David Rosenberg Vindicated
From today's Breakfast with Rosie
NOT IN KANSAS ANY MORE
Well, it took some patience but it looks like the economic environment I was depicting this time last year just shortly after I joined GS+A is starting to play out. Deflation risks are prevailing and a growing acknowledgment over the lack of sustainability regarding the nascent economic recovery. Extreme fragility and volatility is what one should expect in a post-bubble credit collapse and asset inflation that we endured back in 2008 and part of 2009.
History is replete with enough examples of this — balance sheet recessions are different animals than traditional inventory recessions, and the transition to the next sustainable economic expansion, and bull market (the operative word being sustainability) in these types of cycles take between 5 to 10 years and are fraught with periodic setbacks. I know this sounds a bit dire, but little has changed from where we were a year ago. To be sure, we had a tremendous short-covering and a government induced equity market rally on our hands and it’s really nothing more than a commentary on human nature that so many people rely on what the stock market is doing at any moment in time to base their conclusions on what the economic landscape is going to look like.
So, we had a huge bounce off the lows, but we had a similar bounce off the lows in 1930. The equity market was up something like 50% in the opening months of 1930, and while I am sure there was euphoria at the time that the worst of the recession and the contraction in credit was over, it’s interesting to see today that nobody talks about the great runup of 1930 even though it must have hurt not to have participated in that wonderful rally. Instead, when we talk about 1930 today, the images that are conjured up are hardly very joyous.
I’m not saying that we are into something that is entirely like the 1930s. But at the same time, we’re not in Kansas any more; if Kansas is the type of economic recoveries and market performances we came to understand in the context of a post-World War II era where we had a secular credit expansion, youthful boomers heading into their formative working and spending years and all the economic activity that went along with it, and periods when recessions were caused by excess inventories and overzealous central banks fighting inflation — a war that can always be won with traditional interest rate weapons.
Now we are in the process of unwinding the excesses of a parabolic credit cycle of the prior decade, the first of the boomers are now retiring with nobody around to buy their monster homes and the Fed is now fighting a deflation battle that is prompting comparisons to Japan for the past two decades. Moreover, here we have the Fed unexpectedly cutting its forecast for growth and inflation in the past month-and-change, and then we had Ben Bernnake tell us that the macro outlook is “unusually uncertain”. The world’s most important monetary authority, with all deference to the People’s Bank of China, is now openly contemplating more experimental quantitative easing measures to propel economic growth at a time when policy interest rates are zero, the size of the Fed’s balance sheet is already triple its normal size, at $2.3 trillion, and at a time when the budget deficit exceeds $1 trillion, or 10% of GDP, and there are cries now even from incumbent Democrat senators for Obama to extend the once vilified Bush tax cuts. You can’t make this stuff up.
In this increasingly uncertain economic and political climate — not just in the U.S., but abroad, don’t think for a second that the debt problems in Europe have been solved, they haven’t, the problems have merely been delayed — what I want to talk about in this highly uncertain backdrop is what I do know with at least some certainty.
First, I know that there is tremendous complacency out there because based on my extensive daily readings, and the massive volume of emails I receive, there are legions of folks who still think we are in a cyclical bull market; completely oblivious to the fact that both the TSX and S&P 500 are pretty well at the same levels today that they were last November. That is eight months of nothing, except tremendous rounds of volatility because there have been no fewer than six major rallies and selloffs in this range-bound market, and is symbolic of the intense fluctuations we have seen in all the peaks and valleys over the past 12 years with nothing to show for it for a buy-and-hold investor.
So the strategy is not to be “buy and hold”, but to navigate the portfolio in the context of a secular bear market with massive up and down moves. This is done by adopting hedging strategies that actually hedge and with a net short position because, make no mistake, we are still in the throes of a secular bear phase. There are actually ways to profit from this in effective long-short strategies.
Second, we are in a phase where deflation risks trump inflation risks, and this is not a case where cash is king — cash, by the way, has not been king in Japan either for the past two decades — but what is king in a deflationary cycle is income, no matter how you can secure it, whether through classic hybrid funds or through bonds. And, not just government bonds because in some cases, corporate balance sheets today are in better shape than government balance sheets — when I look at classic measures like debt-equity ratios, liquid asset ratios, debt maturity schedules and the ratio of long-term debt-to-total outstanding corporate debt, the corporate balance sheet is as good a shape as it has been in for the past 50 years, and this is coming from a renowned bear.
But corporate bonds are plays off the balance sheet whereas equities are a play off the income statement and I think the income statement, specifically corporate profits benchmarked against where investor expectations, are probably going to disappoint. I think that even if we manage to avert a double-dip recession, it probably won’t be by that much and right now the market is priced for 35% earnings growth in the coming year. That seems too high a hurdle at a time when margins have already expanded to cycle highs in a very short time frame.
The fact the equity markets stopped going up in April, despite how good second quarter earnings season was, is testament to the view that investors have only recently become a little squeamish over the outlook for corporate profits. Guidance has been decidedly mixed.
For corporate bonds, it comes down to credit quality and the ability to service debts. What some analyst at some Wall Street firm does to his or her earnings estimate for Company X, or if Company X issues a profit warning because of a weaker-than-expected economic backdrop, is more a problem for equities as an asset class than it is for corporate bonds. This is especially the case considering the record amount of cash sitting on corporate balance sheets because CEOs understand the economic risks much more than the economists, analysts, strategists and other talking heads you see on bubble-vision.
Moreover, I don’t believe in all the stories about China collapsing. In fact, if there is a bullish story to be told, it is that the secular growth paths in not only China, but India, Indonesia and Korea and that will continue to ensure that the resource sector remains a core holding, with oil and food retaining geopolitical significance and gold remaining a critical hedge against ongoing reflationary policies that weakens the U.S. dollar in coming months as a critical mid-term election approaches.
So, while I continue to advocate underweight positions in equities, a bar bell between basic materials and defensive dividend stocks is a prudent strategy, with the overall emphasis in the asset mix tilted towards bonds, especially the BB sliver or that part of the higher quality non-investment grade space that currently has the greatest unexploited potential for spread compression and capital gains.