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In my last post, I acknowledged logic tends to fly out the window in a market correction, and fear & greed take over the driving. My advice was to take a deep breath, just accept the fact we don’t always know what’s coming next, and to positively transform the compulsion to do something anything to relieve your market-induced stress. Because a correction’s a wonderful upgrade opportunity, a chance to (re)deploy your weaker portfolio holdings & cash into higher quality growth companies – those compounders you hardly ever get to buy. Happily, things look a little rosier now (a special thanks, Japan!), and hopefully we’re now heading into a traditional year-end rally…

Of course, long-term performance is the best reminder to always remain invested in the market. Unfortunately, fear & greed can quickly undermine such compelling logic. Companies face a similar issue – it takes a great leader to keep a company set on its long-term growth trajectory, despite all the setbacks it will obviously encounter. The idea great leaders are great storytellers is interesting in this context – it suggests numbers & analysis aren’t enough, people often require a compelling narrative to motivate & help them stay the course. In terms of the markets, the more you can interpret & understand the narrative of the past, the better equipped you will be to see the long-term narrative arc & how it might continue playing out in the future.

So, let me share some of my market narrative. Remember, it’s a story – it doesn’t require proof, and it won’t necessarily remain set in stone. [Accordingly: I’m sure I’ll include plenty of links, but I’ll try resist the temptation to jam this post full of graphs & figures]. You may nod your head, agree, and ponder the implications for your own portfolio – or you’ll replace it with your own narrative…and that’s good too. I’m going to focus on the US here: i) because it’s the growth-engine of the world, and ii) where the US goes, much of the world tends to follow. I’ll also focus on the Baby Boomers – because they bloody deserve the blame…for just about everything! [I promise you’ll hear this more & more in the years to come]:

The Boomers grew up to a constant refrain: A never-ending list of the immense sacrifices and hardships their parents & grandparents endured during World War II & the Great Depression before it. Quite a dose of survivor guilt to be saddled with… Except when they started to come of age in the ’60s, they looked ’round and saw they were actually living in the richest & most powerful country on earth. Hardship and sacrifice seemed like rather quaint & irrelevant concepts, while sexual & political liberation beckoned as a far more enjoyable way to embrace young adulthood. Unfortunately, just when getting a job, getting married, and having kids began to enter the equation, everything turned to shit…

The Vietnam War (& America’s shameful exit), the devaluation of the dollar, oil crises, a corrupt & ineffectual decade for the US presidency, an economy in the crapper, a soaring inflation rate, a bubble (& subsequent collapse) in gold and silver…and these are just some of the highlights! [At this point, we all enjoy fond cultural memories of the ’70s, but forget it was much less fun then trying to make a living. Speaking of ‘culture’, it ain’t for nothing punk erupted in the ’70s!]. Adding insult to injury, the decade’s last hurrah was the Aug-1979 appointment of Volcker as Fed Chairman, and his imposition of 20%+ interest rates & a savage economic recession. [Though he decisively broke inflation (which peaked around 14%), as intended]. At the time, I doubt anybody suspected this was pretty much the last significant instance of self-imposed austerity by the US, but it was the final straw for the Boomer generation…

Fortunately, the ’80s coincided with their real coming of age – in terms of voting power & access to positions of authority. Yes, it was gussied up as Reaganomics, but it was really far more basic & visceral than that…Boomers simply reclaimed what they saw as their birthright. By God, they’d tasted true American freedom, wealth & power, and they wanted it back! And they sure as hell weren’t going to repeat the hardships of their parents & grandparents, or the economic & political ills of the previous decade. And surely the ’70s were just a bad joke anyway, that could & should be blamed on the outrageous machinations of an oil-rich Middle East?! The Me Generation was ready for a new form of exceptionalism – they deserved to party, and damn the cost!

