Recovery: Long Way to Go

An earlier post Today’s Economic Backdrop for Investing discussed the framework for investing. Value investors are bottom up investors and contrarian in nature. So, top down macroeconomic forecasts don’t carry a lot of weight (the so called risk-on, risk-off) approach to investing.

The premise; forecasting macroeconomics is hazardous (if not impossible) but we can’t ignore reality. We are going through a “balance sheet” recession, these are significantly different than recessions we’re used to, and they can have a large impact on risk and returns.

Over the past sixty years debt levels grew faster than incomes. By 2008 the burden of debt became too much to bear and the debt “supercycle” came to an end.  There is too much debt on our personal and government balance sheets, they need repaired. In their book “This Time Is Different” Carmen Reinhart and Kenneth Rogoff’s  breakthrough study covering sixty-six countries convincingly shows financial crises like we are going through are normal and to be expected. They also show it takes a long and painful process to recover and reduce debt.

The deleveraging cycle takes many years as illustrated below with Sweden and Finland. They had to take the medicine after years of too much debt. Deleveraging begins in the private sector even while government debt continues to grow. Sound familiar? The key point here is it is not a quick process and can take 15-18 years:

SOURCE: International Monetary Fund; Haver Analytics; McKinsey Global Institute

Where we are:

To put the deleveraging cycle in perspective the chart below shows total credit market debt, both private and public borrowing. There is a sharp increase in total debt starting in the 1980’s. It took us a long time to create this problem and as “This Time is Different” demonstrates, it will take a long time to fix.

Of course, some debt can be beneficial, but the amount of debt you can afford is a function of income. Rising income allows for more debt; falling incomes reduces the ability to pay debt.

In the chart below household debt service as a percent of disposable income is improving as debt is paid down (voluntarily) or defaulted (involuntary) since the financial crises. It appears the private sector is deleveraging. Long term this is exactly what is needed for a healthy economy and country. But when people stop borrowing to buy things (they can’t afford) the economy slows.

In the next chart federal debt as a percent of Gross Domestic Product (GDP), one measure of national income is still increasing. Deleveraging at the federal government level has not started as the government continues to use deficit spending in efforts to either stimulate the economy or continue buying things they cannot afford. Hmm.. More debt to solve a debt problem?

That brings us to the acrimonious debates in Washington DC. The bottom line is we must use a rational approach (tax increases and expenditure reductions) to solve the problem and it will take years.  It will not be solved in one legislative session (the fiscal cliff nonsense). We need to take baby steps so we don’t create other unintended problems in this unfamiliar territory. Going back to Sweden and Finland’s experience, it would appear we haven’t taken the first step yet to start the ten year public sector deleveraging!

What about monetary easing policies of the Federal Reserve (QE1, QE2, QE3), will that help? It helps in the short term by keeping interest rates low and temporarily inflating asset prices. Making more money available to borrow when they are trying to pay down debt does not help, or make sense. It just further delays the cure of real debt reduction.

Money velocity is a measure of monetary policy is working. Money velocity measures economic activity by measuring how quickly money is used in a given period of time. Wikipedia illustrates money velocity this way:

If, for example, in a very small economy, a farmer and a mechanic, with just $50 between them, buy new goods and services from each other in just three transactions over the course of a year

  1.  Farmer spends $50 on tractor repair from mechanic.
  2.  Mechanic buys $40 of corn from farmer.
  3.  Mechanic spends $10 on barn cats from farmer.

…then $100 changed hands in the course of a year, even though there is only $50 in this little economy. That $100 level is possible because each dollar was spent on new goods and services an average of twice a year, which is to say that the velocity was 2/year [100/50=2]. Note that if the farmer bought a used tractor from the mechanic or made a gift to the mechanic, it would not go into the numerator of velocity because that transaction would not be part of this tiny economy’s gross domestic product.

But, if the mechanic decides to buy less corn and forgo the cats purchase because he needs to pay down debt or save money then the little economy shrinks and might look like this:

  1. Farmer spends $50 on tractor repair from mechanic.
  2. Mechanic buys $20 of corn from farmer.
  3. Mechanic spends $0 on barn cats from farmer.

Then only $70 changed hands in the course of a year, economic activity slows, and the money velocity drops to 1.4/year (70/50=1.4).

So, back to the U.S. economy, is quantitative easing really helping economic activity since early 2000? As measured by M2, a primary measure of money supply; money velocity is declining. The private sector is not buying as many things so they can pay down debt. The decline will continue when our government starts working the problem and spending less:

We still have a long way to go. How does all this impact investors? Investor face low investment income due to low yields, frequent short term panics, market volatility, aggressive fiscal and monetary policies, restricted credit availability, historically low interest rates,  and the overhang of private and public debt.   These factors influence the degree of risk, capital allocation and timing for investors.  They should be considered while we hold true to the tenets of value investing.

The U.S. economic growth is 70% driven by consumption and will likely:

  1. Have a longer than normal economic “muddle through” recovery for several more years
  2. It will take years for the private and public sector to pay down decades of accumulated debt
  3. Unemployment will remain higher than we’ve experienced during past recoveries
  4. The value of the U.S. Dollar will continue to decline as our world reserve currency is used pay reduce debt

Is it all doom and gloom; shouild we be perma-bears? I don’t think so, we just need to approach investing today carefully and maybe differently. In the next posts we’ll discuss approaches being used by some of the best in the investing business with decades of experience and a knack for preserving capital.

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