David Rosenberg: "Hope And A Prayer"

From David Rosenberg of Gluskin Sheff

Hope And A Prayer For... End The Gridlock!

Survey data indicate the American people are much less polarised than the
broader political class that purports to represent them.

Francis Fukuyama

Senior Fellow. Stanford's Freeman Spogli Institute

Page 9 of the FT. November 6th, 2012


So we get a brand new start. Either way... it was always going to be either a new president or the old president but with a fresh term in which to contemplate his legacy — a legacy that could hardly be another four years of subpar economic performance.

When I was at John Mauldin's conference last spring. I thought the extremely provocative lunch-time speech by Paul McCulley contained many hidden truths. If that sermon is available anywhere on video. I'd highly recommend you watch it — preferably over a tall glass of single malt.

The one 'hidden truth that truly resonated was Paul's comment that the toughest thing in the world right now is to be bullish.

Maybe I should try harder to see whatever silver linings there are.

For example, we are entering into a period of stable consumer prices that should last at least for a generation. This will help prevent erosion in real household incomes. There is a strong probability that after years of very solid productivity gains in the industrial sector, that the U.S. will experience a manufacturing renaissance of sorts and re-emerge as a global export leader. This process is already in its infancy stages, by the way, aided and abetted by cheap natural gas costs. The move towards frugality and savings will make us less reliant on foreign borrowings and usher in a period of stronger household balance sheets.

As far as what that means for investments, my primary strategy theme has been S.I.R.P. — Safety and Income at a Reasonable Price — because yield works in a deleveraging deflationary cycle. Not only is there substantial excess capacity in the global economy, primarily in the U.S. where the "output gap" is close to 6%, but the more crucial story is the length of time it will take to absorb the excess capacity. It could easily take five years or longer, depending of course on how far down potential GDP growth goes in the intermediate term given reduced labour mobility, lack of capital deepening and higher future tax rates. This is important because what it means is that disinflationary, even deflationary, pressures will be dominant over the next several years. Moreover, with the median age of the boomer population turning 56 this year, there is very strong demographic demand for income. Within the equity market, this implies a focus on squeezing as much income out of the portfolio as possible so a reliance on reliable dividend yield and dividend growth makes perfect sense.

We are in a period of heightened financial market volatility which is typical of a post-bubble deleveraging period when the forces of debt deflation are countered by massive doses of government reflationary polices. This to-and-fro is the reason why in the span of a decade we have seen two parabolic peaks in the equity market (March 2000 and October 2007) and two depressed bottoms (October 2002 and March 2009). For any investor, return of capital is yet again re-emerging as a very important theme, and so is the need to focus on risk- adjusted returns. This in turn means that a strategy that minimizes both the volatility of the portfolio and the correlation with the equity market is completely appropriate — the best way to play this is with true long-short hedge fund strategies.

Gold is also a hedge against financial instability and when the world is awash with over $200 trillion of household, corporate and government liabilities, deflation works against debt servicing capabilities and calls into question the integrity of the global financial system. This is why gold has so much allure today. It is a reflection of investor concern over the monetary stability, and Ben Bernanke and other central bankers only have to step on the printing presses whereas gold miners have to drill over two miles into the ground (gold production is lower today than it was a decade ago — hardly the same can be said for fiat currency). Moreover, gold makes up a mere 0.05% share of global household net worth, and therefore, small incremental allocations into .bullion or gold-type investments can exert a dramatic impact. Gold cannot be printed by central banks and is a monetary metal that is no government's liability. It is malleable and its supply curve is inelastic over the intermediate term. And central banks, who were selling during the higher interest rate times of the 19805 and 1990s, are now reallocating their FX reserves towards gold, especially in Asia.

On the political side of things, let's hope we see the return of the two-party system, that the fringe elements in both the GOP and Democrat camps see their influence diminish, and that the populist anti-business sentiment in Washington subsidies.

If we can only end the gridlock finally and begin the necessary process towards fiscal probity that will of course necessitate shared sacrifice but will also remove the clouds of uncertainty, then households and businesses will be able to plan more effectively for the future and perhaps feel more comfortable in releasing their massive cash hoards into the real economy (that may be little more than a hope and prayer, mind you).

All that said, it is not going to be a new government that necessarily ushers in a whole new era of growth, prosperity and confidence. Even under the revered Ronald Reagan, the period of secular growth and bull market activity took two years to unfold — it didn't happen right away. It took the inflationary excesses to be wrung out of the system and concrete signs that the executive and legislative branches could work together to usher in true fiscal reform — and to get blue Democrats on board with reduced top marginal tax rates.

Hope isn't generally a very useful strategy, but there is reason to be hopeful nonetheless. The critical issue is going to be how we get Washington to move back to the middle where it belongs. This requires bipartisanship which in turn requires leadership. Reagan's whole eight-year tenure in the 1980s occurred with the House being in Democrat hands the whole way through. Bill Clinton's second term coincided with both the House and Senate controlled by the Republicans.

It can be done!

The most fascinating article I have read in recent weeks was on page B1 of yesterday's NYT, titled The Election Won't Solve All Puzzles. The title just about says it all, but some heft was added as an economic report jointly published by Stanford and University of Chicago was cited, with this conclusion:

The claim is that businesses and households are uncertain about future taxes, spending levels, regulations, health care reform and interest rates. in turn, this uncertainty leads them to postpone spending on investment and consumption goods and to slow hiring, impeding the recovery", and added that "current levels of economic policy uncertainty are at extremely elevated levels compared to recent history.

With this in mind, the best that can happen is a Reaganesque and Clintonesque return to compromise on the road to fiscal reform.  It will be painful. We all know it will be painful. But all we need is the roadmap to reform so at least we can plan for the future — removing the cloud of policy uncertainty alone will be empowering for the private sector (to this end, I also recommend a read of Business Craves Fresh Certainty on page 3 of yesterday's FT).

In the final analysis, it is up to the business leaders and innovators to step up to the plate. They are the ones that have always been responsible for bringing the economy off the bottom, and taking us over the top. Boy, a new "killer app- or some major innovation that manages to spur sustainable growth in multi-factor productivity would sure be nice to bring me to where I was back in 1987 when I started in this business.

A perma-bull!

Now how good would that be? A sustained decline in oil prices that is induced by new supplies as opposed to demand destruction would act as a he facto tax cut. Structural economic reforms in the world's "surplus saving" countries like China, India and Germany that stimulate their domestic demand, and hence bolster U.S. exports and reduce the global reliance on the U.S. as the consumer of last resort, would be a huge plus. Signs that the debt deleveraging cycle has run its course. Progress in terms of working our way through the domestic balance sheet repair process among households and businesses, though history shows that this is not merely -a two or three year adjustment following a credit bubble and ensuing financial crisis on the scale that we have just endured.