environment.  There are valuable lessons to be learned studying economic history and how certain conditions may impact investment outcome and risk.   Today’s investor face low investment income due to low yields, frequent short term panics, market volatility due to international events, aggressive fiscal and monetary policies, restricted credit availability, historically low interest rates,  and the overhang of private and public debt.   These factors can have a strong influence on the risk, capital allocation and timing for investors.  I believe they should at least be considered while we hold true to the tenets of value investing.

Is it Different this Time?

During the recent financial crises debate centered on when the normal “V” shaped recovery would start as forecasters assumed the recession was similar to recent past recessions.  John Mauldin and Jonathan Tepper in their excellent book Endgame: The End of the Debt Supercycle and How It Changes Everything argues  convincingly that this data is meaningless.  “…it did not reflect the fact that a balance-sheet recession (due to too much debt) requires years of deleveraging….. all the factors that produce the normal “V” are no longer in play. Bank lending is still dropping. Savings rates go up. Debt gets paid down. Governments run into limits as to how much they can stimulate the economy without creating large and destabilizing debt. Central banks push rates to zero, and then what? This is a far different environment than we have had for the last 70 years.”

Mauldin and Tepper draw heavily on history presented by economists Carmen Reinhart and Kenneth Rogoff in a breakthrough study covering sixty-six countries in their book This Time Is Different.  It presents a comprehensive look at the varieties of financial crises, through eight centuries of government defaults, banking panics, and inflationary spikes, from medieval currency debasements to today’s subprime catastrophe.   They argue that these types of financial disruptions are universal for emerging and developed market nations.

Reality

Over the past sixty years debt levels grew faster than incomes. People took on more debt because it was more manageable.  However, by 2008 the burden of debt became too much to bear and the debt “supercycle” came to an end.  People are now deleveraging, demanding their governments reduce debt, banks started collapsing due to low levels of capital and large losses from loans people can’t pay back (housing mortgages).  Aspects of this are ongoing in Europe today while the U.S. still struggles with these issues.

The weak performance of the U.S. economy continues as evident by stubbornly high unemployment, depressed housing prices, low consumer confidence and volatile financial markets.  This drives the point home as argued by Mauldin and Tepper that the recovery following a credit crisis is different than in a normal cycle.

This rapid contraction in debt due to default and deleveraging leads to a fall in economic activity.  People get serious, save and cut spending.  Governments step in to back bank debt and start borrowing and spending more to transfer money to the private sector (individual and business) in hopes of improving the economy.  Private borrowing is replaced with public (government) borrowing.  Can adding more debt really solve the problem of too much debt?  Hmm…  The sovereign debt crisis that are now following is the recognition that at least some of this supposedly secure debt will likely not be paid back.

These macroeconomic issues are significant enough this time that they can’t be ignored.  We really don’t know the outcomes, but we can form a framework for investing over the next few years to help minimize risk based on history.  It doesn’t change the basic tenets of value investing but it will encourage us to look differently at value opportunities.

Even with all its issues the U.S. will continue to be a relatively safe haven because it is the biggest economy in the world, very competitive, large liquid financial markets, rule of law and a world factor.  It will continue to present excellent investment opportunities although in a more challenging environment than we’re used to.

But there will be other opportunities in this environment, some even greater than in the U.S.  I believe we need to consider the following potential impacts on investment decision and discussions:

Governments prefer to print money to solve debt problems.  This may result in:
•Rising inflation
•Reductions in real income as people lose purchasing power due to higher prices
•Countries that do not control their own money supply either pay down debt or default
•Countries that control their own money use inflation, devaluation and regression to pay debt

The U.S. economic growth is 70% driven by consumption and will likely:
•Have a longer than normal economic “muddle through” recovery for several more years
•It will take years for the private sector to pay down decades of accumulated debt
•Unemployment will remain higher than we’ve experienced during recent recoveries
•The value of the U.S. Dollar will continue to decline

Emerging economies:
•People around the world see the U.S. middle class lifestyle and they want their share of it
•Governments will build out infrastructure to meet this emerging middle class demand
•They will compete for global resources with the traditional powerhouses of U.S. and Europe
•Resource rich countries with stable governments will benefit
•Resource rich countries will likely experience stronger currency

These macroeconomic considerations will hopefully provide a helpful framework in which we can practice the traditional tenets of value investing in our search for companies to buy in this shrinking world.  These impacts may originate from faraway places like Europe, Greece, Beijing and of course Washington, places we can no longer ignore.

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