Selection from an excellent speech by Robert Rodriguez, one of the very few investors I follow. His track record and positioning for the last 2 crashes (2000 and 2008) speaks for itself. His strategic view on macro-economics is very interesting and he masterly combines it with stock picks.
Famous writer Roger Lowenstein wrote one of the best books about Warren Buffett: Buffett The Making of an American Capitalist. In his last book, The End of Wall Street, his hero is Robert Rodriguez. As stated in this book review:
Lowenstein starts by describing Rodriquez’s concern in 2006 of the USA’s reliance on debt. He was worried about ultra low interest rates in 2003 which he believed would lead to inflation, reckless borrowing or both. Rodriquez was so concerned about the practices Fannie Mae and Freddie Mac, that by early 2006 he sold all of his bond holdings from the FPA New Income Fund.
Lowenstein highlights Rodriquez throughout the book. Lowenstein states that Rodriquez realized the problem was not one of liquidity of the banks; rather it was a lack of capital. Robert Rodriquez was finally relieved when Henry Paulson decided on direct capital injections into the banking system instead of buying up toxic assets. Lowenstein ends off the book with some very strong praise of Robert Rodriquez. Lowenstein notes that through September 2009 Rodriquez’s FPA capital fund returned 14.77% versus 10.35 for the S&P 500 annually over the past 25 years. This was the best record of any diversified mutual fund for the 25 year period.
Enough introduction… here are my favorite parts of his long and well thought speech:
I battened down the hatches and prepared the portfolios for each of the greatest investment bubbles of our time: the 2000 stock market bust and the credit collapse beginning 2007. I wrote and spoke frequently about the coming dangers of each, but with little impact. Chairman Greenspan’s unwise monetary policy, between 2001 and 2003, was quite disturbing to me. I viewed it as foolish because it might trigger another bubble, possibly in real estate, which could prove to be larger in size and more harmful than the bursting of the recent stock market bubble. Dr. Kurt Richebacher’s economic letters, to which I had been a subscriber for years, first warned of this possible outcome since he was extremely critical and fearful of the Fed’s easy monetary policy. His thinking was grounded in the Austrian school of economics. Paul Volcker said in 1982, “Sometimes I think it’s the job of each Fed chairman to try to prove Richebacher wrong.”
Dangerous credit trends began to appear in 2005. I believed a major credit bubble was emerging and that precautionary actions were warranted. Because my skepticism was so deep, it led to my having a nightmare in early 2006 that was captured in the prologue to Roger Lowenstein’s book, The End of Wall Street. I imagined Fannie Mae and Freddie Mac had filed for bankruptcy. The dream was so vivid and compelling that it helped to solidify my analytical thinking about the credit bubble. The following morning, after consulting with legal counsel on the implications of a bankruptcy filing, we liquidated all corporate debt holdings in both companies, representing approximately 40% of our fixed income assets. It was dawning on me that a potential tectonic shift was in the process of taking place in the U.S. capital markets. Thus began one of the most difficult, but also most rewarding, strategic shifts I ever made in my career.
By the spring of 2008, the unfolding financial crisis impacted me so profoundly, I wrote in my commentary, “Crossing the Rubicon,” that, “…a new financial system is in the process of being created. This is the beginning of a new era.” It was a warning of the dangers to come. That fall, the potential of accelerated Treasury debt growth captured my attention. I estimated that it would rise to between $14.6 and $16.6 trillion, by year-end 2011, from $10 trillion. Once again, my conclusion was viewed by many as being too dour, rather than realistic, which it was proven to be since total U.S. debt stood at $15.2 trillion at year-end 2011.
Analyzing the twists and turns of the European debt crisis has been a roller coaster ride, particularly with the banks. A faulty risk weighting methodology, under the Basel Accords, for determining bank capital requirements, contributed to the 2007 to 2009 credit crisis and this euro-zone mess. It’s amazing to me that this methodology continued since governments and banks were likely to become even more conjoined, leading to potential conflicts of interest. The July 2011 bank stress test exercise is an example of this apparent conflict, when only eight banks were deemed to have a capital shortfall of €2.5 billion, and this was with most sovereign debt included at a zero risk weighting while the Greek crisis was worsening. By December, the shortfalls had increased to €115 billion for 31 banks, while some believe the real number may now be greater than €200 billion. Who knows what the actual number is but the capital markets seem to finally have had enough of these games and, accordingly, European bank funding all but stopped, except for their borrowing from the European Central Bank (ECB).