Publicly, this spawned the mantra of ‘deficits don’t matter’. [Or ‘deficits are necessary’, if you prefer the Democrat version…] While privately it launched the most breath-taking consumer orgy boom the world’s ever seen. Unfortunately, right about the same time, the American Dream was beginning to fade…

We have to remember World War II was as much an industrial victory for the US. In its aftermath, Europe was in ruins, Japan was bombed back to year zero, and a large portion of the world was disappearing behind the Iron & Bamboo Curtains, while various statist regimes also dominated much of the rest of the world. Faced with no real competition, and blessed (at the time) with an economy & culture which could actually deliver a long-term compact between government, big business & unions/workers, the US was able to exploit a gigantic head-start vs. the rest of the world. This led to an explosion in wealth & living standards, which got shared ’round pretty equally for the next few decades – thereby cementing the myth of a classless society, the idea all Americans are middle class.

Granted, there’s some truth to this. In the old-fashioned English sense of class, America was pretty classless…except for the fact class was simply replaced by money. But this didn’t matter so much in the post-war decades. The extraordinary & relatively equal rise in wealth and incomes meant a predominantly blue-collar workforce could enjoy a very comfortable middle class life (particularly from the rest of the world’s perspective). Over time, this enjoyment turned into entitlement, and the idea such affluence was (to a fair extent) a happy accident of history was conveniently forgotten. And then the ’70s came along, and this government-business-labour compact was essentially destroyed. Unfortunately, it was also accompanied by the relentless rise of Germany & Japan as export machines.

We now know the ’80s were a decisive inflection point, where globalisation really started to kick in, and income & wealth inequality returned with a vengeance. Slowly but surely, US manufacturing & its blue collar workforce began to give back its windfall gains – displaced domestically by capital & technology, and internationally by cheaper labour & costs. Average real incomes have been static ever since. But it seems like a majority of Boomers never even noticed – bamboozled as they were over the past few decades by consumerism, inflation, a declining savings rate, easy credit, and the widespread acceptance of dual-income households. Certainly, such threats were only dimly perceived (or were simply ignored) at the time. Unfortunately, a bigger challenge was yet to come…

By which I mean the fall of communism, the most important historical event since WWII. People inevitably remember the fall of the Berlin Wall, which heralded the dissolution of the Soviet Union – even though Tiananmen Square came first (just months earlier, in Jun-1989), basically forcing an acceleration of China’s rural-urban migration & its transition to a capitalist economy (thereby relegating communism to a mere system of political control). Of course, others remember Gorbachev. But to some extent, these were all symbolic – the seeds were sown a decade earlier. At the 3rd Plenary Session (of 1978), for example, where Deng Xiaoping came to power & launched China firmly on the road to economic reform. [Incidentally, Gorbachev was appointed to the Politburo around the same time, on course to becoming General Secretary in 1985]. And far more importantly, in 1980, with the emergence of Solidarity in the Gdansk shipyards. Today, I’m not sure we can viscerally appreciate the sheer brass balls it took to face down the Communist authorities in Warsaw (and in turn, Moscow) during the ’80s. Nelson Mandela would be a popular choice these days, but for my money the enduring hero of the late 20th century is Lech Walesa. His defiance was the genesis of all subsequent protest & revolution in the Soviet Union, leading to the dismantling of a system that killed tens of millions.

Of course, the end of the Cold War was rapturously received by America & the rest of the world. I definitely wouldn’t under-estimate the effect of this… In fact, I’m convinced the psychic impact of no longer staring down the barrel of a Soviet nuclear silo was far more effective than the Fed’s current & otherwise unprecedented experiment in QE – in terms of actual economic stimulus. The idea you’re no longer going to die in a nuclear holocaust, or some Soviet gulag (hey, the Cold War was an anxious time!), is probably the greatest & most enduring wealth effect one could ever imagine. And I believe its impact lasted for many years after, probably well into the 2000s.

