Investment letter – May 25, 2010

During a period of economic uncertainty, an individual who chooses to cut spending and increase savings would be deemed prudent. However, when tens of millions of individuals collectively make the same prudent choice, it becomes more difficult for each individual to save more, if everyone else spends less. And therein lies the paradox of thrift. As the financial crisis intensified in late 2008, millions of Americans became reformed spendthrifts. Within a few months, the national savings rate jumped from under 2% to almost 6%, and the U.S. economy tanked as consumer demand for goods and services evaporated. The government stepped into the breach by shoring up the banking system, and spending billions to prop up demand. The government extended unemployment benefits from 26 weeks to 99 weeks, to more than 8 million workers who had lost their job. This helped those affected directly, and also propped up the economy. The safety net of unemployment benefits, food stamps, Medicare, and Medicaid has led most economists to believe that another depression would not be possible, since consumer demand would be supported by the myriad of safety net programs. The law of unintended consequences is often at work under the best of circumstances, but more so when the government is involved. My take on the government’s safety net programs has therefore been a bit different. Wouldn’t it be ironic if the safety nets actually contributed to the next depression?

When discussing the circumstances that could lead to the next depression with a good friend of mine back in the mid 1980’s, my thoughts ran along these lines. If the U.S. economy experienced a deep recession, the budget deficit would explode as all the safety net programs kicked in. Initially, they would help soften the depth of the recession. The Federal Reserve would also dramatically cut short term rates. But if a confluence of events caused the recession or period of slow growth to be prolonged, and low rates didn’t revive the economy within a reasonable period, monetary policy would effectively be emasculated. The continuation of expensive safety net programs and weak tax receipts would result in chronically high budget deficits. Sooner or later, the bond market might begin to choke on the torrent of paper, and long term interest rates could begin to move higher. Although the Federal Reserve might try to buy bonds, I didn’t think that strategy would work over the long haul. I also dismissed the Fed’s choosing to inflate our way out of debt deflation, since bond market participants aren’t stupid. Any real evidence that the Fed was even contemplating the inflation route would cause interest rates to potentially soar, which would cripple the economy faster than you can say Mickey Mouse.

Back in the mid 1980’s, this analysis was totally theoretical, and the U.S. was just coming down from a huge bout of inflation. The economy had emerged from the deep 1982 recession, and was growing nicely. The 20-year Treasury bond was yielding almost 11% and the Federal funds rate was 8.5%. Today, this mid 1980’s theoretical analysis is the reality we are facing. The primary difference is that this analysis does not just apply to the U.S., but to every developed country in the world. Most of the developed countries reacted to the financial crisis, by increasing their respective budget deficits to unprecedented levels. The annual national deficits of the 30 members of the Organization for Economic Cooperation and Development have grown almost sevenfold since 2007 to $3.4 trillion. The total debt burden for these 30 countries has increased to a record setting $43 trillion. For the 16 countries in the Euro zone, the deterioration has been worse. Annual national debts have soared by $7.7 trillion, more than 11 times their 2007 levels.

According to the International Monetary Fund (IMF), and based on GDP estimates for 2010, the total debt to GDP ratio for Greece is 124.1%, Italy 118.6%, Portugal is 85.9%, Ireland 78.8%, and Spain’s is 66.9%. The U.S’s debt is 92.6% based on 2010 GDP, and that does not include the debt guarantees for Fannie Mae and Freddie Mac. The chart above is based on data compiled by Euorstat for 2009, and the Congressional Budget Office for the U.S. Although the statistics are slightly different, the story and message are the same.

The fiscal policy responses by governments around the world that were required to stabilize the global economy and financial system must now be unwound gracefully. And that’s not going to be easy to pull off in a global interconnected world that trades in microseconds. In medieval times, a gauntlet was a form of punishment or torture in which people armed with sticks or other weapons arranged themselves in two lines facing each other and beat the person forced to run between them. In coming years, the global bond market will represent a Sovereign Debtor’s Gauntlet. We are about to witness the Paradox of Thrift being applied on the sovereign government level. I suspect most governments will take the threat from the global bond market seriously, and so most will present a reasonable deficit reduction plan.