On December 21, the ECB established its new Long-Term Repo Operation (LTRO) that provided €489 billion of three-year 1% loans to 523 banks. At almost twice the expected demand, it demonstrated the seriousness of the banking crisis. A second LTRO takes place on February 29. Shorter-term borrowing costs have declined but longer term sovereign debt yields for Italy, Spain and France, remain elevated indicating that serious reservations persist about the program’s potential long-term success. “Banks represent about 80 percent of the lending to the euro area,” according to ECB President Mario Dragi. The linkage between banks and their sovereign governments will likely increase since many expect these loans to be recycled into additional sovereign debt, hopefully into more periphery debt. Additionally, the ECB relaxed its lending standards so that, in some cases, single-A asset-backed securities may now be pledged as collateral. These initiatives are nothing more than rescues or backdoor bailouts that further reward unsound fiscal and financial behavior.
Will this ploy resolve the euro-zone crisis? I believe for only a short period, unless a fundamental restructuring of the EU occurs. Italian Prime Minister Mario Monti’s December budget plan introduced rules that allow banks to issue bonds, guaranteed by Italy, as collateral for loans from the ECB. Playing this game of recycling money to the banks, so they can buy sovereign debt, allowing sovereign countries to go on their merry way, resembles a shell game. It’s DELUSIONAL! I am skeptical there is the will or the ability to reform the EU because it will require ceding fiscal sovereignty to another. The combination of fiscal austerity and rising interest rates means Europe is either near, or already in, recession. The Euro’s structure will face additional tests until at least one or more members exit. Should the weaker countries exit, a stronger Euro is likely. If there are no exits, it means transfers of wealth from the northern to the southern euro-zone countries, which would result in a weaker Euro and a more unstable EU. On January 13, Standard & Poor’s downgraded France, Italy and seven other European countries while assigning France and 13 other euro-zone nations a negative outlook. Without any exits, the next round of downgrades will likely encompass Germany’s AAA status. EU structural uncertainty and high system-wide leverage should make for a difficult European investment environment.
Japan is next up on my list with a total debt to GDP of 471%; the government portion is equal to about 200%. Because nearly 95% of government borrowing is sourced from internal sources, its cost to borrow ten-year money has averaged less than 1 1/2 % since 1998, allowing Japan to escape a European-style debt crisis thus far. Many speculators have been burned attempting to short Japan’s non-sustainable debt trend. This decade may prove to be different because of demographics. Its population peaked in 2004 and 2011 marked the fifth straight year of population decline while being the largest since 1947. The pool of bond buyers may be cresting since the primary demographic pool of demand, ages 55-75, peaked in 2010 and is expected to fall by 170,000 per year this coming decade. Additionally, Japan’s Government Pension and Investment Fund, the world’s largest pension fund, with approximately 68% of its assets deployed in domestic debt, recently began selling some of these bonds to pay pension benefits. The country’s generation of savers is now retiring and the household savings rate is likely to turn negative in the coming decade. Also worrisome is the new April 2012 budget which anticipates being funded by debt issuance to the unprecedented level of 49%; the fourth consecutive year that new bond issuance has exceeded tax revenue receipts. A primary budget balance, before bond sales and interest payments, is not anticipated until 2020. It is hard to imagine how Japan’s bond or equity markets will perform well under such negative headwinds.
The final member of this trio of fiscal misfits is our own United States. U.S. total debt to GDP is nearly 350%, and this is before taking into account off balance sheet entitlement liabilities and guarantees that would bring it to more than 500%. Deleveraging by the corporate and household sectors is being partially offset by rapid growth in government debt.
I have been highly critical of our nation’s fiscal policies and budgetary trends for years. Both political parties disgust me because of their incredible fiscal ineptitude and unwillingness to be truthful with the American people. A chaotic future will be the result if our representatives continue to fail at their fiscal restructuring responsibilities. It is easy for me to speak of Europe and Japan in cold clinical terms, but not the U.S.; this is home and our nation’s fiscal mess is like a life threatening cancer that is not being treated.
