There are some signs of growth that should carry through the end of 2010, but is this growth self-sustaining?
As the Obama administration and Congress struggled to push financial reform legislation over the finish line, the financial markets enjoyed strong and relatively strong performance over the first half of 2010. This was consistent with the expectations set forth in my 2010 investment outlook (“The Illusion of Calm,” Trusts & Estates, January 2010). Equity and fixed income markets rallied toward the upper end of the range of the price targets I anticipated as the U.S. and global economies showed signs of benefitting from the Herculean efforts by central banks and governments around the world to prevent an economic collapse. The S&P 500 was flirting with the 1200 level and corporate credit spreads were tightening through 550 basis points by early spring. The Federal Reserve's zero interest rate policy remained firmly in place despite the increasingly strident warnings (and dissents) from Kansas City, Mo. Federal Reserve Chairman Thomas Hoenig that the seeds of the next credit bubble were being sown. But the fact remained that inflationary pressures remained dormant as the economy continued to nurse itself back from the deflationary shock of 2008.
At the time of this writing in early May 2010, however, two events were throwing a scare into the markets and causing them to reevaluate their appetite for risk. The first was growing strains in the European Union, the most obvious being the European Union's nearly $1 trillion bailout package for Greece and other weak European states. The second was the horrific oil spill in the Gulf of Mexico, which threatened prolonged environmental damage and threw another monkey wrench into the United State's struggle to develop a coherent energy policy. Failure to successfully address either of these crises could derail the markets' rise and will, at the very least, insure that volatility will increase over the second half of the year.
As argued in my recently published book, The Death of Capital (Wiley, May 2010), the steps taken by governments to prevent economic Armageddon have left enormous fiscal imbalances that will lead to even greater long-term economic instability than we saw in 2008-2009 unless we institute meaningful financial and economic reforms. As this article is being written, the news of the Securities and Exchange Commission's fraud charges against Goldman Sachs Group, Inc. are reverberating through the financial markets and providing a boost to advocates of the strict constructionist school of financial reform. Whatever the legal merits of the charges, the underlying transactions in question highlight the fact that financial markets are dominated by speculative rather than productive activities and that the most respected and powerful interests on Wall Street too often place profit above principle. Synthetic collateralized debt obligations (CDOs) are the ultimate speculative instrument — they don't direct capital to the construction of factories, they don't create jobs (other than for overpaid investment bankers and attorneys) and they don't add to the productive capacity of the economy. Regulation is needed not only to prevent future market and economic collapses, but also to instill a healthier culture in our financial markets. Until firms come to learn that the way they earn profits is just as important as the amount of the profits they earn, our economy will remain, in the immortal words of John Maynard Keynes, “a by-product of the activities of a casino.”1 The 11-hour grilling that Goldman Sachs executives experienced at the hands of senators would have been comical if these were not the same legislators who will be deciding the fate of financial reform. After all, who are these hypocrites to suddenly claim that they are shocked, shocked that there is a casino operating on Wall Street when they are the very individuals that licensed it? The casino has been open 24/7 since the markets hit their lows in March 2009 while Congress and the talking heads have been debating financial reform. Fortunately, the cards have mostly been turning up aces as investors come to realize that the March 2009 valuations were based on end-of-world scenarios that didn't occur. The question now is, “What is the near-term (12-to-18 month) and longer-term (3-to-5 year) outlook for financial markets?”
Briefly, the near-term outlook appears to be sanguine because the U.S. and global economies are showing signs of growth that should carry through the end of 2010 and into 2011, but the long-term prognosis is far murkier due to the fact that consumers are benefitting from enormous transfer payments from the government that will come to an end sooner rather than later, corporate and individual taxes are likely to rise significantly and government stimulus is being withdrawn as we speak. The reality is that the markets shouldn't be confused with the economy. The markets are far healthier than the economy, but ultimately they will have to come to terms with the long-term fiscal and monetary imbalances that are baked into the system.
As of the beginning of May 2010, the S&P 500 was trading at about 15-times estimated earnings of $80 per share. That's well within a reasonable valuation range, particularly in a zero interest-rate environment. During the first quarter 2010 earnings season, a majority of companies issued positive earnings surprises and reasonably good news on the revenue side. The question is whether this performance is sustainable given that many consumers, to the extent they're still breathing, are being supported by the government. Over the next 12-to-18 months, many forms of government support are going to tail off, particularly unemployment insurance. Accordingly, consumer-dependent businesses will need to see employment growth that had yet to show up in the labor statistics by early May 2010.
