Strategic Investment Conference - David Rosenberg
If you haven’t read the notes from the first two speakers, Niall Ferguson and Dr. Woody Brock, I encourage you to do so. The next speaker at the conference is a friend of mine and one of the most widely regarded economists today. David Rosenberg was previously the Chief Economist at Merrill Lynch and is now the Chief Economist and Investment Strategist at Gluskin-Sheff. Here are his thoughts.
The 3-D's Deflation, Deleveraging and Demographics
“People continually label me a “perma-bear” which is very inaccurate. I have been a perma-bull on fixed income for a very long time. The reason that Gluskin-Sheff hired me is that my job is to take the economic data points and put them together in a structure from which investments can be made.”
"A Forecast is nothing more than the midpoint of a distribution curve."
When you talk about risk often enough you get classified as a “perma-bear”. The corner stone of asset management is not capital "appreciation" but capital "preservation".
In the second year of this economic recovery (2011) the economy was growing at 1.6%. This is important to understand because in a “normal” recovery the economy should be growing at 5-6% at this same point.
Bob Farells' 10 Market Rules: The 10 Commandments To Remember
1. Markets tend to return to the mean over time
2. Excesses in one direction will lead to an opposite excess in the other direction
3. There are no new eras — excesses are never permanent
4. Exponential rapidly rising or falling markets usually go further than you think, but they do not correct by going sideways
5. The public buys the most at the top and the least at the bottom
6. Fear and greed are stronger than long-term resolve
7. Markets are strongest when they are broad and weakest when they narrow to a handful of blue-chip names
8. Bear markets have three stages — sharp down, reflexive rebound and a drawn-out fundamental downtrend
9. When all the experts and forecasts agree — something else is going to happen
10. Bull markets are more fun than bear markets.
These are the ten commandments of investing. Not understanding this is what leads to individuals losing large amounts of money over time.
Rules #1 and #9 are the most important to conversation today.
The markets tend to return to the mean over time. Understand this. Just this year there have been two very important covers from Barron’s.
February 2012 - Barron's Dow 15000
April 2012 - Barron's - Outlook Mostly Sunny.
Barron’s has an absolutely horrible track record of putting on their covers bullish sentiment at just about the peak of the market. (He showed many examples of Barron’s covers going back over the past decade.)
At the point of peak bullishness by investors and money managers is when the “reversion” effect will occur. In other words, whatever Barron’s puts on their cover you are wise to do the opposite.
The “Fiscal Cliff”
Under status quo at the end of 2012 roughly 42 tax benefits will expire at the end of 2012. At that point there will be record drag (roughly 4%) on GDP from reduction of those tax benefits to spending. Since the economy is currently barely growing at 2% do the math – a negative 2% economic growth rate is a very large recession.
Ben Bernanke - the Fed has NO ability to offset the impact of the “fiscal cliff.” By the way - recessions tend to happen in the first year of the Presidential cycle.
The last two times, 1960 and 1969, that there was a fiscal retrenchment of the same magnitude both ended in recessions. If there is any one thing to worry about it will be this particular event more than just about anything else.
What about government spending? US government spending runs at approximately $1.50 for every $1.00 brought in. This level of spending is unheard of outside of WWII and is very unsustainable. Furthermore, the longer that this excessive level of debt based spending occurs the more that it becomes a structural problem. Interest payments are at a record share of total revenue as well as the debt as a share of GDP. The high level of debt to GDP, and the subsequent servicing of that debt via interest payments, reduces economic growth. This leads to the real problem facing the U.S. today…Deflation.
Outside of commodity based inflation there is deflation running in everything else from incomes to real estate. This deflation impacts the base of the consumer and the economy. Take a look at the current output gap which is still at some of the largest levels on record. The current economic growth rate is too weak to offset the current slack in the economy.
This is why QE3 is coming and is just a matter of timing.
The deflation in housing is going to continue. Housing is only about 40% through its reversion process. In fact, along with housing, the entire household debt deleveraging process is still in progress and still has a tremendous way to go. This deleveraging cycle will remain a dead-weight drag on the economy for quite a long time.
It is important to understand that the debt bubble didn't happen in 3 years and it won't be cured in three years either.
According to the recent McKinsey study the debt deleveraging cycles, in normal historical recessionary cycles, lasted on average six to seven years, with total debt as a percentage of GDP declining by roughly 25 percent. More importantly, while GDP contracted in the initial years of the deleveraging cycle it rebounded in the later years.
A further pressure on the economy remains excess unemployment. There are roughly 20 million still unemployed versus the long term average of about 13 million. The excess capacity of labor suppresses wages and economic growth. In other words, excess employment leads to deflationary economic pressures.
In regards to employment the only real report to watch is the U-6 report, versus U-3, because it is the most inclusive measure of unemployment. If two full time employees are converted to part time they are not included in the U-3 report but will show up in the U-6 report. The U-6 level of unemployment is still at a higher level than at any other recessionary period.
As I stated, high levels of unemployment, or excess slack in the labor market, leads to deflation in wages. Deflation is wages is very problematic and has a lot do with deflationary prices in the economy.
So, deflationary pressures are why I am still bullish on bonds versus stocks.
Here is an interesting side note. What correlates with bond yields?
88% Fed Policy
75% Core CPI
64% CPI inflation
With the Fed keeping yields at zero through 2014 there is NO rate risk in owning bonds. When bond yields jump up for any reason it is a buying opportunity UNTIL the Fed starts taking the punch bowl away.
Historically, the average yield curve spread between the short and long dated maturities is about 160 basis points. Currently, that spread is about 330 basis points. That spread will revert to the average over time which means that the long bond yield is going to 2%. Buy Bonds and you will get a better return than owning stocks with dramatically less risk.
What type of bonds? I like corporate bonds. Corporate balance sheets are great and have been cleaned up tremendously since the recession. The current corporate default rate is 2% and companies that are BB or BBB rated that have an A rated balance sheet make a lot of sense. There is no debate between stocks and bonds. Bonds are a contractual agreement to pay interest and repay principal over a specified period of time.
Stocks are currently priced for a 10% growth rate which makes bonds a safer investment in the current environment which cannot deliver 10% rates of returns. We are no longer in the era of capital appreciation and growth. The “baby boomers” are driving the demand for income which will keep pressure on finding yield which in turn reduces buying pressure on stocks. This is why even with the current stock market rally since the 2009 lows - equity funds have seen continual outflows. The “Capital Preservation” crowd will continue to grow relative to the “Capital Appreciation” crowd.
Investment Stategy - Safety and Income at a Reasonable Price
- 1.Focus on Safe Yield - Corporate bonds
- 2.Equities - Dividend growth and yield, preferred shares
- 3.Focus on companies with low debt/equity ratios and high liquid asset ratios. The balance sheet is more important than usual.
- 4.Hard assets that provide an income stream - oil and gas royalties, REITS.
- 5.Focus on sectors or companies with low fixed costs, high variable cost, high barriers to entry, high level of demand inelasticity.
- 6.Alternative assets - that are not reliant on rising equity markets and where volatility can be used to advantage.
- 7.Precious Metals - hedge against reflationary policies aimed at defusing deflationary risks.