Steven Romnick on Economy and Deflation

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The most widely used measure for the economy is GDP, and we therefore use it in our economic discussions for the same purpose. However, it’s important to appreciate its flaws, especially those listed below:

  • GDP measures revenue, but the focus should be on a host of variables, including income, return on capital, and employment.
  • GDP can be bought. The government prints money and gives it to someone who ostensibly needs it. That individual spends it and GDP rises. Therefore, the more money the government prints, the faster the economy grows (nominally, anyway).
  • Not everything that reduces GDP is bad for the economy. For example, cancer treatments and services cost $264 billion a year in the United States.8 Those costs represent someone else’s sales (e.g., hospitals, HMOs, drug companies) and contribute to GDP. If we found a cure for cancer, GDP would then be negatively impacted. Yet how could one argue that curing cancer would be bad for the economy?

We are not suggesting there’s a superior measure to GDP, just that economic discussions should take into account the limitations of the metrics at hand. Though anemic, 2011 showed a continuation of the economicrecovery, but GDP sits just 0.2% higher (adjusted for inflation) than the 2007 peak.9 We continue to havedifficulty figuring out how current U.S. economic weakness will be transformed into a place of significantly lower unemployment and strong economic growth. We do believe that we will once again have faith in our economy—some day, anyway, and most likely after further discomfort. Great change only comes from great challenge. What has occurred thus far doesn’t seem to have pushed enough people close enough to the edge to trigger that change. We thus expect continued economic struggles. At best, we see muddling through slow/negligible real growth.

The problem we see is that U.S. policy depends far too much on popular sentiment to run effectively. The majority tends to prefer the best for today at the expense of tomorrow, i.e. short-term gain for long-term pain. Someone needs to be the adult here and say, “enough already,” à la Paul Volcker’s hard line in the early 1980s. The majority of our government officials worry that pushing for tough, but appropriate, resolutions might cost them their jobs, as well as the influence, income, and bright lights that come with them.

Maybe they recognize the need to hang onto the jobs they have, especially amid today’s grim employment market. Indeed, an estimated 8.6 million people lost their jobs in the most recent recession, and this tepid recovery has created just 2.8 million jobs since—leaving us 5.8 million jobs short of 2007’s pre-recession peak.10 We feel, though, that there’s too much focus on the quantity of jobs, and not enough attention paid to their quality. Since not all jobs are created equal, looking at jobs numbers creates an oversimplified view. If a General Motors worker lost his job working on the assembly line, then finds work delivering pizza, the change is neutral as far as the unemployment data are concerned. However, he might earn just the federal minimum wage. At $7.25/hour, that’s a far cry from the more than $70/hour (including benefits) he could have been earning at GM.11 We have had similar, if not as dramatic, negative shifts throughout the nation—a trend that places additional pressure on our economy. The UAW worker is an extreme example, but as Paul Osterman, an economist at M.I.T.’s Sloan School of Management, noted in the book Good Jobs America:
Making Work Better for Everyone:

8 In 2010, the American Cancer Society estimated the overall annual cost of cancer was $263.8 billion.
9 David J. Lynch, “The Hollow Recovery,” Bloomberg Markets, January 2012, p 32.
10 U.S. Bureau of Labor Statistics. Job losses calculated from pre-recession peak in November 2007 through the trough in December 2009. The
number of jobs regained is net of losses from January 2010 through December 2011.
11 The Heritage Foundation.

Careful studies of worker displacement show that when people are laid off from previously stable employment, they take a wage hit—if they are lucky enough to find work—of over 20%, and this gap persists for decades after the job loss. Americans feel that these risks have grown: Successive national surveys show a long-term upward trend in perceived risk of job loss, a trend that remains even after removing the effects of the business cycle and changes in the demographic composition of the workforce.12

Given the insufficient creation of high-paying jobs, what little economic growth there has been has come more from productivity than from the top line (i.e., revenues). That’s pushed up corporate profit margins to an all-time high (since 1980), as reflected in the following BCA Research chart. With margins now at least 50% above average for that period, it’s reasonable to opine that the future holds more margin downside than upside—and that would add further pressure to the economy.