On the other hand, companies with significant exposures to the Euro will be hurt by the weaker European currency, which will remain a factor throughout the rest of 2010 as the European Union wrestles with weak economies in its peripheral states (although the union is learning that in an interconnected world there is no true periphery). Despite recent market volatility, I continue to expect stocks to see further gains before hitting economic headwinds late in 2010 or 2011. (As noted above, events in Europe and the Gulf of Mexico could provide other reasons for markets to retreat unrelated to economic fundamentals in the United States before then.) A level of 1250 to 1275 on the S&P 500 is therefore not out of the question before a sustained pullback occurs. The primary headwind, in addition to withdrawal of government support to consumers, will be higher taxes and reduced spending on education and other government services as governments wrestle with lower revenues and the continued fallout from the 2008 financial crisis.
In the kingdom of the blind, the one-eyed man is king. That adage is particularly apt in describing the world of fixed-income investing in a zero interest-rate world; it also describes the trap that keeps tripping up investors who tend to chase yield at the expense of quality. Since the beginning of 2010, corporate junk bond spreads have declined sharply from over 700 basis points to approximately 550 basis points in early May 2010. This has been primarily due to the fact that capital has been readily available to less-than-investment grade companies, even highly leveraged ones with low credit ratings, and to sharply declining default rates. The problem is that companies have been able to borrow at rates that don't compensate lenders for the risks they're assuming. Signs of over-exuberance include the ability of private equity firms to issue debt to pay themselves dividends as well as to issue covenant-lite bank debt and sell portfolio companies to one another. The abbreviated memories of fixed-income investors are again in evidence and will again cause them trouble sooner rather than later.
Less-than-investment grade debt isn't pure debt — it's a hybrid of debt and equity and includes a significant amount of equity risk. As such, a spread of only 550 basis points (where they stood in early May 2010, and they're likely to continue to tighten) over extremely low risk-free Treasury rates offers very paltry returns to investors in an economic environment that still features significant macroeconomic risk. Accordingly, while the short-term outlook for corporate debt remains positive, investors should understand that the music will stop at some point and their bonds and other debt instruments will suffer price declines due to illiquidity and credit deterioration. The credit markets remain highly cyclical and directional because the economy remains trapped in a boom and bust cycle as a result of years of flawed fiscal and monetary policies. Investors should proceed with caution as the cycle grows increasingly extended and focus on quality rather than yield to avoid future losses.
Interest rates obviously only have one direction in which to move, but it remains highly uncertain how the markets will react when they increase. After all, higher interest rates should be interpreted as a sign that the economy is healing, not as an inflation alarm since signs of higher prices are few and far between. In fact, the U.S. and European economies remain stuck in a deflationary dynamic while only Asia is seeing any type of genuine inflation. The Federal Reserve should move sooner rather than later to raise rates to break with its history of engaging in pro-cyclical policymaking and send a message to the markets that it has learned from the past. Hoenig correctly argues that persistent zero interest rates are problematic, regardless of whether inflationary pressures are apparent. While I would characterize the U.S. economic environment as still basically deflationary, I believe the dynamics of the financial markets are inflationary and require higher rates. In other words, the real economy is suffering from deflationary dynamics but the financial markets remain subject to the illusion of inflation through low interest rates and abundant liquidity for unproductive activities of the type that dominate Wall Street trading today. Accordingly, higher interest rates are needed to put a damper on speculation, whatever the modest cost to Main Street, because in the end Main Street will suffer if Wall Street is not reined in. The unacknowledged truth is that Wall Street is still engaging in a massive carry trade at the expense of the U.S. taxpayer, and the sooner this trade is brought to an end, the better off the U.S. economy will be.
Currencies and Gold
Paper currencies are being devalued before our eyes by the profligate policies of political leaders around the world. The $1 trillion European Union bailout plan was another example of the continuing devaluation of fiat money. Accordingly, every investor should be moving a portion of his assets into physical gold on a steady basis. As I have written many times, gold is the anti-leveraged buyout, the anti-credit default swap (CDS), the anti-collateralized debt obligation and the anti-fiat currency.