Over the next three to five years, the U.S., Britain, Japan, Germany, France, Italy, Spain, and most of the other countries in the E.U. will have to present credible plans to reduce their budget deficit to near 3% of GDP. A few fortunate countries will only have to slow the rate of growth in public spending, and increase taxes modestly to lower their budget deficit to GDP ratio to below 4%. The U.S., Britain, Japan, Germany, France, Italy, and Spain won’t have it so easy, and will have to slow spending growth significantly. But most of the heavy lifting to narrow sovereign budget deficits will come from higher taxes. Any serious effort in the U.S. will wait until after the November election. No one wants to run on the “We’re raising your taxes, and cutting services too!” slogan. Just as George W. Bush reneged on his pledge “Read my lips: No new taxes.” President Obama will be forced to raise taxes on most of the 95% he said he wouldn’t. He will have plenty of company, and misery does love company, as governments around the world are forced to hike taxes on the rich and middle class. Politicians have no choice but to tell most workers the truth – your taxes are going up. This news won’t endure politicians to voters in any country. Less disposable income will make it harder for consumers to save more, especially when their disposable (after tax) income is shrinking due to more taxes. In the United States, many baby boomers were expecting and counting on their home value to fund a nice chunk of their retirement, after it was sold. Now, they’ve got to spend less and save more, which isn’t as much fun as shopping. They’re not in a good mood, and in the next few years, a rising tide of taxes will find them recalling the good old days of 2010.

The combination of less sovereign government spending and higher taxes will curb economic growth, and result in an unintentional coordinated global slowdown that should kick in within a year. The paradox will be that each country is acting in its own best interest! At a minimum, most developed countries, which comprise more than 60% of global GDP, will see 1.0% to 1.5% shaved off their annual GDP growth. As Greece implements the fiscal restraint imposed by the IMF, Greece’s economy is expected to shrink by at least 5%, over the next year or so. Slower economic growth will hinder job creation, which won’t reduce the ranks of the unemployed quick enough. Long term mass unemployment is the Witches Brew of discontent and revolution. As governments are forced to reduce aid to people who depend on their governments’ support to live, governments risk an escalation of frustration, anger, and if left to simmer long enough, outrage that explodes in the type of violence seen in Greece. This is not a good time to be a politician.

Very simply: We are entering a period of unpredictable rapid change that could last another 3 to 6 years, and possibly longer.

Longer term the outlook for many developed countries is even more challenging, since the gap between the ‘official’ figures and a more realistic estimate of the unfunded liabilities is huge for a number of countries. The orange bars show the official debt figures as a percent of GDP. The grey bars include the total amount of unfunded liabilities for social security, pensions, and health care programs like Medicare in the U.S. Spain’s total is 250% of GDP, while Germany and Britain are near 400%, as is the average for the E.U. The United States and France clock in at 500%, while Greece is 800%. This means the U.S. has unfunded liabilities of $70 trillion, while it advertises an official level of debt of ‘only’ $12 trillion. Sooner or later, someone is going to tell the American people what should have been obvious to everyone long ago, had they been paying attention to something other than sports, shopping, Lost, and American Idol. There is no way the U.S. government will ever be able to make good on its promises, since it can’t raise enough in taxes to avoid a serious reduction in promised benefits. It is one thing to make jokes about the viability of social security when retirement is years away. But it is entirely different when confronted with the stark reality of cuts in benefits and an extension in the retirement age for the millions of Baby Boomers on the cusp of their Golden Years.

