Shutdown Dumbness: Walking Softly?
David R. Kotok
Cumberland Advisors September 30, 2013
Markets, media, and manic investors are consumed by the government shutdown, budget fight, debt limit debate, sequester, and assorted other shenanigans of the dysfunctional Congress and increasingly unpopular White House. That is understandable. There is not much we can add to the news flow.
We expect this craziness to last into October and run up against the debt limit fight. In the final gasping throes of squabbling, we expect President Obama to use the President Clinton designed executive order strategy so that the US doesn’t default. There will then ensue a protracted court fight leading to a Supreme Court decision. The impasse may go that far. This is our American way. “Man Plans and God Laughs” says the Yiddish Proverb.
But there is something else going on, and markets and investors are missing it. There is a change in foreign policy that has very broad implications. I will do my best to make the case. Our portfolios are being positioned for it.
First, let me be up front and clear. I do not trust the Russians, the Iranians, the Syrians, or a whole host of other despotic regimes. I do not like them. I would not do my personal business with them. They do not respect property rights. They are ruthless and punish their citizens.
That said, there is now underway a possible strategic shift that could have a massive beneficial impact. I have been, and still am, a harsh critic of some of President Obama’s domestic economic policies, but this evolution has taken place in the realm of foreign policy, and its impact on domestic policy is a second derivative, albeit a very good one. Whether by accident, intent, or good luck, credit for the evolution in approach goes to President Barack Obama.
In the playing out of the Syrian chemical weapons event and the hopeful, projected, uncertain, but possible change in the composition of the chemical weapons arsenal in Syria, we may achieve a positive outcome. This task will be difficult. I am not under any illusion that the players are honorable and forthright. They are not.
But if the Syrian chemical weapons arsenal is reduced or neutralized, wholly or in part, the existential threat to neighboring countries, including Israel, Jordan, and Turkey, will be diminished. A key purpose of Syria’s chemical weapons arsenal has been, after all, to create the perception that the Assad regime (first the father and now the son) has the ability to inflict a highly destructive attack on neighboring countries, Israel and Jordan being two of them.
There are other hopeful developments on the foreign-policy front, as well. Are we going to see a thaw in relations with Iran? Will there be some dialogue? It appears so. The first step has been taken.
Are we being manipulated and played for an extension of time while centrifuges run and nuclear weaponry evolves at 20 sites in that country? Or will there be UN umbrella inspections of the 20 sites and a transition to peaceful use of nuclear power as a tool to generate electricity rather than to make weaponry? Of course the West is skeptical. Who can blame it?
Will there be a thaw of some type that will ease tensions on the Korean Peninsula? Did the craziness perpetrated by the North Korean regime over the past several months inflict so much economic damage on the country that Kim Jong-un got a wake-up call? North Korea’s is a horrible regime. It severely punishes its citizens. But perhaps it now recognizes that it needs the economic support generated by the Kaesong industrial complex it shares with South Korea.
If we look around the world, we see many dangerous trends and troubled countries. Our own natural and historical distrust makes us reluctant to engage with despotic adversaries. We worry that we are being played for fools. Does that mean the United States should reject such initiatives? We think the answer is no. If we confront these regimes through diplomatic channels, breakthroughs may be possible.
Recall when President Richard Nixon opened up relations with China. We did not trust the Chinese then, and in many respects we do not trust them now. But we did pursue a thaw in relations that has contributed to several decades of peaceful changes in that country. That thaw created solid economic ties that may blunt military conflict, though it is unlikely to completely eliminate the prospect. China skeptics are less vocal today than they were when Chou En Lai and Kissinger launched negotiations.
When Ronald Reagan expanded the US defense budget and put Russian oligarchs in the position of having to either match the expenditure or to open up their iron-fisted regime, he launched an initiative that led to the fall of the Berlin Wall and dissolution of the Warsaw Pact. Who would have forecast in the late ’80s that Poland would be a member of the European Union just 15 years later, with a strongly growing economy? Who could have predicted that Estonia, Latvia, and Lithuania would also be in the European Union and participating in commerce and trade with open borders? Could you have foreseen that the Czech Republic would have a peaceful revolution and throw the communist regime’s yoke off its back by 1990? Could anyone have projected such developments before the Reagan initiative with Mikhail Gorbachev occurred? The answer is no.
Can we give peaceful opportunity through diplomatic channels a chance? Are the foreign-policy initiatives we’re witnessing a phenomenon that occurs in the second term of a presidency when the president is in trouble on domestic issues but has the opportunity to create a legacy in the international arena? It appears to us that President Obama has a bent towards passivism and seeks the diplomatic course when he can. With respect to the Syrian chemical weapons arsenal, the possibility for a diplomatic solution may have been handed to him by Vladimir Putin, of all people. Obama may seize it because he has no other choice. Whatever the reason, he seems bent on trying.
The implication for financial markets may be huge if we can shrink the risk premia associated with military options. The minute a military option becomes a military action, massive, open-ended, hugely wasteful expenditures are mandated. Financing through debt or taxation quickly becomes necessary. Readiness for military action must of course be maintained, even as diplomatic solutions are being sought; but there is a great difference, both politically and fiscally, between maintaining readiness to wage war and actually waging it. We must not, however, let our readiness deteriorate because of our recent history in Afghanistan and Iraq, even as we seek diplomatic solutions.
The key in the budget negotiations is not to weaken the underbelly of the US and its military. The key is not to undermine strategic US superiority. If anything, it should be strengthened.
The message from our history is best illustrated by President Theodore Roosevelt’s famous dictum: “Speak softly and carry a big stick.” Roosevelt’s policy is still apt today. Negotiate, and also keep in hand a stick that is huge and feared. Maintain the stick and do not undermine its strength. Markets, our economy, and our citizens will like that approach. Meanwhile, economic growth can pick up if diplomatic successes inspire a belief in the potential for diplomatic solutions around the world.
We have been redeploying cash and taking advantage of selloffs to maneuver back into stocks. Our cash reserve is small, but still there. Our redeployment continues.
We think the budget negotiations and debt-limit issue will all be resolved in our typical, dysfunctional American political way. The US will then continue its low-inflation, slow-growth recovery, while the military-option risk premium is likely to shrink. The bull market is not over. And the muni bond market remains cheap.
David R. Kotok, Chairman and Chief Investment Officer, Cumberland Advisors