"Ultimately, it is tough to bet against the Teflon Economy and the U.S. consumer's robust spending. During our 30-year history, we've seen many walls of worry rise—and fall. We believe that over the long term, the bull will make it over the wall, time and time again."
Will the Credit Crunch Scratch the Teflon Economy?
Recent events in the credit markets have created a wall of worry that extends from Wall Street to Main Street. As the old adage says, "Bull markets climb a wall of worry"—and this bull must contend with a high wall. The architects of the wall are players in the financial world—most notably, the hedge fund industry. Their use of complex derivatives and off-balance sheet financing has resulted in a lack of transparency. This lack of transparency, combined with a lack of accountability, has created a crisis in confidence that has the potential to become a crisis in the global economies.
To operate smoothly, financial markets require participants' trust. Promises to pay, to meet obligations or to hand over hard-earned savings for others to invest are all commitments based on trust. The problem in the credit markets today is that participants don't know who they can trust and who sits on a mountain of leverage with credit priced for perfection, possibly rated improperly and with little margin of safety. The reality is no one knows how bad or not bad things are in the credit markets. The Fed does not know; bankers don't know; corporate chiefs don't know; and, of course, we don't know.
Through its lowering of the discount rate and slashing of the target rate from 5.25% to 4.75%, the Federal Reserve has demonstrated its willingness to actively address liquidity problems. Because it could open the door to potential moral hazards and dollar devaluation, we believe it would be disadvantageous for the Fed to continue these aggressive measures indefinitely. However, within the context of recent events, the Fed's actions appear appropriate. The crisis is now and the Fed's actions did rally the markets broadly. We are not out of the woods yet, but the Fed did buy more time for the markets to clear and for transparency to emerge.
Source: Bloomberg, LP.
Market leadership after the Fed rate cut favored the old leaders in the energy, commodities and economically sensitive groups. To some, this may indicate the global economy is still in an accelerated growth phase. We are not so sure. The risk premium in many assets has already increased, and we expect higher risk premiums across all asset classes in the near future. Debt markets will be more difficult and costly to access, consumer financing should be less available and more costly, working capital may be more difficult to finance, and equity markets more volatile and unforgiving.
Source: Bloomberg, LP. The VIX Index measures expectations of near-term volatility conveyed by S&P 500 stock index option prices. The VIX Index is generally considered to be a barometer of investor sentiment and equity market volatility.
"Although we may be more cautious about the near-term prospects of the economy and certain market sectors, we have a great deal of confidence in our long-term investment philosophy and process. As always, we remain focused on managing risk and enhancing return potential through full market cycles."
Many have assigned the lion's share of blame for current conditions to the sub-prime market. However, the crux of the problem is not the sub-prime loan market, but the leverage and lack of transparency in the credit markets. The sub-prime market happened to be the catalyst for the crisis, but some other financial market excess would have exposed the same issues.
As Transparency Emerges, the U.S. Economy Can Move On
History has shown that the U.S. markets and the economy can withstand devastating shocks. In fact, over the past six years, the U.S. economy has been the Teflon Economy. It has demonstrated considerable resiliency in the face of surging commodity prices, a terrorist attack on U.S. soil, an auto industry recession, unprecedented hurricane destruction in the Gulf, a dollar devaluation, a war with the associated spending, the Enron and WorldCom debacles and a housing market collapse.
Source: Bloomberg, LP. The CRB Index averages prices across 17 commodities and incorporates an average of prices across time (source: CRB).
Can the Teflon Economy withstand a credit crisis? If the credit markets clear (that is, transactions return to normal) and activity forces to light the potential risks, then the economy can continue to grow. Not knowing the risks and what lurks around the corner is most damaging, because not knowing spurs distrust and creates liquidity black holes. The fear of what might be is often worse than the actual event. Once transparency emerges and the market clears, participants will know who they can trust. The economy will move on. The financial markets will move on as well, though with some degree of pain for those in the wrong places and with too much leverage.
If things do get worse before they get better, the banks may come under a degree of pressure. However, although it has been quite awhile since the last banking crisis (the 1990 S&L meltdown), it's important to note that periodic crises have been par for the course. In fact, as we have remarked in the past, we believe it was quite unusual that the banking industry emerged without any damage from the 2000 recession.