Steven Romnick on Economy and Deflation
If it wasn’t for Europe’s difficulties, the markets would be a lot better. But that’s like saying, “If I could bat .400 against major league pitchers, I could play for the Dodgers.” A fractured Eurozone continues to stifle growth, not just in the underlying domestic economies, but in those of their trading partners as well. We don’t see how the Euro survives as a currency without merging monetary and fiscal fiefdoms, a step that would require nations to willingly surrender some of their sovereignty to wealthier neighbors. Such a step would, for the first time, give outsiders the power to influence domestic spending in the weaker nations. We suspect circumstances would have to worsen considerably for that to happen. German sensibility dictates operating with more long-range thinking than other EU countries. For example, Germany placed limits on wage growth, causing labor costs to grow more slowly, thereby enhancing productivity. This has contributed to their stronger GDP growth and better economic circumstances today. The short-range thinking of
others—Italy for example—has produced weaker economies. Such different mindsets will certainly keep Italians from freely ceding control to the Germans, but necessity may nevertheless become the mother of invention. We’d wager that Germany’s more prudent economic policies will create higher real net worth for German citizens in the future, particularly if Italian per capita net worth gets recalculated in Lira.

The notion that we might be able to save our way to prosperity is misguided. The combination of cautious saving, cutting spending indiscriminately, and raising taxes has never driven growth, and it won’t now. In fact, it could do quite the opposite. However, the proposals coming out of Washington and various States suggest that policy makers don’t see the danger of this triple threat. We want to see more investments in technology, education, and infrastructure, and less spending on improvident earmarks like snowmaking in Minnesota or adding another racetrack in North Carolina. We want to see the average age for Social Security benefits raised and uneconomic government pension benefits reduced. And, we want to see our legislators tread carefully when considering tax increases. Corporations can move offshore, as a number of companies in our portfolio have (e.g., Ensco International, Covidien, with Aon expected to move in 2012). States with higher taxes tend to lose corporations and high-income individuals to lower-cost states (e.g., California to Nevada), and create a disincentive for potential new entrants to the state. We’d like to see more corporations establish headquarters here in California, rather than the net exodus we’ve seen. Unfortunately, higher-paying 12 Paul Osterman and Beth Shulman, Good Jobs America: Making Work Better for Everyone (Russell Sage Foundation, 2011), p 2. jobs are currently departing, and what little job creation there has been is coming in the form of lower-paying work.

It is difficult to position a portfolio when one thinks that current deflationary pressures could one day give way to significantly higher levels of inflation. We are ill-equipped to answer the questions, “how much?” and “when?” John Mauldin summed it up well in one of his weekly letters:

Inflation is not being generated because the expectation of inflation remains low, and because there is still overcapacity and over-indebtedness in the private and public sectors. Continued monetary easing could (and will) lead to a substantial monetary overhang that could, if the public loses trust in money, lead to an inflationary bubble. Some argue that inflation is unlikely because of the oversupply of labor and continued competition from new market entrants like China. Certainly we may see continued pressure on wages because of globalization, although the longer low growth persists
in the West, the more likely it is that Western governments will resort to increased protectionism, leading to upward pressure on prices.

An inconclusive resolution to the inflation/deflation debate keeps us from tilting our portfolio either one way or the other. In the inflation outcome, our stocks should do well (at least nominally), but not as well as a portfolio committed to commodities. Should deflation come to pass, stocks will likely perform badly, but in that event, our substantial cash stake will allow for deployment at lower asset prices. We have gone back and forth on the deflation and inflation argument, and since falling in one camp versus another would dictate how one positions a portfolio, we thought we’d share our less-than-conclusive thought process.

Arguments for deflation:

