Market Comment Q2 2009
Wall Street is a short street in lower Manhattan – too short for very many businesses to call home. In public discourse,the term “Wall Street”is used generally to denote investment institutions – especially those who match investors with investment opportunities – actually located all over. In this sense, Wall Street is a synecdoche, a literary construct in which a term denoting a part of something is used to represent the whole thing (and vice versa). Other examples are crown, for king, or White House, for the executive branch of the federal government.
Similarly, the term “financial crisis”, having emerged in the wake of reckless subprime mortgage issuance, became the label for a much larger economic phenomenon that continues to unfold. Like many important historical moments, its potential significance was initially underestimated. In May, 2007, Fed Chairman Ben Bernanke said, “Given the fundamental factors in place…we believe the effect of the troubles in the subprime sector on the broader housing market will likely be limited.” Ultimately, the troubles did spread to the broader housing market and, in fact, destabilized the financial institutions involved in that market. The fear and uncertainty that resulted then undermined the U.S. and global economies.
Pandemic. Many see the current crisis in primarily financial terms. Banks made careless loans and used too much leverage. These loans were securitized and sold labeled as low-risk investments. A vast array of clever security structures overwhelmed regulatory capability. The resulting toxic assets spread poison across a broad swath of financial institutions and investment portfolios.
But given the fundamental factors in place,the financial crisis is only part of a larger economic transformation. It is important to try to understand the dimensions of this transformation in order to gauge the impact on investors and investment opportunities.
It is our view that the recovered economy will differ in significant respects from the one that preceded the current crisis. Many long-running drivers of economic growth appear to have run their course. New drivers will emerge to take their place and will reshape the global economy and markets for years to come.
Consumers retrench. The personal savings rate in the United States reached a postwar peak of 11.2% of disposable income in 1982. Since then, it has steadily declined, actually turning negative in 2005 for the first time since 1933. Not coincidentally, consumption as a share of GDP increased during this period, reaching 71% of GDP in the second quarter of 2008. By some estimates,U.S. personal consumption accounted for nearly 17% of global GDP in 2008.
The structure of the global economy has been to an important extent organized around the economic power of the U.S. consumer. The economies of Japan and the Asian Tigers (South Korea, Singapore, Hong Kong, and Taiwan) all made exports, especially to the U.S., the cornerstone of their postwar economic development models. China’s great growth spurt came from the same source following Deng Xiaoping’s economic reforms in the late 1970’s, accounting for the astounding growth rate of its economy, its huge trade surplus and its accumulated stock of U.S. dollar-denominated investments.
In the U.S., high rates of consumption growth were made possible by income growth, a willingness to save less and an unprecedented propensity to borrow. The ratio of household debt to personal income grew modestly from the 1960 to 1985,increasing from 55% to 65%. Over the next two decades, however, leverage doubled as household debt reached 133% of income in 2007 . Social attitudes regarding the use of debt changed significantly in the past two decades.
As shown in the accompanying chart, much of the run-up in debt through 1985 was supported by increases in income and thereafter by increases in stock market and housing wealth. Innovative financial products were created to make this wealth available for consumption. There was an explosion in the use of credit cards, mortgage debt, home equity loans and other forms of borrowing. Growth of the financial industry since the mid-1980’s is a distinctive feature of the U.S. economy. By 2006, the financial sector came to represent a fifth of the market capitalization of the S&P 500 stock index, and nearly 45% of its earnings.
The current recession is accompanied by a dramatic change in consumer behavior and in the ability of financial institutions to support it. In the face of declines in employment, wealth, and borrowing capacity, personal consumption actually declined in the second half of 2008, and consumers have started to increase savings – most recently measured at 4%. Financial institutions no longer extend loans that should never have been made and even many that should be. If these trends continue, economic growth in the U.S. may be dampened for at least several years as consumers rebuild household balance sheets and financial institutions rebuild their own.
We may be seeing a significant transformation of the U.S. role in the global economy. If the juggernaut of U.S. consumption slows for an extended period, then other sectors and other nations must pick up the slack if the global economy is to expand at acceptable rates. Domestic consumers in emerging markets are perhaps the most viable candidates. Can they do it? Currently, consumption represents less than 40% of Chinese GDP, but there are structural impediments to China emerging as a major global consumer. Government policies favor exports, for example. Global growth may,therefore, rest below potential for a while.
Government expands. The balance sheet of the federal government is moving in the opposite direction from that of households. The chart below shows the historical federal budget balance and current projections for the balance based on President Obama’s proposed budget. Not since World War II has the federal deficit even approached the magnitude of these projected deficits as a share of GDP.
Not shown is the large increase in the balance sheet of the Federal Reserve, which has replaced the banking system as lender to large swaths of the U.S. economy. The numbers suggest a sea change in the role of the government in the economy. Depending on your political persuasion, you can see this as long-overdue or anathema. Either way, it is difficult to see it as a temporary aberration in response to current economic woes.
“Never let a serious crisis go to waste,” said Rahm Emanuel, the President’s Chief of Staff, during the run-up to the President’s budget proposal earlier this year. An equally compelling crisis at the other end of the spectrum birthed Thatcherism and Reaganism in the early 1980’s. After tenable bouts of inflation and soaring interest rates, these twin ideologies on either side of the Atlantic preached less government intervention in free market economies. Events of the past couple years have devalued the political currency of these ideas,suggesting that higher taxes and greater regulation could soon result.
Change is good,or at least inevitable. These are two examples of important social themes reversed by economic events, and there are other candidates – including, for example, the U.S. dependence on imported energy and even the U.S. dollar’s status as a reserve currency. If crisis spells opportunity, as John Kennedy famously observed,then the current one should be especially rich.
Alphabet soup. In the short term, the U.S. equity market remains hostage to the shape of the current recession and the ensuing recovery. We have noted in the past signs that our economic distress is alleviating, but the change in consumer behavior that it has elicited seems likely to dampen the magnitude of recovery. Economists have come to employ a variety of alphabet characters to describe the shape:a V-shaped recovery has not happened; the L-shaped scenario has been averted by government intervention. Debate now centers on whether we have a U- or a W-, the latter implying that today’s green shoots or regrowth will wither once again before a final return to prosperity. Some are even referring to a square root sign (√) which implies that the current prospect of recovery yields to an indifferent intermediate term outlook.
Denouement. We incline to the latter as our most likely case for global economies,and such a pattern does afford opportunity for investment success. What is required is the application of discipline and adaptability in the face of changing conditions. There are signs that investors are seeking greater returns by once again accepting risks that were easily taken just a couple years ago. Improving attitudes improve asset values.