D L CARLSON INVESTMENT GROUP, INC.
101 NORTH STATE STREET
CONCORD, NEW HAMPSHIRE 03301-4334 _______
TELEPHONE (603) 224-5977 FAX (603) 226-2156
“Panics do not destroy capital; they merely reveal the extent to which it has been destroyed by its
betrayal into hopelessly unproductive works,” or so said John Stuart Mill in his 1867 Credit Cycles and
the Origin of Commercial Panics. Indeed, the evidence around us tends to corroborate Mr. Mill’s
assertion as, upon examination, we can see that vast overbuilding of the housing stock and consumer goods to meet society’s leveraged, excessive demand represented a destruction of capital upon hopelessly unproductive works. This kind of asset bubble accumulates excessive inventories and consumption, borrowing from future demand and production; meaning that the inevitable bubble burst will be followed by a period of credit contraction, writedowns, underproduction and oversaving.
Obviously, with Mr. Mill concerned about credit cycles 140 years ago, we can conclude that such things are part of the human economic condition. He said that economic practices were less responsible for crises than emotional factors which influenced business policy, that cycles are best described by initial optimism leading to recklessness leading to disaster leading to pessimism and then stagnation; human nature, making the case for improved legislation and regulatory oversight. Our economic cycle was, however, exacerbated by secular forces which accentuated cyclical patterns. These added an element of danger to the adjustment process; things like emerging country development, with cheap production and oversaving, matching and driving our propensity to overspend; and financial technology, making shortcuts to accoutrements of wealth seem like a plausible entitlement, deluding consumers, Wall Street and regulators alike. Modern risk management tools, otherwise useful to running financial business, were allowed by corporate and regulatory managers to tell them what they wanted to hear about risk exposure, ignoring the fact that their relatively confined samples might make them oblivious to potential disaster.
Moreover, this new “flat earth” appeared as though it had changed the rules of international trade. Those same emerging states appeared to have become increasingly self-sufficient economies, rather more independent of the developed world than they were just a decade earlier when their financial exposure to overseas debt created a brief international financial crisis (remember the Thai baht?) We have made marvelous progress in world trade, and vast populations are upgrading their economic conditions, or are at least in a position to progress toward that end.
However, failures of human nature lead some to repeat the mistakes of 1998, attracting and coming to rely on foreign investment while borrowing in low rate developed currencies. The downturn in investment sentiment saw vast sums repatriate from emerging to developed economies, leaving some emerging currencies to plunge and raising their de facto debt loads, threatening bankruptcies and bringing international credit to a stop.
The U.S. financial crisis and resulting economic slowdown has clearly shown that the world is still highly dependent on us. Europe and other developed economies have slowed, while commodity and emerging states have slowed more: they are even more leveraged to U.S. economic activity. It is difficult to see the world recovering before the U.S., although investors understand the leverage factor and will anticipate emerging country recovery when they sense U.S. recovery.
The U.S. fourth quarter will likely represent the nadir of economic activity. Adjustments are still in midstream in housing and retailing; and probably worsening in employment (lagging indicator), making the outlook for recovery increasingly a mid-2009 or even second half event. Upcoming earnings and outlook indications could be challenging, but should also present important opportunities.
However, massive Federal Reserve liquidity programs are in place which will certainly help financial institutions with mortgage, auto and credit card lending. Treasury investment and TARP programs are being leveraged by the Fed, and have the promise of significant follow through from the new Administration. These programs were critically important in that they stabilized confidence in a
financial system that, left unattended, could have blocked recovery efforts. Negative, or near negative rates on Treasury bills reflected the confidence breakdown that threatened credit flow and economic recovery. The biggest issue is bank confidence in other banks, i.e., raising bank confidence that other banks will begin lending. Only then will credit and the economy recover.
Government moves to lower interest rates, or tighten credit spreads, are beginning to work. Mortgage rates are finally beginning to follow Treasury rates lower, raising the prospect of improved housing demand and reduced inventories. Most recently, the steps by Treasury and the Fed to revive GMAC and auto lending are hugely important as those funds will be deployed directly and immediately, helping to unfreeze consumer credit at point of sale. Such direct action strategically applied, can be conducive to bank confidence and credit extension.
The government programs announced and implemented so far represent significant dollar amounts, raising unwarranted concerns over potential inflation and funding adequacy. These are mostly financing and investment programs, highly likely to be reversed when and as conditions improve. Importantly, and not fully appreciated by commentators, projected government stimulus borrowing does not fully offset the decline that has occurred in private sector borrowing, an important commentary on the magnitude of our financial correction.
Meanwhile, Treasury funding is being done at historically low interest rates, meaning that the real cost to taxpayers is nominal, especially when measured against what history describes as the probable cost of government inaction at a time like this. The world is anxious to lend money to the U.S. government, while the cost and availability of funds to the private sector is prohibitive. This is an historically great time to be a lender and investor; government can make money doing this now, as can private investors who follow this lead.
Many of the Obama stimulus programs seem likely to be the kind of infrastructure capital investment the country can use profitably for years and decades to come, and, done properly during this time of underutilized resources can be viewed as a national investment in the future. As an example, there already seems to be a trend toward living in “walkable” communities; commitments to vastly upgraded rail transportation, a proven magnet for private capital, would help us accommodate those new living patterns and raise societal energy efficiency.
Deflation has become the primary issue for policymakers and markets, making inflation protection (TIPS) cheap and nominal Treasury paper vulnerable to a whiff of recovery. Policymakers would like nothing better than to get such a whiff for what it would mean about demand and about lightening debt burdens. Signs of success in efforts to reflate the economy would likely spur a rush from cash and Treasurys to extraordinarily cheap credit securities and equities; such a move is an important step as well as leading indicator of sustained economic recovery. It should be added, however, that the low point of cyclical inflation tends to come early in the recovery phase, so serious inflation concern is a long way off.
The dollar gets too much attention. If policymakers get macroeconomic policy right, the dollar will take care of itself: it will find a level that reflects U.S. full employment and price stability. The dollar tends to fund developing country investment in good times, and is a safe-haven as funds repatriate in difficult times. The U.S. has clearly suffered economic damage from unproductive investments; however, areas of the world have arguably suffered more from the fallout, suggesting the relative U.S. economic position in the world, as borrower and investor of last resort, has probably strengthened.
Markets like 2008 are reminders about the need for asset diversification appropriate for one’s investment needs. This year was a challenge to diversification goals inasmuch as the emergence of hedge funds and their massive leverage across the full spectrum of investments meant that historically non-correlative assets became as one when the hedge funds needed to deleverage, or sell, at once. The only clear beneficiary of this event was Treasury securities; however, surely, even though there is not likely to be a demand driven inflation issue for several years, Treasuries will underperform when risk becomes popular again and investors flow to corporate debt priced for depression and stocks priced for recession. The amount of such potential investment flows, from cash and Treasurys, is so vast as to boggle the mind; the magnitude of investment opportunity makes that flow inevitable. These flows will anticipate economic recovery by many months; well ahead of any improvement in employment, for example.
Douglas J. Robbins:ls January, 2009