A. Gary Shilling - Six Realities In An Age Of Deleveraging
In Part III of my series of reports from the 10th annual Strategic Investment Conference, presented Altegris Investments and John Mauldin, the question of how to invest during a deleveraging cycle is addressed by A. Gary Shilling, Ph.D. Dr. Shilling is the President of A. Gary Shilling & Co., an investment manager, Forbes and Bloomberg columnist and author - Mr. Shilling's list of credentials is long and impressive. His most recent book "The Age Of Deleveraging: Investment Strategies In A Slow Growth Economy" is a must read. Here are his views on what to watch out for and how to invest in our current economic cycle.
Six Fundamental Realities
- Private Sector Deleveraging And Government Policy Responses
- Rising Protectionism
- Grand Disconnect Between Markets And Economy
- Zeal For Yield
- End Of Export Driven Economies
- Equities Are Vulnerable
Private Sector Deleveraging And Government Policy Responses
Household deleveraging is far from over. There is most likely at least 5 more years to go. However, it could be longer given the magnitude of the debt bubble. The offset of the household deleveraging has been the leveraging up of the Federal government.
The flip side of household leverage is the personal saving rates. The decline in the savings rate from the 1980’s to 2000 was a major boost to economic growth. That has now changed as savings rate are now slowly increasing and acting as a drag on growth.
However, American’s are not saving voluntarily. American’s have been trained to spend as long as credit is readily available. However, credit is no longer available. Furthermore, there is an implicit mistrust of stocks which is a huge change from the 90’s when stocks were believed to be a source of wealth creation limiting the need to save.
My forecast for GDP growth going forward is that it will remain mired around 2%.
The response to the stalled economic environment and deleveraging cycle has been massive government interventions. The Fed’s original program of zero interest rates have failed to promote borrowing. The next step was unprecedented Quantitative Easing.
The Fed’s dual mandate is full employment, currently targeted at 6.5%, and price stability (inflation) around 2%. The Fed has been very clear that the current QE programs are directly tied to these targets.
However, monetary policy is a very blunt instrument, but the Fed believes that it will work within a 5 step process.
- The Fed buys treasuries and mortgage bonds out of the market.
- The increase in liquidity is then reinvested into the equity market.
- The rise in asset prices creates a wealth effect for consumers.
- With stronger confidence consumers spend more which creates demand on businesses.
- The increase in demand leads to job creation.
The problem is that there is little evidence that Q.E. programs are fulfilling their intended role.
History is not a controlled experiment. There is no way to tell what would have really happened had the Fed not intervened after the financial crisis.
However, what we can absolutely measure, is the impact of the Fed’s activities on the economy. If we measure the increase in real GDP for each dollar of increase in debt we find that it has been close to nil. From 2001 through the end of Q2-2012 – we find that there has been only a 0.08% increase in real GDP per dollar of increase in debt.
While the economy has failed to ignite - there has been a sharp surge in market capitalization as a percentage of nominal GDP. Currently at levels well above the long term average it is unlikely that this is the beginning of the next great secular bull market.
The bottom line is that despite trillions of dollars of Federal Reserve interventions there has been very little impact on the real economy. This is because there has been very little follow on effect from the massive increases in excess reserves. Historically required reserves have remained fairly close to the level of excess reserves. However, today, excess reserves are running roughly $1.7 trillion above the level of required reserves. Liquidity remains trapped which is why there is no velocity of money in the economy.
The problem today is that everybody wants to increase exports to boost their respective economies - but no one wants to, or is able to, buy. This has pushed countries into the need to take more drastic actions to stabilize and boost their economies. This has led to currency devaluation schemes.
Japan is the poster child to currency devaluation. They have gone “all in” to debase their currency in hopes that they will create some inflation. For Japan it is “go big or go home.”
It is important to note that NO ONE ever initiates currency devaluation – they are just trying to get back to even.
Currently, the head of the central bank in Japan, has the backing of the country. This will allow him to operate and continue his stimulative actions. The tipping point will be when he loses this approval.