Fiscal reform is an immensely challenging task and it will be made more difficult by substandard economic growth. In my May 2009 Morningstar conference speech, “Reflections and Outrage,” I estimated it would take approximately ten years to rebuild household net worth back to its 2007 pre-crisis level. Negative economic structural shifts, particularly in manufacturing, housing and housing related industries, would likely result in an elevated level of long-term unemployment and reduced living standards. Deleveraging would become a new goal. A higher savings rate would be necessary to help rebuild net worth lost due to the real estate and stock market collapses. Therefore, for the foreseeable future, a substandard real economic growth rate of a little over 2% would likely unfold. Since the Great Recession’s trough in 2009, economic growth forecasts by the Congressional Budget Office, President and Federal Reserve have been consistently overly optimistic, unlike mine. I anticipated a caterpillar-like recovery, with temporary growth spurts driven by short-term fiscal and monetary stimulus programs while a slowing would ensue as these were withdrawn. A traditional recovery growth rate would not be achieved. I believe that the repeated attempts at fiscal and monetary stimulus since then confirm my original conclusions.
Has my consumer financial outlook improved since my 2009 forecast? Not much. The consumer’s balance sheet has recovered somewhat but total household net worth is still down by more than $9 trillion from its April 2007 peak of $66.8 trillion. Total household debt is down by nearly $700 billion from its April 2008 peak; however, between 2000 and 2007, it grew by $6.6 trillion dollars (101%) to $13.1 trillion. Annual debt servicing cost has declined by about $200 billion but a large portion of this contraction is a function of mortgage foreclosure and the ceasing of debt repayments. The ratio of debt to personal income has improved by declining to 114% from 130% at its 2007 peak: however, it remains far above the more typical 90% level of the late 1990s that preceded the consumer debt bubble. According to BCA Research, assuming household incomes grow at an average annual rate of 4.5%, questionable, while debt increases at 2%, this ratio will not return to its 2000 average until 2020. The Fed’s zero interest rate policy (ZIRP), which I consider to be so egregious and deleterious to savers in this country, has retarded a recovery in gross personal income by an estimated $400 to $600 billion annually. I believe it to be a dangerous policy and it will result in serious negative unintended consequences as financial institutions, in an attempt to maintain profitability, increase balance sheet risk. This is a silent growing threat.
I viewed the consumption enhancing stimulus programs of both Presidents Bush and Obama as being ineffective and wasteful, with little bang for the buck, while consumers were in a deleveraging process. Arguments for and against these initiatives have been heated, but this is not the first time that such debates have occurred. Back in 1932, similar disputes unfolded between what would become known as the Austrian and Keynesian schools of economic thought. They focused on the efficacy of stimulating consumption as opposed to “real investment” and the ineffectiveness of “…imprudent borrowing and spending on the part of public authorities.” As a side note, Neville Chamberlain, Chancellor of the Exchequer, initiated a policy of “quantitative easing” in May 1932, as a means of creating “cheap money.” The more things change, the more they remain the same. Unsound fiscal policies waste time and treasure and, thus, prolong long-term structural unemployment while delaying economic recovery.
Both major parties are guilty of irresponsible budgetary management; it doesn’t matter which is in power, as the federal debt spirals continuously upward. President Bush and the Republican dominated congress kick started this fiscal mismanagement process by initiating wars, enacting two major tax cuts and establishing a new entitlement program, the 2003 Medicare prescription drug act that created a present value liability larger than the comparative $7.1 trillion national debt. Not to be outdone, President Obama and the congress shifted into high gear. While Treasury debt grew by 61% over eight years under President Bush, it surged by nearly 66% under President Obama, in just under four years. To put this insanity in better perspective, during the past 62 years, a budget surplus has occurred only nine times for an accumulated total of $576 billion. In each of the last three years, budget deficits have been more than twice this amount. And it will occur again this year. This is OUTRAGEOUS!
