The Long Run Quarterly Letter: October 2009
When a prescient observer like Jim Grant – editor of Grant’s Interest Rate Observer and long-time provider of sobering, bearish and uncannily accurate commentary – pronounces that we are in the first quarter of what is going to be a startlingly steep, V-shaped recovery, some review of the current environment is in order. Many economists agree that we are likely to see coordinated, global GDP growth begin again in the latter half of this year, and even casual observers can’t help but be excited (relieved might be a better word) by the stock market’s meteoric rise from March lows. Over the last two quarters, the S&P 500 has risen more than 30%. Of course, the index is still down nearly 34% from its 2007 high as of this writing.
Our view, however, continues to be cautious. Just as we advised balance in the crucible of crisis, we continue to recommend a disciplined and measured approach as we move toward what we expect will be an uneven and hard-fought recovery. While we believe there are significant opportunities for patient investors, we also recognize that broad recovery in the wake of such a devastating global collapse will take time. Investors should understand the drivers behind the current economic improvement and pay attention to the disruptive changes taking root now that will have significant impact on the shape, direction and sustainability of any recovery to come. Some things to consider:
1. This is not a normal cycle, and we should not expect a normal cycle response. Personal and corporate balance sheets grew to such excessive size on easy credit over the last quarter of a century that asset values in many corners of the global market were pushed beyond sensible limitations. While some bubbles have certainly burst, some asset valuations still may need to come down to Earth. The de-leveraging of the system and the recalibrating of rational valuations after such disruption will be a long process – likely measured in years and not quarters. The chart below outlines the widening of the gap between GDP and credit market debt in the U.S. beginning in 1982. Your browser may not support display of this image.
2. Stimulus can mask structural economic weakness and, worse, create asset inflation when misapplied. The United States has committed over $11 trillion dollars in bailouts, back-stops and stimulus, and yet we have experienced more than 100 bank failures this year with more to follow next year. The depleted FDIC has been forced to turn back to the banking industry for a $45 billion bail-out in order to manage the failures to come. In China, where massive stimulus spending has driven industrial demand and increased GDP, we are seeing evidence of a credit bubble. China has injected approximately $150 billion dollars of credit into its economy every six months since 2003. In the first six months of 2009, however, credit expanded by $1 trillion in China. While it did have a positive impact on the economy, much of the excess credit looks to have worked its way into the investment markets. The Shanghai stock exchange rose nearly 90% through August of this year (only to fall back when market participants sensed a bubble was forming). To date, Chinese real estate prices have risen by more than 100% from March lows on easy credit. Sound familiar?
3. The U.S. consumer is chastened and is likely just beginning a significant retrenchment. From the early 1950s through 1982, consumer spending contributed 62.5% to GDP with only minor deviations. Since 1982, with the movement of the Baby Boom generation through its prime spending years (and, not coincidentally, in lock-step with the expansion of credit in the system), consumer spending has grown to represent more than 70% of GDP. The last time consumer spending rose up through 70% of GDP was in the late 1920s after a similar (but smaller) credit splurge. By the end of the 1930s, however, consumer spending had dropped back down to just over 60% of GDP. We expect to see a similar adjustment in the makeup of GDP over the next ten years. Baby boomers are now heading into retirement and living more on fixed incomes. Younger consumers are saving more in an effort to rebuild their balance sheets and to work out from under extraordinary debt burdens. Add the possibility that U.S. unemployment (which rose to 9.8% in September after employers cut a deeper than expected 263,000 jobs) will remain higher than expected for longer than expected, and the potential for retrenchment becomes all the more likely.
So, we see reason for investment vigilance and careful analysis – but such caution should not be confused with paralysis. There are certainly investments that are trading at promising valuations against longer-term prospects, and significant drivers remain intact:
- The global middle class will grow by 600 million in the next ten years
- Innovation in green technology is creating new industries
- Medical advances are opening broad new frontiers for discovery
In addition, as we learn more about the design and structure of reforms in core areas of the global economy – including health care, climate and finance – we gain a clearer view into who the winners and losers will be in our evolving economy.
Investors who look out over the long term and apportion their risks carefully – staying focused on high-quality companies with powerful balance sheets – have the opportunity to make significant progress through a difficult recovery. Those who expect rising tides and fair winds to carry them through may be in for some ugly surprises.