In terms of growth, China, India, Brazil, South Korea, and a number of smaller Far East countries lead the pack with growth rates far above the developed countries. As I have discussed since December, the central banks in these countries are facing very different challenges than those facing the central banks in developed countries. The primary risk in the developed countries is deflation. In India, China, and Brazil, the greater risk comes from inflation. As I have noted in prior letters, interest rates are already being raised in these higher growth countries to slow their economy’s growth so inflation is tempered, and in the case of China, to also curb real estate speculation. Tighter monetary policy in the growth economies will cause a slowdown in China, Brazil, and India. In the case of China, this could be especially painful, since China used an unprecedented lending spree to goose their recovery. As I noted in the February 2010 letter, “With over 1.3 billion people and the need to build the infrastructure that will create enough jobs to keep the current politicos in power, China is almost forced to pursue a breakneck growth policy. In response to the global financial crisis, China adopted the most aggressive stimulus policies of any country in the world. In 2009, the Chinese government ordered their banks to ramp up lending and they did, increasing lending by almost $1 trillion. Since China’s annual GDP is just over $4 trillion, this lending binge amounted to more than 25% of GDP, an extraordinary statistic. In addition, the Chinese government initiated a $570 billion stimulus plan. To say that China overloaded their economy with stimulus is an understatement.” The People’s Bank of China is walking a tightrope between maintaining strong growth, and curbing real estate speculation and rising inflationary pressures. The lending spree in China last year inflated a real estate bubble that will lead to a decline in real estate prices, and losses for Chinese banks. Since the U.S. and the E.U. nations will experience weaker economic growth in coming years, China’s export growth will be less robust. Less export growth will cause China to have a problem with excess export industrial capacity that will be tough to replace with domestic demand. If China’s economy is unable to maintain its 8% annual growth rate, the ranks of unemployed workers will increase, and lead to social unrest problems we’ll watch on CNN.

In sum, tighter fiscal policy in developed countries and tighter monetary policy in the growth economies are going to lead to a global slowdown. This coming slowdown will increase the risk of a global debt deflation, since the global banking system is still impaired and burdened with bad loans. If asset prices (real estate and stock prices) renew their prior decline, the intense pressure already on the global banking system and sovereign budgets could become unbearable. What would follow wouldn’t be pretty. On February 17, President Obama gave a speech marking the one year anniversary of the $787 billion “American Recovery and Reinvestment Act.” President Obama proclaimed “One year later, it is largely thanks to the Recovery Act that a second depression is no longer a possibility.” I wish I shared his confidence, and pray that his assessment is correct.


Any serious effort in the U.S. to address the federal budget deficit will wait until after the November election, since a campaign platform built on higher taxes and reduced government services is a non-starter. Both parties will try to score a few political points by claiming to be more sincere about cutting the deficit than the other party, but both parties are not relishing actually doing anything. As discussed last month, it is not going to be easy for Congress to significantly cut our budget deficit, since roughly 88% of the federal budget is mandated by law. The breakdown for every $1.00 spent in the 2010 federal budget is: $.21 Health care (Medicare, Medicaid), $.20 Social Security, $.20 Defense, $.14 Aid (Food stamps, child care, housing, and heating assistance), $.06 Benefits (Veterans, retired government workers), + $06 Interest = $.88. Other than defense, in order to lower any portion of this expenditure of $.88 per dollar spent, Congress will have to do some heavy lifting that won’t be very popular back home in their districts. The government also spends $.03 Infrastructure (Highways, transportation), $.03 Education, $.02 Research and Developemnt, $.01 International Aid. This suggests that most of the deficit reduction will come from higher taxes. The initial wave of tax increases will be focused on the top two or three income brackets. However, history suggests there may be a ceiling. Since 1945, federal taxes as a percent of GDP have averaged less than 19% of GDP, which is an amazing statistic. Our country has been through numerous recessions and wars (Korean, Viet Nam, Afghanistan, Iraq), and an ever changing tax code during the past 65 years, and yet this relationship has been maintained. This relationship between federal taxes and GDP was first observed by W. Kurt Hauser of the Hoover Institute 20 years ago. The chart below reflects the percent of taxes of GDP, as GDP grew since 1925. Income taxes were reinstituted in February 1913 with the passage of the aptly named Revenue Act of 1913, with an initial tax rate of 1%. As the tax rate increased over the years, total federal taxes finally reached 20% of GDP in 1945. It will interesting to see if this relationship will allow tax receipts to increase to match spending, which is 26% of GDP.

