Caspar David Friedrich, Wanderer above the Sea of Fog, 1818.
The prevalent view about US debt problems, at least as I interpret recent guru predictions, is that a rendezvous with disaster lies a number of years in the future, say 5 to 10 years. The most visible media gurus -- Taleb, Roubini, Faber -- appear to expect the process to culminate in the free printing of dollars accompanied by rampant inflation and a worthless dollar before the U.S. defaults on its debt. More immediately, many are predicting rising bond yields this year as the Treasury struggles to fund the growing federal debt.
These are not the only viewpoints being presented in the investment community, however. Also, what will be the nature of the path that the world economy traverses in the next few years, default or not?
An interesting scenario is that the immediate future will bring deflation rather than inflation, accompanied by low interest rates and a strong dollar. Longer term, perhaps stretching over years, interest rates may rise, as government bailouts and debt loads increase in scale. Given the importance of the debt question, and uncertainty about the way forward, I decided to give space to deflation-oriented viewpoints today.
David Malpass: Rolling Recovery
Having read a few sensible things from David Malpass of Encima Global, I decided to look further into his concept of a "rolling recovery". Despite his unintuitive conclusions, he agrees with the commonly held view that the U.S. in on the road to debt disaster and must take immediate steps to rein in federal spending. In a recent Forbes article titled "The High Cost of the U.S. Budget" he and Eric Singer wrote that the administration's budget puts the country on a path to danger in just a few years' time:
When a country goes past owing 100% of its nominal GDP in publicly held debt, as this budget schedules us to do by 2020, there is danger.Although he does not predict the outcome, Malpass sees the path to 2020 as punctuated by occasional emergencies of varying magnitudes, a process that he calls a "rolling recovery". That's the long term. As for this year, his "Economic Outlook for 2010" predicts that the wind-down of emergency stimulus will affect asset prices like this:
Currencies should strengthen relative to commodities as emergency stimulus stands down.
Emergency stimulus has distorted both sides of the inflation/deflation barbell trade – commodities, bonds and foreign stocks all up big, esp. in dollar terms. They should soften or retrace as stimulus slows.His February 11 letter at Encima Global, "Rolling Debt Crises -- Where They Lead", expects the global economic recovery to gain strength but be "marked by rolling debt crises – Iceland, GM, Dubai, Greece, California. Stronger sovereigns will extend debt guarantees and subsidies to some but not all of the distressed debtors." The result will be crises for those who cannot be sustained but a gradual process of recovery for the world as a whole:
The trend to government umbrellas is unsustainable, but I think the upward bias in global output and consumption -- including innovation, hard work, and tens of millions of Chinese, Indians and others moving from subsistence agriculture to the cash economy – is strong enough to push the problems into the future.Malpass's scenario is that big bail-outs will produce different outcomes in the short-run and the long-run:
... expanding the too-big-to-fail umbrella – will be pro-growth in the short run.
In the longer-run, however, the process moves even more of the global economy away from market principles. This gradually undercuts the capital allocation process.He expects growth in the U.S. this year, but the growth in government debt will have a price:
Bond yields should rise in the U.S. and Europe when as it becomes clearer that the trend is toward guarantees and bailouts, not bankruptcy. Insurance against deflation (part of the value of Treasuries and bunds) is less valuable if Germany chooses to guarantee Greece.In the longer run, however, governments can only take on so much debt, and they will have to draw the line between those who can be supported and those who cannot:
Governments will try to draw the line between which countries and companies can win their protection and which can’t. The U.S. has many large banks that are too-big-to-fail, but thousands of smaller ones that can be digested by the FDIC and are outside the umbrella. I expect a similar sorting process for municipalities and small countries in Europe.So, he does not predict immediate debt doom, but a longer-term malaise:
Cyclical and secular growth helps float distressed debt for a while. Guarantees save other debt. It probably works in the short run, but the longer-term result is bigger government, a poorer allocation of capital around the world, and slower long-term growth.
