Oct 4th, 2017
Life in a shrinking economy, a forgotten concept
We have forgotten what it’s like to experience a shrinking economy. The economic tailwinds we’ve enjoyed for decades, however, are beginning to turn into headwinds: demographics, consumer behavior and most of all --- the debt mega-cycle. What has worked so well in the investment world for the last few decades may not only work poorly in the future, but also could get many investors into real trouble. Making and keeping money may become a lot more difficult than what we’ve gotten used to.
We at Sicart Associates don’t claim to have discovered a formula to predict the market’s direction for any particular span of time. Moreover, if we did have one, it would not be that helpful to our strategy and goals – wealth preservation over many generations. We believe that our job is to worry so that our clients have less to worry about. We think in terms of decades. So, this is a moment when we are looking backward at the last half century to assess where we might be headed to next. Fundamentally, we couldn’t be bigger optimists… but do we have some concerns about the near-term future.
The best 40 years behind us
The developed world has seen smooth financial sailing for dozens of years now, so long that many of us in the industry have known nothing else. So, let’s look at the special circumstances that brought about this halcyon period:
--we’ve had healthy population growth
--baby boomers have spent big, compensating for their parents’ post-Depression thrift
--productivity increased as technology not only became more prevalent but also lowered costs
--as a result, consumption increased, boosting GDP growth
In addition, fiscal policy has cooperated. We’ve ridden the biggest wave of constantly growing debt ever recorded. When we ran out of capital to lend, we’ve just printed fresh money to extend the “prosperity.” Last, but not least, so much private, corporate, and public debt would not have been possible without an accommodating monetary policy which in my lifetime has cut interest rates from 20% to zero.
Could anyone have asked for easier times? What amazes us is how long they have lasted.
Now, however, we see these trends as increasingly unsustainable. We expect rates to normalize. We expect deleveraging to take its toll, consumption shrinking, population growth slowing, and productivity flat-lining.
Double the debt, cut the rates, double the debt, cut the rates…
There have been economic hiccups in this prosperous period, of course: 1987, 2000, 2008, and smaller bumps in the road. Each time we could count on the government’s generous helping hand - they religiously doubled down on the debt, and cut rates in half to keep the party going. Dr. Greenspan put his gold standard beliefs aside for the time of his tenure as the Fed chairman, then a student of the Great Depression Dr. Bernanke picked up where his predecessor left off. Dr. Yellen not only promised us no crisis in our lifetime, but followed in the footsteps of Dr. Bernanke, keeping the rates very low, and only
raising them (slightly). We understand - it’s almost impossible to disrupt institutional inertia. Or, for that matter, to propose alternatives to received wisdom that everyone accepts.
Why look back and learn something?
Nevertheless, if history teaches us anything, it is that every period of growth, expansion, and eventual credit bubble is followed by a major contraction. We saw it in the US between 1929 and 1932 when the economy shrank by 1/3, the stock market collapsed by 90%, and deflation cut prices by 18% (through 1936). It took the Dow a quarter of a century to recover – a whole new generation was born, raised, and educated, before the market reached its previous high.
So, we wonder: How would have today’s passive investors fared in a turbulent period like that?
Maybe we can’t agree on the remedy, but we can agree on the cause.
No one doubts that there’s a great deal to learn from the Great Depression, but there’s some politically-generated confusion about just what those lessons are. Some claim the government did too much, some say too little. Some believe the wrong policies were put in place while others think the market would have self-corrected in time. Perhaps the more the government tries to “help,” the bigger the problems down the road. The one clear lesson from the past seems to be what conditions usually lead to an economic crisis:
– cheap and easy credit. It seems to have been a no-fail formula over decades, and centuries if not millennia. Looking for examples? How about:
--the Greek Debt Crisis
--Japan’s 1980s Bubble
--the Weimar Republic (Germany, 1920s)
--the South Sea Bubble (England, 1720s)
--the Mississippi Company Bubble (France, 1720s)
--late Roman Empire.
By debasing our currency and racking up a lot of debt in the last 40 years we haven’t invented anything new, but we did it take it to the next level.
