Thinking Things Over

Musings on the Markets from Inside the Beltway


By John L. Chapman, Ph.D.                                             Vol. I, No.5  08/21/11


In this note:

  • Alhambra’s current stance on the global economy and investor prospects 

Next week:

  • How an economy grows – and how investors secure a happier future

I.  Where We Stand on the Economy and the Markets

For the better part of a year, the U.S. economy has exhibited a GDP growth rate of 1% more or less, well below the 2% or so needed just to maintain per capita income levels constant when mapped against workforce population growth in the U.S.  And in recent weeks, investor disquiet has grown due to trading volatility levels not seen since 2008 – and a generally downward trend to accompany the gyrations: U.S. equity markets are off about 14% in the last month.  Pundits in the business media are now talking non-stop about the relative likelihood of a “double-dip recession”, and what that might portend for the markets and the economy moving forward.  In planning for both professional and personal finance reasons, what is one to make of all this?  Or, if we might quote Lenin in a slightly different context, what is to be done?

Here at Alhambra Partners, our team is into non-stop analysis of these matters, and we are pleased to have learned recently that our weekly newsletter is now being read high up in the corridors of power inside the Beltway.  So we will offer here a two-part response to this question, and we aim our thoughts at our solons in Washington, D.C., as much as we do our client readership.  Today we detail explicitly where we think the markets and the economy are going in the next several months (always a dangerous thing given the hapless predictive track record of investment pros far more astute than ourselves, but we feel strongly about our analysis). And then next week we detail what should happen from a policy perspective to end our current “quasi-recession”, or whatever it is, that is deeper and longer-lasting than need be.  Hence, today’s thoughts are in the main descriptive, and next week’s are prescriptive.

With that as preamble, what do we think of the current moment?

i. Recession in the U.S.?  The US economy will not fall back into recession and will perform somewhat better than the market currently expects. Growth may pick up late this year or early next year as construction picks up. Much better growth, however, is dependent on a significant fiscal deal that includes major tax reform, and a stronger dollar. We don’t expect that from the current fiscal commission, nor much new from the Bernanke Fed, so a better outlook probably depends on the 2012 election results. Markets may start to anticipate better fiscal policy well before the election.

Like any good economic prognosticator, let us qualify ourselves a bit.  A “double-dip recession” implies an intervening recovery.  But can what we have been living through in the last two years really qualify as such?  Yes, as President Obama said last week in the Midwest, it is good news that over 2 million jobs have been created in the private sector in the last 18 months.  But this is a far cry from the “250-500,000 jobs per month” predicted by Vice President Biden last year, and takes no account of the 15 million Americans still actively seeking work, the 6-8 million who’d like to work but have given up looking, or the disasters hidden in the “micro-data” of the Bureau of Labor Statistics surveys, such as the 14.5% unemployment rate among those aged 20-24, the 5 million who’ve been out of work for a year or more, or 15% of all households who’ve experienced a recent forced job loss.

So for us, whether what happens next is technically labeled as a “recession” or not is truly academic – the National Bureau of Economic Research dating committee that decides this matter has the arbitrary right to subjectively label cyclical patterns in any case. Market psychology will be sustained, albeit only marginally, if we avoid negative economic growth in the coming quarters, but we await the arrival of better, that is to say, pro-growth, policy, in the time ahead.  In sum, we see continued slow-motion growth and volatile markets in the time ahead, though we expect the S&P 500 to finish the year higher than where it is now.

ii. The mess in Europe and how to resolve?  The Eurozone is very troubled now and will be for some time. Europe will continue to struggle with the debt crisis and growth will be slow until emerging market growth picks up again and with it German exports. Eastern European emerging markets are more attractive than Western Europe.

Resolution in Europe is a much longer conversation than we have space for today. But the irreconcilable contradictions of the over-promising welfare state redistributionism of countries such as Greece, Italy, Portugal, and Spain will likely end in some leaving the Eurozone, and big hits to European banks and now even the European Central Bank (ECB) which, like the Fed, is now holding over-valued assets that will end in realized losses.  We do like what we see of growth prospects in places such as the Czech Republic, Hungary, Poland, and Slovakia, and for that matter, Estonia and Lithuania, and along with Switzerland we see potential as export markets revivify.  But for this to happen, of course, losses must be realized and the Eurozone banking system cleansed, and then matched with pro-growth policies across the region.