For America, this was a tremendous economic benefit – a swords to ploughshares bonanza, in the very broadest sense. Don’t forget the Boomers were firmly in control at this point. The deficits of the ’70s might well have been excused as a necessity, but they were a mere taste of the budgetary excess in the ’80s – mirroring the same abandonment of restraint shown by the Boomers with regard to their own debt & spending. Despite the underlying fiscal irresponsibility, the US enjoyed a Cold War dividend in the ’90s – deficits shrank steadily & Clinton even enjoyed budget surpluses for a few years as the decade ended. But excess breeds excess, and deficits returned with a vengeance in the 2000s – to remain forever, it would appear…

Of course, the fall of the Iron & Bamboo Curtains, and the gradual liberalisation of many statist nations in its wake, finally unleashed a multitude of countries & nigh on two billion people to become active participants in the world market economy. And boy, do those countries love to save (funny how mercantilism has become a dirty word in the West)! As do their people… Yeah, they’re poor by American standards, but they save far more (in percentage terms), and there’s a hell of a lot more of ’em! They’ve got to stash the money somewhere, the dollar’s still the world’s reserve currency, and encouraging America’s wastrel ways probably seemed like a good export strategy anyway… So funding its addiction to never-ending deficits & increasing debt (at ridiculously low interest rates) has become a real doddle for the US – well, as long as that global savings glut remains available.

However, the average Boomer most definitely hasn’t enjoyed the same peace dividend. The gradual unleashing of a couple of billion people (on ridiculously low wages) into the world economy was obviously an existential threat for blue collar (& now white collar) America. German & Japanese competition was a cake walk compared to what was coming over the horizon. But misgivings were soon forgotten as cheap products started pouring into the US, and people were zombified by a whole new level of consumerism. The same thing was happening on a local level: As Wal-Mart & other big box stores opened on the edge of town, everybody insisted they wouldn’t shop there at first. Then they made a visit, just out of curiosity…but soon they were back for the bargains. Naturally, everybody spends a little more & saves a little more (the more you spend, the more you save!), and soon the town begins to think it’s a win-win for everybody. Except one day everybody wakes up, and wonders what the hell happened to Main Street…where did all the damn stores, businesses, restaurants & shoppers go?!

Unfortunately, America’s laissez-faire spirit of enterprise & individualism has proved a mixed blessing. Of course, the US has no equal in terms of entrepreneurial/corporate innovation & profitability. But the notable lack of any kind of strategic industrial, labour & (re)training policies has failed much of the workforce – from workers in dying industries abandoned to the depredations of unions (‘once a steelworker, always a steelworker’), all the way to students who still believe 4 years of college & a back-breaking student loan somehow guarantees their future. Ultimately, a country’s workforce is just as much a part of its infrastructure as its bridges. In America, both need strategic investment – the cracks are really showing…

[And now we’re a step away from MOOCs being unleashed on the rest of the world as an alternative low cost/high quality education. A smart Indian kid isn’t trying to find himself, or pick a good party school, and he definitely isn’t trying to rack up a six-figure debt funding keggers, pizza & four star spring breaks – he simply wants a decent education in double-quick time, and for a fraction of the cost. And now he’s on the verge of being able to access it…US Millennials may want to start thinking about how exactly they’re going to compete with him].

So, where does it all end? Well, it doesn’t… America’s growth & spending binge has been going on for over 30 years now – to expect the fiscal irresponsibility to just stop, after all this time, is lunacy itself. What US politician up for re-election is going to offer austerity & cold turkey to the voters? When voters simply vote for those who offer the sweet lies they prefer to keep hearing. And are those same voters ready to rein in their own excessive spending? Nope, not the Me Generation…

Ever since the ’80s, this Boomer mentality & notion of growth at all costs has enslaved the US in its self-appointed role as the growth engine of the world – in effect, a never-ending global Marshall Plan. The dollar’s suffered accordingly, and its decline would surely be far worse if it wasn’t for the Western world going down much the same path (albeit more sedately). [Not that it’s a one-way bet – ironically, the more the US debases the dollar & its finances, the more the dollar may benefit (sometimes for years on end) from the resulting ersatz growth surge. The recent surge is but the latest example]. But equity investors don’t necessarily have to care so much about inflation or currency depreciation (two sides of the same coin), since they often tend to be compensated accordingly with higher/lower underlying equity returns. But it does matter when the cumulative impact of deficits, debt & debasement threatens to approach an inflection point in terms of national financial stability.

