Risk Latte - On the “New Normal” and Tipping Point

On the “New Normal” and Tipping Point

Aditya Rana
July 03, 2010

bill gross, who runs the largest (and one of the best performing) bond funds in the world came out recently with a short ( and deeply insightful) monthly news letter making the key point that the developed world has indulged in a massive debt build-up over the last few decades to essentially front-load consumption from future years. as this process reverses we are in for a lengthy period of slow growth – the "new normal".

To summarise:

  • bonds are priced for near depression with yields (and therefore future returns) at 3%. stocks have low single digit return prospects as well.

  • deleveraging, reregulation and deglobalization will induce a period of meagre economic growth for a long while – the "new normal".

  • most investors and economists still don’t quite get it and remain overly optimistic - unless their last names start with r – roubini, reinhart, rogoff, rosenberg and _rugman (may i include rana?!)

  • why do companies, individuals and sovereigns borrow? – they do to improve their standards of living by bringing their consumption forward (i.e. buying a house on mortgage which would otherwise be unaffordable!)

  • the debt build-up in the 20th century has been possible for two basic reasons – 1) capitalistic innovation which improves future prosperity and allowed the debt to be rapid through profits and higher wages, and, 2) a growing population which allowed the debt to be spread across more people making it easier to repay.

  • while technological innovation is likely to continue, population growth in the developed world has reached a dead-end making it difficult to repay the overwhelmingly large debt burden.

  • creditors have begun to sense this predicament and are beginning to tighten lending - leading to the greece and european peripherals crisis now and a broader crisis involving other countries down the road.

  • the one gleaming hope are the unencumbered 3 billion consumers in the developing world- however, the developing world is not growing fast enough to pick-up the slack in the developed world.

  • ideally, the consumers of the developing world should be financed to bring their consumption forward, with the developed world supplying these goods and services, leading to higher global prosperity.

  • however, the developing world produces for exports and not for internal consumption, thereby creating a lack of global aggregate demand for goods and services.

  • so be prepared for a relatively long period of abnormally low returns on investment portfolios - whether bonds or stocks.

gross highlights the crux of the issue at hand – a lack of global aggregate demand – arising from there being too much debt in the developed world (making it difficult for them to have consumption growth) and too little consumption (and debt) in the developing world. this is the core issue facing the global economy today, and the root cause of the continuing economic and capital imbalances which will takes years to work out. in the interim, we are likely to have low growth and mediocre investment returns. it is important to have this "view of the forest" as a backdrop as one seeks to maximise returns by taking advantage of the trading ranges which are likely to persist until the end of this secular bear market in about 5 years.

the current market environment looks somewhat treacherous - the key support level of 1040 for the s&p 500 index has been broken –on its fourth such attempt during the course of the year! the ecri leading indicator is in sharply negative territory, which typically presages an economic contraction about 13 weeks later. one of my favourite analysts and managers, john hussman, has put out a recession warning for the second-half of this year based on the ecri leading indicator as well as other indicators he tracks – the yield curve, credit spreads, stock prices and employment growth. the nobel laureate economist paul krugman wrote a recent piece in the nyt titled ‘the third depression” where he states – “ we are now, i fear, in the early stages of a third depression. it will probably look more like the long depression (of 1873) than the much more severe great depression . but the cost — to the world economy and, above all, to the millions of lives blighted by the absence of jobs — will nonetheless be immense. and this third depression will be primarily a failure of policy. around the world — most recently at last weekend’s deeply discouraging g-20 meeting — governments are obsessing about inflation when the real threat is deflation, preaching the need for belt-tightening when the real problem is inadequate spending”. he also makes the important point that a depression can have periods of growth - even the great depression had a period from 1933 until 1937 where the economy grew by 9% per annum - which was finally undone by policy mistakes.

this environment warrants a cautious approach - buy long dated treasuries on dips (as i have mentioned previously- i particularly like the 30 year zero coupon us treasury which currently yields 4.20% and has significant potential to rally further into year-end even though it has rallied by about 25% this year!) , long the euro, and sell stocks (if you have some!) on rallies. i attach an interesting chart below which illustrates how the market correction since late april has reversed all the gains made on an index of 200 global stock leaders over the last 12 months! i also continue to expect another large quantitative easing measure later this year, possible followed by a second fiscal stimulus package, which is likely to produce another stock market rally – which is when i expect to close the above trades and buy some stock indices (i don’t count myself as part of that privileged, and much smaller than you think, group of astute stock pickers)!

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