Businesses are doing great
During 40 years of tailwinds that are both unprecedented and perhaps unrepeatable, business has prospered greatly. High spending and consumption boosted revenues to ever higher levels, productivity and globalization lowered costs, which led to record profitability. The drop in the cost of debt, dramatic increase in leverage, and stock repurchases funded a one-time boost for earnings and stock prices in the last decade. General exhilaration helped expand valuations to record levels. In equities, these valuations are expressed as record high earnings multiples while for real estate and fixed income they’re record low yields. Many private equity deals and real estate projects have been made possible by sustained economic growth, higher prices and ever cheaper credit. At the same time, never-ending rounds of drastically low-cost debt financing have kept alive many otherwise bankrupt companies (zombies).
Consumers would rather go big than go home
Consumers enjoyed the ride as much as business people. The cost to borrow fell and we have been encouraged to borrow more to buy anything and everything. We’ve also been discouraged from saving. Now, we’ve not only recovered from the last correction in 2008, we hold more credit card, student, car, and mortgage debt than ever. Our investments and retirement accounts have been boosted by easy monetary policy, bidding up asset prices all around. We are richer than ever, and we’ve been able to buy more with less money down, and lower payments than ever. Just one outstanding example:
--record car sales (recently finally correcting)
--with record average car prices,
--record percentage of financed cars
-- record percentage of leased cars thanks to customers who want to buy big but can’t handle the monthly payments.
The US government has never been richer
The US government at every level, right down to localities, has also benefited from the last 40 years. Not only did it get easier and cheaper to borrow your way to “prosperity;” but also with all the economic growth, and asset inflation these governmental bodies have enjoyed record tax revenues. Extrapolating all those rosy assumptions into the future makes all promised obligations and benefits seem almost reasonable. We are currently hearing once again about the nervous dance around the federal debt ceiling, and attempts to raise it one more time. The concept of “fiscal discipline” seems to have disappeared from political and economic dictionaries for good.
The trends are shifting though
More with less
More cars, more homes, more things -- the mantra of the last few decades -- resonates less with the younger generation. They are not big buyers, and spenders. Millennials prefer transportation-sharing apps to possessing cars. Access matters more to them than ownership. They’d rather use vacation home-sharing apps rather than owning a second home or staying in hotels. Younger generation has also less disposable income due to both the student debt burden and the limited availability of well-paid jobs which would allow for mortgage, car, or second home payments. Since there are at least as many Millennials as Baby Boomers, they may eventually step up to the plate, and mature into consumers, but still probably not to the same extent as their parents.
Demographics tell the truth
The biggest consumer generation in history is retiring now. They are still in debt, they don’t have enough saved for retirement. Many will have to rethink spending habits and start tapping into savings as income starts to shrink. Overall US population growth is the slowest it’s been since 1937. The current childbearing generation tends to have fewer kids, and to have them later in life. Immigration won’t help our economy as much as it did in the past, either: on one hand, fewer people are coming and on the other, the current administration is less immigration-friendly than previous ones, ignoring the demographic realities.
End of easy, cheap credit
Credit plays a crucial role in the economy. Short-term credit helps companies manage their working capital and helps households get through brief monthly cash flow shortfalls. Long-term credit enables big investments in new productive assets, offices, warehouses, and homes. The economy can grow faster than population and productivity growth would normally permit – but only if we can continue to expand the overall leverage in the system. We are basically spending future savings (in other words, we will have to save in the future to pay off what we borrowed today), unless the central bank buys government debt, mortgage-backed secured and other debt obligations, then we are spending money that does not actually exist. The consequences of such an experiment are unknown, but unlikely to be positive.
Either way, we at Sicart Associates argue that there is a limit to how much debt any economy can maintain. If a free market in interest rates existed, current excessive public debt would have already pushed the cost of money higher. Thus, the general cost of debt would have risen and quickly put an end to the credit expansion. As Richard Ebeling, in his refreshing book Monetary Central Planning and the State, reminds us: “Monetary central planning is one of the last vestiges of generally accepted out-and-out socialist central planning in the world.” He adds “Government can no more correctly plan for the ‘optimal’ quantity of money or the properly ‘stabilized’ general scale of prices than it can properly plan for the optimal supply and pricing of shoes, cigars, soap or scissors.”
Eventually though, the total outstanding debt will not only stop growing; it will start shrinking (paid off, defaulted or not-rolled over), and rising rates will accelerate the process. Our consumption, spending, and financial engineering will correct themselves automatically.
When trends collide
What happens when decelerating population growth and productivity improvement run up against shrinking and more expensive debt and lower spending?