Reinhart & Rogoff might argue that’s already happened, with the US blowing through their critical 90% Debt-to-GDP threshold. But the dollar’s reserve status is still a powerful Get out of Jail Free card. And we’ve seen plenty of countries (in Europe, for example, over the past few decades) learning to live with/recover from debt ratios of 120% (even 140%). Of course, I haven’t even mentioned Japan yet! Regardless, the numbers are bad & only getting worse… I’ve already devoted an excruciating (but hopefully readable) series to this:

US Economy, Government Finances & Debt – Some of the Gory Details I, II, III & IV

[I’m really not trying to pick on the US here – let us labour under no illusions, the developed world’s probably in much the same fix. In fact, Japan’s already run the same course, decades in advance of the US – including its own version of the financial crisis, almost 25 years ago now (in 1990)! [And they’ve continued to debauch their finances ever since, with Debt-to-GDP now a mind-boggling 230%+]. And while Europe has a superior debt-to-GDP ratio & a household savings rate 2-3 times the US rate, and may still be serious about tackling its fiscal imbalances, realistically we must be fearful it’s ultimately heading down the same path].

Because we’ve reached another life-changing Boomer event: Every day, more & more of them are now retiring. They can look forward to the highest US life-expectancy yet, and they intend enjoying it in the manner to which they’re accustomed. So it seems pretty inevitable they’ll spend every single penny of their retirement income & inadequate retirement savings. And why shouldn’t they, their federal & state entitlements will take care of them anyway – which they damn well paid for & deserve! Um, except they didn’t & they don’t… An entitlement isn’t some kind of loan contract. It’s not an insurance policy you collect on either (despite the political sleight of hand which pretends it is). It’s simply a political promise…which can be broken, at some point, like all such promises. And it isn’t a question of paying, or deserving – they mightn’t have much to show for it today, but the Baby Boomers thoroughly enjoyed pissing away over four decades of deficits. And that bill’s still outstanding & they’re obviously never going to pay it…

But you can be damn sure they intend collecting every penny of their ‘entitlements’, no matter how much in the hole it leaves future generations. Don’t be surprised if the Tea Party (& similar organisations, of all political stripes) evolve into equally strident Boomer lobby groups/movements, to make sure they actually get to collect. A galling prospect for Millennials who likely face an uncertain economic future, no inheritance, and a debauched Treasury. I’m not actually predicting some kind of Armageddon, or tipping point, here…the future will probably be far more dreary than that. But let me try paint a little picture of hope first – I see two things that might save America’s finances:

Infrastructure:   Undoubtedly, the current US growth recovery is fake! Absent QE, who’s going to argue the underlying economy wouldn’t still be in the shitter… That’s why the US is right & Europe’s wrong about austerity – it’s the last thing either economy needs right now. Austerity advocates deserve much of the blame: They sound-bite the confidence fairy will grant a quick & relatively painless path to prosperity, and deservedly get shot down. Call a spade a spade, austerity’s never pleasant…but sometimes it’s very necessary financial triage & recovery: If you want to avoid disaster, and hope to ever see genuine growth in the future, you just have to suck it up & wait it out. Any fool knows this (even Krugman?!), when it comes to catching up with their own bills…

Now, we all know America’s infrastructure is becoming increasingly decrepit (don’t even try comparing it with Asia’s) – another sign the US isn’t as rich as it thinks it is… [Simply recognising that problem would greatly help the solution]. But this offers tremendous opportunity: If cutting discretionary spending & tackling bloated entitlements were seriously considered, the negative economic impact of such reform could be offset with a comprehensive multi-year infrastructure programme. This spending strategy wouldn’t necessarily improve the near-term US debt trajectory, but it would substitute productive investment for wasteful spending, it’s a spending commitment that could be gradually throttled back, and of course it’s a gigantic employment/training programme. Then there’s the bizarre lack of US PPP projects, which means there’s a potentially huge opportunity for private capital to absorb much of this infrastructure spending. In combination with sustained spending cuts & entitlement reform, this approach could generate a substantial improvement in the nation’s medium/long-term debt trajectory.

