Dynamite in the hands of children

The problem of the deficit and out of control spending is not as complex as many would make it.  The "deficit problem" for any government is not one issue, but two components:

• Debt: if you have debt you have to pay it back, and the more you have, the more it costs
• Investment: if you borrow money, what you do with it determines the generation of wealth, the economic outcome

So, by simple analogy, if you borrow money and buy a bottle, well, let's make it a case, of Château Ausone St. Emilion 1998, and throw a kicking party, the next day all you have is a headache and the debt to pay back. You may have joie de vivre, but you are impoverished. On the other hand, if you borrow the same amount of money and buy productive assets, the next day and for all future you will have the economic production of those assets. You may be dour, but you are creating wealth, the extent of which is determined by the economic productivity of the asset in which you invested.

To modify this example for sovereign states, you simply need to make the dollars bigger (add zeros !?!) and the time frames longer. A simple, but essentially correct analogy.

Even Moody's , continuing its tradition of better late than never, has noticed that all is not right with the fiscal house of the United States:

a small start to the big task of returning to a sustainable debt trajectory...Unless further measures are taken to reduce the budget deficit further or the economy rebounds more vigorously than expected, the federal financial picture as presented in the projections for the next decade will at some point put pressure on the Aaa government bond rating

Nassim Nicholas Taleb of Black Swan fame is perhaps a little less delicate in his comments to Bloomberg:

“every single human being” should bet U.S. Treasury bonds will decline

“Deficits are like putting dynamite in the hands of children...they can get out of control very quickly.”

If Moody's, Taleb, and WWB agree on the Debt component of the deficit problem, we can declare consensus and move to the government's actions on the Investment side.  Our readers are already familiar with our analyses of Cash for Clunkers and the stimulus package.  More technical readers will recall our noting Mr. Robert J. Barro's comments that "the available empirical evidence does not support the idea that spending multipliers [for governmental stimulus programs] typically exceed one, and thus spending stimulus programs will likely raise GDP by less than the increase in government spending." That's economist-speak meaning we bought the case of Chateau Ausone St. Emilion and threw the party, or more specifically, that the whole concept of 'stimulus' just doesn't work in the first place.

As a consequence, our nation will face a significantly reduced standard of living, our children will have diminished economic opportunities.

Investors will ask, "Ok, we got it. What do we do now?"

Those who know us also know that we are not inclined to modify long term investment strategies based on tactical issues or short term data. We are concerned about the broader, longer term issues and confess, in spite of much effort and open ended strategy sessions with people whose opinions we value, we're not at all sure we've got it figured out.  Humility is probably not a bad starting point.

We're clearly in for a run of greater uncertainty across all kinds of dimensions: 

• domenstic & foreign fiscal, monetary & tax policy;
• less certain property rights & rule of law in the US;
• increasing loss of confidence in broader agency processes of all stripes, both sovereign & corporate; 
• geopolitical instability, conflict & terrorism; 
• credit risks of sovereign, municipal & financial entities;
• an increasing dependency ratio domestically; and 
• instability of the US tax code.

So, one implication is that investment strategy must accommodate uncertainty. Don't think you've got it figured out: you don't. Emotional responses to spot data are rarely constructive and generally very expensive.

Our view has been and remains that asset allocation is fundemental and must accomodate a prudent assessment of risk in face of uncertainty. Liquidity reserves are important and even though short rates are near zero, cash may be viewed in one sense as a call option on cheap assets. You also need it to not go bankrupt.

We do think one needs be cautious about fixed income strategy. The Fed is, of course, trying to drive investors out the yield curve into the killing fields of future inflation. It creates a dilemma: stay short & earn nothing or go long & get slaughtered. It's a real problem for the elderly or others living on fixed income, including many endowments. We thank Bernake for the invitation, but we'll pass. We've had a creeping bias to higher quality, short duration, and TIPS for some time and intend to keep it. 

Inflation risk is on everyone's mind. We are inclined to favor the view that equities over time tend to be the most effective source of real returns. While not a perfect solution, it is a sensible one and arguably a 'least bad'.  TIPS can be an important component of fixed income strategy, but a low real return is still a low real return. We also note that inflation indexing can be 'rigged' by those who tally what inflation is and also note that indexing works in reverse. Note tax inefficiencies for taxable accounts: inflation adjustments on TIPS are taxable.  We're not prepared to place a massive spread trade (buy TIPS/sell nominal long treasuries) but are intrigued with the idea. Nor are we ready to recommend inflation swaps or the purchase of dividend strips. We're not so sure that the people who may put you into these trades will be around to take you out....some of you may remember the firms formerly known as Bear Stearns or Merrill Lynch?

Rising tax rates will drive many to the municipal market, but stay out of the kill zone. Municipal credit & structural risk is non-trivial: note that Pennsylvania considers Chapter 9 bankruptcy protection as an option now. More will follow and many will start to trade like declining emerging markets debt. If you play in this sector, you'd better know your stuff as to credit & structural risk, market liquidity & execution. If not, we suggest you stay with a credit savvy mutual fund.

Equity allocations should be built for the long term. We retain our focus on highly diversified beta driven portfolios and cost efficiency. We haven't changed our approach, although we're always exploring new information. We simply don't buy the notion that short term trading generates sustainable value. We do think it's reasonable to revisit overall portfolio allocation strategy and suggest that any process be grounded by analytics. Emotion can be very costly, as can these four words: "this time it's different."

Longer term we as a nation must hope for and demand more responsible fiscal, economic and regulatory policies ... shall we just say responsible governance?

"Everyone wants to live at the expense of the state. They forget that the state lives at the expense of everyone."  Claude Frédéric Bastiat