Hugh Hendry: Japanese Malaise
Hugh Hendry of Eclectica is hugely optimistic about the dollar and U.S. Treasuries. Zero Hedge reported this strategy as Hendry stated it at the recent Russian Summit of hedge fund leaders: "I am hugely intellectually bullish on Treasuries. I am long." The most contrary part of his strategy is that it is long-term.
He admits that this is against the majority views: (1) that the end of QE will result in higher bond yields, and (2) that a successful reflation of the economy would produce inflation:
I fear the end of QE, the money funds are making on the [curve], I am aware of the issuance, I am aware that the States is going to have to sell $2.5 trillion of this stuff. ... I think there is a lesson in Japan.
The precedent of Japan suggest that if you allow leverage in your society to breach a certain level, let's call it 200 or 230% of GDP, then what happens is monetary policy doesn't work, fiscal policy doesn't work. ... prices are falling and look set to fall further.Hendry gives more of his reasoning about a strong dollar and strong Treasuries in the Eclectica November 2009 letter, which is probably best read at at this address. He believes that dollar devaluation has already happened and hence won't contribute to future inflation. The dollar is not going to decline versus major competitor currencies:
I keep hearing that a dollar devaluation would help matters. I agree; it has. Let me say it again; we have already had the devaluation. That is what the last five years were all about. Now with China rebuilt, and the trade deficit in full retreat (note the -47% contribution from net exports to China's GDP growth in the first 9 months of this year), there are less dollar bills being exported overseas to ungrateful recipients. ... Is it really inconceivable that the dollar could now strengthen?Regarding US Treasuries, he agrees with those who say that they offer poor long-term prospects:
... not an adequate return for lending your money to the profligate United States for 30 years. I agree wholeheartedly. ... I do not propose that anyone adopt a buy-and-hold policy for the next thirty years in bonds. However, a nominal rate of 4.5% might prove very profitable over the coming year should breakeven inflation expectations head south again.So, he may well switch positions at some time, but for now he thinks that the U.S. domestic market will take up the slack in demand from overseas:
... a lower Chinese trade surplus will eliminate a very large source of Treasury buyers at a time of burgeoning supply. ... However, it is our contention that US savings are heading north over the months and years to come. And an America that saves is an America that does not run a current account deficit. It is an American that can finance its own spending domestically.
As a consequence the Chinese surplus is set to fall further and ... their demand for Treasuries will continue to shrink. Now this is potentially a huge headache owing to the massive projected American budget deficits for this year and next ....Many observers might disagree with Hendry and argue that U.S. consumer is too highly leveraged to do much saving of any kind, and that institutional investors cannot take up all of the slack. However, Hendry seems to think that the risk of default will force policy decisions that keep rates low:
Now remember I have been describing a positive macro scenario: a world in which low interest rates make the debt load manageable and that we muddle through with lower growth rates in nominal GDP. ... my opponents (see Ferguson et al.) believe that government bond yields are going much higher. ... It is my contention that the leverage of the economy is only tenable if interest rates stay low ...He says, even if things get bad and bond rates rise, the problems will first appear in other nations' sovereign debt. He proposes Japan as the major domino to fall first:
But first, it may require the spectacle of seeing Japan implode and so we have been actively positioning the Fund to profit from such a scenario. As many of you know, the fiscal situation in Japan is rapidly rising out of control. ... the ratio of public debt to GDP is guaranteed to rise further. It is currently 196% of GDP with the IMF estimating that it will rise to 234% by 2014.
... we have been active buyers of corporate debt default swaps. We find it remarkable that one can insure highly leveraged utilities at 23bps despite their considerable yen debt.
Gary Shilling: Still Bearish, Still Right
Shilling has been bearish and on the side of deflation for so long that I hesitate to mention him, but he deserves credit for recommending this profitable asset allocation for a long time. In one of his recent Forbes columns he cited the pinched consumer and an expectation of a rising savings rate both as reasons to continue liking Treasuries, and he added a recommendation for growing dividend stocks in the staples sector.
Caspar David Friedrich, The Sea of Ice, 1823-24.