Millennials:   Complain all you want, we may be under-estimating Millennials. Don’t forget they do everything later in life – getting a job, renting an apartment (buying a house!?), even buying a car, getting married, having kids, etc. When they finally grow up & start getting on with their adult lives, and actually see what the economic future has in store for them, they might just surprise us. [Remember Johnny Rotten’s famous last words: ‘Ever get the feeling you’ve been cheated?!’] Yes, they fell for the whole college/student debt scam (along with their parents), but otherwise they’re proving to be pretty financially responsible (& conservative).

Sure, by previous standards, they may seem apathetic – but that could change very quickly, if they look ahead & feel like they’ve nothing to lose. They may well be the generation who seizes the reins of power & finally tries to turn this fiscal super-tanker around. And we shouldn’t expect protest to necessarily take the same form as before. As they say, the pen is mightier than the sword. Millennials are the unwitting masters of social & digital media…I can’t think of a more immediate & pervasive way to organise, protest & eventually win any debate.

OK, so that’s the optimism out of the way. Do I really think we’ll see a meaningful multi-year diversion of spending into infrastructure? Well, it sounds much too sensible a (potential) solution – so, probably not… [But I can easily imagine politicians trying to preserve current spending/entitlements and introducing a huge infrastructure spending programme!?] And I suspect any meaningful reform Millennials might achieve may come too little, too late.

Frankly, I’m astonished so many people spend less time debating viable solutions/alternatives, and so much more time agonising whether the US is…turning Japanese. [Sure, the US has a far more profitable & vibrant corporate sector, but it could still end up swamped by the deflationary impact of over-stretched public & private finances]. I believe it’s the obvious default scenario – and there’s nothing theoretical about it, we now have almost 25 years of Japanese depression & mistakes to ponder. But before you start contemplating seppuku…would that outcome necessarily be a disaster?

Depends on your perspective really: The Japanese are still rich (but maybe not getting richer), and the average worker’s salary may have fallen, but deflation has allowed them to basically maintain their living standards & also earn a decent return on their savings. So, what’s the big deal? Personally, I’d be perfectly comfortable with the idea of a static income (in real terms) for years to come – go on, try it on for size, it’s an interesting thought experiment to check if you’re genuinely happy with your lot in life. [And we may, in fact, be on the verge of an unspoken conspiracy: Where Western governments & big business are forced to unite & work together to actively avoid further/new productivity gains…when they finally recognise how dependent they really are on preserving the earning & spending power of the average taxpayer/consumer!] But too many people are seduced by the idea earning more & spending more is the key to greater happiness…no different really than the West’s obsession with growth at all costs.

I won’t predict the timing, but eventually this will have to change…and not by choice. You can expect the establishment to eventually discover unexpected silver linings in Japan’s ongoing depression. [Just as Bernanke was a Depression expert, I’m betting Japan will be a pet subject/thesis for a future Fed Chair]. And slowly but surely, you’ll see the idea a 200%+ Debt-to-GDP ratio is perfectly sustainable taking hold as economic orthodoxy. The US does benefit from its reserve currency status (just as Japan benefits from a large domestic & risk-averse savings pool), but a higher US savings rate will be desirable (& probably necessary). Unfortunately, this will reduce consumer demand – so it requires a gradual & subtle policy change. [That’s quite an inflection point to watch out for…the US is still one of the few countries where it’s considered patriotic to spend, rather than save!?] But ultimately it’s the lesser evil – a larger domestic savings pool will be needed to fund deficits & debt, and to facilitate the eventual transition of the retirement burden from government back to the individual. With de facto capital controls already in place (consider FATCA, and other US extra-territorial over-reaching), plus a widespread reliance on tax-exempt savings vehicles, the authorities will find it easy to guard against capital flight & to subtly steer more savings into government debt. [For example, ongoing money market fund reform’s touted as protecting savers – in reality, it will conveniently re-allocate a substantial chunk of this $2.6 trillion sector into government debt].