However, while Japan is currently happy with their direction, other countries are not. Eventually there will be a reprisal.
The Great Disconnect
“Don’t worry about a thing as long as the Fed is inflating assets and the economy is in the tank.”
Nobody wants to end the current Q.E. programs. What it will take is an economic shock of some magnitude. What type of shock it will be, and when it will occur, are the only questions?
Here is the simple truth: Stocks will eventually revert to the fundamentals of the economy. Such a reversion will devastate most investors that are unhedged for that eventuality.
Zeal For Yield
The chase for yield has reached excessive levels. Despite the rising risks individuals continue to ignore the fundamentals and reach for ever increasing levels of yield.
Junk bonds, emerging market debt and bank loans are at record low levels in yield. The yield on stocks and bonds are equal for the first time decades. This is an indication of a late stage bull market. It is also one that has historically ended badly for investors.
End of Export Driven Growth In Developing Countries.
The demand for exports is slowing as the major developed countries are weak and demand slackens.
(Note: This was seen in the latest trade deficit report as imports for the U.S. plunged sharply last month. In other words the demand for products from other exporters is slowing which negatively impacts their economies.)
As Jeff Gundlach discussed earlier – China’s growth rate is slowing. However, no run really trusts the data coming out of China. It takes China 18 days from the end of the quarter to report GDP. It takes the U.S. 28 days. China never revises their data subsequent to that first report while the U.S. revises its data two more times over a 90 day period. The data is extremely unreliable. For instance, how do you have a flat manufacturing report coming out of China, as measured by Markit PMI, when they supposedly have a 7.7% GDP growth? That simply does not add up.
Going forward emerging economies are focused on creating internal growth to offset the drag from slowing export growth. This will likely lead to problems.
Equities Are Vulnerable
We are still within a secular BEAR market that begin in 2000 with P/E ratios still contained within a declining trend. Despite media commentary to the contrary - this time is likely not different.
In order for valuations just to return to the long term average they would have to decline by 27.5% from current levels. However, the reality is that valuation reversions always exceed the long term mean.
Furthermore, corporate profits have only soared due to declining labor costs and increased productivity. The problem now is that there is an inability to slash costs and increase productivity at levels that can offset the decline in operating earnings and revenue.
This makes equities susceptible to a large reversion at some point in the future.
2013 Investment Themes
“Economists are like lookouts at the house of ill-repute. They are kept away from the action but good to have when the cops arrive.”
The risk on trade is alive and well - but will not last forever. Therefore, the following is what I find attractive and unattractive in the current environment.
- Treasury Bonds
- Quality Bonds And Dividend Stocks.
- Small Luxuries
- Staples And Food.
- Doll Vs Yen, Long Nikkei
- Selected Healthcare Providers And Medical Office Buildings
- Productivity Enhancers – Things That Help Businesses Lower Costs
- North American Energy Producers Excluding Renewables
- Developed Country Stocks
- Homebuilders And Related Companies
- Your House
- Big Ticket Consumer Discretionary Stocks
- Consumer Lenders
- Selected Banks
- Junk Securities
- Developing Country Bonds And Stocks
- Old-Tech Capital Equipment Producers
Austerity Or Stimulus – What Should We Be Doing?
If you don’t get austerity when things are tough you will never get it. This is the problem in Germany.
In the U.S. – Congress has it completely backwards. They should be working on structural deficits rather than fiscal deficits. Change retirement ages, etc. rather than trying to inflate assets.
GDP less inventories is much weaker. Inventories are a residual of activity and small changes on either end have a big impact on the economic figure.
The great disconnect will reconnect over the next couple of years which will negatively impact long only investors.
The Fed Reserve – Does The Fed Have To Exit?
That is an interesting point. With slow growth, which will continue due to the ongoing deleveraging cycle for another 5 years, it is likely that the Fed will not try and exit. However, when the economy begins to reach higher levels of growth in the future the excess reserves will begin to flow into the system. If they Fed doesn’t exit from their policies when that occurs the impact of inflation could be severe.