Peace: the most important “P” by far.
Fuss asks, “to what degree do you lack peace?” From a social perspective there is, indeed, a lack of peace. From a quantitative/market/budget perspective, things are a bit better. However, there is a tendency to lag funding for budget expenditures “you wish you didn’t have to make.” This tendency is exacerbated when misleading budget projections are made during hyper-strong economic environments, as experienced early last decade. Current budget surpluses tend to lead to overly optimistic expectations of future tax receipts and social spending.
Providing a current example, Fuss believes incremental spending on military commitments has not been adequately anticipated. While it is difficult to estimate precisely, Fuss pegs the shortfall at about 2% of GNP, a significant sum but an amount that the US economy can potentially absorb from a budgetary/financing perspective.
People: Demographics don’t change on short-term notice.
The pay-as-you-go Social Security system was created when the age distribution of the population resembled a pyramid, with lots of younger people available to support relatively few older people. Fuss believes the original planners of this system were intelligent, but they failed to foresee the demographic consequences of the progress of modern medicine. Commitments to spending late in life were elevated by entitlement programs introduced in the 1960s. Moreover, people are living longer than ever before.
While it’s difficult to say what will come out of Congress next, Fuss believes it would be unreasonable to expect anything less than a slight increase to these commitments. This problem has been gradual in the making, reinforcing Fuss’ first point: there is a tendency to lag funding for budget expenditures you wish you didn’t have to make, and this is precisely what has happened for Social Security, Medicare and other potential entitlements.
While it’s difficult to say what will come out of Congress next, Fuss believes it would be unreasonable to expect anything less than a slight increase to these commitments. This problem has been gradual in the making, reinforcing Fuss’ first point: there is a tendency to lag funding for budget expenditures you wish you didn’t have to make, and this is precisely what has happened for Social Security, Medicare and other potential entitlements.
Politics: Older people vote their own interests as a block.
The trial balloon of putting old people “out to sea” by rationing care has been floated in the health care debate and, effectively, shot down. Going forward, the voting power of this growing segment of the population will assure its self-preservation. While retirement ages may be pushed back, deferring distributions and creating an incentive for people to continue to pay into the system, this will prove inadequate to meet commitments. Fuss estimates that real American GNP growth would have to be sustained at 3.5% to 4% to fiscally absorb future commitments, a very unlikely scenario.
The demographic problem is not confined to America but is as bad or worse in the UK, Europe and Japan. Moreover, these advanced social democracies make up the four major reserve currencies. A superficial solution is to call for diversifying reserve currencies, but there are no real alternatives for China and other creditor nations. Alternative currency markets are simply not deep enough.
The main point: the combination of demographics and currency market structure will create the underlying push for continued net issuance of government debt by the advanced social democracies. This will have meaningful investment implications.
The main point: the combination of demographics and currency market structure will create the underlying push for continued net issuance of government debt by the advanced social democracies. This will have meaningful investment implications.
The god of markets is Liquidity, and god is back with “bushel-baskets full of money.” The Colossal Corporation (formerly Mega Corporation) is back to old tricks, reinstating the carry trade that it had so dramatically unwound over the course of only 10 days in late August, 2008. Once again, Colossal ore is being mined in Australia, hedged with A$ bonds and financed by Yen, and the business is making money.
The Prognosis: Preface everything with, “I guess.”
The US economy and North America are in statistical recovery. But jobs and prices for goods and services are not in recovery. There is enormous excess capacity to absorb. It will take a couple years to reach the absolute levels of activity attained in November 2007. Due to a growing workforce, per capita recovery will take even longer. As the recovery progresses, tax collections will begin to ramp up and social spending will begin to come down a bit, taking a little pressure off the budget.
However, in reference to above discussions of spending commitments and market structure, Fuss believes that both the future budget deficit and the estimated issuance of Treasury debt are underestimated. Both will continue to be revised upward. At some point, interest rates will rise as debt as a percent of GNP grows. As public debt requirements increase, we will witness a crowding out of the private sector. Larger companies with access to financing will “clean-up” at the expense of smaller companies unable to obtain credit. We’ve seen the prequel to this movie in the 1970s, as many smaller businesses of that era were vanquished.Globally, Fuss is more optimistic. In China, people are beginning to accrue some disposable income for the first time. There will be increasing demand for durables and non-durables from new consumers in Asia. Overall, unless something happens to disrupt world trade, there will be a stronger world economy going forward.
How to invest then? In a nutshell, avoid market risk and seek specific risk.
Look for opportunities with low covariance to the broad markets. In equities, covariance tends to run with liquidity cycles. Drawing from Fuss’ outlook above, the ability to access credit or gain exposure to new sources of demand can create some disparity among companies that investors can exploit. By their nature, bonds have a tighter relationship with interest rates. Fuss believes successful bond investors will be able to exploit anomalies, though he didn’t elaborate on the point. He did say that, with some lag, bond clients will be happier with progressively higher reinvestment rates. In sum, while index huggers will likely trail, there will be opportunities for active managers to demonstrate their value.