Speaking of currencies, the Euro is bound to drop further as the European Union comes to terms with its inherent structural weaknesses. The wealthier northern countries will be supporting the weaker southern members for years to come, a fate that was inevitable from the inception of the union. This will cause years of political strain and economic and political instability that bodes poorly for the European currency. In fact, the best thing that the dollar has going for it is the weakness of the Euro. On its own, the dollar is plagued by the poverty of America's misguided fiscal and monetary policies, which means that the U.S. currency is a poor bet against Asian currencies (other than the Japanese yen, which suffers from that country's terminal economic malaise). The safest currency bets remain the Swiss franc now that the Swiss banks have regained their equilibrium (if not their secrecy) and the Singapore dollar. The Chinese yuan will continue to modestly appreciate against the U.S. dollar as well within the context of China's mercantile policies.
Whatever financial regulation is passed into law, it will not be enough to rein in the wizards of Wall Street. Our financial system will continue to be populated by intellectually overeducated but morally undereducated professionals until a radical cultural revolution takes place. Nonetheless, it appears that financial reform with some teeth is definitely in the cards. We can expect less leveraged financial institutions, more rational compensation regimes, greater transparency and a modicum of derivatives regulation. Unfortunately, none of this will be sufficient to prevent another financial crisis in the near-term due to two missing ingredients. First, the failure to ban naked CDSs will prove to be a fatal error. Second, the reluctance to shift both fiscal and monetary policy from a pro-cyclical to a counter-cyclical regime will exacerbate economic and market instability.
Much of the financial reform debate is centered on the issue of “too big to fail.” This is an important issue because our so-called private enterprise system of capitalism is nothing of the kind — instead, we have a system that privatizes gains among a small elite and socializes losses among the basically disenfranchised U.S. taxpayer. But there's a larger issue that goes unacknowledged in current debates about “too big to fail.” This is the fact that CDSs are an unusually noxious type of financial instrument that effectively connect all financial institutions into one large interconnected web. In other words, all of the firms that trade these instruments are connected into a single large firm (otherwise known as the financial system itself) that is itself “too big to fail.” Like any network or web, that system is only as strong as its weakest link. Unless these instruments of connectivity are banned, the system will remain highly vulnerable to the types of panics and potential collapses that were experienced in 2008.
The second point to consider is that the Obama administration and Federal Reserve need to start working on the nation's unsustainable fiscal position before it's too late. The Keynesian policies that have dominated the response to the financial crisis will only sow the seeds of future crisis unless they are modified with serious budget reforms. This includes reforms of entitlement programs such as Social Security and Medicare and Medicaid (which were not fixed by the healthcare legislation rammed through Congress by the Democrats). Instead of limiting future costs, politicians are increasing them, which is unsustainable. The Federal Reserve has terminated most of the special liquidity programs it introduced to address the crisis but has yet to terminate its zero interest-rate policy, which is a profound mistake. Misguided interest-rate policy under former Chairman Alan Greenspan and current Chairman Ben Bernanke was a primary contributor to the credit bubble that ended in tears in 2008. The central bank is well on its way to repeating that mistake by maintaining interest rates at invisible levels for longer than is justified even with inflationary pressures remaining subdued. As noted above, the financial economy remains inherently prone to inflationary excesses through speculation, and low interest rates are the primary fuel for that activity.
Future of Government Support
Two years after the financial crisis, financial markets are again viewing the world through rose-colored glasses. There are certainly promising signs that the economy is growing again, but there are also doubts concerning whether this growth is self-sustaining. The reality is that the government is now playing a larger role in the economy than it did before the crisis, and government stimulus will never be completely withdrawn. Accordingly, investors can continue to count on government support in the form of low interest rates and other indirect stimuli for the remainder of 2010 and most likely well into 2011. At some point, however, governments are going to be imposing higher taxes and balancing their books to put their own fiscal houses in order. When that occurs, the economy and markets will experience a headwind that will likely result in lower stock and bond prices. Before that, markets will be counting on successful outcomes in Greece and the Gulf of Mexico to insure continued stability and growth.
- John Maynard Keynes, The General Theory of Employment, Interest and Money (New York: Harcourt Brace, 1964), at p. 159.
Michael E. Lewitt is president of Harch Capital Management, in Boca Raton, Fla. He's also the author of The HCM Market Letter and the recently published book, The Death of Capital (Wiley, May 2010)