In order to circumvent the appearance of hiking taxes on the middle class, Congress will at least float the idea of a value added tax (VAT). The VAT is a tax on the estimated market value added to a product or material at each stage of its manufacture or distribution. These taxes are effectively buried in the cost of goods or services, and passed on to the consumer in the form of higher prices. The beauty of the VAT, at least from a politician’s point of view, is that it far more invisible than an increase in sales taxes to voters. If Congress proposed raising the price of each good and service sold in America by 4%, consumers would take notice and more than 50% of them might actually bother to vote in the next election and throw the bums out. A VAT tax would be far more invisible since it would not show up on every sales receipt. Out of sight, out of mind.

Compared to states, the federal government has it far easier, since it is not required to balance its annual budget. Congress can project that the deficit will shrink to under 4% by 2014 based on rosy assumptions and get away with it. Well, at least until the global bond market decides the assumptions are too optimistic and begins to push bond yields higher. Approximately 40% of the total U.S. debt matures in less than one year. If rates rise appreciably, the interest component of the budget will begin to grow faster than GDP, making it far more difficult to pare the deficit. I don’t think the Federal Reserve will be in a position to raise rates anytime soon. With so much U.S. debt being rolled every year, the Fed will be very careful in raising short term rates, since it will have a deleterious effect on interest expense in the federal budget. Currently, interest expense consumes $.06 of each $1.00 in the budget. The down trend line in the 10-year Treasury bond yield from the 1993 peak at 8.0% comes in near 4.5%. A comparable trend line on the 30-year Treasury bond drawn from the 1997 peak at 7.0% comes in near 5.0%. Any breakout above these trend lines would represent a serious warning that global bond investors had lost confidence in our willingness to enact the necessary budget reforms to address our short term and longer term budget deficit issues.

Forty-nine states are required by law to balance their budgets every year. The nation’s 89,000 cities, school districts, and other local governments employ 20 million people, 15% of all jobs. In aggregate, states spend $2.2 trillion each year, or almost 15% of GDP. According to a recent survey by the National League of Cities, tax revenue fell 11.4% in 2009, causing 70% of states to cut jobs and capital projects. Over the next two years, states are expected to experience a shortfall of $160 billion, with half of the cities saying they will need to cut services further. Since the end of 2008, state and local governments have eliminated 234,000 jobs, with more cuts to come. According to the National Governors Association and National Association of State Budget Officers, 29 states have raised $29 billion in revenue, including $11 billion in personal income taxes in their 2010 budgets which end on June 30, 2010. As I have noted on other occasions, state spending averaged an annual increase of 6% over the last 30 years, adding almost .7% to annual GDP. As states pare down the growth rate of their spending, GDP growth will be negatively impacted. According to Macroeconomics Advisors, cutbacks by states will shave .2% off 2010 GDP. Given the outlook for the next two years, state spending will not add much to GDP growth.