  • We haven’t seen much inflation, therefore we won’t. Other than the price increases seen in energy and agriculture, there really hasn’t been much inflation. In fact, higher fuel and food costs crowd out inflation elsewhere. What’s more, we saw very little inflation when Greenspan brought interest rates down dramatically in the early part of the last decade while, at the same time, hundreds of billions of dollars of equity pulled from homes—via refinancing and home equity loans—and found its way into the economy. So now, without those forces, it won’t take much for deflation to take hold.
  • China’s economy rolls over. Commodity prices subsequently decline as the largest buyer of raw materials reduces demand.
  • Low interest rates. For individuals dependent on a fixed income from their investments, today’s low interest rates necessitate a larger portfolio to achieve the same level of income. This means less spending and more saving—Keynes’ paradox of thrift. Low interest rates also carry with them the hope of stimulating the economy through more corporate and personal borrowing, but corporations already hold historically high levels of cash, and individuals either don’t wish to borrow or don’t qualify.
  • Excess capacity. The industrial capacity utilization rate stands at 78.1%, still 2.3 percentage points below its long-run average (1972-2010).13
  • Weak economy. Even with the unprecedented injection of liquidity, U.S. economic growth is punk. In retrospect, a lag seems understandable since the financial system wasn’t built to successfully deploy such a staggering sum of capital. Expectations that the almost $3 trillion increase in the money supply would be put to work right away were almost certainly too optimistic.14 In the short term, interest rates went lower, but velocity declined, contributing to the feeble recovery. Looking at the size of an economic recovery in the context of the size of its preceding decline, this recovery is the worst since 1933, as depicted in the bar chart below.
14 St. Louis Federal Reserve.

Steven Romnick on Economy and Deflation

The fact remains that this recovery continues to be far weaker than expected. As we’ve oft discussed, you can’t force people to borrow, particularly if they expect to earn less in the future, as the University of Michigan consumer survey recently found.15

Arguments for inflation:

  • Quantitative easing. QE is like a drug with a bad longterm side effect. You can feel good over the shortterm, only to suffer from a host of maladies that hit you later—not the least of which is a fear that the value of fiat currencies will erode.
  • Money supply (MZM) velocity increases. That is, the $3 trillion increase in the money supply referenced above gets put to work.
  • China demand continues. We have read and seen pictures of vacant Chinese cities, and job creation has not been keeping pace with the influx of rural citizens into urban areas. But at the end of the day, China is the world’s largest creditor nation, with $3.2 trillion in foreign exchange reserves.16 If necessary, that cash could be pressed into service to buy China both jobs and time. The government could build a whole city, tear it down, and then do it
15 Thomson Reuters/University of Michigan, “Surveys of Consumers,” December 22, 2011.

again if it so desired. That wouldn’t be the highest and best use of capital, but it would give the economy time to grow into the infrastructure that’s been built. We don’t suggest that China cannot
stumble. It can—even severely. We just find ourselves incapable of making such a wager one way or

  • Value-added tax. There has been talk of its introduction, which would be inflationary, at the margin.
  • Protectionism. U.S. reacts to the artificially low currencies of some of our large trading partners by putting in place inflation-inducing protectionist policies.
  • Economic growth. Longer term, the global economy will grow, and demand for homes, autos and other goods and services will increase, absorbing excess capacity.

After all the back and forth, we still fall into the camp that believes there will eventually be inflation, largely because of the unprecedented liquidity creation noted in our arguments for inflation. However, that doesn’t mean that deflationary pressure won’t rule the roost for the foreseeable future.

Our uncertainty sometimes leads us to look to others for guidance—especially to those (such as the parties named below) who should know better than us what’s happening to the economy. Unfortunately, each of the following declarations about how well the economic recovery was proceeding has proven too optimistic.

“I do see green shoots.”
Ben Bernanke, Federal Reserve Chairman, interview on “60 Minutes,” March 15, 2009.

“Administration Kicks Off ‘Recovery Summer’ with Groundbreakings and Events Across the Country.”

White House press release, June 17, 2010.

“Welcome to the Recovery”
Timothy Geithner, Op-Ed piece in the New York Times, August 3, 2010.

“2010 … a year of transformation for the world.”
Dominique Strauss-Kahn, then-managing director of the International Monetary Fund, from an address at
the Asian Financial Forum, January 20, 2010.

We don’t proffer a better ability to divine the future, but we do suggest that you resist putting too much confidence in what you read about the economy (here or anywhere else). We think the market is unlikely to experience a decline similar to that of 2008-09, if for no other reason than that people now view the world more fearfully than they did during the more sanguine pre-2008 period. Once one climbs a wall of worry, there isn’t as far to fall—an oxymoron, but consistent with our view that there’s less to fear when there’s fear. After considering all of the above and more, we still let price be our guide. If an investment discounts the present, allowing for a host of negative outcomes, you will see more equity exposure as our expected risk-adjusted return should be good. If a prospective investment discounts the future and hereafter, you will see more cash.

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