Asset bubbles burst
With consumers spending less and the cost of debt rising, revenues, margins, and cash flow will all come under pressure. Many assets will become less attractive, many businesses unprofitable, and perhaps even unsustainable. Valuation will compress, leading to meaningful correction in prevailing prices. We might see lower profits, lower prices, and higher cost of debt.
It’s a triple whammy for businesses and investors.
Government with emptier pockets and growing obligations
If tax revenue shrinks due to falling profits and incomes, deficits will expand unless the government cuts spending. That would require cutting welfare programs, pension fund benefits, etc. which maintain the livelihoods of an ever-growing senior citizen population. All the long-term assumptions of all pension funds at all levels would need to be rethought, and the gap between what they need and what they can actually earn will widen. Cuts, which may turn out to be unavoidable and necessary, would further undermine consumption, which spills over to businesses. They would suffer from even deeper profit cuts, and resort to even bigger employee layoffs. The result? More pressure on tax revenue on one side, and greater need for unemployment benefits on the other. We might see higher spending needs, lower tax collection, and higher cost of debt.
It’s a triple whammy for the government policies.
Living standards adjustment
The macro correction could lead to higher unemployment, lower income, lower ability of the government to help, failing pension funds and asset price declines – homes, stocks, bonds all re-establishing values at substantially lower levels. We would both feel poorer, and have less disposable income that could be taxed at higher rates to offset a tax revenue drop. The Great Depression was an era of the biggest tax hikes in the U.S. history, with margin rate going from 25% to 94% by 1945. As demand weakened, prices would have to fall, creating a softer landing for those with sustainable income. Lower incomes, lost investments, higher cost of debt.
It’s a triple whammy for individuals.
Seeing and acting on it
It’s not hard to imagine how the last 40 years’ upward spiral driven by debt, demographics and productivity could easily become a death spiral. We at Sicart Associates are not the only ones who perceive the problem, but we are among the few who act on it. We see complacency and paralysis - cash levels among investors are at record low, short positions as well, and passive investing has never been more popular. Even investment professionals choose to either ignore the danger or take a “cautiously cautious” stand.
Buy and hold approach
We are big proponents of a “buy and hold” strategy: one-decision stocks. We buy them right, and hopefully don’t ever have to sell them. We see how that approach has done a magnificent job for us and many long-term investors, Warren Buffett among them. We do believe that times have changed. It’s not only dangerous to remain fully invested, and especially to be a passive investor; it’s also dangerous to stay blindly committed to the “buy and hold” approach. We are under the impression that we’re reaching the end of a huge cycle with peak levels of public, consumer, and corporate debt, ultra-low interest rates prolonging the cycle, and ultra-high asset prices and valuation temporarily masking the problem.
Today, successful investing is less about chasing the tail of a tired bull market, and more about preserving the capital.
Our clients are families, and our job is to take good care of their fortunes for generations to come. Today, our best course is to:
Hold only "highest conviction" stocks
Maintain excess cash positions
Keep fixed-income durations short given interest rate uncertainty
Consider some small gold exposure.
(We are more concerned about deflation hitting us first before inflation catches us by surprise later; thus, the possible role for gold.) Finally, to benefit from a potential market drop, we'd consider a very gradual use of an inverse ETF tracking a broad market index, and preferably one that is not leveraged. Additional leverage can give us a boost if we are absolutely right about the timing of the sell-off, but that's hard to guarantee.
Abundance of investment ideas ahead, the US remains the favorite market
We expect to see some remarkable opportunities ahead, possibly even a true revival of Benjamin Graham- style fundamental equity research. In that situation, we’d probably have more ideas than money -- our favorite time for stock picking.
We make it a practice to look anywhere and everywhere for ideas: among small and big companies, domestic, and foreign. We are exceptionally excited about the US market, though, given its size, diversity, and depth, backed by the 300M+ American population full of hard-working, smart, creative people and a vast, rich economy. It’s been a true talent magnet for a few centuries. We’ve been through ups and downs before. The point is to acknowledge that they happen, and to be prepared.
Bogumil Baranowski August 21st, 2017
This article is not intended to be a client‐specific suitability analysis or recommendation, an offer to participate in any investment, or a recommendation to buy, hold or sell securities. Do not use this report as the sole basis for investment decisions. Do not select an asset class or investment product based on performance alone. Consider all relevant information, including your existing portfolio, investment objectives, risk tolerance, liquidity needs and investment time horizon. This report is for general informational purposes only and is not intended to predict or guarantee the future performance of any individual security, market sector or the markets generally.
Photo: Sarah Lachise