So, what does this all mean for investors? Well, I’ve touched on this repeatedly in my blog posts, and it obviously helps guide my Portfolio Allocation (Parts I to XV). I’m talking about a long event horizon here, so my current (mild) aversion to the US equity market is more about valuation & relative risk/reward, rather than its long-term prospects. And I still prefer European equities: In my opinion, lower corporate margins, cheaper valuations, Europe’s position (vs. the US) in the economic cycle, and the ECB’s huge & still untapped firepower (vs. that of the Fed), all present a superior risk-reward proposition – in terms of market upside, and in terms of potential restructuring and M&A. But as I’ve said, Europe may well follow in the footsteps of the US…and mightn’t even be that far behind, at this point.

In reality, I suspect developed market opportunities will increasingly come from discounted assets, activist/special situations & private equity-type investments – rather than your average growth-oriented companies/stocks. Western companies which possess high value brands & other intellectual property may still be attractive, but only if a majority of their revenues are actually generated from emerging & frontier markets. In most instances, in terms of risk-reward, I expect better growth investments will be found locally – so emerging & frontier markets and stocks should become a dominant focus for investors who are serious about protecting & increasing their long-term wealth.

Fortunately, or perhaps unfortunately, there’s probably no rush…

The lack of developed market inflation is a somewhat terrifying reminder of how much excess production & labour capacity’s now lying idle. But you can’t escape inflation with this much global monetary debasement… So we’re seeing it in the markets instead – primarily the equity & bond markets, and also the property market (though this is more of a marking-up exercise), while the commodity markets continue to reflect the true underlying state of the developed market (and, to some extent, global) economy. And you shouldn’t expect to see these market underpinnings removed – monetary stimulus will remain a stop-go exercise as every last wobble scares the central bankers, there’s no real possibility the stimulus (to date) can ever be withdrawn, and ongoing financial repression continues to force savers into equities (& other markets). So I’m pretty sure we still have an unprecedented developed market bubble to enjoy first..!

At this point, the missing component is (excessive) leverage – but continued central bank support, and the ongoing suppression of market volatility, will surely supply the necessary risk appetite & leverage in due course. Playing the greater fool game might prove very profitable, but in a bubble you also have to keep your head & ultimately determine a good time to walk away. I could suggest emerging & frontier markets as a good place to hide, even now – in reality, they’d probably get whacked just as much, if the developed markets were getting badly hit. But they will offer a superb investment destination, eventually – especially if you end up sitting pretty, all cashed out & waiting for trouble…

Frontier markets are obviously coming off such a low base – in terms of wage rates & the size of their economies – I firmly believe they’ll continue to carve out a larger slice of world GDP & trade for themselves, and also provide an attractive & uncorrelated return for investors. As for emerging markets…as usual, a hand shoots up: Aren’t they screwed if developed markets end up in a permanent growth funk? Well no, I don’t think so – and the fact they’re still ticking along nicely (vs. the developed markets), despite the neutral/tighter policy regimes we’ve seen in quite a few markets, supports that opinion. Anyway, I think it’s a bit of a silly question – in all likelihood, despite a Western slowdown, emerging (& frontier) markets would still offer higher relative GDP growth & lower stock valuations!

And now I believe we’re finally on the cusp of a brand-new & self-perpetuating consumer revolution in these markets. If you look at the figures, we definitely appear to have reached a general inflection point in terms of a burgeoning middle class (obviously starting at a radically different price point than the US), across multiple markets. And if they provide insufficient momentum, emerging & frontier market governments can exploit the inherent advantages & firepower they currently have at their disposal to encourage & accelerate such a consumer revolution. [China will obviously be conducting the most significant & essential of these experiments]. Hopefully they’ll exercise more prudence, but at worst they’ll simply repeat the same mistakes…by promising generous entitlements (which won’t come due for years/decades to come, considering average market demographics), they can hope to create an economic step-change via lower savings rates & escalating consumer spending. All of which would serve to pick up any slack left in the wake of lower Western growth, and to offer attractive new/local investment opportunities.

In the end, haven’t you ever looked back & wished you could have invested in the hopes, wants, needs & desires of the Boomers in the prime of their lives? What an incredible once-in-a-lifetime investment opportunity that was…if only it still existed. But it does! That narrative arc’s ready to play out all over again with a brand-new generation of Baby Boomers. You just have to set sail for the emerging (& frontier) markets to find them…

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