On April 8, I sent out a Special Update reiterating my view expressed in the March letter that “the market is likely close to a short term high, and vulnerable to a pullback of 4% to 7% in coming weeks. Selling into any additional strength, or becoming a bit more defensive is advised.” In my April 20 letter I discussed the internal dynamics at work in the market. “Normally, technicians view rising volume on a sell off as a negative, but that hasn’t been the case, as the market subsequently rallied to new highs after the declines in early October and November. I think the increase in volume now is an indication that investors are finally convinced this rally is for real, and as such, is a sign of optimism and a short term top. The market should get above the high at 1,214 to finish the rally phase that began on February 5. Last week, more than 900 stocks made new 52 week highs, the advance- decline line also set a new high, and the majority of market averages set new peaks. This indicates that the market’s internal strength is healthy, which is why any decline is unlikely to exceed 4% to 7%. This broad market strength also suggests that any decline will be followed by another rally that challenges or exceeds the high I expect soon. The major trend is up, and will remain positive as long as the S&P holds above 1,044. The intermediate trend is positive as long as the S&P remains above 1,086.” The S&P did exceed 1,214 on April 26 when it reached 1,219.80.

The fact the anticipated decline has turned out to more severe than 4% to 7%, only makes the advice to sell and become more defensive above 1,210 more valuable. The internal strength cited in last month’s letter has obviously weakened. On May 20, there were 18 times as many declines as advances, an extreme level, and the number of new lows has expanded significantly. The chart above shows the S&P with the Intermediate Trend indicator (IT), a proprietary indicator I use to measure short term and Intermediate term strength in the market. It combines advances, declines, new highs, new lows, up volume and down volume into a single indicator. In the April 8 Special Update I noted that while the S&P was making a new high, the IT was registering a lower peak. This indicated that the market’s internal strength was weaker, even though the S&P was making a new high. This pattern of higher prices and lower IT readings suggested the market was vulnerable to a sell off. Today, the S&P tested the February low of 1,044, falling to 1,040.78, before rebounding to 1,074. Although the S&P held support, the IT has dipped below the February 5 low.

The intensity of this sell off lowers the odds that the market can rebound to a new high. So far, the decline has only 3 legs, down, up, down. If today’s low is breached, the odds of a new high will be further reduced. I believe the market is in a cyclical rally within the context of a secular bear market that could last until 2014-2016. As noted last month, I anticipate another decline of 20% to 30% developing, if the fundamental headwinds exact the economic toll I expect. Last December, I discussed why I thought the next phase of the financial crisis was likely to start in Europe, since their banks were more leveraged and more exposed to Greece. A decline below today’s low, will likely lead to a sharp drop to 980-1,020. However, the market should then rally and retrace a sizable portion of the decline from the April 26 high at 1,219. If the market has plans on approaching the April peak, the liquidity squeeze that has erupted over the last two weeks in Europe must calm down. The market is oversold, so a short term low is approaching. The next few weeks should clarify, whether the secular bear market has resumed, or if there is still some life left in the cyclical bull that began in March 2009.


The short position in the 20-year Treasury bond via the ETF TBT was bought at $47.89 was stopped on April 22 at $46.55. Treasury yields have fallen significantly as the credit crisis flared in Europe. TBT closed today at $38.60. If the secular bear market has resumed, we do not want to be short Treasury bonds, and they are too overbought to buy.


Last November, when the Dollar index was trading under 75.00, I wrote that I thought it would eventually reach the November 2005 high near 92.00, since virtually everyone hated the Dollar. That sentiment has certainly changed, with most now bullish. The Dollar has benefited with concerns about European banks causing a flight to safety, just as it did in 2008. The Dollar is likely close to a short term high, and will run into resistance as it trades above 88.50, which was the high in November 2008. However, the strength behind this rally has been impressive, and is one more reason to be cautious about the stock market. Remember, the bottom in the stock market in March 2009 coincided with a top in the Dollar almost to the day. If the stock market is going to have anything more than a short term oversold rally, the Dollar will need to show more technical weakness.


Many analysts have confused the Fed’s increasing its balance sheet from $900 billion to $2.2 trillion as signs that inflation is right around the corner. What these folks have failed to understand is that credit is till contracting, the velocity of money is not expanding, and an overhang of excess labor and production capacity caps any pricing power. The real risk is not inflation, but deflation as debt is liquidated, causing money supply and credit to contract even further. Gold is over loved and misunderstood. I think it is going lower.

E. James Welsh

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