Last year’s budgetary soap operas were truly discouraging. The two debt limit increase agreements were a farce! The “cuts” to be realized are questionable since most of them are deferred into the distant future, or are simply illusory. The August debt limit agreement typifies these deficit “cutting” shenanigans. Only $22 billion out of the $917 billion ten-year total estimated cuts are scheduled to begin this year, while approximately two-thirds do not start until after 2016. By the way, this year’s cuts have already been wiped out by a factor of five-fold as a result of the 2011 Social Security payroll tax reduction. If it is extended for 2012 without offsets, another $120 billion will have to be borrowed this year. Again, we see more short-term attempts at stimulating consumption which will have no positive lasting effect and, in reality, simply puts us further in the hole.
Throughout this deficit cutting dance, Chairman Bernanke has argued that no material expenditure cuts should be made in the initial years for fear of harming the nascent economic recovery. His view provides cover for politicians who favor postponing any substantial early cost cutting. I VEHEMENTLY DISAGREE since his record of accurate forecasting is questionable.
If credible and material fiscal reforms are not implemented by the end of 2013, I fear that, between 2014 and 2016, this nation will confront a crisis similar to that of Europe. Time is running out because, starting in 2018 and continuing through 2024, various entitlement trust funds will be either depleted or beginning the process of liquidation. Budgetary financial pressures will explode. Treasury debt outstanding could easily rise to between $22 and $25 trillion by 2022. With just a 200 basis point rise in the average funding rate, debt interest cost could rise to at least $1.2 trillion, thereby wiping out most of the savings from sequestration. Every additional year wasted beyond 2013 will increase the size and scope of the necessary fiscal response; furthermore, negative capital market reactions are more likely. Congress and the president should not become complacent, given today’s low Treasury yields. Without reform, this is only a temporary calm before a much larger storm.
Are these risks discounted in either the U.S. stock or fixed income markets?
The S&P 500’s P/E ratio, has declined over the past 12 years to a level not seen since the mid-1950s and is the longest sustained decline in a half century. Many consider the stock market reasonably or cheaply valued, when compared to history, so, its current valuation discounts numerous risks. The corporate earnings recovery surprised many, including me, particularly with near record pre-tax profit margins, despite substandard economic growth; therefore, case closed–but not so fast. Upon closer examination, 73% of the non-financial corporate pre-tax profit margin expansion resulted from lower interest (38%) and labor (35%) costs. Furthermore, approximately 45% of the S&P’s revenues are internationally sourced, so European and Japanese recessions pose additional risks. Contagion from Europe should not be underestimated since European banks dominate emerging market lending. I believe the market’s P/E decline reflects the growing risk of profit margin contraction, a sluggish economic growth outlook, fiscal policy mismanagement and international economic uncertainty. Increased market volatility adds to this list, as portfolio managers digest and react to news almost instantaneously. When a company’s operations are viewed as having low growth expectations, combined with peak margins and high volatility, investors typically ascribe a lower P/E valuation to the company’s stock. This portrayal describes the market and, therefore, a higher margin of safety, through a lower P/E, should be required for an aggressive equity allocation. In my opinion, low to mid single-digit returns will be the norm for the next decade and this may prove to be optimistic.
Though longer-term Treasury bonds were among the best performing asset categories last year, consider the risk taken. Who would be willing to buy them, at these absurdly low yields, unless they were able to sell quickly? I believe no one. It’s speculation since there is little, if any, underlying real value. Protect your capital and stay within a three-year maturity. Without a material improvement in the fiscal outlook, these low rates should prove to be unsustainable. Remember the suddenness and magnitude of the interest rate rise for Italian and Spanish ten-year sovereign bond yields this past year. Over the next decade, I expect low single-digit to negative total returns for intermediate and long-term bonds.
I know many of you would like more actionable ideas but principal protection is uppermost in my mind. Patience is required now. I believe many investors underestimate the potential risks and disruptiveness from high global financial leverage. We are in phase 2 of a continuing and expanding economic and financial market instability. Flexibility, high liquidity, and concentrated asset deployment, when appropriate, will be key elements in attaining superior investment performance. The era of being fully invested and adjusting portfolio weights relative to an index has been over for more than a decade.
PD: It seems like the base of his thinking is based on the Austrian School, that’s nice to know. Makes now more sense why I agree with him so much. You can find books of Austrian economists; Von Mises; Rothbard; and Hayek in my recommended list of favorite books and download them for free from the mises.org institute.