new entitlement programs.
Passage of the Affordable Care Act, in my opinion, is a fiscal and political nightmare. It has changed the political dialogue in this country for the worse. By creating another entitlement without first addressing those that have been eating away at the fiscal soundness of our country, we have in essence levered up an already highly levered system.
Its ineffective and incompetent implementation, in addition to governmental overreach, may awaken the electorate to the risks of an overly intrusive and excessive government. I can’t think of anything more personal than healthcare. How might the electorates’ dissatisfaction be registered, should implementation problems persist? Possibly, it will be through the ballot box this November.
Until the electorate registers its dissatisfaction with excessive government, the fiscal mess will continue to worsen. Should the electorate “revolt,” my dower view could change. I define revolt by how many seats in the senate shift. During the past 80 years, I believe we’ve had two revolts which marked major turning points in the political direction of this country. Twelve seats switched from Republican to Democrat in 1934, while twelve swung from Democrat to Republican in 1980.4 Our Washington consultant, Washington Analysis, believes probably only 4 to 6 seats will shift to Republican this November. If this occurs, divided government will continue and then we will have to wait until the 2016 presidential election for a clearer outcome. In this case, I believe the next president will not address the fiscal mess in 2017 because it would still be considered too divisive an issue; thus, 2021 would be the more likely timeframe—after the second term presidential election. In my opinion, this would be too late.
If ten senate seats were to swing from Democrat to Republican or Independent, this would represent a tectonic shift, potentially setting up the possibility that the next president could consider addressing the fiscal mess in 2017 in conjunction with the congress. It will require both sides coming together.
I believe the odds favor the first scenario. If this is the case, the Fed will remain active with a monetary easing bias so as to offset the structural impediments in congress. With a $4.5 trillion securities’ portfolio, how much flexibility will it have, particularly if a financial crisis develops and additional QE is required? Will the bond market remain quiescent to an ever expanding Fed portfolio or will it revolt via escalating longer term interest rates? With the likelihood that without a fiscal restructuring before 2021, by 2024, total US debt should be upwards of at least $25 trillion and more likely $28 trillion versus $17.5 trillion currently. Total net interest cost will likely rise to between $1.0 and $1.2 trillion versus the CBO’s $227 billion fiscal 2014 estimate.5 A combination of rising rates, eroding entitlement trust funds and lower remittances from the Fed, account for this increase unless the Fed can maintain its interest rate repression policies. It is difficult to say, but I would place the odds of a bond market revolt at greater than 50%. There are other well respected bond managers who argue that interest rates will remain low or continue to decline due to the effects of demographics. For the first time in this country’s history, a succeeding generation is smaller than the previous one. We’ve never seen this scale of debt and off-balance sheet liabilities, in combination with a rapidly aging population base. This trend is also occurring in several other developed countries. History has shown that, when government financial obligations become too large to service, the most likely solution is to resort to the monetary printing press. I do not believe the financial markets are factoring in this potential risk.
Whenever I am confused about potential outcomes, I generally look back into history for some guidance.
Walter Bagehot wrote in his “Essay on Edward Gibbon,” in 1856, “Much as been written on panics and manias,…….but one thing is certain, that at particular times a great many stupid people have a great deal of stupid money.” I believe this is now occurring in many areas of the financial markets. For example, the Wall Street Journal carried these story titles in their May 23 edition: “Investors Show Little Fear” and “Penny Stocks Fuel Big-Dollar Dreams.”6
At FPA, throughout our various products, a defensive mindset is prevalent. Equity portfolios are holding sizeable levels of liquidity, while our fixed income product remains anchored to a very short duration. We hope that you appreciate our focus and concern on protecting and growing your capital and that you will have the patience to see our thinking vindicated.
Before I close, I would like to leave you with these two thoughts. Norman Mains said, “Wisdom is the anticipation of consequences” while according to Mark Twain, “Courage is resistance to fear, mastery of fear, not absence of fear.” I believe these two traits are required to be a successful investment professional and that our investment teams have them.
Thank you and I hope your thinking will be stimulated by my comments here today.
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