As for our colleagues in places like Greece and Spain, we can only say, we feel sadness at their plight.  And we remind our readers of a near canon in international economics too often forgotten in both Washington and on Wall Street: the world economy depends upon, and indeed follows, the U.S. economy.  That is to say, one of the very best ways we can help our European brethren is to re-ignite growth and prosperity here in the U.S.  Yes, we know our fellow members of the finance and economic punditocracy revel in the possibilities of China or India or Brazil leading a new era of global growth, to replace declining U.S. leadership.  We do not discount that in future centuries that might well be a possibility, given better policies globally.  But for the balance of our lifetimes, as the U.S. goes, so goes the world economy, both for reasons of scale, as well as the moral dimension to U.S. leadership – or, as the case may be, lack thereof.  More on this anon.

iii. Are emerging markets an opportunity for diversification?  Yes, quite possibly, and indeed we are buyers on a select country basis. Developing country markets will enter a rate cutting cycle as growth slows – Brazil’s 3-month rate is 12.4% now atop an inverted yield curve there, for example.  And it is likely that reduced commodity prices, particularly in food, will allow them to cut rates starting later this quarter.  We believe over all that Asian markets are relatively more attractive than Latin America, and have our eyes on the “tigers” and Indonesia especially, while wary of a potential sharp reversal in China.  But in the medium term, emerging market bonds are probably the more attractive alternative until growth rates start to rise again.

iv. Should investors commit more to gold or other commodities? Commodity prices will rise as emerging market countries cut rates unless there is a significant rise in the US dollar. The dollar’s path will depend on whether the Fed initiates more easing measures but the path of least resistance is down. Gold may correct but absent a fiscal deal that increases private investment, is likely headed higher. Indeed, as our friend John Tamny likes to point out, there had been quite a longstanding ratio of gold to oil in the post-War era of 15:1, more or less.  But lately that ratio, still operative as of six months ago, has been torn asunder, and is now over 22:1, with gold at all time nominal highs above $1800 per ounce, and oil down to $82 per barrel of crude. 

What can this mean?  We fear we know only too well: Demand for gold has been divorced from other commodities correcting downward in a time of, to alliterate for emphasis, decreasing demand, debt deflation, and deleveraging.  But gold, the historic medium of exchange and safe store of purchasing power for at least 2700 and perhaps as many as 7000 years, is rocketing toward an all time inflation-adjusted high.  Demand is strong the world over as global investors – and their counterparts in many of the world’s officialdom, such as the Bank of China – are voting with their purchases and heading for an exit to a play at the Bernanke Theatre they’d rather not see.  That is to say, the world now anticipates continued debasement of the U.S. dollar, still, though perhaps not for much longer in this decade, the world’s major reserve currency.  This is in general a negative for real equity returns, though not necessarily the broader market indices. But surely, even Mr. Bernanke knows that when global investors are pouring into gold, to the almost-counterforce exclusion of other commodities, it means that there is an emerging lack of faith in U.S. growth and its necessary concomitant, a strong U.S. dollar.  Our summary: absent much better monetary and fiscal policy, we see gold going higher, even if correcting in the next few months, in the years ahead, and we like natural resources as a safe haven in the extended period of turbulence and torpor to which we are now being subjected.  We do not know whether to predict the longstanding gold:oil ratio of 15:1 will be recaptured; in the short run it might be approached again by movements of both commodities toward each other.  But gold may have essentially broken out now for an extended period based exclusively on global investor fears – and a collective vote of “No Confidence” in the Federal Reserve.

v. What about real estate as a counter to declining equity markets and/or inflation?   REITs are expensive but may start another up leg if the dollar continues to fall.  We are not buyers at the moment but we understand the opportunity – indeed, the necessity – of being deeper into real property-based allocations if inflationary forces pick up.  As we have previously discussed, we are living through an academically fascinating – if economically morbid – “tug-of-war” between inflationary and deflationary forces.  Our bias is toward the former gaining the upper hand but in the medium term we concede the latter is operative.  More on this in time as it will surely influence, in a profound way, equity and bond returns in the next several years.  

vi. Pundits like Larry Kudlow or the inveterate optimist Brian Wesbury like to remind that corporate profits continue to remain strong.  Can they provide lift to the stock market in the time ahead? We concede, and indeed applaud, the news on profits, as a continuing bright spot that has helped stock prices markedly in the last 2 ½ year equity market recovery.  And indeed, virtually all of the S&P 500 have now reported 2nd quarter earnings, and 71% of those who’ve reported have beaten expectations.  That being said, corporate profit margins have probably peaked. Market upside is now dependent on sales gains and P/E multiple expansion, which is grounded in the psychology of investors and general market sentiment.  And this of course depends on government policy.

