Figure 3 shows how the dependence on credit almost doubled during the Great Moderation and then absolutely exploded during the Great Fluctuation. In the last ten years alone, the U.S. economy has taken on a phenomenal $6 in additional debt to produce each $1 increase in annual GDP. As though delighting in our credit-based consumption boom, all indexes, save the still-bruised Nasdaq, were fully resuscitated by 2007. But all was not well.
From the summer of '07 to the summer of '08, dark clouds gathered over home building, mortgage-backed securities, banks and the shadow banking system. Credit hell broke loose by September 2008. Mounting mortgage defaults finally grabbed investors' attention, and policy-makers pounced on an irresistible crisis. Since then, the government has been frantically pressing every conceivable stimulus, bailout and guarantee button in its effort to forestall a reversal of the credit cycle, which would have dire implications for employment and economic activity.
The S&P 500 cratered in early March '09, falling by a stark 55% from its October '07 top. It seemed the world was accepting the inevitability of a bleak deleveraging cycle in the Western world. But like the hero in an old-time cowboy movie, spontaneously or perhaps instinctively some version of a new bull market began to climb the wall of worry. Feeding off bailout optimism, trading momentum, a string of "less bad" economic news and a positive 3Q read on GDP, the index recouped half its decline in eight months. As I write, the index has stalled at 1100, still 29% below the '07 high. Inquiring minds want to know, "Where do we go from here?"
The New Reality: 2010-2020
I don't know whether it is the consensus view that we have weathered the storm and can now expect a V-shaped recovery and a new high in corporate earnings within a year or two. But a 60% gain in stock prices in eight months sure looks like somebody thinks we're out of the woods. As we contemplate the future, I would point to two glaring realities that shift the burden of proof to those betting on a return to some version of the Great Moderation.
One is the extraordinary debt burden that took our credit system to the brink has not been lightened; if anything, it is worse. Shifting worthless private loans onto the backs of taxpayers, especially the owners of job-creating small businesses, does not brighten the outlook for economic growth. Debt must be serviced, and a growing debt service burden increases the cost of production and dampens consumption. Also, history suggests that the true cost of borrowing is closer to 5% than 0% (the going rate on short-term government debt), so an increase in debt service cost undoubtedly lies ahead.
The second reality is that the explosion of government spending as a percentage of GDP is not bullish for private sector growth. Governments do not create net new jobs. The rising standard of living we have taken for granted is the fruit of the increasing productivity of labor, which in turn is a function of capital (aka savings) put to use by hard working, creative risk takers. That's Economics 101, or at least it used to be before General Motors had to seek the permission of Congress to close unnecessary dealerships-permission that was denied.
Here is our new reality: an unprecedented and still-growing debt-service burden, a banking sector still saddled with uncollectible loans and government spending at 45% of GDP-not even counting its unfunded social commitments at 4 times GDP (Figure 4). These circumstances don't portend the kind of economic growth we once enjoyed. Don't just take my word for it. Read Gross and El-Erian, Mauldin, Rosenberg, Hussman, Grantham and other luminaries. Then ask yourself if an economy struggling under debts at 375% of GDP could possibly have the same growth prospects as one with less than half that burden. Ask whether a government with operating deficits at 10% of GDP can possibly preside over future inflation that was lower than we had in the past. And ask Asian and Middle Eastern sovereign funds whether 0.3% is a fair return on a one-year loan to the U.S. Treasury Department, in a currency that has lost 19% this year.
Doesn't it seem that hoping for a "normal recovery" and a return to the growth and high returns of the Reagan/Clinton eras ignores the realities inherent in our runaway debt and our extraordinary government expansion? Doesn't it make more sense to expect that growth will be constrained and that capital will demand a higher return (higher interest rates and lower P/E ratios) until the risks come down and the growth potential improves?
I should add that expecting the necessary deleveraging to take place over ten years is the optimistic view; it would give us time to grow into the obligations we already have. If our debt load is either paid down or written down in a shorter time, we would experience something worse than stagnation. In a couple of years, depending on the policies we get, and depending on the behavior of our trading partners and our enemies, we could find ourselves actually longing for the sideways volatility of Great Fluctuation.
Investment Strategies For A Deleveraging World
If reality for the next decade or so seems likely to include deleveraging and/or rising interest rates, if consumer spending likely yields at least a little ground to a revived savings instinct and if the government holds to its current expansionary, populist track, then surely it makes sense that a portfolio structure suited to the unique circumstances of the '80s and '90s needs to be altered to adapt to these changes. What follows is the outline of our new reality portfolio approach at Financial Advantage.