Japan: A Lesson in What Not to Do
The United States should have a clear picture of what happens when an economy lets debt deflation take hold, as occurred in Japan. A crisis of confidence can grind business to a halt. In 1989, the Japanese financial system and business economy was not allowed to clear. As a result, consumers and businesses had no confidence in the banks, corporate effectiveness or the government. Consumers knew the banks were broke and the jobs they held often did not relate to anything productive. They recognized that the politicians lacked the will to allow the sometimes-destructive forces of capitalism to clear the unproductive, bankrupt business and start anew. Consumers slowed their spending and piled cash under their mattresses; the velocity of money collapsed even as interest rates dropped to zero. Debt deflation took hold and the ensuing crisis in confidence lasted 15 years. Just in the last few years have we seen some promising market-clearing activities in the Japanese economy.
The markets need time to work through the current issues—but not time to cover them up and allow them to build into a larger systemic crisis. Bring the problems to light and we can deal with them in a variety of ways—through regulation of lending, greater transparency requirements for hedge funds, or more realistic security valuation. The leverage and creative financing in many instances have been and are occurring without transparency and accountability to all other market participants. Warren Buffett suggested that all holders of derivative contracts should be required to sell 5% of the contract to mark the price to market. While we believe Buffett's suggestion is impractical—and would present problems of its own—we appreciate the sentiment.
Outlook
Looking back over the past seven years, this is one of the more difficult times we have seen for the economy and for business in general. In order for commerce to occur at levels close to those of the past decade, the credit markets must function. We believe unemployment will likely continue to rise as financial, real estate and construction activity slows. It is probable that capital costs and wages will rise. Energy prices have not provided any relief; and if consumer spending remains linked to housing market activity, growth will slow further. Business spending, government spending and exports can take up the slack in consumer demand, but combined, they represent only 30% of GDP.
Source: Bloomberg, LP.
Source: Bloomberg, LP.
Source: Bloomberg, LP.
Most consumers are facing higher property tax bills, an unfortunate result of the housing price spike. Simply stated, this may be the first time since the last recession that we see slowing growth, falling return on capital and rising cost of capital.
Nonetheless, the broad U.S. economy is still in relatively good shape, apart from the housing and auto sectors. The economy is benefiting from a weak dollar and from robust industrial and IT sector activity. The economy can also withstand a slightly higher level of debt costs, but consumers are the key to our economy's strength. As long as consumer spending does not decline dramatically, the economy can avoid a recession. If consumer trends hold, we might just be facing part two of the mid-cycle slowdown that began in 2006.
Source: Bloomberg, LP.
The equity markets offer some favorable signs. For example, despite the correction in housing values over the last year, the equity markets have increased approximately 15%. These gains help offset some of the decline in consumers' net worth. The equity markets are also generally very good predictors of future economic strength; and, as such, provide a level of comfort for the near term.
Source: Bloomberg, LP. The S&P 500 Index is considered generally representative of the U.S. stock market.
Current Positioning
"Once transparency emerges and the market clears, participants will know who they can trust. The economy will move on."
Our game plan remains the same as it has been over the past two years. We continue to believe stable growth businesses and higher quality investments present the most compelling opportunities. We do not believe it is the appropriate time to increase the risk posture of our portfolios; and in fact, we most likely will continue to migrate to investments with lower credit and business risks.
We have favored non-economically sensitive sectors over the past two years, emphasizing mid-size and larger growth companies that we believe can generate internal cash flows to sustain their growth. We believe leadership is changing to favor growth stocks over value stocks and to favor less leveraged businesses with less cyclical cash-flow streams.
Conclusion
Ultimately, it is tough to bet against the Teflon Economy and the U.S. consumer's robust spending. During our 30-year history, we've seen many walls of worry rise—and fall. We believe that over the long term, the bull will make it over the wall, time and time again.
While the exact scope of the credit crunch remains unknown, we can be certain that the U.S. economy remains well diversified—and this diversification has allowed the economy to weather many previous storms. The U.S. economy should also benefit from the diversification and strength of the global economy. For example, increased wealth and growing consumer demand abroad should provide continued support for U.S. exports.
Although we may be more cautious about the near-term prospects of the economy and certain market sectors, we have a great deal of confidence in our long-term investment philosophy and process. As always, we remain focused on managing risk and enhancing return potential through full market cycles. By continuing our course—one defined by dedication to risk management, to fully understanding the securities we own, and to rigorous proprietary research—we believe we are well positioned to build wealth for investors who have entrusted us with their savings.