vii.  What about monetary policy and interest rates?  Fed Chairman Bernanke is speaking at the Kansas City Fed’s Jackson Hole gathering later this week; could he announce new policies to buoy stocks?  The direction of interest rates is directly dependent on Fed action in the short run only, so while we heard Mr. Bernanke loud and clear last week that short rates will be kept near zero  well into 2013, we cannot predict the same for the long bond. Significant further easing at this point would probably have a major impact on commodity prices and inflation expectations, causing rates to rise.  Indeed, we may be nearing a point similar to 1973, where the market loses all confidence that monetary policy can positively affect growth. Stagflation is therefore a major concern of ours. If that happens, a large spike in interest rates (as Martin Hutchinson has warned)  could occur more rapidly than the market currently expects. 

In short, we do not think monetary policy ease can in any way be further “stimulative” to the U.S. economy.  We say this as stewards of capital who know quite well that in the short run, markets react favorably to monetary easing and in some quarters are now clamoring for a Bernanke-led QE3. But longer term, quite the opposite is true: we are convinced that if the Bernanke Fed and Geithner-led US Treasury collectively changed course, toward a stronger dollar and pro-growth fiscal policy in its “classical” sense (viz., cuts in marginal tax rates on capital and incomes, and lowered federal spending levels), U.S. equity and bond markets would rally in a sustainable way.  For, in no sense can the rise in either in the last two years be said to be sustainable or well-founded.  

II.  Summary of What the Foregoing Means for Investors

Two years ago, Bill Gross and Mohamed A. El-Erian of the giant bond-fund manager Pacific Investment Management Co. (PIMCO) coined the phrase “the new normal”, to describe what might possibly be a decades-long Japan-style economic torpor. They assert a rather grim prospect for U.S. growth indefinitely: our future will likely include a lower standard of living, high unemployment, stagnant corporate profits, heavy government intervention in the economy and disappointing equity returns.  Nor, in their view, with interest rates already low, can investors expect much from bonds, other than their mediocre coupons.

Indeed, as the forgoing recites, it is hard to argue with the basis of their thinking.  The U.S. economy has the flu, if not pneumonia: the Eurozone is troubled, Japan stagnant, China and other emerging economies exhibit signs of asset bubbles that could halt growth sharply at some point if they’re material, and the Middle East is unstable.  Where, in a time of global monetary debasement juxtaposed with an unavoidable deleveraging, which will bring with it painful business closings and restructurings, can an investor have repair, to obtain succor in this global economic storm? 

Next week we will lay out the detailed remedy, and why all is not nearly lost – indeed why the future can be a bright one.  But the short answer is, there is no substitute for U.S. leadership of the global economy.  Absent the dynamism and dramatic permanent evolution of American technology, management, operating, and marketing methods, and vibrant capital markets that have funded an explosion of high-value companies (and their new era services and products), all of which in turn get proliferated rapidly across the world,  there can be no global recovery which is in any way sustainable. 

For the economy – and the markets — to turn around significantly, policy must change in Washington D.C. at both ends of Pennsylvania – and Constitution — Avenues (the Federal Reserve is at 2000 Constitution Avenue, which runs straight to a dead end at the U.S. Capitol building).  

Having said that, can we leave readers with any concrete positives for specific investing ideas, near term?  Beyond being a long term buyer of gold and natural resource entities for defensive reasons, we like, again for defense, solid balance sheets and dividend paying stocks.  We like health care service providers as a long term buy-and-hold in the U.S.; and, near term, the building of free-standing medical facilities  — clinics and outpatient centers and the like – will see explosive growth.  And as a general matter, any company which is in the business of providing customers with tools for increasing productivity is a winner.  Increasing productivity, as a means of increasing output and profits without increasing the company’s labor force, is the name of the game these days in corporate America.  Outsourcing companies or any equipment maker selling into near-final goods industries especially will see above-average growth in the years ahead.


Mr. Chapman is chief economist at Alhambra Investment Partners, and is director of research at Hill & Cutler Company in Washington, D.C. . He and Alhambra founder Joe Calhoun are writing a book on investing and capital preservation in the current turbulent era.

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